Laun v. Commissioner

ALFRED A. LAUN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. J. B. LAUN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Laun v. Commissioner Docket Nos. 45347, 45348. United States Board of Tax Appeals 26 B.T.A. 764; 1932 BTA LEXIS 1252; July 30, 1932, Promulgated *1252 Transactions in 1926 and 1927 between a corporation and certain stockholders, wherein the corporation paid par value to such stockholders for its own preferred stock, which it had issued in 1923 as a stock dividend, held actual sales by the stockholders to the corporation and not a distribution by the corporation of a taxable dividend under section 201(g) of the Revenue Act of 1926. Frederic Sammond, Esq., for the petitioners. W. Frank Gibbs, Esq., for the respondent. MCMAHON *764 These are proceedings, duly consolidated for hearing and opinion, for the redetermination of asserted deficiencies in income taxes as follows: Docket No. Year Amount 45347 [1926] $1,302.88 45348 [1926] 2,376.35 Do [1927] 1,008.40 In Docket No. 45347 the petitioner alleges that the respondent erred in including in gross income as taxable dividends received from the Kiel Furniture Company the amount received by the petitioner upon the selling to the company of 157 shares of its preferred capital stock owned and held by him, and in eliminating from gross income the amount of $1,808.17 reported as a taxable profit arising from the transaction. *1253 In Docket No. 45348 the petitioner alleges that the respondent erred (a) in disallowing as a deduction from gross income for 1926 losses aggregating $5,225.50, sustained upon securities purchased for profit; (b) in treating as dividends subject to tax the amounts of $15,300 and $8,000 received by the petitioner in 1926 and 1927, respectively, upon sales by the petitioner of preferred capital stock of the Kiel Furniture Company, and in failing to compute taxable profits upon the aforementioned sales of preferred capital stock of $3,122.73 and $1,632.80 for 1926 and 1927, respectively. FINDINGS OF FACT. The petitioner, Alfred A. Laun, is an individual, with his principal office at the Kiel Furniture Company, Milwaukee, Wisconsin. *765 The petitioner, J. B. Laun, is an individual, residing at Kiel, Wisconsin. Alfred A. Laun has been a director of the Kiel Furniture Company (hereinafter called the "Company") since 1923. In 1923 he was secretary-treasurer of the Company and has continuously since then held office in the Company, at the present time being president and treasurer. The petitioner, J. B. Laun, has been since 1923 and now is a director and chairman*1254 of the board of directors of the Company, but was not otherwise actively engaged in the business of the Company. Alfred A. Laun and his brother, J. B. Laun, owned about 90 per cent of the common stock of the Company and practically controlled it. At a meeting of the stockholders of the Company held on February 13, 1923, at its office in the city of Milwaukee, Wisconsin, a resolution was adopted authorizing the issuance of first mortgage serial six and one half per cent gold bonds, dated March 1, 1923, in the aggregate principal sum of $400,000, payment of same to be secured by a mortgage or deed of trust constituting a lien on all the properties, rights, privileges and franchises of the Company then owned or thereafter to be acquird by the Company, excepting only current assets. The stockholders at such meeting also adopted a resolution increasing the authorized capital stock of the Company from 5,000 shares of common stock at $100 per share, which was all issued and outstanding, to 10,000 shares of common stock at $100 per share and 5,000 shares of preferred stock at $100 per share, and amended the articles of organization accordingly. The articles as amended provide that*1255 the preferred stock shall be entitled to 6 per cent cumulative dividends, payable on the second day of January, and the first day of July in each year; that the preferred stock shall be preferred over the common stock in any distribution of assets other than profits not exceeding the par value thereof; and that all or any number of shares of preferred stock shall be redeemable at the option of the board of directors at any time at $106 per share together with unpaid accrued dividends. The articles as amended also provide for the creation of a sinking fund for the redemption or purchase of preferred stock out of surplus profits, the amount to be set apart and credited to such sinking fund to be computed by the board of directors as provided in such articles. The articles further provide that the funds in or credited to such sinking fund are to be used in the purchase and cancellation of preferred stock at prices not exceeding $106 per share, in the manner provided for in the by-laws, and the preferred stock so purchased and redeemed shall never be sold or reissued by the Company. *766 The by-laws of the company were also amended at this meeting. Article VIII, as amended, *1256 