Kolkey v. Commissioner

Emanuel N. (Manny) Kolkey, et al., ^{Kolkey v. Commissioner}

Docket Nos. 44520, 44818, 44850, 45063, 45064

United States Tax Court

27 T.C. 37; 1956 U.S. Tax Ct. LEXIS 68;

October 18, 1956, Filed

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">*68 Decisions will be entered under Rule 50.

Three individuals who owned all the stock of corporation C, which had accumulated earnings and profits of approximately $ 598,000, entered into an agreement with tax-exempt organization S, whereby: A new corporation K was organized, with capital stock of $ 1,000, to take over C's business; S contributed the $ 1,000, and received all the stock; the individuals transferred to K all of their shares of C, and received $ 4,000,000 promissory notes of K, which were payable over an 11-year period, after prior provision for dividends to S; and the three individuals were given a 7-year contract to operate K's business, as "managers." Thereupon, K took over all of C's net assets in complete liquidation; and paid the individuals $ 400,000 out of the assets so acquired, in cancellation of part of the notes. After K had operated for about 11 1/2 months with declining earnings, S sold all its shares of K's stock to the individuals, and withdrew from participation in the enterprise.

1. Held, that the $ 4,000,000 notes of K did not, in reality, represent corporate "indebtedness," but rather equity capital investments of the individuals.

2. Held">*69 , that, since there was no recognizable gain or loss on the liquidation of C, the "earnings and profits" of C remained, for purposes of distribution, "earnings and profits" of K ( Commissioner v. Sansome, 60 F.2d 931, certiorari denied 287 U.S. 667">287 U.S. 667); and that the $ 400,000 thereafter paid by K to the individuals, constituted taxable dividends to them as equity capital investors.

3. Held, that K was not exempt from income tax, under section 101 (6) of the 1939 Code.

4. Held, that K is not entitled to deductions for "interest" on certain of the above-mentioned notes, for the reason that such notes did not constitute corporate "indebtedness"; nor is it entitled to a deduction for accrued interest on income tax for its first fiscal period, for the reason that its liability for the tax and such interest has not been conceded, and is still in dispute.

5. Held, further, that K's failure to file its returns within the time prescribed for such filing was due to reasonable cause and not due to willful neglect; and that, accordingly, it is not liable for additions to tax, under section 291 (a) of the 1939 Code.

Morton J. Harris, Esq., ^{Samuel E. Hirsch, Esq., for the1956 U.S. Tax Ct. LEXIS 68">*71 petitioners in Docket Nos. 44818, 45063, and 45064.}

George T. Donoghue, Esq., John E. Owens, Esq., and Geoffrey J. Lanning, Esq., for the respondent.

Pierce, Judge.

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PIERCE

">*38 This proceeding involves deficiencies in income tax, and an addition to tax under section 291 (a) of the 1939 Code, determined by the respondent as follows:

Docket				Addition to
No.	Calendar year	Petitioner	Deficiency	tax under
				sec. 291 (a)
44520	1949	Pauline Kolkey	$ 104,335.88
44850	1949	Emanuel N. (Manny)
		Kolkey	104,335.88
45063	1949	Barnet Perel and Bertha
		Perel	32,412.34
45064	1949	Maurice L. Cowen and
		Rosalie Cowen	31,560.52
	Fiscal period
44818	March 5, 1949,
	to Feb. 28,
	1950.	Kyron Foundation, Inc	110,327.73	$ 11,032.77
	Ended
	Feb. 28, 1951		43,199.33	8,639.87

All of these cases were consolidated for hearing.

Several of the issues raised by the pleadings have been eliminated:

In Docket No. 44520, petitioner Pauline Kolkey has conceded that, by reason of her having filed a joint income tax return for the year involved with her then husband, petitioner Emanuel N. (Manny) Kolkey, she is jointly and severally liable ">*72 for any deficiency which may be established in his case, being Docket No. 44850.

In Docket Nos. 45063 and 45064, the petitioners presented no evidence in support of their assignments of error respecting (a) additional income received through excess reimbursement of expenses, and (b) adjustment of income from a partnership; and also in Docket No. 45064, the petitioners presented no evidence in support of their assignment of error respecting the disallowance of a deduction for sales taxes. Accordingly, these issues are deemed to have been abandoned.

In Docket No. 44818, the petitioner presented no evidence in support of its assignment of error respecting the disallowance of a deduction of $ 7,500 for travel and entertainment expenses for each of the taxable periods involved; and such issue is likewise deemed to have been abandoned. Also, in this Docket No., the petitioner has conceded that it is not entitled to deductions for (a) salaries and wages of $ 1,000 paid to William H. Paul and wife in the first taxable period, and (b) salaries and wages of $ 3,200 paid to Bent Darre and wife in the second taxable period; and the respondent has conceded that the petitioner is entitled to deductions">*73 in the second period, of $ 13,890 for sales expenses paid to Eden T. Brekke and Joseph Greenspahn, and also of $ 4,500 paid to Charles W. Mander for legal expenses.

Effect will be given to all the foregoing in our decisions.

The questions here presented are:

Pursuant to a plan agreed upon by three of the individual petitioners and a charitable organization: The petitioner Kyron Foundation, Inc., was organized with capital of $ 1,000 to acquire all the stock and succeed ">*39 to the business of an operating corporation controlled by the individuals, which had gross assets per books of more than $ 1,200,000, and earned surplus and undivided profits of approximately $ 598,000; the charity paid Kyron $ 1,000 and received all its authorized shares of stock; the individuals transferred to Kyron all stock of the operating corporation and received $ 4,000,000 of Kyron's notes, of which $ 400,000 was immediately satisfied out of assets taken over from the acquired corporation, and of which $ 3,600,000 was to be paid with interest over a 10-year period, out of profits of the continuing business; and the individuals were retained as "managers" of the continuing business, under a 7-year management">*74 contract. After less than 1 year, the charitable organization sold its stock to the individuals and withdrew from all participation.

1. Did the $ 4,000,000 of corporate notes which the individuals received, represent a bona fide debtor-creditor relationship -- so that the $ 400,000 payment thereon constituted proceeds from a sale of their capital investment in the business, and thereby became entitled to capital gains treatment? Or did such notes represent, in reality and irrespective of their form, a continued capital investment of the individuals in the business -- so that said $ 400,000 payment constituted a taxable dividend? (This issue is the only one presented in the cases of the individual petitioners.)

2. Is Kyron Foundation, Inc., exempt from income tax, for both of its fiscal periods here involved, as a corporation organized and operated exclusively for charitable purposes, within the meaning of section 101 (6) of the 1939 Code?

3. Assuming that Kyron Foundation, Inc., is not exempt from income tax, is it entitled to deduction for: (a) $ 86,949.67 which it accrued, in its first taxable period, as interest on certain of the corporate notes mentioned in question 1; ">*75 (b) $ 90,000 which it accrued, in its second fiscal period, as interest on said corporate notes; and (c) $ 3,603.50 which it accrued, in its second period, as interest on the disputed income tax liability for the prior period, which is here in issue?

4. Assuming again that Kyron Foundation, Inc., is not exempt from income tax, is it liable, under section 291 (a) of the 1939 Code, for an addition to the tax for each of the periods involved, by reason of failure to file its return within the time prescribed for such filing?

FINDINGS OF FACT.

Petitioners Emanuel and Pauline Kolkey were husband and wife during the taxable year 1949. Likewise, Maurice and Rosalie Cowen were husband and wife, as were also Barnet and Bertha Perel. Each ">*40 of these couples filed a joint income tax return for such year, with the then collector of internal revenue for the first district of Illinois. The deficiencies determined against the wives arise solely from their being parties to such joint returns. The husbands, who all had a direct interest in the transactions here involved, are hereinafter referred to as Kolkey, Cowen, and Perel.

The petitioner, Kyron Foundation, Inc., hereinafter described">*76 more fully, is a Delaware corporation. It filed its return for each of its taxable periods here involved with the then collector of internal revenue for the second district of New York.

In 1946, Kolkey who was the operator of a barbecue restaurant in Chicago, and Cowen and Perel who were law partners that engaged in various commercial enterprises, organized an Illinois corporation, known as World Wide Laboratories, Inc., to sell through the mails a preparation called "Kyron," which was claimed to be a remedy for obesity. This preparation, which had been developed by Cowen with the assistance of a pharmacologist, was produced in the form of small tablets or pills, and sold with an enclosed booklet which set forth recommended menus to be used therewith, entitled "Reducing the New Common Sense Way." Within about 3 months after said corporation commenced the distribution of its product, the Post Office Department served it with notice to show cause why a fraud order should not be issued, on the ground that it was engaged in a scheme to obtain money through the mails by means of false and fraudulent pretenses, representations, and promises. Thereafter, on July 30, 1947, Kolkey and Cowen">*77 filed an affidavit with the postal authorities, in which they said that the enterprise had been absolutely discontinued and abandoned, and would not be resumed under any name.

