Opinion
No. L-134.
May 2, 1932.
Suit by R.L. Heflin, Inc., against the United States.
Judgment in favor of the defendant dismissing the petition.
This is a suit for the recovery of $22,955.34, with interest, representing income and profits taxes alleged to have been illegally assessed and collected for the years 1920 and 1921.
The court, upon the stipulation of the parties, makes the following special findings of fact:
1. The plaintiff, R.L. Heflin, Inc., is a corporation organized under the laws of the state of Texas, with its principal office at Galveston, Tex.
2. On September 3, 1920, pursuant to the provisions of the Revenue Act of 1918, plaintiff corporation filed an income and profits tax return for its fiscal year ended July 31, 1920, showing a tax due of $6,458.78, which amount was duly paid.
3. On September 12, 1921, plaintiff corporation filed an income and profits tax return for the fiscal year ended July 31, 1921, showing a tax due of $6,349.14, which amount was duly paid.
4. Upon an audit and review of the return filed for the fiscal year ended July 31, 1920, the Commissioner of Internal Revenue determined the tax liability for that year to be $4,321.17, and the difference of $2,137.61 between that figure and the amount paid by the corporation was refunded, with interest, in March, 1925.
5. Upon an audit and review of the return filed for the fiscal year ended July 31, 1921, the said Commissioner determined that the tax liability for that year was $4,529.74, and the difference of $1,819.40 was refunded to the corporation, except the amount of $348.55, which was credited against a tax owing for the year ended July 31, 1923.
6. On August 17, 1925, the Commissioner of Internal Revenue, pursuant to section 274(a) of the Revenue Act of 1924 (26 USCA § 1048 note), addressed a letter to the plaintiff corporation, notifying it of a deficiency in tax of $9,316.18 for the fiscal year ended July 31, 1920, and of $9,530.75 for the fiscal year ended July 31, 1921.
7. On or about November 10, 1925, the plaintiff filed with the Bureau of Internal Revenue the following income and profits tax waiver for the fiscal year ended July 31, 1920, which was in due course signed by the then Commissioner of Internal Revenue:
"Income and Profits Tax Waiver for Taxable Years Ended Prior to January 1, 1922"IT:R:P:WWK.
"November 10th, 1925.
"In pursuance of the provisions of existing Internal Revenue Laws R.L. Heflin, Incorporated, a taxpayer of Galveston, Texas and the Commissioner of Internal Revenue hereby waive the time prescribed by law for making any assessment of the amount of income, excess-profits, or war-profits taxes due under any return made by or on behalf of said taxpayer for the year (or years) fiscal year ended July 31, 1920, under existing revenue acts, or under prior revenue acts.
"This waiver of the time for making any assessment as aforesaid shall remain in effect until December 31, 1926, and shall then expire except that if a notice of a deficiency in tax is sent to said taxpayer by registered mail before said date and (1) no appeal is filed therefrom with the United States Board of Tax Appeals then said date shall be extended sixty days, or (2) if an appeal is filed with said board then said date shall be extended by the number of days between the date of mailing of said notice of deficiency and the date of final decision by said board.
"[Seal] R.L. Heflin, Inc. "[Signed] By Geo. H. Gymer, President, "Taxpayer. "[Signed] D.H. Blair, "Commissioner.
"If this waiver is executed on behalf of a corporation, it must be signed by such officer or officers of the corporation as are empowered under the laws of the State in which the corporation is located to sign for the corporation, in addition to which, the seal, if any, of the corporation must be affixed."
8. The plaintiff corporation, by petition filed October 15, 1925, and designated as docket No. 8100, appealed to the United States Board of Tax Appeals for a redetermination of the tax liability for the fiscal years ended July 31, 1920, and July 31, 1921. The proceeding was heard by the Board on January 27, 1927, and in a decision promulgated August 8, 1927, the Board decided the appeal adversely to the plaintiff corporation, and on August 17, 1927, it entered an order of redetermination finding a deficiency in tax for the fiscal year ended July 31, 1920, in the sum of $9,316.18, and for the fiscal year ended July 31, 1921, in the sum of $9,530.75.
9. Under date of September 19, 1927, the plaintiff, by its authorized attorney, addressed the following letter to the Commissioner of Internal Revenue:
"Quigley Hammers, Attorneys at Law, 501-3 Union Trust Building,"Washington, D.C., September 19, 1927.
"In re: R.L. Heflin, Inc.