provides in part that at any time after February 1, 1924, if there shall be funds in the sinking fund amounting to not less than $10,000, the board of directors shall direct the treasurer of the Company to request sealed offerings of preferred stock from the holders thereof, and to accept for purchase and retirement, so far as the funds in the sinking fund may permit, stock offered at the lowest prices, not exceeding $106. Article IX of the by-laws, as amended, provides that the redemption of preferred stock shall be effected by the adoption of a resolution by the board of directors directing such redemption. At the meeting of the board of directors following the stockholders' meeting on February 13, 1923, the board declared a 30 per cent preferred stock dividend and authorized the issuance to each common stockholder of the number of shares equaling 30 per cent of the whole number of his shares of common stock whenever the Company should be legally authorized to issue such preferred stock, provided that no fractional shares should be issued, but in the event a stockholder was entitled to a fractional share as a part of such dividend, he was to receive in addition to the number*1257 of whole shares to which he was entitled in cash the par value of such fractional share, or, upon the stockholder's paying the par value of a whole share, less such fraction, he was to receive an additional whole share. No resolution to redeem the preferred stock was ever adopted by the board of directors and no preferred stock was ever redeemed in the manner provided in the articles and by-laws of the Company. However, every year from 1924 to 1927, both inclusive, notices were sent to preferred stockholders stating in part that in accordance with the articles and by-laws a certain sum had been credited to the sinking fund out of the surplus profits for the purpose of purchasing and retiring on a certain date, so far as the funds of the sinking fund would permit, outstanding preferred stock at the lowest prices at which such shares may be offered for sale to the Company. Such notices were sent out to preferred stockholders under the dates and with stated amounts of profit set aside for the purpose of purchasing said stock as follows: Date of notice Amount set Out of Date apart surplus profits of for year ended proposed Dec. 31 purchase Feb. 15, 1924 $13,000 [1923] Mar. 15, 1924 Feb. 14, 1925 28,000 [1924] Mar. 15, 1925 Feb. 27, 1926 33,000 [1925] Mar. 15, 1926 Feb. 16, 1927 30,000 [1926] Mar. 15, 1927 *1258 *767 No offers to sell preferred stock to the Company were ever made by preferred stockholders in response to such notices. No sinking fund was ever established. The Company merely set up on its books of account a so-called "Sinking Fund Reserve for the Redemption of Preferred Stock" account, to which it credited the percentage of profit of each year, commencing with profits earned in 1923, applicable for such purpose. These amounts were debited to the surplus account. As and when the preferred stock was purchased the total amount of such purchase was debited to the sinking fund reserve account and credited to the surplus account. The amounts paid by the Company for the preferred stock purchased by it were credited to the bank account and charged directly to the preferred stock account. In 1925 the Company purchased 280 shares of its preferred stock; in 1926 it purchased 330 shares, which included 153 shares purchased from J. B. Laun and 157 shares purchased from Alfred A. Laun; and in 1927 it purchased 300 shares, which included 80 shares purchased from J. B. Laun. The board of directors of the Company did not authorize or direct the above purchases or retirement*1259 of preferred stock by resolution or otherwise at any of its meetings, although it was discussed informally at its meetings. On all such purchases the Company paid the par value plus accrued dividends. As the auditors of the Company wanted the sinking fund reserve reduced in order to improve the position of the petitioner, and as no offers had been received from other preferred stock holders, the petitioners, Alfred A. Laun and J. B. Laun, sold to the Company 157 shares and 153 shares, respectively, in 1926, and in 1927 J. B. Laun sold 80 shares, both petitioners receiving the par value thereof plus accrued dividends. The operations of the Company during 1923 to 1927, both inclusive, resulted in a net profit each year. On July 38 1923, when the 1,500 shares of preferred stock were issued as dividends, the surplus amounted to about $180,000 on the books of account, which was earned subsequent to February 28, 1913. This surplus was not represented by cash or securities or specific assets, but used as working capital and was represented by the buildings, equipment in inventory and accounts receivable. In the year 1923, when the preferred stock dividend was declared, the financial*1260 condition of the Company was not liquid. The bond issue of $400,000 was authorized