United Business Corp. of Am. v. Commissioner , 19 B.T.A. 809 ( 1930 )

UNITED BUSINESS CORPORATION OF AMERICA, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

BURNS LYMAN SMITH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

United Business Corp. of Am. v. Commissioner

Docket Nos. 24641, 25149.

United States Board of Tax Appeals

19 B.T.A. 809; 1930 BTA LEXIS 2326;

April 30, 1930, Promulgated

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1. Petitioner corporation held liable to tax for 1921 under section 220 of the Revenue Act of 1921.

2. If it is clear that a corporation is availed of for the purpose of preventing the imposition of surtax upon its stockholders through the medium of permitting gains and profits to be accumulated instead of distributed, it falls within section 220, whether the accumulations be large or small. Accumulations in excess of needs are evidence of purpose but not necessary. The purpose may appear from other facts.

3. No return or statement is required to be filed under section 220 before the Commissioner may determine or assess tax thereunder.

4. The issue of the statute of limitations must be pleaded to be availed of. It is a plea in bar and not one to the jurisdiction of the Board.

5. Deduction for obsolescence is not to be granted because property is declining in value but not in usefulness.

Edmund H. Lewis, Esq., for the petitioners.

J. W. Fisher, Esq., and T. P. Dudley, Jr., Esq., for the respondent.

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PHILLIPS

These proceedings were consolidated for hearing and decision and involve deficiencies in tax computed under sections 220 of the Revenue Acts of 1918 and 1921, respectively.

The deficiency against petitioner Burns Lyman Smith (hereafter referred to as Burns Smith) is for the calendar year 1920 and in the amount of $25,481.24. The deficiency against petitioner United Business Corporation of America (hereafter referred to as the corporation) is for the calendar year 1921 and in the amount of $19,710.71. In their respective petitions each petitioner asserts the following errors: (1) The alleged deficiency is not founded on an opinion certified by respondent as prescribed by sections 220 of the Revenue Acts of 1918 and 1921, and which is required with respect to all corporations which are not holding companies; respondent conceding that petitioner corporation is not such a company; (2) without reasonable justification respondent has arbitrarily and unwarrantedly determined that the gain and profits of the corporation were permitted to accumulate beyond the reasonable needs of the business; (3) respondent's assumptions that petitioner Burns Smith is subject to tax under section 220 of the Revenue Act of 1918 and that petitioner corporation is subject to tax under section 220 of the Revenue Act of 1921, are not warranted, either by act or failure to act, either by the organizers of the corporation or its subsequently elected directors; (4) the proposed interpretation of section 220 of the Revenue Acts of 1918 and 1921 will have the effect of bringing these sections into disrepute and render them null and void as being within the inhibitions contained in the Federal Constitution.

Petitioner Burns Smith further asserts that the proposed tax under section 220 of the Revenue Act of 1918 violates the Federal Constitution in that it is not a tax upon his income, but in fact is a tax upon his capital.

At the hearing both petitioners amended their respective petitions to conform to the proof and asserted that the net income upon which the respective deficiencies were computed is excessive in that the allowance for depreciation did not include a proper allowance for obsolescence of the buildings and equipment of the corporation.

FINDINGS OF FACT.

The petitioner, Burns Smith, is an individual residing in the city of Syracuse, N.Y. The petitioner, United States Corporation of America, hereinafter called the corporation, is a corporation organized on or about April 1, 1920, under the laws of the State of Washington, with its principal office in the city of Syracuse, N.Y. It has an authorized capital of $6,000,000, divided into 60,000 shares of common stock of the par value of $100 each.

During the entire period from April 1, 1920, to December 31, 1921, the petitioner, Burns Smith, held all of the outstanding shares of capital stock of said corporation, except three shares held by other trustees of the corporation, who paid nothing for their stock. The corporation issued no certificates of capital stock until March 30, 1921. At the close of the years 1922 to 1925, both inclusive, the outstanding stock of the corporation was held as follows:

	1922	1923	1924	1925
Burns Smith	33,990	37,202	37,202	37,002
Lewis P. Smith	1	1	1	1
William A. Mackenzie	1	1	1	1
James S. Westland	1	1
J. F. Kerrins, jr			1	1
Burnice Smith				100
Virginia Smith				100
	33,993	37,205	37,205	37,205

Burnice Smith and Virginia Smith are daughters of the petitioner, Burns Smith.

Petitioner, Burns Smith, is a son of the late L. C. Smith, who also resided at Syracuse, N.Y., and who was one of the leading figures of the typewriter industry. At the time of his death in 1910, L. C. Smith had extensive holdings in several companies. During his lifetime, L. C. Smith became interested in and acquired substantial holdings of real estate in Seattle, Wash. At the time of his death, his holdings of Seattle real estate included six commercial properties. These consisted of the land upon which was later erected the 42-story L. C. Smith Building and the Pacific, New Squire, and Union Trust Buildings, in addition to two other parcels of real estate.

L. C. Smith died intestate. His heirs were his widow, Flora B. Smith, his son, Burns Smith, and one daughter. Burns Smith was then not quite 30 years of age, and his sister was a minor. The Seattle real estate holdings of L. C. Smith were partitioned between the heirs in a legal proceeding which was not contested. In the partition proceedings, Burns Smith received the Pacific Building, and the land upon which was later erected the L. C. Smith Building.

The Pacific Building is located on the corner of Yesler Way and Occidental Avenue in the city of Seattle, and was erected in 1891. It has brick walls, with wooden joists and timbers, is not fireproof, and is known as a class B structure. It has 150 offices and 5 stores available for renting. It is 6 stories in height and is served by 2 passenger elevators.

During his lifetime, L. C. Smith had been considering the construction of a building on the site where the L. C. Smith Building was later erected. He made several trips to Seattle in connection with this project, and had secured plans for the building. These plans were prepared by a firm of architects in Syracuse, N.Y. In the latter part of October, 1910, after the plans and specifications for the building had been prepared L. C. Smith sent his son, Burns Smith, to Seattle for the purpose of filing the plans and securing the permit for the erection of the building. Upon the return of Burns Smith to Syracuse, his father met him at the train and they went to Burns Smith's house, where they talked over the details of the trip. That night, after the conference, on his way from his son's house to his home, L. C. Smith was stricken and died shortly afterwards.

Almost immediately after the death of his father, Burns Smith announced his intention of carrying out his father's wishes in the matter of the construction of the building in Seattle. His lawyers and his mother attempted to dissuade him on account of the general conditions, the fact that it was a long way from his home, and, further, because it would practically exhaust his one-third interest in his father's estate, in addition to a substantial mortgage. However, the son persisted in his determination to erect the building as a monument to his father, and tried to persuade his mother to join him in the enterprise. This she declined to do, and Burns, Smith went ahead with his plans for the erection of the building.

Construction of the building began in 1913, and the building was completed in 1914. A mortgage was placed upon the building in the amount of $800,000, Burns Smith and his wife being required to endorse the mortgage note. The terms of the mortgage required serial payment upon the principal of $50,000 per year.

The building was named the L. C. Smith Building. It was situated on the northeast corner of Second Avenue and Yesler Way, in the city of Seattle, and but a short distance from the Pacific Building. It has 42 stories, and is of the highest known type of construction, being of steel frame, reinforced with concrete. It is entirely fireproof. Its exterior walls are faced with terra cotta. The first 21 floors are of uniform area. The naxt 14 floors are of substantially smaller area. Above them is a tower, 83 feet m height, which is equivalent to 7 floors, and contains observation platforms. There is no office space in the tower, and the office space in each of the 14 floors immediately below is comparatively small. With the exception of some teakwood doors in the Chinese room of the observation tower, and some very few other wooden doors, all of the doors are of steel. The window and sash frames throughout the building are of bronze. The main entrance is trimmed with Mexican onyx and the halls in the upper floors with Alaskan marble. Elevator service is afforded by 8 high-speed passenger elevators, and one freight elevator. Six of the passenger elevators go to the twenty-first floor, and two continue to the thirty-fifth floor. All of these elevators are operated, whether the tenancy increases or decreases, as quick service is essential in retaining tenants and securing new ones. The general level of overhead expense varies little with the loss or gain of tenants.

Exclusive of the second floor, the building contains 573 offices available for renting. The second floor is occupied largely by a subpostoffic, barber shop and other small establishments, which are for the convenience of the tenants.

This building was and remains one of the show places and, with one possible exception, the tallest building on the Pacific Coast. At the date of its erection, and ever since, the principal banks of the city and the financial district were and remain in its vicinity. The public building, which contains the county courthouse and city hall, was erected about the same time and is near the Smith Building.

