Interstate Realty Co. v. Commissioner

INTERSTATE REALTY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Interstate Realty Co. v. Commissioner Docket Nos. 46272, 50981. United States Board of Tax Appeals 25 B.T.A. 728; 1932 BTA LEXIS 1489; February 29, 1932, Promulgated *1489 Petitioner declared a dividend and discharged the same by distribution of purchase money notes which represented profits from the sale of a subdivision project. Held, that it realized income in the amount of such profits as of the date of distribution. John E. McClure, Esq., for the petitioner. Nathan Gammon, Esq., for the respondent. LANSDON *728 The respondent asserts deficiencies in income tax for the fiscal years ended July 31, 1927 and 1928, in the respective amounts of $4,047.02 and $4,396.82. In the deficiency notice for the 1928 fiscal year, which is the basis for the proceeding at Docket No. 46272, the respondent has determined an overassessment for the fiscal year ended July 31, 1927, in the amount of $138.21. The principal issues are (1) whether a certain dividend distributed by the petitioner to its stockholders which it discharged by the distribution of notes and accrued interest was made in the fiscal year 1927 or the fiscal year 1928; (2) whether such distribution effected a realization of income and was taxable in the year in which it was made; and (3) whether respondent properly added $2,199.95 to petitioner's income*1490 for its fiscal year ended July 31, 1927, as proceeds of notes representing profit collected in the taxable year. In the proceeding at Docket No. 50981 there are two additional questions, viz., (1) whether income was realized in an exchange of real estate effected in 1928 and (2) whether a deduction from gross income on account of an alleged loss representing cost of operating an insurance agency was properly disallowed. The two proceedings have been consolidated for hearing and decision. *729 FINDINGS OF FACT. The petitioner is a Tennessee corporation, with its principal office at Memphis. In the taxable years and for some time prior thereto, it was engaged in the real estate business. It is a close corporation and at all times pertinent here all its outstanding stock was owned by Mark R. Koplin, W. V. Fant, and Gilmer Richardson. During the year 1923 the petitioner subdivided and sold the LaBelle Heights Subdivision of the city of Memphis. Each lot was sold on contract under which notes to cover the balance due were taken from the purchaser at the date of deed. On May 10, 1927, it was the owner of such purchase money notes of face value in the aggregate amount*1491 of $25,358, upon which interest aggregating $5,625.55 had accrued at that date. The sales of lots were not made on the installment plan and at May 10, 1927, the petitioner had reported no income resulting from profits therefrom, since at that date it had not recovered all its capital investment in the project. Apparently the parties agree that at such date the notes represented unrecovered cost, profits from sales and accrued interest in the respective amounts of $1,022.05, $24,335.95 and $5,625.55 and that the taxable income, if any, included therein was $29,961.50. In May, 1927, W. W. Fariss, one of the petitioner's stockholders, desired to withdraw from the company on account of failing health. After oral conferences in which all terms were worked out, the four stockholders entered into a stockholders' agreement, which was signed May 16, 1927, the provisions thereof pertinent to this proceeding being as follows: THIS AGREEMENT, Made and entered into this the 16th day of May, 1927, by and between MARK R. KOPLIN, W. V. FANT and GILMER RICHARDSON, hereinafter called the first parties, and W. W. FARISS, hereinafter called the second party: WHEREAS, the parties hereto own all*1492 of the issued and outstanding capital stock of the INTERSTATE REALTY COMPANY, a corporation under the laws of the State of Tennessee, having its principal office in Memphis, Tennessee; and WHEREAS, said corporation, by reason of the personal services of the stockholders in harmonious association, has been successful and profitable; and WHEREAS, the second party, because of ill health, desires to withdraw from said corporation, and dispose of all of his shares of the capital stock thereof, contemplating, however, the possibility of his re-entering said association under some future arrangement mutually agreeable; and WHEREAS, the first parties, appreciating the motives of the second party in severing the aforementioned relations, and desiring to retain among themselves the shares of said capital stock now held by the second party, have agreed among themselves to take over said investment in the proportions in which they now hold capital stock of said corporation; and WHEREAS, said corporation now holds and owns the following described series of promissory notes, to be secured by mortgage deeds of trust on lots or parcels of the LaBelle Heights Subdivision in Memphis, Tennessee, *1493 and which series of promissory notes might properly be distributed as a dividend without impairing the capital stock of said company: [List of notes aggregating $25,358 omitted.] *730 NOW, THEREFORE, the party of the second part has endorsed in blank for transfer, certificates evidencing his one hundred and fifty shares of the capital stock of said Interstate Realty Company, and has delivered the same to the first parties jointly, to be owned and held by them in like proportions as they owned capital stock of said Company immediately prior to said transfer, to wit, Mark R. Koplin, 15/34, W. V. Fant, 15/34 and Gilmer Richardson 4/34, or in such proportions as they may agree upon amongst themselves. And in consideration of said transfer of his said shares of the aggregate par value of Fifteen Thousand ($15,000.00) Dollars, the parties of the first part, jointly and severally, have delivered to the second party, absolutely and unconditionally, all