Wright v. Commissioner

W. Q. WRIGHT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Wright v. Commissioner

Docket No. 4270.

United States Board of Tax Appeals

10 B.T.A. 806; 1928 BTA LEXIS 4027;

February 16, 1928, Promulgated

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Under the facts and circumstances of this case the dividends received by the petitioner in the years 1919 and 1920 constitute stock dividends and are not taxable within the meaning of the taxing statute.

Leon de Fremery, Esq., Rufus H. Kimball, Esq., and Anson Herrick, C.P.A., for the petitioner.

D. D. Shepard, Esq., and G. E. Adams, Esq., for the respondent.

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MORRIS

This is a proceeding for the redetermination of deficiencies in income taxes of $27,992.46 for 1919 and $5,609.37 for 1920. The issues presented for our consideration are:

1. Whether the respondent erred in adding to the net income of the petitioner for the years in controversy certain sums representing alleged cash dividends, and

2. Whether the respondent has incorrectly computed the paid in and earned surplus of the Jersey Island Farm Co., the corporation from which the dividends hereinabove referred to were received.

FINDINGS OF FACT.

The petitioner is an individual residing at Sausalite, Calif. From 1910 to 1916 he owned approximately 25 per cent of the outstanding stock of the Jersey Island Farm Co., formerly known as the Jersey Farm Co., hereinafter referred to as the Company, and since 1916 has owned approximately 50 per cent of the outstanding stock of the Company. The Company is a California corporation owning substantially all of what is known as Jersey Island, located in Contra Costa County, California, and is engaged in farming. The capital stock of the Company has always been controlled by the petitioner or his relatives, who in March, 1919, owned or controlled 49,990 shares of the 50,000 shares outstanding, par value $1 per share. The stock ownership at that time was as follows:

	Shares
W. Q. Wright (the petitioner)	24,980
F. A. Quinby (uncle of petitioner)	12,510
Bay & River Dredging Co.	12,498
W. L. Cobb	10
W. H. Wright	1
Myra E. Wright (mother of petitioner)	1
Total	50,000

Petitioner was also president of the Bay & River Dredging Co., hereinabove, owning about one-third of its capital stock. Petitioner's mother also owned stock in that company, and he, through the power vested in him, and the stock which he himself owned, represented practically 100 per cent of its capital stock.

Extensive reclamation works were constructed by the Company during the years immediately following its incorporation, and in November, 1912, it sold certain of its reclamation works to the reclamation district for $300,000, which was paid by bonds of the above district in that amount. The cost of the reclamation works sold by the Company was $110,319.38.

The reclamation bonds were not set up as an asset on the books of the Company until 1917. In November, 1917, the bonds then outstanding and in the possession of the Company in the amount of $270,000 were set up as an asset on the books of the Company, the corresponding credit being to an account originally entitled "Invested Capital," but changed at the time of transferring the accounts to a new ledger on January 1, 1918, to the title "Assessment Reserve - Profit 1912 held in reserve against assessments Dist. #830."

The balance sheet as shown by the books of the Company on December 31, 1918, was as follows:

Assets		Liabilities
Cost of property	$195,868.12	Capital stock	$50,000.00
Bond account	270,000.00	Bills payable	229,834.96
Liberty bonds	10,000.00	Vouchers payable	15,102.93
Betterments	29,453.31	Bay & River Dredging Co	41,398.04
Crates	12,769.40	W. Q. Wright	1,845.17
Equipment	13,732.38	Investment account	44,508.00
Seeds	614.69	Assessment reserve (profit
		1912 held in reserve
		against assessments -
Hay stored	2,378.40
Levee account	212,707.86	Dist. No. 830)	270,000.00
Miscellaneous accounts
receivable	22,299.91	Surplus	117,207.37
Cash	72.40
	769,896.47		769,896.47

The "Investment Account" appearing on the foregoing balance sheet represents paid-in surplus.

On January 20, 1919, at a special meeting of the board of directors of the Company, it was decided to increase the capital stock from 50,000 to 500,000 shares. The pertinent parts of the resolution authorizing the increase are as follows:

RESOLVED: That this Corporation, Jersey Island Farm Company, increase its capital stock from $50,000 divided into 50,000 shares of the par value of $1.00 each to 500,000 shares of the par value of $1.00 each, and that the said capital stock of $50,000 be and the same is hereby increased to $500,000 as aforesaid.

* * *

AND IT IS HEREBY FURTHER RESOLVED: That the President and Secretary of this Corporation be, and they are hereby, instructed in its name to file with the Commissioner of Corporations of California an application for permission to issue and deliver said shares with the same par value of $1.00 each, to each of said stockholders who shall subscribe and pay therefor, either in cash or a duly executed promissory note, the additional sum of 55?? per share for each additional share purchased by him, it being the purpose of this increased capital stock and of the said issuance of said shares to increase the invested capital of this Corporation to the extent of $247,500, said sum being the difference between the sum of $500,000.00 and the aggregate total of the property owned by the Corporation, consisting of cash and surplus paid into said Corporation including estimated profits on 1918 crop shares, the total of all of said amounts being the sum of $252,500.

