Sauk Inv. Co. v. Commissioner

SAUK INVESTMENT COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Sauk Inv. Co. v. Commissioner Docket No. 74642. United States Board of Tax Appeals 34 B.T.A. 732; 1936 BTA LEXIS 652; July 1, 1936, Promulgated *652 Petitioner corporation was organized in 1927 by its four stockholders holders to take over a contract for the purchase of 1,120 shares of stock of another corporation, the purchase price being payable over a period of five years, which was entered into by one of its stockholders and assigned in parts to the other three stockholders. The stockholders were required to make substantial advances to petitioner to meet payments of interest and principal under the contract. While the petitioner had accumulated a book surplus at the end of 1930, it had no cash on hand and no assets which it could divide or distribute to its stockholders as a dividend. Held, the petitioner was not formed in 1927, or availed of in 1930, for the purpose of preventing the imposition of surtaxes upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed. Joseph Nievinski, Esq., and A. G. Elder, Esq., for the petitioner. Elden McFarland, Esq., for the respondent. MCMAHON *732 This is a proceeding for the redetermination of a deficiency in income tax for the year 1930 in the amount of $62,878.89. *653 It is alleged in the petition that the respondent erred in determining that the gains or profits of the petitioner were permitted to accumulate beyond the reasonable needs of its business instead of being distributed and that the petitioner was formed or availed of to prevent the imposition of surtaxes on its stockholders. FINDINGS OF FACT. Under date of September 2, 1927, Wm. C. Butler of Everett, Washington, and C. H. Cobb of Seattle, Washington, entered into a written *733 agreement, hereinafter referred to as the Butler-Cobb contract, wherein C. H. Cobb agreed to sell and Wm. C. Butler agreed to buy 1,120 shares of the capital stock of the International Timber Co., hereinafter referred to as the Timber Co., a Washington corporation, for and in consideration of $400 per share, or a total consideration of $448,000, payable as follows: $162,000 upon execution of the agreement, which amount was paid by Wm. C. Butler accordingly, $58,000 on or before September 1, 1928, and $57,000 on or about September 1, of each year from 1929 to 1932, inclusive, the deferred payments to bear interest at the rate of 6 percent payable semiannually, commencing September 2, 1927, on the*654 first days of March and September. The contract recites, among other things, that the 1,120 shares, endorsed in blank, have been deposited with the First National Bank of Everett, hereinafter referred to as the National Bank, and it provides that all payments under the contract shall be made at such bank; that upon payment in full of the purchase price, with interest, such bank shall deliver the stock to Wm. C. Butler; that in case of default, the stock shall, upon 30 days notice mailed to Wm. C. Butler, be returned to C. H. Cobb for sale by him at public auction at which the latter may be a purchaser, the proceeds, less the expense of sale, to be credited upon the contract, Wm. C. Butler being liable for any deficiency after such credit; and that all dividends declared upon the stock prior to full payment therefor shall be delivered to the bank and credited on the payment next due. In 1927 and thereafter the Timber Co. had 5,000 shares of this stock outstanding. Under date of September 7, 1927, Butler assigned interests in the Butler-Cobb contract for considerations paid in part and deferred as follows: Consideration Interest Paid on or about Sept. 7, 1927 Payable in 5 equal annual installments beginning on or before Sept. 1, 1928 T. N. C. Jamison 229/1120 $33,123.20 $58,476.80 To Eleanor E. Butler, wife of Wm. C. Butler 200/1120 28,928.56 51,063.44 To L. L. Crosby 100/1120 14,464.28 25,531.72 *655 The assignments, all in similar form, provide that all dividends declared and paid upon the 1,120 shares of Timber Co. stock shall, as and when credited on the Butler-Cobb contract, be credited upon the deferred payments required to be made by each assignee to the extent of the proportionate interest of each; that when all deferred payments have been made, together with interest at 6 percent per *734 annum, payable semiannually, from September 2, 1927, on the first days of March and September, Butler shall cause to be delivered to the assignees 229, 200, and 100 shares, respectively, of the stock of the Timber Co.; and that, in the event that any default in the payment of any deferred installment or interest thereon is not made good after 30 days notice, the defaulting assignee shall thereafter have no interest in the Butler-Cobb contract, or the subject matter thereof, and all moneys theretofore paid shall be