W. O. Covey, Inc. v. Commissioner

W. O. Covey, Inc. v. Commissioner. W. O. Covey, Inc. v. Commissioner Docket No. 4518-67. United States Tax Court T.C. Memo 1969-273; 1969 Tax Ct. Memo LEXIS 24; 28 T.C.M. (CCH) 1379; T.C.M. (RIA) 69273; December 15, 1969, Filed Robert W. Tunnell, Race St., P.O. Box 151, Georgetown, Del., for the petitioner. Bert W. Hunt for the respondent. SCOTT Memorandum Findings of Fact and Opinion SCOTT, Judge: Respondent determined deficiencies in petitioner's income taxes for the fiscal years ended March 31, 1963 and March 31, 1964, in the amounts of $1,820 and $931.36, respectively. The issue for decision is whether petitioner is entitled to deduct as interest, payments made in 1963 and 1964 to Julia E. Covey with respect to an instrument in the form of a demand note which petitioner gave to Julia E. Covey on January 2, 1958, in exchange for 240 shares of petitioner's common stock. Findings of Fact Some of the facts have been stipulated and are found accordingly. W. O. Covey, Inc. (hereinafter referred to as petitioner) is a Delaware corporation with its principal place of business at the date of the filing of the petition in this case in Seaford, Delaware. Petitioner filed its Federal corporate income tax returns for its fiscal years ending March 31, 1963 and March 31, 1964, on an accrual method of accounting. These returns were filed with the district director of*26 internal revenue, Wilmington, Delaware. Petitioner was incorporated as a successor to the business of a sole proprietorship engaged in food distribution which was founded in 1923 by William O. Covey, Sr. The incorporation of the business was in 1935 shortly after the death of William O. Covey, Sr. Of petitioner's authorized 1,000 shares of no par value stock, only 720 were issued. Of the 720 issued shares, 240 were issued to Julia E. Covey, 240 to her son, William O. Covey, Jr., 220 to her daughter, Lucile C. Hitchens, and 20 to her son-in-law, Norris H. Hitchens. From 1935 until January 2, 1958, there was no change in petitioner's stockholders or the number of shares held by each. Julia E. Covey exchanged her 240 shares of stock for an instrument in the form of a demand note dated January 2, 1958. At the time of this exchange on January 2, 1958, Julia E. Covey was 76 years old. The minutes of a meeting of petitioner's board of directors, held January 2, 1958, read as follows: A meeting of the Board of Directors of W. O. Covey, Inc. was held in the office of the corporation in Seaford, Delaware, at 7:30 P.M. on January 2, 1958. The following directors were present: William*27 O. Covey, Jr. Julia E. Covey Norris H. Hitchens Lucile C. Hitchens After some discussion it was decided by the directors and agreed upon by Julia Covey that she would sell back to the corporation the 240 shares of common stock that she owns of W. O. Covey, Inc. The price agreed upon was $70,000.00 and Mrs. Covey agreed to accept a note in that amount from the Corporation. It was also agreed that approximately $3,000.00 per year would be paid on the principal of the note plus interest on the unpaid balance at 5% rate. 1380 It was also agreed that Mrs. Covey's salary remain the same. There being no further business, the meeting adjourned. (Signed) Lucile C. Hitchens, Secretary On January 2, 1958, the only directors of petitioner were those listed in the minutes as being present at the meeting of the board of directors. Julia E. Covey's basis in her 240 shares of stock was $24,398.08 and the approximate fair market value of the stock on January 2, 1958, was $70,000. On January 2, 1958, the officers of petitioner were: President W. O. Covey, Jr. Vice President Julia E. Covey Secretary Lucile C. Hitchens Treasurer Norris H. Hitchens Julia*28 E. Covey had been vice president of petitioner since July 6, 1935, and continued as vice president until August 17, 1961. She was a member of the board of directors from January 20, 1936, until August 17, 1961. From January 2, 1958, until June 1, 1961, she received a yearly salary as vice president in the amount of $2,400. Dividends were paid by petitioner as follows: Fiscal year ending March 31 Amount [1951] $ 15,000 [1952] 20,000 [1953] 15,000 [1954] 15,000 [1955] 15,000 [1956] 15,000 [1957] 15,000 [1968] 18,000 No dividends were paid after the fiscal year 1957 until the fiscal year ending March 31, 1968. The instrument given by petitioner to Julia E. Covey was on a printed form which contained the provisions customary to a demand note which provides for confession of judgment. The instrument was executed as follows: Witness our hands and seals the day and year aforesaid. WITNESS: W. O. Covey, Inc. (Seal) W. O. Covey, Jr., Pres. (Seal) Norris Hitchens, Treas. (Seal) The note contained no restriction on transferability. Julia E. Covey from the time the note was issued in 1958 until her death in February 1967, made no demand upon petitioner to*29 pay any part of the principal of the note and received no such payment. Petitioner each year paid $3,500 to Julia E. Covey which it denominated as interest at the rate of 5 percent per annum on the $70,000 note. Norris H. Hitchens was executor of the estate of Julia E. Covey. No demand was made upon petitioner to pay any part of the principal of the $70,000 during the settling of the estate and no such payment was made. Julia E. Covey in her will left the residue of her estate which included the instrument in question to her granddaughter, Julia L. Hitchens, who has made no demands on petitioner to pay any part of the $70,000 principal. Julia L. Hitchens is the daughter of Norris H. Hitchens. On January 28, 1968, a new instrument was issued to Julia L. Hitchens. This instrument was also in the form of a demand note, given under seal, bearing 5 percent interest per annum, and providing for confession of judgment. There was no restriction on transferability of the new instrument. In September 1968, petitioner made a payment of $5,000 as its first payment on the principal of $70,000 to show "good faith." There was a closely knit family relationship between the members of the Covey*30 family. At the time of the transaction concerning the exchange of stock by Julia E. Covey for the instrument dated January 2, 1958, and during the years which followed, there was never any dissension between Julia E. Covey and her children nor between her and her son-in-law, Norris H. Hitchens. W. O. Covey, Jr., died on July 9, 1963. Lucile C. Hitchens died prior to December 1966. Norris H. Hitchens has a life estate and Julia L. Hitchens has a remainder interest in the 220 shares held by Lucile C. Hitchens prior to her death. On August 17, 1967, Julia L. Hitchens was elected as a director of petitioner and 1381 has continued from that time to serve as a member of the board. She was elected secretary of petitioner on October 25, 1966, and has continued to serve in that capacity. The following tables show the balance sheets and profit and loss statements of petitioner for the years 1959 through 1968: *10 Profit and Loss Statement, 1964-1968 [1968] Sales (net) $2,790,155 $3,269,923 $3,481,157 $3,913,681 $3,922,182 Cost of goods sold Inventory--Beginning 235,094 290,941 306,327 336,422 406,451 Purchases 2,455,383 2,852,162 3,042,131 3,460,008 3,357,079 Freight 5,576 10,373 5,074 4,044 8,571 Total 2,696,053 3,153,476 3,353,532 3,800,474 3,772,101 Inventory--Ending 290,941 306,327 336,422 406,451 401,132 Cost of goods sold 2,405,112 2,847,149 3,017,110 3,394,023 3,370,969 Gross profit on sales 385,043 422,774 464,047 519,658 551,213 Other income: Purchase discount 15,883 18,441 24,858 28,383 32,565 Dividends [216] Rent [825] Interest [0] Total other income 17,511 19,838 26,123 29,562 33,606 Total income 402,554 442,612 490,170 549,220 584,819 Expenses: Operating expense 371,469 397,503 436,801 490,117 530,472 Officers' life insurance 2,403 2,684 3,109 3,233 3,359 Contributions 1,008 1,500 1,500 1,550 [73] Interest 3,500 3,500 3,645 6,071 9,562 Employees' profit sharing plan 12,087 18,188 19,967 23,627 22,939 Less endorsed note [0] Total expenses 390,467 423,375 465,072 524,598 566,045 Net income before Federal taxes 12,087 19,237 25,098 24,622 18,414 Federal income taxes 4,020 4,663 6,410 6,611 3,775 Net income 8,067 14,57m 18,688 18,011 14,639 *31 1382 *10 Balance Sheet, 1959-1963 [1963] Assets Current assets Cash $ 26,190 $ 20,076 $ 52,451 $ 18,240 $ 46,519 Accounts receivable 81,112 79,561 113,656 117,678 126,159 Inventory 141,510 160,578 197,358 164,539 235,094 Investments (at cost) 10,650 10,650 10,650 10,650 10,650 U.S. Government bonds 49,000 49,000 49,000 49,000 49,000 Cash surrender value of life insurance 8,475 9,738 10,736 11,745 12,774 Advance on commissions [0] Total current assets $316,937 $329,603 $433,851 $371,852 $480,196 Fixed assets Land 1,500 1,500 1,500 1,500 1,500 Bldg., fixtures and equip. 