On March 29, 1919, the board of directors held a special meeting and took the following action:

Secretary Kimball then reported that pursuant to the instructions of the Jersey Island Farm Company's stockholders, issued at their special meeting, held January 20, 1919, he and president W. Q. Wright, as chairman and secretary of said stockholders' meeting, and a majority of the stockholders of said corporation, signed the certificate of increase of capital stock of Jersey Island Farm Company, required by law, and showing the increase of the capital stock of said company from 50,000 shares of the par value of one dollar each, or a total authorized capitalization of $50,000, to 500,000 shares of the par value of one dollar each, or a total authorized capital stock of $500,000 and that thereafter he, as such secretary, had filed such certificate in the office of the county clerk of the City and County of San Francisco, State of California on March 28, 1919, and a certified copy thereof duly certified by said County Clerk with the Secretary of State, on March 29, 1919, and that on March 30, he mailed another copy of said certificate of capital stock to the Corporation Commissioner of the State of California, whose permit to issue said stock he had duly obtained and which said permit is hereto attached, marked Exhibit "A" and hereby made a part hereof.

Thereupon and upon motion of director W. Q. Wright, seconded by F. A. Quinby and unanimously carried, it was resolved; that

WHEREAS, a statement of the assets and liabilities of this corporation, dated and prepared as of December 31, 1918, shows that the sum of $252,500, estimated as closely as possible, has been invested in this corporation by the stockholders hereof, said investment being itemized as follows:

Paid for capital stock	$50,000
Additional subscribed investment	44,508
Surplus December 31, 1917	100,579.89
Surplus December 31, 1918	17,164.20
Estimate on net income on crops for year 1918	40,247.91
making a total of	$252,500.00

AND, WHEREAS, that portion of the Jersey Island Tract which is owned by Jersey Island Farm Company, consists of approximately 3755 acres, which together with the betterments, equipment, stock on hand, and estimated share of rent on crops * * * is worth approximately $500,000; and

WHEREAS, the difference between the amount of the investment by the said stockholders and the value of the said tract of land owned by the said corporation viz, the difference between $500,000 and $252,500 is the sum of $247,500; and

WHEREAS, the capital stock of this corporation has now been increased from $50,000 divided into 50,000 shares of the par value of $1.00 each to $500,000 divided into 500,000 shares of the par value of $1.00 each; and

WHEREAS, it is the desire and purpose of this corporation and the directors thereof to sell and issue the newly authorized issue of capital stock of this corporation to the stockholders thereof, for the sum of $247,500, in addition to the amount already paid in by said stockholders for the stock of this corporation so as to make the total amount paid by said stockholders the sum of $500,000 for $500,000 worth of stock and therefore make the stock worth par, or $1.00 per share and also the invested capital of this corporation the sum of $500,000.00.

NOW THEREFORE, IT IS HEREBY RESOLVED, that the total authorized capital stock of this corporation that is, 500,000 shares of the par value of $1.00 each, be issued and sold to each of the present stockholders thereof, in the proportion to each of said stockholders that the number of shares now held by him bears to the number of shares now issued and outstanding, not exceeding in the aggregate number thereof 450,000 additional shares in addition to the 50,000 now owned by said stockholders, said additional 450,000 additional shares to be sold at and for the price of 55?? per share, cash, lawful money of the United States, or in exchange for the promissory note of the subscriber therefor, upon the condition that all shares issued in exchange for any note or notes shall be held by the company as a pledge for the full payment of the principal sum of said note or notes and any interest accrued thereon, and upon the further condition that a true copy of the permit issued by the Corporation Commissioner to the Jersey Island Farm Company and dated March 3, 1919, be exhibited and delivered to each prospective subscriber for or purchaser of said securities before his subscription therefor, shall be taken or any sale thereof made to him, it being necessary that each such stockholder shall deliver his old certificate or certificates of stock, together with the required amount in cash or promissory notes for the same, to the secretary of the corporation prior to receiving his new certificate of stock herein authorized to be delivered and sold to him.

The president and secretary shall affix the necessary war revenue stamps to the stubs in the certificate book for the new certificates of stock, and also to any and all promissory notes signed and delivered to said secretary by said stockholders.

There being no further business to come before the meeting, upon resolution duly made and seconded, it was thereupon adjourned.

RUFUS H. KIMBALL, Secretary.

W. Q. WRIGHT F. A. QUINBY M. E. WRIGHT, Myra E. Wright

(By W. Q. WRIGHT, Attorney in fact)

Directors.

