Drayton Mills v. Commissioner

DRAYTON MILLS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Drayton Mills v. Commissioner Docket No. 31064. United States Board of Tax Appeals 19 B.T.A. 76; 1930 BTA LEXIS 2469; February 27, 1930, Promulgated *2469 1. DEPRECIATION. - Increased deduction allowed. 2. INTEREST DEDUCTION. - Where it was provided that preferred stock in petitioner was entitled to 7 per cent cumulative dividends to be paid out of net earnings and that when any such dividend was deferred the deferred dividends should bear interest at 7 per cent, the interest is not deductible from gross income. A. E. Tinsley, Esq., and L. C. Dodge, C.P.A., for the petitioner. C. H. Curl, Esq., for the respondent. BLACK *76 Deficiencies in income taxes were determined by respondent for the fiscal years ending March 31, 1923, and March 31, 1924, in the sums of $5,747.36 and $3,563.30, respectively, and for the fiscal year 1925 an overassessment on the original return was found of $570.22. No deficiencies were determined for the fiscal years ending March 31, 1921, and March 31, 1922, respectively. Petitioner alleges that the respondent erred in not allowing it depreciation on machinery at the rate of 7 1/2 per cent per annum instead of 5 per cent in each of the taxable years, and in not allowing it deduction for interest paid by it on deferred preferred stock dividends as follows: *2470 fiscal year 1921, $21,807.45; fiscal year 1923, $11,630.64; fiscal year 1924, $21,807.44; fiscal year 1925, $14,174.84. FINDINGS OF FACT. Petitioner is a South Carolina corporation with its principal office and place of business at Spartanburg, S.C. It is engaged *77 in the cotton-mill business and operates what is known as a specialty mill, which requires frequent changes in machinery resulting from changes in styles, patterns, and fabrics. The mill began business in 1902 and many of the basic parts of the machinery were still in use in the taxable years. Changes in machinery made necessary by changes in styles were usually made by changes in attachments, and discarding those previously used, while the main part of the machinery was continued in use. During the years in controversy the mill operated approximately 30 per cent overtime, which increased depreciation. Respondent allowed 5 per cent depreciation on machinery for the years in question, and had allowed 7 1/2 per cent for previous years. Petitioner claims 7 1/2 per cent depreciation for each taxable year in controversy. A normal rate of depreciation on petitioner's machinery for each year in controversy*2471 without overtime operation was 5 per cent. A reasonable rate of depreciation for each of such years, after giving consideration to 30 per cent overtime operation, was 6 1/2 per cent. When organized, the petitioner had a capital stock of $250,000, which was all common stock. In 1906 the capital stock was increased to $600,000, the increase of $350,000 being preferred stock, which had the following rights: FIRST: The holder of said Preferred Stock shall be entitled to receive from the date of its issue, from the net earnings of the Company, dividends payable semi-annually, upon Jan. 1, and July 1, of each year, such dividends to be at the rate of seven per cent per annum - to be cumulative - and to be paid before any dividend shall be paid upon the Common Stock. If such dividends are deferred, they are to bear interest at the rate of seven per cent per annum. SECOND: That at any time after five years from the date of its issuance, all, or any portion of said Preferred Stock, may be retired at the option of said Company, at par - the Company paying in such cases, all accumulated dividends and interest that may be due thereon. The Corporation shall have the right through its*2472 Directors, by lot or otherwise, to determine what portion of said Preferred Stock shall be retired at any given time. THIRD: The said Preferred Stock shall not be convertible into Common Stock, and the holders thereof shall not have the right to vote the same at Stockholders Meetings. FOURTH: In case of liquidation of this Corporation, said Preferred Stock then outstanding shall be paid in full, with all accumulated dividends and interest thereon, before payment is made upon the Common Stock. Subsequently, the third provision supra was changed to give holders of preferred stock the right to vote. It does not appear how much of this preferred stock was issued, but no dividends were paid thereon from January 1, 1912, to January 1, 1920, because of insufficient earnings. Beginning in December, 1919, the board of directors, by proper resolutions in meetings from time to time, authorized the payment of the deferred dividends on the preferred capital stock, *78 together with the interest thereon from the due dates until paid. A sample of the resolutions reads as follows: SPARTANBURG, S.C., May 14, 1923. On motion of Mr. G. H. Milliken, the President and Treasurer*2473 was authorized to pay on July 1, 1923, the current dividend of $3.50 per share due on that date on the outstanding Preferred Stock, and also the past due dividends of $3.50 per share and accrued interest thereon due July 1, 1915, and January 1, 1916. On motion the Board adjourned, G. ROUQUIE, Secy. BEN W. MONTGOMERY, President. These payments were made by checks mailed to the stockholders accompanied by a statement of which the following is a sample: SPARTANBURG, S.C., July 1, 1924. The enclosed checks are in full payment to date of all dividends and accumulated interest thereon on Preferred Stock as per statement below: Per share Dividend due July 1, 1917 $3.50 Interest at 7 per cent to date 1.715 5.215 Dividend due Jan. 1, 1918 3.50 Interest at 7 per cent to date 1.5925 5.0925 Dividend due July 1, 1918 3.50 Interest at 7 per cent to date 1.47 4.97 Dividend due July 1, 1924 3.50 BEN W. MONTGOMERY, Treasurer. Petitioner kept its books on the accrual basis, but did not accrue the interest on the deferred preferred stock dividends. No entry was made or account relative thereto was set up until the dividend was*2474 declared and its payment with interest was authorized. Petitioner claims deductions for these interest payments in the years in