Opinion
No. 46076.
December 6, 1948.
Scott P. Crampton, of Washington, D.C. (Geo. E.H. Goodner, of Washington, D.C., on the brief), for plaintiff.
John A. Rees, of Washington, D.C., and Theron Lamar Caudle, Asst. Atty. Gen. (Robert N. Anderson and Andrew D. Sharpe, both of Washington, D.C. on the brief), for defendant.
Before JONES, Chief Judge, and LITTLETON, WHITAKER, MADDEN, and HOWELL, Judges.
Special Findings of Fact
1. Plaintiff is an individual presently residing in England and is a citizen of the United States. At all times material hereto, particularly during the calendar years 1937 to 1941, inclusive, plaintiff maintained an office and was represented by an agent in Boston, Massachusetts. Plaintiff keeps his books and files his federal income tax returns on the cash receipts and disbursements basis of accounting and by calendar years. Plaintiff's agent in Boston, acting under a general power of attorney from plaintiff, filed with the collector of internal revenue for the district of Massachusetts all of the federal income tax returns and claims for refund here involved.
2. On March 5, 1938, plaintiff filed a federal income tax return for the calendar year 1937 which disclosed a net income of $57,434.66, a surtax net income of $54,934.66, and a total tax liability of $11,202.35. Plaintiff paid that tax in four installments as follows:
March 8, 1938 .............. $2,802.35 June 10, 1938 ............... 2,800.00 September 7, 1938 ........... 2,800.00 December 8, 1938 ............ 2,800.00
3. On March 4, 1939, plaintiff filed a federal income tax return for the calendar year 1938 which disclosed a net income of $30,122.21, a surtax net income of $27,622.21, and a total tax liability of $3,462.82. Plaintiff paid that tax on March 7, 1939.
4. On March 8, 1940, plaintiff filed a federal income tax return for the calendar year 1939 which disclosed a net income of $39,984.57, a surtax net income of $37,484.57, and a total tax liability of $5,853.64. Plaintiff paid that tax on March 12, 1940. Upon audit of that return the Commissioner of Internal Revenue determined a net income of $41,269.53, a surtax net income of $38,769.53, and a deficiency in tax of $344.33. After appropriate assessment, plaintiff paid that deficiency on June 30, 1943, together with interest thereon in the amount of $67.31, the total payment being $411.64.
5. On February 18, 1941, plaintiff filed a federal income tax return for the calendar year 1940 which disclosed a net income of $41,922.05, a surtax net income of $39,922.05, and a total tax liability of $10,320.60. Plaintiff paid that tax on February 20, 1941. Upon audit of that return the Commissioner determined a net income of $46,963.80, a surtax net income of $44,963.80, and a deficiency in tax of $2,260.78. After appropriate assessment, plaintiff paid that deficiency on October 15, 1942, together with interest thereon in the amount of $214.77, the total payment being $2,475.55.
6. Plaintiff is a beneficiary of the trust under the indenture of Ida A. Higginson and is also a beneficiary of the residuary trust under the will of Ida A. Higginson. His distributive interest under these two trusts was 100 percent and 75 percent, respectively. Throughout the years 1937 to 1940, inclusive, each of these trusts owned 265 shares of preferred stock of the Gauley Coal Land Company on which distributions were received by the trustees and paid over to the plaintiff as follows:
_____________________________________________________________ | | | | Residuary | Trust | Year | trust under | under | Total | will | indenture | _________________|________________|_____________|____________ 1937 .......... | $3,776.25 | $5,035.00 | $8,811.25 1938 .......... | 993.75 | 1,325.00 | 2,318.75 1939 .......... | 1,590.00 | 2,120.00 | 3,710.00 1940 .......... | 1,590.00 | 2,120.00 | 3,710.00 _____________________________________________________________
All of the payments next above were reported in full as taxable income upon returns filed for plaintiff as aforesaid except the two items aggregating $3,710 for the year 1940. These two items in the total amount of $3,710 were included in plaintiff's taxable income for 1940 by the Commissioner when he determined the deficiency referred to in the preceding finding.
The cost basis for federal income tax purposes for the 265 shares of preferred stock owned by each trust as set out above was $17,225 for the trust under the indenture and $5,167.50 for the trust under the will. Nontaxable distributions were made by the Gauley Coal Land Company prior to January 1, 1937, in amounts exceeding such cost basis.
7. The Commissioner determined that the dividends paid by the Gauley Coal Land Company and distributed as set forth above are taxable, if taxable at all, to the beneficiaries of the trusts here involved. Neither trust during the years here involved was engaged in a trade or business and neither was buying and selling stock or real estate in this period.
8. The trust under the indenture of Ida A. Higginson filed timely fiduciary income tax returns for the calendar years 1937 to 1940, inclusive. Ida A. Higginson died on May 6, 1935, and the residuary trust under her will filed timely fiduciary income tax returns for the calendar years 1937 to 1940, inclusive.
9. The Gauley Coal Land Company is a corporation organized in 1903 under the laws of West Virginia. At the time of its organization it acquired certain coal and timber-lands located in West Virginia from the Gauley Coal Land Association in exchange for its capital stock. The mineral properties so acquired were not being worked at that time. The capital stock issued in payment for these properties consisted of 11,440 shares of $100 par value 6 percent cumulative preferred stock and 22,880 shares of common stock of the par value of $100 per share. Each stock had voting rights, one vote for each share outstanding. The mineral properties were set up on the books of the Gauley Coal Land Company at the cost figures which were shown on the books of the Gauley Coal Land Association but no costs were shown on the books of the latter for timber properties and none were set up on the books of the former upon its organization.
