William C. Atwater & Co.
v.
Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Feb 4, 1948
10 T.C. 218 (U.S.T.C. 1948)

Docket No. 8999.

1948-02-4

WILLIAM C. ATWATER & COMPANY, INCORPORATED, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Charles B. McInnis, Esq., and G. Kibby Munson, Esq., for the petitioner. William A. Schmitt, Esq., for the respondent.


1. S, an employee of petitioner, had in prior years acquired 100 shares of petitioner's stock, which were subsequently increased to 1,500 shares by a stock dividend, under an employment arrangement by which petitioner's services. S resigned April 23, 1936, and demanded that petitioner purchase his share at ‘book value,‘ plus two years or earnings. Petitioner refused. S brought suit and in 1943 the Court of Appeals of New York affirmed the lower court's decision in favor of S. Petitioner paid this judgment in 1943, together with interest and certain court costs, and thus reacquired S's 1,500 shares of stock. It also paid some legal fees and litigation expenses in connection with the suit in 1942. Held, the stock plan petitioner had with S was an employment arrangement, rather than an outright sale and repurchase of stock, and under section 23(a)(1)(A), I.R.C., petitioner is entitled to deduct in 1943 the part of the judgment paid which represented additional compensation to the employee rather than a capital expenditure; held, further, petitioner is also entitled to deduct in 1942, under the same section, the legal fees and litigation expenses paid in 1942 in connection with the suit.

2. The respondent, in examining petitioner's return for 1942, determined that he had allowed an excessive deduction for capital stock tax in determining petitioner's net income for 1941. Upon the basis of this determination the respondent included the determined excessive deduction for 1941 in petitioner's income for 1942. Held, the respondent erred in so doing.

3. The respondent determined that the capital stock tax liability accrues at the beginning of the capital stock tax period rather than at the close of the period and adjusted petitioner's capital stock deductions for 1942 and 1943 accordingly. Held, this determination was correct, petitioner being on the accrual basis.

4. During the year 1942 petitioner's business required large sums of cash and its cash resources were needed in the business. There was pending at the end of the year the possibility that the Court of Appeals would affirm the large judgment awarded against petitioner in the suit brought by S. Petitioner's directors had been advised by reputable certified public accountants and lawyers that petitioner was in no position to declare and pay a dividend in 1942. Held, petitioner was neither formed nor availed of in the taxable year for the purpose of preventing the imposition of surtax upon its stockholders and is not subject to the surtax on corporations imposed by section 102 of the Internal Revenue Code. Charles B. McInnis, Esq., and G. Kibby Munson, Esq., for the petitioner. William A. Schmitt, Esq., for the respondent.

The respondent determined deficiencies as follows:

+-------------------------------------------------------------+ ¦Tax ¦Year ended ¦Year ended ¦ +---------------------------------+-------------+-------------¦ ¦ ¦Dec. 31, 1942¦Dec. 31, 1943¦ +---------------------------------+-------------+-------------¦ ¦Declared value excess profits tax¦None ¦$3,204.83 ¦ +---------------------------------+-------------+-------------¦ ¦Income tax ¦$9,589.12 ¦5,647.77 ¦ +---------------------------------+-------------+-------------¦ ¦Surtax under section 102 ¦42,261.96 ¦24,155.91 ¦ +-------------------------------------------------------------+

The deficiencies in declared value excess profits tax and income tax are due to certain adjustments set out and explained in the statement attached to the deficiency notice as follows:

Taxable Year Ended December 31, 1942

+--+ ¦¦¦¦ +--+

ADJUSTMENTS TO NET INCOME Net income as disclosed by return $169,898.65 Unallowable deductions and additional income (a) Legal fees $296.17 (b) Litigation expenses 20,975.37 (c) Capital stock tax 2,701.25 23,972.79 Net income adjusted 193,871.44

EXPLANATION OF ADJUSTMENTS

(a) and (b) It is held that legal fees of $296.17 and expenses of litigation of $20,975.37, representing the cost of the defense of a suit by John L. Steinbugler to enforce the purchase by you, under an agreement, of his stock in your company, do not constitute an ordinary and necessary business expense which is deductible under section 23 of the Internal Revenue Code, but represent a capital expenditure which is not deductible under the provisions of section 24 of the Internal Revenue Code.

(c) Inasmuch as your income is reported on the accrual basis, it is held that you are entitled to a deduction for capital stock tax of $1.25, whereas you claimed a deduction of $2,500.00. The difference of $2,498.75 has accordingly been disallowed as a deduction. It is further held that the amount of $202.50 which represents and overaccrual of capital stock tax for the taxable year 1941, constitutes taxable income in the current year. Your taxable income for the current year has accordingly been increased by a total of $2,701.25.

+-----------------------------------+ ¦Taxable Year Ended December 31, ¦ ¦1943 ¦ +-----------------------------------¦ ¦ ¦ ¦ ¦ +-----------------------------------+

ADJUSTMENTS TO NET INCOME Net loss as disclosed by return ($230,646.29) Unallowable deductions and additional income (a) Bad debts $17,536.22 (b) Judgment awarded in litigation 308,909.00 (c) Court costs awarded in litigation 3,392.10 329,837.32 Total $99,191.03 Nontaxable income and additional deductions (d) Capital stock tax 2,498.75 Net income adjusted $96,692.28

EXPLANATION OF ADJUSTMENTS

(a) It is held that you are not entitled to a deduction for a bad debt of $17,536.22 due from John L. Steinbugler under the provisions of section 23(k) of the Internal Revenue Code.

(b) It is held that the amount of $308,909.00 deducted as ‘judgment awarded in litigation‘ constitutes a capital expenditure for the purchase of your stock from John L. Steinbugler under the provisions of section 24 of the Internal Revenue Code and is not deductible from income.

(c) It is held that the amount of $3,392.10 deducted as ‘court costs awarded in termination of litigation‘ constitutes additional cost of stock purchased from John L. Steinbugler and his not deductible from income under the provisions of section 23 of the Internal Revenue Code.

(d) Inasmuch as your income is reported on the accrual basis, your deduction for capital stock tax has been increased by $2,498.75 in order to reflect the proper accrual of such tax.

The deficiencies in surtax under section 102 are due to the above mentioned adjustments to net income for each of the taxable years and to the respondent's holding set out in the said statement for each of the taxable years as follows:

It is held that your earnings or profits have been accumulated for the purpose of avoiding surtax by your stockholders and that you are subject to the surtax computed at the rate prescribed by section 102 of the Internal Revenue Code.

Petitioner by appropriate assignments of error contests each of the above mentioned adjustments to net income and also the holding relative to the determination of the deficiencies in surtax under section 102.

The issues thus raised fall into three main divisions, namely, the Steinbugler litigation issues, the capital stock tax issues, and the section 102 issues.

FINDINGS OF FACT.

Petitioner is a corporation, organized under the laws of the State of New York in 1909, with its principal office in New York City. At the time of organization petitioner took over the business of a predecessor company that had existed since 1900. Since the time of its incorporation petitioner has been engaged continuously in the business of selling coal on a commission basis for various coal mines in the Pocahontas coal field of southern West Virginia. It also received some income from trading in coal, mine management, dividends, and interest. Its returns for the calendar years 1942 and 1943 were filed with the collector for the third district of New York.

Steinbugler Litigation Issues.

Petitioner at the time it was incorporated in 1909 employed one John L. Steinbugler, who had been in the employ of petitioner's predecessor. Steinbugler remained in petitioner's employ continously from 1909 until he resigned April 23, 1936. He was made a director in 1909 and was secretary of petitioner from 1909 until 1932 and president from 1932 until the date of his resignation. He also acted as general counsel for petitioner and supervised its accounting.

At the time of incorporation petitioner's capital stock consisted of 1,000 shares of the par value of $100 per share. William C. Atwater, Sr., owned 712 shares and Charles P. Hutchins owned 280 shares. Both Atwater and Hutchins were directors. Atwater was president and Hutchins was treasurer. Atwater remained president until 1932, when he was succeeded by Steinbugler. Atwater died February 22, 1940. William C. Atwater, Jr., has been president since the date of Steinbugler's resignation.

Beginning January 1, 1912, and continuing through the month of October 1915, petitioner paid to Steinbugler and another employees, David W. Allen, each a monthly bonus of 2 1/2 per cent of its net profits. The bonuses were in addition to their regular compensation.

On or shortly after November 20, 1915, petitioner acquired from Hutchins 200 shares of its capital stock at a cost of $800 per share.