On August 6, 1947, which was 1 week after the above affidavit was filed, Kolkey, Cowen, and Perel organized a new Illinois corporation, known as Continental Pharmaceutical Corporation, Distributors (hereinafter called Continental), for the purpose of distributing the product Kyron, through wholesale and retail outlets rather than through the mails. The initial paid-in capital of this corporation was $ 4,725; but as of June 30, 1948, this capital was reduced by stock redemptions to $ 3,071.25, and was at no time thereafter increased. Kolkey was president, but took only a relatively minor part in the management; Cowen was secretary-treasurer and the principal operating executive, and had charge of sales and advertising; and Perel was vice president, and had charge of personnel and purchases. At all times hereafter material, these three individuals owned all of ">*41 the outstanding shares of stock, in the ratio of 55 per cent, 22 1/2 per cent, and 22 1/2 per cent. ^{1956 U.S. Tax Ct. LEXIS 68">*78 Continental distributed its product Kyron principally through wholesale jobbers, chain and independent drug stores, department stores, and supermarkets. It had no manufacturing facilities but had all of its product manufactured and packaged by other concerns which, in some instances, also shipped the product directly to customers. Initially, it had a sales force of its own; but after the summer of 1948, sales were handled under contract with an independent sales agency which provided its own sales organization. On about March 1, 1949, this contractual arrangement was terminated, and thereafter Cowen handled the sales with the assistance of a few salesmen who had worked for the former contractor. The corporation's offices were located in Chicago, in a building purchased from its three stockholders at a price of $ 492,000, of which $ 125,000 was evidenced by outstanding demand notes payable to said stockholders. The approximate number of its employees, exclusive of its officers, was about 45, consisting mostly of stenographers and clerks. It had no patents, but the name of its product was registered in most of the States.}

Extensive advertising was essential in the marketing of">*79 the product Kyron. In Continental's first fiscal period ended July 31, 1948, it expended $ 548,752.16 for advertising, in producing net sales per books of $ 1,745,859.97; and in its second fiscal period ended March 13, 1949, it expended $ 817,685.26 for advertising, and had net sales per books of $ 2,655,258.41. This advertising was handled under contracts with professional advertising agencies. It was carried in newspapers and magazines, on streetcar cards, and on the radio; and in addition, window and counter displays were supplied to retail dealers. The character of such advertising was adversely criticized by the National Better Business Bureau, the American Medical Association, and the New York City Department of Public Health, all of which took the position that the product Kyron had no weight-reducing properties and that the advertising was misleading. In November 1948, the New York City Department of Public Health directed its inspectors to remove the false and misleading advertising from all drug stores in the five boroughs of New York City. And at about the same time, ">*42 Continental issued a letter to its retail outlets in said area in which it urgently requested">*80 that its window and display advertising be removed.

The net earnings per books of Continental were: For its first fiscal period ended July 31, 1948, $ 482,782.26 before taxes, and $ 299,324.98 after taxes; and for its second fiscal period ended March 13, 1949, $ 553,348.86 before taxes, and $ 343,076.28 after taxes. The only dividends which it paid were $ 29,250 in the first of these periods, and $ 6,500 in the second period. The aggregate salaries and bonuses paid to Kolkey, Cowen, and Perel were $ 105,272.08 in the first period and $ 215,000 in the second period.

The balance sheet of Continental, as of March 13, 1949, was substantially as follows:

Assets
Cash	$ 172,117.08
Accounts and notes receivable, less reserve for bad debts	405,706.90
Inventories -- merchandise in stock and consigned	170,658.57
Accrued interest and rent receivable	1,422.35
Land, building, and improvements, less depreciation	494,236.20
Furniture and fixtures and automobiles, less depreciation	26,493.05
Deferred charges and miscellaneous	17,428.52
Total assets	$ 1,288,062.67
Liabilities
Demand notes payable to officers	$ 125,000.00
Accounts payable	117,776.49
Federal taxes accrued	302,001.22
Other taxes accrued	16,118.51
Expenses accrued	124,260.85
Rent deposits of tenants	1,845.00
Capital stock	3,071.25
Earned surplus and undivided profits	597,989.35
Total liabilities and capital	$ 1,288,062.67
Net worth -- $ 601,060.60
Ratio of current assets to current liabilities -- $ 1.09 to $ 1

">*81 In the fall of 1948, Kolkey, Cowen, and Perel became concerned about their potential income tax liabilities if Continental's profits were distributed, and about the amounts which would be left for them after such tax liabilities were met. They consulted with their attorney about this matter, and also with their accountant, and these advisors suggested that they attempt to sell their stock. Accordingly, they retained a so-called business broker to search for a buyer. This broker spent several months contacting companies which he thought might be possible purchasers; but his efforts to effect a sale were unsuccessful.

On about February 1, 1949, the attorney for these three stockholders met with certain individuals in New York City (hereinafter called Finders); and he told them that his clients would like, for tax reasons, ">*43 to sell their stock to a tax-exempt organization. The Finders, shortly thereafter, reported that they had contacted representatives of an organization known as Survey Associates, Inc. (hereinafter called Survey), who had expressed interest. Thereupon, Kolkey, Cowen, and Perel authorized their attorney and the Finders to attempt to sell the Continental">*82 stock to Survey; and signed a written agreement to pay each of these parties a commission of 2 1/2 per cent (total 5 per cent) of all cash received on the sale price, if they succeeded in their efforts.

Survey was a corporation, organized under the Membership Corporation Laws of New York, with offices in New York City. Its principal activity was the publication of a magazine called "The Survey," which dealt with social reform; and by reason thereof, it was exempt from Federal income tax as a charitable or educational corporation. It was not an educational organization which maintained a faculty and curriculum and had an organized body of pupils; nor was it a hospital or an institution for the rehabilitation of physically handicapped persons. Its funds were obtained partly from subscriptions to its magazine, and the balance was made up principally from donations of benefactors. It was in straitened financial condition and needed money for the continuation of its publication work.

The Finders told representatives of Survey that Cowen controlled the stock of Continental which was earning large profits; and that, for tax reasons, he contemplated selling the business to some tax-exempt">*83 charitable organization. The Finders then proposed a plan, under which Survey could acquire such business without making any substantial outlay of its own funds, could share in the annual profits of the business for a number of years while the plan was in operation, and could thereafter own the business free and clear. The proposed plan was, in substance: (a) That a downpayment on the purchase price to be agreed upon would be made in approximately the amount which could be borrowed on the present worth of the Continental business; (b) that the balance of such purchase price would be divided into fixed annual installments, which would mature over a long period of years and be payable out of the net profits of the business; (c) that such net profit would be placed in a sinking fund, of which about 60 per cent would be used to anticipate unpaid installments due the selling stockholders, and of which about 40 per cent would be used to meet cash and other requirements of the business, to provide for income taxes if tax exemption should not be allowed, and to make payments of the balance to the charitable organization; and (d) that the present management, composed of the selling stockholders, ">*84 would continue to operate the business as "managers," under a management contract. The Finders stated that the object of such plan was to permit the existing stockholders of Continental to obtain capital gains, ">*44 rather than ordinary income, out of the profits of the business up to the amount of the purchase price.

Survey's directors discussed the proposal among themselves; obtained the advice and suggestions of attorneys and an accountant; and made inquiries respecting the character of Continental's management, its product, and its advertising methods. At no time during the consideration of the proposal, did any director or representative of Survey visit Continental's offices, examine the corporation's books, or cause any appraisal of the corporation's physical assets to be made; they obtained their information principally from balance sheets, earning statements, and other accounting data supplied by the Continental stockholders. ^{1956 U.S. Tax Ct. LEXIS 68">*85 near future. Following such examination, Survey's directors received an opinion of their attorney that the pattern of trade-marked drugs on the market was not predictable, and that it was strictly a gamble whether the business under consideration would last 2 years or 25 years.}

">*86 Survey's directors, as the result of their discussions and investigations, proposed various changes in the original proposal:

1. They proposed that the business of Continental be acquired by a new corporation; and that Cowen and his associates take retirable preferred stock thereof, in exchange for the transfer of their Continental stock. Cowen and his associates positively rejected this proposal. They stated that, for tax reasons, they would have to receive "interest"; and they indicated that they would terminate the negotiations if preferred stock were insisted upon.

