Proctor Shop, Inc. v. Commissioner

THE PROCTOR SHOP, INCORPORATED, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Proctor Shop, Inc. v. Commissioner Docket Nos. 58909, 66268. United States Board of Tax Appeals 30 B.T.A. 721; 1934 BTA LEXIS 1278; May 16, 1934, Promulgated *1278 1. Petitioner issued so-called "debenture preference stock" which is determined to be evidence of indebtedness rather than stock, and the payments made thereon at the rate of 6 percent per annum are held to be deductible as interest paid. 2. The evidence establishes that amounts equal to 2 3/4 percent of gross sales allowed by respondent as additions to reserve for bad debts are insufficient to cover actual bad debts, and that additions equal to 4 percent of gross sales as claimed by petitioner represent reasonable additions to the reserve. Roscoe C. Nelson, Esq., for the petitioner. Warren F. Wattles, Esq., for the respondent. ARUNDELL *721 These proceedings, duly consolidated for hearing, involve deficiencies in income tax for the fiscal years ended January 31, 1929 and 1930, in the respective amounts of $3,878.99 and $681.74. A salary question raised by the pleadings was abandoned by petitioner at the hearing, leaving for determination the question of the amounts deductible as additions to a reserve for bad debts for the period ended January 31, 1928, and the fiscal year ended January 31, 1929, and whether amounts accrued and deducted*1279 as interest were allowable *722 as such or constituted dividends on preferred stock. No deficiency has been asserted for the period ended January 31, 1928, but it is involved here by reason of the fact that petitioner claims to have sustained a net loss for that period which is carried over and used as a deduction for the succeeding year. FINDINGS OF FACT. Petitioner is an Oregon corporation organized on October 6, 1927. Upon its organization it purchased the assets of an existing business known as Proctor's, Incorporated, which was engaged in selling ready to wear women's apparel on the installment basis. Petitioner took over the assets and business as of October 1, 1927, and continued to conduct the business on the installment basis. Prior to the organization of petitioner several conferences were held between M. H. Holtz, who became president of petitioner, his father, Aaron Holtz, and the attorney for the petitioner on the question of financing the new enterprise. Aaron Holtz was willing to lend the necessary funds to the contemplated organization, but was not willing to accept stock because he desired to be assured that his advances would be repaid, and he*1280 also wanted a definite income from the funds. It was deemed inadvisable to issue bonds to cover the loans, as that would affect the credit of the corporation. It was finally decided by the attorney for the petitioner to have the new corporation issue a form of "debenture preference stock" to Aaron Holtz as evidence of the amounts advanced by him. The conclusions of the attorney were set forth in a letter to M. H. Holtz, reading in part as follows: I have, therefore, reached the conclusion that the best solution would be to create a form of obligation, which we will call for want of a better name, "debenture preference stock." While the certificates will be called "stock", you will understand that it is not stock in any real sense. Labels are of little significance. A mortgage, for instance, remains a mortgage even though it may be in the form of a deed. The advantage of calling it "stock" is that in your statements to banks and mercantile agencies you need not list it as a liability, because, under the plan I am suggesting, while it will represent a liability as between the corporation and Aaron Holtz, it will not be a liability insofar as concerns the banks and mercantile*1281 creditors, because I understand from my talk with him that Aaron Holtz is willing that the banks and mercantile creditors, in the event of insolvency or liquidation take precedence over him. He in turn will take precedence over stockholders. The so-called "stock certificates" will provide definitely for the payment of interest whether profits are earned or not, so that except for the fact that Aaron Holtz waives his right to share with other creditors until they have been paid, he will be entitled to a definite interest return, and the failure to pay this interest will place him in position to sue the corporation for the principal amount represented by the certificates. As a stockholder, of course, he would have no such right. *723 Petitioner's articles of incorporation filed with the corporation department of the State of Oregon on October 6, 1927, state that the authorized capital stock consists of 10 shares of common stock of the par value of $100 each, and 990 shares of preferred stock of the par value of $100 each. The preference, rights, privileges, and restrictions on each class of stock are described as follows in the articles of incorporation: The capital*1282 stock of this corporation shall be $100,000.00 divided into the following classifications: (a) Debenture preference stock of which there shall be 990 (nine hundred and ninety) shares of