On November 23, 1915, the board of directors of petitioner adopted the following resolution:

Resolved, that out of the 200 shares of its Capital Stock now in its Treasury, the Corporation sell and issue, as of date November 1st 1915, to the following officers and employees a number of shares, on terms and conditions, as follows:

+--------------------------------------------+ ¦To John L. Steinbugler, Secretary¦50 ¦Shares¦ +---------------------------------+---+------¦ ¦To David W. Allen ¦50 ¦Shares¦ +---------------------------------+---+------¦ ¦To George H. Lachnicht ¦10 ¦Shares¦ +---------------------------------+---+------¦ ¦To George A. Dies ¦10 ¦Shares¦ +---------------------------------+---+------¦ ¦Total ¦120¦ ¦ +--------------------------------------------+

That the price shall be Eight Hundred ($800.00) Dollars per share:

That the Company shall carry such stock for the purchasers and allow payments therefor to be made through the dividends that may be hereafter paid out of the earnings;

That accounts be opened on the books of the Company to carry these purchases, which accounts shall be charged with the purchase price of the stock, and on which accounts interest at the rate of five (5%) per cent per annum shall be computed and charged quarterly on the last days of March, June, September and December of each year;

That such stock shall not be assignable nor transferable except to the Corporation, and shall be issued subject to the following conditions, which shall be endorsed on the margin of the certificate:

Face of Certificate. ‘This Certificate of Stock is issued subject to the conditions endorsed on the reverse hereof.‘

Reverse of Certificate. ‘This Certificate is not assignable nor transferable except to William C. Atwater & Co., Inc. (of New York). In the event that the holder of this Certificate shall cease to be in the employ of the said Company, or in the event of his death, then this stock shall be re-sold to William C. Atwater & Co., Inc. at a price equal to the book-value at the time of re-sale, plus the equivalent of the aggregate earnings per share, for the two (2) years preceding the time of such re-sale, as shown by the books of the Corporation.‘

It was further Resolved that the said Certificates of stock be at once prepared and issued and placed in the Treasury of the Corporation, for delivery as and when payment therefor shall have been fully made; and the President was requested to deliver to each of the above named gentlemen a certified copy of the foregoing resolution.

An account, hereinafter sometimes referred to as the Steinbugler stock account, was opened on petitioner's books, in which Steinbugler was charged, as of November 1, 1915, with $40,000 representing the stated price of the 50 shares allocated to him. At or about the same time, petitioner's stock certificate No. 7 was issued to Steinbugler as of November 1, 1915, for 50 shares of petitioner's stock.

Petitioner discontinued, as of October 31, 1915, the payment of monthly bonuses of 2 1/2 per cent each to Steinbugler and Allen in consideration of the stock purchase plan adopted by the directors on November 23, 1915, as set forth in the above resolution of that date.

The minutes of a special meeting of the board of directors of petitioner held on March 30, 1916, report the following as having occurred:

The President reported the receipt of an offer from Mr. John L. Steinbugler, to purchase for cash, (subject to the same terms and conditions as in the case of the Fifty Shares (50) of Stock purchased by him from the Company as of date November 1st 1915) Twenty (20) Shares of the Capital Stock of the company, now in the Treasury of the Corporation, at the basic price of Eight Hundred Dollars ($800.00) per share as of November 1st 1915, with an adjustment for the dividend of Fifty Dollars ($50.00) per share, paid December 31st 1915, and interest to March 18th 1916, at the rate of five per cent (5%) per annum. The President reported further that the Company had on March 18th 1916 received Mr. Steinbugler's check in tender of payment for said Twenty Shares (20) of Capital Stock, in the amount of $15,298.00, or at the rate of $746.90 per share. On motion of the President it was: Resolved to accept the offer of Mr. Steinbugler to purchase Twenty Shares (20) of the Treasury Stock, and the President was requested to forthwith have prepared and issued, a proper certificate of stock for Twenty Shares (20) endorsed on the margin in the form set out on page 142 of this Minute-Book (Board of Directors meeting November 23rd 1915), and to deliver the same to Mr. Steinbugler.

Mr. Atwater then offered the following, which was adopted by the Board:

Resolved, that the Company sell and issue the Sixty Shares (60) of its Capital Stock remaining in its Treasury, on terms and conditions, as follows.

+-------------------------------------------+ ¦To John L. Steinbugler, Secretary¦30 Shares¦ +---------------------------------+---------¦ ¦To David W. Allen ¦30 Shares¦ +---------------------------------+---------¦ ¦Total ¦60 Shares¦ +-------------------------------------------+

That the price shall be Seven Hundred Sixty-four and 90/100 ($764.90) Dollars per share, as of date March 18th 1916;

That the Company shall carry such stock for the purchasers; and allow payments therefor to be made through the dividends that may be hereafter paid out of the earnings;

That the accounts of the purchasers now standing on the books of the Company shall be charged with the purchase price of the stock, with interest at five (5%) percent per annum to be computed quarterly on the last days of March, June, September and December of each year, from and after March 18th 1916;

That such stock shall not be assignable nor transferable except to the Corporation, and shall be issued subject to the conditions set out on page 142 of this Minute-Book (Board of Directors meeting November 23rd 1915), which conditions shall be endorsed on the margin of the certificates.

It was further Resolved that the said certificates be at once prepared and issued, and the President was requested to deliver to each of the above named gentlemen a certified copy of the foregoing resolution.

Petitioner's stock certificate No. 12, for 20 shares, was issued to Steinbugler as of March 18, 1916, to carry out the acceptance of the offer referred to in the first resolution set out in the above minutes dated March 30, 1916. The certificate contained on its face and reverse sides exactly the same legend as the certificate representing the 50 shares issued to Steinbugler pursuant to the resolution of November 23, 1915.

Petitioner's stock certificate No. 14, for 30 shares of stock, was issued to Steinbugler as of March 18, 1916, pursuant to the second resolution set out in the above minutes dated March 30, 1916. That certificate contained on its face and reverse sides exactly the same legend as the two certificates previously issued to him.

The Steinbugler stock account was charged as of March 18, 1916, with $15,298 representing the stated price of the 20 shares sold for cash, and also with $22,947 representing the stated price of the additional 30 shares allocated to him. The said account was also credited as of March 18, 1916, with $15,298 representing the stated price of the 20 shares sold for cash.

Certificates Nos. 7 and 14 were delivered to Steinbugler with a letter dated as of March 18, 1916, which modified the previous arrangement by requiring that only one-half of the dividends paid on the said stock be applied against its purchase price.

On December 30, 1922, petitioner paid a stock dividend of 1,400 per cent. Certificates Nos. 7 and 14, representing the 80 shares of stock originally issued to Steinbugler on open account, were surrendered by him and a new certificate, No. 28, for 1,200 shares was issued to him in exchange therefor. Certificate No. 12, representing the 20 shares originally issued to Steinbugler for case, was surrendered and a new certificate, No. 29, for 300 shares, was issued in exchange therefor. Each of the new certificates, Nos. 28 and 29, had typed on the face thereof the following: ‘THIS CERTIFICATE OF STOCK IS ISSUED SUBJECT TO THE CONDITIONS ENDORSED ON THE REVERSE HEREOF.‘ Each of them had typed on the reverse thereof the following:

This Certificate is not assignable nor transferrable, except to William C. Atwater & Co., Inc. (of New York). In the event that the holder of this Certificate shall cease to be in the employ of the said Company, or in the event of his death, then this stock shall be re-sold to William C. Atwater & Co., Inc. at a price equal to the book value at the time of re-sale, plus the equivalent of the aggregate earnings per share for the two years preceding the time of such re-sale, as shown by the books of the Corporation.

The said new certificates were held by Steinbugler at all times material to this proceeding and were surrendered by his attorneys on January 25, 1943, at which time petitioner paid the judgment, interest, and court costs resulting from the final decision of the Court of Appeals of New York, as will hereinafter appear.

The cash dividends paid by petitioner on the 80 shares (later 1,200 shares) allotted to Steinbugler on open account were credited to the Steinbugler stock account on petitioner's books and interest at 5 per cent on the unpaid balance was computed quarterly and charged to the account. Except for 5 withdrawals which were debited to this account, Steinbugler permitted the entire amount of such dividends to remain in the account until August 1932. The 5 withdrawals were made on the following dates and in the following amounts:

+---------------------+ ¦Nov. 30, 1920 ¦$2,000¦ +--------------+------¦ ¦Jan. 6, 1923 ¦6,000 ¦ +--------------+------¦ ¦Jan. 29, 1931 ¦5,000 ¦ +--------------+------¦ ¦Dec. 5, 1931 ¦5,000 ¦ +--------------+------¦ ¦June 13, 1932 ¦15,000¦ +---------------------+

The first two withdrawals were repaid to petitioner on December 31, 1920, and February 1, 1923, respectively, and were credited to the Steinbugler stock account on those dates. On December 31, 1917, the said account was credited with a cash payment of $2,201.57 which Steinbugler made on the said 80 shares allotted to him. On or about August 18, 1932, Steinbugler caused the account to be restated for the period November 1, 1915 to June 30, 1932, on a basis whereby only one-half of the dividends paid on the original 80 shares of stock (later 1,200 shares) were credited against payment for the stock. The account, as restated, allowed him interest on the remaining one-half of the dividends from the date on which each particular dividend was credited to June 30, 1932. The account, as restated, indicated that the one-half of the dividends which Steinbugler was not obligated to apply thereon from the respective dates of payment to June 30, 1932, after taking into consideration the $25,000 of withdrawals that was not repaid and the said cash payment of $2,201.57, amounted to $35,644.35, which amount was withdrawn by Steinbugler on or shortly after August 19, 1932. The effect of this restatement was to place the account in the same position as if Steinbugler had withdrawn one-half of the dividends when paid on the 80 shares of stock (later 1,200 shares) and had paid nothing for such shares except the one-half of the dividends that were credited to the account. Thereafter, only one-half of the dividends paid on the 80 shares were credited against the agreed price until Steinbugler resigned on April 23, 1936, at which time the debit balance in the account stood at $116,366.75.

