Schalk Chem. Co.
v.
Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Jul 9, 1959
32 T.C. 879 (U.S.T.C. 1959)

Docket Nos. 63853 63855 63862.

1959-07-9

SCHALK CHEMICAL COMPANY, A CALIFORNIA CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.GERALD I. FARMAN AND HAZEL I. FARMAN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.JOHN CARVER BAKER AND PATRICIA BAKER, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Donald K. Hall, Esq., for the petitioners. Marion Malone, Esq., and J. Earl Gardner, Esq., for the respondent.


Donald K. Hall, Esq., for the petitioners. Marion Malone, Esq., and J. Earl Gardner, Esq., for the respondent.

1. Corporation, on an accrual basis, held not entitled to deduct as an ordinary and necessary business expense a liability it voluntarily assumed in 1950 to reimburse three beneficiaries of a spend-thrift trust, which held all of its stock, for a downpayment of $25,000 made by them in 1948, pursuant to the terms of an agreement with S, the fourth beneficiary, wherein S agreed to sell, and they agreed to buy, for $45,000 his one-sixth minority interest in the stock of the corporation at the termination of the trust.

2. Corporation held not to be entitled to deduct as an ordinary and necessary expense, or as interest, the amount of the liability it assumed in 1950 to reimburse the three beneficiaries for the interest they had paid on money borrowed to make the $25,000 downpayment.

3. Three beneficiaries held to have received a dividend from corporation to the extent that they participated in the distribution made by it in 1951 to reimburse them for the $25,000 downpayment.

4. Three beneficiaries held to have received a distribution essentially equivalent to the distribution of a dividend in 1951 when the corporation satisfied their contractual obligation to pay the $20,000 balance of the purchase price of S's one-sixth minority stock interest at the termination of the trust.

5. Assessment of deficiencies determined against individual petitioners held not barred by statute of limitations.

Respondent determined the following deficiencies in income tax:

+---------------------------------------------------------------+ ¦Year¦Docket No.¦Petitioner ¦Deficiency¦ +----+----------+------------------------------------+----------¦ ¦1950¦63853 ¦Schalk Chemical Company ¦$15,087.22¦ +----+----------+------------------------------------+----------¦ ¦1951¦63855 ¦Gerald I. Farman and Hazel I. Farman¦11,589.98 ¦ +----+----------+------------------------------------+----------¦ ¦1951¦63862 ¦John Carver Baker and Patricia Baker¦2,465.86 ¦ +---------------------------------------------------------------+

The issues are:

1. Was the amount of $45,000 paid by Schalk Chemical Company to Hazel I. Farman, Patricia Baker, Evelyn Marlow, and Horace O. Smith, Jr., or any part thereof, deductible by it as a business expense in 1950?

2. Was the amount of $3,697.92, paid by Schalk Chemical Company to Hazel I. Farman, Patricia Baker, and Evelyn Marlow, deductible by it as interest, or as a business expense in 1950?

3. Was the amount of $25,000 paid by the Schalk Chemical Company to Hazel I. Farman, Patricia Baker, and Evelyn Marlow during the year 1951 a dividend?

4. Did any part of the $20,000 paid by Schalk Chemical Company in 1951 to Horace O. Smith, Jr., constitute a dividend, or a distribution essentially equivalent to a dividend, to Hazel I. Farman and Patricia Banker, or either of them?

5. Did petitioners John Carver Baker and Patricia Baker and petitioners Gerald I. Farman and Hazel I. Farman omit from their gross income for the year 1951 an amount properly includible therein which is in excess of 25 per centum of gross income stated in their returns?

FINDINGS OF FACT.

Some of the facts have been stipulated and, as stipulated, they are incorporated herein by reference.

Schalk Chemical Company (hereinafter referred to as Schalk) was organized in 1903 under the laws of the State of California. It manufactures and distributes nationally a line of associated paint products and home repair products. Its books were kept and its returns filed on an accrual basis.

Schalk filed its Federal income tax return for the year 1950 with the then collector of internal revenue, Los Angeles, California. In that return it deducted, among other expenses, the amount of $45,000 as a business expense and the amount of $3,697.92 as accrued interest. Respondent disallowed both of these deductions (the interest being disallowed under section 23(b) of the Internal Revenue Code of 1939).

