Columbia Concerts v. Commissioner

COLUMBIA CONCERTS, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Columbia Concerts v. Commissioner Docket No. 105401. United States Board of Tax Appeals 46 B.T.A. 1072; 1942 BTA LEXIS 778; May 6, 1942, Promulgated *778 A contract entered into by petitioner, its executives and a creditor of petitioner, who was also a stockholder, providing for a dividend restriction on common stock on the first $54,000 of its net profits for the taxable year, held to restrict payment of dividends from current profits and surplus so that petitioner is entitled to a credit under section 26(c)(1) of the Revenue Act of 1936. Max Freund, Esq., and Walter J. Petschek, Esq., for the petitioner. Conway Kitchen, Esq., for the respondent. ARUNDELL *1072 The commissioner determined a deficiency in petitioner's income tax for the fiscal year ended May 31, 1937, in the sum of $5,466.38. The sole question before the Board is whether or not petitioner is entitled to a credit under section 26(c)(1) of the Revenue Act of 1936. FINDINGS OF FACT. Petitioner was incorporated under the laws of the State of New York in 1933. It is engaged in the business of managing artists and booking their engagements throughout the United States and Canada. Its return for the taxable year was filed with the collector of internal revenue for the third district of New York. Petitioner's returns*779 are filed on the basis of a fiscal year ending May 31. Petitioner was formed to succeed a corporation of similar name which had been unsuccessful. Over the period of the former corporation's existence, the Columbia Broadcasting System, hereinafter known as CBS, had advanced considerable sums of money so that the former corporation became indebted to CBS in the sum of approximately $211,000. after the formation of petitioner, CBS exchanged its claim against the former corporation for the entire outstanding preferred stock of petitioner, consisting of 162 shares of no par value stock, and petitioner's demand note for $49,132.78 bearing *1073 interest at 3 percent. The preferred stock was to be retired at $1,000 per share plus accumulated dividends. Of the common stock of petitioner issued and outstanding during the period from August 31, 1934, to May 31, 1937, CBS at all times owned at least 8,319 shares. From August 31, 1934, until August 31, 1936, 15,920 shares of petitioner's common stock were outstanding. During the period of January 29 to May 31, 1937, 569 shares of petitioner's common were held in petitioner's treasury and 15,351 shares were outstanding. In the*780 latter part of 1934 it became apparent that adjustments would have to be made in order that petitioner might be financially able to continue operations. Petitioner was under contract to increase the salaries of its executives, new leases would soon have to be entered into, a certain portion of the preferred stock was due to be retired, and the demand note of $49,132.78 was outstanding. In addition, petitioner had insufficient cash with which to operate. Because of these conditions representatives of petitioner and CBS had a series of discussions from which evolved a rearrangement of petitioner's method of operation. As a result of the discussions between representatives of petitioner and CBS, an agreement was entered into by petitioner, petitioner's executives, and CBS under date of February 15, 1935. This agreement provided in part as follows: FIRST: If and as long as the company operates at a profit and earns in each fiscal year of its operations a net profit of at least ten thousand dollars ($10,000.), and if and so long as the Company promptly pays to Columbia the thirty dollars ( $30.) per share per annum cumulative dividends on the Company's Preferred stock and the three*781 percent (3%) interest per annum on the promissory note aforementioned (or on any promissory note in an equal or smaller amount which may be substituted therefor, both the original note and any such substitute therefor being hereinafter referred to as the "aforesaid promissory note"), Columbia agrees that for the three year period from June 1, 1935 through May 31, 1938 it will waive the retirement provisions of the Preferred stock of the Company and agrees that for the same period it will not demand payment of any part or all of the principal of the aforesaid promissory note. SECOND: During the said three year period from June 1, 1935 through May 31, 1938, the first $54,000. of net profits earned by the Company in each of its fiscal years shall not be distributed in the form of dividends unless the distribution thereof in the form of Common stock dividends shall be requested or consented to by Columbia. For the purpose of determining (a) whether or not the Company has operated at a net profit and the amount of such net profit under the provisions of Article "FIRST" hereof and/or (b) whether or not more than $54,000. of net profits have been earned in any one year under this Article*782 "SECOND" hereof, there shall first be deducted and charged among the expenses of the business (a) the amount of all accumulated and unpaid dividends on the Preferred stock, (b) all accumulated and unpaid interest on the aforesaid promissory note, (c) all taxes, and (d) depreciation. All such net profits of the Company in excess of $54,000. a year during each of the aforesaid three fiscal years shall be declared and paid as dividends on *1074 the Company's Common stock provided that the foregoing shall not constitute a commitment to declare and pay dividends in excess of an aggregate of $80,000, in any one of said three fiscal years. The agreement further provided new employment contracts with petitioner's executives and cancellation of the old contracts. It provided for the resumption of periodic retirement of petitioner's preferred stock after the expiration of the three-year moratorium provided for by paragraph "FIRST" of the agreement. It also provided for the satisfaction of the note in the sum of $49,132.78 held by CBS