2. The directors then proposed, as an alternative, that a new corporation be organized with total authorized capital of $ 1,000, which would be paid in by Survey; and that the stock of Continental be transferred to such new corporation, solely in exchange for promissory ">*45 notes to be issued by such corporation. The directors' reason for this proposal was, not only to avoid any possible jeopardy to Survey's tax-exempt status, but also to limit any possible loss to Survey to $ 1,000, and to entirely eliminate any possible liability on the part of its officers or members. Cowen and his associates agreed to accept">*87 this change from the original plan.

3. The directors further proposed that all payments of principal and interest on the notes be subordinated, not only to provision for any income taxes that might be payable if the new corporation should not be allowed tax exemption, but also to minimum annual dividends to Survey of $ 75,000 in the first fiscal period and $ 100,000 in each subsequent fiscal period. Cowen and his associates agreed also to this change.

4. The directors indicated that they would be agreeable to the suggestion of Cowen and his associates that the "purchase price" be $ 4,000,000; but they proposed that the suggested interest rate of 3 per cent on the installment notes be eliminated, or reduced. Cowen and Perel agreed to a 2 1/2 per cent rate.

After these and other modifications of the original proposal had been agreed upon, Survey's directors were advised by counsel that all amounts of principal and interest to be paid for acquisition of the Continental stock would be paid out of assets and future earnings of the business; and that, if the business should fail, Survey's financial loss would be limited to its $ 1,000 investment. The directors were not, however, unanimous">*88 in approving the proposal. One stressed the importance of Survey making an actual investment in the business; another had reservations as to the tax consequences; and a third prominent member, who resigned, took the position that Survey should not enter into a business of such character, no matter how much it might gain financially. However, on March 3, 1949, the directors adopted resolutions authorizing their representatives to proceed with the plan.

On March 5, 1949, the petitioner Kyron Foundation, Inc. (hereinafter called Kyron), was incorporated under the laws of Delaware, with total authorized capital stock of $ 1,000, divided into 10 shares of the par value of $ 100 each. The incorporators were employees of a law firm. The certificate of incorporation, which they prepared and filed, recited in part that the corporation was organized and would be operated exclusively for charitable, scientific, and educational purposes; that none of its net profits or property should inure, directly or indirectly, to any one other than a trust or corporation organized and operated for such purposes; that none of its stock should be owned or held by any one other than such a trust or corporation; ">*89 and that, subject to such limitations, it would have power to acquire the stock and ">*46 assets of, and to operate, any business. Three New York attorneys, named Ruskin, Deyrup, and Berle, were elected to act as directors. Also, all the legal instruments necessary to make the proposed plan effective were drafted; and a typewritten outline of all the steps to be taken was prepared.

Thereafter, on March 14, 1949, at a conference attended by Cowen and Perel and their attorney, by the three Kyron directors, and by attorneys representing Survey, the following pertinent events and transactions took place:

1. An initial meeting of Kyron's board of directors was convened. Ruskin was elected president and treasurer, and Deyrup was elected vice president and secretary. The plan for acquiring the Continental stock was approved.

2. Survey paid to Kyron, as its total authorized capital, the sum of $ 1,000; this sum was obtained by Survey from donations of two of its directors in the amount of $ 500 each. Kyron then issued to Survey all of its authorized shares of stock, represented by a single certificate (identified as certificate No. 1) for 10 shares.

3. Cowen and Perel, acting on behalf">*90 of themselves and Kolkey, then transferred to Kyron all shares of the stock of Continental; and they received in exchange therefor $ 4,000,000 of corporate notes executed by Kyron, which were neither endorsed nor guaranteed by any other party. They also received, as sole "collateral" for such notes, the certificate for all 10 shares of Kyron stock, which Survey supplied after having endorsed the certificate in blank; and, in addition, signed and undated resignations of all the Kyron directors and officers.

Said corporate notes consisted of 2 non-interest-bearing demand notes, each in the face amount of $ 200,000; and 2 installment notes in the face amount of $ 1,800,000 each, which provided for interest payments at the rate of 2 1/2 per cent per annum at 4-month intervals commencing July 1, 1949, and for principal payments in installments of specified amounts at 4-month intervals commencing November 1, 1950, and continuing to March 1, 1960, with the right to make prepayments. One of the demand notes and one of the installment notes was made payable to the order of Cowen, and the others to the order of Perel.

Each of the installment notes, which consisted of 8 typewritten pages, ">*91 contained, among others, provisions which were in substance as follows:

(a) That payments of principal or interest would not be in default if they could not be paid out of net earnings, after prior provision for taxes and also for minimum dividends to Kyron's stockholder of $ 75,000 in its first fiscal year and of $ 100,000 in each subsequent fiscal year. Any payments of principal or interest not ">*47 made for such reason would be spread over the remaining installments of principal.

(b) That a default in respect of either of the notes would constitute a default upon both notes, and would cause the entire unpaid principal of both notes to become immediately due and payable without notice.

(c) That in the event of any default in payment of principal or interest when due, or any breach of any term or condition of the notes, or the commencement of any insolvency, bankruptcy, or receivership proceeding, all unpaid principal and interest would become due, without demand or notice. And thereafter, the holders would have complete power and authority to sell the collateral, including the above-mentioned shares of Kyron stock, at public or private sale, without demand, notice, or advertising">*92 of any kind; to buy the stock, and to use the notes in part or full payment of the bid; and also to accept the above-mentioned resignations of all directors and officers of Kyron.

(d) That whenever the unpaid balance of principal and interest on the notes should be greater than the net worth of Kyron, such corporation would be obligated to maintain a reserve, in an amount equal to 60 per cent of its net earnings, after provision for taxes and also after provision for the above-mentioned minimum dividends to the stockholder. In determining the amount of such reserve, borrowing from banks or from any other sources would be treated as operating expenses. The reserve would be used to meet current payments of principal and interest, and to anticipate future payments of principal.

(e) That no officer, director, incorporator, or stockholder of Kyron would be personally liable for payment of any obligation under the note.

4. Kyron, immediately after so acquiring all stock of Continental, caused that corporation to adopt a plan of complete liquidation, under which all assets and liabilities would be turned over to Kyron. The latter then accepted such assets, assumed the liabilities, and">*93 surrendered the Continental stock for cancellation.

5. Kyron thereupon pledged the accounts receivable taken over from Continental to a factoring firm, for the sum of $ 350,000; and then immediately turned over to Cowen and Perel, in cancellation of the $ 400,000 demand notes, not only the factor's checks for $ 350,000, but also $ 50,000 in checks of its own which were drawn on one of the bank accounts taken over from Continental. The rate of interest on the factor's loan was one-thirtieth of 1 per cent per day, which equals about 12 per cent per annum.

6. The agreed management contract was then executed, under which Cowen, Perel, and Kolkey were given broad powers to handle ">*48 the operation of the business for a period of 7 years, with annual salaries of $ 25,000 each. (Kolkey never signed this contract, but he acted thereunder and received the salary.)

7. $ 125,000 demand notes, payable to Kolkey, Cowen, and Perel, which Continental had issued in part payment for the office building used in the business, were refunded by Kyron with installment notes payable over a 10-year period.

8. Kyron paid, out of one of the bank accounts taken over from Continental, $ 25,000 to the ">*94 attorneys who had represented Survey, for legal services in connection with the foregoing transactions.

All the foregoing steps were completed within a period of about 3 or 4 hours, on the afternoon of March 14, 1949.

The effect of the foregoing transactions on the current assets of Kyron was: The cash of $ 172,117.08 taken over from Continental was reduced by $ 74,000, representing the difference between the $ 1,000 received from Survey, and the checks of $ 50,000 issued to Cowen and Perel and of $ 25,000 issued for legal services; and all the accounts receivable were encumbered by an obligation of $ 350,000, which was the amount borrowed thereon from the factor and paid to Cowen and Perel on the demand notes. These reductions in the current assets, plus the setting up of the $ 3,600,000 installment notes as additional liabilities, would have produced a large capital deficit; and therefore, in order to balance the books, a compensating asset entry was made in Kyron's balance sheet as of March 31, 1949, which read: "Trade-Marks, Trade-Names, Patents, Copyrights, Goodwill, Etc. -- $ 3,398,939.40." This entry was changed and explained in Kyron's balance sheet of February 28, 1950, as">*95 follows: "Intangible Asset (Representing the excess of Cost over Book Value of Net Assets Acquired from Predecessor Company as at Date of Acquisition) -- $ 3,450,711.09."