Gerald I. Farman and Hazel I. Farman, husband and wife, filed a joint income tax return for the year 1951, on March 12, 1952, with the then collector of internal revenue at Low Angeles, California. Therein they reported gross income of $17,364.38 and net income of $14,341.63. Respondent determined that they received from Schalk during 1951 dividends of $27,000 (three-fifths of $45,000), and the deficiency determined against them results from the addition of this amount to the net income reported in their 1951 return.

John Carver Baker and Patricia Baker, then husband and wife, filed a joint income tax return for the year 1951 on March 15, 1952, with the then collector of internal revenue, Los Angeles, California. In this return they reported gross income of $6,740.55 and net income of $5,058.49. In determining the deficiency against them, the respondent adjusted the net income reported in their return by disallowing $520 of claimed automobile expense and adding $788.13 for omitted interest income and $9,000 (one-fifth of $45,000) for dividends received from Schalk during 1951. Petitioners do not contest the automobile expense and interest adjustments.

Respondent's notices of deficiency to petitioners were issued on May 23, 1956. The petitioners filed their petitions in this Court on August 20, 1956.

Consents extending until June 30, 1956, the period of assessment of income taxes for the year 1950 were executed by Schalk and respondent. No consents extending the period of assessment for any of the taxable years were executed by the other petitioners.

In 1928 Horace O. Smith died testate, being survived by his widow, Hazel I. Smith (now Hazel I. Farman); their three children, Evelyn Smith (now Evelyn Smith Marlow), Horace O. Smith, Jr., and Patricia Smith (now Patricia Baker); and his mother, Charlotte E. Wood. The children were minors at the time, being 15, 14, and 3 years of age, respectively.

A will contest was filed by decedent's widow which was settled by a Stipulation and Agreement dated September 26, 1929. Pursuant to the Stipulation and Agreement and final decree of distribution in the Estate of Horace O. Smith, Deceased, Los Angeles Superior Court, No. 100125, a spendthrift trust was created, the principal asset of which consisted of all the then-issued and -outstanding stock (100,000 shares) of Schalk.

The trust came into being on December 29, 1930, for a term of 20 years, expiring on December 29, 1950.

The beneficiaries of the trust were Hazel I. Smith (now Hazel I. Farman), Charlotte E. Wood, Evelyn Smith (now Evelyn Smith Marlow), Horace O. Smith, Jr., and Patricia Smith (now Patricia Baker). Hazel I. Smith became the wife of petitioner Gerald I. Farman on August 14, 1931.

After the demise of Charlotte E. Wood prior to 1940 (the children succeeding to her 12 1/2 per cent interest pro rata) and until termination of the trust on December 29, 1950, the beneficial interests were:

+-------------------------------+ ¦ ¦Per cent ¦ +--------------------+----------¦ ¦Hazel I. Farman ¦50 ¦ +--------------------+----------¦ ¦Evelyn Smith Marlow ¦16 2/3 ¦ +--------------------+----------¦ ¦Horace O. Smith, Jr ¦16 2/3 ¦ +--------------------+----------¦ ¦Patricia Baker ¦16 2/3 ¦ +-------------------------------+

The declaration of trust appointed three persons to serve successively as ‘supervisor,‘ each of whom while in office was to have the equivalent of absolute power of management over the trust and Schalk, including the power and right to appoint a majority (three out of a total of five members) of the board of directors of Schalk and the power and right to vote all the shares of Schalk.

The first-named supervisor refused to serve. The second, Curtis C. Colyear, served from 1930 until his decease in 1943. The third, Horace O. Smith, Jr., held the office until his resignation in 1948. He was succeeded by Stanley W. Guthrie, who was appointed by court order and who acted as supervisor for the remainder of the term of the trust.

As supervisor of the trust and director and president of Schalk from 1943 to 1948, and through officers and directors which he caused to be elected, Horace O. Smith, Jr., dominated and controlled the board of directors of Schalk and in consequence dominated and controlled the management and policies of Schalk.

Hazel I. Farman was a ‘minority director’ by virtue of the terms of the declaration of trust. Gerald I. Farman was appointed a ‘minority director’ in 1945 by Evelyn smith Marlow and Patricia Baker, pursuant to the power to designate a director reserved to them under the declaration of trust.