at the rate of 50 percent in each of the two years following the end of the three-year moratorium on payment. By a letter dated May 20, 1937, petitioner*783 informed CBS that it had an approximate net income of $86,000 for the taxable year and that it had paid or would pay a dividend on its preferred stock in the amount of $22,684. It requested CBS to consent to a dividend by petitioner equal to $4.25 a share, which would amount to petitioner's entire undistributed earnings of the taxable year. CBS, by letter dated May 20, 1937, refused to permit petitioner to pay any dividend on common stock in excess of $2 a share on petitioner's 15,351 shares of common stock then outstanding. On its Federal income and excess profits tax return for the taxable year, petitioner reported net income of $105,569.05 and adjusted net income of $90,893.69. Petitioner claimed a credit for a contract restricting dividend payments in the sum of $37,507.69. Respondent disallowed an item of depreciation which petitioner does not contest. Petitioner's net income for the taxable year was $106,857.81 and its adjusted net income for that year was $91,989.14. As of June 1, 1936, petitioner's earnings and profits accumulated after February 28. 1913, amounted to the sum of $166,729.58. Respondent disallowed petitioner's claim for credit for a contract restricting*784 dividend payments. OPINION. ARUNDELL: We are confronted with the question of whether petitioner is entitled to a credit under section 26(c)(1) of the Revenue Act of 1936 for a contractual restriction of dividends in the taxable year. Respondent argues that the provision of the contract specifically dealing with dividend payments restricted distribution of dividends by petitioner only from the first $54,000 of net profits of the taxable year and that a dividend in excess of petitioner's adjusted net income might have been paid from petitioner's accumulated earnings. If the contract be susceptible of such a construction under the decided cases, the credit under section 26(c)(1) would have to be reduced by the amount of dividends which might be so paid. . On the other hand, where *1075 by contract dividends may be paid only with the consent of the creditor, the contractual restriction upon dividend payment is the amount of earnings and profits which can not be distributed as dividends because of the creditor's failure to consent thereto. *785 . Thus, in the instant case, if the contractual restriction should apply to accumulated earnings as well as to current profits, petitioner would be entitled to a credit in the amount of the difference between petitioner's adjusted net income and the sum of the amount which CBS permitted petitioner to distribute as a dividend on the common stock and the amount paid as a dividend on preferred. The provision for which the credit is claimed provides that "the first $54,000 of net profits earned by the * * * [petitioner] in each of its fiscal years shall not be distributed in the form of dividends unless the distribution thereof * * * shall be requested or consented to by * * * [CBS]." This provision clearly restricts payment out of current earnings. We are of the opinion that it also restricts payment out of accumulated earnings. Any other interpretation would make the contract practically a nullity. The contract was entered into so that petitioner might obtain operating capital. CBS allowed petitioner to retain funds for such purpose provided that CBS might be given some protection on its investment. The $54,000 restriction was*786 to operate for a three-year period. The preferred stockholding of CBS had a retirement value of $162,000, exactly three times the amount of the yearly restriction. By foregoing its right to an allocable retirement of preferred stock for the three-year period, CBS was risking its investment. Accordingly, the first $54,000 of each year's earnings was to act as a cushion for the eventual retirement of the preferred stock. If petitioner were to be allowed to declare dividends out of accumulated earnings, petitioner might destroy the security of CBS by merely waiting until after the end of any fiscal year for declaration of its dividends. Current earnings become accumulated earnings if they are retained past the current year. If the contract had permitted petitioner to declare dividends out of surplus without the consent of CBS, petitioner, by retaining current earnings one day past the end of the year, might completely avoid the provisions of the contract which CBS had placed therein for its security. To the extent that CBS failed to give its permission to petitioner for payment of dividends on common, petitioner was restricted in payment of dividends on common stock from either*787 current or accumulated earnings. We do not think , is in point. In that case the contract was between the sole "stockholders-directors" and the corporation and the restriction provided for was simply to promote a conservative business policy. The restriction in the *1076 case before us was dictated by a creditor who, it is true, was also a stockholder. The demand note of petitioner in the sum of $49,132.78 held by CBS was subject to the three-year moratorium provided for in the contract. But for the contract CBS could have called in the note at any time. For purposes of determining whether petitioner is entitled to the credit under section 26(c)(1) CBS must be treated as a bona fide creditor. We hold that petitioner is entitled to a credit for purposes of the surtax on undistributed profits in the amount of the excess of its adjusted net income over the amount which it could distribute without violating the terms of the contract. The latter amount in the present case is the sum of the amount which was distributed on the preferred stock of the petitioner and the amount for which CBS gave its consent to be distributed*788 on petitioner's common stock. Petitioner is accordingly entitled to a credit in the amount of $38,603.14. Decision will be entered under Rule 50.