Delaware Terminal Corp. v. Commissioner ( 1939 )

DELAWARE TERMINAL CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Delaware Terminal Corp. v. Commissioner

Docket No. 86105.

United States Board of Tax Appeals

40 B.T.A. 1180; 1939 BTA LEXIS 743;

December 20, 1939, Promulgated

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Upon the organization of petitioner in 1932 by Terminal Barber Shops, Inc., a corporation having a large surplus accumulated over a period of about 25 years, but which sustained an operating loss in 1932, the latter's nine stockholders exchanged their stock for all of the stock of the former, and promptly thereafter Terminal Barber Shops, Inc., paid a dividend of $370,000 to petitioner in cash and securities to hold for the purpose of rendering financial assistance to its subsidiary in the event business conditions in the future rendered such action necessary. The intention was to transfer to petitioner all of the stock of subsidiaries of Terminal Barber Shops, Inc., but the transfers were never made because of certain conditions arising subsequent to petitioner's formation. Held, from the evidence, that petitioner was not formed or availed of during 1932 for the purpose of preventing the imposition of surtax upon its shareholders by permitting its gains to accumulate instead of being divided or distributed.

Hugh Satterlee, Esq., and I. Herman Sher, Esq., for the petitioner.

H. D. Thomas, Esq., for the respondent.

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DISNEY

This proceeding involves the redetermination of a deficiency of $185,591.57 in income tax for the period from September 13 to December 31, 1932. The issue is whether the petitioner was formed or availed of for the purpose of preventing the imposition of surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed within the meaning of section 104(a) and (b) of the Revenue Act of 1932.

FINDINGS OF FACT.

In 1907 Joseph B. Schusser, a journeyman barber employed in a shop in New York City, obtained a lease for a new barber shop in the new Hudson Terminal Building, which formed the New York terminus of the Hudson Tunnel, then in the course of construction. He then discussed with Henry F. Wolff, a lawyer customer, the matter of becoming a partner.

On March 10, 1908, the Terminal Barber Shops, Inc., hereinafter referred to as Terminal, was organized for the general purpose of operating barber shops and dealing in toilet preparations and barbers' supplies. Its bylaws required a majority of the stock to be represented at every meeting of the stockholders. Of the corporation's authorized capital stock of 50 shares, par value $100 each, Schusser received 25 shares in exchange for his lease, and Wolff and four of his friends, Herman W. Block, Howard S. Gans, Leon S. Hartman, and Fred M. Stein, each paid $500 in cash for five shares. Schusser placed one share of his stock in escrow so as to give the remaining stock a voting control. No additional capital was ever paid in. Except for the later issuance of a small number of shares to others, the ratio of Terminal's stockholdings did not change thereafter to September 1932, when the petitioner was organized. At that time Schusser held 1,000 shares, Wolff, Gans, Stein, Block, and Hartman each held 200 shares, Howard W. Carlough held 10 shares, and Fred A. Sudro and Charles H. Keller each held 2.5 shares, a total of 2,015 shares.

Terminal opened its first barber shop on May 1, 1908, in the Hudson Terminal Building. Schusser was very ambitious. His plans were to revolutionize the barber business on a large scale, but he did not know whether he could raise the necessary money at that time. The shop had small losses at the beginning, but Schusser was able to eliminate the operating losses by hard work.

In July 1909 Terminal opened another shop on the Hudson Terminal Concourse. Thereafter through 1931, 56 additional barber shops and beauty shops were opened up. In each instance, except one, the beauty shop was operated in connection with the barber shop at the same address. Four of the shops were opened in 1927, ten in 1928, six in 1929, five in 1930, and six in 1931. Thirty-six of the additional shops were located in New York, New York, eight in Detroit, Michigan, five in Chicago, Illinois, three in Cincinnati, Ohio, and two each in Pittsburgh, Pennsylvania, and Baltimore, Maryland. To operate the shops outside of New York and to protect its name in those and other states, subsidiary corporations were formed, seven under the name of Terminal Barber Shops and six under the name of Terminal Beauty Shops. In 1928 Terminal organized the Waldorf Products Co., Inc., under the laws of New York to furnish preparations for the hair and skin and other supplies to the various shops. The capital stock of the subsidiary corporations was at all times owned by Terminal.

Of the total of 58 shops opened up, all are still operating, with the exception of four shops in New York City, two of which were closed in 1914 and one each in 1930 and 1937, and two in Cincinnati, which were closed in 1937.

