S. Davidson & Bros., Inc. v. Commissioner

S. DAVIDSON & BROS. INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. S. Davidson & Bros., Inc. v. Commissioner Docket Nos. 25623-25625. United States Board of Tax Appeals 21 B.T.A. 638; 1930 BTA LEXIS 1821; December 11, 1930, Promulgated *1821 1. Upon the evidence, held that petitioner changed its method of computing income to the installment basis by an original return for 1917, and respondent erred in determining deficiencies for 1917, 1919, and 1920 upon the basis of net incomes which included amounts collected in those years on account of installment sales made in 1916. 2. Respondent's action in excluding from invested capital for 1919 and 1920 the unrealized profits in 1916 installment sales contracts uncollected at the beginning of those years, approved upon authority of Blum's, Inc.,7 B.T.A. 737, and Jacob Bros. Co.,19 B.T.A. 59. 3. Invested capital for 1919 and 1920 may not be reduced on account of additional taxes for 1918 when assessment and collection of such taxes are barred by the statute of limitations. 4. Consolidated invested capital for 1920 should not be reduced by additional taxes assessed against an affiliated company for 1919, under the circumstance that the former stockholders agreed to assume and pay, and did pay, such additional taxes. Houston Belt & Terminal Railway Co.,6 B.T.A. 1364. 5. Upon the evidence, held that the*1822 petitioner and the Iowa Furniture Store were affiliated during the period May 26 to December 31, 1920. Denver A. Busby, C.P.A., for the petitioner. Arthur Carnduff, Esq., for the respondent. LANSDON *638 In these proceedings, which were duly consolidated for hearing and decision, the petitioner seeks a redetermination of the deficiencies *639 which the respondent has asserted for the years and in the amounts as follows: Docket No. Year Deficiency 25625 [1917] $8,428.68 25623 [1919] 6,624.52 25624 [1920] 19,813.78 Petitioner makes the following assignments of error: (1) Net income for 1917, 1919, and 1920 has been increased by the amounts of $77,658.37, $11,403.33, and $3,378.10, respectively, representing profits realized through collections on 1916 installment sales; (2) invested capital for 1919 and 1920 has been reduced by the amounts of $16,260.68 and $4,488.18, respectively, representing the unrealized profits in 1916 installment-sale contracts outstanding and unpaid at the beginning of those years; (3) the adjustments of invested capital for 1919 and 1920, on account of additional income and profits taxes*1823 for 1917, are excessive in amounts; (4) invested capital for 1919 and 1920 has been reduced by the amounts of $15,623.96 and $36,971.02, respectively, on account of additional income and profits taxes due for 1918, the assessment and collection of which are barred by the statute of limitations; (5) the adjustment of invested capital for 1920 on account of 1919 income and profits taxes is excessive in amount; (6) invested capital for 1920 has been reduced by $16,799.58 on account of the 1919 income and profits taxes of an affiliated company, which were assumed and paid by the former stockholders; and (7) respondent holds that the petitioner and the Iowa Furniture Store were not affiliated during 1920, and computed the tax upon the basis of a separate return. FINDINGS OF FACTS. Petitioner, an Iowa corporation with its principal office at Des Moines, was engaged, throughout the taxable years on appeal, in a retail furniture business, selling for cash, on credit, and on the installment plan. Under the method of accounting regularly employed in keeping the books prior to 1917, petitioner took into the accounts of each accounting period all sales made during the period, whether*1824 for cash, on credit, or on the installment plan, and accounted for the profits on installment sales as income of the period in which such sales were made. The net income reported by the petitioner in the several income-tax returns filed during the same period was computed in accordance with the method of accounting regularly employed in keeping the books. *640 In 1917 petitioner changed its accounting method so as to defer the accounting for profits from installment sales to the year or years in which such profits were reduced to possession. At the close of 1917 and subsequent years, entries were made in the journals and properly posted to the ledgers, reducing gross sales by the estimated amount of uncollected deferred payments on installment sales of the year, and increasing the closing inventory with the estimated unrecovered cost of sales represented in such deferred payments. Net income reported by the petitioner in the original return for 1917 was computed in accordance with the method of accounting employed in keeping the books. Respondent added to net income for 1917, 1919, and 1920 the amounts of $77,658.37, $11,403.33, and $3,378.10, respectively, representing*1825 profits on 1916 installment sales collected and reduced to possession in those years. Respondent reduced invested capital for 1919 and 1920 by the amounts of $16,260.68 and $4,488.18, respectively, representing profits on 1916 installment sales which had not been collected and reduced to possession at the beginning of those years. Respondent reduced invested capital for 1919 and 1920 by the amounts of $9,707.20 and $13,674.14, respectively, on account of additional income and profits taxes alleged to be due for 1917. Respondent reduced invested