Docket No. 6415.
Sidney H. Wall, Esq., for the petitioner. E. A. Tonjes, Esq., for the respondent.
A corporation was indebted on a note in the amount of $400,000 to petitioner's mother, a stockholder. The note was secured by a mortgage on the corporation's building. Interest was paid by the corporation on the note during the lifetime of the owner of it and it was carried on the books of the corporation as bills payable due her. Petitioner's mother had expressed to certain members of the family her intention to never collect the principal of the debt, but during her lifetime she made no formal cancellation of it and did nothing to indicate that she intended to make a contribution of the principal of the note to the capital of the corporation. Upon the mother's death the $400,000 was transferred to a ‘Surplus Paid-In‘ account and subsequently the note was declared barred by the statute of limitations in a suit brought by the executor of the estate against the corporation. In 1940 and 1941 petitioner, a stockholder, received certain distributions from the corporation charged to ‘Reduction Surplus‘ account. Held, that petitioner's mother did not gratuitously forgive the indebtedness of the corporation's note; held, further, that the distributions made to petitioner are dividends within the meaning of section 115(a) of the Internal Revenue Code. Sidney H. Wall, Esq., for the petitioner. E. A. Tonjes, Esq., for the respondent.
This proceeding involves deficiencies in income tax for the calendar years 1940 and 1941 in the respective amounts of $10,110.78 and $20,605.75. The deficiencies are due to several adjustments to petitioner's net income as disclosed by her returns for the years 1940 and 1941. Petitioner contests three of these adjustments by appropriate assignments of error. In the stipulation filed herein one of the assignments of error was waived and one of the assignments of error was adjusted. Effect will be given to this stipulation in the recomputation under Rule 50. This leaves for our consideration only the contested adjustment for the years 1940 and 1941, which was explained by the respondent in a statement attached to the deficiency notice as follows:
The entire amounts distributed to you during the years 1940 and 1941 as a stockholder of the I.N. Van Nuys Building Company are determined to constitute taxable dividends under the provisions of section 115 of the Internal Revenue Code. Accordingly, dividend income from that source has been increased from $10,746.62 to $35,246.38 for 1940 and from $3,128.02 to $24,149.16 for 1941.
The sole issue, therefore, is whether the distributions made in the years 1940 and 1941 by the I.N. Van Nuys Building Co. constituted ‘dividends‘ within the meaning of section 115(a) of the Internal Revenue Code.
FINDINGS OF FACT.
The petitioner is an individual, residing in Los Angeles, California. Petitioner's income tax returns for the calendar years 1940 and 1941 were filed with the collector of internal revenue for the sixth district of California.
The I.N. Van Nuys Building Co., hereinafter sometimes referred to as the building company, was at all times material herein a corporation, which was organized on or about February 15, 1911, under the laws of the State of California.
The petitioner is one of the three living children of I. N. Van Nuys and Susanna H. Van Nuys, both now deceased, the other children being Kate Van Nuys Page and J. B. Van Nuys. I. N. Van Nuys died on February 12, 1912, leaving a last will, pursuant to which his entire estate, including the major portion of the shares of the building company, was transferred, one-half to his widow, Susanna H. Van Nuys, and one-sixth to each of his three children named above. The petitioner was during 1940 and 1941 the owner of approximately one-third of the outstanding capital stock of the building company. The stock of the building company was at all times between January 1, 1913, and December 31, 1941, held by members of the Van Nuys family, except for one qualifying share for a director which was held outside the family.
During 1940 and 1941 petitioner received upon the stock of the building company distributions in cash of $35,246.38 and $24,149.16, respectively.
The building company owns certain real property at the southwest corner of Seventh and Spring Streets, Los Angeles, California; upon which is located the building commonly known as the Van Nuys Building. This building was constructed approximately in 1912 and 1913 by the building company, and during the course of its construction Susanna H. Van Nuys loaned to the company the sum of $400,000, which loan was evidenced by a promissory note dated March 1, 1913, payable three years after its date, with interest at 5 per cent. This note was secured by a mortgage dated March 1, 1913, on said real property which was never recorded.