"Commissioner of Internal Revenue, Treasury Department, Washington, D.C."Dear Sir: By letter dated August 17, 1927 (IT:CA:2552-10-60D) R.L. Heflin, Inc., Security Building, Galveston, Texas, was notified of a deficiency in tax for the fiscal year ended July 31, 1920, of $9,316.18 and a deficiency in tax for the fiscal year ended July 31, 1921, of $9,530.75.
"An appeal was taken to the Board of Tax Appeals, Docket #8100. This appeal was decided adversely to the taxpayer corporation in a decision promulgated by the board on August 8, 1927, and the amounts in question were shown in a final order of redetermination entered August 17, 1927.
"Under the provisions of the revenue act of 1926 the taxpayer has six months in which to note an appeal to the courts for a review of the board's decision. Such an appeal can apparently be prosecuted whether the tax is paid or not. It is the desire of the company to pay the tax at this time and thus avoid the necessity of paying interest on the amount during the time the appeal is being considered, should the decision of the board be upheld.
"It is requested, therefore, that the deficiencies set out in the board's order of August 17, 1927, be placed on the assessment list for collection.
"Yours very truly, "[Signed] Wm. S. Hammers, "WSH:LB. Attorney for Taxpayer."
10. On or about February 5, 1929, the plaintiff filed with the collector of internal revenue for the First district of Texas, at Austin, Tex., for transmission to the Commissioner of Internal Revenue, separate claims for refund for the fiscal years ended July 31, 1920, and July 31, 1921, respectively. Copies of these claims are attached to the stipulation marked "Exhibit A," and made a part of these findings by reference.
11. The plaintiff was advised by letter, dated July 25, 1929, that the claims for refund above mentioned were rejected by the Commissioner of Internal Revenue on schedule dated July 25, 1929.
12. From the evidence presented in the proceeding heard before the United States Board of Tax Appeals, and referred to in finding 8 of these findings, the Board made the following findings of fact, upon which it predicated its decision of August 8, 1927:
"Findings of Fact"The petitioner is a Texas corporation with its principal office at Galveston. It is engaged in the business of purchasing cottonseed products for export trade. The corporation was organized early in the year 1919 and began operations August 1, 1919. The capital stock authorized and outstanding during the years in question amounted to $20,000. It was all owned in equal shares by Kate Heflin and G.H. Gymer. The former was the widow of R.L. Heflin, who had conducted the business individually for a number of years prior to its incorporation. G.H. Gymer was, for many years, an employee and business associate of R.L. Heflin. During the years 1920 and 1921 he served as manager of the business and received as compensation for his services a salary of $3,600 for the first year and $5,000 for the second year.
"The business in which the petitioner was engaged was generally considered a hazardous one. There was often required the use of considerably more capital than was available to the corporation in order to operate to the best advantage. To obtain the necessary additional credit the petitioner entered into agreements with its two principal stockholders whereby the latter were each to assign over an equal amount of private securities to the petitioner's bank for the credit of the petitioner and were to receive in return a one-fourth part each of the net profits of the business. Pursuant to these agreements the following instruments of assignment were executed:
"Whereas it is contemplated that the corporation of R.L. Heflin, Inc., of Galveston, Texas, in the conduct and management of its business of exporting cottonseed products, etc., will require loans and advances of funds from its bankers, Hutchings, Sealy Co., of Galveston, Texas, in excess of its capital stock and said capital stock being owned largely by Geo. H. Gymer of Galveston, Texas, and myself, and it being desirable that said bankers should be secured as far as possible in any loans or advances made said corporation of R.L. Heflin, Inc.
"Now, therefore, in consideration of the premises, and as a pledge to secure the said Hutchings, Sealy Co. in any loans or advances which may be made by said firm of Hutchings, Sealy Co. to the corporation of R.L. Heflin, Inc., during the season of 1919-1920, beginning August 1, 1919, and ending July 31, 1920, I have this day deposited with said Hutchings, Sealy Co., the following deeds, documents, papers, and securities, conditioned that the said Geo. H. Gymer shall deposit or cause to be deposited with said firm of Hutchings, Sealy Co., securities, papers, and documents of equal value as those now deposited by me, as a pledge also to secure any and all loans and advances which may be made to said corporation of R.L. Heflin, Inc., and under the same terms and conditions as the securities so deposited by me with said firm of Hutchings, Sealy Co.