10. After the advent of the federal income tax laws it became necessary to determine the cost on the date of acquisition in 1903 and the fair market value as of March 1, 1913, of the properties owned by the Gauley Coal Land Company in order to comply with various provisions of the several revenue acts in computing the taxable income of that company, and also the extent to which dividends received by the stockholders of that company were taxable. During that period and including the years with which we are concerned in this proceeding there was in effect in the Income Tax Unit of the Internal Revenue Bureau established procedure for determining the valuation of the type of property here involved and the use of such valuation in determining tax liability in which such valuations were a factor. Under that procedure the audit of income tax returns was made by an audit division and when in the course of the audit a question arose of valuation of property on which the audit division desired an engineering determination, the audit division would request a report from the engineering division on the valuation matters involved. After such a matter was referred to the engineering division that division would proceed with its determination which often included an examination of the properties involved, the submission by the taxpayer of data with respect to the valuation, and conferences with the taxpayer or his representative. Upon the completion of its consideration of the matter, the engineering division would prepare a valuation memorandum or report which it would forward to the audit division for such use as it considered appropriate in connection with the issuance of a notice of deficiency or other final determination of tax liability. A copy of these valuation memoranda or reports was not, as a matter of established procedure, mailed to the taxpayer or his representative but in most instances upon request a copy of such memorandum or report would be furnished to the taxpayer or his representative and in the event the taxpayer or his representative did not agree with the findings therein further conferences might be had with the engineering division on the subject matter of the memorandum or report. Changes made therein would be made in a supplemental memorandum or report to the audit division. However, the recommendations contained in the valuation memorandum or report did not become final for the year or years involved until such matter was reflected in the final notice of the determination of a deficiency or other final determination of tax liability as reflected in a letter from the audit division.
11. In connection with the audit of the returns of the Gauley Coal Land Company for the years 1923 and 1925, a question arose as to the depletion sustained on cost and allowable on March 1, 1913, value and the audit division made an appropriate request on the engineering division with respect to that matter. After conferences with that corporation's representatives the engineering division on August 25, 1926, prepared a valuation memorandum which it forwarded to the audit division. It also furnished a copy thereof to counsel for plaintiff who was likewise counsel for the Gauley Coal Land Company. That memorandum set out in part that —
1903 cost (value) 115,333 acres surface and timber at $7.50 per acre .......... $864,997.50 173,000 acres Mineral rights at $7.50 per acre .................................. 1,297,500.00 ------------- Cost of original acquisition ............ 2,162,497.50
* * * * * * * * *
230.000,000 recoverable tons of coal acquired prior to 1913 cost $0.00564 per ton $1,297,500.00
* * * * * * * * *
"4. It is therefore recommended that as of acquisition in 1903 the cost of the land be fixed at $2,162,497.50, the March 1, 1913, value be fixed at $2,209,637.50 and depletion be allowed as of March 1, 1913, at 1 3/4 cents per ton on 4,000,000 tons of recoverable leased coal on bloc and on 226,000,000 tons of recoverable unleased coal at $0.00564 per ton, as outlined in paragraph 3."
The evidence does not satisfactorily show what use, if any, was made of these cost figures by the Commissioner in his determination of the tax liability of the Gauley Coal Land Company.
12. Thereafter further controversies arose between the Gauley Coal Land Company and the Commissioner with respect to the March 1, 1913, value of plaintiff's properties and the allowable depletion thereon, and the engineering division prepared and transmitted to the audit division two valuation memoranda in connection therewith, one dated September 12, 1929, and the other September 17, 1930. These memoranda fixed a March 1, 1913, value for the coal in the seam of coal (Seam A) that was being mined in and prior to the years involved in these proceedings of $2,076,700 and a depletion rate for such coal of 2 3/8 cents per ton. That valuation and depletion rate were used by the Commissioner in the determination of the Gauley Coal Land Company's tax liability for the years 1923 to 1940, inclusive. In the same memoranda the engineering division likewise fixed a March 1, 1913, value on seams other than the one referred to above and owned by the Gauley Coal Land Company in the total amount of $1,731,850 and fixed various depletion rates for the several seams. However, no coal was mined prior to 1941 other than from Seam A and the March 1, 1913, value and depreciation rate fixed by the engineering division for the other seams were not used by the Commissioner in any determination of the tax liability of the Gauley Coal Land Company for any year prior to 1941.
In addition, the Commissioner, after appropriate consideration by the engineering division fixed a March 1, 1913, value of $1,761,706.79 for 50,532 acres of merchantable timber owned by the Gauley Coal Land Company and of $11,127.40 for 11,127.4 acres of cut-over timber. The Commissioner used those March 1, 1913, values in the determination of the tax liability of the Gauley Coal Land Company for the years prior to 1941 where various sales of timberlands were made and it became necessary to determine the gain or loss from such transactions.
13. On December 31, 1912, the Gauley Coal Land Company had accumulated earnings or profits as shown by its books of $44,553.05. It sustained losses from the operations of its business in 1913 and 1914 in excess of such accumulated earnings. Gains were realized or losses sustained from operations which included sales of property over the period from January 1, 1913, to December 31, 1936. As will hereinafter appear, in 1930 and 1931 it reduced the par value of its preferred stock from $100 to $1 through the payment of $99 on each share of such stock, and in 1934, 1935, and 1936 made substantial payments on account of the accumulated dividends on the preferred stock. As a result at December 31, 1936, all earnings and profits accumulated since March 1, 1913, had been distributed and at least a part of the distributions made prior to that time had been made from sources other than earnings or profits accumulated since March 1, 1913.
14. As shown in finding 9, the Gauley Coal Land Company had 11,440 shares of 6 percent cumulative preferred stock which was issued at the time of its organization in 1903 and the acquisition of its properties. Under the articles of incorporation accumulated dividends on the preferred stock had to be paid before any dividends could be paid on the common stock. Prior to 1925 it had little or no income with which to pay dividends. However, during the period from 1925 to 1930, inclusive, it realized substantial profits largely through the sale of its timberlands. As of December 31, 1930, the accumulated dividends on the preferred stock amounted to $2,307,50. Of that aggregate sum $448,060 represented dividends accumulated on September 1, 1903, by reason of the fact that it assumed and agreed to pay as part of the price for the timber and mineral lands acquired in exchange for its capital stock dividends theretofore accumulated on shares of preferred stock of a predecessor company dating back to and accruing from January 1, 1897, 1898, and 1899. In view of the foregoing situation, it decided to reduce the face amount of preferred stock from a par value of $100 to a par value of $1, which action was permissible under its articles of incorporation, and thereby to curtail the accruing of dividends on the preferred stock. Payments aggregating $99 per share were made during 1930 and 1931 upon the preferred stock in conformity with the foregoing decision.
