Angelus Bldg. & Inv. Co. v. Commissioner

ANGELUS BUILDING & INVESTMENT CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Angelus Bldg. & Inv. Co. v. Commissioner Docket Nos. 27089, 32736. United States Board of Tax Appeals 20 B.T.A. 667; 1930 BTA LEXIS 2061; September 5, 1930, Promulgated *2061 Payments to stockholders carried on corporate books as interest held to be dividends. Alex W. David, Esq., for the petitioner. James L. Backstrom, Esq., for the respondent. VAN FOSSAN *667 These proceedings were brought to redetermine the income taxes of the petitioner for the years 1922 and 1923 in the sums of $4,147.21 and $4,147.50, respectively. The petitioner alleges that the respondent erred in refusing to allow as deductions the sums of $31,242.78 and $10,919 paid as interest on indebtedness during the years 1922 and 1923, respectively, and holding that such payments constituted dividends on the outstanding capital stock of the petitioner. The respondent filed amended answers, averring that the petitioner should be estopped from claiming that such sums were not dividends on outstanding capital stock by reason of its having filed income and excess-profits-tax returns for the years 1920 and 1921, in which the amounts claimed in these proceedings to be loans were included as its invested capital for such years. The cases were consolidated for hearing and decision. *668 FINDINGS OF FACT. The petitioner was incorporated*2062 in December, 1910, for the purpose of engaging in the purchase, subdivision, improvement and sale of real estate in the vicinity of Los Angeles. Under its charter its corporate powers were very broad. The capital stock of the petitioner consisted of 1,000,000 shares of the par value of $1 each. From the date of its incorporation to December 28, 1915, inclusive, 561,082 shares were issued, a large majority of which was owned and controlled jointly by A. H. Braly and his brother-in-law, Herman Janss. All of such stock was canceled as of December 31, 1919. On that day the following capital stock was issued: Certificate No. 29, A. H. Braly, Emma Braly Janss, H. H. Braly, Trustees $ 210,000 30, A. H. Braly, Emma Braly Janss, H. H. Braly, Trustees 20,000 31, A. H. Braly 79,999 32, A. H. Braly [1] 33, A. H. Braly 50,000 34, Herman Janss 34,999 35, Herman Janss [1] 395,000 A. H. Braly, Emma Braly Janss, and H. H. Braly were trustees for their father, J. H. Braly, who was a man 88 years of age and who had entrusted his affairs to his children, the said three trustees. On January 24, 1920, the petitioner issued to the said trustees certificates of capital*2063 stock Nos. 36 and 37, in the amounts of 8,000 and 4,000 shares respectively. The shares so issued were the only ones issued by the petitioner during the year 1920. During the year 1921 the petitioner issued certificates Nos. 40, 41, and 42 to A. H. Braly, Emma Braly Janss, and H. H. Braly, trustees, A. H. Braly, and Braly, Janss and Braly, trustees, in the amounts of 39,000, 85,000, and 8,650 shares, respectively. During that year it also canceled and reissued to A. H. Braly and Herman Janss and retired numerous other shares previously issued. On October 31, 1922, the petitioner issued to A. H. Braly certificate No. 63, calling for 61,000 shares of its capital stock, and on August 25, 1923, it issued to A. H. Braly and Herman Janss each 342 shares of the capital stock. All of the other transfers of stock during the years 1922 and 1923 were either readjustments of stock already issued or stock issued to "treasury." In its income and profits-tax returns for the years 1920 and 1921 the petitioner asserted that its capital stock was $395,000 and $407,000, as of the close of the years 1919 and 1920, respectively. At *669 the close of the years 1920 and 1921 the petitioner*2064 reported earned surplus and undivided profits of $331,060.73 and $325,288.80, respectively. Excess-profits credits were allowed to the petitioner on the basis of such invested capital. On December 31, 1919, the petitioner corporation was indebted in the following amounts: J. H. Braly, trustees $ 230,000 A. H. Braly 130,000 Herman Janss 35,000 The J. H. Braly indebtedness represented the sums advanced by him to the petitioner in order to assist his son and his son-in-law. Through the war period, during which time there existed a decided depression in the real estate business, the amounts so advanced by J. H. Braly were carried on the books of the petitioner as credits to his open account. Ninety-five thousand dollars of the A. H. Braly indebtedness was incurred through advances made by him to the petitioner and was also carried on its books as an open account. Thirty-five thousand dollars of the A. H. Braly indebtedness and the $35,000 due to Herman Janss arose out of the prior purchase by the petitioner of assets of the Braly-Janss Investment Co. and also were carried on the books of the petitioner as open accounts. On January 18, 1920, the following*2065 written agreement was entered into by the petitioner and the J. H. Braly trustees: This agreement, made this 18th day of January, 1920, between the Angelus Building and Investment Co., a corporation, party of the first part, and A. H. Braly, Emma Braly Janss and H. H. Braly, Trustees, parties of the second part, witnesseth: Whereas, the party of the first part has sold, transferred and delivered to the party of the second part, certain certificates