Opinion
Docket Nos. 58660 58661.
1957-04-30
KINGSMILL CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.THOMAS M. BROOKS LUMBER COMPANY, INCORPORATED, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
George R. Humrickhouse, Esq., for the petitioners. Elmer E. Lyon, Esq., for the respondent.
George R. Humrickhouse, Esq., for the petitioners. Elmer E. Lyon, Esq., for the respondent.
Held, the transactions by and between petitioner corporation and Horace A. Gray, Jr., resulted in the creation of a corporation-stockholder relationship instead of a debtor-creditor relationship; therefore, the sums paid out by the petitioner in the taxable year were nondeductible dividends and premium on the retirement of preferred stock. Held, further, the sums expended by petitioner for professional fees are nondeductible corporate organizational expenses.
The respondent determined a deficiency in income tax against petitioner Kingsmill Corporation for the taxable year ended May 31, 1951, in the amount of $18,245.81. The respondent determined a deficiency in income tax against Thomas M. Brooks Lumber Company, Incorporated, for the taxable year ended May 31, 1951, in the amount of $18,245.81 as transferee of Kingsmill Corporation. The term ‘petitioner’ will generally be used hereinafter to denote Kingsmill Corporation only.
The first question presented in this consolidated proceeding is whether the substance of the transactions by and between Kingsmill Corporation and Horace A. Gray, Jr., created a debtor-creditor relationship, whereby petitioner made certain interest payments, as is contended by the petitioner, or a corporation-stockholder relationship, whereby petitioner made certain dividend and premium payments upon the redemption of preferred stock, as is contended by the respondent.
The second issue is whether certain payments which were deducted by petitioner as ‘professional fees' were properly deducted as loan expenses, as contended by the petitioner, or are nondeductible organizational expenses as contended by the respondent.
FINDINGS OF FACT.
Some of the facts have been stipulated and are found accordingly.
The petitioner Kingsmill Corporation was organized as a corporation under the laws of Virginia on June 5, 1950. The corporate income tax return for Kingsmill Corporation for the taxable year ended May 31, 1951, was filed with the then collector of internal revenue at Richmond, Virginia. The petitioner Thomas M. Brooks Lumber Company, Incorporated (hereinafter referred to as the Lumber Company), was chartered in 1946 and was an existing corporation doing business on August 29, 1952. By order of the State Corporation Commission of Virginia, on August 29, 1952, Kingsmill Corporation was merged into the Lumber Company and its assets and liabilities were transferred to the Lumber Company. By reason of this merger, it has been stipulated that the Lumber Company is liable as transferee for any deficiencies in income tax that may be determined in this proceeding to be due from Kingsmill Corporation.
Thomas M. Brooks (hereinafter referred to as Brooks), as president of the Lumber Company, entered into an agreement on May 17, 1950, with J. N. Pew, Jr., et al., wherein the Lumber Company agreed to purchase a tract of timberland, known as King's Mill Properties, for a stated consideration of $1,000,000. The contract provided that time was of the essence and the closing date was set at not later than June 3, 1950. A cash downpayment of $500,000 was required, with the balance secured by a first mortgage on the property, payable in full in 1 year.
The Lumber Company, through Brooks, applied to a Richmond, Virginia, bank for a loan of $400,000 to close the land transaction but on May 20 or May 22, 1950, Brooks was notified that the loan would not be approved. Brooks then went to Galleher and Company, investment brokers in Richmond (hereinafter referred to as Galleher), to try to effect a loan. There, Brooks was told that it would be virtually impossible to get a loan of such size from an insurance company on the property involved because of the limited time to close the transaction. Brooks was also told that Horace A. Gray, Jr. (hereinafter sometimes referred to as Gray), who was a man of considerable wealth, might be interested in furnishing the money needed.
Galleher then contacted Gray with reference to a loan of $300,000 for the Lumber Company. Gray told Galleher that he was not interested in making a loan to anyone but would be interested if he could make some money out of it and get capital gains treatment on any money made. Brooks was thereupon notified that the money could be raised but only under conditions as set out by Gray and his attorneys shortly before and on June 2, 1950.
Simply, the plan proposed by Gray, through his attorneys, was that a new corporation be formed, called the Kingsmill Corporation. Under the plan, Gray would be issued 3,000 shares of preferred stock of the par value of $100 per share for $300,000 cash; the Lumber Company would be issued 2,000 shares of common stock in the new corporation with a par value of $100 per share in consideration for the conveyance to the new corporation of all its right, title, and interest in the timberland, subject to the first deed of trust in the amount of $500,000. Brooks, acting for the Lumber Company, objected to the formation of a new corporation but nevertheless agreed to the conditions set out on June 2, 1950. On the basis of this agreement, the parties borrowed $300,000 from a Richmond bank, secured by a second deed of trust on Kings Mill Properties. The Lumber Company furnished $200,000, acquired title to the timber tract, and immediately deeded the property to Kingsmill Corporation. The second deed of trust was paid off by Gray after the charter was granted to the new corporation, and Gray had been issued 3,000 shares of petitioner's preferred stock. A charter was obtained for Kingsmill Corporation on June 5, 1950.