Yesler Way, which bounds the L. C. Smith Building on the south, was at the date of the erection of that building and still is known as the "dead line" between the business portion of the city, to the north, and the manufacturing and what was the vice and saloon district and what is now known as the Oriental District, to the south. From 1895 to 1900 the locality in which the Smith Building is now situated was the commercial and financial center of the city. From 1900 the general trend of population and of business has been to the north. This trend was especially noticeable in retail establishments. The largest department store in the city moved from this vicinity to the the north in 1915 or 1916 and others followed. It thus became and is now difficult to secure tenants in this district for stores and other spaces on the level of the street. This northward trend resulted in the erection of office buildings to the north. The erection of the Smith Building tended to retard but did not stop this northward trend. Among the forces thus drawing office tenants to the north was what is known as the Metropolitan District. This property, about ten acres in extent, is owned by the University of Washington, a state institution, and was leased by the University to the Metropolitan Building Co. By the terms of the lease the lessee was required to erect a certain number of buildings within a certain period. The lessee has gone beyond the requirements of this contract. These buildings are of a very modern and fine construction and quite attractive to tenants, both by reason of the character of construction and their location in the new business district. Two of these buildings were erected in 1909 and 1910. From that date on the lessee has continued from time to time to erect new office buildings. The Metropolitan Co. had a distinct advantage over other real property owners in that it is not taxable upon its lands or improvements, but only upon its leaseholds. The buildings, when erected, become at once the property of the State. There was and still exists a great rivalry and competition between these buildings and other office buildings to secure tenants. New tenants are offered special advantages, such as the cost of moving and the temporary reduction of rent, but the general level of rent per square foot has changed but little in the best office buildings in Seattle, wherever situated. This competition for tenants reached its peak in 1920 and 1921. It was then quite uncertain how far the lessee of the Metropolitan District would go. The matter was common talk and great uneasiness existed in the district where the Smith Building is situated as to the future of this section. The National Bank of Commerce had moved several blocks north. In April or May, 1920, the Seattle National Bank, a bank with total resources of over $28,000,000, after much hesitation and deliberation, and after protest by a number of its directors determined to and did purchase a lot on Second Avenue, some three blocks north of the Smith Building, for the purpose of erecting its bank building thereon. The building was constructed in 1921 and 1922 and the bank is now occupying it. In 1922 the construction of the Dexter Horton Building, which is the largest office building in Seattle, was begun on a tract of land not far distant from the Smith Building. This latter building was constructed by and on land owned by the Dexter Horton estate, and in two units. Spaces in the first unit were leased in the early part of 1923. The remaining unit was completed in December, 1925. This building, which houses as tenant the Dexter Horton National Bank, a bank with about $37,500,000 deposits, contains 1,033 offices and its rentals per square foot are the highest in this district and about equal to those in the Metropolitan District. As a result of the determination of those large banks to remain in this vicinity and not to follow the trend of retail and other business to the north, evidenced by the erection of these buildings, the financial center of the city remained and now is in the vicinity of the Smith Building, and this situation now appears to be established.

During the latter period of the World War, Seattle thrived on war industries, especially the construction and operation of ships. In the years 1920 and 1921 reaction and deflation set in. Many of those engaged in such industries left the city, some in 1920, but the principal exodus took place in 1921. During the war period the influx of office renters spread over the whole city and the exodus affected all parts of the city in approximately the same proportion.

Leases of offices are generally made in Seattle on a month to month basis. Leases for a year or term of years were not and are not now popular in that city. For the years 1917 to 1927 (except during a short period in 1918 and 1919) the supply of offices in that city was at all times in excess of the demand. At the end of 1920 or 1921 the corporation adopted the policy of giving a reduction of 10 per cent to tenants who would enter into leases for a period of one year or longer.

The following statement discloses the amount of rents received from and the operating expenses and taxes paid on account of the L. C. Smith Building and the Pacific Building from 1914 to 1921; also, the average number of offices occupied in each of such years. The term "offices occupied" refers to offices as shown on the original plan of the building, and has no reference to subdivided offices or to the number of tenants:

SMITH BUILDING
Year	Receipts	Expenses,	Average
		including	number of
		taxes	offices
			occupied
1915	$ 72,128.03	$ 95,158.38	134
1916	103,211.53	108,130.44	198
1917	139,413.24	128,715.34	290
1918	218,860.72	150,121.08	467
1919	310,437.55	183,098.53	564
1920	412,912.00	210,521.81	557
1921	375,965.13	208,568.97	456
PACIFIC BUILDING
1915	$ 35,630.00	$ 18,865.92	59
1916	30,134.50	18,715.46	68
1917	30,522.33	20,058.15	69
1918	37,737.00	22,277.97	75
1919	45,005.15	22,844.69	95
1920	56,494.38	30,056.72	125
1921	53,276.35	26,304.09	118

The amounts set out above as expenses do not include interest on the mortgage indebtedness of the corporation, which varied from $44,000 to $38,000 per year and do not include any allowance for depreciation. The number of offices occupied in the Smith Building and the Pacific Building during 1920 and 1921 were as follows:

	1920		1921
Month	Smith	Pacific	Smith	Pacific
	Building	Building	Building	Building
January	573	120	500	126
February	572	126	498	123
March	568	127	469	125
April	570	125	467	126
May	572	127	466	124
June	565	127	454	124
July	556	127	447	122
August	558	127	444	120
September	562	124	432	117
October	553	123	434	114
November	526	125	436	111
December	510	126	425	107

In the early part of 1920 Burns Smith, who was then about 42 years of age, consulted his attorney, who also had been the attorney for his father and his father's estate, relative to the best manner in which his property might be handled. At this time Burns Smith was not in good health and had a family consisting of his wife and two daughters, one of whom was then between twelve and thirteen years to age and the other above seven years of age. Burns Smith referred to the fact that a large part of his estate was invested in the Seattle realty and stated that it would be very difficult to sell the property as a whole, and that he desired to be in position to sell a part of it in case an emergency developed. He was advised by his attorney that this could be accomplished best by the organization of a corporation; that it would be easier to sell stock in the corporation than to sell a part interest in the building. His attorney further pointed out that in case of his death it would be difficult to partition his real estate but that stock in the corporation could be easily divided. Nothing was said by either party at these interviews relative to Federal or other taxation. The advice given related to including in the corporation the Seattle real estate.

The corporation was organized under the laws of the State of Washington on April 1, 1920. Its authorized capital stock was $6,000,000, divided into 60,000 shares of the par value of $100 each. The corporation was authorized, among other things, to take lease, acquire, handle, deal in, sell, purchase, mortgage or pledge real estate and personal property, to borrow and lend money with and without security, and to erect buildings.

Certain cash, land, buildings and equipment, stocks, bonds and other securities were paid in or transferred by Burns Smith to the corporation from time to time, during the period April 1, 1920, to December 31, 1923. The cash and other property so paid in or transferred, the years in which said payments and transfers were made, and the manner in which such transactions were treated or carried on the books of the corporation are set forth in the following schedule. The amounts shown in said schedule as "credited to capital stock" are the amounts of the par value of the capital stock of the corporation issued to Burns Smith in consideration of said transfers. The amounts shown in said schedule as "credited or debited to Burns Smith" are the amounts credited to the personal account of Burns Smith on the books of the corporation, in consideration of said transfers, and the amounts charged to said personal account on said books are for capital stock of the corporation issued for said transfers. The amounts shown in said schedule in the column "Shares of stock issued" are the number of shares of capital stock of the corporation issued to Burns Smith for said transfers:

Properties transferred to corporation by Burns Smith	Amount entered on books	Capital stock issued to Smith	Credited to surplus	Credited to personal account of Smith
1920
L. C. Smith and Pacific Buildings (net equity subject to mortgage of $700,000)	$1,947,527.89	$1,947,500.00	$27.89
Cash	1,312.58	1,300.00	12.58
Securities	449,075.00	449,000.00	75.00
1921
Securities	390,667.00	390,300.00	367.00
Cash	25,000.00	25,000.00
1922
Securities	860,072.56	586,200.00		273,872.56
1923
One-half interest in New Squire and Union Trust Building	117,500.00	117,500.00
Securities	203,770.00	203,700.00		70.00

The securities transferred to the corporation in 1920 and 1921 were transferred on the dates and at the values listed below:

Date	Description	Value
1920
May 1	1,350 sh. Syracuse Trust	$254,000.00
Dec. 20	2,601 sh. Great Lakes S.S. Co	195,075.00
	Total for year 1920	449,075.00
1921
Jan. 18	1,650 sh. L. C. Smith & Br. Ty. Co., preferred	115,500.00
	2,484 sh. L. C. Smith & Br. Ty. Co., common	49,680.00
20	500 sh. U.S. Steel, common	46,937.00
	792 sh. Crucible Steel, preferred	71,280.00
	250 sh. N.Y.C. & H.R.R	16,812.50
	250 sh. Northern Pacific	17,625.00
	200 sh. Pennsylvania R.R	7,650.50
Apr. 12	42 sh. Whitehead & Hoag	6,300.00
	357 sh. Washington Securities Corporation	35,700.00
	238 sh. Washington Securities Corporation	21,182.00
June 1	1,000 sh. Halstead Realty Corporation	1,000.00
	1,000 sh. Syracuse Ath. Park, Inc	1,000.00
	Total for year 1921	390,667.00

Flora B. Smith, mother of Burns Smith, died on July 5, 1920. Under her will Burns Smith received one-half of her estate. Substantially all of the property transferred by Burns Smith to the corporation in 1922 and subsequent years was received from his mother's estate.