the par value of $100.00 (One Hundred Dollars) each, aggregating $99,000.00; and (b) Common stock of which there shall be 10 (ten) shares of the par value of $100.00 (One Hundred Dollars) each, aggregating $1,000.00. Said debenture preference stock shall be entitled to cumulative interest at the rate of six per cent per annum, payable quarterly, commencing October 1, 1927, before any dividends are paid on the common stock, and the common stock is entitled to all dividends in excess of said six per cent. In the event of the dissolution of the corporation or distribution of its assets, the debenture preference stock outstanding at that time shall first be paid at par, plus all accumulated unpaid interest, and the remainder of the corporate assets shall be divided ratably among the holders of the common stock. The voting power at any stockholders' meeting shall be confined exclusively to holders of common stock. The corporation shall reserve the right to redeem any number or all of the certificates*1283 of debenture preference stock at par plus accumulated interest at any time after December 1, 1927. The said corporation shall be bound to redeem monthly, beginning December 1, 1927, debenture preference stock of the par value of $1500.00 (Fifteen Hundred Dollars) as a minimum. Such retirement, unless same be incidental to liquidation, shall follow the certificates in numerical order. In the event of the issuance of new certificates upon surrender of original certificates, such new certificates shall take the place of those originally issued insofar as the order of redemption is concerned. Failure of said corporation for a period of two years to pay any quarterly interest hereon, as same becomes due and payable, shall render the corporation in default as to such payment and entitle the owners of certificates as to which delinquency occurs, to declare the principal amount of such certificates due and to institute action against the corporation for the par value of said certificates and the accumulated interest thereon. The rights of the holders of debenture preference stock shall, however, be limited in the following respect: In the payment of their several claims all general creditors*1284 shall rank superior to the holders of debenture preference stock, but all holders of debenture preference stock shall rank pari passu with each other and superior to holders of any other class of stock of the corporation. Upon incorporation 990 shares of the stock described as debenture preference stock were issued to Aaron Holtz. The stock certificates for such stock contained on the face of them the provisions above quoted from the articles of incorporation. In its annual report to the state corporation department for the year ended January 31, 1928, petitioner reported its authorized *724 capital stock to consist of 10 shares of common stock and 990 shares of debenture preference stock, each of the par value $100of per share. Amounts representing 6 percent per annum on the amount of $99,000 were paid by petitioner to Aaron Holtz, and accrued on its books for the period ended January 31, 1928, and the fiscal years ended January 31, 1929 and 1930. The amounts so paid and accrued have been claimed as interest deductions by petitioner and have been disallowed as deductions by the respondent. Among the assets which petitioner acquired at October 1, 1927, from its*1285 predecessor were accounts receivable which aggregated $124,686.36. At that time it was determined that at least 12 1/2 percent of such receivables were worthless and petitioner was allowed a discount equal to that percentage amounting to $15,585.79, the result of which was that petitioner paid $109,100.57 for the accounts. In making its opening entries petitioner entered the accounts receivable at the face amount of $124,686.36 and credited the discount of $15,585.79 to a reserve for bad debts. Petitioner established a fiscal year basis ending January 31 for filing its income tax returns. Throughout the years here involved petitioner followed the practice of charging against its reserves for bad debts the amount of those accounts ascertained to be worthless, and crediting to the reserve an amount equal to the total of those accounts upon which no payments had been made for four months or more and which it classified as doubtful accounts. The figures for the several years are as follows: [1930] Initial reserve $15,585.79 $18,369.94 $22,518.55 Bad debts 15,636.98 12,812.81 21,331.71 Balance in reserve 1 51.19 5,557.13 1,186.84 Doubtful accounts 18,369.94 22,518.55 21,171.56 Added to reserve 18,421.13 16,961.42 19,984.72 *1286 Petitioner's gross sales and the amounts of the additions to reserves for bad debts allowed by the respondent, which additions were based on a percentage of gross sales were as follows: Period or year ended - Gross sales Additions allowed Percent of sales January 31, 1928 $197,294.79 $5,425.61 2 3/4 January 31, 1929 544,406.09 14,971.17 2 3/4 January 31, 1930 515,325.80 25,766.29 [5] *725 Amounts of $7,891.79 for the period ended January 31, 1928, and $21,776.24 for the year ended January 31, 1929, which are equal to 4 percent of gross sales for