With a few exceptions a single lease covered the space occupied by the barber shop and the beauty shop operated in conjunction therewith. Practically all of the shops were located in large hotels or office buildings where barber shops were required as a business necessity from the standpoint of the owner of the premises.

Reconstruction work is required in connection with the opening of a shop in a new location. The cost of opening a new shop depends, among other things, upon the size of the shop and whether the owner of the premises assumes part of the cost. Terminal spent $86,000 to get the shop in the Empire State Building, New York City, ready for operation. In every instance, Terminal had to assume the cost of movable equipment, consisting, among other things, of chairs, machinery, vibrators, linens and hair brushes. The depreciated cost of the improvements and fixtures in the shops of Terminal and its subsidiaries at the close of 1924 was $161,000 and at the close of 1931 it was $665,000. Terminal depreciated the property at the composite rate of 20 percent per annum.

There is a barbers' strike organized in New York City every spring. In 1932 the American Federation of Labor made a special attempt to organize the shops operated by Terminal in New York City. Police protection was considered necessary and 65 policemen were assigned to protect the shops and barbers for a period of eleven weeks. The barbers of Terminal had their own brotherhood. In 1932 Terminal had about 800 employees in New York City and the subsidiaries had between 500 and 600 employees. The number of employees of all the corporations in 1929 was 1,800.

With a view to obtaining the interest and good will of its employees and improving its business and as a safeguard against strikes and labor trouble, in May 1924 Terminal offered to its employees an issue of 1,000 shares of its 7 percent cumulative preferred stock, par value $100 each, redeemable on any dividend date at $110 per share, plus accumulated dividends. By the terms of the offer any holder could, upon the giving of 60 days' notice thereof, require Terminal to repurchase the stock at its par value, plus accumulated dividends, and borrow money from Terminal from time to time upon the security of the stock. Only employees were permitted to subscribe for and hold the stock. No employee, however, was required to make a subscription. The issue was oversubscribed about two to one and each employee who subscribed was allotted from one to three shares. In April 1926 and December 1928 like issues were offered to the employees upon the same terms and both were oversubscribed. Shares of stock were retired from time to time upon request of the stockholders. At one time about 500 employees held the stock.

The preferred stock outstanding, including subscriptions, at the close of the years 1924 to 1937, inclusive, was as follows:

1924	$89,000
1925	70,900
1926	170,000
1927	126,200
1928	107,800
1929	$220,700
1930	183,800
1931	156,000
1932	126,400
1933	102,700
1934	$89,300
1935	71,400
1936	57,500
1937	51,400

In 1928 Charles of the Ritz, an outstanding operator in the hairdressing business, who operated a total of 11 beauty shops in New York, Boston, and Atlantic City, offered to sell his business to Terminal for about one million dollars. After negotiations lasting more than a year, a contract was prepared for the purchase, but Terminal postponed the execution of the agreement indefinitely on account of the stock market crash in October 1929. Negotiations were resumed in the spring of, and continued throughout, 1930 on the basis of a lower price and less cash and preferred stock. The cash outlay was not to exceed $290,000. Terminal desired Charles of the Ritz to manage the shops, but it was not until the latter part of 1930 that he agreed to serve Terminal as general manager of its shops for at least nine months each year. Charles of the Ritz did not agree to the terms of the sale and the negotiations were discontinued. He then proposed a merger of the two businesses, and thereafter an officer of Terminal discussed the subject with the general manager of Charles of the Ritz from time to time until probably 1933, but no agreement was ever reached.

In about 1928 an investment banker suggested to Terminal that it acquire the Thomas System, which operated 25 hair-dressing shops for both men and women and licensed about an equal number. Terminal considered the offer and decided in 1929 or 1930 that it would not acquire the business at any price.

In or about 1930 Schusser seriously considered the licensing of shops to use its name and service. He mapped out about 222 cities where it might take the best operated shop in each city and sell to it Terminal service, train its barbers in a school conducted by Terminal and allow the shop the use of a designation as a licensed Terminal barber shop. The licensed shops were to be required to purchase their supplies and equipment from the Waldorf Products Co., which bought at wholesale and sold at retail to subsidiaries of Terminal. No shops were ever licensed by Terminal under the proposed plan. At about the same time Terminal conducted negotiations with the owners of two hotel chains to operate their barber shops for an agreed fee. The plan involved supervision of the shops, including a monthly visit by a district manager of Terminal and the schooling of barbers. National advertising was contemplated for the benefit of the shops.