In February 1919 Susanna H. Van Nuys gave to her three children in equal shares all or substantially all of the property distributed to her from her husband's estate and still owned by her at the time. Such property included certain shares of stock of the building company. At about the same time she gave to her three children in equal shares the remaining shares of the building company owned by her independently of her husband's estate except one share, which she retained until her death.
At about the time of the aforementioned gift in 1919, as well as before that time and as early as 1915 and as late as 1920 Susanna H. Van Nuys, stated to various members of her family including her son, J. B. Van Nuys, who was then secretary of the building company, that she did not intend to enforce the collection of the note. She made no attempt during her lifetime to collect the note and it was not surrendered to the building company by her during her lifetime or canceled, nor was the indebtedness represented thereby gratuitously forgiven by her.
Susanna H. Van Nuys died on May 1, 1923, leaving a will, which was executed on October 27, 1920, in which she made certain specific bequests of real and personal property and left the residue equally to her three children. Her will made no mention of the $400,000 promissory note of the building company or the mortgage given to secure it.
Interest on the $400,000 note was paid semiannually to Susanna H. Van Nuys by the building company up to and including December 31, 1922, but no amount was ever paid on the principal and no interest was paid after December 31, 1922. Such interest payments were treated as expenses on the books of the company and on its income tax returns. The building company was solvent at all times mentioned herein. The $400,000 was carried on the books of the building company as a liability until January 21, 1924, when the amount was, pursuant to a resolution of the board of directors, transferred to ‘Surplus Paid-In‘ account.
The ‘Inventory and Appraisement‘ filed on or about November 16, 1923, in the Superior Court of the State of California in In the Matter of the Estate of Susanna H. Van Nuys, Deceased, showed this $400,000 note as being of no value, and the Federal estate tax return filed for the estate likewise reported the note as being of no value. In a letter dated September 17, 1925, the respondent advised the Title Insurance & Trust Co., the executor of the will of Susanna H. Van Nuys, of his tentative determination of a deficiency in the Federal estate tax upon this estate, based in part upon his tentative determination that said note should be included as an asset of the estate and should be valued at its face amount of $400,000. On October 28, 1925, the Title Insurance & Trust Co. commenced an action in the Superior Court of the State of California in and for the County of Los Angeles upon this promissory note and for foreclosure of the mortgage against the building company. In its answer thereto the building company pleaded the statute of limitations in effect in California. The cause was tried on November 4, 1925, before the court without a jury and the court found on November 6, 1925, that, by reason of the failure of Susanna H. Van Nuys to institute an action to enforce the payment of this note and/or foreclose the mortgage securing the same within four years after the first day of March 1916, the date upon which the same matured, the said note and mortgage became barred by the statute of limitations and the same were so barred at the time of the death of Susanna H. Van Nuys on May 1, 1923. The Court, after making its findings of fact, stated its conclusions of law as follows:
As a conclusion of Law from the foregoing facts, the court finds that the plaintiff is not entitled to judgment against the defendant; that the note and mortgage securing the same; and each of them is and are, barred by the statute of limitations, and were so barred at all times subsequent to March 1, 1920; that the plaintiff and its successors in interest are estopped and debarred from enforcing the same or asserting any claim or right by reason thereof; that by reason thereof the defendant is entitled to judgment here and it is ordered that judgment be entered accordingly.