of the aforedescribed series of promissory notes, the same being for the aggregate principal sum of Twenty-five Thousand, Three Hundred and Fifty-eight ($25,358.00) Dollars, with accrued interest thereon, calculated as of May 10th, *1494 1927, amounting in the aggregate to the sum of Five Thousand, Six Hundred, Twenty-five and 55/100 ($5,625.55) Dollars. Moreover, the first parties, jointly and severally, covenant and agree to cause good and sufficient warranty deeds to be executed by Interstate Realty Company, conveying lots and parcels of land agreeably to the contracts pursuant to which said notes were executed; and to secure from the makers of said notes, severally and respectively, and file for registration, good and sufficient purchase money mortgage deeds of trust to secure the payment of said promissory notes. And the first parties, jointly and severally, covenant and agree that they shall and will, in due legal form and manner, and by unimpeachable corporate action, procure from said Interstate Realty Company, a good, legal and sufficient absolute title to all and every of said promissory notes. It is understood that the second party shall immediately take over, hold and collect for his own use and exclusive benefit, all of said promissory notes; that the sale and transfer, as aforesaid, of said one hundred and fifty shares of capital stock shall be deemed final, unconditional and absolute; and that*1495 the first parties shall and will secure and vest in the second party as absolute title to all of said promissory notes. The first parties will also procure at their own expense policies of title insurance as provided in lot sale contracts. In default of procuring such title to said promissory notes as hereinbefore provided, the first parties, jointly and severally, covenant and agree to and with said second party, his heirs, personal representatives and assigns, to indemnify, protect and save harmless said second party of and from all loss, liability and expense by reason thereof. On October 3, 1927, corporate action was effected and made of record as reflected by the following: At a meeting of the Board of Directors of Interstate Realty Company incorporated under the laws of the State of Tennessee, held on October 3rd, 1927, with all of the members of the Board present, the following resolution was unanimously adopted: RESOLUTION. WHEREAS, the accounts of the Interstate Realty Company at July 31, 1927, have been audited and closed, and it appears that the Company has an earned surplus of $33,053.04; NOW THEREFORE, Be it resolved that a dividend of $31,000.00 be and*1496 is hereby declared on the outstanding Common Stock of this Company; *731 BE IT FURTHER RESOLVED, that this dividend be discharged by the transfer and delivery of a series of promissory notes held and owned by the Company, as per list hereto attached and made a part hereof. Between May 16, 1927, and October 23, 1927, certain collections on the notes enumerated in the stockholders' agreement were made and the proceeds thereof, less commissions, were credited and paid to the retiring stockholder. In the year 1928 the petitioner exchanged 15 lots which had cost $2,255.70 for improved real estate which was encumbered by a mortgage for $8,756.08. The respondent has determined that the property received had a market value of $12,206.08 and that profit in the amount of $1,194.30 was realized from the transaction. On February 18, 1928, Koplin, Fant and Richardson, owners of all the outstanding capital stock of the petitioner, entered into an insurance agency contract with one Parrish and operated under such contract as the Interstate Insurance Agency for the account of the petitioner. The business was unprofitable. During 1928 the petitioner advanced $1,500 to such agency. *1497 In its income-tax return for that year it claimed a deduction of such amount as a loss sustained in the taxable year. Upon audit this claim was disallowed and the amount was added to income. After the notes in controversy were delivered to Fariss on May 16, 1917, petitioner undertook the collection thereof on a commission basis. Between that date and October 3, 1927, collections were made for the account of Fariss in the aggregate amount of $2,183.50, which was credited and paid to him after the deductions of commissions at the rate of 15 per cent. OPINION. LANSDON: In the proceeding at Docket No. 50981 relating to petitioner's tax liability for the fiscal year 1927, the deficiency is based upon determination of the respondent as follows: The addition to income of $22,152.45, $5,625.55 and $2,199.95 representing, respectively, realization of profit from the collection of deferred payment notes, interest on the notes, and a collection on the principal thereof. The additional tax liability asserted for such year is $4,047.02. At Docket No. 46272, the deficiency for 1928 in the amount of $4,396.82 is based upon respondent's additions to income of $22,152.45, $5,625.55, $1,194.30, *1498 $347, $2,199.95 and $1,500, representing realization of profit from deferred payments notes, accrued interest on such notes, profit on an exchange of property, rent, collection on notes and loss from the operation of an insurance agency. The first three items in each of the above categories are identical and decision thereon for either year automatically removes it from consideration as an element of tax liability for the other. *732 The major controversy here relates to the taxability of certain distributions of notes and accrued interest thereon. The respondent has determined that such distribution took place on October 3, 1927, which is within the petitioner's taxable year ended at July 31, 1928, and that it falls within the provisions of section 44(d) of the Revenue Act of 1928. The petitioner contends that the transaction was completed within its taxable year ended at July 31, 1927; that it was a distribution in kind and so not taxable, and