In Terminal's business, as in any barber business, the ratio of income to expense is approximately constant. The business of Terminal began to decline in the middle of 1930 as the result of the depression. The principal expenses in connection with the operation of the shops were for labor, rent, and supplies. The largest expense was for labor; rent was the next largest. About 70 percent of the expenses incurred by Terminal in the operation of its shops was for labor and rent.

Until about the middle of 1930 Terminal's barbers received for their services a fixed salary of $30 per week, plus a commission on receipts in excess of $60 per week. When business declined as a result of the depression, some of Terminal's barbers received as compensation for their services under that plan amounts in excess of their receipts. As business declines barbers can be discharged, laid off or placed on a straight commission basis. Terminal took advantage of the condition and laid off some of its barbers and in 1931 and 1932 put those retained on a commission basis. The beauty shop operators continued to a great extent to receive fixed salaries for their services. The salaries and wages and commissions paid by Terminal and its subsidiaries in the years 1929 to 1933, inclusive, were as follows:

Year	Salaries and wages	Commissions
1929	$1,430,876.66	$239,994.04
1930	1,301,002.11	353,584.72
1931	1,237,741.11	282,108.48
1932	983,754.48	199,613.21
1933	543,664.12	494,019.02

The salaries of the officers of Terminal were also reduced. The salary of Schusser as president was reduced from a high of $35,000 in 1929 to $16,500 in 1932 and $15,000 in subsequent years.

In 1932 Terminal and its subsidiaries held 36 leases, some of which covered both the barber shop and the beauty shop operated at the same address. When the business of Terminal and its subsidiaries began to be seriously affected by the depression, Terminal requested the lessors of shops being operated at a loss for rent reductions. In most instances the lessors demanded a balance sheet of Terminal. In some cases, after much persuasion, Terminal was able to secure reduction in rent without producing the balance sheet. In one instance the balance sheet was furnished and the lessor refused to reduce the rent. In other cases, the lessors refused reductions because they were not furnished a balance sheet. The lessors of two shops consented to rent reductions after the organization of petitioner in 1932 upon being furnished a balance sheet of Terminal. In most cases Terminal was able to obtain rent reductions without submitting balance sheets. Some rent reductions were obtained prior to September 1932.

Some of the leases were for a fixed rental, while others provided for a guaranteed minimum rental and a percentage of the receipts, and still others were on a purely percentage basis. In 1932 Terminal (a) secured reductions amounting to $11,125 in the fixed rental of five leases; (b) reduced the guaranteed minimums of other leases to the extent of $69,167; and (c) in other cases, where the rent was based upon a percentage of receipts, obtained a reduction of the basic figure. In the case of six leases of Terminal under the terms of which the rent was based upon a percentage of the receipts with a minimum amount guaranteed, the minimum amount guaranteed was removed. Rents paid by Terminal and its subsidiaries for the years 1930 to 1933, inclusive, were:

1930	$456,330.12
1931	415,261.47
1932	359,005.43
1933	307,231.80

During the early part of 1931 the officers of Terminal considered the question of organizing a corporation which subsequently became the petitioner. Schusser desired to place Terminal in a position to submit balance sheets to lessors in connection with requests for rent reduction, showing less surplus, and foresaw that if Terminal's surplus was not segregated the corporation might not be able to redeem, upon request, the preferred stock held by employees. He also believed that the segregation in a new corporation of a large part of the surplus of Terminal would be a means of preserving funds with which to reorganize in case Terminal was forced through bankruptcy. A lawyer and an accountant had suggested to and discussed with officers and directors of Terminal the organization of a corporation in a state other than New York to hold the stock of Terminal's subsidiaries and its securities to avoid double taxation. It was the desire of Terminal to place a large part of its surplus out of reach of landlords and free from other business hazards.

With the view of accomplishing the objects just set forth, on September 13, 1932, Terminal organized the petitioner under the laws of Delaware, with a capital stock of 4,200 shares of a par value of $5 per share.

The certificate of incorporation of petitioner recites that it was organized for the purpose, among other things, of undertaking or assuming the whole or any part of the obligations or liabilities of any corporation, and to aid in any manner any corporation whose stocks, bonds, securities, or other obligations it held, and to do any act for the preservation, protection, improvement, and enhancement in value of such property. The bylaws of petitioner required that a majority of the stock issued and outstanding be present for the transaction of business and provided that no stock of Terminal, or any corporation having the name Terminal Barber Shop or Terminal Beauty Shop, or similar name containing the word Terminal, should be sold, pledged, or in any manner encumbered or otherwise disposed of, except by a vote of not less than 75 percent of the stockholders of petitioner.