In addition to the Steinbugler stock account, petitioner also maintained a ‘Steinbugler Deposit Account‘ on its books, to which Steinbugler's salary was credited each month and from which he made withdrawals from time to time. Petitioner paid him interest on the credit balance in this deposit account, just as it did with respect to similar deposit accounts maintained by some of it's other officers and stockholders. The dividends paid by petitioner on the 20 shares (later 300 shares) were credited to this deposit account on petitioner's books. The balance remaining in this deposit account, with the exception of an amount of $3,334.44 representing dividends paid after his resignation plus interest thereon, with withdrawn by Steinbugler in February and March of 1940.

Steinbugler resigned as president and director and left the employ of petitioner on April 23, 1936. Thereafter, he demanded that petitioner reacquire the 1,200 shares (original 80 shares) and the 300 shares (original 20 shares) on the basis and terms endorsed on the reverse side of the certificates and as outlined in the resolution of the board of directors adopted at the special meeting held November 23, 1915. Petitioner refused to reacquire the stock.

Steinbugler refused to accept credit for any dividends paid on the 1,500 shares of stock subsequent to his resignation. Petitioner credited the dividends paid on the 1,200 shares which had been issued on open account to a dividend suspense account on its books and credited the dividends paid subsequent to Steinbuler's resignation on the 300 shares to his deposit account. The dividends so credited by petitioner on the 1,500 shares of stock standing in Steinbugler's name subsequent to his resignation and prior to petitioner's reacquisition of that stock pursuant to the final decision of the Court of Appeals of New York, as will hereinafter appear, amounted to $15,000.

Petitioner continued to charge Steinbugler interest on the debit balance in his stock account from the date of his resignation until sometime during the year 1939 and reported as taxable income the amount of such interest in the respective years in which it was accrued on petitioner's books. The total amount of interest accrued and charged against Steinbugler subsequent to his resignation was $17,870.66. During the same period, petitioner credited Steinbugler with interest on the dividends on the 300 shares paid into the deposit account in the total amount of $334.44, leaving a net balance of $17,536.22 on petitioner's books at the date of the final decision of the Court of Appeals of New York.

On December 22, 1938, Steinbugler filed suit against petitioner in the Supreme Court of the State of New York, County of Kings, alleging two causes of action. The first cause of action was to compel petitioner to pay him the book value of the 1,500 shares of stock (1,200 shares on open account and 300 shares issued for cash) plus an amount equal to the aggregate earnings per share for the 2 years preceding the date of his resignation. The second cause of action was for a sum of money which the plaintiff alleged he had on deposit with petitioner and which was due from petitioner, plus interest.

Steinbugler, in his complaint in the above mentioned suit, alleged, among other things, that he entered the employ of petitioner's predecessor in 1900; that when petitioner was organized in 1909 was elected a director and secretary therefor; and that:

* * * in or about the year 1911, for and in consideration of the plaintiff's good and faithful performance of his duties, and for and in consideration of the plaintiff's continuing in the employ of the defendant, and predicated upon other did pay, to the plaintiff herein a sum equal to 2 1/2% of the net profits of the said corporation during each and every year beginning with the year 1911 and continuing up to the time of the special meeting hereinabove referred to, namely, November 23, 1915.

The complaint continued in part as follows:

Eighth: That on or about the 23rd day of November, 1915, for and in consideration of the plaintiff's continuing in the employ of the defendant, for and in consideration of the plaintiff's termination of his 2 1/2% net profit sharing agreement, and in consideration of the mutual promises made by the defendant to John L. Steinbugler, David W. Allen, George H. Lachnict and George H. Dies, and made by them to the corporation, and predicated upon mutual covenants and other good and valuable consideration, and for the purpose of granting to the said employees a bonus of share of the profits of the said business for their continued good and faithful performance of their duties, it was agreed by the defendant corporation with the said persons that it would sell to and repurchase from the said employees one hundred and twenty shares of capital stock of William C. Atwater & Co., Inc; that the said price was in the sum of $800.00 per share, payment to be made out of dividends received from the said stock, fifty (50) shares of which were to go to the plaintiff herein, and that for the purpose of continuing the defendant as a closed corporation the defendant herein agreed to repurchase the said stock from the above named persons, and the persons aforementioned were without right to re-sell except to the corporation, the price of resale to be determined pursuant to the terms of the mutual covenants then agreed upon, and as set forth in substance in a copy of the resolution of the special meeting of theBoard of Directors * * *

. * * *

Eleventh: Thereafter and on or about the 30th day of March, 1916, based on a like consideration and like mutual covenants, the corporation, pursuant to agreement and a resolution adopted at a special meeting of the Board of Directors held on the 30th day of March, 1916 * * * sold to John L. Steinbugler and David W. Allen each, thirty (30) shares of the capital stock of the said corporation at a price of $764.90 per share as of the date March 18, 1916, payment upon the said purchase price to be made out of dividends received from the said stock; and it was further agreed that in the event of the termination of employment or death of the said parties respectively, that the said stock should be re-sold to the corporation at a price equal to the book value at the time of re-sale plus the equivalent of the aggregate earnings per share for two years preceding the time of the said re-sale as shown upon the books of the corporation * * *

Fourteenth: That on or about the 18th day of March, 1916, the defendant herein sold to the plaintiff twenty (20) shares of stock of the defendant corporation, pursuant to the same terms and conditions of sale and re-purchase hereinabove set forth, except that the purchase price was $774.00 per share, or a total of $15,480.00, which total sum was paid by the plaintiff in cash, and it was agreed that the said stock should be re-sold to the corporation in the event of the death of the plaintiff or the termination of his employment, at a price equal to the book value at the time of said re-sale plus the equivalent of the aggregate earnings per share for the two years preceding the time of such re-sale, as shown upon the books of the corporation * * *

As previously found, the actual purchase price of these 20 shares was $764.90 per share or a total of $15,298.

Sixteenth: That pursuant to the mutual covenants hereinabove referred to and in reliance upon and in consideration of the agreement by the defendant corporation to re-purchase the said stock, the plaintiff continued in the employ of the defendant, and the corporation availed itself of the services of the plaintiff until the termination of employment by resignation on April 23, 1936.

Petitioner, as the defendant in the above suit, filed an answer to the complaint demanding that the complaint be dismissed and that the defendant be awarded judgment on four counterclaims. Plaintiff moved to strike out the separate defenses, counterclaims, and set-offs, and in passing upon this motion Justice Steinbrink, on April 15, 1930, handed down an opinion which is in part as follows:

Plaintiff moves to strike out the separate defenses, counterclaims and set-offs as insufficient in law * * *.

The complaint sets forth two causes of action, one for breach of contracts and the other for money had and received. Under the first cause of action it is alleged that the parties hereto entered into contracts under the terms of which the defendant agreed to repurchase shares of stock it had sold to the plaintiff. The pertinent facts as they appear in the complaints are as follows: Upon the organization of the defendant in 1909 the plaintiff entered its employ and was elected a director and officer thereof. * * * Some time in 1911 the defendant, for consideration, agreed to pay the plaintiff annually a sum equal to 2 1/2 per cent of its net profits. This arrangement continued until November 23, 1915. On that date, in consideration of plaintiff's continued employment with defendant and the cancellation of his 2 1/2 per cent, profit-sharing agreement and in consideration of mutual promises made by the defendant and four of its employees, including the plaintiff, and for the purpose of rewarding such employees with a bonus or share of the profits of the defendant's business in return for the continued good and faithful performance of their duties, the defendant agreed that it would sell to said employees 100 shares of its capital stock at $800 per share, payment therefor to be made out of dividends received from the said stock; 50 shares were allotted to the plaintiff. * * *

On March 18, 1916, the defendant sold to the plaintiff 20 additional shares of stock for cash at a price of $774 per share. Such shares were to be held by the plaintiff upon the same conditions governing the previous sale.

On March 30, 1916, the defendant agreed to sell to the plaintiff 30 additional shares of stock at a price of $764.90 per share upon terms substantially similar to those governing the sale of November 23, 1915. The agreements were then modified to provide that payment for the said shares of stock was to be made out of dividends received in a sum of not less than one-half of the amount thereof.

As a result of an increase in the capitalization of the defendant to $1,500,000, plaintiff was allotted 1,500 shares of new stock in exchange for those he held subject to the aforesaid provisions and covenants. * * *

The answer, drawn in complete disregard of section 261 of the Civil Practice Act, contains, in addition to denials, seven affirmative defenses to the first cause of action, designated as special and distinct defenses, and four counterclaims also pleaded as special defenses and set-offs.