In accordance with the resolutions hereinabove the entire authorized capital stock of the Company was issued to the following stockholders in the amounts set opposite their names:

	Shares
F. A. Quinby	125,100
W. Q. Wright	249,800
W. H. Wright	10
W. L. Cobb	100
Myre E. Wright	10
Bay & River Dredging Co	124,980
Total	500,000

Upon the issuance of the above shares by the Company it took notes in payment thereof from the following stockholders in the amounts set opposite their names:

W. Q. Wright	$123,651.00
F. A. Quinby	61,924.50
Bay & River Dredging Co	61,865.10
W. L. Cobb	49,50
Myra E. Wright	4.95
W. H. Wright	4.95
Total	247,500.00

The following journal entry was made recording the issuance of the above shares and the receipt of notes therefor:

Bills Receivable	$247,500.00
Capital Stock		$247,500.00

At the time of the increase in the capital stock of the Company and the issuance thereof to the stockholders, it was agreed that the available surplus on the books should go toward part payment of the shares issued, and that the notes therefor were given in the interim until the assessment reserve became available, but were not to be paid, and when the bonds were paid the reserve was to be debited and the bills receivable credited. No subscriptions were taken for the increase in capital stock, and in posting the journal entry to the ledger the item of bills receivable $247,500 was entered in the ledger as a lump sum and not posted to the individual accounts of the stockholders.

The procedure for levying the several assessments by the reclamation district during the years 1919 and 1920 and for payment thereof by the Company was, briefly, as follows:

The assessment was levied by the reclamation district against the property owners of Jersey Island as provided for by statute, creating a subsisting legal debt against these property owners in favor of the district. The assessment having been levied and the debt created, the Company drew its check and presented it to the county treasurer for payment of said assessment. Simultaneously with the foregoing, it presented the bonds of the reclamation district for redemption, receiving a warrant, provided for under the laws of the State of California, in the amount of said bonds plus accrued interest. The assessment having been paid with the Company's check and the bonds having been redeemed by a warrant of the district, the bonds were canceled and the Company's check returned to it in exchange for the warrant issued in redemption of the bonds.

During 1919, Reclamation District 830 levied an assessment of $213,000 against the property owners of Jersey Island, of which the Company's proportion was $211,725.34. The Company paid this assessment and all later assessments in the manner outlined above. The following journal entry and explanations were made on the books of the Company in 1919, recording the assessment aforesaid and the redemption of bonds of the district:

Cost of property	$211,725.34
Bonds		$148,725.34
Assessment paid to District 830 redeemed by District 830 Interest		63,000.00
Coupons redeemed by District 830.

At a special meeting of the board of directors held on June 13, 1919, a dividend in the amount of $212,000 was declared out of the so-called "assessment reserve." The resolutions adopted at that meeting were as follows:

WHEREAS, this corporation did on December 14, 1912, purchase from Reclamation District No. 830, a political subdivision of the State of California, bonds issued by said district in the sum of $300,000, par value, and paid for the same by delivering to said district warrants issued thereby in the said sum of $300,000; and

WHEREAS, this corporation had previously purchased said warrants by selling to said Reclamation District in payment therefor, certain works of reclamation consisting of levees, ditches, etc., previously constructed by this corporation; and

WHEREAS, subsequent to said sale of said works of reclamation in exchange for said warrants by this corporation to said Reclamation District, this corporation still retained perpetual use of said works of reclamation thereby practically owning them; and

WHEREAS, the sale of said works of reclamation in no way decreased the value of any portion of the real property then owned by this corporation, to-wit, the greater part of Jersey Island, together with the works of reclamation and levees thereon; and

WHEREAS, therefore, said warrants issued by said Reclamation District 830 in payment for said works of reclamation and said bonds purchased with said warrants actually represented and constituted surplus profits earned by this corporation during the year 1912 and prior to January 1, 1913; and

WHEREAS, $30,000 the par value of said bonds, together with accrued interest thereon matured and was paid on or before January 1, 1914, to this corporation, and said funds have been expended thereby; and

WHEREAS, successive installments of $30,000 each matured upon said bonds on January 1, 1915, January 1, 1916, January 1, 1917, January 1, 1918, and January 1, 1919, respectively, making a total of $150,000, and interest coupons matured upon said bonds making a total on January 1, 1919, of $63,000, which together with said five payments of $30,000 each, made a total due on said bonds to this corporation of the sum of $213,000; and

WHEREAS, Call Number 3, properly issued upon Assessment No. 1 levied by Reclamation District 830, consisting of 71% of the original levy of $300,000 made by said district was responded to by the owners of land within said Reclamation District No, 830, by payment by said owners to said Reclamation District No. 830, on or before June 12, 1919, of the sums set out after their respective names, as follows to-wit:

Jersey Island Farm Company	$204,262.97
Agnes Cox	6,869.73
W. Q. Wright.	592.64
Fred Watson	272.65
Total	$211,997.99

and,

WHEREAS, C. F. Montgomery, a land owner of said District was delinquent in his portion of said call in the sum of $1,002.01; and

WHEREAS, said Reclamation District No, 830, had funds on hand in excess of the sum of $2.01; and

WHEREAS, said Reclamation District No. 830, therefore paid to this corporation from said funds on hand the sum of $2.01 and also the total collected upon the call of said assesment, to-wit: the sum of $211,997.99 making a total of $212,000; and

WHEREAS, said Reclamation District No. 830 therefore paid to this corporation corporation in 1912, at the time the said bonds were so sold to it, as aforesaid;