"I further agree and bind myself that of such securities now deposited by me with Hutchings, Sealy Co., as may not be negotiable, I will, upon demand of said Hutchings, Sealy Co. to make them so, and further agree to execute any and all papers, deeds, releases, etc., as may be necessary to put the title to the property mentioned in any such papers or deeds, in Hutchings, Sealy Co. should there be any default in the payment of any or all advances so made by said Hutchings, Sealy Co. to said corporation, of R.L. Heflin, Inc., and should the same become necessary. And in the event I shall fail to do so, I hereby constitute and appoint John Sealy of Galveston, Texas, my true and lawful attorney, to execute, in my name, all deeds, papers, and other documents which may be necessary to accomplish the purpose of this agreement, hereby ratifying and confirming any and all lawful acts which my said attorney may do by virtue thereof:
"The deeds, documents, and papers and securities mentioned above and which are now deposited with said Hutchings, Sealy Co. are as follows:
95 shares of the capital stock of the American Indemnity Co. of Galveston — value 186.6 per share ............................ $17,727.00 100 shares of the capital stock of R.L. Heflin, Inc., par value .................... 10,000.00 __________ Total .................................... 27,727.00
"[Signed] Mrs. Kate E. Heflin.
"The first three paragraphs of the agreement executed by Geo. H. Gymer were identical with the first three paragraphs of the foregoing. The agreement then provided —
"The deeds, documents, and papers and securities mentioned above and which are now deposited with said Hutchings, Sealy Co. are as follows:
100 shares of the capital stock of R.L. Heflin, Inc., of the par value of ......... $10,000.00 Liberty bonds of the face value of $4,300.00 but of estimated value of ................. 4,050.00 Second Liberty loan: Bonds Nos. 1338087, 1338088, and 1338089 each for $100 ......... $ 300.00 Bond No. 191107 ................ 500.00 Bond No. 191108 ................ 500.00 Fourth Liberty loan: Bonds Nos. 117861 to 117870, ten bonds of $100 each ............ 1,000.00 Bond #702669 ................... 1,000.00 Bond #2761733 .................. 1,000.00 __________ Total Liberty bonds ...................... 4,300.00 My life insurance policy in the Great Western Life Insurance Co. of Kansas City, Mo., now International Life Insurance Co., #GW 894, of the cash value ........... 1,503.00 My life insurance policy in the Franklin Life Insurance Co. of Springfield, Ill., #89403, of the cash value of .............. 382.00 15 shares of the capital stock of the American Indemnity Co. of Galveston, of the value of $186.66 per share, valued at ........................................ 2,800.00 2 shares of the capital stock of Dickinson State Bank, Dickinson, Texas .............. 200.00 20 shares of stock of the Caldwell Oil Mill Co., Caldwell, Texas, of the par value of $100 per share, cost me .......... 3,000.00 Deeds: Deeds to 9-13/100 acres of land out of Perry Austin League, north bank of Dickinson Bayou, addition to town of Dickinson, Galveston County, Texas, and Improvements, of the value of ..................................... 4,100.00 __________ Total ................................... 26,035.00
"[Signed] Geo. H. Gymer.
"The agreements were formally adopted by the petitioner at a stockholders' meeting held July 31, 1919. The minutes of such meeting read as follows:
"Galveston, Texas, July 31, 1919.
"At the annual meeting of the stockholders of R.L. Heflin, Inc., this day held in Galveston, the President stated:
"`That in negotiating credit with the company's bankers, Hutchings, Sealy Co., they had declined to extend to the company sufficient line of credit to enable it to transact a profitable business, stating that the company's capital of $20,000.00 was not sufficient to justify more than a moderate line of credit; that in attempting to arrive at a solution of the difficulty, he and Mrs. Kate E. Heflin had decided to make a proposition to the company which would properly finance it for the ensuing year; that he and Mrs. Kate E. Heflin would deposit with Hutchings, Sealy Company personal collateral in such an amount as demanded by Hutchings, Sealy Co. to secure line of credit needed by the company for the transaction of its business, provided that he and Mrs. Kate E. Heflin would receive 50% of the profits earned in the operation of R.L. Heflin, Incorporated, during the twelve months next succeeding, commencing August 1st, 1919, and ending July 31st, 1920, less necessary expenses, and that the company would receive 50 per cent. of the profits during stated period.'
"Motion was made and unanimously adopted as follows:
"`That the proposition made the company by Mr. Geo. H. Gymer and Mrs. Kate E. Heflin to finance the business of the company for twelve months, they to receive one-half of the profits earned in the transaction of the business of the company, less necessary expenses.'
