Tennessee Co. v. Commissioner , 40 B.T.A. 154 ( 1939 )

THE TENNESSEE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Tennessee Co. v. Commissioner

Docket No. 91137.

United States Board of Tax Appeals

40 B.T.A. 154; 1939 BTA LEXIS 888;

June 27, 1939, Promulgated

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1. Held, that two instruments denominated promissory notes were in fact evidences of indebtedness and not shares of preferred stock.

2. Held, that petitioner, prior to January 1, 1934, incurred an "indebtedness" within the meaning of section 351(b)(2)(B) of the Revenue Act of 1934 and, further, that it used a reasonable amount of its 1934 income to partially retire such indebtedness within the meaning of that section.

Paul Patterson, Esq., and John C. Morley, Esq., for the petitioner.

DeWitt M. Evans, Esq., Wilford H. Payne, Esq., and Paul A. Sebastian, Esq., for the respondent.

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TYSON

The petitioner seeks redetermination of a deficiency in surtax for the year ended December 31, 1934, in the amount of $23,605.96 determined by the respondent upon the basis that petitioner, a personal holding company under the applicable revenue act, had an undistributed adjusted net income of $78,686.53 for that year.

The petitioner assigns as error the respondent's determination that it had undistributed adjusted net income in any amount for the taxable year and, more particularly, (1) in disallowing as a deduction from "adjusted net income" under section 351(b)(2)(B) of the Revenue Act of 1934 the amounts of $47,000 and $50,000 alleged to have been paid during the taxable year "to retire indebtedness incurred prior to January 1, 1934" within the meaning of that act, or (2), in the alternative, in not allowing the deduction of such amounts as "dividends paid during the taxable year" within the meaning of section 351(b)(2)(C) of that act.

This proceeding has been submitted upon a stipulation of facts which, together with the numerous exhibits attached thereto, is included herein by reference. Only the salient facts will be set forth herein.

FINDINGS OF FACT.

The petitioner, a Delaware corporation with its principal office in Cleveland, Ohio, was organized on May 24, 1933, with an authorized capital stock of 3,000 no par value shares. On June 8, 1933, the W. W. Hawkins Co., a corporation (hereinafter referred to as the Hawkins Co.), subscribed and paid $150,000 in cash for all of petitioner's 3,000 shares of capital stock. On the same date the Hawkins Co. agreed to advance petitioner $5,000 as working capital and such amount was so advanced to petitioner as a loan sometime prior to December 13, 1933.

On or about June 12, 1933, petitioner paid the above mentioned $150,000 to the receivers of the Minnesota and Ontario Paper Co. as part payment for all of the capital stock of the Memphis Commercial Appeal, Inc., which stock, then owned by those receivers, petitioner had contracted to purchase for a total consideration of $300,000. The Memphis Commercial Appeal, Inc., was engaged in publishing a newspaper and, through a subsidiary, in operating a radio station in Memphis, Tennessee.

On December 13, 1933, James Hammond, the Hawkins Co., the Roy W. Howard Co. (hereinafter referred to as the Howard Co.), and the petitioner entered into a contract and the transactions, meterial here, carried out in pursuance thereof were as follows: On or about December 13, 1933, the Hawkins Co. loaned petitioner the sum of $153,600, which the latter used on December 15, 1933, to pay the balance due on the purchase price of the Memphis Commercial Appeal, Inc., stock plus interest. During December 1933 petitioner duly reduced its capital stock from $150,000 to $1,000 and, on or about December 22, 1933, pursuant to such reduction in capital stock, paid over as a return of capital to its sole stockholder, the Hawkins Co., the sum of $149,000, which amount was loaned to petitioner by the Howard Co. on December 22, 1933.

The agreement of December 13, 1933, provided further that the Howard Co.'s loan of $149,000 and the Hawkins Co.'s two loans of $5,000 and $153,600 would be evidenced by petitioner's interest bearing "income notes" payable as to principal and interest "only out of the net earnings" of petitioner. That agreement further provided that the principal of such income notes that interest thereon would be paid prior to the declaration or payment of any dividends by petitioner. The agreement also provided that the Hawkins Co. should assign to James Hammond 54 percent of the stock of petitioner. The petitioner's board of directors at a meeting on December 22, 1933, duly ratified and approved all of the provisions of said contract and also all of the transactions theretofore carried out in pursuance thereof.