Now, THEREFORE, said sum of $212,000, is hereby distributed as such surplus profits to the stockholders of this corporation by the declaration of the dividend in the sum of $.424 per share for each and every share owned by stockholders in the sum of $ .424 per share for each and every share owned by the stockholders corporation is hereby instructed to distribute said sum of $212,000, in checks of this corporation, aggregating a dividend of $.424 per share, for every share owned by its stockholders, to-wit:

Name of Stockholder	No. of Shares	Amt. of Dividend
W. Q. Wright	249,800	$105,915.20
Fred A. Quinby	125,100	53,052.40
Bay and River Dredging Company	124,980	52,991.52
W. L. Cobb	100	42.40
W. H. Wright	10	4.24
Myra E. Wright	10	4.24
Total	500,000	$212,000.00

Treasurer W. Q. Wright was thereupon instructed to make the proper entries in the books of the corporation, showing said payments and also to correct any previous entries that may appear upon said books in order to show plainly that said words of Reclamation and warrants and bonds of said Reclamation District No. 830, for which they were subsequently exchanged, and also of course the amounts paid on the maturity of the principal and interest coupons of said bonds, were and at all times have been since November 1912, and prior thereto, surplus profits of this corporation.

There being no further business to come before the meeting it was thereupon, upon motion duly made and seconded, adjourned.

RUFUS H. KIMBALL,

Secretary.

Approved

W. Q. WRIGHT F. A. QUINBY

MYRA E. WRIGHT

Directors.

The following journal entries and explanations were made on the books of the Company evidencing the dividend declared in the above resolutions:

Interest		$63,000.00
Coupons on bonds.
Assessment Reserve		150,000.00
Profits, 1912, in reserve for assessment
Dividend			$213,000.00
Profit on bonds - Int. 1912 distributed
Dividend		$213,000.00
Paid to share holders
Bay & River Dredging Co			40,784.63
Bills Receivable			172,215.37
Received from share holders for account of endorsement on notes -
W. Q. W	$86,038.80
F. A. Q	43,088.29
B. & R. D. Co	43,046.96
W. L. C	34.44
W. H. W	3.44
M. E. W	3.44
Total	172.215.37

A second assessment of $36,200 was levied by the district during 1919 against the property owners of Jersey Island, of which the Company's proportion was $35,784.56. This assessment was paid in the same manner as the former assessment for 1919 hereinabove outlined. The following journal entries were made on the books of the Company in 1919 recording this assessment and the redemption of bonds of the district:

Levee Account	$34,784.56
Bonds		$29,000,00
Interest		6,784.56
Distribution bonds and interest Contra Costa.

The bonds having been redeemed by the district, the board of directors at a special meeting held on December 30, 1919, declared a dividend in the amount of $36,200. The pertinent provisions of the minutes of that meeting are as follows:

WHEREAS, this corporation has recently collected and received upon the bonds of Reclamation District No. 830, owned and held by it, the sum of Thirty-six Thousand Two Hundred (36,200) Dollars, and

WHEREAS, said sum constitutes surplus profits made by this corporation during the year 1912 and is therefore available for the purpose of declaring a dividend therefrom;

Now, THEREFORE, said sum of $36,200, is hereby distributed as and for such a dividend to the stockholders of this corporation by the declaration of a dividend in the sum of $.0724 per share, for every share owned by its stockholders, to wit:

NAME OF STOCKHOLDER	NO. OF SHARES	AMT. OF DIVIDEND
W. Q. WRIGHT	249,800	$18,085.52
FRED A. QUINBY	125,100	9,057.24
BAY AND RIVER DREDGING COMPANY	124,980	9,048.56
W. L. COBB	100	7.24
W. H. WRIGHT	10	.72
MYRA E. WRIGHT	10	.72
Total	500,000 shares	$36,200.00 Dividend

There being no further business to come before the meeting and upon motion duly made and seconded, the same was duly adjourned.

RUFUS H. KIMBALL

Secretary.

Approved:

W. Q. WRIGHT F. A. QUINBY

MYRA E. WRIGHT

Directors.

The following journal entries and explanations were made on the books of the Company evidencing the dividend declaration as set forth in the above minutes:

Assessment Reserve		$29,000.00
Interest		7,200.00
Dividends			$36,200.00
Dividends		36,200.00
Bills Receivable			36,200.00
Credit on bills receivable and proportion or dividend -
W. Q. W	$18,085.52
F. A. Q	9,057.24
B. & R. D. Co	9,048.56
W. L. C	7.24
M. E. W	.72
M. H. W	.72
Total	36,200.00

The following are the assets and liabilities of the Company as they appeared on the books at December 31, 1919:

Assets		Liabilities
Cost of property	$408,152.53	Capital stock	$500,000.00
Bond account (Dist.
830 bonds)	91,000.00	Bills payable	171,240.88
Bills receivable	39,084.63	Vouchers payable	16,110.13
Liberty bonds	20,000.00	Bay & River Dredging Co	69,318.35
Betterments	29,399.11	W. Q. Wright	1,820.17
Crates	16,351.72	F. A. Quinby	1,500.00
Nails	500.50	Assessment reserve (profit
		1912 held in reserve
		against assessments -
		Dist. No. 830)	91,000.00
Equipment	12,760.28
Seeds	355.92
Hay stored	854.40	Surplus	26,186.90
Levee account	248,492.42
Miscellaneous accounts
receivable	9,700.24
Cash	534.68
	877,186.43		877,186.43