capital for 1919 and 1920 by the amounts of $15,623.96 and $36,971.02, respectively, on account of additional income and profits taxes alleged to be due for 1918. The additional taxes have not been paid and assessment and collection were barred by the statute of limitations when the deficiencies were asserted for the year 1918 and the taxable years here involved. On January 2, 1920, petitioner purchased the entire outstanding capital stock of L. Harbach Sons Co. from the heirs of L. Harbach. Under the terms of the agreement, the vendors agreed to pay any and all additional income and profits taxes which might be assessed against*1826 L. Harbach Sons Co., for any year prior to 1920. Subsequently, an assessment was made against that company for additional income and profits taxes for 1919 in the amount of $39,866.10, which was paid by the vendors. Respondent reduced the consolidated invested capital for 1920 by $16,799.58 on account of the additional taxes above referred to. On or about May 26, 1920, petitioner organized the Iowa Furniture Store, a corporation, under the laws of Iowa, for the purpose of selling through that organization all merchandise repossessed from persons defaulting in their installment obligations to the petitioner, and other merchandise in petitioner's stock which had become damaged or obsolete. All such merchandise was charged to the Iowa Furniture Store at prices fixed by petitioner's officers. *641 During 1920 the capital stock of the petitioner and the Iowa Furniture Store was held as follows: S. Davidson & Bros. Iowa Furniture (Inc.) Store Stockholders Shares Percentage Shares Percentage S. Davidson 1,825 31.20 [53] 21.2 J. Davidson 1,825 31.20 [54] 21.6 L. Davidson 1,825 31.20 [53] 21.2 J. J. Garry 62 1/2 1.07 [10] 4.0 W. H. Cotton 112 1/2 1.92 [10] 4.0 A. Davidson [150] 2.56 [10] 4.0 S. H. Nelson [50] .85 M. Kohan [50] 20.0 H. G. Roth [10] 4.0 Total 5,850 100.00 [250] 100.0 *1827 M. Kohan and H. G. Roth were employees of the petitioner at the time the Iowa Furniture Store was organized. They were permitted to purchase shares of capital stock of the latter company, under an agreement which reads as follows: AGREEMENT made and entered into on the date at the foot hereof, by and between S. Davidson & Bros. Inc., a corporation of the city of Des Moines, Iowa, as first party, and of said city, as second party, and Iowa Furniture Store, third party WITNESSETH: THAT, WHEREAS, second party has borrowed from first party the sum of , and therewith second party has purchased and paid for in cash, shares of common stock issued to him by third party, each of a par value of one hundred dollars ($100.00), the same being of the aggregate par value of . NOW, THEREFORE, these presents witness, that for the sum so borrowed, second party shall execute his negotiable promissory note in the sum of , payable to first party, on or before five years from the date thereof, the same to bear interest from its date, at the rate of six (6) per cent per annum until paid. IT IS FURTHER AGREED by the parties hereto that as collateral security for the payment of said promissory*1828 note second party shall transfer to first party the certificate for the common stock so issued and all dividends declared and paid on said stock, said transfer to be by the usual indorsement upon the back of said certificate, and the secretary of third party as provided by law, note upon the stub of said certificate that the same is held as collateral security for the payment to S. Davidson & Bros. Inc., of the principal of said promissory note for with interest thereon from the date of said note at the rate of six (6) per cent per annum, until paid in accordance with the terms of the contract between S. Davidson & Bros. Inc., , and the Iowa Furniture Store, dated Jan. 1, 1920. It is further agreed by the parties hereto that second party shall write upon the margin or across the face of said certificate, date and sign the same a clause to the effect that "this certificate of stock is issued subject to the right of said Iowa Furniture Store to re-purchase the same in accordance with the contract between said stockholder and said Iowa Furniture Store & S. Davidson & Bros. Inc." dated on the 1st day of January, 1920. *642 IT IS FURTHER AGREED between all of the parties hereto, *1829 that any and all dividends declared and paid on this certificate, shall be paid to first party and applied by it first upon interest due and unpaid upon said above described promissory note at the date said money is received by first party and the balance of any shall be applied upon the principal of said note. IT IS FURTHER AGREED by the parties hereto, that second party may, at any time, pay to apply upon the principal and interest of said promissory note, the sum of Fifty dollars ($50.00), or any multiple thereof, the same to be applied first upon accrued interest and the balance upon the unpaid principle thereof; and second party may, at any time, pay off the whole of said promissory note or the part thereof remaining unpaid, with interest as therein provided, and thereupon said certificate or certificates for said stock shall be re-delivered to second party, his legal representatives or assigns, and third party shall cause a cancellation in proper form of the entry upon the stub of the stock books of the holding of the same as collateral security for the payment of said promissory note and interest. It is further expressly agreed by the