S. K. Ames, Inc. v. Commissioner

S. K. AMES, INC. (NOW KNOWN AS KENNEDY & CO.), PETITIONER. v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. S. K. Ames, Inc. v. Commissioner Docket Nos. 105891, 106946. United States Board of Tax Appeals 46 B.T.A. 1020; 1942 BTA LEXIS 786; April 28, 1942, Promulgated *786 Petitioner entered into a contract to purchase from X corporation the common stock of Y corporation, the price to be the net worth of Y. The price was paid and the stock delivered. The same contract contained an executory agreement that petitioner would purchase or cause to be purchased from X certain preferred stock of Y, payments to be made on or before a certain date in each year. X was permitted at any time to sell all or any part of the preferred stock to any other person. Petitioner caused Y to purchase the preferred stock, which Y then held as treasury stock. Respondent seeks to tax to petitioner the payments made by Y to the extent such payments were made out of earnings as constituting a constructive dividend received through the discharge of an obligation. Held, that purchase of the stock by Y itself was a satisfaction of the obligation in accordance with its very terms and did not constitute income to petitioner. United Statesv. Kirby Lumber Co., 284 U.S. 1, distinguished; held, further, that dividends paid to the owners of the preferred stock, none of which was owned by petitioner, are not taxable to it. Edward J. Keelan, Jr., Esq.,*787 and Joseph N. Welch, Esq., for the petitioner. J. T. Haslam, Esq., for the respondent. SMITH *1021 These proceedings, consolidated for hearing, are for the redetermination of deficiencies in income tax and excess profits tax as follows: Docket No. Year Income tax Excess profits tax 105891 [1936] $47,378.75 $3,169.60 106946 [1937] 35,061.71 2,889.00 The petitioner contends that no deficiencies are due and that it overpaid its taxes in the amount of $4,284.80 for the year 1936 and in the amount of $6,374.18 for the year 1937. The issues presented for consideration are (1) whether the petitioner constructively received dividends in the taxable years in the amounts of $120,594.87 in 1936 and $142,090.18 in 1937; and (2) whether the petitioner is entitled to credits against its undistributed net income in each of the taxable years under the provisions of section 26(c)(1) and (2) of the Revenue Act of 1936. FINDINGS OF FACT. The petitioner is a Massachusetts corporation, with its principal office located in Boston. Petitioner's income and excess profits tax returns for the years involved were filed with the collector*788 of internal revenue for the district of Massachusetts. In 1940 the petitioner merged with another corporation, "Kennedy & Co., Inc.," and since then that has been petitioner's name. Whenever Kennedy & Co. is mentioned hereinafter we do not refer to petitioner but to the company which was known by that name prior to the merger of the two. On December 27, 1929, the petitioner and Adriel U. Bird, as buyers, entered into two written contracts with Kennedy Bros., Inc., as seller, to purchase the entire outstanding common stock of Kennedy & Co. then owned by it. Bird's relation to the transaction was that of guarantor of the petitioner's performance of the contract. One of these contracts merely sets forth the procedure to be followed in purchasing the common stock and will not be referred to hereafter. Under the other contract the petitioner agreed to pruchase the outstanding 25,000 shares of the common stock of Kennedy & Co. The *1022 cost of the stock to the petitioner was to be the net worth of the company as determined in accordance with a formula provided in the contract. In December 1929 Kennedy & Co. had outstanding 5,000 shares of 8 percent cumulative preferred*789 stock with a par value of $500,000. It was agreed that the capital structure of Kennedy & Co. would be rearranged by the issuance of 10,000 shares of cumulative 7 percent preferred stock having a par value of $100 per share in place of the outstanding preferred stock. Paragraph 17 of the contract provided that "The SELLER will sell and the BUYERS will purchase or cause to be purchased said One Million Dollars ($1,000,000) of preferred stock of said Kennedy & Co., Inc., at One Hundred Dollars ( $100) per share, plus accrued dividends." Paragraph 17 further provided that payments in the amount of $200,000 would be made by the buyer on or before December 31, 1931, and on the same date in each ensuing year up to and including 1935, provided the net earnings of the company were sufficient to make such payments. It was agreed that the net earnings of Kennedy & Co. would be applied to the obligations of the buyers to the seller under the contract. Paragraph 30 of the contract provided that in the event the seller desired to sell the stock to any person other than the petitioner it might do so and would then be under no further obligation to sell and deliver the stock to the petitioner*790 and the petitioner would be under no further obligation to purchase the stock. The contract also provided that when the seller received the new issue of preferred stock it would deliver the certificates endorsed in blank to an agent who was to receive all payments and make all transfers to buyers. The dates on which payment on the preferred stock was due were changed in a contract executed on January 31, 1934. In that contract it was provided that payment would be due on January 31 in the years 1935 and 1936 and additional payments would be due on or before December 31 in the years 1936, 1937, and 1938. The 1934 contract made no other material modifications of the 1929 agreements. The net worth of Kennedy & Co. was computed in accordance with the formula provided in the contract. Thereafter, in February 1930, Kennedy & Co. purchased 12,800 shares of its own common stock at the formula price of $276,986. The remainder of the outstanding common stock of Kennedy & Co., or 12,200 shares, was purchased by the petitioner at the formula price of $244,423.86. Petitioner has never received any dividends on this common stock. In addition the petitioner caused Kennedy & Co. from time*791 to time to purchase all of the preferred stock which was issued in accordance with the contract executed in 1929. The petitioner never purchased any of the preferred stock of Kennedy & Co. In 1936 Kennedy & Co. paid *1023 $200,000 to Kennedy Bros., Inc. for its own preferred stock. Of this amount $101,344.87 was paid out of earnings and the balance was paid out of capital. In 1937 Kennedy & Co. paid $150,000 to Kennedy Bros., Inc. for the preferred stock. Of this amount $131,590.18 was paid out of earnings and the balance was paid out of capital. At the close of the year 1937 all of the outstanding preferred stock had been purchased by Kennedy & Co. The preferred stock purchased in each year by Kennedy & Co. was not retired, but was retained as treasury stock. During the calendar year 1936 Kennedy & Co. paid dividends to the owners of its preferred stock in the amount of $19,250 and during the year 1937 it paid similar dividends in the amount of $10,500. Petitioner did not own any of the preferred stock of Kennedy & Co. during those years and received no part of the dividends paid upon it. OPINION. *792 SMITH: The respondent argues that the petitioner constructively received dividends in the taxable years in the aggregate of the amounts paid by Kennedy & Co. in the purchase of its own stock from Kennedy Bros., Inc. (to the extent that such payments were made out of earnings), plus the dividends paid on the preferred stock by Kennedy & Co. to Kennedy Bros., Inc. His contention is that Kennedy & Co. in effect distributed its earnings as dividends to the petitioner, the owner of its common stock, and the petitioner used these distributions to satisfy its obligation to purchase the preferred stock; but by means of a short cut, i.e., the direct payment by Kennedy & Co. to Kennedy Bros., Inc., the petitioner avoided the necessity of reporting the dividends as income. That there was no actual distribution of earnings to the petitioner is immaterial, it is argued, because the same result was achieved by what was done; the earnings of Kennedy & Co. were distributed, the seller received the money for the stock, and the obligation of the petitioner to pay for the stock was reduced in a corresponding amount. The respondent concludes that this satisfaction of the petitioner's obligation*793 by another corporation constituted income to the petitioner in accordance with the principle of . The fallacy in respondent's argument is that the petitioner in fact had no absolute obligation to purchase the stock from Kennedy Bros., Inc. Its obligation with respect to the preferred stock was precisely as outlined in the contract which was executed in 1929. That contract provides that the petitioner "will purchase or cause to be purchased" and "the SELLER will sell" the stock to the petitioner or to any other person to whom it may desire to sell. This contract *1024 was plainly executory and did not pass title to the stock to the petitioner. The deposit of the stock, endorsed in blank, with the escrow agent also did not pass title to the petitioner. . It was clearly intended that title should not pass prior to payment since the seller retained the right to sell all or any part of the stock to others at any time. The payments required by the contract were to be made to the escrow agent on or before a specified date each year. After each payment it was provided*794 that the agent would deliver the certificates paid for to the buyer whether such buyer was the petitioner or any other person. The facts outlined above fail to bear out the respondent's argument that the petitioner incurred an absolute obligation under the contract executed in 1929 to pay a certain amount of cash at once and in addition to pay $1,000,000 in installments for the preferred stock of Kennedy & Co. The petitioner did incur an obligation with respect to the preferred stock it is true, but it was an obligation which by its very terms had several alternative modes of satisfaction. One possible method of satisfaction was that a third party might buy the stock and this is what actually occurred prior to the due date in each year. The obligation having been satisfied precisely in accordance with its terms, the earnings of Kennedy & Co. can not be said to have been used for the benefit of the petitioner and no income has resulted to the petitioner from the satisfaction of an obligation. ; *795 . Dividends on the outstanding preferred stock of Kennedy & Co. in the amounts of $19,250 in 1936 and $10,500 in 1937 were paid to the owners of that stock, none of which was owned by the petitioner in the taxable years. There is clearly no merit in the respondent's determination that such dividends should be treated as income to the petitioner. Cf. . The petitioner's claim for a determination of overpayment in each of the taxable years is stated on brief to be contingent upon a finding that it received a constructive dividend as the respondent has determined. Since the respondent's determination has not been approved, it is not necessary to consider petitioner's claim for overpayment. However, in any event, that claim must be disallowed, since it is based on section 26(c)(1) and (2) of the Revenue Act of 1936, which permits credits against net income for amounts which can not be distributed as dividends without violating the provisions of a written contract, and for amounts which the taxpayer is required by a written contract to set aside for the*796 discharge of a debt. There is no contract in evidence which meets the requirements of the statute. Decisions will be entered under Rule 50.