7,811 6,685 6,380 5,036 3,815 Total fixed assets 9,311 8,185 7,880 6,536 5,315 Total assets $326,248 $337,788 $441,731 $378,388 $485,511 Liabilities Current liabilities Accounts payable 63,935 60,474 141,826 $ 49,768 $116,944 Payroll taxes 2,810 4,018 3,934 3,692 4,356 Notes payable--bank 3,000 9,000 4,000 [0] Accrued commissions and salaries 6,198 23,063 33,740 33,692 41,848 Profit sharing trust 16,944 13,832 13,497 19,745 20,294 Federal income tax 7,000 4,601 4,444 6,055 8,071 Loanspayable--officers and others 20,015 5,352 15,212 30,128 40,092 Total current liabilities $119,902 $120,340 $216,653 $143,080 $231,605 Long-term liabilities Notes payable Redemption of stock 70,000 70,000 70,000 70,000 70,000 Officers [0] Employees' profit sharing [0] Total long-term liabilities 70,000 70,000 70,000 70,000 70,000 Total liabilities 189,902 190,340 286,653 213,080 301,605 Shareholders' Equity Capital assigned to common stock--1,000 authorized, no par value--720 outstand- ing, 240 treasury stock 73,179 73,179 73,179 73,179 73,179 Retained earnings 133,167 144,269 151,899 162,129 180,727 Total 206,346 217,448 225,078 235,308 253,906 Less treasury stock 70,000 70,000 70,000 70,000 70,000 Total shareholders' equity-- capital 136,346 147,448 155,078 165,308 183,906 Total liability and capital $326,248 $337,788 $441,731 $378,388 $485,511 *32 *10 Balance Sheet, 1964-1968 [1968] Assets Current assets Cash $ 57,688 $ 60,012 $ 63,528 $ 47,034 $ 51,682 Accounts receivable 143,736 165,423 204,735 214,620 193,951 Inventory 290,941 306,327 336,422 406,451 401,132 Investments (at cost) 10,650 10,650 5,650 5,650 5,650 U.S. Government bonds [0] Cash surrender value of life insurance 8,578 9,230 13,242 17,305 20,926 Advance on commissions [0] 1,500 [0] Total current assets $511,593 $551,642 $625,077 $691,060 $673,341 Fixed assets Land 1,500 1,500 1,500 1,500 1,500 Bldg., Fixtures and equip. 2,814 3,954 11,065 11,962 21,542 Total fixed assets 4,314 5,454 12,565 13,462 23,042 Total assets $515,907 $557,096 $637,642 $704,522 $696,383 Liabilities Current liabilities Accounts payable 147,187 150,916 158,564 188,682 157,042 Payroll taxes 3,470 7,252 5,060 4,423 4,605 Notes payable--bank [0] 26,000 Accrued commissions and salaries 25,361 27,691 40,784 37,520 20,017 Profit sharing trust 12,087 18,188 19,967 23,627 22,939 Federal income tax 4,020 4,663 6,410 6,611 3,775 Loans payable--officers and others 46,407 56,437 92,209 56,937 50,023 Total current liabilities 238,532 265,147 322,994 317,800 284,401 Long-term liabilities Notes payable Redemption of stock 70,000 70,000 70,000 70,000 70,000 Officers [0] 50,000 50,000 Employees' profit sharing [0] 25,000 Total long-term liabilities 70,000 70,000 70,000 120,000 145,000 Total liabilities 308,532 335,147 392,994 437,800 429,401 Shareholders' Equity Capital assigned to common stock--1,000 authorized, no par value--720 outstand- ing, 240 treasury stock 73,179 73,179 73,179 73,179 73,179 Retained earnings 204,196 218,770 241,469 263,543 263,803 Total 277,375 291,949 314,648 336,722 336,982 Less treasury stock 70,000 70,000 70,000 70,000 70,000 Total shareholders' equity--Capital 207,375 221,949 244,648 266,722 266,982 Total liability and capital $515,907 $557,096 $637,642 $704,522 $696,383 *33 1384 Proft and Loss Statement, 1959-1963 [1963] Sales (net) $2,022,559 $2,076,500 $2,297,429 $2,561,922 $2,602,270 Cost of goods sold Inventory--Beginning 119,716 141,509 160,578 197,358 164,539 Purchases 1,735,759 1,795,424 2,009,054 2,156,190 2,257,176 