Paramount Knitting Mills v. Commissioner , 17 B.T.A. 91 ( 1929 )

PARAMOUNT KNITTING MILLS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Paramount Knitting Mills v. Commissioner

Docket No. 29902.

United States Board of Tax Appeals

17 B.T.A. 91; 1929 BTA LEXIS 2363;

August 6, 1929, Promulgated

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During the taxable year, petitioner, in order to meet the demands of the holders of some of its notes for an increase of 2 per cent per annum in the interest rate on the notes, issued to such creditors shares of its 8 per cent special preferred stock having a par value equal to the principal amount of the notes. On the facts, held that the issuance of the stock did not discharge petitioner's liability under the notes, and being on the accrual basis, the interest accrued on the notes during the taxable year is deductible from gross income.

Harry Sigmund, Esq., for the petitioner.

O. J. Tall, Esq., for the respondent.

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ARUNDELL

In this proceeding, involving the redetermination of a deficiency of $944.63 in income tax for the fiscal year ended November 30, 1923, the petitioner assigns as error the respondent's action in treating the sum of $6,720 as a dividend payment instead of interest on indebtedness.

FINDINGS OF FACT.

The petitioner is a Pennsylvania corporation with its principal place of business in Philadelphia, Pa.

On December 1, 1922, the petitioner was indebted to Harry Largman and Joseph Largman, owners of 52 per cent of its capital stock, in the amount of $84,000 for money advanced to it. The loans were evidenced by 10 notes drawing interest at the rate of 6 per cent per annum. All of the notes were past due on December 1, 1922.

At the beginning of the taxable year the holders of the notes demanded payment. Subsequently, but before February 9, 1923, they consented to leave the money with the petitioner provided the rate of interest on their loans was increased to 8 per cent per annum.

On February 9, 1923, the petitioner's board of directors adopted the following resolution:

On motion duly made, seconded and unanimously carried, it was resolved that the proper officers are directed to issue to Harry Largman certificate for 260 shares, and to Joseph Largman certificate for 780 shares, of the Special Preferred Stock, full paid and non-assessable, in consideration of debts, in like amounts as the par, due by this Corporation to said Harry Largman and said Joseph Largman; Provided, however, that the said Harry Largman and Joseph Largman, respectively, may at any time demand that the said amounts, as also the amounts as debts equal to the par value of any other of said Special Preferred Stock to the extent of $32,000. additional which said Harry Largman and (or) Joseph Largman may now or hereafter hold, be paid them in cash, respectively, and that when so paid, the corresponding number of shares of stock shall be returned to and so be reacquired by the Corporation; and that if the stock be redeemed or purchased by the Company under the provisions, agreements and conditions of said stock, the redemption or purchase money so paid in cash shall cover and discharge such debts correspondingly; and that until such debts are paid and discharged in cash, interest at the rate of 6% per annum shall be due and paid on same until they are paid to and received by the said Harry Largman and Joseph Largman, respectively; and that, as to any dividends for any year, respectively, that may be received by the holders of the stock, as much therefor as equals six per cent, on said debts shall be deemed the interest on said debts for the particular year in question, any excess of dividends above that to belong to and so be retained by the holder of the stock as such dividend.

Pursuant to the provisions of the above-quoted resolution, on May 14, 1923, the petitioner issued 1,100 shares of its 8 per cent special preferred stock, each of the par value of $50, to Joseph Largman, and 580 shares of the same stock to Harry Largman. The stock was accepted by them subject to the terms of the resolution. The stock transaction was recorded on the corporate books by charging "notes payable" and crediting "special preferred stock." The creditors did not surrender the notes to the petitioner in exchange for the stock and throughout the remainder of the taxable year they both held the notes and the stock.

During the taxable year the petitioner did not declare any dividends on its special preferred stock, pay anything on the principal of the notes held by Harry Largman and Joseph Largman, or redeem any of the stock issued to the latter. The indebtedness was paid in the year 1928.

The petitioner was on the accrual basis of accounting during the taxable year.

In its return for the taxable year, the petitioner claimed as a deduction from gross income the sum of $6,720 as interest on the notes held by Harry Largman and Joseph Largman. The respondent disallowed the claimed deduction on the ground that the item represented dividends on capital stock and not interest on indebtedness.

OPINION.

ARUNDELL: The transaction involving the issuance of special preferred stock to Harry Largman and Joseph Largman having a par value equal to the principal amount of the notes, was entered into by the petitioner to meet the demands of the holders of the notes for an increase of 2 per cent in the interest rate on their loans. The resolution, under the terms of which the stock was issued by the petitioner and accepted by its creditors, did not provide for the discharge of the notes or an exchange of the notes for the stock. That this provision of the resolution was carried out is shown by the fact that at all times during the taxable year the Largmans held both the notes and the stock. The holders of the notes reserved the right to demand payment of the instruments, and upon the payment of all or part of the principal amount of any of the notes, the holders thereof were to return stock of a par value equal to the payment on the notes. Any cash paid to the Largmans in connection with the redemption of the stock held by them was to be applied to the liquidation of the notes. Until the debts were paid, the notes were to draw interest at the original rate of 6 per cent per annum, and any dividends paid on the stock up to 6 per cent were to be treated as payments of interest, any sum in excess of 6 per cent to be regarded as a dividend payment.

No dividends were declared on the petitioner's special preferred stock during the taxable year and nothing was paid on the face amount of the notes. The liability of the petitioner to pay 6 per cent interest on the full face amount of the notes was constant throughout the taxable year.

At the hearing counsel for the petitioner admitted error in claiming as a deduction interest on the debts in excess of 6 per cent per annum. The deficiency should be recomputed by allowing as a deduction for interest on indebtedness, a sum equal to 6 per cent of $84,000, the principal amount of the notes.

Judgment will be entered under Rule 50.