"For the next fiscal year ended July 31, 1920, the stockholders executed similar instruments assigning approximately the same assets, and the agreements were duly approved by the petitioner at a stockholders' meeting held July 31, 1920. The firm of Hutchings, Sealy Co. with whom the securities were pledged, advanced to the petitioner the credit that was needed to carry on its business during the years 1920 and 1921. The petitioner gave to the bank its demand notes for the amounts advanced and paid interest thereon to the bank. These notes were usually paid when the petitioner realized upon the particular transaction for which they were given. Each note purported to be secured by a lien upon the bill of lading covering the shipment of the goods described therein, but the bills of lading were at all times in the possession of the petitioner. The credit with Hutchings, Sealy Co. was increased by the assignment to it of the private securities of the stockholders at least to the extent of the value of such securities, exclusive of the capital stock of the petitioner which was pledged by the stockholders.
"For the fiscal years ended July 31, 1920, and July 31, 1921, the petitioner paid over to the stockholders one-half of the net income of the business amounting to $19,722.82 and $20,516.76 for the respective years. These amounts the petitioner charged to expenses and deducted from gross income upon its income-tax returns for those years. The respondent has refused to allow the deduction in computing the petitioner's net taxable income."
William S. Hammers, of Washington, D.C. (John Neethe, of Galveston, Tex., and Edward T. Quigley, of Washington, D.C., on the brief), for plaintiff.
Charles B. Rugg, Asst. Atty. Gen. (Ralph C. Williamson, of Washington, D.C., on the brief), for the United States.
Before BOOTH, Chief Justice, and GREEN, LITTLETON, WILLIAMS, and WHALEY, Judges.
This case was before the Board of Tax Appeals ( 7 B.T.A. 1002). The findings of fact made by the Board have been stipulated as facts herein. We have gone over the opinion of the Board of Tax Appeals and think the same is correct, and the petition will have to be dismissed. It is so ordered.
The opinion of the Board of Tax Appeals was in full as follows:
Smith: The only question to be decided in this appeal is whether the amounts paid out by the petitioner to its principal stockholders under the agreements above described come within the deductions permitted by section 234(a)(1) of the Revenue Acts of 1918 and 1921 ( 40 Stat. 1077, 42 Stat. 254). The section, which is identical in both acts, reads as follows:
"Sec. 234. (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
"(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity. * * *"
There is no question raised as to the legality or the bona fides of the agreements entered into between the petitioner and its stockholders. Presumably the securities deposited with Hutchings, Sealy Co. were, during the years involved, subject to the uses and purposes stated in the agreements.
We are of the opinion, however, that the payment of 50 per cent. of the net profits of the business for the use shown to have been made by the petitioner of the additional credit provided by the pledging of the securities did not constitute an ordinary and necessary expense of carrying on the petitioner's business. We do not know, in the first place, to what extent the additional credit was really necessary or was actually used by the corporation. The evidence is to the effect that the credit needed to carry on the business to the best advantage was at times greatly in excess of the company's capital. There is not shown, however, any specific instance of the use of the credit provided by the pledging of the securities. As to the general method of conducting the business, G.H. Gymer deposed as follows:
"Q. Now, the money that you borrowed for the corporation, Mr. Gymer, was practically all on short loans, wasn't it, demand notes? A. Most of it, averaging.
"Q. Not over 10 days after payment? A. No, they were indefinitely.
"Q. Weren't they demand notes? A. They were demand notes, but at the same time we were never called upon to pay them, until we had shipped the goods, and were able to satisfy the notes.
"Q. The fact is, in that case, the bank was willing to hold those notes for you? A. Yes, sir.
"Q. And then accept payment from the goods that they held the notes against? A. Yes, sir, exactly. * * *
"Q. When you gave the notes with this memorandum to the bank, showing the cars it covered as security, did you furnish something to Hutchings, Sealy to indicate that they had a lien on that property? A. Oh, the receipt itself states so.
"Q. The trust receipt? A. The trust receipt, yes, sir, and the car numbers are cited on this trust receipt, together with the number of pounds contained, and the amount, the amount of the draft."
The total face value of the securities pledged, including the $20,000 of capital stock of the petitioner, was approximately $54,000. The petitioner paid to the stockholders approximately $20,000 for each of the years 1920 and 1921. This was not an ordinary expense.
The two stockholders to whom the money was paid owned all of the petitioner's stock in equal shares and received proportionate parts of the money. The result would have been precisely the same if the company had paid out the money by regular dividends. In the light of the evidence before us, the transaction was simply a distribution of the earnings of the corporation. Cf. Appeal of Universal Milking Machine Co., 4 B.T.A. 506.
Reviewed by the Board.
Judgment will be entered for the respondent.