All the securities transferred by Burns Smith to the corporation consisted of shares of the capital stock of domestic corporations, with the following exceptions:

	Face value
Auburn & Northern Electric R.R. Co. bond	$1,000
Armour & Co. bonds	700
Liberty Joint Stock Land Bank of Salina, Kans	7,000
Halstead Realty Corporation bond	1,000
Syracuse Athletic Park, Inc., bond	1,000

A substantial portion of said stocks was listed on stock exchanges, and the balance, while unlisted, was traded in and had a local market in the city of Syracuse.

The amount of gross income and losses (exclusive of dividends received) of Burns Smith for each of the years 1917 to 1921, inclusive, the amounts of dividends on stocks of corporations received by Burns Smith during each of said years, the amounts of the deductions allowable to Burns Smith for each of said years, the amounts of taxable income of Burns Smith (exclusive of the amount here in controversy) and the amounts of income and profits taxes paid by Burns Smith for each of said years are as hereinafter set forth:

	1917	1918	1919	1920	1921
Gross income or loss (exclusive of dividends received)	-$72,282.00	-$11,902.62	$43,075.75	$37,687.89	$13,199.22
Total deductions	44,953.71	51,761.52	135,259.45	69,863.82	18,762.16
Loss (excluding dividends received)	117,236.70	63,664.14	92,183.70	32,175.93	5,562.91
Dividends received	1 123,369.46	87,466.36	81,580.75	70,876.75	3,474.00
Taxable income	None.	23,802.22	None.	38,700.82	None.
Loss	34,691.40		10,602.95		2,088.94
Tax liability:
Excess-profits tax	481.20	None.	None.	None.	None.
Normal tax	None.	-3.00	None.	-3.00	None.
Surtax	None.	1,070.22	None.	3,176.15	None.
	481.20	1,067.22	None.	3,173.15	None.

The cost of securities acquired by purchase, other than those transferred by Burns Smith in exchange for capital stock of the corporation, and the cost of securities sold by the corporation during the years 1920 to 1925, both inclusive, were as follows:

Year	Purchased	Sold
1920	$17,794.28
1921	93,085.87	65,009.30
1922	209,876.63	326,379.00
1923	$182,847.58	$120,837.50
1924	898,489.95	473,280.00
1925	648,245.58	692,799.15

The net income of the corporation, including all items of income and expense or deductions (except Federal income and profits taxes) for the period April 1, 1920, to December 31, 1920, and for 1921 are as set forth in the following schedule. The amounts set forth in said schedule opposite the item "Depreciation" are the amounts allowed by respondent for exhaustion, wear and tear and obsolescence for the respective years indicated:

Detail	Apr. 1, 1920-Dec. 31, 1920	1921
INCOME:
Gross rentals	$365,503.07	$421,188.92
Interest income		60.00
Gain or (loss) - sale of securities		9,329.85
Dividends received	8,040.00	57,490.50
Miscellaneous		801.65
Gross revenues	373,543.07	488,870.92
DEDUCTION:
Interest paid -
Smith Building mortgage	20,625.00	35,750.00
Seattle loans	4,964.07	384.15
Syracuse loans	304.91	8,894.32
Taxes	83,064.65	88,214.01
Depreciation	53,832.16	72,570.53
Operating expenses	130,670.00	148,908.03
Donations	1,882.20	610.00
Total deductions	295,342.99	355,331.04
Net income	78,200.08	133,539.88

The amounts of deductions for exhaustion, wear and tear, including obsolescence, allowed by respondent to the corporation for the period April 1, 1920, to December 31, 1920, and for the year 1921, and the cost and rates used by respondent in computing said allowances, are as set forth in the following schedule. The amounts of the deductions for that account charged off the books of the corporation and taken on the returns filed by said corporation are also set forth in said schedule. The returns made by the corporation for the year ending December 31, 1920, and for the year 1921 used the same rates of depreciation as determined by respondent, except that for the year 1921 the returns used the rate of 5 per cent on the Pacific Building:

Year	Property	Cost	Rate	Amount
			Per ct.
1920	L. C. Smith Building	$1,553,180.32	2	$23,297.70
1921	do	1,554,824.82	2	31,080.06
1920	Pacific Building	121,583.40	3	2,735.63
1921	do	121,583.40	3	3,647.50
1920	Smith Building equipment	339,558.93	10	25,568.91
1921	do	355,116.08	10	34,869.75
1920	Pacific Building equipment	29,732.24	10	2,229.92
1921	do	29,732.24	10	2,973.22

The balance sheets of the corporation, including all items of assets and liabilities at April 1, 1920, at December 31, 1920, and at December 31, 1921, were as follows:

	Apr. 1, 1920	Dec. 31, 1920	Dec. 31, 1921
ASSETS
Cash	$912.58	$3,622.39	$31,349.51
Receivables:
Due from Burns Smith -
Accounts receivable (personal)	0	4,512.17	277,757.73
Demand notes	0	231,625.00	321,637.17
Due from other than Burns Smith -
Accounts receivable	0		8,548.01
Notes receivable	0	1,000.00	24,000.00
Stocks and bonds	0	466,869.28	885,612.85
Mortgages	0	0	0
Land	603,473.00	603,473.00	603,473.00
Buildings	1,674,763.72	1,674,763.72	1,676,408.22
Equipment	369,291.17	372,011.02	384,848.32
Restaurant equipment	0	0	0
Fox ranch	0	0	0
Harrisville property	0	0	0
Law library	484.56	144.26	54.26
Total	2,648,925.03	3,358,020.84	4,213,689.07
LIABILITIES AND CAPITAL
Notes payable	0	165,000.00	456,651.86
Accounts payable	484.56	13,073.13	5,312.09
Mortgages payable	700,000.00	650,000.00	600,000.00
Deferred credits	0	0	0
Reserve for depreciation	0	53,832.16	126,402.69
Capital stock	1,948,400.00	2,397,800.00	2,813,100.00
Surplus	40.47	78,315.55	212,222.43
Total	2,648,925.03	3,358,020.84	4,213,689.07

The surplus account of the corporation, showing the amounts of taxable net income, nontaxable income (representing dividends on stock of domestic corporations), deductions and expenses unallowable for Federal income-tax purposes, dividends paid by the corporation, and amounts carried to surplus, for the period April 1 to December 31, 1920, and for 1921 was as follows:

	1920	1921
Balance at beginning	$40.47	$78,315.55
Add:
Net taxable income	72,042.28	76,659.38
Nontaxable income	8,040.00	57,490.50
Adjustment to surplus	0	0
Paid-in surplus	75.00	367.00
Total	80,197.75	212,832.43
Less donations	1,882.20	610.00
Balance to close	78,315.55	212,222.43

The personal account of Burns Smith on the books of the corporation, and the amounts and character of all charges and credits to said account for the period April 1, 1920, to December 31, 1920, and for each of the years 1921 to 1925, inclusive, are as set forth in the following schedule. The item shown in the schedule as "Securities from the estate of Flora B. Smith" represents and comprises the securities which belonged to Burns Smith, as part of his distributive share in the estate of his deceased mother, Flora B. Smith, and are the same securities which are specifically set forth and described as being paid in for stock of the corporation by Burns Smith on January 19, 1922. The items shown as "Union Trust property" and "New Squire property" represent and comprise an undivided one-half interest in certain real estate which also belonged to Burns Smith, as part of his distributive share in the said estate of his deceased mother.