At the first meeting of the board of directors of petitioner held at 3:30 p.m., September 16, 1932, an offer from the owners of all of the stock of Terminal to exchange their stock for stock of petitioner, on the basis of two shares of petitioner's stock for one of Terminal, was accepted, and the exchange was made immediately. Schusser and Wolff, president, and secretary and treasurer, respectively, of Terminal at all times important, were elected to the same offices in petitioner.

At a meeting held at 4:30 p.m., September 16, 1932, the board of directors of Terminal declared a dividend of $370,000 upon its common stock, payable three days later to stockholders of record on that day. At a meeting of the board of directors of Terminal held on September 23, 1932, it was resolved, subject to the consent of the stockholders, to pay the dividend by the delivery of securities held by it having a market value, plus accrued interest, of $268,446.37 and cash of $101,553.63. At a meeting of petitioner's board of directors held subsequently on the same day, it was resolved to accept payment of the dividend in that manner and to pay a dividend of $50,375. Both dividends were paid. The dividend paid by Terminal was entered in the books of petitioner in an account entitled "Surplus-Initial."

In 1932 Terminal and some of its subsidiaries were parties to litigation involving infringement of their trade name. Terminal's counsel was of the opinion that it would be advantageous to Terminal in the proceedings to be able to prove that the stock of the subsidiaries was held by a parent corporation bearing the name "Terminal Barber Shops, Inc.", and for that reason the plan previously discussed by the directors of Terminal to transfer stock of the subsidiaries to the petitioner was abandoned during the fall of 1932, and was not thereafter made effective.

The gross income and expenses of the petitioner during the years 1932 to 1937, inclusive, were as follows:

	1932	1933	1934
Income
Interest	$83.78	$8,987.06	$8,615.28
Dividends	6,305.00	11,222.50
Sales of property		2 1,038.26
Total	1,597.53	9,102.49	18,799.52
Expenses
Legal	$187.24	$1,005.79	$511.12
Taxes	147.95	157.00	538.60
Miscellaneous	98.23	238.56	179.86
Reserve for taxes (Fed.)
Total	433.42	1,401.35	1,229.58
Net profit	$1,164.11	$7,701.14	$17,569.94

At about the beginning of the depression Terminal expected to expand its activities to the west coast, and had negotiated with the owners of a number of hotels, and with the operator of 11 barber shops in the States of California, Washington, and Oregon for the purchase of his shops. Terminal's business kept on declining in 1932, irrespective of the drives it made for customers. Schusser, however, believed that it was good business judgment to try to expand at that time because of the advantageous terms that could have been made for leases covering shops in the outstanding hotels and buildings throughout the country, and for the operation of shops in such places on a fee basis. No expanding was done under negotiations then being conducted by Schusser, because due to illness he was unable to work more than half a day for about three months in each of the years 1933, 1934, and 1935. He was removed as president in March 1937. Wolff died in 1935 after a long illness.

Terminal has maintained a school for training barbers since a short time after its organization. In 1929 it had one instructor for New York City, and one for shops operated by its subsidiaries. In 1932 four additional instructors and a dermatologist were engaged and trained to give instructions to barbers of any shops licensed under the plan then being considered.

Terminal and its subsidiaries had a surplus of about $950,000 at the close of 1931, and about $960,000 at the close of 1932. Thereafter it decreased each year to about $840,000 in 1936. At the close of 1937 it was about $700,000. Their principal assets consisted of cash, improvements and fixtures, stocks, and bonds. Cash on hand at the close of each year ranged from a low of about $120,000 in 1924 to a high of about $280,000 in 1934. At the same time during the same period, the improvements and fixtures account ranged from a low of about $160,000 in 1924 to a high of about $665,000 in 1931. The securities ranged from a low of about $235,000 in 1937 to a high of about $495,000 in 1927.

For the years 1922 to 1925, inclusive, Terminal had a good will account in the amount of $500,000. The account did not represent a purchase. When the account was set up in 1922, $145,000 was transferred from surplus to capital stock account, and the capital stock account was increased from $5,000 to $650,000. When the account was decreased in 1926 to $600, the figure at which good will was carried at all times thereafter, the balancing entry was made in the capital stock account.