After Smith became supervisor of the trust and president of Schalk, the other beneficiaries of the trust made a number of suggestions to Smith and the officers and directors of Schalk he had caused to be appointed which they thought were in the best interests of Schalk. These suggestions related in part to sales promotion, new products, advertising costs, and automatic equipment. Because of the failure of the corporation to adopt and follow many of these suggestions, controversies arose between Smith and the other beneficiaries of the trust. Attempts to settle these controversies by setting up an executive committee composed of Smith, Hazel I. Farman, and Gerald I. Farman (Smith's stepfather) to manage the company and by permitting Gerald I. Farman to fill the position of vice president and expediter of raw materials, were unsuccessful. In April 1947 Evelyn Smith Marlow and Patricia Baker filed suit to remove Smith, as supervisor of the trust. This suit and the controversy between Smith and the other beneficiaries of the trust were settled, after extended negotiations, by an agreement dated January 15, 1948 (hereinafter sometimes referred to as the settlement agreement), resulting in the elimination of Smith's interest in and control over Schalk and the payment to Smith of $25,000 in 1948 and $20,000 in 1951. During the course of the negotiations leading to the settlement agreement, the other beneficiaries of the trust proposed that the settlement be by agreement between Smith and Schalk. Smith rejected their proposals that Schalk be a party to the agreement or pay any part of the money which he was demanding. He insisted upon dealing directly with the other beneficiaries.

The foregoing settlement agreement of January 15, 1948, by and between Horace O. Smith, Jr., first party, and Hazel I. Farman, Evelyn Smith Marlow, and Patricia Farman Baker, second parties, provided in part as follows:

For and in consideration of the sum of $25,000 to First Party in hand paid by Second Parties, receipt of same sum being hereby acknowledged by First Party, First Party agrees to sell to Second Parties jointly and severally, and Second Parties jointly and severally agree to buy from First Pary, subject to the terms and conditions herein contained, upon the termination and distribution of that certain trust dated December 29, 1930 * * * all of the then right, title and interest of First Party in and to the corpus and any accumulations thereof then belonging or distributed to First Party.

On or before thirty days after the termination of said Trust No. 1071 (which said termination date is hereby agreed as being the 29th day of December 1950), and the actual distribution by the trustee of the corpus and accumulated assets of the trust estate to the beneficiaries then entitled to receive the same, Second Parties jointly and severally agree to pay to First Party the sum of $20,000 in then current funds of the United States of America, less the amount of any distribution of any type or character whatsoever, including income, made by said trustee to First Party subsequent to the date hereof and prior to the date of final distribution of the trust estate.

It is understood and agreed that this agreement shall not be intended or construed as an assignment or transfer by First Party of any present right, title or interest of First Party in or to said trust or to the corpus or income thereof, and that no transfer of any interest of First Party in or to said trust, or in or to any corpus or income therefrom, shall be made by First Party until said trust has terminated and the corpus and any accumulated income thereon shall have been distributed to First Party.

It is distinctly understood and agreed that First Party agrees to sell and Second Parties agree to buy all of the assets of said Trust No. 1071 distributed to First Party upon the termination of said trust in whatever form said assets distributable to First Party may then exist, including cash, stocks, securities and real and personal property of every kind, nature and description whatsoever. In the event that First Party's beneficial or distributable interest in said trust shall for any reason be increased by reason of the terms and provisions of said trust agreement subsequent to the date hereof and prior to the actual distribution to First Party, such increase shall be included as a part of the property to be transferred by First Party to Second Parties hereunder.

Within five days after actual distribution by the trustee of said trust to First Party of the property herein agreed to be sold to Second Parties or notice that said beneficial interest of First Party in said trust is ready for distribution to First Party, First Party agrees to deposit into an escrow to be opened with Security-First National Bank of Los Angeles or Bank of America National Trust and Savings Association, in the City of Los Angeles, all of the property of every kind, nature and description received by First Party and agreed to be sold hereunder, together with such bills of sale, deeds, conveyances, assignments, or other instruments as may be necessary to vest title thereto in Second Parties, with instructions to deliver all thereof to Second Parties or their assignees upon the payment to First Party of the sum of $20,000.00, less the amount of any distributions made to First Party from said trust subsequent to the date hereof as hereinbefore provided. First Party shall likewise deposit concurrently in said escrow an itemized statement of any such distributions made to him by said trust and shall notify Second Parties of the opening of said escrow.

Second Parties agree within twenty-five days after the receipt of such notice to deposit into such escrow the balance of the purchase price herein provided, and upon receipt of said sum said escrow holder shall be instructed to close said escrow and distribute the remainder of said purchase price to First Party, and the property herein provided to be sold to Second Parties or their assigns, the costs and expenses of said escrow to be paid by Second Parties. Any taxes assessed against the transfer of all property to be sold by First Party hereunder shall be paid by First Party promptly when due.