of the corporate stock of said first party, the Angelus Building and Investment Company, to wit, one certificate No. 21 for 218,000 shares, and a second certificate, No. 22 for 20,000 shares in consideration of the parties of the second part having paid in cash to said first party, for the said certificate No. 21 the sum of $218,000 and for said certificate No. 22 the sum of $20,000 or at the rate of $1.00 for each share of said stock; Now Therefore, it is hereby mutually agreed between the respective parties hereto, that the parties of the second part will re-sell and deliver to the party of the first part all or any part of the aforementioned certificates of stock upon payment by the party of the first part, its successors or assigns, *2066 of $1.00 per share for each of such shares so resold and delivered to the party of the first part by the second parties, together with an amount equal to six per cent interest per annum compounded quarterly and to be figured from the date of issuance of said first mentioned certificates by the first party up to the date of retransfer of said stock to the first party. It is also understood and agreed between the parties hereto that none of the assets of the party of the first part will be diverted, paid out, or in any way disposed of except for the proper conduct of its business, or with the approval of the parties of the second part. *670 It is further understood and agreed between the parties that any certificate of the corporate stock of the said first party hereafter issued by said first party in favor of the parties of the second part shall be governed by the terms of this agreement and be issued and treated in all respects in like manner as is provided in the agreement for the first certificates herein mentioned namely, one (1) share of stock for each dollar so invested; and second parties shall have the same repurchase privileges as are provided for the certificates*2067 first herein mentioned; the amount to be computed as interest in each case to commence from the date of issuance of the certificate of stock. In Witness of the foregoing, we have hereunto subscribed our names this 18th day of January 1920. Angelus Building and Investment Co. By Herman Janss, Pres. W. B. Sims, Secy. A. H. Braly, Trustee Emma Braly Janss, Trustee H. H. Braly I approve, J. H. Braly. On the same day a collateral agreement was entered into between A. H. Braly and the J. H. Braly trustees, as follows: In consideration of H. H. Braly, Emma Braly Janss and A. H. Braly Trustees entering into a certain agreement with the Angelus Building and Investment Company in which it is provided that the above mentioned trustees, parties of the second part, accept from the Angelus Building and Investment Company, party of the first part, certain capital stock of said Company in the amount of Two Hundred Eighteen Thousand (218,000) shares at One Dollar ($1.00) per share in lieu of certain indebtedness owing to said second parties by said first party. I hereby agree to personally pay the interest mentioned under said agreement on or before December the 31st, *2068 1920, and each year thereafter and until said stock is taken up by first party under the terms of said agreement. A. H. Braly Additional advances were made by the J. H. Braly trustees and A. H. Braly and shares issued correspondingly so that on April 1, 1922, there were outstanding 436,150 shares of the capital stock of the corporation. On that day all of the stockholders of the petitioner entered into the following agreement: This Agreement made and entered into this the first day of April 1922 by and between the Angelus Building and Investment Company, a corporation, hereinafter designated and referred to as party of the first part, and the Trustees for J. H. Braly, Emma Braly Janss, Herman Janss, A. H. Braly, H. H. Braly and L. D. Willis, each by its, her and himself, both individually and collectively, hereinafter designated and referred to as parties of the second part, all of the County of Los Angeles, State of California, WITNESSETH: WHEREAS, at the time of the making of this agreement all of the issued capital stock of the corporation, party of the first part, to-wit: 436,150 shares, is issued in the amounts and in the names of the parties as follows: 289,650*2069 shares, par value $289,650.00 to Trustees for J. H. Braly; 136,840 shares, par value 136,840.00 to A. H. Braly; 9,657 shares, par value 9,657.00 to Herman Janss; 1 share, par value 1.00 to Emma Braly Janss; 1 share, par value 1.00 to H. H. Braly; 1 share, par value 1.00 to L. D. Willis. 436,150 shares, par value $436,150.00 *671 These parties being all of the holders and owners of the issued stock of this corporation, and WHEREAS, certain amounts of the said capital stock so issued, to-wit: 289,650 shares, par value $289,650.00 to Trustees for J. H. Braly; 127,184 shares, par value 127,184.00 to A. H. Braly, was issued under the express agreement and understanding by and between all of the parties hereto that said stock might be retired, redeemed or repurchased by the corporation, at any time upon payment of One ($1.00) Dollar per share, together with an amount of money equal to seven per cent. (7%) interest per annum, compounded quarterly from the date of the issuance of same, and that the holders of said stock should have no further or other interest in or to the assets or profits of said