The amounts of the payments which Survey, and Cowen and his associates, were to receive pursuant to the above-mentioned transactions, if Kyron's net earnings after provision for taxes proved sufficient, were as follows:

		To Cowen and
	To Survey	associates
	minimum	"Down	Total
	dividends	Payment" and
		"Principal"
Mar. 14, 1949 to Feb. 28, 1950	$ 75,000	$ 400,000.00	$ 475,000.00
Mar. 1, 1950 to Feb. 28, 1951	100,000	116,666.66	216,666.66
Mar. 1, 1951 to Feb. 28, 1952	100,000	349,999.98	449,999.98
Mar. 1, 1952 to Feb. 28, 1953	100,000	349,999.98	449,999.98
Mar. 1, 1953 to Feb. 28, 1954	100,000	349,999.98	449,999.98
Mar. 1, 1954 to Feb. 28, 1955	100,000	366,666.66	466,666.66
Mar. 1, 1955 to Feb. 28, 1956	100,000	400,000.02	500,000.02
Mar. 1, 1956 to Feb. 28, 1957	100,000	400,000.02	500,000.02
Mar. 1, 1957 to Feb. 28, 1958	100,000	400,000.02	500,000.02
Mar. 1, 1958 to Feb. 28, 1959	100,000	400,000.02	500,000.02
Mar. 1, 1959 to Feb. 28, 1960	100,000	400,000.02	500,000.02
Mar. 1, 1960 to Feb. 28, 1961	100,000	66,666.64	166,666.64
Total	$ 1,175,000	$ 4,000,000.00	$ 5,175,000.00

">*96 ">*49 In addition to the foregoing amounts, Cowen and his associates were to receive 2 1/2 per cent interest on all unpaid installments of principal. The amounts of such interest obligation for the first two of the above periods only, for which deductions were subsequently claimed, were $ 86,949.67 and $ 90,050.33, respectively.

The cash and installment notes which Cowen and Perel received on March 14, 1949, in the above-mentioned transactions were dealt with by them as follows: Of the $ 400,000 cash received, $ 55,000 was paid to the Finders, the business broker, and their attorney, for commissions and legal services; and the balance of $ 345,000 was allocated among Kolkey, Cowen, and Perel, in the proportions that they had previously held the Continental stock, to wit: 55 per cent to Kolkey, and 22 1/2 per cent to each of the others. As to the $ 3,600,000 installment notes, these were likewise allocated among the three of them, in the proportions that they had held the Continental stock. For the purpose of such allocation, Perel endorsed and delivered to Kolkey, without recourse, one of the $ 1,800,000 installment notes; and he and Kolkey attached thereto a statement to the">*97 effect that the note had been "the actual legal and equitable property" of Kolkey from the beginning. The other note, made payable to Cowen, was retained by him; but it was agreed that 5 per cent of the same belonged to Kolkey and that the balance belonged to Cowen and Perel in equal portions.

Following the above-mentioned transactions of March 14, 1949, Kolkey, Cowen, and Perel conducted the business operations of Kyron, in the capacity of "managers," from the same offices, in substantially the same manner, and with the performance of the same duties, as they had previously operated Continental in the capacity of officers. On the other hand, the elected officers and directors of Kyron, who were Ruskin, Deyrup, and Berle, continued their private practice of law in New York City and did not actively participate in the business operations. Ruskin and Deyrup received annual salaries from Kyron of $ 7,000 each; and Berle received none. Ruskin and Deyrup visited the Chicago office for a period of about 4 days in the latter part of March 1949; and thereafter Ruskin alone made three other visits, each of 2 or 3 days duration. Berle never visited the Chicago office. These officers and">*98 directors obtained their information regarding the business operations principally through communications and reports from Cowen and Perel, from the company's bookkeeper, and from the company's auditor. They had had no experience in operating such a business, and they were dependent on Cowen and Perel. They established an office for Kyron in New York City, which was located in the law office with which Ruskin had been associated; and in respect of this, Kyron paid $ 150 per month for rent, telephone, and stenographic and messenger service. They reviewed Kyron's advertising, discussed its financial condition, and drew checks on one of the bank accounts in ">*50 order to transfer money into another bank account which Cowen and his associates used in operating the business. Most of the board of directors' meetings, which were held from time to time, were attended only by Ruskin and Deyrup; and the only business transacted at such meetings, as shown by the minutes, was the declaration of dividends to Survey, and the handling of such matters as fixing officers' salaries, authorizing signatures for bank accounts, retaining lawyers and accountants, and making arrangements for tax ">*99 returns.

Shortly after Kyron commenced operations, friction developed between the elected directors and the "managers." The directors were dissatisfied with the way the business was being conducted by Cowen and his associates, and with the lack of cooperation from them; they felt that the reports received from them were not satisfactory and were not complete; and they were displeased also because Cowen and his associates did not clear the title to the corporation's realty by paying the back taxes which they owed thereon. Ruskin recommended that the existing accountant be replaced by someone who was less closely identified with Cowen and his associates; but Cowen objected, and the services of such accountant were continued, although a second accountant was employed who performed no services except to recommend forms for intracompany reports and to make one tentative audit.

Kyron, from the time it commenced business and throughout both of the taxable periods involved, experienced a serious shortage of working capital, by reason of the large payments which had been made in the above-mentioned transactions. Its balance sheet as of March 31, 1949, disclosed cash of only $ 4,426.81; and">*100 total current assets of $ 569,559.18, as compared with total current liabilities of $ 771,700.88. And its balance sheet as of the close of its first fiscal period on February 28, 1950, disclosed cash of only $ 2,793.78, and total current assets of $ 291,931.05 as compared with total current liabilities of $ 448,569.70. Its total expenses for this first period were $ 1,720,009.25. In order to meet this situation, Kyron pledged its accounts receivable with a factor, as they became available, at the interest rate of one-thirtieth of 1 per cent per day; and this became an almost continuous practice. But the factor soon placed a limit on the amount he would loan on these accounts; and in the second fiscal period, he discontinued making such loans entirely. In about May 1949, the directors suggested that additional working capital be obtained by mortgaging the office building property; but Cowen objected and the suggestion was abandoned. Also, the title to the property was not clear.

Kyron's sales and net profits declined. Those reflected on Kyron's books for its first fiscal period of 11 1/2 months and those of Continental for the preceeding 12-month period were, in nearest dollar">*101 amounts, as follows: ">*51

	Continental,	Kyron,
	Mar. 14, 1948, to	Mar. 14, 1949, to	Decrease
	Mar. 13, 1949	Feb. 28, 1950
Net sales	$ 3,866,515	$ 2,242,716	$ 1,623,799
Net profits:
Before taxes	844,901	199,611	645,290
After taxes	523,839	123,759	400,080

The results of Kyron's operations per books for its second fiscal period ended February 28, 1951, were:

		Decrease from
		prior fiscal
		period
Net sales	$ 1,083,630	$ 1,159,086
Net loss	16,177	215,788

In November and December 1950, checks issued to Kolkey for his salary could not be cashed because of insufficient funds.

In June 1949, Kyron's board of directors, acting in accordance with the plan made prior to the corporation's organization and reflected in the provisions of the installment notes, authorized the creation of a reserve for payment of dividends to Survey, in the amount of $ 75,000 for the first fiscal period. But, in about October 1949 after only a portion of this amount had been paid, the directors became concerned as to whether dividends could lawfully be paid, in view of the decline in sales and the possibility that the above-mentioned compensating entry ">*102 of more than $ 3,000,000 that had been entered on Kyron's books might be questioned. They therefore made a written agreement with Kolkey, Cowen, and Perel, under which these parties waived all claims which they might have against any of the directors for declaring and paying dividends; and under which these parties agreed also to subordinate, for a period of 6 months, any payment of principal or interest on their notes to the claims of all creditors of the corporation. The following dividends paid to Survey during the first fiscal period were the only amounts ever declared and paid by Kyron, as dividends, at any time or in any fiscal period:

Apr. 29, 1949	$ 3,125
May20, 1949	6,250
June 22, 1949	6,250
July 14, 1949	6,250
July 15, 1949	3,125
Aug. 24, 1949	6,250
Nov. 10, 1949	12,500
Total	$ 43,750

Kyron, during its first fiscal period, paid the following amounts to Kolkey, Cowen, and Perel, as "interest" on the installment notes:

July 1, 1949	$ 27,000
Nov. 1, 1949	30,000
Total	$ 57,000

">*52 Kolkey received 55 per cent of the above amounts, and Cowen and Perel received 45 per cent jointly. No other payments of "interest" on the installment notes, ">*103 and no payments of "principal" whatever, were ever made.