Said escrow instructions shall provide that if Second Parties or their assigns fail, neglect or refuse to deposit in the aforesaid escrow, within the time and subject to the conditions herein contained, the balance remaining of the aforesaid purchase price, then all property and documents deposited by First Party in said escrow shall immediately be returned to First Party on demand and said escrow shall be terminated.

In consideration of First Party agreeing to resign as supervisor of the trust hereinbefore described and as officer and director of Schalk Chemical Company, a corporation, and of his securing the resignation of Henry O. Wackerbarth as an officer, director and attorney for said corporation, and of H. T. Rausch as a director and auditor of said corporation, the parties hereto agree to enter into a stipulation for the entry of a judgment in the action in the Superior Court of the State of California in and for the County of Los Angeles, entitled Evelyn Smith Marlow and Patricia Farman Baker, as Plaintiffs, vs. Union Bank and Trust Co. of Los Angeles, a corporation, et al, as Defendants, and numbered 528,107 in said Court, which said stipulation is being entered into concurrently herewith.

In the event that Second Parties, their heirs, successors, or assigns, shall fail, neglect or refuse to pay the balance of the purchase price as herein provided, First Party shall be released from any and all obligation to sell, transfer, convey or assign the property herein described, and Second Parties, their heirs, successors and assigns, shall be released of any and all obligations to purchase said property or to pay to First Party any additional moneys hereunder.

The entire purchase price for the property herein agreed to be sold by First Party to Second Parties shall be the sum of $45,000.00, less any distributions made by First Party from said trust as herein provided, and the sum of $25,000.00 paid by Second Parties as consideration to First Party for entering into this agreement shall, in the event Second Parties, their heirs, successors or assigns, comply fully and promptly with the terms and conditions hereof, be applied towards said total purchase price.

This agreement may be assigned by Second Parties, their heirs, successors and assigns, at any time during the term hereof.

First Party agrees, immediately upon request from Second Parties so to do, to apply for and use his best efforts to secure a policy of life insurance insuring the life of First Party, in such form and with such insurance company as Second Parties may request, in the principal sum of $25,000.00, with Second Parties as joint and several beneficiaries thereunder. Second Parties jointly and severally agree to pay the initial and all subsequent premiums and costs in connection with the securing of said policy, and immediately upon the issuance thereof said policy shall be delivered to and become the property of Second Parties, First Party assuming no liability as to the payment of premiums thereon. Any dividends on said policy shall become the property of Second Parties and no change of beneficiaries shall be made without the consent of Second Parties, First Party hereby agreeing to join in and consent to any change of beneficiaries upon request of Second Parties so to do.

Time is to be and is of the essence of this agreement.

This agreement shall inure to the benefit of the heirs, executors, and assigns of the parties hereto.

At a special meeting of the board of directors of Schalk held on January 15, 1948, Horace O. Smith, Jr., presented to the board his resignation as supervisor of the trust and as an officer and director of Schalk and also the resignations of the officers and directors of Schalk whom he had caused to be elected, and resolutions were adopted accepting these resignations.

On January 15, 1948, Hazel I. Farman, Patricia Baker, and Evelyn Smith Marlow paid Horace O. Smith, Jr., the amount of $25,000. Hazel I. Farman paid $15,000, and Patricia Baker and Evelyn Smith Marlow each paid $5,000. Hazel I. Farman and Patricia Baker borrowed the money to make their portions of the $25,000 payment. The promissory notes given by them for the loans were due and payable on or before January 15, 1951, and bore interest at the rate of 5 per cent per annum.

As of December 31, 1947, the book value of the issued and outstanding stock of Schalk was $1.33 per share. Schalk had done a considerable amount of advertising over a long period of years, and it was the concensus of its board of directors that it had established an extensive goodwill for its products. No amount for goodwill was shown on its books.

By resolution of the board of directors of Schalk, adopted on December 15, 1950, Schalk was authorized to accept an assignment of the settlement agreement as of December 29, 1950, provided Horace O. Smith, Jr., survived that date; to assume the obligations to Hazel I. Farman, Evelyn Smith Marlow, and Patricia Baker under the settlement agreement; to pay them the amount of $25,000 with interest at 5 per cent from January 15, 1948; and to pay to Smith the amount of $20,000 upon delivery to Schalk of all the property received by Smith as a distributive beneficiary of the trust.