Article Fourth of the Kingsmill Corporation's charter, insofar as is pertinent to the issues involved, is as follows:
The Preferred Stock and the Common Stock shall be issued upon the terms and conditions and with the rights and privileges following, that is to say:
(a) Except as hereinafter set forth, the Preferred Stock and Common Stock, shall have equal voting powers and the holders thereof shall be entitled to one (1) vote in person or by proxy for each share of stock held. The Common Stock, however to the exclusion of the Preferred Stock, shall have the sole voting power with respect to the following:
(1) The election of Directors up to January 2, 1951; and
(2) Determination as to whether or not the Preferred Stock shall be redeemed, as hereinafter provided.
So long as any shares of the Preferred Stock are outstanding, however, the unanimous consent of the holders of the Preferred Stock given in person or by proxy, either in writing or at a special meeting called for the purposes, at which the holders of the Preferred Stock shall vote separately as a class, shall be necessary for effecting or validating any one or more of the following transactions:
(1) The amendment of the Corporation's charter;
(2) The issue by the Corporation of any authorized but unissued stock of any class;
(3) The sale, lease or conveyance by the Corporation of all its property or business or any material part thereof necessary to the continued conduct of its business or the parting with control thereof, or the voluntary dissolution, liquidation or winding up of the Corporation;
(4) The merger of the Corporation into any other corporation, the merger of any other corporation into the Corporation or the consolidation of the Corporation with any other corporation;
(5) The Corporation's creation, issue and sale or assumption of any indebtedness for borrowed money or giving of any guarantee or similar obligation for the payment of any debt or performance of any obligation of any other person, firm or corporation;
(6) The loan of the Corporation's property or credit to any person, firm or corporation;
(7) The investment by the Corporation in the securities of any person, firm or corporation;
(8) The acquisition by the Corporation of property, real or personal, the cost of which exceeds $10,000 as to any one item.
(b) The holders of the Preferred Stock shall be entitled to receive, when and as declared by the Board of Directors, dividends from the surplus or net profits of the Corporation at the rate of Six Per Cent (6 percent) per annum before any dividends shall be paid upon, or provided for, the Common Stock. Such dividends shall be payable in semi-annual installments on December 15 and June 15 of each year, beginning June 15, 1951, shall begin to accrue from and after December 15, 1950, and shall be cumulative, so that, if in any semi-annual dividend period dividends at the rate of Six Per Cent (6 percent) per annum shall not be paid upon, or declared and provided for the Preferred Stock, the deficiency shall be fully paid or declared and set apart, with interest at Six Per Cent (6 percent), before any dividends shall be paid or declared upon the Common Stock.
After all accrued and unpaid dividends at the rate of Six Per Cent (6 percent) per annum on the Preferred Stock have been fully paid or declared and provided for, the holders of the Preferred Stock shall then be entitled to participate equally with the holders of the Common Stock, so that the holders of the Preferred Stock, in addition to the Six Per Cent (6 percent) preferred dividends above provided, shall receive a further amount per share of Preferred Stock equal to the amount per share of Common Stock to be received by the holders of the Common Stock.
(c) The Preferred Stock shall be preferred as to both earnings and assets, and in the event of liquidation, dissolution or winding up of the Corporation, whether voluntary or involuntary, the holders of the Preferred Stock of the Corporation shall be entitled, before any assets of the Corporation shall be distributed among or paid over to the holders of the Common Stock, to be paid in full $125 per share of Preferred Stock, together with all accrued and unpaid dividends and with interest on said dividends at the rate of Six Per Cent (6 percent) per annum. After payment in full of the above preferential rights of the holders of the Preferred Stock, then the holders of the Preferred Stock and Common Stock shall participate equally in the division of the remaining assets of the Corporation, so that from such remaining assets the amount per share of Preferred Stock distributed to the holders of the Preferred Stock shall equal the amount per share of Common Stock distributed to the holders of the Common Stock.
(d) Out of any surplus or net profits of the Corporation remaining after full cumulative dividends on the Preferred Stock for all previous dividend periods, and for the current dividend period, shall have been paid or declared and provided for, dividends may be declared and paid on the Preferred Stock and Common Stock in equal amounts per share regardless of class; provided that no dividends whatsoever shall be paid on the Common Stock so long as any dividend on the Preferred Stock shall be due and unpaid and no dividends whatsoever shall be declared prior to January 3, 1951 on the Common Stock.