The consolidated net income of Terminal and its affiliates for the years 1924 to 1937, inclusive, as disclosed by its books, the dividends paid by Terminal on its common stock, and the number of shops in operation were as follows:

Year	Net income	Dividends paid	Shops operated
1924	$197,345.71	$78,480.00	21
1925	208,094.72	105,040.00	23
1926	259,280.90	140,415.33	26
1927	288,344.01	141,155.00	30
1928	306,589.77	209,716.00	40
1929	309,107.62	120,990.00	46
1930	279,063.58	194,361.25	51
1931	146,451.33	65,536.25	56
1932	395,187.50	56
1933	27,533.44		56
1934	89,298.16	80,525.00	56
1935	73,973.09	60,000.00	56
1936	16,881.64	53,000.00	56
1937	1 -83,506.14		55

The surplus of the petitioner at the close of each year, its net income, and the dividends paid by it each year were as follows:

Year	Surplus	Net income	Dividends
1932	$320,789.11	$50,375.00
1933	292,220.25	7,701.14	36,270.00
1934	282,587.69	17,569.94	27,202.50
1935	281,511.53	149,298.84	150,375.00
1936	281,939.98	71,828.45	71,400.00
1937	207,470.61	4,184.27	50,000.00

The stock of Terminal has been continuously carried on petitioner's books at its par value of $20,150.

In its return for 1932, petitioner reported as income the amount of $1,513.75 as dividends received on stock of domestic corporations, and $129.79 as interest. It claimed deductions in the amount of $1,947.17, consisting of taxes, dividends, and expenses incurred for representation in Delaware, books, rental of a safe deposit box, bank charges, and legal fees.

The cash and securities received by petitioner as a dividend from Terminal were shown as assets in the opening balance sheet filed by it with its initial income tax return. Capital stock of $20,150 and initial surplus in the amount of $370,000 were shown as liabilities. A footnote below the balance sheets read "$50,375.00 of the initial surplus was paid out to stockholders a few days after organization." The petitioner gave a negative answer to the following question on the return: "Was the corporation in any way an outgrowth, result, continuation, or reorganization of a business or businesses in existence during this or any prior year since December 31, 1917?"

The amount of taxes reported on the income tax returns filed by the six principal stockholders of the petitioner for 1932 and the tax liability of each, in the event all of the taxable net income of the petitioner in that year had been distributed to them, are as follows:

	Tax reported	Tax liability if profits had been distributed
Joseph B. Schusser	$1,977.90	$74,348.64
Henry F. Wolff	492.12	7,839.42
Herman W. Block	None	6,551.43
Howard S. Gans	13.50	4,678.07
Leon S. Hartman	None	None
Fred M. Stein	None	None

Wolff, Block, and Gans each owned, at the close of 1932, securities having potential losses in excess of his proportionate share of the taxable net income of the petitioner for 1932. Schusser had potential losses of about $29,000, an amount sufficient to reduce his tax liability to about $68,000.

The balance sheet of Terminal at the close of each of the years indicated was as follows:

	1930	1931	1932
Assets
Cash	$108,528.02	$104,474.34	$59,329.89
Notes and accounts receivable:
Affiliated companies	109,362.17	94,813.06	96,872.01
Others	43,804.96	32,313.05	57,191.16
Supplies	34,011.85	34,076.27	25,887.35
Improvements, fixtures, etc	444,468.52	529,617.28	457,673.20
Stocks and bonds:
Affiliated companies	106,100.00	106,100.00	106,100.00
Of others	408,843.89	360,542.39	14,425.00
Prepaid and suspense items	70,346.21	72,547.63	35,304.31
Total	1,325,465.62	1,334,484.02	852,782.92
Liabilities
Common stock	$150,487.50	$151,237.50	$151,125.00
Preferred stock	183,800.00	156,000.00	126,400.00
Surplus	762,289.13	797,185.30	363,890.20
Accounts payable	82,879.12	113,956.80	69,946.83
Agreements with affiliated companies	97,900.00	97,900.00	97,900.00
Accrued and suspense items	48,109.87	18,204.42	43,520.89
	1,325,465.62	1,334,484.02	852,782.92

The balance sheet of petitioner at the close of the years 1932 to 1937, inclusive, was as follows:

	1932	1933	1934	1935	1936	1937
Assets
Cash	$80,048.06	$10,032.73	$2,408.43	$1,855.36	$34,608.81	$5,814.44
Stocks and bonds:
Affiliated Companies	20,150.00	20,150.00	20,150.00	20,150.00	20,150.00	20,150.00
Of others	265,701.05	331,575.02	330,179.26	279,556.17	247,181.17	201,506.17
Prepaid and suspense items		612.50
	365,899.11	362,370.25	352,737.69	301,561.53	301,939.98	227,470.61
Liabilities
Common stock	$20,150.00	$20,150.00	$20,150.00	$20,050.00	$20,000.00	$20,000.00
Surplus	320,789.11	292,220.25	282,587.69	281,511.53	281,939.98	207,470.61
Accounts payable, affiliated companies	24,960.00	50,000.00	50,000.00
	365,899.11	362,370.25	352,737.69	301,561.53	301,939.98	227,470.61