	4/1/20 to 12/31/20	1921	1922	1923	1924	1925
DEBITS
Cash	$213,750.00	$95,187.07	$173,674.62	$320,313.51	$186,241.57	$3,005.00
Business prior to April 1, 1920	4,512.17
interest on mortgage, prior to April 1, 1920	17,875.00
Advances to the estate of Flora B. Smith to pay notes of Burns Smith		369,333.32
5862 shares stock of Un. Bus. Corp. of Am			586,200.00
Net receipts New Squire & Un. Trust Bldgs			5,435.66
Offsets			177,878.00
1175 shares-stock of Un. Bus. Corp. of Am				117,500.00
2037 shares-stock of Un. Bus. Corp. of Am. for 500 shares Malleable Iron Works and 3916 shares Smith Wheel Co				203,700.00
Note receivable paid					5,057.50
Total debits	236,137.17	464,520.39	943,188.28	641,513.51	191,299.07	3,005.00
CREDITS
Law library	484.56
Demand notes	236,137.17	85,500.00	131,151.67	122,900.00	26,500.00
Business prior to April 1, 1920		1,185.00
Cash		99,593.10	37,175.23	5,026.50	75,808.29
Securities from estate Flora B. Smith			860,072.56
Union Trust property			37,500.00
New Squire property			$80,000.00
Offsets			177,878.00
1 share American Gas & Elec. Co. stock				$50.00
3916.6 shares stock of Smith Wheel Co				73,570.00
500 shares Malleable Iron stock				130,200.00
Dividends from Un. Bus. Corp. of Am					$110,000.00
Total credits	$236,621.73	$186,278.10	1,323,777.00	331,746.50	212,308.29
Credit balances - amount owing to Smith by Corporation	484.56		102,831.45
Debit balances - amount owing to Corporation by Smith		277,757.73		206,935.56	185,926.34	$188,931.34

The amounts of indebtedness of Burns Smith to the corporation, including therein the amounts of notes of said Smith held by said corporation, and the amounts of debit balances in the personal account of said Smith on the books of said corporation at the end of each of the years 1920 to 1925, both inclusive, and the amounts of indebtedness of said corporation to said Smith, including therein the amounts of outstanding notes of said corporation made payable to said Smith, the amounts of the credit balances in the personal account of said Smith, on the books of said corporation, and the amounts of outstanding notes of said corporation endorsed by said Smith, at the close of each of the years 1920 to 1925, both inclusive, are set forth in the following schedule:

	End of 1920	End of 1921	End of 1922
BURNS SMITH'S INDEBTEDNESS
TO CORPORATION
Notes of Burns Smith held by
corporation at end of each year	$236,137.17	$321,637.17	$452,788.84
Amount owing to corporation by
Burns Smith in open account at
end of each year		277,757.73
Total	236,137.17	599,394.90	452,788.84
CORPORATION'S INDEBTEDNESS
TO BURNS SMITH
Outstanding notes of corporation
at end of each year payable to
Burns Smith		189,000.00	115,090.00
Amount owing to Burns Smith by
corporation in open account at
end of each year	484.56		102,831.45
Total indebtedness of corporation
to Burns Smith at end of each
year	484.56	189,000.00	217,921.45
Additional liability of corpor-
ation on its notes indorsed by
Burns Smith		50,000.00	103,500.00
Total	484.56	239,000.00	321,421.45

	End of 1923	End of 1924	End of 1925
BURNS SMITH'S INDEBTEDNESS
TO CORPORATION
Notes of Burns Smith held by
corporation at end of each year	$567,688.84	$545,188.84	$536,188.84
Amount owing to corporation by
Burns Smith in open account at
end of each year	206,935.56	185,926.34	188,931.34
Total	774,624.40	731,115.18	725,120.18
CORPORATION'S INDEBTEDNESS
TO BURNS SMITH
Outstanding notes of corporation
at end of each year payable to
Burns Smith	110,169.64	152,505.00	272,505.00
Amount owing to Burns Smith by
corporation in open account at
end of each year
Total indebtedness of corporation
to Burns Smith at end of each
year	110,169.64	152,505.00	272,505.00
Additional liability of cor-
poration on its notes indorsed
by Burns Smith	50,000.00	276,000.00	161,000.00
Total	160,169.64	428,505.00	433,505.00

All of the notes designated in the above schedule as "Outstanding notes of corporation * * * payable to Burns Smith" were notes given to Burns Smith and by him discounted with various banks and the proceeds thereof turned over to the corporation. At the respective dates mentioned in said schedule, all of said notes were held by said banks. All of the notes designated in the above schedule as "notes endorsed by Burns Smith" were notes made by the corporation payable to various banks and endorsed by Burns Smith, and at the respective dates mentioned in said schedule all of said notes were unmatured and no default in the payment of said notes had yet occurred, and the liability of the corporation to Burns Smith on account of said notes was wholly contingent.

Smith made payments on the demand notes given by him to the corporation, together with interest thereon, as follows:

	1923	1924	1925	1926	1927
Principal	$8,000.00	$49,000.00	$9,000.00	$24,000.00	$10,000.00
Interest	1,358.08	12,477.67	2,162.15	3,146.42	291.67

No dividends were declared by the corporation during any of the years 1920 to 1923, both inclusive. On November 5, 1924, the corporation declared a dividend of 3 per cent on its outstanding capital stock, which dividend amounted to $111,615. On November 4, 1925, the corporation declared a dividend of 3 per cent on its outstanding capital stock, which dividend amounted to $116,814.

All meetings of the board of trustees of the corporation from April 1, 1920, to December 31, 1925, both inclusive, were held in Syracuse, N.Y. The offices of the corporation were maintained in Seattle, Wash., and in Syracuse, N.Y. One of the trustees of the corporation, who was also manager of the office buildings in Seattle, resided in Seattle, and was in charge of the Seattle office of the corporation. The leasing of space in the Seattle office buildings, the collection of rent and other income from said buildings, and the payment of expenses of operation of the office buildings, including local real and personal property but not including interest on the mortgage upon the Seattle real estate, were handled by the Seattle office, and these transactions were reported in detail monthly or oftener to the Syracuse office. Books of account showing the transactions handled by the Seattle office were kept in said office. All other business of the corporation was transacted and all other books and other records of the corporation were kept by the Syracuse office and by the officers and trustees who resided in Syracuse. In the Federal tax returns filed by the corporation for the years 1920 to 1925, both inclusive, the address of said company was given as Syracuse, N.Y., and said returns were filed with the collector of internal revenue of the collection district in which Syracuse, N.Y., is located.

No salaries were paid to Burns Smith by the corporation during any of the years 1920 to 1925, inclusive, and no salaries were paid to any of the other trustees during said years, except that the Seattle trustee received a salary as manager of the Seattle real estate.

On February 23, 1924, the internal revenue agent in charge at Buffalo, N.Y., transmitted to the corporation a copy of a report of an internal revenue agent dated February 9, 1924, relative to the income-tax liability of the corporation for the years 1920 and 1921. The said report contains, among other things, information to the effect that all that had been paid in for capital stock of the corporation during the years 1920 and 1921 had been paid in by Burns Smith and that he owned all the shares of the capital stock of the company, except three qualifying shares held by the other trustees. It also disclosed the amount of cash on hand on April 1, 1920, the paid-in surplus for the nine months ending December 31, 1920, the earnings for said nine months, the paid-in surplus for the year 1921, the earnings for the year 1921, the amount of capital stock for both years, and the fact that no dividends had been paid during said years. Said revenue agent recommended that the net income of the corporation for the years 1920 and 1921 be taxed under section 220 of the Revenue Acts of 1918 and 1921, respectively. The corporation filed with the internal revenue agent in charge at Buffalo protests dated March 12, 1924, and March 26, 1924, against the findings contained in said revenue agent's report. The said protests, contained, among other things, some of the grounds asserted by petitioners in these proceedings. Respondent sent the corporation a letter dated July 24, 1924, in which respondent informed the corporation that an audit of its income-tax returns for the period April 1, 1920, to December 31, 1920, and for the calendar year 1921, had resulted in an overassessment of $6,789.02 for the year ending December 31, 1920, and of a deficiency amounting to $19,660.71 for the calendar year 1921; and that these determinations had been made under section 220 of the Revenue Acts of 1918 and 1921. The letter further informed the corporation that it was granted 30 days from the date of said letter within which to present a protest, supported by additional evidence or proof. Thereafter, the corporation filed with respondent a protest dated August 15, 1924, in which it made certain contentions, some of which were similar to contentions made in these proceedings. Thereafter, respondent set to the corporation a letter dated September 10, 1925, which reads in part as follows:

An examination of the income and profits tax returns filed by your company for the period from April 1 to December 31, 1920, and for the calendar year 1921, together with a Revenue Agent's Report of his investigation of your books and accounts for those years, discloses that you have permitted gains and profits to accumulate beyond the reasonable needs of this business. It, therefore, becomes necessary to invoke the provisions of Section 220 of the Revenue Acts of 1918 and 1921.