relies upon our decision in . It also argues that even if we should find that the distribution was made in the petitioner's taxable year ended July 31, 1928, the*1499 realized profits therein are not taxable under the provisions of section 44(d) of the Revenue Act of 1928, since that section applies expressly and only to profits resulting from the realization of installment notes and the sales in question were on the deferred payment plan, under which capital must be recovered before any profit becomes taxable. A further question of law, not argued by either party, is whether the 1928 Act is applicable in any event, since the taxable transaction, if any, occurred in 1927 and the law relied on by the respondent was not enacted until late in May, 1928, and, except as to certain matters not pertinent to the issues of these proceedings, was not retroactive. The historical sequence of the events involved in this controversy is clearly disclosed by the record. Fariss, a stockholder, director and the president of this petitioner, desired, on account of failing health, to dispose of his stock and withdraw from all participation in the affairs of the corporation. After many oral conferences the stockholders' agreement, which we have incorporated in our findings of fact, was entered into by all the parties in interest. On May 16, 1927, under that agreement, *1500 Fariss endorsed his stock certificates in blank and turned them over to Koplin, Fant, and Richardson, who, at the same time, delivered to him the deferred purchase money notes of the face value of $25,358.45, upon which interest had then accrued in the amount of $5,625.55. Apparently the petitioner contends that these acts and the nature of the stockholders' agreement effected a closed transaction at May 16, 1927, in which stock was transferred and a dividend was declared and discharged. A careful study of the agreement indicates that it is an executory contract in which all the parties recognized that Fariss was receiving assets of the corporation from the stockholders as individuals who were discharging their private obligations by using the property of the petitioner. This agreement, therefore, includes a provision in which Koplin, Fant, and Richardson "jointly and severally covenant and agree that they shall and will, in due legal form and *733 manner, and by unimpeachable corporate action, procure from said Interstate Realty Company, a good, legal and sufficient title to all and every one of said promissory notes." It is perfectly clear that the "good legal and sufficient*1501 title" to the notes could lodge in Fariss in only one way, that is, by the corporate distribution of such notes to Koplin, Fant, and Richardson, as a dividend payable from "the assets of the corporation" and the delivery thereof to Fariss by such distributees. Petitioner argues that the terms of the agreement explicitly declare the intention of the first parties and as they had the power as the sole stockholders and directors of the petitioner to accomplish any lawful corporate act at any time it must be presumed that every obligation imposed by the agreement was discharged at the date of the exchange of the stock for the notes and that any subsequent formal act of the corporation was no more than a bookkeeping record of something already done. The theory of the petitioner is plausible, but not convincing, and is not supported by the evidence. The record shows that on May 16 the stockholders of the petitioner delivered corporate assets equal in value to accumulated earned surplus to Fariss, with a guaranty that by appropriate corporate action they would later lodge title thereto in him. There is considerable testimony by the petitioner's attorney that the action contemplated*1502 was taken in June and counsel offered in evidence an undated and unsigned carbon copy of what purported to be a resolution which it was alleged was adopted by the corporation some time before June 15, 1927. No officer or director of the petitioner has testified that such a meeting was held or that the resolution was adopted. No satisfactory evidence that the original, if any, had been lost was offered. The respondent's objection to the carbon copy as evidence was sustained by the sitting member of the Board. The only other evidence of corporate action to effect the guarantee in the stockholders' agreement is the minutes of a directors meeting held on October 3, 1927. These minutes, set out in full in our findings of fact, were produced from the records of the petitioner and are duly and properly signed by the president and secretary thereof. The corporate acts there recorded are (1) a recital that at July 31, 1927, the books of the petitioner, after audit, showed earned surplus in the amount of $33,053.04; (2) the declaration of a dividend on the outstanding common stock of the petitioner in the amount of $31,000; and (3) that the dividend so declared should be discharged by*1503 the transfer and delivery of a series of notes held and secured by the company. Obviously this was the "unimpeachable corporate action" pledged in the agreement. Petitioner must destroy the probative value of the minutes of October 3, 1927, in order to prevail on its contention that the distribution *734 was effected in either May or June of that year. The preponderance of authority favors the view that the records of a private corporation are conclusive evidence of its acts and may not be varied or contradicted by parol testimony. Corpus Juris 22, at page 1088, citing , in which the court said that "the written minutes may be explained but not changed, barred or modified by oral testimony." In ; 36 Atlantic 129, the Supreme Court of Rhode Island said: The declaration of a dividend is one of the most important acts of a corporation. It is an assignment pro tanto of its property. It clearly implies corporate action to that effect. It is action of such a character that it should appear on the