to retire heavy bank indebtedness. The cash balance was about $10,000 in July, 1923. It had no investment securities on hand. The purpose of the Company in providing for preferred stock was not only to issue a part of it as a dividend, but also to give the employees an opportunity to purchase the same. *768 In filing his income-tax return for the year 1926 the petitioner, J. B. Laun, did not report any profit as resulting from the sale to the Company of the 153 shares of preferred stock to the Company in 1926, nor did he report any profit in his income-tax return for the year 1927 as resulting from the sale of 80 shares of such stock to the Company in 1927. The petitioner, Alfred A. Laun, in his income-tax return for the year 1926 reported a profit of $1,808.17 as resulting from the sale to the Company of 157 shares of preferred stock of the Company. OPINION. MCMAHON. At the hearing the petitioner, J. B. Laun, moved to amend his petition by striking out the allegation of error (a) in Docket No. 45348 and subparagraph (a) of paragraph (5) of the petition, all relating to the*1261 alleged failure of the respondent to allow a deduction of $5,225.50 for losses alleged to have been sustained in the year 1926. This motion was granted. Therefore, the respondent's determination in this respect will not be disturbed. This leaves for consideration only one question. The respondent contends that the shares of preferred stock of the Kiel Furniture Company originally issued as a stock dividend were purchased and canceled "at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend," within section 201(g) of the Revenue Act of 1926. This contention is also made with respect to similar transactions between the petitioner, J. B. Laun, and the Company in 1926 and 1927. Both petitioners, on the other hand, contend that the transactions constituted sales, and Alfred A. Laun, in his income-tax return for 1926, reported the transaction as a sale with a resultant profit of $1,808.17. Section 201(g), supra, provides as follows: If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and*1262 in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend. In the case of the cancellation or redemption of stock not issued as a stock dividend this subdivision shall apply only if the cancellation or redemption is made after January 1, 1926. Whether or not the transactions between petitioners and the Company in 1926 and 1927 amounted to sales or were distributions "essentially equivalent to the distribution of a taxable dividend" depends upon whether or not the issuance of the preferred stock in *769 1923 by the Company was in fact a stock dividend. Whether or not it was a stock dividend is dependent upon the relevant facts. ; ; *1263 . In , it is held that a stock dividend is not taxable, and the Supreme Court states as follows: A "stock dividend" shows that the company's accumulated profits have been capitalized, instead of distributed to the stockholders or retained as surplus available for distribution in money or in kind should opportunity offer. Far from being a realization of profits of the stockholder, it tends rather to postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for actual distribution. The essential and controlling fact is that the stockholder has received nothing out of the company's assets for his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever accretions and accumulations have resulted from employment of his money and that of the other stockholders in the business of the company, still remains the property of the company, and subject to business risks which may result in wiping out the entire investment. * * * The board of directors of the*1264 company by resolution declared a preferred stock dividend. It is undisputed that the company did not have sufficient cash on hand to pay the dividend declared in cash. The Company had, however, a surplus of about $180,000, which was in excess of the amount of the dividend declared, but this surplus was not available for cash dividends. Although it was the intention of the Company, as is customary with respect to preferred stock, to retire and redeem preferred stock out of future earnings, such stock issued as a dividend is not a charge against future earnings, but against surplus already accumulated. . Whenever a cash dividend is declared the relation of the Company and its stockholders thereto is changed, the corporation becoming the debtor of the stockholders and the stockholders becoming the creditors of the corporation. , and cases cited therein. The relationship of debtor and creditor at no time arose in this proceeding between the Company and its stockholders or between the Company and the petitioners. The Company, instead of redeeming and retiring the stock as provided in its articles*1265 and by-laws, sent out notices giving the stockholders an opportunity to offer their stock for purchase by the Company, as provided in its by-laws. The purchase of such stock by the