A statement of protest, dated January 9, 1926, was filed on behalf of the executor of the estate of Susanna H. Van Nuys, in which protest was made among other things, against the tentative determination of the respondent that the $400,000 note should be included as an asset of the estate. In a letter dated January 8, 1927, the respondent advised the executor of his determination of a deficiency in the Federal estate tax upon the estate again based in part upon his determination that the $400,000 note should be included as an asset of said estate at its face amount. No action was taken by the executor before the Board of Tax Appeals with respect to such notice of deficiency. On or about May 10, 1927, the executor paid to the collector of internal revenue of the sixth district of California, under protest, the amount of the deficiency asserted in said notice. On or about April 19, 1928, the executor commenced an action in the United States District Court for the Southern District of California, entitled Title Insurance & Trust Co. v. Welch, 37 Fed.(2d) 617, seeking a refund of a portion of the amount so paid. The court held in that action, among other things, that the $400,000 note had no taxable market value for Federal estate tax purposes and should not be taxed in said estate, and entered its judgment on July 18, 1929, in favor of the executor for a refund of the amount of tax paid under protest with respect to said note.
On September 13, 1938, the board of directors of the building company adopted three resolutions: The first increased the stated capital of the company by the amount of $400,000 theretofore transferred to ‘Surplus Paid-In,‘ as set forth above; the second authorized the reduction of the stated capital of the company by the amount of $400,000; and the third authorized the distribution to the shareholders of the company of the $400,000 of reduction surplus resulting from the reduction of stated capital. All of the stockholders of the building company consented in writing to the reduction of the stated capital of the company.
On September 13, 1938, pursuant to these resolutions, $400,000 was transferred by appropriate entries on the books of the company from ‘Surplus Paid-In‘ account to ‘Stated Capital‘ account and from ‘Stated Capital‘ account to ‘Reduction Surplus‘ account.
In the years prior to and including 1937, dividends paid to the stockholders of the building company were charged against ‘Earned Surplus‘ account. In 1938 and years thereafter the distributions made to stockholders were first charged against the ‘Earned Surplus‘ account until that account was exhausted and the balance was charged against ‘Reduction Surplus‘ account. The ‘Earned Surplus‘ account included all the earnings and profits of the building company which were available for distribution to its stockholders at the respective times of the distributions in the taxable years involved, except that respondent contends that the $400,000 constituted additional earnings or profits, while petitioner contends that it did not constitute earnings or profits.
The total distributions made to petitioner in the taxable years by the building company and the accounts charged therefor were as follows:
+------------------------------------------------------------------------------+ ¦ ¦Total distributions ¦Charged “Earned ¦Charged “Reduction ¦ ¦ ¦paid ¦surplus” ¦Surplus” ¦ +----+-----------------------+-----------------------+-------------------------¦ ¦1940¦$35,246.38 ¦$10,746.62 ¦$24,499.76 ¦ +----+-----------------------+-----------------------+-------------------------¦ ¦1941¦24,149.16 ¦3,128.02 ¦21,021.14 ¦ +------------------------------------------------------------------------------+
Only the portions of each of the above distributions in 1940 and 1941 which were charged to the ‘Earned Surplus‘ account on the books of the company were treated as taxable dividends by the petitioner in her income tax returns for those years. Respondent has included as taxable dividends, and, therefore, as additional income to the petitioner, for each of the taxable years the portions of these distributions which were charged to ‘Reduction Surplus‘ account on the books of the company.
The stipulated facts are incorporated herein and made a part hereof.
As we have stated above, the sole issue herein is whether certain distributions made by the building company in the years 1940 and 1941 constituted ‘dividends‘ within the meaning of section 115(a) of the Internal Revenue Code.
Petitioner contends that Susanna H. Van Nuys during her lifetime and while she was a shareholder of the building company forgave the indebtedness of the building company as to the principal of the $400,000 note; that this forgiveness of corporate indebtedness by a shareholder constituted a contribution to the capital of the building company; that capital so contributed does not constitute ‘earnings and profits‘ of the building company; and that distributions out of such contributed capital to petitioner as a shareholder of the building company are not taxable dividends within the meaning of section 115(a) of the code, but should be applied against and reduce the adjusted basis of the stock of the building company held by petitioner in accordance with section 115(d). The applicable portions of the Internal Revenue Code are set out in the margin.
SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(a) DEFINITION OF DIVIDEND.— The term ‘dividend‘ when used in this chapter (except in section 203(a)(3) and section 207(c)(1), relating to insurance companies) means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. * * *(d) OTHER DISTRIBUTIONS FROM CAPITAL.— If any distribution by a corporation to its shareholders is not out of increase in value of property accrued before March 1, 1913, and is not a dividend, then the amount of such distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113, and if in excess of such basis, such excess shall be taxable in the same manner as a gain from the sale or exchange of property. This subsection shall not apply to a distribution in partial or complete liquidation or to a distribution which, under section (f)(1), is not treated as a dividend, whether or not otherwise a dividend.
Respondent concedes that if petitioner's premise, that Susanna H. Van Nuys in her lifetime foregave the indebtedness of $400,000 to the building company and made a contribution of that amount to its capital surplus, were sound, then such $400,000 would not constitute a fund from which taxable dividends could be paid. Respondent contends, however, that such was not the case, but that the way the building company secured freedom from the payment of the note was to plead the statute of limitations in a suit brought by the executor of Susanna H. Van Nuys after her death, and that the building company's success in having this plea sustained by the court at a time when the corporation was thoroughly solvent resulted in increasing its earnings and profits by the sum of $400,000.
Respondent therefore contends that the entire distribution of $35,246.38 and $24,149.16 paid to petitioner during the years 1940 and 1941, respectively, by the building company was paid out of ‘earnings and profits accumulated after February 28, 1913,‘ and constitutes taxable dividends within the meaning of section 115(a), supra.
The courts and the Treasury regulations have long recognized that a gratuitous forgiveness by a stockholder of a debt of his corporation may amount to a capital contribution. See Carroll-McCreary Co. v. Commissioner, 124 Fed.(2d) 303; American Cigar Co. v. Commissioner, 66 Fed.(2d) 425; Commissioner v. Auto Strop Safety Razor Co., 74 Fed.(2d) 226. Respondent maintains that the facts herein do not permit application of the above doctrine.
Sec. 19.22(a)-14 (Regulations 103). Cancellation of indebtedness.— (a) In general.— The cancellation of indebtedness, in whole or in part, may result in the realization of income. If, for example, an individual performs services for a creditor, who in consideration thereof cancels the debt, income in the amount of the debt is realized by the debtor as compensation for his services. A taxpayer realizes income by the payment or purchase of his obligations at less than their face value. (See section 19.22(a)-18.) In general, if a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation to the extent of the principal of the debt.
The problem here is largely one of fact. The question turns upon whether Susanna H. Van Nuys, a stockholder of the building company, forgave the indebtedness of the building company as to the principal of the $400,000 note so as to amount to a capital contribution.
We agree with respondent's contention that the evidence herein does not establish that Susanna H. Van Nuys forgave the indebtedness of the building company as to the note herein so as to amount to a capital contribution. The evidence shows that during the lifetime of Susanna H. Van Nuys the building company continued to pay her interest on the note and carried the note on its books as an obligation which it owed her. It may have been the intent of Susanna H. Van Nuys never to collect the principal of the note, as she indicated at various times in conversations with members of her family, but this falls short of the proof required to establish that payment thereof was forgiven, so as to amount to a capital contribution. No action was taken by either Susanna H. Van Nuys or the corporation to indicate that the debt had been forgiven. There was no record made, no resolution adopted, and no other action taken consistent with the thought that the indebtedness was forgiven. As we have already said, the note was carried on the books of the building company as a liability during her lifetime and she continued to receive payment of the interest. The very fact that interest was paid by the corporation each year on the note to Mrs. Van Nuys and that the corporation continued to carry it upon its books under bills payable shows that she had not in fact forgiven the indebtedness and had not made a capital contribution of it to the corporation. We think it is also significant that in February 1919, when she gave to her three children, including the petitioner, all of the stock of the building company owned by her, except one share, nothing was done to show that the payment of the note was to be forgiven so as to vest in the children complete ownership of the building company freed from the obligation of the debt. Moreover, when the executor of the estate of Susanna H. Van Nuys brought an action on the note in the California court and the building company pleaded only the statute of limitations as a defense, we think it indicated that the parties believed in the existence of the debt. There was no claim in that suit that Mrs. Van Nuys had forgiven the indebtedness to the building company during her lifetime.