which made. Payments were made for each of the fiscal years ending March 31, as follows: 1922, $21,807.45; 1923, $11,630.64; 1924, $21,807.44; and 1925, $14,174.84. Respondent in his deficiency letter shows disallowance of interest in the respective fiscal years ending March 31, as follows: 1921, $18,943.30; 1922, $7,868.72; 1923, $10,540.27; 1924, $6,178.68. Petitioner had a net loss in fiscal year ending March 31, 1921, and the part of such loss allowable under the Act of 1921 was *79 carried forward and used as directed by statute affecting the fiscal years ending March 31, 1922, and March 31, 1923, resulting in no net income for 1922 and reducing net income for 1923. OPINION. BLACK: No deficiencies were determined for the fiscal years ending March 31, 1921, and March 31, 1922, and we would have no jurisdiction over such years but for the fact that under the Act of 1921 the petitioner is entitled to have the same proportion of its net loss for the fiscal year ending March 31, 1921, carried forward and deducted from the net income of*2475 the petitioner for the succeeding fiscal year, which the portion of such fiscal year falling within the calendar year 1921 is of the entire fiscal year. Under this provision of law petitioner's 1921 net loss is carried forward and wipes out all of its income in the fiscal year ending March 31, 1922, and the balance of such net loss is carried forward and used as a deduction in determining petitioner's net income for the fiscal year ending March 31, 1923. In view of the fact that respondent has asserted a deficiency for 1923 amounting to $5,747.36, it is necessary for us to consider the years 1921 and 1922 in order to determine the correct amount of the deficiency for 1923. We therefore have jurisdiction over the fiscal years ending March 31, 1921 and 1922, for the purpose of determining the amount of net losses, notwithstanding no deficiencies have been asserted for either of those two years. For the fiscal year ending march 31, 1925, there is an overassessment. We have no jurisdiction over appeals involving overassessments, and the appeal for 1925 is dismissed. Petitioner alleges that respondent erred in not allowing it depreciation on machinery at the rate of 7 1/2 per*2476 cent per annum, instead of 5 per cent in each of the taxable years. After a careful review of all the evidence we have found that 6 1/2 per cent would be a reasonable rate of depreciation to allow petitioner on its machinery used in operation for each of said years 1921, 1922, 1923, and 1924. Section 234 of the Revenue Acts of 1921 and 1924 provides in substance that deductions shall be allowed to corporations in computing net income for (1) all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business; (2) all interest paid or accrued within the taxable year on indebtedness. It is not contended by petitioner that these amounts of so-called interest on deferred dividends on preferred stock which it paid out in each of the taxable years were ordinary and necessary expenses paid or incurred in the respective years in carrying on any trade or business. *80 It is plain that such payments were not ordinary and necessary expenses within the meaning of the subdivision of the statute above referred to. It is contended, however, by the petitioner that the deferred preferred stock dividends constituted indebtedness of the*2477 petitioner and that the interest paid thereon was interest paid on indebtedness and therefore deductible; while respondent claims that the interest is payable only from net earnings and is merely a part of the dividend and not deductible either as an expense or interest paid. In many cases the question has arisen whether so-called stock was in reality preferred stock, or a mere evidence of indebtedness, but we have no hesitancy in holding that the stock here involved is preferred stock and not evidence merely of a loan of money and creation of an indebtedness. The preferred stockholders in petitioner corporation have the right to vote. At this point it may be well for us to point out that the Revenue Acts of 1921, 1924, 1926, and 1928 all carry identical language with reference to the deductions allowed corporations, in determining their net income, for ordinary and necessary expenses and for interest paid or accrued on indebtedness. Article 564, Regulations 62 (Revenue Act of 1921) reads: Interest paid by a corporation on scrip dividend is an allowable deduction, So-called interest on preferred stock, which is in reality a dividend thereon, can not be deducted in computing*2478 net income. This same regulation is carried forward in Regulations 65, relating to the Act of 1924; Regulations 69, relating to the Act of 1926; and Regulations 74, relating to the Act of 1928. We think that these regulations correctly interpret the law and that the interest on deferred preferred dividends which petitioner seeks to deduct in this proceeding is not a deductible item. We hold that the preferred dividend provided for in the preferred stock certificate of petitioner was measured by the dividend proper, plus its accumulation, and the amount of this aggregate sum at the date declared would be the measure of the dividend. In other words, the preferred stockholder was entitled under his stock certificate to receive an amount equal to the 7 per cent dividend plus its accumulated interest before the common stockholder was entitled to receive any dividend at all. No indebtedness existed between petitioner and holders of the preferred stock until payment of the dividend with interest thereon was authorized, and then the relationship of creditor and debtor existed until payment of the dividend plus its so-called accumulated interest. Any interest paid on the preferred*2479 stock dividend from the date it was declared to the date of its actual payment would be in the same category as interest paid on scrip dividends and should be allowed *81 in the year in which it is paid or accrued. The action of the respondent in disallowing as a deduction the so-called interest paid on these preferred stock dividends for the period prior to the date of their declaration is approved. Judgment will be entered under Rule 50.