* * *

By virtue of the authority vested in me by Section 220 of the Revenue Acts of 1918 and 1921, I hereby certify that in my opinion the accumulation of gains and profits and the additions to surplus by your company for the period from April 1 to December 31, 1920, and for the calendar year 1921, were unreasonable for the purpose of your business. Such accumulation of gains and profits and additions to surplus are construed as evidence of a purpose to escape the surtax for such years. It is held, therefore, that the stockholders of your company are subject to taxation on their proportionate shares of the net income of the company for the period from April 1 to December 31, 1920, under the provisions of Section 220 of the Revenue Act of 1918, and that your company is subject to taxation for the calendar year 1921, under the provisions of Section 220 of the Revenue Act of 1921.

Thereafter, the corporation filed with respondent a protest dated November 12, 1925, which protest made contentions, some of which are similar to those made in these proceedings.

On March 7, 1924, the internal revenue agent in charge at Buffalo transmitted to Burns Smith a copy of report of an internal revenue agent dated February 25, 1924, concerning the income-tax liability of said Burns Smith for the years 1920 and 1921. In this report the revenue agent approved the previous recommendation of February 9, 1924, that the net income of the corporation for the year ending December 31, 1920, be taxed to Burns Smith individually. Thereupon, Burns Smith filed with the internal revenue agent in charge at Buffalo a protest dated March 26, 1924, in which said tax was protested on certain grounds, among which are certain of the grounds asserted in these proceedings.

Respondent sent to Burns Smith a letter dated May 8, 1924, informing him that an examination of his income-tax returns and of his books and records for the years 1920 and 1921 disclosed an additional tax liability for the year 1920 in the amount of $25,481.24, and referring him for explanation to the report of the revenue agent previously sent to him. The letter further informed him that he was granted 30 days within which to file an appeal or protest.

A letter dated October 12, 1926, was sent by the General Counsel of the Bureau of Internal Revenue to the attorneys representing Burns Smith and the corporation, inviting their attention to the fact that at a previous hearing they had offered to submit additional evidence in support of their protest and that such evidence had not been filed. They were informed that if they so desired they could submit further evidence in verified form and, further, that verified statements covering the activities of Burns Smith and the corporation for the years subsequent to 1921 might be helpful. Thereafter, in response to said letter said Burns Smith and the corporation filed with the respondent a joint protest dated October 21, 1926, in which the matters involved were gone into and argued at length.

On February 15, 1927, respondent sent by registered mail to Burns Smith the deficiency letter upon which the appeal of Burns Smith is based.

On January 27, 1927, respondent sent by registered mail to the corporation the deficiency letter upon which the appeal of the corporation is based.

Subsequent to January 27, 1927, respondent delivered to the attorney for the corporation an opinion of the General Counsel of the Bureau of Internal Revenue dated December 23, 1926. This opinion reviews the facts of the case and reaches the conclusion that the corporation was not a "mere holding company" but that it was both formed and availed of during the taxable years for the purpose of preventing the imposition of a surtax upon its principal stockholder through the medium of permitting its gains and profits to accumulate instead of being divided and distributed.

OPINION.

PHILLIPS: In addition to oral testimony the parties have submitted a voluminous stipulation. A substantial part of the stipulation is of evidence which it seems unnecessary to detail in formal findings of fact, the substance thereof or conclusion reached therefrom being stated. These proceedings involve the construction and application of sections 220 of the Revenue Act of 1918 and of the Revenue Act of 1921. This section of the 1918 Act reads:

SEC. 220. That if any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders or members through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, such corporation shall not be subject to the tax imposed by section 230, but the stockholders or members thereof shall be subject to taxation under this title in the same manner as provided in subdivision (e) of section 218 in the case of stockholders of a personal service corporation, except that the tax imposed by Title III shall be deducted from the net income of the corporation before the computation of the proportionate share of each stockholder or member. The fact that any corporation is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax; but the fact that the gains and profits are in any case permitted to accumulate and become surplus shall not be construed as evidence of a purpose to escape the tax in such case unless the Commissioner certifies that in his opinion such accumulation is unreasonable for the purposes of the business. When requested by the Commissioner, or any collector, every corporation shall forward to him a correct statement of such gains and profits and the names and addresses of the individuals or shareholders who would be entitled to the same if divided or distributed, and of the amounts that would be payable to each.

Section 220 of the 1921 Act reads:

SEC. 220. That if any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders or members 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 25 per centum of the amount thereof, which shall be in addition to the tax imposed by section 230 of this title 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: Provided, That if all the stockholders or members of such corporation agree thereto, the Commissioner may, in lieu of all income, war-profits and excess-profits taxes imposed upon the corporation for the taxable year, tax the stockholders or members of such corporation upon their distributive shares in the net income of the corporation for the taxable year in the same manner as provided in subdivision (a) of section 218 in the case of members of a partnership. The fact that any corporation is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax; but the fact that the gains and profits are in any case permitted to accumulate and become surplus shall not be construed as evidence of a purpose to escape the tax in such case unless the Commissioner certifies that in his opinion such accumulation is unreasonable for the purposes of the business. When requested by the Commissioner, or any collector, every corporation shall forward to him a correct statement of such gains and profits and the names and addresses of the individuals or shareholders who would be entitled to the same if divided or distributed and of the amounts that would be payable to each.

These sections are highly penal. Section 220 of the Revenue Act of 1918 imposes a tax upon the stockholders of a corporation, which falls within its terms, on income which they have not received. Section 220 of the Revenue Act of 1921 imposes, in addition to the tax imposed by section 230, a tax which is two and one-half times the tax imposed by that section for the year 1921 and twice the tax imposed by it for subsequent years. The severity of this penalty appears when it is contrasted with the penalty provided by section 250(b) of the same act. There it is provided that if any part of a deficiency is "due to fraud with intent to evade tax * * * there shall be added as part of the tax 50 per centum of the total amount of the deficiency in the tax." In the case of section 220 the penalty for the year 1921 is equal to two and one-half times the tax, while the penalty for a fraudulent deficiency is but one-half, not of the tax, but of the deficiency in tax.

While the plain intent of such a statute must be given full effect, it should be strictly construed and should not be extended to cover cases which do not fall within its letter.

It is conceded that the petitioner corporation was not a "mere holding company" and the evidence fails to support the respondent's contention that it was formed for the purpose of evading surtax. The testimony shows that in the early part of 1920 Burns Smith, a resident of Syracuse, N.Y., was the owner of two pieces of real estate in Seattle, Wash. On one of these lots was a six-story office building which had been erected in 1891 and on the other a very handsome 42-story office building, completed in 1914, which was one of the show places of the Pacific Coast. While the record is not sufficiently complete to permit precise determination of the results of the operation of these two office buildings, there is sufficient to indicate that there were losses of approximately $120,000, $110,000, $90,000, and $30,000 during the years 1915, 1916, 1917, and 1918, respectively, and a gain of $40,000 in 1919. By 1920 the war activities which had filled the office buildings of Seattle had started to subside and the future was uncertain. These buildings represented an investment by Smith of approximately $2,000,000 in excess of a mortgage thereon of $700,000 and comprised over two-thirds of his property. Smith was in ill health. His family the consisted of his wife and two infant daughters. Having observed the difficulty which arose in the partition of his father's real estate, he wished to avoid any such trouble in the event of his own death and particularly any situation which might make necessary a forced sale of this property. He was also desirous of being able to sell, in case of an emergency, undivided interests in his realty. He communicated his views to his attorney, who had also been attorney for his father and his father's estate, and who was thoroughly conversant with the situation. His attorney advised that a corporation be formed to which the realty should be transferred in exchange for shares of its capital stock. The petitioner corporation was thereupon organized and on April 1, 1920, Burns Smith transferred to it the office buildings in Seattle, at a value of $1,947,527.89, in consideration of 19,475 shares of its capital stock, the sum of $27.89 being credited to surplus. All of the evidence is to the effect that at the date of organization the only purpose in the mind of Burns Smith was to place his investment in the two office buildings in corporate form and thus make these assets more available for the purpose of sale or, in case of his death, of partition. The question of taxation, Federal or otherwise, was not discussed in the interviews between Smith and his attorney. It was not until later that Smith conceived the idea of transferring other investments to the corporation. It seems reasonably clear that the corporation was formed for perfectly sound reasons other than to permit Smith to avoid payment of surtax.