parties hereto that, in the event*1830 that second party, for any reason or in any manner, ceases to be an employee of first party, or of some corporation fifty per cent or more of whose stock is owned by the owners of fifty per cent or more of stock of first party, then in that case, third party reserves the right to purchase from second party, and second party hereby agrees to offer in writing for a period of thirty days to sell, assign and transfer to third party, the certificate or certificates, evidencing said shares of stock so deposited as collateral security and third party agrees that if it decides to purchase said stock, it will pay to second party therefor, whatever sum or sums he has paid to apply in whole or in part upon said promissory note, exclusive of interest paid thereon, added to interest on said principal sum so paid at the rate of six (6) per cent per annum from the date of the last annual declaration of dividend, but subject to the deduction of any amount owing by second party to first party. It is further agreed that; notwithstanding this agreement, second party shall, at each and every meeting of the stockholders have the right to vote the shares evidenced by said certificate, in person or by*1831 proxy, as if said stock had not been so deposited as collateral security. DATED at Des Moines, Iowa, this 1st day of Jan. A.D. 1920. The certificates of capital stock issued to Kohan and Roth bore the following notations: May 27, 1920. This Certificate of Stock is issued subject to the right of said Iowa Furniture Store to repurchase same in accordance with the contract between said stockholder, Iowa Furniture Store and S. Davidson & Bros., Inc., Dated 1/1/20. The articles of incorporation of the IOWA FURNITURE STORE contain the following provisions and this certificate is subject thereto: "No stockholder shall at any time sell any of his shares of capital stock of this corporation without first offering in writing to sell the same to the corporation and to its other stockholders for a period of at least sixty (60) days at the value of such shares as shown by the books of the corporation and no purchaser of any such shares shall obtain any title to any of such shares until they have been so offered by the holders to the corporation and to its other stockholders but nothing herein contained shall prevent any stockholder from pledging his shares for money borrowed. (Signed) *1832 MOSE KOHAN, Sec'y. *643 Kohan made an initial payment of $1,000 for the stock of the Iowa Furniture Store out of his personal funds. The balance of his subscription, $4,000, and the entire subscription of Roth, $1,000, were paid for from funds borrowed from the petitioner on their personal notes, and their stock certificates were held by petitioner as collateral security for the payment of such notes. Kohan was placed in charge of the operations of the Iowa Furniture Store. He strongly opposed the charges which the petitioner was making for merchandise sent to the Iowa Furniture Store for sale, on the ground that they were entirely too high and resulted in consistent losses to the latter. Because of this opposition, Kohan was requested to resign, which he did in 1922; whereupon he sold his stock in the Iowa Furniture Store to the petitioner. Roth left the petitioner's employ in 1925, and, in accordance with the terms of the purchase agreement, surrendered his stock in the Iowa Furniture Store. OPINION. LANSDON: No brief having been filed, or oral argument made, in respondent's behalf, we are not advised of his views on the several issues raised by the petition, *1833 or the reasons for his several acts against which petitioner complains. Respondent has added to net income as returned by petitioner for 1917, 1919, and 1920, the amounts of $77,658.37, $11,403.33, and $3,378.10, respectively, representing profits received in those years on account of installment sales made in 1916. Petitioner attacks this as improper under the provisions of section 705 of the Revenue Act of 1928, which read as follows: (a) If any taxpayer by an original return made prior to February 26, 1926, changed the method of reporting his net income for the taxable year 1924 or any prior taxable year to the installment basis, then, if his income for such year is properly to be computed on the installment basis - (1) No refund or credit of income, war-profits, or excess-profits taxes for the year in respect of which the change is made or any subsequent year shall be made or allowed, unless the taxpayer has overpaid his taxes for such year, computed by including, in computing income, amounts received during such year on account of sales or other dispositions of property made in any prior year; and (2) No deficiency shall be determined or found in respect of any such*1834 taxes unless the taxpayer has underpaid his taxes for such year, computed by excluding, in computing income, amounts received during such year on account of sales or other dispositons of property made in any year prior to the year in respect of which the change was made. (b) Nothing in this section shall be construed as in any manner modifying section 607, 608, 609, or 610 of this Act, relating to the effect of the running of the statute of limitations. *644 Respondent admits in his answer that net income for each of the years on appeal is properly to be computed on the installment basis. Therefore, whether respondent is correct in adding to net income of the years on