(e) At any time after January 1, 1951, and not later than one year following issue of the Corporation's charter, the Corporation may, at its option expressed by resolution adopted by a majority of the shares of Common Stock, upon ten (10) days' written notice to the holders of the Preferred Stock, or without notice if agreed to in writing by all holders thereof redeem all shares of the Preferred Stock then outstanding at the following prices:
$125 if redeemed on or before February 15, 1951; and
$130 if redeemed after February 15, 1951. together in each case with a sum equal to all dividends accrued or in arrears to the redemption date. The Corporation, however, without obtaining the prior written consent of the holders of all outstanding Preferred Stock shall not
(1) Redeem less than all outstanding shares of Preferred Stock; or
(2) Redeem any Preferred Stock before January 2, 1951, or more than one year following issue of the Corporation's charter.
In the fall and early winter of 1950, Gray began asking about the progress being made in cutting and selling timber on the property bought and also inquired as to whether his stock could be retired after January 1, 1951.
On February 24, 1951, Gray, under authority of the charter and bylaws, gave notice of a meeting of stockholders to be held on March 7, 1951, for the purpose of electing new directors. Before such meeting was held, Brooks arranged to borrow from a Richmond bank the sum of $450,000. After the loan was arranged, Brooks was advised that instead of petitioner redeeming the preferred stock the Lumber Company was to purchase the stock from Gray and then the stock would be redeemed from the Lumber Company. Thereafter the Lumber Company obtained the loan and purchased the preferred stock held by Gray for $386,839.72 on March 31, 1951, and the preferred stock was canceled and retired in the hands of the Lumber Company.
In its return for the fiscal year ended May 31, 1951, petitioner claimed a deduction of $92,507.87 as ‘Loan expense,‘ explaining the expense as including ‘cost of retiring preferred stock under an agreement entered into at the time of issue.’ This deduction was disallowed ‘to the extent of $86,839.72 because it has been determined that the expenditure represents premium on retirement of 3,000 shares of preferred stock.’
Under the terms of the original agreement between Brooks and Gray on June 2, 1950, it was agreed that petitioner would pay all taxes, fees, and expenses in connection with the acquisition of the timber tract, the organization of the new corporation, the issuance of stock, and all other costs in connection with the transactions herein provided for. Petitioner paid, and claimed deductions for, $12,974.17 in the fiscal year ended May 31, 1951, terming the deductions ‘professional fees.’ The deduction was disallowed to the extent of $10,474.17 ‘because it has been determined that the amount in excess of $2,500.00 represents organizational expense.’
The transactions herein, by and between petitioner and Gray, created a corporation-stockholder relationship whereby petitioner expended the sum in issue as dividends and premium on the retirement of preferred stock, and such sum is therefore not deductible.
The deduction taken by petitioner of $10,474.17 for ‘professional fees' was properly disallowed by the respondent as the amount represents organizational expense.
OPINION.
MULRONEY, Judge:
The first and principal issue before us is whether certain sums paid by petitioner corporation constituted payment of dividends and premium on the retirement of preferred stock within the meaning of section 115(a), Internal Revenue Code of 1939, or payment of interest on a loan within the meaning of section 23(b), Internal Revenue Code of 1939. If the former, as contended by the respondent, the payments are not deductible in determining net income. If the latter, as contended by the petitioner, the payments are deductible. We think the petitioner has failed to sustain the burden of proving error in the respondent's determination.
The facts in the instant case are relatively simple. The Lumber Company had approximately 2 weeks in which to close a million dollar timber purchase. In addition to the cash on hand, the Lumber Company had to raise $300,000 cash within that time to close the transaction. It became clear within a few days that a loan could not be obtained through normal banking and investment channels because of the limited time available. Gray was contacted by a broker relative to making the loan and he agreed to furnish the money on certain conditions.
Because of his high income tax bracket, Gray made it clear that he did not want to enter anything unless he could get capital grains treatment on any profit he might make. Therefore a plan was proposed and accepted whereby a new corporation (the petitioner) was formed to take over the newly acquired timber tract. Under the plan, the Lumber Company would be issued 2,000 shares of common stock of the new corporation, and Gray would be issued 3,000 shares of preferred stock. The preferred stock would be redeemed at a premium and retired under conditions as set out in the charter. We do not deem it necessary to recount all of the conditions, restrictions, and privileges listed in the charter pertaining to the stock as that part of the charter is set out in full in our Findings of Fact.
The petitioner contends that the sum and substance of all the manipulations between Gray and the petitioner resulted in the creation of a debtor-creditor relationship. Therefore, according to the petitioner, the ‘preferred stock’ certificates held by Gray were mere evidences of indebtedness and any sums expended for the use of the money advanced were properly deductible as interest. The respondent, on the other hand, contends that the relationship created by the transactions related above was that which the parties themselves labeled it— a corporation-stockholder relationship, because of which the petitioner paid nondeductible dividends and premium on the retirement of preferred stock.