Freight 8,805 10,008 8,827 4,433 6,871 Total 1,864,280 1,946,941 2,178,459 2,357,981 2,428,586 Inventory--Ending 141,510 160,578 197,358 164,539 235,094 Cost of goods sold 1,722,770 1,786,363 1,981,101 2,193,442 2,193,492 Gross profit on sales 299,789 290,137 316,328 368,480 408,778 Other income: Purchase discounts 9,835 16,261 11,766 13,366 14,940 Dividends [430] Rent [900] Interest 1,630 2,320 [940] 1,495 1,380 Total other income 12,500 19,716 13,796 16,041 17,650 Total income 312,289 309,853 330,124 384,521 426,428 Expenses: Operating expense 266,700 274,464 300,166 340,778 374,168 Officers' life insurance 1,078 1,075 1,225 [803] 1,141 Contributions 1,200 1,000 1,200 1,070 1,075 Interest 3,800 4,126 [539] 2,379 3,574 Employees' profit sharing plan 16,944 13,831 13,497 19,745 20,829 Less endorsed note [0] Total expenses 289,722 295,413 316,627 364,775 400,787 Net income before Federal taxes 22,567 14,440 13,497 19,746 25,641 Federal income taxes 7,000 4,601 4,443 6,056 8,071 Net income 15,567 9,839 9,054 13,690 17,570 *34 1385 Petitioner in each of its fiscal years ended March 31, 1963, and March 31, 1964, claimed a deduction for the amount of $3,500 paid to Julia E. Covey with respect to the $70,000 instrument as interest paid. Respondent in his notice of deficiency disallowed these claimed deductions. Ultimate Finding of Fact Payment of $3,500 made by petitioner in each of its fiscal years ended March 31, 1963, and March 31, 1964, with respect to the instrument issued to Julia E. Covey on January 2, 1958, is not interest paid on an indebtedness so as to be deductible under section 163, I.R.C. 1954. 1 Opinion Petitioner contends that the yearly payments of $3,500 to Julia E. Covey in connection with the instrument originally issued to her in 1958 in exchange for her certificate of 240 shares of petitioner's stock are deductible under section 163(a) which provides for the allowance of a deduction for all "interest paid or accrued within the taxable year on indebtedness." We must therefore decide whether*35 the transaction which occurred on January 2, 1958, did in fact create a bona fide debt of petitioner to Julia E. Covey within the meaning of section 163. The substance of the economic relationship, rather than the form in which a transaction is cast, determines the incidents of Federal income taxation. Gregory v. Helvering, 293 U.S. 465 (1935), and Edwin C. Hollenbeck, 50 T.C. 740 (1968), on appeal (C.A. 9, Nov. 18, 1968). The instrument issued to Julia E. Covey was in the form of a demand note. There is nothing in the record to indicate that Julia E. Covey could not have enforced payment of the note in a court of law or could not have assigned the note for value. We will therefore assume that under State law and in form the instrument created a valid indebtedness of petitioner to Julia E. Covey. This assumption does not, however, answer the question of whether this instrument should be treated as creating a bona fide debt for purposes of taxation. The form of the instrument or its validity under State law does not control its treatment for Federal tax purposes. *36 United States v. Snyder Brothers Company, 367 F. 2d 980 (C.A. 5, 1966). All the surrounding circumstances at the time of the issuance of an instrument and the subsequent treatment of the transaction by the parties must be examined to determine whether for tax purposes there was an "indebtedness." Ambassador Apartments, Inc., 50 T.C. 236 (1968), affirmed per curiam 406 F. 2d 288 (C.A. 2, 1969). Cases dealing with whether an instrument in form evidencing an indebtedness does in substance create an indebtedness by the maker arise from many diverse factual situations. In many such cases funds advanced by shareholders to corporations in return for an instrument in the form of a note or bond are determined by the Commissioner to be in substance capital contributions to the corporation. In determining whether there is in fact an indebtedness of the corporation to the shareholder, all of the surrounding facts are considered. One of the primary facts to be determined is whether there is an unconditional