15. The payments of $99 per share referred to in the preceding finding were made pursuant to appropriate corporate action as follows:
At a meeting on June 10, 1930, of its Board of Directors, a committee appointed at a previous meeting on February 21, 1930, presented a report suggesting and recommending that the company would be in a stronger position to liquidate accumulated and unpaid dividends on its outstanding preferred stock ($200 per share on January 1, 1930) if the principal of that stock were to be reduced as permitted by a provision in the corporation's charter reading:
"All the preferred shares shall be redeemable at par and accrued dividends at any time at the option of the corporation, in whole or in part, from time to time, either as drawn by lot or pro rata as the Directors from time to time determine, and shall be entitled to payment, whether in liquidation or otherwise, of principal and dividends in full, before the common stock is entitled to anything, dividends or principal. Dividends on any preferred shares drawn or on any amounts distributed pro rata on account of the principal shall cease on the day set for redemption or distribution."
with the recommendation that a dividend in liquidation of principal in the amount of $50 per share be paid on preferred stock July 1, 1930, and that further dividends in liquidation of the principal of the preferred stock be paid on January 1, 1931, January 1, 1932, and January 1, 1933, in the respective amounts of $10, $25, and $10, or at such earlier or later dates as might seem wise within the discretion of the Board of Directors.
After full discussion it was voted that although the corporation was unable to pay preferred dividends maturing or already accumulated, its treasurer was authorized to pay as "provided in the certificate of incorporation" on July 1, 1930, $50 per share to preferred stockholders of record on June 10, 1930, in part liquidation of the principal amount of its preferred stock then issued and outstanding. That payment was conditioned upon a return of the outstanding certificates of preferred stock by the owners to the treasurer who was to write or stamp thereon over his signature a memorandum reading:
"$50.00 per share has this day been paid to the registered holder of this certificate in liquidation, or pro rata redemption, of the principal amount represented by this certificate. From and after this date preferred dividends shall accrue and be paid only on $50.00 per share of the principal amount which remains unredeemed and unpaid of this certificate."
At further meetings of the Board of Directors on December 12, 1930, April 24, 1931, and September 11, 1931, the treasurer was authorized to make further payments of $30, $10 and $9, respectively, in part liquidation of the remaining principal amount of their preferred stock under the same conditions as with respect to the first payment of $50 per share. The authorized payments were made during 1930 and 1931 and the stock certificates endorsed as required. The foregoing actions were ratified, approved, and confirmed by the stockholders of the Gauley Coal Land Company in meetings held on February 20, 1931, and February 19, 1932. Payments so made were not made as part of any arrangement for the complete retirement of the stock. The stock with accumulated dividends were retired and canceled on September 1, 1944.
The Commissioner treated the foregoing reductions of the par value of the preferred stock as distributions in partial liquidation.
16. After the par value of its preferred stock had been reduced, as shown in the preceding finding, the Gauley Coal Land Company in 1934 began the making of payments on account of the accumulated dividends on its preferred stock, payments of $65, $31, and $30 for each share of stock being made during the years 1934, 1935, and 1936, respectively. As a result of these distributions, all earnings and profits of the corporation accumulated since March 1, 1913, had been distributed at December 31, 1936, and a part of the distributions so made was from sources other than earnings and profits accumulated since March 1, 1913.
The Gauley Coal Land Company made similar distributions on account of the accumulated dividends on its preferred stock during the years 1937, 1938, 1939, and 1940, such payments being in the total respective amounts for each year on each share of stock of $19, $5, $8, and $8. The first payment in 1937 was made pursuant to a resolution adopted by its Board of Directors on December 18, 1936, reading as follows:
"Voted: That a payment of Ten ($10.00) Dollars per share on account of accumulated preferred dividends, be and hereby, is declared payable January 4, 1937 to preferred stockholders of record December 18, 1936, and that the Treasurer be and hereby is authorized and directed for and on behalf of this Company to make said payment of ten dollars per share on January 4, 1937 to preferred stockholders of record as provided for in this vote."
Similar corporate action was taken with respect to the other payments in those years.
The following tabulation shows the total earnings which the Gauley Coal Land Company had in each of the years 1937 to 1940, inclusive, and the total payments made in each of those years on account of the accumulated dividends on the preferred stock as mentioned in the preceding finding:
-------------------------------------------------------------- | | | | Distributions | | Total | paid | | distributions Calendar year | per share | Earnings | | | | -----------------|----------------|------------|-------------- | | | 1937 ........... | $19.00 | $72,496.73 | $ 215,251.00 1938 ........... | 5.00 | 31,487.75 | 56,558.00 1939 ........... | 8.00 | 29,355.91 | 90,328.00 1940 ........... | 8.00 | .......... | 90,178.00 --------------------------------------------------------------
17. On April 10, 1941, the Gauley Coal Land Company filed information returns with respect to the distributions referred to in the preceding finding, the letter transmitting those returns reading as follows:
"We enclose herewith form 1096 `Annual Information Return' for each of the calendar years 1937, 1938, 1939, and 1940, setting forth the distribution to stockholders in each of said years and the portion thereof deemed to be paid out of earnings and the portion out of funds other than earnings. We also enclose four copies of an analysis of surplus for the period December 31, 1912, to December 31, 1940.
"We would appreciate an early examination of our accounts for the purpose of receiving approval of our findings."