* * * ;

What was the manifest intention of the parties? By failure to deny, the defendant admits that prior to November 23, 1915, William C. Atwater, owned 712 of the 800 outstanding shares of stock of the defendant. That the intention was to limit control of the defendant to Atwater and to share such control only with those participating as officers or employees in the internal management of the defendant is evident from the form of the corporate resolutions pertaining to the sales of the shares of stock to its officers and employees. The indorsement on the reverse side of each certificate of stock sold to such officer and employee prevented its assignment or transfer except to the corporation. The provision that it ‘shall be resold‘ to the corporation in the event that the certificate holder shall cease to be in the employ of the corporation or in the event of his death left the certificate holder or his representative no choice but to sell to the corporation upon the happening of these contingencies. The words used were directory, not precatory. They were used in that sense advisedly, for only by imposing the foregoing prohibition and by repurchasing the stock upon the happening of these contingencies could the defendant continue as a completely close corporation. Such is found to be the manifest intention of the parties, and to give it full expression there must be implied in the agreement correlative promises on the part of the defendant to repurchase the shares of stock sold to the plaintiff. * * *

Under the second defense it is alleged in substance that the agreements, all of which were integrated in the corporate resolutions of November 23, 1915, and March 30, 1916, were lacking in consideration; that at no time did the plaintiff have a term contract of employment with the defendant, and that the defendant had not agreed to employ the plaintiff or to continue him in its employ either prior to November 23, 1915, or prior to March 30, 1916.

Whether this defense will be available to the defendant depends upon the true nature of the agreements. If they were intended to rest on mutual promises alone, that is, the plaintiff's promise to purchase the shares of stock in exchange for the defendant's promise to repurchase them, they would be lacking in consideration. The defendant's promise to repurchase would be illusory as binding only in the event that the defendant had a surplus out of which the repurchase price could be paid (Topken, Loring & Schwartz v. Schwartz, 249 N.Y. 206). The allegations in this defense that the agreements were completely integrated in the corporate resolutions must be accepted as true for the purpose of this motion. From these resolutions alone there is some basis for an assumption that the agreements were intended to rest on mutual promises. The plaintiff's contention that the agreements were supported by other and good consideration involves matter of proof rather than of pleading. Accordingly, this special defense must be held sufficient.

The fourth defense alleges in substance that it was the intention of the parties to the agreements that the 80 shares of stock, to be paid for out of dividends, were not to be delivered to or owned by the plaintiff until the purchase price thereof was fully paid, and until the plaintiff became the lawful owner of such certificates of stock he was precluded from offering them for resale to the defendant * * *

* * * Fixation of the date of sale and issuance of the shares of stock of November 1, 1915, together with defendant's agreement to hold such shares of stock for the purchasers clearly points to a completely executed sale. It cannot be said that the passage of title to the shares of stock was intended to be deferred by the provision for delivery of the certificates upon full payment of the purchase price. Such provision simply imports an intention on the part of the defendant to

As a result of the above opinion, petitioner filed a first amended answer to the complaint, demanding that the complaint be dismissed and that the defendant be awarded judgment on two counterclaims. On December 19, 1939, an order was entered directing a separate trial of the issues raised by the defendant's counterclaims. These issues were tried before Justice Steinbrink on February 7 and 8, 1940. On February 8, 1940, Justice Steinbrink rendered a decision dismissing the counterclaims. This decision is in part as follows:

The two equitable counterclaims that are here to be disposed of * * * are as follows:

First counterclaim in substance alleges that the Directors of the company were without authority to deliver this stock or to issue this stock to the plaintiff; and that the plaintiff was not entitled to the benefits of that stock.

The second equitable counterclaim pleaded by the defendants, seeks an accounting from the plaintiff for certain monies received by him, and expenditures which it is alleged, in rather general language, were wrongfully charged to the corporation, in violation of the defendant's contract rights with the plaintiff. * * *

* * * The plaintiff, over a long period of years, was employed by this defendant company. He gradually made himself more useful and more valuable to the company, and this fact was splendidly recognized by William C. Atwater, Sr. Prior to his acquisition of any of the stock of this company, plaintiff, in addition to his other compensation, was in the receipt of a commission or percentage of 2 1/2 per cent. on the profits of the business.

In 1915, Mr. William C. Atwater, Sr., deemed it advisable to take over from his associate and friend, Charles Hutchins, 200 of the shares of stock which Hutchins held. This stock was taken over on the basis, I believe of $800 a share to Mr. Hutchins, and payment was made out of the surplus from the company. That stock, thereupon, technically, became Treasury Stock; and promptly, William C. Atwater, Sr., who undoubtedly at that time was the guiding genius of this company, and its dominant figure, offered to certain of his employees the opportunity to acquire some of this Hutchins Treasury stock, on the same basis on which the company had taken it over from Mr. Hutchins. * * *

At the time that the plaintiff was given the opportunity and privilege of acquiring some of this stock, it was stated to him, that since he would benefit by this, as he naturally expected to, that, of course, his commission or percentage arrangement, would cease. It did cease.

Mr. William C. Atwater, Sr. quite properly, and shrewd business man that he undoubtedly was, did not desire that this stock should find its way into strange hands, or into the hands of competitors, and there was exacted as a condition of the plaintiff's acquisition of this stock, an agreement, that that stock not only could not be sold to outsiders, but the stock certificates were endorsed so that they could not pass into the hands of any innocent purchaser for value.

Now the defendant in these two equitable counterclaims, asserts that this action of the corporation was void. With this contention the Court disagrees, and will, if necessary, make any additional findings in support of this conclusion that are deemed necessary. * * *

A formal judgment dismissing the counterclaims on the merits was entered on February 24, 1940. This judgment was affirmed by the Appellate Division, Second Department, on July 2, 1940. This affirmance is noted at 22 N.Y.S.(2d) 197. A motion for leave to appeal to the Court of Appeals was denied on September 30, 1940. This action is noted at 22 N.Y.S.(2d) 926.

After the rendition of the court's decision on February 8, 1940, Steinbugler was required to file a bill of particulars answering certain demands made by counsel for the defendant. That bill of particulars alleged, inter alia:

2d and 2e. The full and entire consideration which passed from the plaintiff to the defendant, and from the defendant to the plaintiff, for the agreement referred to in paragraphs Eighth and Ninth of the complaint, was that the plaintiff would receive additional compensation in the nature of a portion of the profits of the said business over and above his then annual salary for the continued good and faithful performance of his duties; that the plaintiff would continue in the employ of the defendant and the defendant would continue the plaintiff in its employ. The employment of the plaintiff continued under a term contract of employment. The plaintiff was to surrender and did surrender his agreement whereby he received the sum of 2 1/2% of the annual net profits of the business of the corporation. * * *

3d and 3 e. The full and entire consideration which passed from the plaintiff to the defendant and from the defendant to the plaintiff for the agreement referred to in paragraph Eleventh of the complaint was that the plaintiff would receive additional compensation in the nature of a portion of the profits of the said business over and above his then salary for the continued good and faithful performance of his duties; that the plaintiff would continue in the employ of the defendant and the defendant would continue the plaintiff in its employ, and the employment of the plaintiff continued under a term contract of employment. * * *

4c. The consideration for the modification hereinabove referred to was the same as that set forth in paragraphs 2d, 2e, 3d and 3e. * * * and the plaintiff, in consideration and in reliance thereon agreed to work and did work at certain specified annual salaries taking into consideration that he would receive certain benefits to be derived from the agreements and the modification thereof; and the said modification herein referred to was for the purpose of inducing the plaintiff to continue in the employ of the defendant, and the said employment did continue for many years thereafter, and the plaintiff rendered services of great value to the defendant in reliance of the said agreements and the modification thereof, which was simply a method of payment to the plaintiff and compensation for services rendered and to be rendered; and the defendant saved sums of money which would have had to be paid as additional compensation in order to continue the plaintiff in its employ were it not for the agreements in question and the modification thereof; * * *

5d and 5e. The consideration which passed from the plaintiff to the defendant and from the defendant to the plaintiff for the agreement referred to in paragraph Fourteenth of the complaint was the payment of the sum of $15,480; by the plaintiff to the defendant; the acceptance by the defendant from the plaintiff of the sum of $15,480;2 the delivery by the defendant to the plaintiff of the stock certificate in question; the agreement by the plaintiff to sell to the corporation, and the agreement by the corporation to repurchase the said stock upon the terms endorsed upon the certificate itself; the surrender by the plaintiff of any right to assign or sell to any other person but to the corporation the stock in question; the agreement by the plaintiff to sell to the defendant, and the defendant to purchase at a specified time and in a specified amount thereby limiting the plaintiff's right to the free enjoyment of the said property; the continuation of the plaintiff in the employ of the defendant, and the agreement by the plaintiff to continue in the employ of the defendant, and the defendant's agreement to continue the defendant (plaintiff) in its employ, and the continuance of the plaintiff in its employ, all in reliance upon the said agreement, and those hereinbefore referred to. * * *

See footnote 1.

Thereafter, the defendant filed a second amended answer, a bill of particulars, and a further bill of particulars. The case was tried before Justice Brennan from February 17 to February 26, 1941. On June 22, 1941, the court handed down its opinion, Steinbugler v. Atwater & Co., 28 N.Y.S.(2d) 613, the last paragraph of which is as follows:

The plaintiff is entitled to $200 per share, and $21.38 per share, representing two years' earnings, or a total of $332,070 from which shall be deducted $116,366.75, the balance that he owes defendant on account of the purchase price of the shares, leaving the sum of $215,703.25, for which he shall have judgment with interest from December 22, 1938.