The basic question whether the payees of money from a corporation are stockholders or creditors and whether the payments constitute dividends or interest turns upon the consideration of all the relevant facts of an individual case. Crawford Drug Stores, Inc. v. United States, 220 F.2d 292. The basic question has been presented to this and other courts many times under widely varying facts. William Cluff Co., 7 B.T.A. 662; Greensboro News Co., 31 B.T.A. 812; Commissioner v. Proctor Shop, 82 F.2d 792, affirming 30 B.T.A. 721; Commissioner v. Meridian & Thirteenth R. Co., 132 F.2d 182, reversing 44 B.T.A. 865; United States v. Title Guarantee & Trust Co., 133 F.2d 990. Because of the widely varying facts underlying the conclusions reached in these and other cases, the many criteria named in the cases can, at best, serve only as general guides in our determination of the issue in the present case. The cases do agree that the decisive factor is not what the relationship and payments are called, but what in fact they are. United States v. Title Guarantee & Trust Co., supra.
In distinguishing between payment of dividends on stock and payment of interest on indebtedness, the determining elements, no one of which is conclusive, but all of which are usually recognized for consideration are (1) the name given to the transactions; (2) the presence or absence of a maturity date; (3) the source of the payments; (4) the remedies of the holder on default; (5) the right of the holder to participate in management; (6) the priority status of the holders as regards general corporate creditors; and (7) the intention of the parties. Crawford Drug Stores, Inc. v. United States, supra; Commissioner v. Meridian & Thirteenth R. Co., supra.
In the instant case, every document of the petitioner corporation referred repeatedly to the certificates held by Gray as preferred stock. As we have said, neither the nomenclature used nor any one of the other criteria listed above is conclusive standing alone but each is a factor to be considered. The certificates did not have a definite maturity date. This is another factor indicating that Gray did not make a loan to petitioner but invested in stock. It is a common attribute of a debt that the holder thereof is entitled to interest regardless of earnings on definite dates. Here, dividends were to be paid from earnings only when declared by the corporation. The remedies afforded Gray on default were those of a stockholder and not of a creditor. He could, after a certain period of time, take over the operation of the petitioner through the election of directors and participation in management, but this is a common remedy of a preferred stockholder, not a creditor. Gray, as a preferred stockholder, was preferred only to the common stockholders on liquidation or dissolution, the charter making the preferred stockholders subordinate to general creditors of the corporation.
Petitioner argues that Gray forced so many restrictions upon it and gained so many privileges for himself, that Gray was practically a mortgage creditor of the petitioner. As we see it, Gray perhaps drove a hard bargain and gained ‘as much preference over the common stockholders as the common stockholders themselves were willing to permit’ and surrounded himself with as many protective measures as the laws of Virginia would allow. Greensboro News Co., supra. None of the restrictions imposed upon petitioner's rights to function were inconsistent with the rights of a preferred stockholder.
Petitioner places great weight on the ‘intent of the parties' criterion. It is its argument that it intended to make a loan and Gray, in effect, was merely advancing the money in a transaction that he could label a stock transaction. Obviously, the Lumber Company wanted to make a loan when negotiations began. It is equally obvious that Gray did not intend to make a loan for the reason that he did not want interest, or ordinary income, to be added to his already high ordinary income. Gray expressed interest, in helping the Lumber Company acquire the timber tract, only if the transaction could be put on a capital gains basis. This, Gray insisted upon and this, the Lumber Company agreed to in order to acquire the timber tract.
The Lumber Company was apparently forced, by the limited time available to close the timber purchase, to accept the proposition of Gray even though it may not have been to the best advantage of the Lumber Company to do so. The Lumber Company, having decided to accept the terms of Gray, caused the petitioner corporation to be formed. Certainly we cannot say that the petitioner corporation did not intend to issue preferred stock to Gray, since the petitioner corporation would never have been brought into existence had there not been an agreement to issue preferred stock to Gray.
All of the criteria named in the cases cited, when applied to the instant fact situation, indicate that Gray was a preferred stockholder of petitioner. Therefore, the sums paid were dividends and premium on the retirement of the preferred stock held by Gray and cannot be deducted.
The second issue is whether sums totaling $10,474.17, paid by the petitioner in the taxable year in question and deducted as ‘professional fees,‘ were properly deductible. The respondent disallowed the deduction ‘because it has been determined that the amount * * * represents organizational expenses.’ The petitioner alleges in its petition that the respondent erred in disallowing this deduction as loan expense and in designating it organizational expense. This is denied by the respondent.
Of course the petitioner has the burden of proving error in the respondent's determination and petitioner has not done so. There was no evidence presented concerning this allegation of error except it was stipulated that payments were made to certain attorneys and a broker totaling $10,474.17. Therefore, the respondent must be upheld on this issue.
Decisions will be entered under Rule 50.