On December 28, 1949, representatives of Survey met with Kyron's directors and with Cowen and his attorney to consider the financial condition of the company. All parties agreed that Kyron's sales and profits had decreased greatly, and that there was no reasonable basis for anticipating that they would improve in the near future. Survey's representatives proposed that the debt structure of the corporation be revised to "a more realistic basis"; but Cowen would not agree. Survey then suggested that Cowen and Perel buy its shares of Kyron stock for $ 25,000; but Cowen rejected this proposal also. Following the meeting, Survey attempted to obtain additional capital from outside sources; but its efforts were unsuccessful. Finally, on about February 7, 1950, which was before the close of Kyron's first fiscal period, Survey's directors concluded that there was no probability of continued dividend distributions to Survey, and that Survey should terminate its connection with Kyron.

On February 23, 1950, which was also before the end of Kyron's first fiscal period, Cowen and Perel paid Survey the sum of $ 5,000, out of their own">*104 funds, for all of Kyron's stock; and on said date, they caused Survey to execute and deliver to their attorney an "Assignment Separate from Certificate" for all of the 10 outstanding shares, on which the assignee was designated as: "S. Harvey Klein, as Trustee for a charitable, religious and educational Trust." The shares were not transferred of record on the books of the corporation; and the certificate therefor (certificate No. 1) continued to be held by Cowen and Perel as "collateral." There is no evidence that either the assignment or the stock certificate was ever delivered to Klein, or that he ever took office as a trustee, or that the trust mentioned in the assignment ever existed. Cowen's attorney told Ruskin in the summer of 1950 that Klein was not acting, nor would he act, as the trustee mentioned in the assignment.

About 4 or 5 months after the beginning of Kyron's second fiscal period, Cowen and Perel caused Survey to execute and deliver to their attorney a second "Assignment Separate from Certificate" for all the Kyron stock, in which the assignee was designated as: "Thomas D. O'Bryan, as Successor Trustee for a Charitable, Religious and Educational Trust." This assignment">*105 was antedated to February 23, 1950, and a notation thereon stated that it confirmed the previous assignment of said date. O'Bryan, who was a friend of Cowen, was ">*89 not then a trustee; but Cowen had requested him to act as such, for the purpose of holding the Kyron stock; and thereafter, during about the first week of August 1950, O'Bryan signed a "Declaration of Trust," prepared by the attorney for Cowen and Perel, of which the preamble read as follows:

Whereas a certain donor [Cowen and Perel] has purchased all of the shares of the capital stock of KYRON FOUNDATION, INC., a Delaware corporation, from Survey Associates, Inc. for the purpose of having the undersigned, as trustee, hold and use the same for the objects and purposes hereinafter set forth; and

Whereas it was and is the wish and intent of the donor to create a trust to be administered exclusively for religious, charitable, scientific, literary, or educational purposes, no part of the net income of which will inure to the benefit of any private shareholder or individual; and

Whereas the trustee is willing to accept such trust hereby evidenced and to administer such trust in accordance with the provisions of this ">*106 trust declaration;

Now, Therefore, the undersigned, as trustee, for itself and each successor in trust, if any, declares as follows:

This declaration further recited, among other things, that the initial corpus of the trust estate would consist of all the outstanding stock of Kyron; and that the trustee would administer the trust for the benefit of charitable institutions, subject however to a power in the board of directors of Kyron to determine the identity of the particular beneficiaries. Also, the trustee agreed, in said delaration, to vote Kyron's stock for the election of Ruskin, one Betar, and one Malone, as "the first directors to be elected after the execution of this declaration."

Neither said assignment obtained from Survey nor the certificate for the Kyron shares mentioned therein was ever delivered to O'Bryan; nor were the shares transferred of record to him as trustee, or otherwise. O'Bryan at no time saw either of these instruments; and the certificate for all the Kyron stock (certificate No. 1) at all times remained in the possession of Cowen and Perel, as "collateral" for the installment notes. O'Bryan never held any assets, received any income, kept any books, ">*107 or filed any return, as a trustee. He never became a stockholder of Kyron.

Subsequent to February 23, 1950, which was before the end of the first fiscal period, Deyrup who had been elected vice president, secretary, and a director of Kyron, and Berle who had been elected a director, took no part in the business or affairs of Kyron. Ruskin continued to act as president, treasurer, and director; but he did not, after said date, visit Kyron's Chicago office, and his activities were limited to receiving reports and signing corporate instruments. No meeting of stockholders or of any board of directors was held, and no new officers or directors were elected, at any time after Survey sold ">*54 its stock in the first fiscal period. ^{1956 U.S. Tax Ct. LEXIS 68">*108 Kyron, throughout its first fiscal period, permitted to remain outstanding an account receivable, representing advances of funds in the amount of $ 1,422.50, to a corporation for profit of which Cowen and Perel owned all the stock; and during said period, it increased the amount of this loan to $ 1,700.92. Also, during its second fiscal period which is here involved, Kyron made other advances of its funds, in the amount of $ 7,000, to four other corporations for profit controlled by Cowen and Perel.}

During Kyron's first fiscal period, $ 1,000 of its funds were used to pay the wages of a chauffeur and a cook, who were employed by Cowen as his household servants. And during its second fiscal period, $ 3,200 of its funds were expended for the same purpose. Kyron's counsel conceded at the hearing herein that said amounts were not deductible expenses of Kyron.

In July 1950, Kyron prepaid to Cowen, Perel, and Kolkey the sum of $ 100,000 on the above-mentioned 10-year promissory notes for $ 125,000, which it had issued to them during the transactions of March 14, 1949, in refunding demand notes previously issued by Continental; and, in about January 1951, it prepaid to Cowen, Perel, and">*109 Kolkey the remaining $ 25,000 balance of said notes. The first installment on these notes was not due until September 1950. Kyron obtained the funds for such prepayments by placing a first mortgage of $ 100,000 and second mortgage of $ 25,000 on its office building property.

There was no authorization for such prepayments, other than the above-mentioned minutes of the fictitious meeting of Ruskin and Betar, as "directors," which actually was never held.

In September 1950, during Kyron's second fiscal period, Cowen caused the $ 25,000 salaries for himself, Perel, and Kolkey, which had been provided for in the above-mentioned management contract, to be increased to $ 37,500 per year; and at about the same time, Ruskin's salary as president was decreased from $ 7,000 to $ 3,600. Ruskin ">*55 orally approved these salary revisions; but there was no other elected officer or director then acting, and the revisions were not approved by any board of directors.

In about November 1950, Cowen and Perel endeavored to induce Kolkey to loan between $ 60,000 and $ 75,000 to Kyron; but he refused. Thereafter, in December 1950, which was in Kyron's second fiscal period, they paid $ 35,000 to">*110 Kolkey for the $ 1,800,000 installment note which had previously been transferred to him; and Kolkey then assigned this note, without recourse, to a corporation controlled by Cowen and Perel. Also, shortly after the purchase of this note, Cowen and Perel arranged for Ruskin to discharge Kolkey from his position as one of the "managers" under the management contract of March 14, 1949. This action was taken without approval of any board of directors.

In 1952 Cowen and Perel moved to California; and at about the same time, they also moved the office and operations of Kyron to California. Survey, at a time not established by the evidence but which was after the summer of 1950, was liquidated by a receiver, because of financial difficulties.

No attempt has ever been made by Kolkey, Cowen, Perel, or any other holder of either of the two defaulted $ 1,800,000 installment notes, to enforce or collect the same, either by foreclosure of the "collateral" or otherwise. At the time of the hearing, these notes, and also the original certificate for all of Kyron's outstanding stock (certificate No. 1), which had been issued to Survey and endorsed by it on March 14, 1949, were produced by Cowen. ">*111 None of them were canceled; the stock had not been transferred of record; and there is no evidence that any other shares of Kyron stock were ever issued.

Kolkey, Cowen, and Perel, on the joint income tax returns which they filed with their wives for the year 1949, treated their respective shares of the $ 400,000 which they received from Kyron on March 14, 1949, as an installment of proceeds from the sale of capital assets. But the respondent, in his notices of deficiency, determined that such amounts were taxable as ordinary income. None of said individuals at any time included in their incomes any "interest" received from Kyron, other than their proportionate shares of the $ 57,000 which Kyron actually paid as "interest" in 1949.