The court, in arriving at the figure of $200 per share, which was less than the book value of the defendant's stock at the time of Steinbugler's resignation, took into consideration the fact that the defendant (petitioner herein) carried on its books at cost certain stock in three coal companies which had greatly depreciated in value since the date of its acquisition by the defendant. As to interest, the court later amended its judgment nunc pro tunc so as to allow interest from April 23, 1936, (the date of Steinbugler's resignation) instead of from December 22, 1938.

Both sides appealed, and the Supreme Court, Appellate Division, Second Department, handed down a decision dated June 1, 1942. Steinbugler v. Atwater & Co., 35 N.Y.S.(2d) 349, in which it modified the judgment on the law and the facts by increasing the amount of damages to $270,767.25, with interest from April 23, 1936. It held that ‘plaintiff was entitled to recover the book value of the shares of stock appearing on the books at the time of his resignation, plus the equivalent of the aggregate earnings per share for the two years preceding the time of such resignation.‘ It found this book value to be $238.35 per share and held that the ‘defendant's attack on the book value at the time of resignation may not be considered‘ except by an action in equity. It did not disturb the ‘$21.38 per share, representing two years' earnings‘ or the $116.366.75, the balance that he owes defendant,‘ determined by the lower court, but did take into consideration ‘a concession by plaintiff of $2,461‘ which had not been considered by the lower court.

Thereafter, petitioner appealed to the Court of Appeals of New York, which court handed down a decision on January 14, 1943, affirming, per curiam, the judgment of the Appellate Division. See Steinbugler v. Atwater & Co., 289 N.Y. 816, 47 N.E.(2d) 432.

The judgment was paid by petitioner on January 25, 1943, at the office of the Indemnity Insurance Co. of North America, by delivery to Steinbugler's attorneys of two certified checks in the aggregate amount of $388,013.97. At the same time, Steinbugler's attorneys delivered to petitioner's attorneys the 1,500 shares of stock, properly endorsed and bearing the appropriate revenue stamp. These shares of stock had at that time a fair market value of $115.36 per share. The above amount of $388,013.97 was arrived at as follows:

+-----------------------------------------------------------------------------+ ¦Book value of 1,500 shares at $238.35 per share at March 31, ¦$357,525.00¦ ¦1936, as determined by Appellate Division ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦Aggregate of two preceding years' earnings on 1,500 shares at ¦32,070.00 ¦ ¦$21.38 per share ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦Total ¦389,595.00 ¦ +-----------------------------------------------------------------+-----------¦ ¦Less: Amount conceded to be due petitioner by Steinbugler ¦2,461.00 ¦ +-----------------------------------------------------------------+-----------¦ ¦Total principal ¦387,134.00 ¦ +-----------------------------------------------------------------+-----------¦ ¦Less: Balance owed by Steinbugler on the stock at date of ¦116,366.75 ¦ ¦resignation ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦Amount of damages as determined by Appellate Division ¦270,767.25 ¦ +-----------------------------------------------------------------+-----------¦ ¦Unexplained addition ¦20.00 ¦ +-----------------------------------------------------------------+-----------¦ ¦Interest from date of Steinbugler's resignation to January 25, ¦113,834.62 ¦ ¦1943 ¦ ¦ +-----------------------------------------------------------------+-----------¦ ¦Court costs ¦3,392.10 ¦ +-----------------------------------------------------------------+-----------¦ ¦Total cash payment ¦388,013.97 ¦ +-----------------------------------------------------------------------------+

Following the conclusion of the Steinbugler litigation, petitioner transferred to surplus the amount of $15,000 representing the dividends which it had credited on the 1,500 shares of Steinbugler stock subsequent to Steinbugler's resignation. At the same time petitioner charged off to profit and loss, and deducted in computing its taxable income for 1943, the amount of $17,536.22 representing the net amount of interest which it had charged Steinbugler on the balance owed on the 1,200 shares of stock subsequent to his resignation and which it had previously reported as taxable income. The respondent disallowed the claimed deduction.

Petitioner deducted, in computing its taxable income for the year 1943, the interest of $113,834.62 paid on the Steinbugler judgment, the court costs of $3,392.10, and a portion of the principal in the amount of $308,909, computed as follows:

+-----------------------------------------------------------------------------+ ¦Judgment (principal) ¦$387,154¦ +--------------------------------------------------------------------+--------¦ ¦Less: Agreed price of the 1,500 shares of Steinbugler's stock (50 ¦78,245 ¦ ¦old shares at $800 per share and 50 old shares at $764.90 per share)¦ ¦ +-----------------------------------------------------------------------------+

Balance considered by petitioner to be compensation to Steinbugler 308,909

The respondent allowed the interest of $113,834.62 as a deduction for the year 1943, but disallowed the court costs of $3,392.10 and the portion of the principal in the amount of $308,909.

During the calendar year 1942 petitioner paid, and deducted in computing its taxable income for that year, legal fees, printing costs, bond premium (on appeal bond), and other miscellaneous disbursements in connection with the Steinbugler litigation, in the aggregate amount of $21,271.54. These items were disallowed by the respondent in two separate items in the respective amounts of $296.17 and $20,975.37. The attorney fees, bond premium, printing costs, and other litigation expenses paid by petitioner during the year 1942 in carrying on the Steinbugler litigation constitute allowable deductions as ordinary and necessary business expenses in computing petitioner's taxable income for that year.

At least the amount of $214,094 representing the net payment which petitioner was compelled to make to Steinbugler in satisfaction of the principal of the judgment rendered against the petitioner in that litigation in excess of the fair market value of the 1,500 shares of Steinbugler's stock which petitioner acquired upon payment of the judgment, constitutes an allowable deduction as ordinary and necessary business expenses in computing petitioner's taxable income for the year 1943.

Capital Stock Tax Issues.

Petitioner deducted in its income tax return for the calendar year 1941 an amount of $3,625 as representing its capital stock tax liability for the capital stock tax period July 1, 1940, to June 30, 1941. On October 27, 1941, petitioner paid a capital stock tax for this period of $2,500. Upon final determination for the calendar year 1941, petitioner was allowed a deduction on its income tax return of $2,702.50 as representing its capital stock tax liability for the capital stock tax period July 1, 1940, to June 30, 1941. The respondent, in determining the deficiency for the calendar year 1942, determined that for the calendar year 1941 petitioner was entitled to a deduction for capital stock tax of only $2,500 instead of $2,702.50 and that the excess allowance of $202.50 represented taxable income to petitioner in the calendar year 1942.

Petitioner deducted in its income tax returns for the calendar years 1942 to 1944, inclusive, the capital stock tax which it paid in those respective years for the capital stock tax period which ended on June 30 of those respective years in amounts as follows:

+-----------------------------------------------------------------------------+ ¦ ¦ ¦Amount ¦Calendar ¦ +---------------------------+------------+---------------+--------------------¦ ¦Capital stock tax period ¦Date paid ¦paid and ¦year in which ¦ ¦ ¦ ¦deducted ¦deducted ¦ +---------------------------+------------+---------------+--------------------¦ ¦July 1, 1941, to June 30, ¦Nov. 27, ¦$2,500.00 ¦1942 ¦ ¦1942 ¦1942 ¦ ¦ ¦ +---------------------------+------------+---------------+--------------------¦ ¦July 1, 1942, to June 30, ¦July 29, ¦1.25 ¦1943 ¦ ¦1943 ¦1943 ¦ ¦ ¦ +---------------------------+------------+---------------+--------------------¦ ¦July 1, 1943, to June 30, ¦July 28, ¦2,500.00 ¦1944 ¦ ¦1944 ¦1944 ¦ ¦ ¦ +-----------------------------------------------------------------------------+

Petitioner kept its books and filed its returns upon the accrual basis.

The respondent in determining the deficiencies for the calendar years 1942 and 1943 determined that the capital stock tax of $2,500 paid in 1942 accrued as a liability on July 1, 1941, and was deductible by petitioner for the calendar year 1941 instead of for the calendar year 1942; that the tax of $1.25 paid in 1943 accrued as a liability on July 1, 1942, and was deductible by petitioner for the calenday year 1942 instead of for the calendar year 1943; and that the tax of $2,500 paid in 1944 accrued as a liability on July 1, 1943, and was deductible by petitioner for the calendar year 1943, instead of for the calendar year 1944. The respondent, therefore, disallowed $2,498.75 of the amount of $2,500 deducted by petitioner for 1942, which amount, plus the excess allowance of $202.50 for 1941, equals $2,701.25, the amount added to petitioner's net income under adjustment (c) for 1942; and under adjustment (d) for the year 1943 the respondent allowed petitioner a deduction for capital stock tax of $2,498.75 in addition to the amount of $1.25 deducted by petitioner on its return.

Section 102 Issues.