that period and year, respectively, are reasonable additions to petitioner's reserve for bad debts. OPINION. ARUNDELL: The first question is whether petitioner's payments to Aaron Holtz of 6 percent on his "debenture preference stock" were payments of dividends or interest. Petitioner claims that the real relation between it and Holtz was that of debtor and creditor and the annual sums paid are deductible as interest on borrowed money. This question has been presented a number of times to the Board and the courts under slightly varying facts. *1287 In some cases the so-called stock was to be retired at a fixed date, ; reversed, , and in others at the option of the corporation or the stockholder, ; affd., . In some cases the interest or dividends were payable regardless of earnings, , and in others payments were to be made only out of surplus or profits, , sustaining ; ; ; affd., . None of the decided cases lay down any comprehensive rule by which the question presented may be decided in all cases, and "the decision in each case turns upon the facts of that case." ; affirming *1288 ; ;. In each case it must be determined whether the real transaction was that of an investment in the corporation or a loan to it. On this the designation of the instrument issued by the corporation, while not to be ignored, is not conclusive, . The real intention of the parties is to be sought and in order to establish it evidence aliunde the contract is admissible. If the evidence establishes "that dividends paid are, according to the intent of the parties, in fact interest, and the stock on which the dividends are paid is merely held by the creditor as security, it makes no difference what the reason was for paying in that form." In the present case it was obviously the intent of the interested parties that the $99,000 advanced by Aaron Holtz to the petitioner corporation was to be regarded as a loan. The uncontradicted evidence *726 is that Holtz did*1289 not want to stand in the relation of a stockholder to the corporation. He wanted a definite income from the money advanced and assurance that he would be repaid. The only reason for not openly treating the $99,000 as a loan was to aid the corporation in obtaining a credit rating. The lender was not restricted to corporate earnings for the return on his advances, and upon default for two years had a right of action against the corporation for both principal and interest. It is our opinion that in reality the relation of Aaron Holtz to the petitioner corporation was that of creditor rather than stockholder. Consequently, the sums representing 6 percent upon his loans are interest and deductible by the petitioner. The issue on the reserve for bad debts covers the period ended January 31, 1928, and the fiscal year ended January 31, 1929. The fiscal year ended January 31, 1930, is not involved under this issue, although evidence pertaining to that year was introduced. The amounts claimed by petitioner in its returns for the periods under review, the amounts allowed by the respondent, and the amounts now claimed by petitioner as reasonable additions to the reserve for bad debts*1290 are as follows: January 31, 1928 January 31, 1929 Originally claimed $18,421.13 $16,961.42 Allowed 5,425.61 14,971.17 Presently claimed 7,891.79 21,776.24 The amounts now claimed represent 4 percent of gross sales, and the amounts allowed by respondent are 2 3/4 percent of gross sales. As set out in the findings of fact, the practice of petitioner was to credit to the bad debt reserve an amount equal to the total of accounts which were delinquent for four months. Against the reserve was charged the actual bad debts. The actual bad debts for the period ended January 31, 1928, were $15,636.98 and for the fiscal year ended January 31, 1929, they were $12,812.81, a total of $28,449.79, against total additions to reserves now claimed in the amount of $29,668.03, and $20,396.78 allowed by the respondent. These figures demonstrate that the additions allowed by the respondent were insufficient to care for bad debts and also establish that the amounts now claimed by petitioner are not unreasonable additions. In our opinion the amounts now claimed by petitioner should be allowed as deductions of reasonable additions to its reserve for bad debts. At*1291 the trial of these proceedings a question arose as to the effect of setting up an initial reserve for bad debts in the amount of $15,585.79 representing 12 1/2 percent of the accounts receivable purchased *727 by petitioner from its predecessor. The evidence develops that the amount so credited to the reserve account has not been charged to earnings or surplus, nor has a deduction ever been claimed in respect of it in petitioner's income tax returns. Petitioner does not now claim any deduction on account of the $15,585.79 credited to the reserve at the opening of its books, but claims deductions for additions thereto in amounts representing 4 percent of its sales, which we have held above are allowable. The initial reserve does not appear to have any bearing upon the questions presented for decision. Decision will be entered under Rule 50. Footnotes 1. Deficit. ↩