corporation, provided, that until said stock has been retired, *2070 redeemed or repurchased by the corporation, that the assets of the corporation would not be diverted, paid out, or in any way disposed of, except for the proper conduct of its business, or with the approval of the purchasers of said stock, and WHEREAS, the parties hereto, the same being all of the holders and owners of the stock of said corporation, have adjusted all interest due on above said stock up to and including December 31, 1921, and desire to continue the aforesaid agreements and understandings as to the retirement, redemption or repurchase of certain shares of said stock. THEREFORE, the parties hereto agree by and between themselves as follows, to-wit: 1st. That the party of the first part will not issue any other or further of its capital stock and that all of the other parties will hold their stock in their own names and will not transfer or assign same without the written consent of the other parties thereto. 2nd. That 289,650 shares of the par value of $289,650.00 of the capital stock of (the corporation) party of the first part, now held by the Trustees for J. H. Braly, and 127,184 shares of the par value of $127,184.00 of the capital stock of (the corporation) *2071 party of the first part, now held by A. H. Braly, shall be considered by the parties hereto as preferred stock and shall be guaranteed dividends in an amount equal to seven per cent. (7%) interest per annum, compounded quarterly, figured from the first day of January, 1922, and that said stock shall not participate in any other of the profits of said (corporation), party of the first part; that said shares of stock may at the election of the party of the first part be retired, redeemed or repurchased by (the corporation), party of the first part upon payment to the holder or holders thereof of the par value plus dividend equal to seven per cent. (7%) interest per annum, compounded quarterly, flgured from the first day of January, 1922, and that upon the payment of said sum or sums of money, together with the accumulated interest thereon, that the holders of said stock will surrender said stock, and shall not have any further right, title, interest or equity in or to any of the assets of (said corporation), party of the first part; *672 that the parties hereto have adjusted among themselves all equities, profits and interests on the above stock up to and including December 31, 1921, and*2072 hereby agree that the holders of this stock have no interest in or to the accumulated profits of said corporation or to any accruing profits, except as same may be held intact as a guarantee for the payment of the par value of this stock, together with the accruing interests from and after the first day of January, 1922. IN WITNESS WHEREOF, the parties hereto, have, each for its, her and himself, set their hand the day and year first above written. A. H. BRALY Trustees of J. H. Braly EMMA BRALY JANSS H. H. BRALY EMMA BRALY JANSS HERMAN JANSS A. H. BRALY H. H. BRALY L. D. WILLIS On October 31, 1922, the petitioner owed A. H. Braly a balance of $61,000 on an open loan account beginning March 23, 1922. Certificate No. 63 was issued to him by the corporation to close that open account. The petitioner corporation did not issue the capital stock mentioned above in accordance with the provisions of the laws of the State of California under which it operated. The petitioner entered on its books of account the loans or advances received from the J. H. Braly trustees and A. H. Braly as "loan accounts" and credited thereon the amounts of such "loans." When it issued*2073 its capital stock a corresponding entry was made on the debit side of the account. The payments made on the capital stock were called and entered as "interest" on the petitioner's books of account. Similar denominations are contained in the check record and ledger of the petitioner. The petitioner corporation at no time formally declared dividends through its board of directors, nor did any entries termed "dividends" appear on the petitioner's books. During the years 1922 and 1923 payments were made regularly at the rate of 7 per cent on the total outstanding stock, including all stock owned by Herman Janss and A. H. Braly. All such payments were entered on the petitioner's books as interest payments. The stock held by Herman Janss and a portion of the stock held by A. H. Braly during 1922 and 1923 did not represent advances or loans made by them to the petitioner. OPINION. VAN FOSSAN: The sole issue in these proceedings is whether the amounts of $31,242.78 and $10,919 paid by the petitioner in the years 1922 and 1923, respectively, represented interest paid on loans or *673 dividends paid on capital stock. If the former position is correct, it follows that the*2074 recipients of such payments, the J. H. Braly trustees and A. H. Braly, were creditors of the petitioner corporation, and not its stockholders. Consequently, such amounts would be deductible from the gross income of the petitioner. The petitioner was a close corporation whose stock was originally owned and controlled jointly by A. H. Braly and his brother-in-law, Herman Janss. It was incorporated for the purpose of carrying on the business of those two individuals. During the war period the real estate business became much depressed and the petitioner found it necessary to borrow money