The reclamation district levied one assessment during the year 1920, in the sum of $36,400, against the property owners of Jersey Island, all of which was borne by the Company. This assessment was paid in the same manner as the two assessments for 1919 hereinabove outlined. The following journal entries were made on the books of the Company in 1920 recording this assessment and the redemption of the bonds of the District:

Levee Account	36,400.00
Bonds		$31,000.00
Interest		5,400.00
"J" pays to Treasurer, Contra Costa on account first call of assessment #2, $36,400.00 and at the same time collects from Treasurer, Contra Costa County, bonds, $31,000.00; coupons, $5,400.00; a total of $36,400.00 from District #830.

The bonds of the district having been redeemed, the board of directors pursued the usual practice of the Company, and held a special meeting on December 30, 1920, at which a dividend in the amount of $36,400, was declared. The following are the pertinent provisions of the minutes of that meeting:

WHEREAS, this corporation has recently collected and received upon the bonds of Reclamation District No. 830, owned and held by it, the sum of Thirty-six Thousand, Four Hundred ($36,400.00) Dollars, and

WHEREAS, said sum constitutes surplus profits made by this corporation during the year 1912 and is therefore available for the purpose of declaring a dividend therefrom;

Now, THEREFORE, said sum of $36,400, is hereby distributed as and for such a dividend to the stockholders of this corporation by the declaration of a dividend in the sum of $.0728 per share, for every share owned by its stockholders, to wit:

Name of Stockholder	No. of Shares	Amt. of Dividend
W. Q. Wright	249,800	$18,185.44
Fred A. Quinby	125,100	9,107.28
Bay and River Dredging Company	124,980	9,098.54
W. L. Cobb	100	7.28
W. H. Wright	10	.73
Myra E. Wright	10	.73
Total	500,000	$36,400.00

There being no further business to come before the meeting and upon motion duly made and seconded, the same was duly adjourned.

RUFUS H. KIMBALL

Secretary.

Approved:

W. Q. WRIGHT. F. A. QUINBY

MYRA E. WRIGHT

Directors.

The following journal entries and explanations were made on the books of the Company, evidencing this dividend declaration as set forth in the above minutes:

Assessment reserved		$31,000.00
Interest		5,400.00
Dividends			$36,400.00
Dividends		$36,400.00
Bills receivable			$36,400.00
Distributing same in dividend as from profit accrued in 1912 and applying the amount of dividend to payment of notes due from stockholders to J. Is. F. Co.
	$39,084.63
	36,400.00

Dividend to be distributed to following stockholders and credited on the notes which they owed to Jersey Island Farming Company:

	Shares
W. Q. W	249,800	$18,185.44
F. A. Q	125,100	9,107.28
D. & R. D. Co	124,980	9,098.54
W. L. C	100	7.28
M. E. W	10	.73
W. H. W	10	.73
Total	500,000	$36,400.00

The minutes of the directors' meetings show that on December 30, 1921, a dividend of $33,600 was declared and that on December 30, 1922, another dividend of $31,800 was declared, based upon collections and the redemption of bonds of District 830. On September 15, 1923, these declarations of dividends were annulled, rescinded and declared null and void because the reported declarations of dividends "were made under misapprehension, and were erroneous, for the reason that there were no moneys at that time available for the declaration of any dividend whatsoever, * * *."

The declarations of dividends by the company were made pursuant to an understanding among the stockholders and directors that they should not be paid in cash, but that the pro rata shares of the stockholders should be applied in reducing the notes due the company from the individual stockholders. On June 13, 1919, the date of the first declaration of dividend, the cash on hand amounted to $230.92; on December 31, 1919, cash on hand was $534.68; and on December 30, 1920, cash on hand was $241.18.

The monthly cash balances as they appeared on the books of the company for the years 1919 and 1920 were as follows:

1919	Cash balances	1920	Cash balances
Jan. 1	$72.40	Jan. 1	$534.68
Feb. 1	413.66	Feb. 1	8,612.13
Mar. 1	243.23	Mar. 1	192.09
Apr. 1	1,709.45	Apr. 1	544.52
May 1	12,610.93	May 1	2,361.73
June 1	1,536.57	June 1 (overdraft)	4.89
July 1	101.58	July 1	544.14
Aug. 1	460.35	Aug. 1	44.26
Sept. 1	2,667.73	Sept. 1	425.47
Oct. 1	1,663.07	Oct. 1	226.01
Nov. 1	1,072.05	Nov. 1	355.25
Dec. 1 (overdraft)	922.22	Dec. 1	467.88

The stockholders never made a demand on the corporation for payment of the dividends declared, nor did the corporation ever demand payment of the notes representing the pro rata increase in shares held by the individual stockholders, but it was understood that the dividends declared, as the district bonds were redeemed, should be and were in fact used in cancellation of the amount of the bills receivable set up in the books of account against the stockholders. This agreement was not evidenced by any writing. No dividend checks were drawn by the Company for the three dividends in question, nor was any payment made by the Company of those dividends or any portion thereof to any of the stockholders, either in cash or by endorsement on any promissory note.