Pursuant to the agreement of December 13, 1933, and with the approval of petitioner's board of directors, the petitioner executed and delivered an instrument designated "promissory note", dated December 13, 1933, payable to the Hawkins Co., in the principal amount of $158,600, and a like instrument, dated December 22, 1933, payable to the Howard Co., in the principal amount of $149,000, as evidence of petitioner's indebtedness to those payees, respectively. Except for the name of the payee, the date, and the face amount, the two notes were in the following identic form:

PROMISSORY NOTE

FOR VALUE RECEIVED, The Tennessee Company, a Delaware corporation (hereinafter called the Company) promises to pay to the principal sum of Dollars, and to pay simple interest thereon at the rate of one-half of one (1/2 of 1%) per cent per month until the principal sum hereof shall be paid in full, both principal and interest to be paid in lawful money of the United States of America.

The payment of the principal of and interest on this note, except as hereinafter provided, shall be made only out of net earnings of the Company as hereinafter defined determined by the Board of Directors of the Company to be available for that purpose. "Net earnings" applicable to the payment of the principal of and interest on this note shall be the amount remaining after deducting from gross earnings and income of the Company from all sources for the fiscal year all expenses and charges for operation, taxes, interest, losses, depreciation, amortization and all reserves for any of the above purposes, and such other reserves as may in the absolute discretion of the Board of Directors of the Company be determined to be expedient in the proper management of the business of the Company.

Any net earnings determined to be available as aforesaid shall be applied first to the payment of interest hereon. Any balance of said net earnings in excess of said interest shall be applied in reduction of the principal hereof. The interest on this note is cumulative, so that if during any fiscal year the earnings are not sufficient to pay the interest hereon in full the deficiency shall become a charge against the earnings of the Company and the Company shall be under obligation to pay such deficiency from net earnings in any succeeding fiscal year or years.

So long as this note shall be outstanding, the Company shall not, without the written consent of the holder hereof, obligate itself for the payment of any indebtedness other than for current expenses unless such indebtedness shall be subordinate to the prior payment of the principal of and interest on this note or unless this note shall be redeemed from the proceeds of such indebtedness.

This note may be redeemed in whole or in part at any time at the option of the Company whether out of earnings or other funds at the principal amount hereof plus cumulative interest accrued and unpaid to the date of redemption.

In Witness Whereof, the Company has caused this note to be executed in its corporate name by its President or a Vice-President, and its corporate seal to be hereunto affixed, attested by its Secretary or an Assistant Secretary.

Dated:

THE TENNESSEE COMPANY,

By MASON H. BIGELOW,

Vice-President.

Attest:

C. RODNEY KLEINHANS

Secretary.

(SEAL)

At no time prior to January 1, 1934, did the petitioner repay any portion of the $158,600 advanced by the Hawkins Co. or of the $149,000 advanced by the Howard Co. and evidenced by the above mentioned notes.

At a meeting held on May 23, 1934, the petitioner's board of directors found and determined that on or about May 31, 1934, the petitioner would "have on hand net earnings as defined in said notes sufficient to provide for payments" of $50,000 toward the reduction of the principal amount of the $149,000 note dated December 22, 1933, payable to the Howard Co., and also of $50,000 toward the reduction of the principal amounts of the $158,600 note dated December 13, 1933, and a $2,300 note dated January 15, 1934, payable to the Hawkins Co., in addition to interest due to May 31, 1934, on all three notes. On the same date, petitioner's board of directors adopted a resolution directing that such payments be made upon receipt of the expected income.

On June 1, 1934, the Memphis Comercial Appeal, Inc., paid a dividend of $115,000 on its capital stock owned by the petitioner, and such amount constituted petitioner's total gross income for the taxable year. Pursuant to the resolution of May 23, 1934, and from the proceeds of such dividend, the petitioner, on June 6, 1934, paid the sum of $54,503.33 to the Hawkins Co. and the sum of $53,965.32 to the Howard Co. Of such amount paid to the Hawkins Co., $2,300 was in full payment of the principal of petitioner's note dated January 15, 1934, $4m,700 was for the reduction of the principal of the petitioner's $158,600 note dated December 13, 1933, which was endorsed to that effect, and the balance was for interest due on such notes to May 31, 1934. Of the amount paid to the Howard Co., $50,000 was for the reduction of the principal of petitioner's $149,000 note dated December 22, 1933, which was endorsed to that effect, and the balance was for interest due on such note to May 31, 1934. Those payments were irrevocable and on June 11, 1934, petitioner's board of directors adopted a resolution approving and ratifying the payments so made. During the year ending December 31, 1934, no further payments of principal were made by petitioner on account of such notes.