in order to pay its current obligations. Funds for that purpose were provided by J. H. Braly, the father of A. H. Braly, and by A. H. Braly himself. Considerable sums were secured from these sources and were termed advances or loans. They were so designated on the books of the petitioner and the amounts paid for the use of such sums were entered as interest. These transactions remained in that status in December, 1919, when the petitioner, through its controlling stockholders, A. H. Braly and Herman Janss, decided to place the money so advanced on a regular revenue-producing basis in order to*2075 provide for the requirements of J. H. Braly. Consequently, the petitioner issued to A. H. Braly, Emma Braly Janss, and H. H. Braly, as trustees for J. H. Braly, and to A. H. Braly, individually, certain shares of stock in the amounts equivalent to the loans or advances then existing on the books of the petitioner in favor of J. H. Braly and A. H. Braly. At the same time the petitioner issued to Herman Janss and A. H. Braly, each, 35,000 shares of stock representing a prior purchase made by the petitioner from the Braly-Janss Investment Co., whose stock was owned equally by A. H. Braly and Janss. Later, additional advances were made by the J. H. Braly trustees and A. H. Braly and corresponding stock was issued to them in amounts equivalent to such advances. The first point we must consider is the contention of the petitioner that the issues of stock so described were made contrary to the provisions of the laws of California, in that no permit therefor was granted by the corporation commissioner, and that certain capital stock of the corporation was retired or issued as "treasury stock," without due regard for the requirements of the laws of that State. Assuming it to be a fact*2076 that the stock issue was without legal sanction, it comes with bad grace from the petitioner to seek in these proceedings the benefits of its confessed wrongdoing under its own State laws. Laws of that character are established for the protection of the stock-buying public. If the petitioner and its stockholders violated the laws of California, that is a matter between them and *674 the officials of that State. This fact is not controlling here. We may look upon the stock exactly as the record shows it was issued - the regular and authorized common stock of the petitioner corporation of the par value of $1 per share. The form of the capital stock in controversy was no submitted to us. We may assume that the certificates, therefore, were of the usual character and contained the customary provisions. The main contention of the petitioner is based upon the agreements entered into between it and the stockholders by which the shares of common stock issued "to represent loans" were informally constituted a sort of preferred stock. The petitioner maintains that it was its purpose and the purpose of its stockholders to establish a more convenient arrangement for the payment*2077 of interest to J. H. Braly and A. H. Braly and to give them some security for their personal loans. The petitioner further contends that the continuation of its custom of entering on its books payments to the J. H. Braly trustees and A. H. Braly as "interest" and its inclusion of the stock transactions in its loan accounts established the status of the stock so issued as loans rather than capital stock. It is fundamental that the stock in controversy can not be both capital stock and loans. Their holders must be either stockholders or creditors. They can not be both. . The petitioner claims that the stock was an evidence of indebtedness. It could be so only by virtue of a collateral agreement, since it is obvious that holders of only one class of stock authorized to be issued necessarily must be stockholders of a corporation in the absence of any agreement or stipulation changing their status. If the only purpose was to evidence and secure the indebtedness, corporate notes or bonds would better have served the purpose. *2078 . In reaching a conclusion, agreements filed as exhibits in these proceedings must be carefully scrutinized. The agreement between the petitioner and stockholders dated January 19, 1920, states that the corporation has "sold, transferred and delivered" certain certificates of its corporate stock. It further provides that the purchasers will "resell and deliver" the said certificates of stock under certain conditions. There appears nothing in the agreement which indicates that such stock shall be deemed collateral security for a loan or shall constitute a loan in itself. In fact, in the agreement between Braly and the J. H. Braly trustees, bearing the same date, appears the statement that the agreement just referred to provides for the acceptance by the said trustees of "certain capital stock, amounting to 218,000 shares, in lieu of certain indebtedness owing to said second *675 parties (the said trustees) by said first party (the petitioner)." This recital indicated clearly that it was the intention of the parties to the agreement of January 18, 1920, that the issuance and delivery of the capital stock of the petitioner*2079 was an exchange for, or in consideration of, the loans or advances made by the individuals to the petitioner corporation, and terminated the loan status. The agreement of April 1, 1922, is perhaps a more significant decument. It was entered into during