Petitioner relies upon American Cigar Co. v. Commissioner, supra, in support of her contention that a contribution to the capital of a corporation may be made by one of its shareholders by means of a loan to the corporation which the shareholder does not expect or intend to collect, even though the shareholder holds promissory notes of the corporation evidencing the debt which have never been surrendered or canceled in any way. The instant case is distinguishable on its facts from that case. In the American Cigar Co. case the taxpayer held bonds and stock of another corporation which was in a poor financial condition and was unable to pay interest on its bonds. The taxpayer was reluctant to allow the debtor corporation to go into receivership and advanced money to enable it to meet its operating expenses and pay interest on its bonds. The taxpayer made the advances firmly believing that the obligations were worthless and uncollectible and were advanced in the belief they would never be repaid. The Second Circuit held that such advances made in the belief that they would not be repaid were in the nature of gifts and contributions to the capital of the debtor corporation. The building company herein was solvent during the entire period and there is no evidence whatever that the loan was made in the belief that the amount would not be repaid.
Having found that Susanna H. Van Nuys did not make a contribution to the capital of the building company, was the $400,000 ‘earnings and profits‘ within the meaning of section 115(a) of the code? We think it was. In fact, we do not understand that petitioner contends to the contrary if we fail to sustain her contention that Susanna H. Van Nuys forgave the note to the corporation in her lifetime. When the corporation was relieved of the debt of $400,000, its free assets were correspondingly increased. This enhancement was due to the judgment of the California court in the suit on the note brought by the executor of the estate of Susanna H. Van Nuys, wherein the court upheld the contention of the building company that the statute of limitations in effect in California was a bar. It was not until the judgment of the California court that the right of the noteholder was finally determined, because the only defense to the payment of the note was the plea of the bar of the statute of limitations, which must be affirmatively pleaded and could have been waived. Since the note was barred by the statute of limitations, it was not a gratuitous cancellation so as to amount to a gift within the rationale of Helvering v. American Dental Co., 318 U.S. 322. By virtue of the judgment of the California Court, the amount of $400,000 was released to the general uses of the building company and its assets, previously offset by the obligation of the note, were made available to the building company. This benefit, we think, is ‘earnings and profits‘ within the meaning of section 115(a). Cf. United States v. Kirby Lumber Co., 284 U.S. 1; Helvering v. American Chicle Co., 291 U.S. 426; Walker v. Commissioner, 88 Fed.(2d) 170; certiorari denied, 302 U.S. 692; B. F. Avery & Sons, Inc., 26 B.T.A. 1393; petition for review dismissed, 67 Fed.(2d) 985; Lutz & Schramm Co., 1 T.C. 682; R. O'Dell & Sons Co., 8 T.C. 1165.
Petitioner argues that it was not the date of the judgment of the Superior Court of California to the effect that the note was barred by the statute of limitations that is the determinative date. Petitioner argues that, inasmuch as the note was barred on March 1, 1920, it was unenforceable from that date. Therefore, contends petitioner, March 1, 1920, is the pivotal date even if respondent's view be accepted. We do not see where that makes any difference. If March 1, 1920, be accepted as the date when the note became unenforceable and petitioner's assets became freed from its payment to the extent of $400,000, the result is the same so far as we can see.
We hold, therefore, that the distributions herein made to petitioner were dividends within the meaning of section 115(a) of the Internal Revenue Code.
Decision will be entered under Rule 50.