forfeited as liquidated damages and the interest of the defaulting assignee in such contract shall revert to Butler. To induce Cobb to consent to the assignment of the Butler-Cobb contract to a corporation, Butler and Cobb entered into another agreement under date*656 of September 12, 1927, wherein Butler guaranteed to Cobb, his heirs, personal representatives, and assigns, that such corporation as assignee would comply with all the terms of the Butler-Cobb contract and, in the event of its failure so to do, obligated himself, his heirs, and personal representatives to make all the payments and perform all the conditions of such contract. On November 14, 1927, the petitioner, Sauk Investment Co., was organized under the laws of the State of Delaware, with an authorized capital stock of 5,000 shares of no par value, for the purpose of acquiring the Butler-Cobb contract, its principal place of business being at the National Bank, Everett, Washington. The interests of Butler, his wife, Jamison, and Crosby in the Butler-Cobb contract were duly assigned to and accepted by the petitioner under date of December 24, 1927, in full payment for the issuance to them of the stock of the petitioner as follows: Butler 591 shares, his wife 200 shares, Jamison 229 shares, and Crosby 100 shares. Such assignment recites that it is understood that Butler is bound to make the deferred payments provided for in the Butler-Cobb contract, and that Jamison, Butler's wife, *657 and Crosby are bound to make the deferred payments, heretofore set forth, to Butler, and pledges their shares of petitioner's stock to Butler as security therefor. The Timber Co., after the execution of the Butler-Cobb contract, paid dividends in cash as follows: October 29, 1927 $11,200 May 4, 1928 11,200 December 1, 1928 11,200 These dividends were paid by the Timber Co. to the National Bank and by it credited to the account of Cobb and applied on the Butler-Cobb contract. On or about January 2, 1930, the Timber Co. declared a dividend out of its book surplus, $2,598,000, in bonds of the face value of $2,500,000, consisting of $500,000 first mortgage bonds and $2,000,000 second mortgage bonds, the rate of interest on both issues being 6 percent payable quarterly. Funds for the payment of these *735 bonds and interest thereon were to be provided by the creation of a sinking fund, deposited with the Everett Trust & Savings Bank, as trustee, hereinafter referred to as the trustee, by the payment to the trustee of $3.75 per thousand as the timber was cut. The surplus of the Timber Co. was represented almost entirely by fixed assets consisting mostly*658 of standing timber. The bonds were held by the trustee and, in lieu thereof, the trustee issued participation certificates to the stockholders of the Timber Co. proportionate to their stockholdings. The bond dividend allocated to the 1,120 shares of such stock consisted of $112,000 face value first mortgage bonds and $448,000 face value second mortgage bonds and participation certificates therefor were issued to Cobb, who endorsed them and turned them over to the National Bank pursuant to the Butler-Cobb contract. The first mortgage bonds were retired to the extent of slightly in excess of 50 percent during 1930 and were paid in full and retired on March 17, 1932. Prior to July 1930 the trustee made four payments in the aggregate amount of $41,888 in retirement of the first mortgage bonds issued to Cobb, which payments were made to the National Bank to be applied on the Butler-Cobb contract. As $70,112 of the face value of the first mortgage bonds issued to Cobb remained unpaid on July 1, 1930, Butler purchased such bonds pursuant to still another agreement with Cobb to purchase the same if not paid by July 1, 1930, by the Timber Co., and paid therefor $70,112, which was applied*659 on the Butler-Cobb contract, and received the trustee certificates for such bonds. Interest on the first mortgage bonds in the aggregate amount of $2,906.59 was paid to the National Bank and by it applied on the Butler-Cobb contract. The trustee made three payments of principal on the second mortgage bonds - one in November 1933 of $21,600, one in December 1933 of $59,000, and one in July 1934 of $25,000. No further payments of principal have since been made on such second mortgage bonds. The share of the first two payments of principal allocated to the $448,000 second mortgage bonds was $4,838.40 and $13,216, respectively. One payment of interest, in the amount of $6,720, was made in April 1930 on the second mortgage bonds for the three-month period ending March 31, 1930, which was paid to the National Bank and applied on the principal of the Butler-Cobb contract. The stockholders waived the interest due on the second mortgage bonds for 1931 and 1932. The Timber Co. is in default on account of principal and