Since the corporation does not fall within the classification of a mere holding company or of one formed for the purpose of preventing the imposition of surtax upon its stockholders, we need not consider in what circumstances corporations which do fall within such classification are within the provisions of section 220 of the two revenue acts. It becomes necessary to determine only whether the petitioner corporation was availed of during the years before us for the purpose stated in the statute.

The section in question recognizes the right of every corporation to keep its capital intact and provide a surplus for its reasonable needs. No corporation which is actively engaged in business is to be subjected to the penalty of the statute unless and until it permits its course of conduct to be diverted from its normal business interests by a purpose to save its stockholders from surtax. The emphasis in the statute is placed upon the purpose and if this purpose clearly appears the corporation is subject to the tax, whether the accumulation be large or small. Accumulations in excess of the needs of the business are evidence of the purpose but are not necessary to subject the corporation to the tax. This seems to us to be the necessary construction of the statutory language. To bring any case within the statute the evasion of surtax must, of course, be accomplished by means of permitting gains and profits to accumulate instead of being divided or distributed. In the instant case it seems clear that gains and profits were accumulated instead of being distributed, and that if the purpose was to use the corporation to prevent the imposition of surtax, the medium used was that set out in the statute. We think the ultimate question presented in the instant proceeding is whether this purpose existed.

Although the statute provides that certain facts shall be prima facie evidence of the purpose, the same purpose may appear from other facts. In the instant case the purpose to use the corporation to prevent the imposition of surtax upon its stockholder appears from the character of the transactions between it and its stockholder.

The corporation was organized for the purpose of operating the two office buildings in Seattle. Had it confined its activities to the operation of these buildings, declaring no dividend during the years 1920 and 1921, but permitting the surplus income to be accumulated, it would seem clear that upon the record made before us with respect to real estate conditions in Seattle affecting these buildings, the corporation would not have fallen within the provisions of section 220. But we find that in 1920 the sole stockholder of the corporation transferred to it shares of stock having a value of approximately $450,000 and in 1921 transferred other shares having a value of over $400,000. The dividends upon this stock were taxable to Smith so long as he continued to hold them, but were not taxable when received by the corporation. Instead of dividends of some $80,000 which Smith reported in 1919 before the transfer was made, we find him reporting some $3,500 as dividends in 1921. Clearly the effect was to reduce the amount of income upon which Smith was subject to surtax. It is urged that these securities were transferred to the corporation in order to improve its financial condition and increase the salability of its capital stock, but in the face of this argument we find that at the close of 1920 Smith had borrowed from the corporation some $236,000 and that at the close of 1921 his borrowings totaled some $600,000. Nor is this all. In order to provide funds to make these loans the corporation was obligated on notes payable at the close of 1920 in the amount of $165,000 and at the close of 1921 in the amount of $456,000. There were similar manipulations of the funds of the corporation in subsequent years. These were not transactions designed to build up the corporation, but were perfectly designed for the purpose of evading surtax upon the income from the stocks transferred to the corporation while at the same time permitting the sole stockholder to enjoy the use of such income and substantial parts of the principal. The manner in which the corporate funds were handled seems to us to establish that, for the year 1921, the corporation was availed of for the purpose of preventing the imposition of surtax upon its stockholder through the medium of permitting its gains and profits to accumulate. We shall hereafter state the reasons which lead us to a different conclusion as to the year 1920.

It is urged that since Smith had not been subject to surtax in years prior to 1920 and to a surtax of only $3,176.15 in 1920, he had no reason to suppose there was a surtax to be avoided at the time the corporation was organized. We see no merit in this suggestion. During the years prior to 1919 the two office buildings had been operated at substantial losses and these losses had been available to Smith in preparing his tax returns. In 1919 it would appear that it was operated at some profit, but by reason of deductions of some $135,000 taken on his tax return Smith did not become subject to surtax. The nature of these deductions is unexplained, but it will be noted that the amount was substantially greater than in any period or subsequent year of which we have evidence. The reasonable conclusion is that there was a deduction in 1919 in some substantial amount which was not of a recurring nature. Except for the loss at which the building had been operated in years prior to 1919 and the substantial deduction taken in 1919, Smith would have been subject to surtax and it must have been evident to him at the time the 1919 return was prepared that he faced substantial surtaxes if he continued to hold the building and his corporate stocks and the operation of the building in 1920 resulted in any profit. The decision which we have reached is not influenced by this probability and we speak of it only for the purpose of disposing of petitioner's argument based upon the fact that Smith paid no surtaxes in prior years.

It is urged that the securities were paid in to the corporation for its stock and thereby became capital assets. It is also urged that the loans to Smith did not affect the surplus or profits and gains of the corporation. These arguments are beside the point unless the sole evidence of purpose is that a surplus was built up which was unreasonable for the needs of the business. We have already stated that the purpose may be shown by other evidence and have already indicated that we believe these transactions constitute valuable evidence of the intention to use the corporation to avoid surtax. We may say here that we appreciate the administrative difficulties involved where purpose or intention is made the basis for levying taxes. However, the provision in question is penal in character, as we pointed out above, and the issue of intent is one which is common in such cases.

The record discloses that on May 1, 1920, Smith turned over to the corporation for its stock, stock of the Syracuse Trust Co. having a value of $254,000; that on December 20, 1920, there was a like transaction in which the corporation acquired stock of the Great Lakes Steamship Co. valued at $159,075. The dividends paid to the corporation upon this stock during 1920 appear to have been some $8,040. In view of the fact that the corporation had outstanding a mortgage of $700,000, there is some basis for the argument of petitioners that the transfer of these securities served a purpose other than merely to permit Smith to avoid surtax upon the dividends. Considering also the comparatively small amount of dividends upon which tax was thus avoided, and the penal nature of the tax imposed by section 220, we are of the opinion that there is sufficient doubt respecting the purpose of the 1920 transactions to require us to resolve that doubt against the imposition of the tax for that year under section 220. As we have pointed out above, however, no such doubt remains with respect to the purposes of the transactions which took place in 1921.

The petitioners contend that an authorized "return or its equivalent" is a prerequisite to any assessment of tax under the Revenue Act, that section 220 provides that a statement of its gains and profits may be required of any corporation, that such statement is the equivalent of a return and the only provision for making a return under section 220, that no such statement was requested of the petitioner corporation or furnished by it, that until there is a failure on its part to make such a statement no such statement may be made on its behalf by any other person and that therefore "the procedure followed by the Commissioner in reaching his determination of an occasion for tax under section 220 is unauthorized and is a denial of due process of law." We do not understand that the law requires that a return or statement be filed under section 220 before the Commissioner may determine or assess the tax. The procedure followed, which is outlined in our findings of fact, appears to provide adequate opportunity for hearing and we fail to see wherein there was any denial of due process of law.

After both parties had submitted their testimony and rested their case counsel for the petitioner suggested that the tax might be barred by the statute of limitations. This question was not raised in either of the petitions and, although counsel asked for and was granted leave to amend his petition to raise another issue, counsel refrained from making a similar motion to raise the issue of the statute of limitations. Where such issue is raised the burden has been placed by the Board upon the Commissioner to show any extension of the statutory period. But there is no such burden and indeed no need to do so where the issue is not raised in the pleadings. In their brief the petitioners concede that waivers of the statutory time within which to assess income taxes were executed and filed by them and set out what they claim to be the form of waiver executed, and from this they argue that the form so set out in their brief does not apply to a tax assessed under section 220. It is evident that counsel for the petitioners appreciated the necessity of amending their pleadings to raise the issues upon which they relied and that their failure to do so with respect to this issue was intentional. Had the issue been raised, the waivers extending the time would undoubtedly have been placed in the record and we would have been in a position to have passed upon the question. Orderly procedure requires that the issues be clearly framed in the pleadings that both parties may have notice and an opportunity to produce their evidence. An orderly procedure is necessary if the Board is to handle the large number of cases filed with it and if proper records are to be made for review in the courts. To attempt to decide any issue with respect to the statute of limitations upon the basis of an ex parte statement in the brief that a certain waiver in terms therein quoted was filed would be to deny the respondent a hearing upon this issue and an opportunity to produce his evidence. (See . In these proceedings argument of the cases was permitted after briefs were filed and at that time counsel for the petitioner took the position that the statute of limitations was jurisdictional and that if the statute had expired the Board had no jurisdiction of these proceedings. The proposition that a statute of limitations is a defense in bar and not a plea to the jurisdiction would seem to require no citation. However, that may be, it is clear that the statute governing the proceedings before the Board treats the statute of limitations as a defense, for it is provided in section 906(e) of the Revenue Act of 1924, as amended by section 601 of the Revenue Act of 1928, that -

If the assessment or collection of any tax is barred by any statute of limitations, the decision of the Board to that effect shall be considered as its decision that there is no deficiency in respect of such tax.