books of the corporation. In our opinion the*1504 record does not sustain the petitioner's contention. The stockholders' agreement and the delivery of the notes to Fariss on May 16 are not enough to establish a dividend in kind at that date. The probative value of the minutes of October 3 has not been impeached by the oral evidence. On that date the dividend of $31,000 was voted and discharged by surrender of title to the notes which had been delivered to Fariss on May 16, 1927. The petitioner further contends that even if the dividend was voted and discharged by the notes on October 3, 1927, the transaction does not fall within the provisions of section 44(a) of the Revenue Act of 1928, which explicitly applies to the realization of profits from the disposition of installment notes. The notes in question represented deferred payments and the petitioner was required to report no profit as income until its capital investment had been recovered. In our opinion this is not a transaction to which section 44(a) of the Revenue Act of 1928 is applicable. The controversy here is not disposed of, however, by our conclusions above. The parties agree that at May 16, 1927, the petitioner had recovered all its investment in the LaBelle*1505 subdivision except the amount of $1,022.05. From that date all realization from the notes in question in excess of the unrecovered capital was taxable income. Had there been no disposition or realization other than by collection it is clear that income so derived was reportable only as and when it resulted from such collections. The facts, however, destroy the petitioner's right to report its income from the notes as and when collected. On October 3, 1927, the corporation declared a dividend of $31,000 payable to its stockholders of record. The legal effect of that act was to separate such amount from surplus and create a corporate liability equal thereto. ; ; *735 ; ; ; . The liability so created was discharged by the distribution of the notes. In our opinion the petitioner then realized taxable income to the extent that profit was included in the distribution. The record*1506 indicates that the distribution included profits and interest in the respective amounts of $24,335.95 and $5,625.55, or a total of $29,961.50. This amount was income to the petitioner in the fiscal year ended July 31, 1928, and is taxable to it at the corporation tax rates imposed by the Revenue Act of 1928. The instant proceeding is clearly distinguishable on its facts from The distribution there was in kind and apparently was one of the steps in the liquidation of the taxpayer. There it was impossible to determine to what extent the notes distributed represented the return of capital or the realization of profit. Here the conditions are quite different. The distribution was in kind, but was not made in the course of liquidation. It was in discharge of a liability incurred by the declaration of dividend out of surplus. In the circumstances it is clear that the petitioner realized the profits that it had theretofore derived from the sale of its property. There is no reason that it should escape taxation on realized income. Its distributees are subject only to the surtax on dividends received from a domestic*1507 corporation. The petitioner must pay the normal tax unless the revenues are to be deprived of an impost authorized by law. The respondent has determined that the exchange of property in 1928 set out in our findings of fact resulted in a profit of $1,194.30. This determination is based on a finding that the property received by the petitioner had a fair market value of $12,206.08 at date of the exchange. A witness for the petitioner, Richardson, who is a director thereof, testified that in his opinion the property was not worth more than $10,000 when received. In cross-examination he admitted that he had priced it in proposed trades for other property at $12,500 and at $15,000. This testimony is not sufficient to overcome the presumption that the determination of the respondent was correct. On this issue the contention of the petitioner is denied. On February 18, 1928, Koplin, Fant, and Richardson, who were the owners of all the capital stock of the petitioner outstanding at that time, entered into a contract with one Homer A. Parrish for the purpose of conducting an insurance agency with Parrish as manager. The petitioner contends that such agency was its property at all*1508 times and that the losses sustained were its losses and deductible from its income in the year in which they were sustained. *736 The insurance agency was conducted under a different name because of petitioner's charter limitations under the laws of Tennessee. Witnesses testified that the petitioner was at all times the beneficial owner of the insurance agency. This evidence was not overcome by any rebuttal testimony. We conclude, therefore, that on this issue the respondent must be reversed. Cf. ; . The respondent has determined that petitioner realized income in its fiscal year ended July 31, 1927, in the amount of $2,199.95 resulting from the collection of notes from the sale of lots in the LaBelle subdivision upon which the original capital investment had been recovered. This amount was included in the notes delivered to Fariss on May 16, 1927, and was collected by the petitioner for his account and paid to him. It is included in the notes which discharged the dividend of $31,000 declared on October 3, 1927, and in conformity with our conclusions*1509 above is already included in the computation of the petitioner's tax liability for the year 1928. In almost every particular the matters involved in Dockets 50981 and 46272 are identical and the two proceedings are practically duplicates. Our conclusion is that there is no deficiency involved in the proceeding at Docket No. 50981 and that the deficiency asserted at Docket No. 46272 must be redetermined under Rule 50. Reviewed by the Board.