appeal the profits received in those years on account of installment sales made in 1916, depends entirely upon whether the petitioner changed its method of reporting income to the installment basis by an original return for a taxable year prior to 1924. The facts we have found leave no doubt that the change in method of reporting income to the installment basis was made by an original return for 1917. The effect of the adjustments made in the books at the close of that year and the two later years on*1835 appeal was to defer the accounting for the estimated profits represented in the uncollected deferred payments to a later period than that in which the sales were made. Whatever may be said as to the correctness of the accounting procedure followed, its purpose and effect were of place the accounting for income from installment sales on the installment basis. Since the net income reported in the original return for 1917 was computed in accordance with the method employed in keeping the books, it must be held that the change in method of computing income to the installment basis was made by that return. Accordingly, we must hold that respondent erred in determining deficiencies for the years on appeal upon the basis of net incomes which included amounts received in those years on account of installment sales made in 1916. The respondent's action in excluding from invested capital for 1919 and 1920 the amounts of $16,260.68 and $4,488.18, respectively, representing the unrealized profits in 1916 installment sales contracts outstanding and unpaid at the beginning of those years, is approved upon authority of *1836 , and . The proper adjustments of invested capital for 1919 and 1920 on account of any additional taxes found to be due for 1917 under this decision will be made upon final order of redetermination under Rule 50. The respondent's action in reducing invested capital for 1919 and 1920 by the amounts of $15,623.96 and $36,971.02, respectively, on account of additional income and profits taxes for 1918, the assessment and collection of which were barred by the statute of limitations when the deficiencies for 1918 and the taxable years were asserted, is held to be erroneous upon authority of ; ; and . The proper adjustment of invested capital for 1920 on account of any additional tax found to be due for 1919 under this decision, will be made upon final order of redetermination under Rule 50. *645 In view of the agreement on the part of the former stockholders of L. Harbach Sons Co. to assume and pay any and all additional income*1837 and profits taxes which might be assessed against that company for any year prior to 1920, and the fact that they did assume and pay the assessment of additional taxes for 1919 in the amount of $39,866.10, the respondent's action in reducing consolidated invested capital for 1920 by the amount of $16,799.58 on account of such additional taxes for 1919 is held to be erroneous, upon authority of . The last question for consideration is whether the petitioner was affiliated, during the period May 26 to December 31, 1920, with the Iowa Furniture Store within the meaning of section 240(b) of the Revenue Act of 1918. During the period in question, 76 per cent of the capital stock of the Iowa Furniture Store was owned outright by the same persons who owned 99.15 per cent of petitioner's capital stock. Of the remaining 24 per cent of the stock of the Iowa Furniture Store, 4 per cent was owned by Roth, an employee of the petitioner, and 20 per cent was owned by Kohan, an employee of the Iowa Furniture Store, who had formerly been in the petitioner's employ. Both Roth and Kohan had acquired their stock under agreements in*1838 which the right of repurchase of the stock was reserved in the Iowa Furniture Store should said individuals, "for any reason or in any manner," cease to be employees of the petitioner or "of some corporation fifty per cent or more of whose stock is owned by the owners of fifty per cent or more of the stock" of the petitioer company. The events related in the findings of fact clearly demonstrate the significance of this reservation and the futility of any opposition to the policies of the Davidsons, on the part of Roth or Kohan. Any opposition from that source which seriously challenged the control of the Davidsons over the affairs of the Iowa Furniture Store, or their right alone to determine, to the fullest extent, its business policies without interference on the part of stockholder-employees, could be effectively removed by peremptory discharge of the offending party with the consequent relinquishment of status as a stockholder. This, in effect, is precisely the course they finally took in dealing with Kohan, when they deemed it no longer advisable to tolerate his continued objections to the prices which they determined should be made by the petitioner for merchandise furnished*1839 to the Iowa Furniture Store. Kohan's objections led only to a forced severance of his relations with the Iowa Furniture Store, as an employee and stockholder. All circumstances considered, we find that substantially all of the stock of the petitioner and the Iowa Furniture Store was owned or controlled by the same interests, and that respondent erred in *646 holding that these two corporations were not affiliated for the period May 26 to December 31, 1920. Cf. ; and . Reviewed by the Board. Judgment will be entered under Rule 50. MORRIS, TRAMMELL, and MURDOCK dissent.