the taxable year in which the petitioner claims its so-called interest payments as deductions, under Docket No. 27089. It was executed after the year in which the petitioner had reported as a part of its invested capital the capital stock issued under conditions similar to those existing on the date of the agreement. It was not executed by the petitioner corporation, buy does bear the signatures of all the stockholders thereof. Consequently, it may be considered to reflect properly the intention and understanding of all the stockholders and hence the corporation itself. The agreement recits that 289,650 shares of capital stock were issued to the J. H. Braly trustees and 127,184 shares were issued to A. H. Braly (including the 230,000 shares and 95,000 shares issued to the J. H. Braly trustees and A. H. Braly, respectively, on December 31, 1919), under the express understanding that such stock might be received, redeemed or repurchased*2080 by the corporation upon payment of $1 per share (the par value) plus an amount equal to 7 per cent interest per annum and "that the holders of said stock should have no further or other interest in or to the assets or profits of said corporation." The agreement states that all stockholders had adjusted all interest due on such stock and desired to continue their previous arrangement. Thereupon the parties agreed that no additional capital stock should be issued and that the stockholders would not transfer their stock without the consent of all the other stockholders. The agreement further provides that the 289,650 shares of stock held by the J. H. Braly trustees and the 127,184 shares of stock held by A. H. Braly "shall be considered by the parties hereto as preferred stock and shall be guaranteed dividends in an amount equal to 7 per cent per annum, compounded quarterly, figured from the first day of January, 1922, and that said stock shall not participate in any other of the profits of said corporation." The agreement then establishes a method by which the corporation may retire, redeem or repurchase, at its own election, the capital stock so mentioned. The corporation*2081 may pay par value of such stock "plus dividends equal to 7 per cent interest per annum" and upon such payment the stockholder shall not have any further right, title, interest or equity in and to the assets of the said corporation. The *676 agreement further sets forth that the stockholders have adjusted among themselves all equities, profits and interests on the above stock up to and including December 31, 1921, and agree that they have no interest in or to the cumulative profits of said corporation or to any accruing profits except as such may be held intact as a guaranty for the payment of the par value of the stock, together with the accruing interest from and after January 1, 1922. The terms employed in this agreement are significant and clearly indicate that the J. H. Braly trustees and A. H. Braly possessed the rights of common stockholders as modified by the voluntary agreement of all stockholders transforming their common stock into a species of preferred stock. The use of the word "dividend" is persuasive that the stockholders recognize the fact that the common stock received by them in the liquidation of their loans made to the petitioner had been transformed*2082 into a preferred stock having the usual attributes of such a security. The provisions relating to the retirement of the preferred stock are not uncommon and do not convert such stock into a debt against the corporation. The fact that no dividends were formally declared is immaterial, since the corporation was a family affair and the status of the "security" was established by a special agreement among its stockholders. The same reason may be advanced to explain why J. H. Braly, the father, took no interest in the affairs of the corporation. By virtue of their stockholding the J. H. Braly trustees possessed all the rights and potential interests of stockholders in the corporation and could have exercised them if they had so desired. The fact that the payments made on the stock were referred to in the books of the corporation or considered by the stockholders as "interest" is likewise immaterial. The terminology of the company's bookkeeper is not determinative of the legal character of the accounts. ; *2083 ; . Moreover, the agreement did not provide for the payment of dividends or interest unless the profits of the corporation should be sufficient to warrant their payment. It is noted further that the corporation paid dividends to Herman Janss and A. H. Braly on the shares of stock which admittedly did not represent loans. Though obviously dividends, these payments also were termed "interest" on the books of the corporation. This fact is persuasive and militates strongly against the contention of petitioner. In , we held that the name which had been given to stock was not a thing to be ignored, "for it is not lightly to be assumed that parties have given an erroneous name to their transaction." The petitioner and its *677 stockholders have called the shares of capital stock in controversy preferred shares. We are of the opinion that they were correct in that designation and consequently are not entitled to decuct as interest from their gross income the amount paid as dividends*2084 on the said shares of stock. Decision will be entered for the respondent.