Kyron, at the time prescribed for filing its return of income for its first fiscal period, filed a blank return form, to which it attached a request for a 60-day extension of time within which to file its return. Thereafter, without having received any reply to its request for the extension, it filed its corporation income tax return (Form 1120) on July 14, 1950, which was within the 60-day additional period requested. On this return, it claimed a deduction, ">*112 among others, of ">*56 $ 86,949.67 for accrued interest on the $ 3,600,000 installment notes, although only $ 57,000 "interest" actually had been paid. It also indicated on this return that no tax was due, on the ground that it was exempt from income tax under section 101 (6) of the 1939 Code; and it paid no tax for said period and no interest thereon.

Similarly on May 14, 1951, which was 1 day prior to that on which Kyron's return for its second fiscal period became due, it filed a blank return to which was attached a request for an extension of the time for filing to August 15, 1951; and thereafter, on August 16, 1951, without having received any reply to its request, it filed its corporation income tax return (Form 1120). On this return, it claimed, among other deductions, $ 90,050.33 for accrued but unpaid interest on the $ 3,600,000 installment notes; and $ 3,603.51 for accrued but unpaid interest on its income tax liability of the prior year, which liability is here being disputed. Also on this return, like that for the prior fiscal period, it reported no tax to be due, on the ground that it was exempt from income tax under section 101 (6) of the 1939 Code.

The respondent, ">*113 in his notice of deficiencies to Kyron, disallowed all of the above-mentioned deductions for interest; and he also determined that Kyron was not exempt from income taxes for either of the taxable periods involved. In addition, he determined that Kyron was liable for an addition to the tax for each of said periods, under section 291 (a) of the 1939 Code, by reason of its failure to file its returns within the periods prescribed for such filing.

The $ 4,000,000 corporate notes which Kolkey, Cowen, and Perel received from Kyron on March 14, 1949, in exchange for their shares of stock in Continental, were not intended to represent, and did not represent, a bona fide debtor-creditor relationship. Said notes were intended to represent, and did represent, equity capital investments of these individuals in Kyron.

The $ 400,000 which Kolkey, Cowen, and Perel received from Kyron on March 14, 1949, was a taxable dividend, within the meaning of sections 22 (a) and 115 (a) of the 1939 Code.

The total fair market value of all the shares of capital stock of Continental, which were transferred to Kyron on March 14, 1949, was not more than $ 1,100,000.

At all times after February 23, 1950, all of">*114 the 10 authorized and issued shares of capital stock of Kyron were owned and held by Cowen and Perel as private individuals; and no charitable organization was, after said date, a stockholder of Kyron.

Kyron was not organized or operated during either of the fiscal periods here involved exclusively for charitable or educational purposes, within the meaning of section 101 (6) of the 1939 Code; and part of its net earnings, for each of said periods, inured to the benefit of private stockholders or individuals.

">*57 The failure of Kyron to make and file its return for each of its taxable periods here involved, within the time prescribed for such filing, was due to reasonable cause and not due to willful neglect.

OPINION.

I.

The basic question underlying the cases of all the petitioners here involved is: Did the $ 4,000,000 of the corporate notes which the Kyron corporation, immediately after it was organized with $ 1,000 capital stock, issued to Cowen and his associates in exchange for all the stock of the operating Continental corporation, represent a bona fide debtor-creditor relationship resulting from the "purchase and sale" of this stock? Or did such notes, in reality and">*115 irrespective of their form, represent equity capital investments of Cowen and his associates in the continued business?

In the cases of the individual petitioners, which we shall consider first, these petitioners contend that, in the transactions of March 14, 1949, Cowen and his associates "sold" to Kyron all of their interests in the stock and going business of Continental, for said $ 4,000,000 corporate notes; that thereafter the only relationship of these individuals to Kyron and its business was that of "creditors," "pledgees" of all the Kyron stock, and employed "managers"; that when Kyron thereupon took over the net assets of Continental in liquidation and paid Cowen and his associates $ 400,000 out of the assets so acquired, this sum was received by the latter solely in the capacity of "creditors," and as part payment for their "sale" of the Continental stock; and that, accordingly, this sum is entitled to capital gains treatment for income tax purposes. The respondent, on the other hand, contends that the transfer of the Continental stock to Kyron was not in truth and reality a "sale," but rather a contribution of equity capital to the reorganized business; that Cowen and">*116 his associates were not thereafter bona fide "creditors," but actually equity capital investors who had arbitrarily cast the evidences of their investments in the form of "notes"; and that the $ 400,000 which they received in the transactions of March 14, 1949, constituted a taxable dividend to them, as such equity capital investors. Our analysis of the facts and the applicable authorities impels us to agree with the conclusions of the respondent.

It is true that the form of the notes, and also the manner in which the transactions of March 14, 1949, were reflected on the Kyron books, would, standing by themselves, tend to indicate that the Continental stock had been "sold," and that the notes were evidences of corporate debt. But in determining the effect of transactions for Federal income tax purposes, form, though of some evidentiary value, is not conclusive. ">*58 Gregory v. Helvering, 293 U.S. 465">293 U.S. 465. The same is true of bookkeeping entries. Doyle v. Mitchell Brothers Co., 247 U.S. 179">247 U.S. 179. The important consideration is not the formalities, however meticulously observed, in which the parties cast their transactions, ">*117 but rather the substance of such transactions and the true nature of the relationship created thereby. Griffiths v. Helvering, 308 U.S. 355">308 U.S. 355; 1432 Broadway Corporation, 4 T.C. 1158, affirmed per curiam, 160 F.2d 885 (C. A. 2). The Supreme Court said in the Griffiths case, supra:

We cannot too often reiterate that "taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed -- the actual benefit for which the tax is paid." Corliss v. Bowers, 281 U.S. 376">281 U.S. 376, 281 U.S. 376">378, 50 S. Ct. 336">50 S. Ct. 336, 74 L. Ed. 916">74 L. Ed. 916. And it makes no difference that such "command" may be exercised through specific retention of legal title or the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency. * * *

The essential difference between a "stockholder" and a "creditor" was pointed out by the Court of Appeals for the Sixth Circuit in United States v. Title Guaranty & Trust Co., 133 F.2d 990, 993,">*118 as follows:

The essential difference between a stockholder and a creditor is that the stockholder's intention is to embark upon the corporate adventure, taking the risks of loss attendant upon it, so that he may enjoy the chances of profit. The creditor, on the other hand, does not intend to take such risks so far as they may be avoided, but merely to lend his capital to others who do intend to take them. * * * [Italics in original.]

To substantially the same effect, see Wilshire & West. Sandwiches v. Commissioner, 175 F.2d 718, 721 (C. A. 9); Commissioner v. Meridian & Thirteenth R. Co., 132 F.2d 182, 186 (C. A. 7); Commissioner v. O. P. P. Holding Corp., 76 F.2d 11, 12 (C. A. 2).

In McGuire v. Commissioner, 84 F.2d 431, affirming 32 B. T. A. 1075, the Court of Appeals for the Seventh Circuit said at page 432:

Neither artifice, subterfuge, or bad faith need be present to bring a transaction within the meaning of the statute here involved, for as we read the law a taxpayer may well act with the utmost">*119 good purpose and without evil intent and yet his transactions may in effect be the equivalent of the distribution of a taxable dividend.

The problem of determining the true nature of advances to business enterprises has arisen frequently in cases involving a so-called thin corporation, wherein the major portion of the cash and property required to get the business established and under way has been evidenced by corporate notes. See for example: R. M. Gunn, 25 T.C. 424, on appeal C. A. 10; Estate of Herbert B. Miller, 24 T.C. 923, on appeal C. A. 9; Colony, Inc., 26 T.C. 30, on appeal C. A. 6; Erard A. Matthiessen, 16 T.C. 781, affd. 194 F.2d 569 (C. A. 2), Isidore Dobkin, 15 T.C. 31, affirmed per curiam, 192 F.2d 392 (C. A. 2); Swoby Corporation, 9 T.C. 887.

">*59 None of the decided cases dealing with thin corporations lay down a comprehensive "rule of thumb," by which the true nature of advances made to a new enterprise may be determined">*120 in all situations. But such cases have pointed out or suggested various tests or criteria which may be applied in seeking out the realities, among which are the following: Was the capital and credit structure of the new corporation realistic? What was the business purpose, if any, of organizing the new corporation? Were the noteholders the actual promoters and entrepreneurs of the new adventure? Did the noteholders bear the principal risks of loss attendant upon the adventure? Were payments of "principal and interest" on the notes subordinated to dividends and to the claims of creditors? Did the noteholders have substantial control over the business operations; and if so, was such control reserved to them as an integral part of the plan under which the notes were issued? Was the "price" of the properties, for which the notes were issued, disproportionate to the fair market value of such properties? Did the noteholders, when default of the notes occurred, attempt to enforce the obligations?