It seems clear that when the defense of the statute of limitations is raised the Board is to pass upon the merits and not dismiss for lack of jurisdiction.

At the first hearing held in Seattle, counsel for petitioners stated that he raised no contention relative to the income of the corporation as determined by respondent, either with respect to gross income or deductions. At a continuance of that hearing held in Washington both petitioners filed amended petitions, seeking a deduction for obsolescence. This claim was based upon very general statements made by certain witnesses at the Seattle hearing to the effect that during the years 1920 and 1921 the corporation would have been justified in setting up a reserve for obsolescence. This testimony appears from its context to have been based upon the opinion of these witnesses that in those years real estate values were declining in the neighborhood of the petitioners' buildings and that the future of those buildings was uncertain. A deduction from income for obsolescence is not granted because of declining values. It is to be granted because property is becoming obsolete. The Smith Building represented the highest known type of construction and, whatever may have been its future prospects with respect to declining value or yield, it was unquestionably one of the least obsolete of the city's buildings. In the years before us there was no prospect that this building would become useless or would have to be demolished to make way for some more profitable use before the termination of the 50-year life fixed by the Commissioner in allowing depreciation at 2 per cent or that it was in any sense obsolescent. The evidence discloses, however, that the Pacific Building was in a state of obsolescence and we are of the opinion that the deduction allowed by the Commissioner for depreciation of that building should be increased from the 3 per cent allowed to 6 per cent in order to reflect a reasonable allowance.

Reviewed by the Board.

Decision will be entered for the petitioner in Docket No. 25149. Decision will be entered under Rule 50 in Docket No. 24641.

MARQUETTE dissents.

TRAMMELL

TRAMMELL, dissenting: I am unable to concur in the decision reached in the foregoing opinion in respect to the tax liability of the petitioner corporation for the year 1921, and can concur only in the result of the decision with respect to the tax liability of the petitioner, Burns Smith, for the year 1920. My objection goes to the conclusion as well as the fundamental reasoning upon which it is based.

The construction placed upon the statute in the prevailing opinion invokes the penalty upon a corporation which permits an accumulation of earnings, however small, and without regard to its business necessities. If there is any accumulation, importance then attaches only to the matter of intent or purpose, which, the majority holds, may be determined from any other relevant circumstance, wholly aside from and independent of the question as to the reasonableness of the accumulation for business needs.

This view, in my opinion, is unsound. The right of a corporation to accumulate from its earnings a surplus reasonably commensurate with its business needs is generally recognized not only in the business world, but by the courts. The prescribed intent should not, therefore, be imputed to a corporation engaged in doing that which it has a legitimate and lawful right to do, namely, to accumulate a reasonable surplus. The question whether there is a purpose to prevent the imposition of the surtax upon the stockholders becomes of importance only when the accumulated gains and profits exceed the reasonable needs of the business. To hold otherwise would be to penalize a corporation engaged in the accumulation of a reasonable surplus, if we should conclude from some fact, other than reasonableness of the accumulation, that in addition to the purpose of providing for its business necessities, there was also the purpose to evade the surtax.

Again, it is obvious that to whatever extent a corporation permits its gains and profits to accumulate, even though it be only one dollar, just to that extent the corporation is in fact availed of for the purpose of preventing the imposition of the surtax upon its stockholders, since that result inevitably follows. Under the above construction of the statute it might then be argued that any accumulation, whether large or small, reasonable or unreasonable, would establish the prohibited intent and bring the corporation within the provisions of section 220. This leads to an unjust and absurd result. Clearly, I think Congress never intended, by the enactment of section 220, to impede corporations in the performance of their legitimate and necessary functions, nor to impose a penalty, in the form of a burdensome tax, in the case of a corporation engaged in accumulating not more than a reasonable surplus. Escaping the surtax is a necessary incident to the accumulation of a reasonable surplus, which the statute was not designed to prevent. However, when the accumulation exceeds the reasonable requirements of the corporate business, then a wholly different situation is presented.

It is clear that, if a corporation is formed for the purpose of evading the surtaxes upon its stockholders, but does not actually do so by accumulating a surplus of any kind, no penalty can be imposed. There is nothing upon which it can be based, yet a literal construction of the section seems to include such a case and the prevailing opinion holds that the section should be literally construed. But if a corporation is formed for the prohibited purpose and accumulates a surplus, however small, it comes within the section of the statute. In such a case the corporation is not only formed but availed of for the prohibited purpose.

In this case it is conceded that the corporation was not formed for the prohibited purpose, but for legitimate business reasons. Nevertheless, the majority finds that it was availed of for the purpose of evading the surtaxes upon the stockholders, not by reference to or on account of any unreasonable accumulation of profits, but upon another ground.

While the statute does not specifically provide that other evidence as to the purpose to escape the tax than accumulation beyond reasonable business needs might not be considered, in my opinion, the whole history of the legislation, the regulations of the Commissioner, the administration of the law, and the reports of the committees of Congress in charge of the legislation, lead to the conclusion that unless there has been an accumulation of profits beyond the reasonable needs of the business, the corporation does not come within the penal provisions of the statute. In case of ambiguity in the language used, such sources may properly be resorted to for interpretation of the Congressional intent.

Treasury Decision 2135 under the 1913 Act provided:

Sub. 2 of paragraph A. Income Tax Law Oct. 3, 1913, imposes no duty on the taxpayer to ascertain his distributive interest in the undivided profits of corporations for the purpose of making return of the amount, in addition to the amount of dividends declared on his stock, unless the Secretary of the Treasury has certified that in his opinion such accumulation is unreasonable for the needs of the business.

While the 1913, 1916, and 1917 Acts used the expression "formed or fraudulently availed of for the purpose * * *," and the 1918 Act is the first act where the expression "fraudulently" was omitted, the purpose of the various acts was the same. Under all the acts the regulations and rulings of the Commissioner required an unreasonable accumulation to bring a corporation under the section. A certification was required that the accumulation of profits was unreasonable. The same interpretation in this respect has been given the 1918 and the 1921 Acts.

The Senate Committee on Finance, in its report on the revenue bill of 1918, with respect to section 220, said:

It was believed that the incentive to withhold from distribution as dividends earnings not required for legitimate business uses exists chiefly in the case of certain corporations the stock of which is very closely held, * * *. The Committee * * * has provided that in the case of any corporation formed or availed of for the purpose of permitting gains or profits to accumulate instead of being divided the income shall be taxed to the stockholders in the same manner that partnership earnings are taxed to partners. (Italics supplied.)

At the time of the enactment of section 220, the evil sought to be remedied was the evasion of taxation by a corporation withholding from distribution as dividends "earnings not required for legitimate business uses," and it was undoubtedly in such a situation that Congress intended the provisions of the section to apply.

Upon the enactment of the Revenue Act of 1918, the Commissioner of Internal Revenue promulgated Regulations 45 thereunder, in which it was provided:

ART. 352. Purpose to escape surtax. - The application of section 220 of the statute depends upon the two elements of (a) purpose to escape the surtax and (b) unreasonable accumulation of gains and profits. * * *

ART. 353. Unreasonable accumulation of profits. - An accumulation of gains and profits is unreasonable if it is not required for the purpose of the business, considering all the circumstances of the case. * * *

While the regulations under the 1921 Act do not use this language, there is nothing therein inconsistent with this interpretation, and the rulings of the Commissioner under that act are substantially in accord with the rulings and regulations under the 1918 Act and previous acts as to the accumulation of surplus. In the case of a corporation engaged in business as distinguished from a mere holding company, the question has been whether the accumulation of profits was unreasonable for the business needs. See Advisory Board Memo. 2, 1 C.B. 181; O.D. 106, 1 C.B. 181; S.M. 1117, F.C.B. 182; O.D. 838, 4 C.B. 226.