Company was at the option of the Company. At no time was the stockholder given the right to demand an exchange of cash for the stock. The redemption, retirement or purchase of the preferred stock was under the control of the board of directors of the corporation. *770 The fact that officers and directors anticipate future profits out of which to redeem or purchase preferred stock is not determinative of its character as a stock or cash dividend. If this were true, no preferred stock could be issued as a stock dividend. The respondent contends that the purchase of this stock by the Company was under the authority of the general scheme adopted in 1923. Even so, there is no evidence that a cash dividend was intended. It is proper for a corporation at the time it makes provision for the issuance of preferred stock also to make provision at the same time for its redemption, retirement or purchase by the company. This of itself does not indicate an intention on the part of the company or its*1266 directors and stockholders to evade taxation. That the laws of the State of Wisconsin permit the Company to purchase such stock, hold it as treasury stock, and treat it as an asset (Pabst v. Goodrich, 113 N.W.(Wis.) 398), as pointed out by respondent, is no reason why the Company could not legally purchase the preferred stock and retire and cancel the same. Its articles provide that the sinking fund is to be used for the purchase and cancellation and redemption of preferred stock and that the preferred stock purchased or redeemed by the Company shall never be sold or reissued by the Company. There is nothing in the record to indicate that the issuance of the preferred stock dividend was not a bona fide stock dividend. In view of the entire record and the intent and purpose of the Company therein disclosed and a consideration of all the relevant facts, we are of the opinion that the dividend declared in 1923 by the Company was a stock dividend, resulting in a dilution of the shares then outstanding. See also *1267 ;. The only case cited by the respondent in support of his contention that the distributions received by the petitioners represented proceeds from the retirement, redemption and cancellation of their stock by the Company and, therefore, under section 201(g), Revenue Act of 1926, were taxable as a dividend is . As pointed out in the opinion in that case, the testimony was confusing. The opinion further states that all the record clearly shows is that the taxpayer received a stock dividend in 1921 consisting of 249 shares, which, with some additional shares, he turned in to the corporation and thereupon his indebtedness to the corporation in the amount of $36,400 was canceled. The Board held in that case that the taxpayer's showing was not sufficient to warrant an overturning of the Commissioner's determination. That case is clearly not controlling in this proceeding and is not helpful. At the hearing it was stipulated that, in the event the Baord should hold that the transactions in question constituted sales, and *771 the amounts received*1268 by the petitioner, Alfred A. Laun, in 1926 and by petitioner, J. B. Laun, in 1926 and 1927, respectively, from the Company did not represent a taxable dividend, the petitioner Alfred A. Laun had reported the correct profit in his income-tax return for the year 1926, and that the profit from the sale of 153 shares in 1926 and 80 shares in 1927 by J. B. Laun to the Company should be computed upon the basis of $79.59 per share. Since we have held that the petitioners did not receive taxable dividends from the Company in the years involved, judgment will be entered in accordance with such stipulation. Reviewed by the Board. Judgment of no deficiency will be entered as to petitioner Alfred A. Laun. Judgment will be entered under Rule 50 as to petitioner J. B. Laun. TRAMMELL, MATTHEWS, and GOODRICH concur in the result. SMITH SMITH, dissenting: The transactions here involved were not sales, but in substance the "redemption in * * * part" of the stock distributed as a dividend by the corporation in 1923. At that time, the corporation had accumulated profits in excess of the amount of the stock dividend; instead of a cash dividend it declared the stock dividend, *1269 retaining the assets reflected in its surplus account, and provided for the redemption of the preferred stock from future earnings set aside for that purpose. Section 201(g) of the 1926 Act is not ambiguous and does not prescribe the method of redemption; the only restriction being that the redemption be treated as a taxable dividend to the extent of earnings accumulated since March 1, 1913. This stock was redeemed out of current earnings. I do not agree that the petitioners sold their stock to the corporation; but in any event, what is the basis upon which to compute their gain? I think the amount received by these petitioners was "essentially equivalent to the distribution of a taxable dividend" and should be taxed as such.