The total direct expenses of Terminal Barber Shops, Inc., and affiliated companies for the years 1930, 1931, and 1932 were $2,460,728.13, $2,294,126.77, and $1,893,777.69, respectively; while the total direct expenses of Terminal Barber Shops, Inc., the New York corporation alone, for the same years were $1,625,402.54, $1,514,784.28, and $1,277,978.05, respectively.

Petitioner was in the taxable year a mere holding company.

The gains and profits of petitioner were not in the taxable year permitted to accumulate beyond the reasonable needs of the business.

The petitioner was not formed or availed of during the taxable period for the purpose of preventing the imposition of surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.

OPINION.

DISNEY: In his determination of the deficiency the respondent adjusted the return of petitioner by including therein certain items as taxable income under the provisions of section 104(c) of the Revenue Act of 1932 and held the resulting net income to be taxable under the provisions of section 104(a).^{*1191 surtax. *766 show his hand", , and the tax may not be imposed unless the purpose was to prevent the imposition of surtax upon the shareholders of the taxpayer. ; affd., ; certiorari denied, ; . We think we should make findings as to the facts which under section 104(b) of the Revenue Act of 1932 constitute prima facie evidence of purpose to escape surtax. Was petitioner a mere holding or investment company?}

The petitioner acquired all of the common stock of Terminal by an exchange of all of its stock for all of the stock of Terminal, and promptly thereafter received a dividend in the amount of $370,000 on Terminal's stock . The dividend was paid in cash and securities of other corporations. Except for casual sales, petitioner continued to hold the securities.

The dominant purpose for petitioner's existence in 1932 appears to have been to act as what may be characterized as a financing company for Terminal, and during the taxable year petitioner is not shown to have done anything more than hold the stock of Terminal and receive a dividend therefrom. We should not, we think, consider alone what was done in the taxable year, any more than we should consider alone the charter powers of the corporation. Both elements, and any other evidence material to the point, should be considered. The charter powers were broad, and petitioner had potentialities of acts outside those of a mere holding company, yet, when considered with the obvious object of the petitioner to protect Terminal and its subsidiaries by holding its finances ready for its rescue in case of financial storm and to conceal from some creditors at least the true financial status of Terminal, we come to the conclusion and hold that petitioner was a mere holding company.

Did petitioner permit its gains to accumulate beyond the reasonable needs of its business? The question is one of fact, and the answer can not be found without considering the business needs of Terminal and its subsidiaries.

The record discloses a consistent policy of Terminal to expand its activities and distribute a large part of its earnings to stockholders as dividends. The expansion continued through 1931, during which year 5 new shops were opened for business; 35 shops were opened during the preceding 7 years. Negotiations were conducted at various times for an extension of Terminal's activities into other fields of the barber business. Terminal and its subsidiaries had built up a surplus of about $950,000 by the close of 1931 and it does not appear that respondent ever questioned the reasonableness of the accumulation for business needs. From 1924 to 1931 investments in improvements and fixtures increased about $500,000 and the investments of earnings in securities increased only about $112,000. During that period about 60 percent of the consolidated net income was paid out in dividends. Dividends were paid in 1932, when Terminal operated at a loss.

In 1932 Terminal's officers were alarmed about the financial effect that a continuation of the depression would have upon the corporation's business. There was considerable justification for their pessimism. It was known that net earnings had decreased from $309,000 in 1929 to $146,000 in 1931, and to a net loss in 1932, notwithstanding the existence of ten more shops in operation; that landlords were not inclined to decrease rents, which was a very heavy item of expense; that there was no absolute certainty that wages being paid barbers, a large portion of the total expense, could be changed to a straight commission basis and, among other things, that Terminal would not be called upon to redeem, in greater volume, preferred stock held by its employees. The annual expense of Terminal was very heavy. Considering the New York corporation only, it had been $1,625,402.54 in 1930, $1,514,784.28 in 1931, and $1,277,978.05 in 1932. The total direct expense of Terminal and its affiliates, consolidated, was much higher. The net amount of money accumulated in the hands of petitioner (after deduction of approximately $50,000 in a dividend almost immediately paid out) was approximately $320,000. We think that a company which in the course of three years had seen its net earnings decrease from over $300,000 to a small net loss, and decrease by approximately $150,000 during the last year, might very reasonably desire to accumulate funds of $320,000, that amount being a little more than twice the amount of the decrease in the earnings for the past year, and approximately the same amount as the decrease in three years. Had the company's financial situation continued in the same trend for two years more, the $320,000 would, approximately speaking, have been necessary to repair the situation. Without pointing to other facts disclosing a need for a substantial surplus, we find that Terminal did not at any time accumulate earnings beyond it reasonable business needs. There was no accumulation of earnings current in the taxable year, for it operated at a loss.