At all times that the above mentioned notes were outstanding, they were reflected on petitioner's ledger and balance sheet as "Notes Payable." Of the total amount of $108,468.65 paid to the Hawkins Co. and the Howard Co. on June 6, 1934, $100,000 was charged against "Notes Payable" and $8,468.65 was charged against "Interest Paid" on petitioner's books of account. On the books of the Howard Co. and the Hawkins Co., respectively, such notes were reflected as "Notes Receivable" and the payment thereon, on June 6, 1934, were credited to "Notes Receivable" and "Interest Received" in the appropriate amounts, respectively. In all of the resolutions of the petitioner's board of directors relating to those "promissory notes" they were referred to as loans to petitioner or its borrowings or indebtedness.

In February 1935 the petitioner paid $25,000 to the Hawkins Co. and the Howard Co., respectively, as a reduction of the principal of the petitioner's notes dated December 13 and December 22, 1933, respectively. On December 31, 1936, the petitioner and the Memphis Commercial Appeal, Inc., were consolidated into a new corporation, the Memphis Commercial Appeal Co., which succeeded to the assets and liabilities of petitioner. On January 2, 1937, the above mentioned notes, having a total unpaid balance of $159,900, were marked "Paid in full and cancelled" in lieu thereof the Memphis Commercial Appeal Co. executed and delivered to the Memphis Press-Scimitar Co., the then holder of the notes, its interest bearing promissory note, dated January 2, 1937, for $159,900, which was paid in full on June 30, 1937.

Throughout the taxable year 1934 the petitioner was a personal holding company, as defined by section 351(b) of the Revenue Act of 1934.

On June 6, 1934, when petitioner made the above mentioned payments of principal and interest on its notes dated December 13 and December 22, 1933, payable to the Hawkins Co. and the Howard Co., respectively, the petitioner had earnings and profits accumulated after the date of its incorporation in the amount of $111,653.16. For the taxable year ended December 31, 1934, the petitioner had no net income under Title I of the Revenue Act of 1934, and its "adjusted net income", as defined by section 351(b)(3) of that act, amounted to $104,947.32, computed as shown in the stipulation. In determining the surtax deficiency in controversy, the respondent determined the petitioner's "undistributed adjusted net income" as defined by section 351(b)(2) of that act to be in the amount of $78,686.53 after disallowing the claimed deduction of $97,700 involved in this proceeding, on the ground that the petitioner's indebtedness to the Hawkins Co. and the Howard Co. was payable at petitioner's convenience.

OPINION.

TYSON: In this proceeding there is no dispute as to the amount of the petitioner's "adjusted net income" within the meaning of section 351(b)(3) of the Revenue Act of 1934. The primary question presented here is whether, in determining the amount of petitioner's "undistributed adjusted net income", the petitioner is entitled to a deduction of the amounts, totaling $97,700, paid to the Hawkins Co. and the Howard Co. during 1934, as amounts used to retire indebtedness incurred prior to January 1, 1934, within the meaning of section 351(b)(2)(B) of the Revenue Act of 1934. ^{*900 The petitioner contends that its two "promissory notes" given in December 1933 evidenced indebtedness incurred prior to January 1, 1934, and that the payments of $97,700 in question were made to retire a portion of such indebtedness, within the meaning of section 351(b)(2)(B), supra. The respondent contends (1) that the instruments designated "promissory notes" were not evidences of indebtedness, but in reality constituted certificates of preferred stock issued by petitioner for contributions of capital subject to the risk of the enterprise and returnable only out of net earnings and that the payments in question were merely a return of capital and, if not certificates of preferred stock, respondent further contends (2) that petitioner's "promissory notes" constituted contingent obligations payable only out of earnings and at the petitioner's convenience and were not evidences of absolute obligations incurred prior to January 1, 1934, to pay fixed amounts on demand or within a given time and that the payments in question were not made to retire an indebtedness within the meaning of section 351(b)(2)(B), supra.}

The contention that the two instruments designated "promissory notes" constituted certificates of preferred stock of petitioner can not be sustained, for, in our opinion, such a holding would be contrary to the facts herein and the principles of law heretofore announced by this Board.