A stipulation was filed at the hearing, wherein the parties agreed that the earnings since March 1, 1913, available for dividends were as follows:

	Earnings after Mar. 1, 1913	Mar. 1, 1913 earnings and paid-in surplus	Total
3/1/13		$215,169.84
Paid in surplus		44,508.00
Earnings 3/1/13-12/31/13	$387.80	$259,677.84
Loss 1914	387.80	39,128.75	$39,516.55
1/1/15-3/1/13 earnings and paid in surplus		$220,549.09
1915 earnings	$38,213.09
1916 earnings	54,783.47
1917 earnings	13,616.59
1918 earnings	16,680.79
1/1/19-6/13/19 earnings	12,343.99
6/13/19	$135,637.93	$220,549.09
6/13/19 dividend	135,637.93	76,362.07	$212,000
		$144,187.02
Earnings 6/13/19-12/31/19	$15,298.39
12/31/19 dividend	15,298.39	20,901.61	$36,200
		$123,285.41
1920 income	$31,128.03
12/31/20 dividend	31,128.03	5,271.97	$36,400
		$118,013.44
1919 60.812%
1920 85.516%

The parties stipulated that the percentage 60.812 per cent is the percentage of dividends paid in 1919 by the Company out of earnings accrued since February 28, 1913, and that the percentage 85.516 per cent is the percentage of dividends paid in 1920 by the Company out of earnings accrued since February 28, 1913.

The revenue agent made an investigation of the Company in July, 1923, and rendered a report in which he set up as "Stock Discount" the bills receivable of $247,500 and the charge to the Bay & River Dredging Co. of $40,784.63, which had been put upon the books in 1919 at the time of the increase in capital stock. The agent charged the total of $288,284.63 to stock discount and then reduced the amount of this discount by $213,000, the journal entry of the dividend declared on June 13, 1919, and $36,200, the dividend declared on December 31, 1919, leaving a balance as stock discount of $39,084.63.

The taxpayer on his income-tax returns for the years 1919 and 1920 reported no income as a result of the dividends declared in those years by the Company. The Commissioner has held that the dividends credited to bills receivable constitute taxable income to the taxpayer, in so far as the dividends represent a distribution of surplus or earnings accumulated since February 28, 1913.

OPINION.

MORRIS: The first allegation or error urged by the petitioner is that the respondent erred in adding to the net income of the petitioner for the years in controversy certain amounts representing alleged cash dividends. The petitioner contends that the dividends received by him were stock and not cash and therefore did not constitute income within the meaning of the Sixteenth Amendment of the Constitution as defined by the United States Supreme Court in Eisner v. Macomber,252 U.S. 189. Cf. United States v. Mellon,279 Fed. 910, affd. 281 Fed. 645, and United States v. Davison, 1 Fed.(2d) 465, affirmed 9 Fed.(2d) 1022, certiorari denied 271 U.S. 670. The respondent on the other hand contends that the dividends in question were cash dividends and therefore taxable for the years in question within the meaning of the taxing statutes.

The petitioner owned approximately 50 per cent of the outstanding stock of the Jersey Island Farm Co., referred to herein as the Company, and in effect represented a further 25 per cent. The Company owned substantially all of what is known as Jersey Island and was engaged in farming. The stock had always been closely held by the petitioner or his relatives, who in March, 1919, owned or controlled 49,990 shares of the 50,000 shares outstanding. The petitioner was also president of the Bay & River Dredging Co., and he, through his stock ownership and through the stock owned by his mother, represented practically 100 per cent of the total outstanding capital stock.

The company owned certain reclamation works in 1912 which it sold to Reclamation District No. 830 for $300,000, which sum was paid by bonds of that district. In 1917 when the bonds were taken up in the books of the Company, the entry was made in the amount of $270,000 since a portion of the bonds had already been redeemed.

By resolution of the board of directors of the Company the capital stock was increased in 1919 from $50,000 to $500,000, $1 par value, to be sold to each stockholder "either in cash or a duly executed promissory note" at 55 cents per share for each share purchased. The purpose of the increase of the capital stock was to capitalize the difference between the amount invested in the Company by the stockholders plus its surplus, and the value of the land owned by the Company. The authorized capital stock of the Company having been increased, it issued 249,800 shares to the petitioner, 125,100 shares to F. A. Quinby, uncle of the petitioner, 10 shares to Myra E. Wright, mother of the petitioner, and 124,980 shares to the Bay & River Dredging Co., which Company, as has been stated, the petitioner actually controlled, making a total of 499,890 shares out of a total authorized issue of 500,000 shares. Upon the issuance of the increased stock the Company took notes in payment thereof in the total amount of $247,500, which sum was charged to bills receivable and a corresponding credit was made to capital stock in the books of account of the Company. It was agreed among the petitioners at the time that these notes were not to be paid but were to be canceled upon the declaration of certain future dividends.