interest due on the second mortgage bond issue. The stockholders of petitioner advanced to the petitioner in proportion to their respective interests, from 1927 to 1932, *660 inclusive, a total of $42,491.09 to meet interest payments under the Butler-Cobb contract and from 1928 to 1932, inclusive, a total of $130,773.41 to *736 meet installments of principal due under such contract, as the petitioner did not have sufficient cash on hand to meet such payments. None of these advances was repaid to the stockholders by the petitioner except the amount of $15,833.61 paid to them in 1933. Interest in the total amount of $42,491.09 was paid on the Butler-Cobb contract by the petitioner. Final payment on principal was made on the Butler-Cobb contract in September 1932. The petitioner on December 31 of each year from 1927 to 1932, inclusive, had no cash on hand. On December 31, 1933, it had cash on hand in the amount of $1,311.91. The petitioner's books of account in 1930 showed a surplus of $144,115.11. The first and second mortgage bonds of the Timber Co. were entered as received by the petitioner on its books of account under date of January 2, 1930, at par. Of such par value, in the aggregate amount of $560,000, the amount of $138,936 was credited to the surplus account and the amount of $421,064 was credited as a return of capital upon the*661 1,120 shares of stock of the Timber Co. On December 31, 1930, the total amount of accounts payable appearing on petitioner's books of account was $169,820.89, consisting of the balance due on the Butler-Cobb contract in the amount of $49,373.41, and advances made by stockholders to the petitioner on account of principal payments made on such contract in the amount of $81,400 and on account of interest payments made thereon in the amount of $38,047.48. The gross profits of the Timber Co. for 1929 were approximately $1,230,000 and its net income for that year was $235,843. The income tapered off in the last part of the year. In his computation of the tax liability of the petitioner the respondent allocated $426,654.95 of the aggregate par value of the first mortgage bonds and second mortgage bonds of $560,000 to a return of capital and $133,345.05 to income from dividends received. He determined petitioner's net income under section 104(c) of the Revenue Act of 1928 to be $125,757.77, arrived at by deducting a net loss of $7,587.28 from the above amount of $133,345.05. The petitioner was not formed in 1927 for the purpose of preventing the imposition of the surtax upon its*662 shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed; it was not availed of in 1930 for such purpose; and petitioner's gains and profits were not permitted to accumulate in 1930 beyond the reasonable needs of its business. OPINION. MCMAHON: The question to be considered herein is whether the petitioner was formed in 1927 or availed of in 1930 for the purpose of preventing the imposition of the surtax upon its shareholders *737 through the medium of permitting its gains and profits to accumulate instead of being divided or distributed within the meaning of section 104(a) and (b) of the Revenue Act of 1928. 1 Subsection (b) of that section provides that the fact that any corporation is a mere holding or investment company shall be prima facie evidence of a purpose of evading the surtax. However, this presumption is not sufficient to fix liability under such statute; "the test remains the state of mind itself, and the presumption does no more than make the taxpayer show his hand." *663 . Here the petitioner was organized in 1927 for the purpose of acquiring the Butler-Cobb contract, and, except for the acquisition of such contract*664 and the performance of the obligations arising thereunder, the petitioner transacted no other business. Butler testified, in substance, that the purchase of the stock was a very large purchase, payments for which extended over a period of five years during which something might happen to any one of the four interested therein; that it was necessary for his protection as guarantor of the contract to keep the stock together; that the petitioner was organized so that he could keep the stock together by his control of the petitioner; that, further, it would have been very disrupting in the event one of the parties to whom he has made a partial assignment died or the interest of any one of them became subjected to an attachment by creditors. Jamison testified, in substance, that the reason for incorporating the petitioner was to hold the block of stock purchased intact, to control the vote and to protect Butler if anything happened to the minor participants in the contract, as he understood that the whole contract, being a joint contract, under the laws of the State of Washington would be subject to probate upon the death of any one of the assignees. The