intent to repay the amount of the claimed indebtedness*37 in all events. Without such an intent to repay, there can be no indebtedness. In Edwin C. Hollenbeck, supra, at 747, we stated: The debt-equity inquiry is essentially the same in all areas. The precise determination to be made - is there more than one class of stock, are notes bona fide indebtedness, etc., varies from case to case, but the basic standards remain the same in all cases where the respondent seeks to reclassify debt or equity. The test is whether the form in which the taxpayer has cast the transaction has substantial economic reality. * * * The instrument which was issued on January 2, 1958, to Julia E. Covey was in exchange for all her common stock in petitioner. Respondent makes an extended argument that the transaction did not amount to a redemption of stock within the definition of sections 302(a) and 317(b). 2 1386 Petitioner does not contend that the transaction was a distribution in redemption of the stock of Julia E. Covey within the meaning of these sections, apparently for the reason which respondent points out, that Julia E. Covey remained an officer and director of petitioner for several years after the transaction of January 2, 1958. *38 *39 Since Julia E. Covery remained an officer and director of petitioner for several years after January 2, 1958, it is obvious that under the attribution provisions, she is considered to own the stock owned by her son and her daughter. After the exchange of her common stock for the instrument dated January 2, 1958, she would be considered as owning, under the attribution provision, over 95 percent of petitioner's common stock. Petitioner takes the simple position that the transaction of January 2, 1958, constituted a purchase by the corporation of the stock of Julia E. Covey just as much as if cash had been paid for the stock. Upon consideration of all the facts here present, we agree with respondent that the instrument issued to Julia E. Covey on January 2, 1958, though in the form of a demand note, did not actually create a debtor-creditor relationship between Julia E. Covey and petitioner from the standpoint of economic reality but more nearly resembled an exchange of common stock for a form of preferred stock. The financial situation of petitioner was such that regular yearly payments could have been made on the principal, but the note could not have been paid on demand without*40 greatly curtailing petitioner's ability to carry on its operations. In fact, in its brief, petitioner states: In 1958 when the $70,000.00 note was given to Mrs. Covey the petitioner enjoyed a line of credit at the bank of only fifteen or twenty thousand dollars. According to the testimony of Mr. Hitchens (T. p. 23) the company has never been in a position, since 1958, to pay off the $70,000.00 obligation. * * * In order to clearly point out the desperate working capital position of the petitioner a document entitled "Working Capital Position of W. O. Covey, Inc. as of March 31, 1959 through 1968" was prepared and put in evidence as Petitioner's Exhibit No. 9. * * * Petitioner then pointed out that Julia E. Covey did not need the cash and had sufficient funds from the $3,500 she was collecting annually from petitioner under the designation of "interest" plus other assets to live comfortably. The substance of petitioner's argument is that Julia E. Covey did not, at the time the note was issued or at any time thereafter, intend that any portion of the $70,000 face amount of the so-called demand note be paid to her unless the financial position of petitioner was such that it could*41 be paid with no inconvenience to petitioner. Since petitioner could not make such payment at any time after January 2, 1958, without substantially curtailing its operation, Julia E. Covey made no request for any payment. The inference from the record is unmistakable that it was the intent of Julia E. Covey, as well as the other officers of petitioner, that the investment which Julia E. Covey had in the corporation would not actually be taken out of the corporation but that Julia E. Covey