As of December 29, 1950, Hazel I. Farman, Evelyn Smith Marlow, and Patricia Baker, as ‘First Parties' and Schalk as ‘Second Party’ entered into an agreement. Therein the first parties assigned to Schalk all of their rights and interests in the settlement agreement of January 15, 1948; Schalk accepted the assignment and assumed and agreed to be bound by all of the obligations of Hazel I. Farman, Evelyn Smith Marlow, and Patricia Baker therein; and Schalk agreed to pay them the amount of $25,000, plus interest at 5 per cent per annum from January 15, 1948.

In February 1951, Schalk paid $20,000 to Union Bank & Trust Co. of Los Angeles for the account of Horace O. Smith, Jr., $17,364.38 to Hazel I. Farman, and $5,788.13 each to Patricia Baker and Evelyn Smith Marlow. Of such sums the amount of $2,364.38 paid to Hazel I. Farman and the amounts of $788.13 paid to Patricia Baker and Evelyn Smith Marlow, respectively, are claimed by Schalk to be interest at the rate of 5 per cent per annum from January 15, 1948.

On February 28, 1951, Horace O. Smith, Jr., and Schalk executed escrow instructions to Union Bank & Trust Co. of Los Angeles whereby Schalk deposited $20,000 to be paid to Horace O. Smith, Jr., when the bank held for the benefit of Schalk, pursuant to court order, the 16,666 shares which otherwise would have been distributed to Horace O. Smith, Jr.

On March 20, 1951, an order was entered in the Estate of Horace O. Smith, Deceased, Los Angeles Superior Court, No. 100125 directing that there be distributed to Hazel I. Farman 50,000 shares, to Evelyn Smith Marlow 16,667 shares to Patricia Baker 16,667 shares, and to Schalk 16,666 shares, of the stock of Schalk.

No formal dividends were declared or paid by Schalk in 1951.

The net profit or loss (before taxes) of Schalk for the years 1942 through 1951 was as follows:

+----------------------------+ ¦ ¦Net profit or loss ¦ +------+---------------------¦ ¦Year ¦(before taxes) ¦ +------+---------------------¦ ¦1942 ¦$18,170.84 ¦ +------+---------------------¦ ¦1943 ¦63,280.34 ¦ +------+---------------------¦ ¦1944 ¦77,526.87 ¦ +------+---------------------¦ ¦1945 ¦46,867.94 ¦ +------+---------------------¦ ¦1946 ¦95,030.80 ¦ +------+---------------------¦ ¦1947 ¦($32,158.67) ¦ +------+---------------------¦ ¦1948 ¦26,504.07 ¦ +------+---------------------¦ ¦1949 ¦5,252.45 ¦ +------+---------------------¦ ¦1950 ¦1 47,603.13 ¦ +------+---------------------¦ ¦1951 ¦8,638.91 ¦ +------+---------------------¦ ¦ ¦ ¦ +----------------------------+ FN1 Does not include the deductions of $45,000 and $3,697.92 which are at issue.

Post-1913 accumulated earnings and profits of Schalk as of December 31, 1950, totaled $67,861.31.

Petitioners Gerald I. Farman and Hazel I. Farman and petitioners John Carver Baker and Patricia Baker omitted from their gross income for the year 1951 an amount properly includible therein in excess of 25 per centum of the amount of gross income reported in their returns.

OPINION.

RAUM, Judge:

Schalk accrued on its books and deducted in its return for 1950 the liability, which it assumed in the assignment agreement of December 29, 1950, to pay $45,000 to Hazel I. Farman, Patricia Baker, Evelyn Marlow, and Horace O. Smith, Jr., and interest at 5 per cent per annum on $25,000 from January 15, 1948. The respondent disallowed the claimed deduction. Petitioners now concede that $20,000 of the $45,000 is not deductible by Schalk, but contend that the remaining $25,000 plus the interest is deductible by it as an ordinary and necessary business expense.