testimony of Crosby was to similar*665 effect. Butler testified further that, although in 1927 the prospect of a dividend from the Timber Co. was excellent, there was then no immediate prospect of a dividend; that the payment of a dividend by the Timber Co. was dependent upon future trade conditions and operations; and that the question of paying for the stock in the next five years absorbed them. *738 The respondent argues that if the corporation had not been formed by Butler, his wife, Jamison, and Crosby, they would have received the bond dividends in 1930 and would have had to pay taxes computed upon the par value of the bonds, in the additional amounts of at least $14,072.89, $4,762.40, $850.06, and $476.24, respectively. However, in , the Board stated, "But the taxes under these statutory provisions are not imposed because of effects; avoidance per se is not prohibited. It is the purpose, the intention motivating a course of conduct which is made controlling by the very words of the statute. Unless the purpose was to prevent the imposition of surtaxes, the tax may not be imposed." In our opinion, and we have so found, the petitioner*666 was not formed in 1927 for the purpose of preventing the imposition of the surtax upon its stockholders in 1930 through the medium of permitting its gains and profits to accumulate instead of being divided or distributed. Was the corporation availed of in 1930 for such purpose? It is apparent that, although the petitioner had a book surplus of $144,115.11 at the end of 1930, the petitioner had no funds or property which it could distribute to its shareholders; it had no cash on hand and the participation certificates representing the first and secon mortgage bonds issued by the Timber Co. as a dividend were held by the National Bank in escrow under the terms of the Butler-Cobb contract. Its only remaining asset was the Butler-Cobb contract, which had not been completed and upon which there was still owing an unpaid balance of $49,373.41. The instant proceeding is distinguishable from cases wherein it was held that the corporations therein involved were formed or availed of for the purpose of preventing the imposition of surtaxes upon its shareholders, it appearing therein that the shareholders withdrew or borrowed substantial available sums from such corporations for their own*667 purposes. 2 In the instant proceeding the stockholders did not withdraw funds from the petitioner, but the petitioner was indebted to its stockholders at the end of 1930 for advances made to it from 1927 to 1930, inclusive, in the aggregate amount of $119,447.48. Except for the profit for the year 1930 in the amount of $4,522.52, representing the difference between interest received in 1930 in the amount of $9,626.59 and interest paid in 1930 in the amount of $5,104.07, the surplus account discloses no other profits, except the cash dividends received in 1927 and 1928 in the amounts of $11,200 and $22,400, respectively, *739 and the amount of $138,936, representing the portion of the par value of the first and second mortgage bonds received as a dividend in 1930 allocated to income or earned surplus, which latter amount was adjusted by the respondent to $133,345.05. Prior to 1930 the petitioner had no interest income. The total amount of interest paid in each year prior to 1930 was carried into surplus as a loss for each year. There was no accumulation of surplus beyond the reasonable needs of petitioner's business in 1930. Except that portion represented by the second*668 mortgage bonds, all of it had been applied and paid on the Butler-Cobb contract. As heretofore stated, the participation certificates representing the second mortgage bonds were held in escrow by the National Bank. Under all the facts and circumstances we are of the opinion, and have so found, that the petitioner was not availed of in 1930 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed; and its gains and profits were not permitted to accumulate in 1930 beyond the reasonable needs of its business. The respondent points on brief to his Exhibit F as*669 strong evidence that the petitioner was availed of for the purpose of evading surtaxes, and in particular to the statement therein as follows: * * * It is understood that when such assignment shall have been made such dividends as may be declared upon the International Timber Company shares will, in effect be payable to the Delaware Corporation, although the said shares of the International Timber Company still stand in the name of the seller, assigned by him in blank and deposited in escrow in a bank with the contract of purchase, and said dividends being in effect payable from one corporation to another corporation, will not be subject to the Federal Income Tax until they are paid out by the Delaware Corporation [petitioner] by way of