The analysis of surplus attached to those returns for the period December 31, 1912, to December, 31, 1940, inclusive, set up earned surplus and appreciation at March 1, 1913, as follows:
Earned surplus ................... $441,290.74 Mineral appreciation ............. 481,152.09 Timber appreciation .............. 1,241,518.93 ------------- Total ......................... 2,163,961.76
How the amount for "Earned surplus $441,290.74" at March 1, 1913, as shown in the above analysis of surplus, was arrived at does not satisfactorily appear from the evidence, though on account of the relatively inactive status of the corporation from 1903 to March 1, 1913, and other evidence of record, a reasonable conclusion is that at least a substantial part of this amount represents an amount other than earned surplus by the Gauley Coal Land Company and in fact represents, in part at least, a surplus figure of some nature appearing on the books of the Gauley Coal Land Association.
The amount set out in the analysis of surplus as "Mineral appreciation $481,152.09" was computed by taking the difference between the cost of coal properties as shown by its books (set up as shown above) and the March 1, 1913, value for these coal properties as determined and used by the Commissioner in his determination of the Gauley Coal Land Company's tax liability. The amount in the same analysis of surplus for "Timber appreciation $1,241,518.93" was computed by taking no cost for timberlands (since, as shown above, no cost was set up on the corporation's books at organization) and using an entire March 1, 1913, value as appreciation.
18. Using the figures described in the preceding finding for earned surplus and appreciation at March 1, 1913, as a starting point, the analysis of surplus shows the extent to which the distributions made from 1937 to 1940, inclusive, were paid from earnings accumulated since March 1, 1913, and the extent to which from appreciation existing on March 1, 1913, but realized since that time through sales of property or otherwise, as follows:
------------------------------------------------------------- | | | | | Amount | | Amount | paid from | Calendar year | paid from | realized | Total paid | earnings | appreciation | | | | -------------------|------------|---------------|------------ | | | 1937 ............. | $72,496.73 | $142,754.27 | $215,251.00 1938 ............. | 31,487.75 | 25,070.25 | 56,558.00 1939 ............. | 29,355.91 | 60,972.09 | 90,328.00 1940 ............. | .......... | 90,178.00 | 90,178.00 -------------------------------------------------------------
The above distributions as shown in the second column represented appreciation in the value of property accrued prior to March 1, 1913, and existing on that date and such distributions were from a realization of that appreciation.
On the basis of the tabulation set out above, the percentage of distribution from earnings and the percentage from realized appreciation were as follows:
------------------------------------------------------ | | | | Percentage of | Percentage of | distribution Calendar year | distribution | from realized | from earnings | appreciation | | | | | | --------------------|----------------|---------------- | | 1937 .............. | 33.65 | 66.35 1938 .............. | 55.64 | 44.36 1939 .............. | 32.52 | 67.48 1940 .............. | ............. | 100 ------------------------------------------------------
19. In the introduction of evidence in this proceeding, plaintiff called as a witness the certified public accountant who had prepared the information returns and analysis of surplus described in findings 17 and 18. He submitted a revised analysis of the accounts of the Gauley Coal Land Company with the view of showing the source from which the 1937 to 1940 dividends were paid.
In this second analysis or computation, earned surplus at December 31, 1912, is shown of $44,553.05 instead of earned surplus of $441,290.74 at March 1, 1913, as shown in the former analysis. In lieu of the cost figures as shown on the books of the company and used in the prior computation, he used as cost the cost figures shown in the valuation memoranda from the engineering division and mentioned in findings 11 and 12, and as March 1, 1913, values, the values as fixed and used by the Commissioner in the determination of the tax liability of the Gauley Coal Land Company. The result of his computation, so far as the source from which the distributions were made for the years 1937 to 1940, inclusive, is concerned, was the same as the former computation.
20. After the receipt of the information returns referred to in the preceding finding, the Commissioner on May 19, 1941, advised the Gauley Coal Land Company in part as follows:
"Reference is made to annual information returns, form 1096, reporting distributions made to your shareholders during the calendar years 1937, 1938, 1939, and 1940.
"Upon a final audit of your corporation income tax returns for the years 1937, 1938, and 1939, the distributions made during the years 1937, 1938, and 1939 have been finally determined to be taxable as shown below:
----------------------------------------------------------- | | | | | | | Amount | Taxable | Nontaxable Year paid | paid | percentage | percentage | | | ----------------|-------------|--------------|------------- | | | 1937 .......... | $215,251.00 | 33.65 | 66.35 1938 .......... | 56,558.00 | 55.64 | 44.36 1939 .......... | 90,328.00 | 32.52 | 67.48 -----------------------------------------------------------
"You are requested to prepare a form 1099 for each shareholder, other than a corporation, who received gross distributions of $100.00 or more during the calendar years 1938 and 1939. These forms will be marked in this office to show that the distributions for the year 1938 are 55.64% taxable and for the year 1939 are 32.52% taxable as dividends.
"On the basis of the data available, it has been tentatively determined that the distributions of $90,178.00 made during the calendar year 1940 are nontaxable in their entirety as dividends to the individual shareholders, pending the final audit of your corporation income tax return for the year 1940.
"Please prepare a form 1099 for each shareholder, other than a corporation, who received gross distributions of $100.00 or more during 1940. These forms will be marked to show that the distributions reported thereon are 100% nontaxable as dividends to the individual shareholders."
In a ninety day deficiency letter to plaintiff dated October 20, 1942, for the year 1940, the Commissioner stated:
"Although the dividends paid by the Gauley Coal Land Company in the year 1940 have been determined to be 100% nontaxable, the cost of the preferred stock has been recovered by nontaxable distributions prior to the year 1940."