In support of their contention, petitioners argue that the settlement agreement was not a purchase and sale agreement although cast in the form of one; that therein, for $25,000, Smith agreed to resign as supervisor of the trust and as an officer and director of Schalk (and to obtain the resignation of the officers and directors whom he had caused to be elected or maintained in office); and, for $20,000, Smith granted to Hazel I. Farman, Patricia Baker, and Evelyn Marlow (hereinafter referred to as the other beneficiaries) an option to purchase for $20,000 the stock interest in Schalk distributed to him upon termination of the trust. Assuming this construction of the agreement to be correct, they argue that the $25,000 payment made by the other beneficiaries to Smith at the time of the execution of the agreement was justified and necessary for the preservation of the business of Schalk; that if Schalk had paid, or by resolution of its board of directors had authorized the payment of, the $25,000, this amount would have been deductible by Schalk; that, disregarding form, the substance of the transaction was that it was authorized by the ‘majority owners' (the other beneficiaries) on behalf of and for the benefit of Schalk, and, therefore, by Schalk; that Schalk was, therefore, morally obligated to reimburse the other beneficiaries for the $25,000 payment and for interest on the money they borrowed in order to make that payment; and that when it assumed the obligation to reimburse them it became entitled to deduct $25,000 and interest in the amount of $3,697.92.

After Smith became supervisor of the trust in 1943 the other beneficiaries, led by Gerald I. Farman, Smith's stepfather, became dissatisfied with the management and policies of Schalk. Suggestions made by them which they thought were in the best interests of Schalk were not followed by Smith and the officers and directors whom he had caused to be appointed. In April 1947, Evelyn Smith Marlow and Patricia Baker filed a suit to have Smith removed as supervisor. Demurrers to the complaint were sustained, and during the period that the plaintiffs might have filed an amended complaint, representatives of Smith and the other beneficiaries entered into negotiations to settle the controversy. During these negotiations Smith offered to sell his interest in the trust and resign as supervisor of the trust and officer and director of Schalk. The other beneficiaries suggested that Schalk purchase Smith's interest in the trust. Smith refused, and insisted that any settlement agreement had to be between Smith, as an individual, and the other beneficiaries, as individuals.

The parties to the settlement agreement were in fact the other beneficiaries and Smith. Schalk was not a party to, and did not authorize the other beneficiaries to enter into, the agreement. Petitioners' argument that the agreement was nevertheless informally authorized by Schalk and that it was, therefore, obligated in equity and good conscience to reimburse the other beneficiaries for the $25,000 payment made by them, is without merit. Their reasoning is that the other beneficiaries beneficially owned 83 1/3 per cent of Schalk; that as ‘majority owners' they were acting on behalf of and solely for the benefit of Schalk and for the preservation of its business when they entered into the agreement; and that their action was in substance the action of Schalk. This reasoning overlooks the fact that the trust agreement, which created their beneficial interests, placed complete control of Schalk in Smith, the supervisor of the trust, and prevented them from acting for or on its behalf. Not having any power to act for Schalk, we fail to see how any action taken by them can be deemed to be the action of Schalk. Moreover, we think petitioners place undue stress on the benefits to Schalk from the settlement agreement and not enough on the benefits they were seeking for themselves. The other beneficiaries sought the resignation of Smith as supervisor of the trust because they were dissatisfied with the management and policies of the corporation under his regime and wanted to acquire the right, which they did not have, to participate in its management and control. We are satisfied that they thought their participation would be beneficial to the corporation, but we are not convinced that the management of the corporation under Smith was incompetent and that their action was either necessary or desirable to preserve its business. If the anticipated benefit to the corporation materialized they would benefit personally therefrom as income beneficiaries of the trust whose principal asset was the stock of Schalk. In the circumstances we think it reasonable to assume that they were not overlooking that benefit and that their action in entering into the settlement agreement was motivated to some extent, if not entirely, by the benefits they thought would accrue to them personally. In any event, Schalk did not authorize them to act, formally or informally, and it was not obligated, morally or legally, to reimburse them for the $25,000 they paid pursuant to the terms of the settlement agreement. Its failure to do so distinguishes the facts here involved from those in cases, such as Catholic News Publishing Co., 10 T.C. 73, cited by petitioners.

There being no obligation on the part of Schalk to reimburse the other beneficiaries for the $25,000 payment made by them in 1948, its action approximately 3 years later in agreeing to reimburse them for that payment together with the interest they had paid on money they borrowed to make it, and for assuming their remaining obligations under the settlement agreement, did not, in our judgment, result in an ordinary or necessary business expense.