The petitioner's entire authorized capital stock of 3,000 no par value shares had been issued and were outstanding prior to December 13, 1933, and remained outstanding subsequent thereto and at all times material here. On December 13, 1933, the petitioner entered into an agreement with the Hawkins Co. and the Howard Co. whereby it acknowledged an "existing indebtedness" in the principal sum of $5,000 to the Hawkins Co. and the latter agreed to "loan" to petitioner an additional sum in excess of $150,000 and, also, the Howard Co. agreed to "lend" to petitioner the sum of $149,000. In the same agreement the petitioner agreed to issue its interest bearing@ "income note" to each of those companies in the principal amount of their respective loans payable out of net earnings prior to the declaration or payment of any dividends on petitioner's capital stock. The terms of that agreement were carried out. The agreed loans were made to petitioner during December 1933 and at the same time the petitioner issued instruments denominated "promissory notes" as evidences of its indebtedness so incurred. Clearly, the parties to those transactions intended to create a debtor-creditor relationship in December 1933, and all of their acts have been upon the basis of and have given full effect to such a relationship.

By the terms of each note, the petitioner promised to pay a definite principal sum of money and a specified rate of interest thereon to the Hawkins Co. and the Howard Co., respectively. The interest was cumulative and, which the payment thereof might be deferred by the obligor only if it lacked sufficient earnings in any one year, the petitioner was not thereby relieved of its obligation for such interest to the obligees, since the unpaid interest of one year would be payable out of the earnings of later years. Both principal and interest were payable out of petitioner's net earnings, as defined in the "promissory notes", or, at petitioner's option, out of other funds. The incurring by petitioner of additional liabilities, other than for current expenses, was specifically circumscribed so that the holders of the notes were, to a certain degree, preferred creditors. The petitioner was obligated to apply its available net earnings first to the payment of interest due and then to the reduction of the principal of the notes, and such obligation has, in fact, been met. The holders of the notes were not required to await final liquidation of petitioner for the return of the principal of their loans. They had no voting rights, no right to participate in the general management of petitioner, and no right similar to a stockholder's pro rata participation in the final distribution of any net assets on hand upon dissolution or liquidation of petitioner. The fact that both principal and interest of the notes were payable primarily out of net earnings and that the notes had no fixed due date does not, in the light of their other attributes, destroy the character of the "promissory notes" as evidences of indebtednesses. Upon authority of the principles of law announced in , and the cases cited therein, as applied to the facts of the instant case, we hold that the petitioner's two instruments denominated "promissory notes" dated December 13 and December 22, 1933, to the Hawkins Co. and the Howard Co., respectively, did not constitute shares of preferred stock, but constituted evidences of petitioner's indebtedness to each of those two creditor companies. Cf. , reversing . While the Schmoll case, supra, involved a claimed deduction for interest paid on indebtedness for the purpose of determining income tax on ordinary net income and the instant case involves a claimed deduction for payments in partial retirement of an indebtedness for the purpose of determining surtax on the undistributed adjusted net income of a personal holding company, the fundamental question in the Schmoll case was whether an indebtedness had been incurred, just as in the instant case. Here, the facts disclose a stronger case for the taxpayer, for petitioner was obligated to apply its available net earnings to the repayment of the principal of the loans to it, while in the Schmoll case the principal of the loans became due only at the option of the taxpayer, except in case of bankruptcy, dissolution, or liquidation.

In our opinion the petitioner incurred, prior to January 1, 1934, an "indebtedness" of $158,600 to the Hawkins Co. and of $149,000 to the Howard Co., as evidenced by the above mentioned two instruments, within the meaning of section 351(b)(2)(B), supra. During the taxable year 1934 petitioner paid a total of $97,700 to partially retire such indebtedness and since it was obligated to do so by the terms of its indebtedness there is no question but that such amount was reasonable. The respondent erred in disallowing the claimed deduction of $97,700 from petitioner's adjusted net income for the purpose of determining its undistributed adjusted net income.

In view of this conclusion, petitioner's alternative assignment of error need not be considered.

Reviewed by the Board.

Decision will be entered for the petitioner.

MELLOTT and KERN dissent.

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Footnotes

• 1. SEC. 351. SURTAX ON PERSONAL HOLDING COMPANIES.

  (a) IMPOSITION OF TAX. - There shall be levied, collected, and paid, for each taxable year, upon the undistributed adjusted net income of every personal holding company a surtax equal to the sum of the following:

  * * *

  (b) DEFINITIONS. - As used in this title -

  * * *

  (2) The term "undistributed adjusted net income" means the adjusted net income minus the sum of:

  (A) 20 per centum of the excess of the adjusted net income over the amount of dividends received from personal holding companies which are allowable as a deduction for the purposes of the tax imposed by section 13 or 204;

  (B) Amounts used or set aside to retire indebtedness incurred prior to January 1, 1934, if such amounts are reasonable with reference to the size and terms of such indebtedness; and

  (C) Dividends paid during the taxable year. ↩