After this long period of executive interpretation the Congress in subsequent revenue acts has used substantially the same language to accomplish the same purpose, which would indicate a Congressional approval thereof. This is shown more clearly by the language of the Committee reports on the various revenue bills.

In the 1921 Act, the tax is imposed directly upon the corporation instead of the stockholders. With this exception and a change in the rate of tax from 25 per cent to 50 per cent, the provisions of section 220 have been continued in all revenue acts since 1918. In the 1928 Act it appears as section 104.

In that connection, the Staff of the Joint Committee on Internal Revenue Taxation stated in its report:

The Congress has recognized since 1913 that corporations could be formed, or availed of, for the purpose of evading surtax on the stockholders of such corporations. * * *

* * *

The two greatest difficulties facing the administration in applying the present provision consist, first, in proving the "purpose" to evade, and, second, in proving what constitutes "the reasonable needs of the business."

A provision is suggested which will tend to give some incentive to corporations to make reasonable distributions, without going to the extent of forcing unwise distributions.

And the Senate Committee on Finance, in its report on the 1928 bill, stated:

The House bill (sec. 104), through an artificial definition of personal holding companies, attempted to strengthen the provisions of the existing law (sec. 220) relating to the evasion of surtaxes through the formation of corporations and the accumulation of income. As in the case of all arbitrary definitions, the effect was to penalize corporations which were properly building up a surplus and to fail to recognize business necessities and sound practices. * * * Accordingly, your committee recommends that the provision of the House bill be eliminated and the provisions of existing law be restored.

The recommendation of the Finance Committee was adopted in the final passage of the 1928 Act, and here again we have unmistakable evidence that it was the legislative intent that the provisions in question should not be so construed as "to penalize corporations which were properly building up a surplus," and that in the application of those provisions recognition should be given to business necessities and sound practices.

So far as appears, the Commissioner has not changed his construction of section 220, as embodied in the regulations promulgated under the 1918 Act, namely, that the application of this section depends upon the two elements of (a) purpose to escape the surtax and (b) unreasonable accumulation of gains and profits. That the deficiencies involved in this case were determined upon that basis is disclosed by a letter addressed to the petitioner corporation under date of September 10, 1925, in which the respondent stated:

An examination of the income and profits tax returns filed by your company for the period from April 1 to December 31, 1920, and for the calendar year 1921, together with a Revenue Agent's report of his investigation of your books and accounts for those years, discloses that you have permitted gains and profits to accumulate beyond the reasonble needs of this business. It, therefore, becomes necessary to invoke the provisions of Section 220 of the Revenue Acts of 1918 and 1921.

The prevailing opinion does not hold that the evidence supports the finding of the Commissioner that the accumulation was unreasonable, and it clearly does not support such a conclusion. On the other hand, the evidence supports the conclusion that the certificate of the Commissioner was not founded on fact and the prevailing opinion is based upon other grounds. In my opinion, the evidence must show that the facts certified are true to warrant the penalty of the statute.

The real question for consideration, in my opinion, is whether or not the corporation was formed or availed of for the purpose of preventing the imposition of the surtax upon the stockholders through the medium of permitting the profits to accumulate beyond the reasonable needs of the business. In my opinion both intent or purpose and an overt act are necessary to bring a corporation within the penal provisions, and the overt act is the accumulation beyond business needs, not simply an accumulation, except in a case where it is shown that a corporation is formed for the prohibited purpose.

The prevailing opinion does not hold that the corporation herein was formed for the prohibited purpose, but concedes that it was not. The only question here, then, is whether the corporation was availed of for the prohibited purpose. If the evidence justifies the conclusion that the accumulation was beyond the reasonable needs of the business, then the penalty should be imposed. But if the accumulation was not unreasonable for the business necessities, we may not impute the prohibited intent because tax is avoided as an inherent result of such accumulation.

Applying these principles to the instant case, I can reach no other conclusion, under the evidence before us, than that the accumulation of earnings by the petitioner corporation in the taxable years not only was not excessive, but at the end of 1921 was still inadequate for its business needs. Since the prevailing opinion does not hold that there was an unreasonble accumulation, it might not be of importance to discuss that feature, but the testimony on this question is to my mind of such a convincing character that I refer to it briefly.

The petitioners offered a number of witnesses who were qualified in an unusual degree to testify from personal knowledge and experience with respect to the conditions existing in Seattle during and prior to the taxable years, and also to express opinions as to the reasonableness of the corporation's accumulation of surplus.

The credibility of these witnesses is not questioned, and their testimony, which stands uncontradicted, shows that during 1920 and 1921 the petitioner corporation faced a very uncertain situation in reference to the earning of future profits, and that its financial position was precarious. The consensus of opinion of these witnesses was that the corporation should have accumulated and maintained an earned surplus greater in amount than it accumulated either for 1920 or 1921.

The record discloses that for the 9-month period of 1920, the operating expenses of the corporation amounted to $267,566, and during 1921 the operating expenses totaled $309,692, or an average for the two years of $288,629. In addition to its annual operating expenses, the corporation was obligated to make a payment of $50,000 each year on the principal of the mortgage of the L. C. Smith building, assumed by it, exclusive of interest.

In 1920 the gains and profits of the corporation which were permitted to accumulate and become surplus, including a small paid-in surplus, amounted to only $78,315.55, which was increased at the end of 1921 to $212,222.43. The total amount accumulated to the end of 1921, the last taxable year before us, was more than $100,000 less than the amount of its operating expenses for the 9-month period of 1920, plus the annual payment of the principal of the L. C. Smith Building note. In the light of the evidence in the record, I can not regard this accumulation of earnings as unreasonable for the business needs of the corporation, nor does the majority in its opinion so conclude.

However, in the majority opinion, the question of reasonableness of the accumulation is given scant consideration. No finding is made on this point, and the case is decided on the theory that in 1921 the corporation was availed of for the purpose of preventing the imposition of the surtax on its sole stockholder, Burns Smith, for the reason that in that year Smith paid in to the corporation for shares of its capital stock large amounts of stocks and bonds of other domestic corporations, and since the petitioner corporation accumulated all of its earnings for that year, Smith thereby escaped the surtax.

As before stated, I am unable to concur in the soundness of this view, because a corporation has the unquestioned right to accumulate a reasonable surplus, and avoidance of the surtax is an inherent incident to such accumulation. Hence, the provisions of the statute should not be applied by imputing the prohibited intent to a corporation whose earnings have not been accumulated in excess of its reasonable business needs. However, I am constrained to reach the same conclusion in this case on yet another ground.

The petitioner corporation represented an investment by Smith of approximately $2,000,000 and comprised more than two-thirds of all his property. It seems to me, therefore, that it was vastly more important to Smith to safeguard his investment by placing the corporation in a sound financial position through the accumulation of a reasonable surplus than to effect the saving of a comparatively small amount of surtax. For this reason I am unable to agree with the majority conclusion that Smith's motive in providing his newly organized corporation with the means of accumulating a reasonable surplus was to escape the surtax.

So far as the merits of this case are concerned, I do not regard the borrowings by Smith from the corporation of importance. They do not indicate that the corporation's surplus was in excess of its business needs and the prevailing opinion does not consider them indicative of such fact. The surplus remained unchanged on that account. The amounts were not shown not to have been available to the corporation. The were still assets. Bona fide loans to a solvent stockholder by a corporation, where its surplus was not unreasonable for business needs, are legitimate transactions and do not in my opinion indicate the prohibited purpose. The obligations of Smith bore interest and the fact that interest was not actually paid during the year involved is not important. These transactions would be important and material only in the event the corporation had a surplus beyond its business needs. The borrowings by Smith should properly be considered in connection with all the other evidence on the question as to the reasonableness of the accumulation of profits, but the other evidence on this point is overwhelming.

There is some suggestion in the record that in the later years Smith continued to exchange securities for stock of the petitioner corporation and that the corporation continued to accumulate earnings until its surplus exceeded its reasonable needs. But the later years are not before us here, and such facts, if they be facts, are not relevant in determining the tax liability of the petitioners for the years 1920 and 1921.

For the reasons indicated, it is my opinion that our decision on this point should be for the petitioners in both cases.

MATTHEWS agrees with this dissent.

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Footnotes

• 1. Includes dividends received in 1917 but earned in 1916 in amount of $40,824.16. ↩