The reclamation district was organized under the laws of the State of California and is a political subdivision of the State, depending entirely upon the assessments which it is authorized to make against the property owners within its district. In 1919 and 1920 the district levied three assessments against the Company, aggregating in amount $283,910. These assessments were paid, in the final analysis, by the cancellation of bonds of the district which the Company held.

As the bonds of the district were redeemed by payment of the several assessments levied against the Company, the so-called "assessment reserve," which had been set aside in the books of account as a result of the sale of the reclamation works to the district in 1912, was made available for the dividends which were declared in 1919 and 1920. As the assessments were made in 1919 and 1920, dividends were declared aggregating in amount $285,600. Upon the declaration of each dividend the assessment reserve was charged and dividends credited for the amount of the dividend declared.

The petitioner, believing that the dividends in question were nontaxable, did not report them in his income-tax return for the years 1919 and 1920.

If the dividends in question are cash dividends as distinguished from stock dividends, the amounts thereof, to the extent of earnings accumulated subsequent to March 1, 1913, are taxable to the petitioner; if not, they are not taxable.

In United States v. Mellon, supra, decided by the District Court, Western District of Pennsylvania, later affirmed by the Circuit Court of Appeals, Third Circuit, the court, having under consideration facts resembling those in the instant case, held that the amounts received by the defendant upon which the plaintiff proposed to assess a tax constituted stock dividends and therefore were not taxable within the meaning of the taxing statutes. In that case the defendant owned certain shares of stock of the Gulf Oil Corporation, which corporation, while its earnings had been large, had never declared a dividend, nor had it been in such a financial position that it would have been justified in declaring a dividend, for the reason that all its earnings had been utilized for extension and developmental purposes. That corporation on December 31, 1912, had an outstanding capitalization of $11,280,200, and its indebtedness was around $15,000,000, of which $2,750,000 were in accounts payable and $4,750,000 in bills payable. That corporation had quick assets of $12,500,000, which amount included some $600,000 of cash. It was agreed that that corporation should increase its capital stock to $60,000,000 and that out of the increase an amount equal to 100 per cent of the then outstanding stock, namely, $11,280,200, was to be sold at par for cash in order to provide the corporation with the funds needed to pay existing debts, and to carry on its business. The stockholders, as an inducement to purchase these further shares, were to receive a 100 per cent dividend, the same to be accepted by them in stock. In order to insure success of the plan agreed upon, the directors of that corporation, including the defendant in that case, agreed in advance to accept and pay for their proportionate amount of stock, and at the same time A. W. Mellon and R. B. Mellon, who were large stockholders and who had endorsed the outstanding paper of that corporation agreed that, in case any stockholders should decline to take payment of said dividend in shares of stock or fail to subscribe for their share of the additional 100 oer cent of stock to be sold, they would take and pay the corporation therefor. The principal stockholders accepted payment of said dividend in stock of the corporation, but the holders of a small number of shares received cash. The court found in that case as a fact, that at the time of the declaration of said dividend and payment thereof, the corporation did not have cash with which to pay the same "or any substantial part thereof." The language of the District Court in summarizing the result of that transaction is as follows:

After the transaction, the defendant had two shares to represent the interest in the same property which prior thereto was represented by one. After the transaction, there were twice as many shares of the corporation in the hands of the stockholders as there were before. The corporate assets had not been diminished by the transaction. Therefore, for two shares which defendant possessed at the close, there was for him the same value as for one share represented at the beginning.

The District Court said in its discussions:

It is clear, that if the resolution declaring the dividend in question, had provided for the payment of the dividend in stock, the dividend would not have been taxable. It is also clear that the defendant received payment of the dividend in shares of stock, and that he did this pursuant to an agreement made prior to the declaration of the dividend, which agreement was communicated to the corporation before that declaration was made.

The Court said further, "In every view of the transaction, we find that its substance is clear. In cases like the present, substance is controlling, and not form."

In considering the instant case we should carefully examine the facts as they existed, not only in the taxable years in question but prior thereto; we should weigh the understanding and agreements had between the stockholders and directors of the Company and consider the financial status or the financial ability of the Company to pay in cash the amounts of dividends which were declared in the years 1919 and 1920. In other words, we must pierce the veil of form and look to the substance of the transaction in question. Bailey v. Railroad,106 U.S. 109; Lynch v. Turrish,247 U.S. 221; Southern Pacific Co. v. Lowe,247 U.S. 330; Gulf Oil Corporation v. Lewellyn,248 U.S. 71; Eisner v. Macomber,252 U.S. 189; United States v. Phellis,257 U.S. 156; and Weiss v. Stearn,265 U.S. 242.