Application of such tests requires a consideration and weighing of all the relevent facts and circumstances of the particular case. Precedents provide no ready answer, for the question is">*121 factual and no single factor may be said to be controlling. Talbot Mills, 3 T.C. 95, 99, affd. 146 F.2d 809 (C. A. 1), affd. 326 U.S. 521">326 U.S. 521; Commissioner v. Meridian & Thirteenth R. Co., supra;Proctor Shop, Inc., 30 B. T. A. 721, 725, affd. 82 F.2d 792 (C. A. 9). As was said by the Court of Appeals for the Sixth Circuit in Gooding Amusement Co. v. Commissioner, 236 F.2d 159 (C. A. 6), affirming 23 T.C. 408, wherein the issue was the reality of a purported debtor-creditor relationship:

most of the authorities are of little value in the determination of a particular case, for the reason that "each depends for its solution upon its own peculiar facts," to be determined in the light of all the surrounding circumstances. * * *

In the instant case, the capital structure of Kyron was patently unrealistic, and grossly inadequate for carrying on the business which it was organized to take over. The gross assets per books of the corporation which it ">*122 was to succeed were approximately $ 1,288,000; the expenditures of that corporation for advertising alone, during the prior 19-month period, totaled $ 1,366,437.42; and the prearranged "price" which Kyron was to pay for such business was $ 4,000,000. Yet, the only amount which Survey contributed to Kyron for all the authorized capital stock was $ 1,000. This was the minimum for which a Delaware corporation could be organized (8 Del. Code Ann. § 102 (4)">8 Del. C., sec. 102 (4)); and it was not even sufficient to cover the $ 25,000 costs of organization, which Kyron paid on the same day out of the assets taken over from Continental. The situation was practically the same as if Cowen and his associates had purported to "sell" their business for $ 4,000,000 ">*60 to a penniless individual. Moreover, there is no indication that Kyron had any source, other than an equity capital investor, from which it could have obtained a $ 4,000,000 advance of cash and property for its business purposes. Survey was in straitened circumstances; and it had insisted upon the organization of a separate corporate entity, so that the risk of loss to it, and to its members, would be limited to the $ 1,000. Likewise, the officers">*123 of Kyron inserted a provision in the notes that no present or future officer, director, incorporator, or stockholder would be personally liable thereon. Even after Kyron had taken over the assets of the predecessor corporation, it was necessary for it to pledge all the accounts receivable and to pay interest at the rate of one-thirtieth of 1 per cent per day, or approximately 12 per cent per annum, in order to procure a loan of $ 350,000. All these facts indicate that the real intention of Cowen and his associates was to provide substantially everything which Kyron required to commence business and to remain in business -- at the risk of the enterprise and as the predominant part of the true capital structure.

The business purpose and operating facilities of Kyron were identical with those of the corporation which Cowen and his associates had theretofore been operating as stockholders and officers. No new capital was added, other than the $ 1,000 which, as we have pointed out, was less than the costs of organization. No new customer was obtained; no competitor was eliminated; no new product or operation was made available; no new management was brought in; no new plant or other">*124 physical properties were acquired; and there was no change which could reasonably be expected to increase earnings. The logical conclusion is that the purpose of Cowen and his associates, in transferring their operating business to Kyron, was twofold: (1) To formulate a purported "sale" under which they could masquerade as "creditors," and withdraw earned surplus and profits in the guise of capital gains; and (2) to create a pretext for tax exemption, which they hoped would increase the amount of distributable profits by more than the dividends to Survey, and also decrease their risk of loss in the adventure.

The installment notes provided, inter alia, that payments of "principal" and "interest" thereon would not be in default, if they could not be paid out of net earnings, after prior provision for minimum dividends to Survey in the amounts of $ 75,000 in the first fiscal year and $ 100,000 in each subsequent fiscal year. These terms, in themselves, are characteristics of a subordinated class of "stock."

As regards control over the business operations, Cowen and his associates had substantially the same duties and responsibilities as "managers" of Kyron that they previously">*125 had as "officers" of Continental; and this same control continued after Survey had sold its stock and withdrawn from the business. Cowen and Perel were the principal ">*61 operators. Petitioner Kolkey, who had a 55 per cent interest both in the predecessor corporation and in the installment notes received therefor, stated in an affidavit which he identified at the trial: "They [Cowen and Perel] ran the company as they saw fit and Mr. Ruskin [the elected president of Kyron] always abided by their decisions by long distance phone calls to New York."

The $ 4,000,000 "price" for the Continental stock was, in our opinion, grossly excessive; we have hereinbefore found, as a fact, that the fair market value of this stock at the time of its transfer to Kyron was not more than $ 1,100,000. In determining such value, we have taken into consideration the fact that the stock was unlisted, and had no established market; the character of the assets, the net worth, and the ratio of current assets to current liabilities; the earnings and dividend payments; the period for which the corporation had operated; the nature and reputation of its product; the absence of patents, and of manufacturing">*126 and research facilities; the lack of diversification in products; the characteristics and risks of the industry of which it was a part; the management; the operating costs, including the expenses for advertising and sales promotion; the expert testimony presented at the trial; and all other relevant factors having a bearing on the value of the stock. As a check on the reasonableness of our valuation, we have not overlooked that, within 1 year after the Continental business was taken over by Kyron, Survey sold all of its shares of stock in said company for $ 5,000; and that, in December 1950, after Survey had withdrawn and Cowen and his associates held all the equity in the business, Kolkey sold one of the $ 1,800,000 installment notes to Cowen and Perel for $ 35,000. Inflation of the "sale price" served to extend the period during which Cowen and his associates could participate as purported "creditors"; increased the amount which they could withdraw as "principal," if the enterprise were successful; and also increased the possibilities for recapture of the properties, under the stringent default provisions of the notes.

Furthermore, although no payment of "interest" was made on">*127 the installment notes after November 1, 1949, and no payment of "principal" thereon was ever made, Cowen and his associates at no time made any attempt to enforce or collect these notes, either by foreclosure of the "collateral" or otherwise. They had complete power, under the terms of the notes, to transfer the stock into their own names and to accept the resignations of officers which had been lodged with them, but they took no such action, even down to the time of the trial. This tends to show that they were not bona fide creditors; that they regarded the provisions for foreclosure of "collateral" to be mere formalities; and that their intention was that their advances should remain indefinitely at the risk of the going business, as a part of the permanent capital structure.

">*62 It is our opinion that Cowen and his associates did not "sell" their Continental stock to Kyron, but contributed it as equity capital; that they were not bona fide creditors, but equity capital investors; and that the $ 400,000 which they received from Kyron constituted taxable dividends to them, within section 115 (a) of the Internal Revenue Code of 1939, to the extent of the available earnings ">*128 and profits.

As to the extent of such earnings and profits, we hold that, when Kyron as sole stockholder of Continental took over all of the net assets of that corporation in complete liquidation, no gain or loss was recognizable, as provided in section 112 (b) (6) of the 1939 Code. Accordingly, the undistributed "earnings and profits" of Continental remained, for purposes of distribution, "earnings and profits" of Kyron. Commissioner v. Sansome, 60 F.2d 931 (C. A. 2), certiorari denied 287 U.S. 667">287 U.S. 667; Putnam v. United States, 149 F.2d 721 (C. A. 1). The amount of Continental's earnings and profits at the time of its liquidation exceeded $ 400,000; and therefore the $ 400,000 distribution by Kyron is includible in the gross incomes of Kolkey, Cowen, and Perel as dividends of the taxable year involved, in the proportions in which they received the same, to wit: 55 per cent to Kolkey, 22 1/2 per cent to Cowen, and 22 1/2 per cent to Perel.

By reason of our above holdings, it is unnecessary to consider the alternative contention of respondent, that said $ 400,000 payment constituted a taxable">*129 dividend under section 112 (c) (2) of the 1939 Code.

II.

The next question is whether the petitioner Kyron is exempt from income tax for each of its fiscal years here involved, under section 101 (6) of the 1939 Code. ^{1956 U.S. Tax Ct. LEXIS 68">*130 that did not include any direct charitable activity. Thus, any possible claim for its exemption under the above statute must be based on the theory that it was organized and operated during said periods exclusively for the benefit of Survey or some other tax-exempt charity; and that no part of its net earnings for either of such periods inured to the benefit of any private shareholder or individual.}

">*63 We have hereinbefore found and held that the true relationship of Cowen and his associates to Kyron was not that of bona fide creditors; but that they actually were equity capital investors. Our conclusion, from analysis of all the facts, is that the dominant purpose for the organization and operation of Kyron was not to aid charity, but rather to provide for the inurement to said individuals, as equity capital investors, of most of the net income of the enterprise.