During the year 1942 and 1943 and at all other times material to this case petitioner's books and records were kept on the accrual basis and were closed at March 31 of each year and again at December 31 of each year. Petitioner's tax returns were filed on a calendar year basis. Its books and records have been audited by Ernst & Ernst, certified public accountants, since 1918. The audits are made on the basis of a fiscal year ending March 31 and the accounting firm furnishes petitioner with a written report at the conclusion of each annual audit.

Petitioner's founder, William C. Atwater Sr., pioneered in the introduction of Pocahontas coal into New England. When petitioner was organized in 1909, it continued in the business of selling Pocahontas coal in the New England area. The Pocahontas coal field was comparatively new at that time and the mines in that area found it difficult to sell coal in the New England area, where they came in competition with anthracite coal. Petitioner had no difficulty in obtaining a supply of Pocahontas coal during the years prior to the first World War, because the producing mines were glad to get any agency that could sell their coal in the New England market.

When the first World War came along the demand for Pocahontas coal increased greatly and the owners of Pocahontas coal properties had no difficulty in selling their coal. Many of them decided to do their own selling in order to avoid paying commissions to sales agencies. Other agencies were organized in competition with petitioner with the result that petitioner found it difficult to hold a supply of coal. In order to meet this changed situation, petitioner and a related company began acquiring interests in coal companies in the Pocahontas field. In 1916 petitioner purchased stock in the Pocahontas Collieries Co. In 1918 it purchased a large minority interest in the Central Pocahontas Coal Co. In 1920 petitioner purchased control of the American Coal Co. of Allegany County, hereinafter sometimes referred to as American, and in 1923 it purchased the Williams Pocahontas Coal Co. In 1924 petitioner purchased a minority interest in the Mill Creek Coal & Coke Co., hereinafter sometimes referred to as Mill Creek.

By the end of the first World War petitioner's officers realized that the New England market for Pocahontas coal had about reached the saturation point. At the same time petitioner was confronted with the problem of keeping its mines operating during the summer season, when the demand for Pocahontas coal in New England and New York was light. In order to meet this problem, petitioner purchased a large minority stock interest in the Inland Coal & Dock Co., Duluth, Minnesota, hereinafter sometimes referred to as Inland, and began selling coal in the Great Lakes area, such coal being shipped during the summer, which was a slack season in other markets.

In 1935 petitioner acquired control of the New York Fuel Co., in an effort to promote the retail sale of coal in the Bronx. Petitioner had planned to deliver through the New York Fuel Co.'s dock on the Harlem River, but found that the company was a losing proposition and finally abandoned it in 1939, with a loss of $123,036.56.

The stock interests acquired by petitioner and its associated company in the other coal companies were disposed of at losses amounting to $879,474.52 prior to the year 1942, with the exception of the stock of American, Mill Creek, and Inland. The stock of the latter company was sold during the year 1945 at a loss of $101,129.32.

Since its organization in 1909, petitioner has followed the usual practice of coal sales agencies in guaranteeing to the producing mines the selling price of the coal and settling with the mines on the 22d day of each month for all coal sold and shipped during the preceding month, regardless of whether petitioner has been able to collect for the coal. For its services petitioner receives an agreed commission, which varies from time to time. Since 1935 its commission has been 18 1/2 cents on each ton of coal sold for the mines. If a customer fails to pay for the coal, petitioner stands the loss. Petitioner's business has tended to fluctuate with conditions in the coal industry.

Conditions in the bituminous coal industry were good from 1900 up to about 1922 or 1923, and then turned downward. From 1923 to 1940 the bituminous coal industry was on the downgrade and petitioner, in common with the industry generally, suffered reduced earnings and, in many instances, losses. The value of the stock owned by petitioner in below the cost to petitioner.

When petitioner began selling coal in the Great Lakes market after the end of the first World War, it had to ship the coal to the lakes during the open summer season, but could not collect for it until cold weather arrived so that the dock companies could sell the coal. This made it necessary for petitioner to extend generous credit terms to its customers on the Great Lakes and increased its need for working capital.

The stocks of American, Mill Creek, and Inland were carried on petitioner's books at cost from date of acquisition up to the time that Steinbugler resigned on April 23, 1936, despite the fact that such stocks had depreciated in value. The certified public accountant who has supervised the audit of petitioner's books and records since 1918 suggested several times prior to Steinbugler's resignation that the value of the stocks be written down on petitioner's books, but Steinbugler, who had charge of the petitioner's accounting, did not agree to the suggestion. The stock of American had a cost to petitioner in 1920 of slightly more than $65 per share. By 1936 the stock was selling on the New York Stock Exchange within a range of $27 to $34 per share. The stock of Mill Creek and the stock of Inland had also depreciated to a substantial extent. After Steinbugler resigned, the annual audit reports of Ernst & Ernst contained a note to the effect that petitioner's investments in the above mentioned stocks had shrunk below their cost.

Following Steinbugler's resignation, the directors of petitioner decided to adopt the practice of setting up reserves to cover the difference between the cost of the stock on petitioner's books and the fair market value of the stock at the end of each accounting period. The first such adjustment was made in connection with the audit by Ernst & Ernst of petitioner's books and records for the fiscal year ended March 31, 1936, and a similar adjustment has been made on the occasion of each annual audit since that time. Harold J. Rover, who has charge of the annual audit on behalf of Ernst & Ernst, usually assembles the pertinent figures relating to earnings and balance sheet position for each of the companies whose stock is owned by petitioner, and then meets with petitioner's directors, who determine the fair market value of each stock as of March 31 of each year. The value so determined is used by Ernst & Ernst in their annual audit report for the period ending March 31 of each year and the same value is also used by petitioner in closing its books and in preparing its balance sheets on December 31 of each year.

The valuations determined by the directors of petitioner for the stock of American, Mill Creek, and Inland were what the directors considered to be fair, actual values of the stock to petitioner. The stockholder-directors had an agreement among themselves that in the event of the death of any one of them his estate would sell and petitioner would buy the amount of petitioner's stock held by the particular director, at the book value per share as reflected by the values determined for the stock of the above mentioned companies. During the year 1944 one of petitioner's directors, David H. Atwater, died and his estate sold the stock previously owned by him to petitioner at its book value, after giving effect to the write-downs, pursuant to the said agreement.

During the years 1942 and 1943 section 664 of the Penal Law of the State of New York, entitled ‘Misconduct of Officers and Directors of a Stock Corporation,‘ provided as follows:

A director of a stock corporation, who concurs in any vote or act of the directors of such corporation, or any of them by which it is intended : 1. To make a dividend, except from surplus, and in the cases and manner allowed by law * * * is guilty of a misdemeanor.

During the years 1942 and 1943 section 58 of the Stock Corporation Law of New York provided in part as follows:

Dividends. No stock corporation shall declare or pay any dividend which shall impair its capital, nor while its capital is impaired, nor shall any such corporation declare or pay any dividend or make any distribution of assets to any of its stockholders, whether upon a reduction of the number or par value of its shares or of its capital, unless the value of its assets remaining after the payment of such dividend, or after such distribution of assets, as the case may be, shall be at least equal to the aggregate amount of its debts and liabilities, including capital. In case any such dividend shall be paid, or any such distribution of assets made, the directors in whose administration the same shall have been declared or made, except those (1) who may have caused their dissent therefrom to be entered upon the minutes * * * shall be liable jointly and severally to such a corporation and to the creditors thereof to the full amount of any loss sustained by such corporation or by its creditors respectively by reason of such dividend or distribution.

The annual audit reports of Ernst & Ernst for the fiscal years ended March 31, 1942 and 1943, reflected deficits of $109,000 and $6,318, respectively.

Petitioner has found it necessary to borrow large amounts of cash from the banks to supplement its working capital. From the date of its organization in 1909 to about 1924, it enjoyed a good credit rating and was able to borrow money on its notes without collateral. The Chase National Bank continued to extend petitioner credit on its straight paper without collateral until about 1930. From 1930 until 1934, petitioner was able to borrow from the Chase National Bank by pledging its accounts receivable, but was advised by the bank in 1934 that the bank would be reluctant to extend petitioner any further financing. The peak amounts of loans obtained by petitioner from the Chase National Bank during each of the years 1927 to 1934, inclusive, were as follows:

+--------------+ ¦1927¦$300,000 ¦ +----+---------¦ ¦1928¦500,000 ¦ +----+---------¦ ¦1929¦650,000 ¦ +----+---------¦ ¦1930¦700,000 ¦ +----+---------¦ ¦1931¦525,000 ¦ +----+---------¦ ¦1932¦455,000 ¦ +----+---------¦ ¦1933¦640,000 ¦ +----+---------¦ ¦1934¦525,000 ¦ +--------------+

On April 1, 1935, petitioner, being unable to obtain the necessary financing, entered into a contract with the Consolidation Coal Co. under which that company undertook to procure the orders and do all of the financing, guaranteeing the accounts to the mines and making payment to the mines on a 30-day basis. In return for this financing, petitioner agreed to allow the Consolidation Coal Co. 12 cents per ton out of its 18 1/2 cents per ton commission on each ton of coal sold, retaining 6 1/2 cents per ton for its own services for management and supervision of the mines.