21. Upon receipt of the letter of May 19, 1941, quoted in the preceding finding, the Gauley Coal Land Company on May 31, 1941, sent a letter to each of its preferred stockholders advising them of the ruling by the Commissioner with respect to the taxability of the distributions made for the years 1937 to 1940, inclusive, quoting in such communication paragraphs two and four of the Commissioner's letter of May 19, 1941. The two trusts, of which plaintiff is a beneficiary and which held preferred stock, received such notices.
22. The current earnings available to the Gauley Coal Land Company for distribution in the years 1937 to 1940, inclusive, were sufficient in amount to pay the percentage of the distributions shown in the Commissioner's letter of May 19, 1941 as "taxable," namely:
Percent 1937 .............................. 33.65 1938 .............................. 55.64 1939 .............................. 32.52 1940 .............................. 0
During the same years, appreciation which existed on March 1, 1913, but which had been realized subsequent thereto was available at least in amounts equal to the remainder of such distributions and shown in the Commissioner's letter as "nontaxable," as follows:
Percent 1937 .............................. 66.35 1938 .............................. 44.36 1939 .............................. 67.48 1940 .............................. 100
In addition to current earnings and realized appreciation, the corporation had capital available during the years 1937 to 1940, inclusive, more than sufficient to pay the distributions made in those years.
23. As shown in finding 6, plaintiff reported as taxable income in his returns for the years 1937 to 1939, inclusive, the total amount of the distribution received for those years on the preferred stock of the Gauley Coal Land Company. He did not include in his return for 1940 and 1940 distribution as taxable income, but the Commissioner, in his final determination of the deficiency, included the entire amount as taxable income in determining a deficiency for that year. Plaintiff filed claims for refund for the years 1937 to 1940 as follows:
----------------------------------------------------- | | | | Amount Calendar year | Date filed | claimed | | ----------------------------------------------------- | | 1937 .............. | Feb. 24, 1941 | $2,008.79 1938 .............. | Nov. 17, 1941 | 234.66 1939 .............. | ... do ...... | 723.82 1940 .............. | Dec. 2, 1942 | 1,908.01 -----------------------------------------------------
Each of the claims for the years 1937 to 1939, inclusive, was based on the ground that parts of the distribution from the Gauley Coal Land Company received by plaintiff through the trusts in which plaintiff was a beneficiary were tax exempt. The claim for 1940 was based on the ground that all of the distributions received by plaintiff in that year were tax exempt. This last claim also set forth an alternative contention that if and to the extent the distributions may be held to be taxable, they are taxable as long-term capital gains in which event only 50 percent of the distributions so received are includable in plaintiff's taxable income. The Commissioner rejected plaintiff's claim for refund for 1938 on March 20, 1943; the claims for refund for 1939 and 1940 on December 27, 1943; and the claim for refund for 1937 on November 1, 1944. The claims were rejected on the ground inter alia that since the cost of the stock to the holders thereof had been recovered through capital distributions prior to 1937, the entire amount of distributions received in each of the years was includable in gross income.
24. Article Eighth of the will of Ida A. Higginson, referred to in finding 6, contained the following provision with respect to the powers granted to the trustees of the residuary trust created by Article Sixth of that will:
"* * * if they see fit in their sole discretion, they may retain a portion of the income of such investments to diminish the cost or book value of the principal; * * * and generally to determine all questions as between principal and income in regard to both receipts and expenditures, and their decisions made in good faith shall be final."
25. Throughout the calendar year 1940 the residuary trust under the will of Ida A. Higginson owned a two-thirds interest in an apartment building located at 191 Commonwealth Avenue, Boston, Massachusetts. In the fiduciary return for 1940, the trustees reported the income and deductions on account of that apartment building as follows:
Rent ..................................... $21,740.29 Less:
Depreciation ............ $4,236.35 Repairs ................. 2,834.66 Other expenses .......... 14,933.17 ---------- 22,004.18 ---------- Loss ............................. 263.89
In addition, the return showed income from other sources including dividends and interest, and gains and losses from sales of stocks and bonds, the net result being a loss of $9,992.11.
26. After an examination of that return by a revenue agent, the Commissioner made certain adjustments therein one of which was to reduce the depreciation on that apartment building from $4,236.35 to $2,823.62, that is $1,412.73. The result of the Commissioner's adjustment was that instead of showing a loss of $263.89 from the apartment building, income was shown of $1,148.84, that is, an increase of $1,412.73. Since plaintiff had a three-fourths interest in that trust, the net result in the determination of the deficiency referred to in finding 5 was an increase in his income by three-fourths of that amount, namely, $1,059.54.
27. On December 31, 1940, the trustees under the trust, acting pursuant to the powers granted under the provision of the will set out in finding 24, determined that $4,066.67 of the amount received as rent from the building should be retained to amortize the cost of certain alterations which had been made to the building and an entry was made on the books of the trustees showing that amount transferred to the principal of the trust. However, no separate fund was set up on account of such amount, all rents received being commingled with other income of the trust and expenses and distributions of the trust being made without regard to the source of such distribution.
No part of the gross rents of $21,740.29 (finding 25) was distributed to plaintiff by the trustees in 1940. The trustees, in the exercise of their discretion, determined in good faith that no part of the gross rents from said apartment building should be distributed to the beneficiaries, and that all of such gross rents in excess of repairs and expenses should be retained as corpus or capital by the residuary trust and should be applied against and reduce the cost of the investment in said building.
28. On September 25, 1944, plaintiff filed a claim for refund of $2,185.82 for the year 1940 on the following ground:
"The trustees under the will of Ida A. Higginson in the income of which trust this taxpayer had an interest of three quarters, transferred from income to capital for depreciation on a rented building more than the amount claimed in their Federal income tax return, the difference being incorrectly charged to the beneficiaries.
"Claim is hereby made for the additional tax of $2,185.82 which was paid with interest according to law."