would receive yearly payments which would be denominated "interest" whether or not any corporate dividends were declared to the other stockholders. The minutes of January 2, 1958, referred to payments of $3,000 annually on "principal" of the "note." However, the fact that no such payments were made or sought leaves the clear inference that it was never intended that such payments be made if petitioner had a more pressing need for use of its funds. Petitioner contends that there were several business reasons why petitioner desired to purchase the stock of Julia E. Covey. It contends that William O. Covey, Jr., and Norris H. Hitchens were carrying the major work of the corporation and that their percentage*42 interest was increased when the corporation purchased the stock of Julia E. Covey; that Julia E. Covey was 1387 growing older and might have given her stock to a person who would not have petitioner's interest at heart; that the other stockholders of petitioner desired to ease Julia E. Covey out of petitioner without hurting her feelings; and that her stock could be held as treasury stock in the event it was desired to issue the stock to key employees. None of these so-called business reasons, when analyzed, is a business reason from the standpoint of the corporate petitioner. The logical way for William O. Covey, Jr., and Norris H. Hitchens to have increased their stock interest would have been for them to have personally purchased the stock of Julia E. Covey. Certainly, more havoc might have been wrought had Julia E. Covey given the so-called note to an outsider who would have enforced its collection than had she given her common stock to an outsider who would not have had a controlling interest. The fact is that Julia E. Covey did remain an officer and director after the transaction of January 2, 1958. Also the facts show that there was unissued stock of petitioner which could*43 have been used to distribute to key employees and none of that stock or the stock previously held by Julia E. Covey has been so used. The fact that no payment was made on the "principal" of the "note" to Julia E. Covey or to her estate supports the inference from other facts in the record that the intent at the time of the transaction was that no payment was to be made on the note unless the circumstances of the business were such that petitioner had funds for which it had no need in its business. The clear inference is that there was not an unconditional intention to pay the so-called indebtedness and that in economic reality Julia E. Covey retained an equity interest in petitioner after the exchange of January 2, 1958. The fact that shortly before the trial of this case a payment on the so-called note was made to show "good faith" is not persuasive that during the years here in issue the instrument dated January 2, 1958, evidenced a bona fide debt of petitioner. The payment of $3,500 in each of the years here in issue by petitioner to Julia E. Covey was in the nature of a dividend on preferred stock and not interest on a loan. Decision will be entered for respondent. Footnotes 1. All references are to the Internal Revenue Code of 1954.↩ 2. SEC. 302. DISTRIBUTIONS IN REDEMPTION OF STOCK. (a) General Rule. - If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph (1), (2), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock. (b) Redemptions Treated as Exchanges. - (1) Redemptions not equivalent to dividends. - Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend. * * * (3) Termination of shareholder's interest. - Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder. * * * (c) Constructive Ownership of Stock. - (1) In general. - Except as provided in paragraph (2) of this subsection, section 318(a) shall apply in determining the ownership of stock for purposes of this section. (2) For determining termination of interest. - (A) In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if - (i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor, * * * Sec. 317(b)↩ Redemption of Stock. - For purposes of this part, stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.