Conditions in the coal industry were extremely bad during 1935 and some subsequent years, and the Consolidation Coal Co. found it difficult to procure enough business to keep its own mines running, with the result that it gave petitioner's mining companies a very small percentage of its orders. This was disastrous for petitioner's subsidiaries and inflicted upon them heavy losses. The Consolidation Coal Co. contract was terminated March 31, 1939, and petitioner resumed the entire burden of selling and financing coal on its own account.

When petitioner resumed the direct selling and financing of coal for its own account after March 31, 1939, it became necessary to secure additional bank loans. Petitioner's officers negotiated with officers of the Chase National Bank, the Manufacturers Trust Co., the Fidelity Union Bank in Newark, the Bank of New York, and the Chemical Bank & Trust Co., but without much success. The Bank of New York made petitioner two loans, secured by pledges of its accounts receivable, in October and November of 1941, in the aggregate amount of $145,000, part of which was repaid at the end of November. On December 22, 1941, another loan of $100,000 was made to petitioner, secured by a pledge of its accounts receivable. That loan was paid off in January 1942. Thereafter, petitioner was unable to secure any further bank loans during the years 1942 and 1943.

After Justice Brennan handed down his decision in the Steinbugler suit against petitioner, in June 1941, with no stay of execution, Steinbugler's attorneys immediately entered judgment and attached petitioner's bank accounts, thereby tying up its bank accounts. Petitioner's attorney and its officers made numerous efforts to obtain a bond with which to release the attachment, on the basis of petitioner's credit rating, but were unable to do so. The only way in which petitioner could obtain a bond was to deposit with the Manufacturers Trust Co. an amount equivalent to the amount of the judgment and have the Manufacturers Trust Co. issue a certificate of deposit to the bonding company, thereby securing the bonding company in the event that it should have to make payment on the bond. Petitioner was unable to borrow the necessary money from the banks, but finally succeeded in borrowing, on July 1, 1941, $250,000 from American, for which petitioner gave its demand note, secured by 25,000 shares of the capital stock of American. That loan was outstanding throughout the year 1942 and was gradually reduced during the year 1943. At December 31, 1943, petitioner still owed American $175,000 on the loan.

After the Appellate Division rendered its decision against petitioner on June 1, 1942, increasing the amount of the judgment, it became necessary for petitioner to increase the amount of its deposit with the Manufacturers Trust Co. to $375,000 in order to secure the payment of the judgment in the Steinbugler litigation and thereby protect its bank accounts.

After the Consolidation Coal Co. had taken over the financing of petitioner's coal under the contract of April 1, 1935, petitioner during the years 1936 and 1937 loaned the Dead River Co., in which some but not all of petitioner's stockholders owned stock interests, an amount of $75,000, which was subsequently on June 1, 1937, converted into preferred stock. Thereafter, during the years 1937 and 1938 petitioner made further loans to the Dead River Co. in the aggregate amount of $56,000. These loans were intended as short term investments and no additional loans were made to the Dead River Co. after October 21, 1938. That company gradually reduced its loan and accrued interest to $52,966.06 at December 31, 1941. Payments were made by the Dead River Co. to petitioner in the amounts of $10,091.06 and $2,573.84 during the calendar years 1942 and 1943, respectively. Petitioner endeavored to collect the balance during 1942 and 1943, but was unable to do so. An attempt to collect the loan forcibly would have resulted in the crushing of the business of the Dead River Co. The Dead River Co. is located in the State of Maine and is engaged in the pulpwood and timberland business.

During the calendar years 1926 to 1943, inclusive, petitioner received dividends from corporations in which petitioner owned stock, and during those years it reported net income or (net loss) and paid taxes on its net income, and also paid dividends on its own stock, as follows :

+---------------------------------------------------+ ¦Year¦Dividends ¦Net income ¦Taxes paid¦Dividends¦ +----+-----------+-------------+----------+---------¦ ¦ ¦received ¦or (net loss)¦ ¦paid ¦ +----+-----------+-------------+----------+---------¦ ¦1926¦$108,888.27¦$172,594.88 ¦$10,094.29¦$27,600 ¦ +----+-----------+-------------+----------+---------¦ ¦1927¦114,794.62 ¦143,836.40 ¦6,279.72 ¦27,900 ¦ +----+-----------+-------------+----------+---------¦ ¦1928¦138,599.00 ¦153,032.81 ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1929¦155,913.00 ¦118,739.52 ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1930¦162,655.00 ¦178,736.20 ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1931¦141,144.85 ¦165,256.80 ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1932¦43,001.67 ¦(104,993.99) ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1933¦29,937.05 ¦59,100.13 ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1934¦101,123.69 ¦103,977.98 ¦416.73 ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1935¦115,899.00 ¦165,591.52 ¦6,856.78 ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1936¦52,313.10 ¦82,036.33 ¦4,381.78 ¦84,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1937¦3,304.74 ¦19,929.59 ¦1,127.78 ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1938¦4,070.00 ¦(34,261.33) ¦ ¦28,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1939¦4,110.00 ¦(80,772.89) ¦ ¦7,000 ¦ +----+-----------+-------------+----------+---------¦ ¦1940¦4,675.00 ¦94,691.71 ¦10,065.61 ¦ ¦ +----+-----------+-------------+----------+---------¦ ¦1941¦66,420.00 ¦162,049.94 ¦32,483.82 ¦ ¦ +----+-----------+-------------+----------+---------¦ ¦1942¦64,765.00 ¦169,898.65 ¦45,939.36 ¦ ¦ +----+-----------+-------------+----------+---------¦ ¦1943¦85,045.00 ¦(230,646.29) ¦ ¦ ¦ +---------------------------------------------------+

The surplus or (deficit) reflected by petitioner's books at the end of each of the calendar years 1935 to 1943, inclusive, was as follows:

+-------------------------------------------------------+ ¦Dec. 31, 1935¦$1,921,105.08¦Dec. 31, 1940¦($225,512.56)¦ +-------------+-------------+-------------+-------------¦ ¦Dec. 31, 1936¦361,647.37 ¦Dec. 31, 1941¦(109.159.85) ¦ +-------------+-------------+-------------+-------------¦ ¦Dec. 31, 1937¦303,976.37 ¦Dec. 31, 1942¦5,219.83 ¦ +-------------+-------------+-------------+-------------¦ ¦Dec. 31, 1938¦299,378.77 ¦Dec. 31, 1943¦181,089.20 ¦ +-------------+-------------+-------------+-------------¦ ¦Dec. 31, 1939¦63,956.07 ¦ ¦ ¦ +-------------------------------------------------------+

The surplus set forth above as of December 31, 1935, is on the basis of carrying petitioner's stock in American, Mill Creek, and Inland at cost. The surplus and (deficit) figures for the years 1936 to 1943 are after annual adjustment for the write-down of petitioner's stock in those companies to market value.

Petitioner's balance sheets, after reflecting the annual adjustment for the write-down of petitioner's investment in the stock of American, Mill Creek, Inland, and two other small companies, as of December 31, 1940, 1941, 1942, and 1943, were as follows:

+-----------------------------------------------------------------------------+ ¦ ¦Dec. 31, ¦Dec. 31, ¦Dec. 31, ¦Dec. 31, ¦ ¦ ¦1940 ¦1941 ¦1942 ¦1943 ¦ +-------------------------+------------+------------+------------+------------¦ ¦ASSETS ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Cash ¦$42,827.79 ¦$94,811.78 ¦$304,753.79 ¦$248,194.24 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Accounts receivable ¦696,666.92 ¦906,232.78 ¦757,969.10 ¦697,175.24 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Inventory ¦ ¦ ¦39,592.07 ¦38,450.17 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Certificate of deposit ¦ ¦284,412.48 ¦375,000.00 ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Investments in stock of: ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦American ¦522,300.00 ¦534,504.00 ¦539,100.00 ¦677,250.00 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Mill Creek ¦49,018.87 ¦52,796.25 ¦48,291.75 ¦277,281.80 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Inland ¦47,326.07 ¦28,801.91 ¦17,812.31 ¦27,290.84 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Casco Corporation ¦1.00 ¦1.00 ¦1.00 ¦1.00 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Brooklyn Edison Co ¦3,650.00 ¦6,000.00 ¦5,800.00 ¦5,000.00 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Dead River Co ¦75,000.00 ¦75,000.00 ¦75,000.00 ¦75,000.00 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Total investments ¦697,295.94 ¦697,103.16 ¦686,005.06 ¦1,061,823.64¦ +-------------------------+------------+------------+------------+------------¦ ¦ ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Deferred charges ¦$3,320.44 ¦$4,050.78 ¦$1,428.75 ¦$4,622.40 ¦ +-------------------------+------------+------------+------------+------------¦ ¦Furniture, fixtures and ¦4,498.26 ¦5,819.26 ¦5,806.97 ¦4,674.68 ¦ ¦automobiles ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Life insurance, cash ¦ ¦ ¦ ¦7,703.00 ¦ ¦surrender value ¦ ¦ ¦ ¦ ¦ +-------------------------+------------+------------+------------+------------¦ ¦Total ¦1,444.609.35¦1,992,430.24¦2,170,555.74¦2,062,643.37¦ +-----------------------------------------------------------------------------+

LIABILITIES AND CAPITAL Notes payable 344,671.96 250,000.00 175,000.00 Accounts payable 260,226.86 332,858.02 476,896.55 506,554.17 Reserve for taxes 19,895.05 34,060.11 48,439.36 Capital stock 1,390,000.00 1,390,000.00 1,390,000.00 1,200,000.00 Surplus or (deficit) (225,512.56) (109,159.85) 5,219.83 181,089.20 Total 1,444,609.35 1,992,430.24 2,170,555.74 2,062,643.37

Toward the end of the year 1939 or early in 1940, petitioner's attorney, Henry S. Miller, examined petitioner's balance sheets and advised petitioner's directors that, in his opinion, there was a serious question whether petitioner had any surplus available for the payment of dividends under New York law, and he further advised the directors to discontinue the payment of dividends. He repeated this advice from time to time during 1940 and 1941.