The Commissioner rejected that claim on November 16, 1945. On April 23, 1945, plaintiff filed an amended claim for refund for 1940 in the amount of $507.51 which, after quoting the provision of Article Eighth of the will heretofore mentioned and explaining the manner in which the Commissioner had reduced the depreciation on the building, stated:
"As a matter of fact, the trustees of said trust under Article Sixth, acting under the powers contained in Article Eighth above quoted, did not distribute to the taxpayer any part of the receipts from said real estate but retained the entire amount thereof to amortize the cost of certain improvements which had been made to the property in question.
"Taxpayer submits that his taxable income from the Residuary Trust u/w Ida A. Higginson was improperly increased in the amount of $1,059.54. This amount was neither "income of the * * * trust for its taxable year which is to be distributed currently by the fiduciary to the * * * beneficiaries" under Internal Revenue Code, § 162(b) [ 26 U.S.C.A. § 162(b)], nor "income of the * * * trust for its taxable year, which is properly paid or credited during such year to any * * * beneficiary" under Internal Revenue Code, § 162(c), and hence is taxable to the trustees of said trust and not to the taxpayer."
The Commissioner rejected that claim September 21, 1945.
Conclusion of Law
Upon the foregoing special findings of fact which are made a part of the judgment herein, the court concludes as a matter of law that the plaintiff is entitled to recover.
Entry of judgment for the total amount due, with interest, will be suspended to await the filing by the parties of a stipulation showing the amounts of the overpayments for 1937 to 1940, inclusive, together with the amounts on which and the dates from which interest as provided by law should be computed.
The first question presented is whether distributions by a corporation in payment of accumulated dividends on its preferred stock in the years 1937 to 1940, inclusive, to the extent that they represented distributions out of appreciation in value of property existing on March 1, 1913, and realized thereafter, were exempt from income tax, as claimed by plaintiff, or were taxable to the extent that they exceeded the basis of the stock, as claimed by defendant.
The facts with reference to the appreciation in value of property owned by the Gauley Coal Land Company on March 1, 1913, which was realized thereafter and distributed during the taxable years in payment in part of accumulated dividends on its preferred stock, are set forth in detail in findings 6 to 23, inclusive.
Plaintiff is a beneficiary under two trusts created by Ida A. Higginson, his interest under the first trust created by indenture being 100 percent and under the second residuary trust created by will, being 75 percent. Throughout the years 1937 to 1940, inclusive, and prior thereto, each trust owned 265 shares of the preferred stock of the Gauley Coal Land Company. Since 1903 the Gauley Company has had outstanding 11,440 shares of 6% cumulative preferred stock and 22,880 shares of common stock both of which had voting rights (finding 9). Under the charter no dividends could be paid on the common stock until all accumulated dividends on preferred stock had been paid. The accumulated and unpaid dividends on preferred stock were $200 a share on January 1, 1930. In 1930 the corporation decided to reduce the par value of its preferred stock and in that year and in 1931 the corporation made certain distributions in partial liquidation of the preferred stock from a par value of $100 a share to a par value of $1 a share (findings 14, 15). These distributions were not payments made as part of an arrangement for the complete retirement of the stock.
The cost basis for federal income tax purposes (gain or loss on sale) for the 265 shares of preferred stock owned by each trust, as set out above, was $17,225 for the trust under the indenture and $5,167.50 for the trust under the will. Nontaxable distributions were made by the Gauley Coal Land Company prior to January 1, 1937, in amounts exceeding such cost basis (finding 6).
After the par value of its preferred stock had been reduced, as above stated, the Gauley Company in 1934 began making payments on account of the accumulated dividends on its preferred stock, payments of $65, $31, and $30 for each share of stock being made during 1934, 1935, and 1936, respectively. As a result of these distributions, all earnings and profits of the corporation accumulated since March 1, 1913, had been distributed at December 31, 1936, and a part of the distributions so made was from sources other than earnings and profits accumulated since March 1, 1913. Similar distributions were made on account of the accumulated dividends on the preferred stock during 1937, 1938, 1939, and 1940, such payments being in the total respective amounts for each year on each share of stock of $19, $5, $8, and $8.
The total earnings which the Gauley Company had in each of the years 1937 to 1940, inclusive, and the total payments made in each of those years on account of the accumulated dividends on the preferred stock, as above-mentioned, were as follows:
------------------------------------------------------------- | | | | Distributions | | Total Calendar year | paid | Earnings | distributions | per share | | | | | -----------------|---------------|------------|-------------- | | | 1937 ........... | $19.00 | $72,496.73 | $215,251.00 1938 ........... | 5.00 | 31,487.75 | 56,558.00 1939 ........... | 8.00 | 29,355.91 | 90,328.00 1940 ........... | 8.00 | .......... | 90,178.00 -------------------------------------------------------------
The extent to which the distributions made from 1937 to 1940, inclusive, were paid from earnings accumulated since March 1, 1913, and the extent to which paid from appreciation existing on March 1, 1913, but realized since that time through sales of property or otherwise, were as follows:
----------------------------------------------------------- | | | | Amount | Amount | | paid from | paid from | Calendar year | earnings | realized | Total paid | | appreciation | | | | -----------------|------------|---------------|------------ | | | 1937 ........... | $72,496.73 | $142,754.27 | $215,251.00 1938 ........... | 31,487.75 | 25,070.25 | 56,558.00 1939 ........... | 29,355.91 | 60,972.09 | 90,328.00 1940 ........... | .......... | 90,178.00 | 90,178.00 ------------------------------------------------------------
Section 115 of the Revenue Act of 1936, 26 U.S.C.A. § 115, so far as here material provides:
"Sec. 115. Distributions by Corporations
"(a) Definition of Dividend. — The term "dividend" when used in this title (except in section 203(a)(3) and section 207(c)(1), relating to insurance companies) means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.
"(b) Source of Distributions. — For the purposes of this Act every distribution is made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits. Any earnings or profits accumulated, or increase in value of property accrued, before March 1, 1913, may be distributed exempt from tax, after the earnings and profits accumulated after February 28, 1913, have been distributed, but any such tax-free distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113."