What then were the business needs of petitioner? It was organized to hold funds of Terminal in such a manner as to make them available for reorganization purposes in the event the depression forced Terminal into receivership or bankruptcy proceedings, and other business hazards existing at that time. Under the circumstances, petitioner's need for accumulating the income for probable futrue business purposes was equal to Terminal's requirements prior to the payment. Distribution of all or most of the fund by petitioner as a dividend would have defeated the purposes for its creation and prevented petitioner from protecting the value of the stock it held of Terminal.

The statute does not compel a business to remain static, , and "a corporation certainly must have the untrammeled right, within reasonable limits, to financially protect itself and its shareholders." . Terminal's officers had these objects in mind when the fund was distributed and petitioner accumulated the earnings to perpetuate the plan. Whether creditors of Terminal could have reached the fund to satisfy their claims is not decisive of the question.

The business of Terminal constituted the life work of Schusser. He, and other directors of the corporation, desired to protect the business from the uncertainties of the depression. The amount needed for that protection could not be determined with mathematical certainty. Those most interested in the plan determined upon a specified sum for accumulation and from the facts of record we are, we think, warranted in holding it to not be beyond the reasonable needs of the business.

However, even though we hold that petitioner was a mere holding company, and take such fact and consideration as prima facie evidence of purpose to escape surtax, the respondent can not prevail if there is satisfactory proof that petitioner was not organized or availed of for the prohibited purpose, for "The test is the state of mind of those persons responsible for the formation and operation of the petitioner." We think petitioner has net its burden of establishing that it was not organized or availed of during the taxable year for the purpose of preventing the imposition of surtax upon its shareholders.

No useful purpose would be served by a restatement of all of the evidence on the point. First as to purpose of formation of petitioner: The plan was to form a corporation under the laws of a state other than New York to act as a reservoir for part of the surplus Terminal had accumulated over a period of many years, and to take title to the stock of Terminal's subsidiaries and its securities to eliminate double taxation. Petitioner was organized and received some of the accumulated earnings of Terminal as a protection to it against business hazards its officers thought existed or might result from the depression. If Terminal had not made the distribution the Commissioner could not have succeeded in applying the provisions of section 104 to its earnings, since the result of operations for the year was a loss, the first one in its history. Petitioner never acquired the stock of Terminal's subsidiaries, on account of circumstances arising after its formation. In holding the money and securities petitioner was carrying out one of the purposes of its creation, that of protecting Terminal against business hazards. The respondent argues that Terminal would have received the same protection by a distribution directly to its old stockholders, citing , and that therefore formation and use of petitioner was unnecessary, demonstrating petitioner to be a mere holding company. That case involved a corporation with a single stockholder. Terminal had nine stockholders, who did not always agree, as is shown by the ouster of Schusser as president. Obviously, segregation of the fund in the hands of petitioner gave Terminal more protection than would have been possible by a pro rata distribution to stockholders as a dividend.

Schusser testified that he did not approve the formation of petitioner for the purpose of preventing the imposition of surtaxes and that during the course of his discussions of the subject with other stockholders of Terminal, the question of Federal taxes was never mentioned. Counsel who handled all of the legal affairs of Terminal for several years prior to and after 1932 under the supervision of Wolff, including the organization of petitioner, testified that in his discussions with Terminal's stockholders regarding the organization of petitioner nothing was ever said to indicate intent to form petitioner for the prohibited purpose. Terminal's accountant, who suggested to Wolff as early as March 1931 that a corporation such as petitioner would eliminate New York taxes on dividends paid by Terminal's subsidiaries, testified that Wolff did not at any time disclose a purpose to organize petitioner to prevent the imposition of surtax. While testimony of this nature is not determinative of the question, it is important because of its consistency with other evidence.