During Kyron's first fiscal period, Cowen and his associates actually received $ 400,000 on March 14, 1949, as a purported payment of "principal" on the notes; $ 27,000 on July 1, 1949, as a purported payment of "interest"; and $ 30,000 on November 1, 1949, as another purported payment of "interest." Also during ">*131 this first fiscal period, Kyron permitted a corporation, owned by Cowen and Perel, to have the benefit of advances from its funds in the amount of $ 1,422.50, and actually increased such advances during the period to $ 1,700.92. During its second fiscal period, it made other advances of its funds, in the amount of $ 7,000, to four corporations controlled by Cowen and Perel. During its first fiscal period, it paid $ 1,000 for wages of a chauffeur and a cook, who were employed by Cowen as his personal household servants; and during its second fiscal period, it expended $ 3,200 for the same purpose. In the second period, it placed first and second mortgages on its office building; and delivered the $ 125,000 proceeds therefrom to Cowen and his associates in prepayment of 10-year promissory notes, on which the first installment had not become due. Also during the second period, it permitted Cowen and his associates to increase to $ 37,500 their respective salaries as "managers," which had previously been fixed under the management contract at $ 25,000; and it did this without approval of any authorized board of directors. All such actions inured to the benefit of private individuals.

">*132 On February 23, 1950, before the first fiscal period had ended and before the net earnings of such period had become determinable, Survey sold all its stock in Kyron for $ 5,000, which was paid by Cowen and Perel out of their own funds. Such sale cut off the possibility of inurement to Survey of any net earnings of Kyron, in excess of the $ 43,750 dividends which it had received. This was far from "all" the net profits of Kyron for its first fiscal period, which were $ 199,611 before taxes and $ 123,759 after taxes.

At the time Survey sold its stock, on February 23, 1950, the attorney for Cowen and Perel caused it to sign and deliver to him an "Assignment Separate from Certificate" for all the shares, in which the assignee was designated as "S. Harvey Klein, as Trustee for a charitable, religious and educational Trust." The shares were never transferred ">*64 to such trustee; and subsequently said attorney told Kyron's president that Klein was not acting as trustee, and did not intend to so act.

Later, in the summer of 1950, the attorney for Cowen and Perel caused Survey to sign a second "Assignment" for the stock, in which the assignee was designated as "Thomas D. O'Bryan, as">*133 Successor Trustee for a Charitable, Religious and Educational Trust." O'Bryan, however, did not purport to declare himself a trustee until August 1950; and in the "Declaration of Trust" which he then signed, he did not purport to qualify as a successor trustee for any existing trust. Rather, said declaration recited that a certain "donor" (who actually was Cowen and Perel) had "purchased" all of the Kyron shares, and wished "to create a trust." Almost half of Kyron's taxable year had then expired. Also, we have hereinbefore found, as facts, that neither the assignment nor the certificate for the stock was ever delivered to O'Bryan; that he never held any trust corpus or received any trust income; that he never kept any trust accounts or made any returns as trustee; and that he never became a stockholder of Kyron. It follows that, at all times after Survey sold its stock on February 23, 1950, the entire net earnings of Kyron inured to the benefit of Cowen and his associates, as private shareholders or individuals.

We hold that the petitioner Kyron was not exempt from income tax under section 101 (6) of the 1939 Code for either of its taxable years here involved. It is unnecessary">*134 for us to consider the further question, on which there have been conflicting decisions, as to whether Kyron could qualify for the exemption in any event, by reason of the fact that it conducted a commercial enterprise and did not directly engage in any charitable activity.

III.

There remains the question of whether Kyron is entitled to certain deductions, and whether it is liable for additions to tax under section 291 (a) of the 1939 Code.

Kyron contends that it is entitled to a deduction of $ 86,949.67, in its first taxable period, for "interest" accrued on the $ 3,600,000 installment notes held by Cowen and his associates; and a deduction of $ 90,000, in its second fiscal period, for "interest" accrued on said notes. We have hereinbefore held that said notes did not constitute "indebtedness" of Kyron; and, accordingly, the corporation is not entitled to any deduction for interest paid or accrued thereon. Cf. R. M. Gunn, supra.It is unnecessary to consider respondent's further contention that the deductions are not allowable, in any event, by reason of the provisions of section 24 (c) of the 1939 Code.

">*65 Kyron further contends that it">*135 is entitled to a deduction of $ 3,603.50 in its second fiscal period for interest accrued on its liability for income tax for its first fiscal period. However, Kyron did not report any tax to be due on its income tax return for the first period; it has not conceded liability for such tax; and the existence of such liability is one of the issues here in dispute. Neither a tax nor interest thereon is accruable while the liability therefor is in dispute. Cf. Dixie Pine Products Co. v. Commissioner, 320 U.S. 516">320 U.S. 516. We hold that the claimed deduction is not allowable.

The respondent determined that Kyron is liable, under section 291 (a) of the 1939 Code, for an addition to the tax for each of the periods involved, by reason of failure to file its returns within the time prescribed for such filing. Section 291 (a) provides, in substance, that the addition to tax shall be imposed for failure to make and file a timely return, "unless it is shown that such failure is due to reasonable cause and not due to willful neglect." We have hereinabove found, as a fact, based upon evidence as to the reasons for the delays, that Kyron's failure to file timely returns, ">*136 for the two periods here involved, was due to reasonable cause and not due to willful neglect. Accordingly, we hold that no addition to the tax, under section 291 (a), should be imposed for either of such periods.

Decisions will be entered under Rule 50.

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Footnotes

• 1. The following cases are here consolidated: Pauline Kolkey, Docket No. 44520; Kyron Foundation, Inc., Docket No. 44818; Emanuel N. (Manny) Kolkey, Docket No. 44850; Barnet Perel and Bertha Perel, Docket No. 45063; Maurice L. Cowen and Rosalie Cowen, Docket No. 45064.↩

• *. Withdrew as counsel.↩

• 2. Shortly before March 14, 1949, when the disputed and subsequently described transactions concerning the Continental stock occurred, Cowen and Perel purported to take over all of Kolkey's shares, through foreclosures on a promissory note against which such shares had been pledged as collateral; and at about the same time, Kolkey was "removed" as president.

  Kolkey has conceded herein, however, that at the time of said disputed transactions, he still had the 55 per cent interest in Continental; and all three parties returned their income from said transactions on the basis of stock ownership in the above ratio of 55 per cent, 22 1/2 per cent, and 22 1/2 per cent.↩

• 3. Among the accounting data submitted to Survey by Cowen and his associates, was an "Amended" audit report as of July 31, 1948, which showed sales and profits that were greatly in excess of those reflected on Continental's books and tax return. This excess represented "contingent sales" in respect of goods delivered to customers on consignment or for payment when sold, which had not yet accrued as income under Continental's method of accounting. The differences in figures for Continental's first fiscal period were:

  	Per report	Per books
  	submitted to	and tax
  	Survey	return
  Net sales	$ 2,233,055	$ 1,745,860
  Net profits:
  Before taxes	832,711	482,782
  After taxes	516,281	299,325

  Also, during the negotiations, Cowen and his associates represented to Survey that the office building, which Continental had purchased from them, was not encumbered by liens, or by any taxes not shown on the balance sheet. But actually it was encumbered by unpaid taxes owed by Cowen and Perel for prior years, which were not reflected on the corporation's balance sheet and which affected the amount for which the property could be mortgaged.↩

• 4. Kyron's minute book contains minutes of a purported meeting of board of directors on July 24, 1950, which recite that the meeting was attended by Ruskin and one Betar as "acting directors," and that Betar presided as chairman. But Betar had not been elected a director; and Ruskin did not attend such meeting, and never met Betar at any time. The purported meeting was fictitious.

  Also, after Survey withdrew, Perel prepared several letters addressed to himself and Cowen, and sent them to O'Bryan and Betar for signature by them as "trustees," in order to give the impression that Perel and Cowen as "managers" were working under the supervision of trustee-stockholders. But none of the Kyron stock was held by either of these parties; neither of them was a trustee of such stock; and several of the statements contained in these letters, particularly those which referred to meetings had with Ruskin, were untrue in fact.↩

• 5. SEC. 101. EXEMPTIONS FROM TAX ON CORPORATIONS.

  The following organizations shall be exempt from taxation under this chapter --

  * * * *

  (6) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, and no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation.↩