Section 113 contains provisions with reference to the determination of the cost or value basis of property, including stock, for the purpose of measuring the gain or loss upon the sale or disposition thereof.
Counsel for defendant take the position that dividend distributions of the character here involved are exempt from tax under subsection (b) above only until the amounts received by the stockholder equal the adjusted basis of the stock, as provided in section 113, and that all amounts thereafter received are taxable income. We cannot agree. Since the advent of the income tax in 1916, earnings accumulated prior to March 1, 1913, or increase in value of property existing on that date, have been treated in cases such as this as being in the nature of capital and exempt from tax when distributed. Southern Pacific Co. v. Lowe, 247 U.S. 330, 335, 38 S.Ct. 540, 62 L.Ed. 1142.
The defendant would have us read § 115(b) as providing that distributions of the character here involved shall be exempt from tax until they equal the adjusted basis of the stock and shall thereafter be taxable as other income. The difficulty with this position of defendant is that the statute expressly provides otherwise, and to interpret it as defendant contends would amount to legislation. The test of the exemption provided for in the statute is not the basis of the stock in the hands of the stockholder. The basis of the exemption from tax is the source of the distribution. The provision that the "tax-free distribution" shall be applied against and reduce the basis of the stock "provided in section 113," relates to a matter entirely different from the taxation of the distributions when received; i.e., gain or loss upon the sale or disposition of the stock. The two provisions in subsection (b) are entirely consistent. The statute exempts the distributions from tax because they are treated as being in the nature of distributions of capital and they are applied against the basis of the stock, until they equal such basis, for the same reason. There is no indication whatever of an intention to impose a tax on the amounts distributed in excess of the basis. We think the obvious intention is to the contrary. The application of the distributions against the cost or other basis of the stock has no effect whatever upon taxability or nontaxability of the distributions when received by the stockholder. This view is supported by the decision of the Tax Court in Ernest E. Blauvelt v. Commissioner, 4 T.C. 10, 18, in which the court said:
"* * * we conclude and hold that Congress has made no provision for taxing as gain amounts such as are involved herein, and that the provisions relative to application of distributions against basis contain nothing upon which to bottom such taxation, contrary to the definite language providing the exemption." [Italics supplied.]
Reports of the Committees of Congress relating to the statutory provision in question also support our interpretation of the section.
Ways and Means Committee Report No. 179 on the Revenue Bill of 1924, 68th Cong., 1st Sess., p. 11, states: "In subdivision (b) of the existing law it is provided that tax-free distributions out of earnings and profits accumulated prior to March 1, 1913, shall be applied against and reduce the basis of the stock only for the purpose of determining a loss from the subsequent sale of the stock; such a distribution is not applied against the basis of the stock for determining the gain from its sale. The proposed bill in section 201(b) provides that a distribution out of earnings and profits accumulated prior to March 1, 1913, shall be applied against the basis of the stock for the purposes of determining both gain and loss from its subsequent sale.
"The theory which causes the allowance of the receipt of the dividend free of tax is that this distribution, being out of earnings accumulated prior to March 1, 1913, constitutes a return of capital to the stockholder. If it is treated as a return of capital for purposes of taxation, it should manifestly be considered a return of capital for purposes of determining his capital investment in the stock, and the resulting gain or loss from its subsequent sale."
In the Revenue Bill of 1928, the House of Representatives eliminated the exemption provision of Section 115(b) at the request of the Treasury Department (Hearings before the Committee on Ways and Means on Revenue Revision, 1934, 73d Cong., 2d Sess., p. 77), and its Report No. 2, 70th Cong., 1st Sess., p. 20, the Committee said: "Under previous revenue acts corporate distributions from surplus accumulated prior to March 1, 1913, were exempt from tax. There appears to be no reason for continuing this exemption indefinitely. Over fourteen years have elapsed since March 1, 1913, and most corporations have distributed the surplus accumulated by them prior to March 1, 1913. It seems an appropriate time (particularly in view of the resulting simplification) to eliminate this exemption."
However, the exemption provision was restored by the Senate and the Committee on Finance of the Senate, in its Report No. 960, 70th Cong., 1st Sess., p. 12, said: "Under the present law, if a corporation pays a dividend out of earnings or profits accumulated before March 1, 1913, or out of increase in value of property accrued before March 1, 1913, the dividend in either case is not taxable to the shareholder, but the amount of the dividend reduces the basis of the stock in his hands. Under the House bill the dividend would be subject to the surtax as in the case of any other dividend, and the basis of the stock is not reduced. The provisions of the present law have been in force, except for certain amendments, since the 1916 act, and your committee believes that they should continue in force. Consequently, they had been restored without change." See, also, Senate Finance Committee Report No. 665, 72d Cong., 1st Sess., pp. 30, 31, on the Revenue Bill of 1932, and Report No. 558, 73d Cong., 2d Sess., p. 36, on the Revenue Bill of 1934.
The Committee on Ways and Means, in its Report No. 708, 72d Cong., 1st Sess., pp. 21, 22, on the Revenue Bill of 1932, stated, with reference to Section 113(b)(1), Adjusted Basis, in part, as follows: "The 1928 act required the basis of stock to be reduced by distributions which, under the law when made, were applicable against basis. The new bill in subparagraph (D), requires, in addition, that basis be reduced by distributions which were free of tax when made. The Board of Tax Appeals has held that distributions out of profits accumulated before March 1, 1913, were not technically a return of capital, because made out of profits rather than capital, and could not be applied against basis in the absence of a specific statutory requirement. Some of the earlier revenue acts, while exempting such distributions from tax, did not in terms require them to be applied against basis, and distributions made during the effective periods of these acts would not, under the language of the 1928 provisions, be applicable against basis. The reason for exempting distributions of this character was that they were regarded as closely akin to a return of capital, whether or not technically such, and the same reasoning requires that they be applied in reduction of basis."