Moreover, we do not agree with petitioners that the consideration the other beneficiaries received for the $25,000 payment was the resignation of Smith as supervisor of the trust and as an officer and director of Schalk. Smith agreed to resign if the other beneficiaries would purchase his one-sixth minority interest in the stock of Schalk at the termination of the trust. Under the terms of the settlement agreement he received no cash consideration for his resignation. Therein the other beneficiaries agreed to pay him $45,000 for his stock interest, $25,000 of which was to be paid at the time of the execution of the agreement and the remaining $20,000 on or before 30 days after the termination of the trust. The provision relating to the $25,000 payment reads, in part, as follows:

For and in consideration of the sum of $25,000.00 to First Party (Smith) in hand paid by Second Parties (the other beneficiaries) * * * First Party agrees to sell * * * and Second Parties * * * agree to buy * * * upon the termination and distribution of that certain trust dated December 29, 1930 * * * all of the then right, title and interest of the First Party in and to the corpus and any accumulations thereof then belonging or distributed to First Party. (Emphasis supplied.)

It is apparent from this provision of the agreement that $25,000 was the downpayment the other beneficiaries obligated themselves to make (and made) at the time of the execution of the agreement in consideration for Smith's agreement to sell them his minority stock interest at the termination of the trust. If Schalk had made this payment in the first instance, it clearly would not have been entitled to deduct it as an ordinary and necessary business expense because it was part of the purchase price of an asset, particularly in the absence of a satisfactory showing that the purchase price was excessive. Its character was not changed by reason of the fact that Schalk assumed the obligation to reimburse, and did reimburse, the other beneficiaries for the payment made by them. Respondent did not err in determining the Schalk was not entitled to any ordinary and necessary expense deduction in 1950 when it voluntarily agreed to reimburse the other beneficiaries for the $25,000 payment, and for the interest they had paid on the money they had borrowed to make this payment.

Petitioners make the alternative contention that if the liability assumed by Schalk to reimburse the other beneficiaries for interest in the amount of $3,697.92 is not deductible as a business expense, then it is deductible as ‘interest.’ This amount is clearly not deductible as ‘interest’ as there was no indebtedness on the part of Schalk on which interest could accrue.

Petitioners' next contention is that the respondent erred in determining that the payment of $25,000 made by Schalk to the other beneficiaries in 1951 constituted a dividend to Hazel I. Farman and Patricia Baker in that year to the extent that they participated in the receipt of the payment.

The trust in which the other beneficiaries owned beneficial interests in the stock of Schalk terminated on December 29, 1950. On that date, for all practical purposes, Hazel I. Farman became the owner of 50,000 shares, Patricia Baker 16,667 shares, and Evelyn Smith Marlow 16,667 shares, although the order directing distribution was not entered until March 20, 1951. In february 1951 Schalk made a distribution to them of $25,000. Hazel I. Farman received $15,000 of this amount and Patricia Baker and Evelyn Smith Marlow $5,000 each, which were the amounts each of them had paid to Smith at the time of the execution of the settlement agreement.

A dividend is defined in section 115(a), I.R.C. 1939, as ‘any distribution made by a corporation to its stockholders * * * out of its earnings or profits.’ A distribution of corporate earnings may constitute a dividend notwithstanding that the formalities of a dividend declaration are not observed, and that it is not in proportion to stockholdings. Paramount-Richards Theatres, Inc. v. Commissioner, 153 F.2d 602, 604 (C.A. 5), affirming a Memorandum Opinion of this Court.

On December 31, 1950, Schalk had post-1913 accumulated earnings and profits substantially in excess of the $25,000 distributed in February 1951, and the other beneficiaries who received that distribution were in full control of the corporation. It reimbursed them for the downpayment they made and were obligated to make, pursuant to the terms of the settlement agreement, in consideration for Smith's agreement to sell them his minority interest in the stock of Schalk at the termination of the trust. As already noted, Schalk was not a party to the settlement agreement, did not authorize the payment, and was not obligated, legally or morally, to reimburse them therefor. Its action in reimbursing them for the payment was, therefore, voluntary, and in the absence of any evidence by petitioners that the amount distributed to them did not come from its accumulated earnings and profits, the distribution constituted a dividend as defined in section 115(a), supra. Respondent did not err in his determination that the individual petitioners, to the extent that they participated in the distribution, received a dividend.

The third contention of petitioners is that the respondent erred in determining that the payment by Schalk of $20,000 in 1951 constituted a distribution essentially equivalent to a dividend to Hazel I. Farman and Patricia Baker to the extent that the corporation discharged a contractual obligation of these petitioners.