As set out in the minutes of the meeting of the board of directors held on March 29, 1919, the amount invested in the Company by the stockholders was approximately $252,500 and the value of the property owned by the Company was $500,000, and it was to capitalize the difference of $247,500 that the capital structure was increased. It was thought that the amount of $270,000 carried on the books as "assessment reserve" was not immediately available as surplus, and that during the interim until the payment of the bonds it was necessary to have the notes. It was understood, however, that the makers of the notes were not to pay the same. They were regarded as purely a "Pro forma matter" pending the redemption of the bonds. The increase in capital stock was charged to surplus to the extent that it was thought available when the stock was increased. The remainder was charged to "bills receivable," it being understood by the stockholders that as the surplus became available, surplus would be charged and bills receivable credited until the entire increase in capital stock had been charged to surplus. No dividend checks were drawn by the Company for the dividends in question, nor was any payment made by the Company of any of the dividends or any portion thereof to any of the stockholders, either in cash or by endorsement on any promissory note. Furthermore, as each of the dividends in question was declared, notwithstanding the language used in the minutes of the meetings of the board, it had already been agreed that the dividends should never be paid in cash, nor did any of the stockholders make demand upon the Company for the payment thereof.

Examining the financial ability of the Company to meet these obligations in cash, we find that it had in its balance sheet at December 31, 1918, quick assets in a round amount of $32,400, including $72.40 in cash. The Company's current liabilities, as disclosed by the balance sheet above referred to, amounted to many times the current assets of the Company available for dividends at December 31, 1918. The average monthly cash balance during 1919 was in the neighborhood of $1,800 and in 1920 it was in the neighborhood of $1,200. The balance sheet of December 31, 1919, discloses Liberty bonds of $20,000 and cash of $534.68. It also includes bills receivable, the nature of which we are not informed, and the bonds of the reclamation district. Certainly the current assets which were readily realizable were negligible as compared with the amount of dividends declared, particularly when we review the liabilities as they appeared in the balance sheet of December 31, 1919, which were largely in excess of any amounts, under the broadest interpretation, that could be turned into cash within a reasonable time. After a consideration of these facts, we are led to the conclusion that the Company was not at any time during the years involved financially able to pay these dividends in cash. It may be argued, of course, that the directors of the Company contemplated borrowing money, but the facts and circumstances surrounding the declaration of these dividends clearly rebut any presumption that may arise in this connection. In fact we seriously doubt the ability of the Company to borrow on its assets any large sums of money to be used in paying dividends.

In Appeal of Theresa Zellerbach,2 B.T.A. 1076, the question presented for the consideration of this Board was whether certain dividends, declared to the taxpayers by a corporation in which they were stockholders, contstituted income within the meaning of the law. In that case the Board said (p. 1083):

If we were to rely upon the records of the company as contained in the minute books alone we would of necessity be compelled to sustain the Commissioner.

It may not be inappropriate at this juncture to add that if we were in the instant case relying solely upon the wording of the minutes of the board of directors, we would be compelled to sustain the views of the respondent. In that case, however, we said, "we must have regard for the very truth of the matter and look to substance rather than form to reach a conclusion as to the merits of the taxpayers' contentions." In that case it appears that the holders of 92 per cent of the stock had agreed upon the plan of dividend and knew that they would pay no money for the stock issued to them, nor would they receive any money from the dividend declared. In the instant case the stockholders who owned or controlled 99 per cent of the stock of the Company had agreed and thoroughly understood that the notes which they gave in payment of their stock would never be called for payment in cash, and furthermore, that the dividends ultimately to be declared would never be paid to them in cash. In that case the Board said (p. 1084):

Nothing was given to the stockholders which they had not theretofore had. The company still had the $750,000 and the stockholders merely had an increase in the number of pieces of paper, which represented the same proportionate interest in the property of the corporation that their original holdings did.

In the instant case the petitioner received no cash but merely received in exchange for each share of his stock, ten shares of the new capitalization; he had received nothing more nor less than a further division of his interest in the assets of the Company which he owned prior to the increase in its capital.

The respondent relies, inter alia, upon Appeal of W. J. Hunt,5 B.T.A. 356, in which the Board held that the dividends therein under consideration were cash and therefore taxable to the recipient. In that case the Board said (p. 358):

Whether, in any case, a dividend is a stock or cash dividend is a question of fact and the question must be decided upon the peculiar facts in each case.

In that case, unlike the facts in the instant case, there was a segregation of the profits of the corporation and the corporation issued its check to the stockholders for their proportionate share of the corporate earnings. Each stockholder endorsed the check which he had received and turned it back to the corporation and it was deposited to the stockholder's credit, whereupon checks given by the stockholders for stock were presented and paid. We are of the opinion that the facts and circumstances in Appeal of W. J. Hunt, supra, are clearly distinguishable from the facts and circumstances in the instant case.

Having carefully reviewed the facts and circumstances of this case, and convinced as we are that the dividends here in question were intended to be paid in stock instead of cash, and considering the fact that no cash was ever paid to the stockholders, we can not escape the conclusion that the amounts in question constituted stock dividends, and, therefore, under the decided cases, are not taxable income within the meaning of the statute.

Having so concluded with respect to the first issue herein it becomes unnecessary for us to give any consideration to the second issue raised by the petitioner.

Reviewed by the Board.

Judgment will be entered for the petitioner on 20 days' notice, under Rule 50.

SMITH did not participate.

TRAMMELL and PHILLIPS dissent.