Plaintiff is entitled to recover the overpayments, with interest, resulting from the erroneous inclusion in income for the four years in question, of the amounts of the tax-free distributions hereinabove set forth, and judgment will be entered accordingly.
The next question is whether plaintiff is entitled to recover, as an overpayment, the tax exacted by reason of defendant's inclusion in his income for 1940 the amount of $1,059.54 which was, in the discretion of the fiduciary under the residuary trust, withheld and not paid or credited to plaintiff. In this question is also the further question whether plaintiff filed a sufficient and timely claim for refund (findings 25-23).
Under the facts we are of the opinion that the amount of $1,059.54 in question was not taxable income to plaintiff; that his original timely claim for refund of September 25, 1944, was sufficient when analyzed in the light of the facts, and that the clarifying amendment thereof filed April 23, 1945, was proper. Neither claim had been acted upon by the Commissioner of Internal Revenue at the time this suit was instituted. Both claims were thereafter disallowed.
The item of $1,059.54 in question was a part of the total rent of $21,740.29 received for 1940 by the trustees under the Ida A. Higginson Trust, on an apartment building in Boston (finding 25). The expenses chargeable and charged against the rental income, including $4,236.35 depreciation set up by the trustees and deducted in the fiduciary return for 1940, totaled $22,004.18, or $263.89 in excess of the rent received. See tabulation in finding 25. There can be no question about the fact that the items of "repairs" and "other expenses" of the trust totaling $17,767.83 had been incurred and were proper charges, and that no portion of this sum was distributable income to plaintiff. No adjustment was made in either of these items by the Commissioner. The trust therefore had left in the item of rent received, a balance of $3,972.46 out of which the trustees had the right and authority to deduct depreciation on the building before paying or crediting any of the rental income to the plaintiff as a beneficiary of the trust. The trustees charged on their books and in the fiduciary return for 1940 the amount of $4,236.35 for depreciation of the apartment building, or $263.89 in excess of the balance of the rent received, thereby showing a loss of that amount. As hereinafter shown no part of the balance of $3,972.46 in the rent account before depreciation, as abovementioned, was distributable to plaintiff; no portion of that sum was paid or credited to him, and he had no right under the terms of the trust to demand payment. Plaintiff did not return any portion of the $3,972.46 as income.
The defendant audited the fiduciary return after an investigation and audit of the books and records of the trust, and reduced the depreciation claimed in the return from $4,236.35 to $2,823.62. This had the effect of showing a balance in the rent account of $1,148.84, three-fourths of which, or $1,059.54 was charged by defendant to plaintiff, a beneficiary, and treated as income to him subject to tax.
If nothing further had occurred during 1940 with reference to the rent received by the trust, the action of the defendant in treating the amount mentioned as income to plaintiff would have been proper. However, the will, under which the trust was created, authorized the trustees in their sole discretion to retain a portion of the rental income of $21,740.29 received from the investment in the apartment building, to diminish the cost or book value of the principal, and further authorized them to determine all questions as between principal and income in regard to both receipts and expenditures, and made their decisions as to these matters final (finding 24). Under this authority the trustees, in the exercise of their discretion, determined in good faith (finding 27) that the sum of $4,066.67 of the total rent received should be held to amortize the cost of certain alterations to the apartment building, and transferred that amount from the rental income to the principal of the trust. This, even on the basis of the defendant's decision as to the depreciation item, left no amount distributable to plaintiff under the will and Section 162(b), Internal Revenue Code, 26 U.S.C.A. § 162(b), or properly to be paid or credited to him under 162(c). It is clear, therefore, that plaintiff is entitled to recover the deficiency and interest assessed and collected on the item of $1,059.54, if he filed a timely and sufficient claim for refund.
It is our opinion that such a claim was filed September 25, 1944, which was clarified by a proper amendment filed April 23, 1945. The original claim, made after the deficiency had been determined and collected, stated that "The trustees * * * transferred from income to capital for depreciation on a rented building more than the amount claimed in their * * * return, the difference being incorrectly charged to the beneficiaries." The facts upon which this claim was based were those already before the Commissioner as disclosed by his investigation and audit of the books, records and return of the trust. The Commissioner was not misled by the rather awkward manner in which the ground of the claim was set forth. Read literally the language of the claim was not entirely clear, and a casual reading of the claim might indicate that plaintiff was making some claim with reference to depreciation. However, when the claim is read in the light of the subject matter to which it related and the facts before the Commissioner and upon which it was based, the substance of the ground stated in the claim is clear enough. The statement that the trustees had "transferred from income to capital for depreciation more than the amount claimed in their return" obviously had reference to the $4,066.67, transferred from income to principal in addition to the claim of the trustees for $4,236.35 depreciation in the return. The use by plaintiff of the word "depreciation" instead of "amortization" was not fatal to the claim in the circumstances. In this instance both words mean substantially the same thing. The claim was made after the deficiency had been assessed and collected and the phrase, "the difference being incorrectly charged to the beneficiaries," appearing at the end of the claim, obviously had reference to the difference of $1,059.54 between the amount of depreciation claimed and the amount of $2,823.62 allowed, which difference plaintiff was asserting could not be taxed as income to him. No other reasonable interpretation can be given to the claim. The sufficiency of a claim for refund is to be judged by the substance as related to the facts rather than the form in which it is stated.
The amendment filed April 23, 1945, did not state a new or different ground, but simply clarified the ambiguous language of the original claim. The amendment, which was filed before the Commissioner had taken any action on the original claim, was, therefore, timely and proper.
Plaintiff is entitled to recover the over-payment of tax and interest on this item of his claim, together with interest on the total, as provided by law.
Judgment will be entered in favor of plaintiff for the total amount due with interest, in accordance with the findings of fact and the foregoing opinion, upon the filing by the parties of a computation or stipulation showing the exact amounts of the several overpayments, the dates of payment, and the amounts on which and the dates from which interest at 6% per annum is to be included in the judgment. It is so ordered.