The respondent contends that Schalk in 1951 made a $20,000 distribution in redemption of the minority interest in its stock held by Smith, which the other beneficiaries were contractually obligated to purchase under the terms of the settlement agreement, and that such a distribution is essentially the equivalent of a dividend to them since it operated to discharge their obligation.

Petitioners urge that the settlement agreement gave the other beneficiaries a mere option to purchase Smith's minority stock interest at the time of the termination of the trust, which they did not exercise; that they assigned the option to Schalk; and that the exercise of the option by Schalk did not benefit them directly or indirectly in any appreciable degree and did not discharge any obligation of theirs which would result in a distribution essentially equivalent to the receipt of a dividend. Petitioners cite Holsey v. Commissioner, 258 F.2d 865 (C.A. 3), reversing 28 T.C. 962.

Petitioners rely on the paragraph of the settlement agreement which provides that if the other beneficiaries should ‘fail, neglect or refuse to pay the balance of the purchase price,’ $20,000, Smith would be released from any obligation to sell his one-sixth stock interest and the other beneficiaries ‘shall be released of any and all obligations to purchase’ the same ‘or to pay * * * any additional moneys' to Smith.

This isolated provision of the settlement agreement merely restricts the remedy of Smith, in the event the other beneficiaries default and fail to pay the $20,000 balance of the purchase price, to the retention of the $25,000 downpayment. Somewhat similar provisions in other contracts have been held not to give the purchaser a mere option to purchase where other provisions thereof clearly indicate that it was the intention of the parties to enter into a binding contract for the purchase and sale of property. See Vance v. Robers, 93 Fla. 379, 118 So. 205; Wright v. Suydam, 72 Wash. 587, 131 Pac. 239; and cf. Rodriguez v. Barnett, 333 P.2d 407 (Cal. App. 1958). Here the settlement agreement provides that ‘(i)t is distinctly understood and agreed that First Party (Smith) agrees to sell and Second Parties (the other beneficiaries) agree to buy all of the assets of said trust’ and that the ‘First Party agrees to sell * * * and Second Parties jointly and severally agree to buy * * * all of the then right, title and interest of First Party in and to the corpus and accumulations * * * of the trust.’

Our conclusion is that the other beneficiaries were obligated under the terms of the settlement agreement to purchase, and Smith to sell, Smith's minority interest in the stock of Schalk; that the purchase price was $45,000, $25,000 of which was payable at the time of the execution of the agreement and the remaining $20,000 when the trust terminated; and that the provision upon which petitioners rely did not convert the binding contract for the purchase and sale of Smith's interest into a mere option. When Schalk paid the $20,000 it satisfied a contractual obligation of the other beneficiaries, two of whom, Hazel I. Farman and Patricia Baker, are petitioners in these proceedings. Had the other beneficiaries made the payment it would have cost them $20,000 and they would have become the owners of all of Schalk's outstanding stock. When Schalk assumed their obligation and paid $20,000 in redemption of the 16,666 shares of its stock held by Smith, the other beneficiaries became the owners of all of its outstanding stock without cost to themselves. When the transaction was concluded therefore the other beneficiaries were in substantially the same position they would have been in Schalk had not assumed their obligation and had distributed to them $20,000 and they had used this money to satisfy their obligation to purchase the portion of Schalk's outstanding stock, owned by Smith, which they did not then own. In the circumstances we are convinced that the respondent did not err in his determination that the $20,000 payment by Schalk in 1951 constituted a distribution essentially equivalent to a dividend to Hazel I. Farman and Patricia Baker to the extent that Schalk discharged their contractual obligation, and we so hold. Wall v. United States, 164 F.2d 462 (C.A. 4); Zipp v. Commissioner, 259 F.2d 119 (C.A. 6), affirming 28 T.C. 314; Garden State Developers, Inc., 30 T.C. 135.

The remaining issue is whether the assessment of deficiencies, determined against petitioners Gerald I. Farman and Hazel I. Farman and petitioners John Carver Baker and Patricia Baker for the year 1951, is barred by the statute of limitations. Deficiency notices were mailed to them within 5 years, but not within 3 years, after their 1951 returns were filed. Assessment of the deficiencies is, therefore, barred under section 275(c), I.R.C. 1939, if they did not omit from their gross income for 1951 an amount properly includible therein in excess of 25 per centum of the reported gross income. In view of our holding in respect of the dividend issue, simple arithmetic demonstrates that there was an omission of more than 25 per cent of gross income; accordingly, assessment of the deficiencies is not barred under section 275(c).

Decisions will be entered for the respondent.