We incline to the view that some of the arguments urged by petitioner as indicative of purpose other than that of avoiding surtax have little weight. Thus an idea of necessity of money for investment in the Thomas System of shops, which was dropped not later than 1930, can not candidly be said to have had any influence on the formation of petitioner in September 1932; there is little or no definite evidence that the idea of investing in the system of Charles of the Ritz, dropped in 1929, revived in 1930 and again dropped, was a factor in mind in the formation of petitioner; and of course the desire to secure rent reductions by presenting less favorable balance sheets to landlords could have been effectuated by distribution of dividends of Terminal to stockholders, equally as effectively as concealing the funds in a new corporation. Yet, when the whole situation is reviewed, we think it plain that the purpose was not to escape surtax, but rather to escape creditors, landlords, and others, who might, in the depressed times then existent, have seriously threatened the solvency of Terminal, the net income of which in three years had decreased from over $300,000 to a net loss. We can not say that the fears of the parties were so unjustified as to indicate a purpose which is categorically denied. Purpose to escape creditors is one thing; purpose to escape surtax is another. Even if it were admitted that there was a positive plan to convey in fraud of certain creditors, purpose to evade surtax would not follow. Considering all of the evidence on the record, we conclude and hold that the purpose in the formation of petitioner was not to escape surtax, as interdicted by the language of section 104, Revenue Act of 1932.

Neither are we of the opinion that petitioner was availed of for the prohibited purpose. The charter powers of petitioner were broad enough to finance and otherwise assist Terminal in the manner contemplated by its organizers. It received, by way of a dividend, a fund for that purpose and, with the exception of a comparatively small amount subsequently paid out as a dividend, held it for the remainder of the taxable year subject to such use. Any other use of the money would have been incomsistent with the purpose for which the fund was created. The intent was to preserve the fund, not dissipate or distribute all of it so that it would not be available for Terminal's activities. The failure of petitioner to use part or all of the money to assist Terminal out of financial difficulties was due to the ability of Terminal to adjust its affairs without outside help. There was reason in 1932 for Terminal's officers to be alarmed about the effect the depression would continue to have upon its affairs and the need for accumulating the earnings must be judged by conditions existing at that time and reasonably expected to occur in the future, rather than from what actually happened during future years.

We think petitioner has shown that it was not formed or availed of during the taxable year for the purpose of preventing the imposition of surtax upon its shareholders by accumulating its gains and profits instead of dividing or distributing them, and we so hold.

Reviewed by the Board.

Decision will be entered for the petitioner.

TURNER

TURNER, dissenting: In mu opinion, the petitioner was both formed and availed of for the purpose of preventing the imposition of surtax upon its shareholders. During the period of its existence up to the time of the formation of the petitioner, Terminal had accumulated a surplus in excess of twice its capital stock liability. It is claimed that this surplus was required by the reasonable needs of its business, the explanation being that due to the depression it might be forced through a reorganization in bankruptcy unless its entire surplus, including the $370,000 distributed to the petitioner, should be retained within reach. On the other hand, it is explained that it was necessary for Terminal to outwardly divorce itself from the said $370,000 before it could convincingly contend with its lessors that it was in sufficiently straitened circumstances to merit the reduction of rents under the various leases. To me the stories do not ring true and are not at all convincing. It is true that Terminal's net income for 1931 was approximately half of what it had been in 1930 and for several years preceding, but its net income for 1932 was still equal to approximately half of its capital stock liability. It is also true that Terminal sustained a net loss in 1932, but that net loss amounted to only $5,606.02, and, according to the record, that is the only year up to 1937 that it did not earn a net income and in practically every year a very creditable net income for a corporation of its size. Furthermore, after making the distribution to petitioner, Terminal still had at the end of 1932 a surplus of $363,890.20 to stand between it and bankruptcy, the only indication of which so far as the record shows, was the $5,606.02 loss in 1932. In my opinion, the only convincing reason advanced for making the distribution from surplus was that Terminal desired to put itself in a better position to argue for the reduction of rentals. If, however, it distributed such a portion of its accumulated surplus to its stockholders, those stockholders, Schusser in the main, would have been required to pay substantial surtaxes, and, in order to accomplish a reduction of its surplus and at the same time prevent the imposition of surtax on its stockholders, Terminal and its stockholders caused the petitioner to be organized.

For the reasons stated, I respectfully note my dissent.

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Footnotes

• 1. Exclusive of $370,000 received from Terminal. ↩

• 2. Loss. ↩

• 1. Loss. ↩

• 1. Exclusive of $370,000 dividend received on stock of Terminal. ↩

• 1. (a) If any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 13 and shall be computed, Collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax. ↩

• 2. (b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax. ↩