dividends. The accountant testified, among other things, that he was secretary of the petitioner merely for the purpose of keeping its books since its incorporation; that he had two other men who assisted him in keeping the records and in preparing the tax returns for 27 corporations; that he usually prepared a memorandum similar to Exhibit F so that if anything happened to him the men would know what he had done; that he knew, as appears in*670 the memorandum, that the petitioner was to be formed; that the information contained in the first part of the above quoted statement was obtained from the Butler-Cobb contract itself and not from his discussion with Butler; that he did not talk about the transaction with any stockholder other than Butler; that, when he added the portion of such statement to the effect that dividends payable by one corporation to another corporation will not be subject to Federal income tax until paid out *740 to shareholders, he probably had in mind the effect that this would have upon the petitioner's Federal income tax return because that was the law and he knew that he would be called upon to make its returns and take care of matters of that sort; that he prepared the memorandum for his own use and attached it to the journal of petitioner; that he did not at any time exhibit such memorandum to Butler or the other shareholders; and that he voluntarily turned over such memorandum to the revenue agent who examined the books of petitioner and permitted him to take it out of the office for the purpose of making a copy thereof. Butler testified that such accountant was the "head of the office", *671 that such accountant was entrusted with the bookkeeping and the preparation of the tax return of petitioner; that he never looked over the books and records of the corporation; that the accountant and the books were on the floor above; that he never went up to the accountant but that the accountant came down to him; and that he had never seen such memorandum. Section 23(p)(1) of the 1928 Act provides that dividends received by a corporation from a domestic corporation shall be allowed as a deduction from gross income; and the Butler-Cobb contract provided that any dividends which might be received from the Timber Co. were to be applied on the contract. Hence, the accountant's explanation of the preparation of such memorandum, and in particular the quoted portion thereof, is plausible and reasonable, especially in view of the fact that he was expected to prepare the petitioner's tax returns. Under all the facts and circumstances, in any event, such statement in the memorandum is not sufficient to sustain a finding or holding of a purpose or intention on the part of Butler and his associates to form the petitioner in 1927 or avail of it in 1930 for the purpose of evading surtaxes*672 as contemplated by the applicable statute. There is no evidence that such purpose or intention was disclosed to the accountant, or that such memorandum actually reflected such purpose or intention on the part of Butler and his associates, or that such purpose or intention on their part existed, sufficient to justify such findings or holdings. The petitioner also adduced evidence as to the value of the bonds of the Timber Co. issued as dividends and in particular pertaining to the value of the second mortgage bonds in support of its claim that the book surplus was overstated in that the value of the bonds was considerably below par. It is also contended by petitioner that the bonds were payable out of a sinking fund to be created by contributions on the basis of $3.75 per thousand feet of lumber logged and hence were not a taxable distribution. In view of our holding that the petitioner was not formed in 1927 or availed of in 1930 for the purpose of preventing the imposition of surtaxes upon its shareholders through the medium of permitting its gains and profits to *741 accumulate beyond the reasonable needs of its business instead of being divided or distributed, as heretofore*673 fully set forth, it is not necessary for us to pass upon these or other contentions of the petitioner not heretofore disposed of herein or other questions suggested by the record; but see , to the effect that a corporation owning less than a majority of the stock of another corporation may be a "holding" company within the meaning of the applicable statute. Reviewed by the Board. Decision will be entered for the petitioner. Footnotes 1. SEC. 104. ACCUMULATION OF SURPLUS TO EVADE SURTAXES. (a) If any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 13 and shall be computed, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax. (b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax. ↩ 2. ; affirmed in ; certorari denied, ; ; ; . See Gardiner v. Welch,↩ Fed.Supp. (Dist. Ct., S. Dist. Cal., Feb. 13, 1936).