During the years 1942 and 1943 Rover advised petitioner's officers and directors that there was a serious question as to the legality of the payment of dividends by petitioner, in view of the deficits reflected by petitioner's balance sheets and the contingent liability in connection with the Steinbugler litigation until it was settled in 1943.

During the year 1943 William C. Atwater, Jr., consulted petitioner's attorney, Charles B. McInnis, stating that he was very anxious to have petitioner pay a dividend, and requested an opinion as to whether petitioner could legally pay such a dividend. He was advised by the attorney that, in his opinion, petitioner's surplus was restricted by an amount in excess of the surplus reflected by its last balance sheet and that petitioner could not legally pay a dividend.

Petitioner required considerable cash with which to make its monthly settlements with the mines. During 1942 petitioner paid cash to the mines for coal shipped during the preceding month, as follows:

+------------------------+ ¦Jan. 22 ¦$419,996.97 ¦¦¦ +--------+-------------++¦ ¦Feb. 21 ¦374,516.24 ¦¦¦ +--------+-------------++¦ ¦Mar. 21 ¦376,275.61 ¦¦¦ +--------+-------------++¦ ¦Apr. 22 ¦409,774.09 ¦¦¦ +--------+-------------++¦ ¦May 22 ¦363,789.93 ¦¦¦ +--------+-------------++¦ ¦June 22 ¦386,994.43 ¦¦¦ +--------+-------------++¦ ¦July 22 ¦400,766.45 ¦¦¦ +--------+-------------++¦ ¦Aug. 22 ¦390,964.94 ¦¦¦ +--------+-------------++¦ ¦Sept. 22¦395,518.85 ¦¦¦ +--------+-------------++¦ ¦Oct. 22 ¦425,448.29 ¦¦¦ +--------+-------------++¦ ¦Nov. 23 ¦392,448.24 ¦¦¦ +--------+-------------++¦ ¦Dec. 22 ¦376,613.39 ¦¦¦ +--------+-------------++¦ ¦Total ¦4,713,107.43 ¦¦¦ +------------------------+

Petitioner's cash balance after the settlement on December 22, 1942, was $93,099.42. On December 31, 1942, its cash balance was $304,753.79. On January 22, 1943, it made a cash settlement with the mines of $375,575.37, after which its cash balance on that day was $33,325.90.

The stock of petitioner during the years 1942 and 1943 was owned as follows:

+-----------------------------------------------------------------------------+ ¦ ¦1942 ¦1943 ¦ +-----------------------------------------------------------+--------+--------¦ ¦ ¦Shares ¦Shares ¦ +-----------------------------------------------------------+--------+--------¦ ¦Total shares authorized ¦20,000 ¦20,000 ¦ +-----------------------------------------------------------+--------+--------¦ ¦Number of shares outstanding ¦15,000 ¦15,000 ¦ +-----------------------------------------------------------+--------+--------¦ ¦Less number of shares in treasury ¦1,100 ¦3,000 ¦ +-----------------------------------------------------------+--------+--------¦ ¦Total ¦13,900 ¦12,000 ¦ +-----------------------------------------------------------+--------+--------¦ ¦Chase National Bank of New York, trustee under trust dated ¦7,500 ¦7,500 ¦ ¦Feb. 9, 1931 (income payable to Ida W. Atwater) ¦ ¦ ¦ +-----------------------------------------------------------+--------+--------¦ ¦Old Colony Trust Co. and Curtis M. Hutchins, trustees, ¦1,320 ¦1,320 ¦ ¦under trust of Charles P. Hutchins, dated 7/1/1931 ¦ ¦ ¦ +-----------------------------------------------------------+--------+--------¦ ¦William C. Atwater, Jr ¦795 ¦795 ¦ +-----------------------------------------------------------+--------+--------¦ ¦John J. Atwater ¦225 ¦25 ¦ +-----------------------------------------------------------+--------+--------¦ ¦H. A. Whitten & Co ¦570 ¦570 ¦ +-----------------------------------------------------------+--------+--------¦ ¦Marjory W. Atwater ¦ ¦200 ¦ +-----------------------------------------------------------+--------+--------¦ ¦David H. Atwater ¦795 ¦795 ¦ +-----------------------------------------------------------+--------+--------¦ ¦Margaret A. Olds ¦795 ¦795 ¦ +-----------------------------------------------------------+--------+--------¦ ¦John L. Steinbugler (in litigation) ¦1,500 ¦ ¦ +-----------------------------------------------------------+--------+--------¦ ¦George A. Dies ¦150 ¦ ¦ +-----------------------------------------------------------+--------+--------¦ ¦George H. Lachnicht ¦150 ¦ ¦ +-----------------------------------------------------------+--------+--------¦ ¦Emmanuel Lichtenstein ¦100 ¦ ¦ +-----------------------------------------------------------+--------+--------¦ ¦Total ¦13,900 ¦12,000 ¦ +-----------------------------------------------------------------------------+

Ida W. Atwater is the widow of William C. Atwater, Sr. She had no taxable income for the calendar year 1942 and had taxable income of $1,098.48 for the calendar year 1943.

William C. Atwater, Sr., during his lifetime and after his death, his estate, and Ida W. Atwater had deposit accounts with petitioner similar to the Steinbugler deposit account. Petitioner charged interest on debit balances in these accounts and allowed interest on credit balances. The debit or credit balances in these accounts as of December 31 for the years 1936 to 1943, inclusive, were as follows (credit balances are in parentheses) :

+--------------------------------+ ¦Year ¦William C. ¦Ida W. ¦ +-------+--------------+---------¦ ¦ ¦Atwater, Sr., ¦Atwater ¦ +-------+--------------+---------¦ ¦ ¦or his estate ¦ ¦ +-------+--------------+---------¦ ¦1936 ¦($7,094.40) ¦$8,696.09¦ +-------+--------------+---------¦ ¦1937 ¦33,865.21 ¦18,417.52¦ +-------+--------------+---------¦ ¦1938 ¦(10,615.41) ¦26,152.61¦ +-------+--------------+---------¦ ¦1939 ¦(43,303.06) ¦29,276.08¦ +-------+--------------+---------¦ ¦1940 ¦(39,894.63) ¦44,464.38¦ +-------+--------------+---------¦ ¦1941 ¦(35,963.41) ¦57,203.84¦ +-------+--------------+---------¦ ¦1942 ¦1,442.05 ¦68,899.81¦ +-------+--------------+---------¦ ¦1943 ¦(12,832.57) ¦None ¦ +-------+--------------+---------¦ ¦Average¦(1,429.95) ¦3,163.88 ¦ +--------------------------------+

Each of petitioner's directors believed in good faith that petitioner needed all of its available cash for the carrying on of its business; that petitioner had no free surplus out of which to pay a dividend; and that the payment of a dividend during the years 1942 and 1943 might have subjected them to liability under the New York law.

Petitioner is not a mere holding on investment company.

Petitioner did not during the calendar year 1942 permit its earnings or profits to accumulate beyond the reasonable needs of its business.

Petitioner was not formed for the purpose of preventing the imposition of the surtax upon its shareholders, and it was not availed of for that purpose during the calendar year 1942.

OPINION.

BLACK, Judge:

The issues fall into three main divisions, previously mentioned, and will be considered in that order.

Steinbugler Litigation Issues.

The issues under this main division are whether the respondent erred in making the adjustments labeled (a) and (b) for 1942 and (a), (b), and (c) for 1943, which we have set out in our opening statement.

We first consider adjustment (b) for 1943, because upon our decision as to that adjustment will largely depend our decision as to the other four adjustments. Petitioner deducted on its return for 1943 the amount of $308,909 as ‘Judgment awarded in litigation‘ and attached to the return a long memorandum in explanation thereof, the last paragraph of which is as follows:

This entire transaction arose out of an employment contract and the entire payment is deductible under the principle decided by the Tax Court of the United States in the United States Steel Corporation versus Commissioner, 2—T.C. No. 52, decided July 20, 1943. (2 T.C. 430.)

The manner in which petitioner arrived at the amount of $308,909 is set out in our findings, together with a detailed analysis of the total cash payment of $388,013.97. Petitioner now concedes that is is not entitled to a deduction of the full amount deducted on the return. It contends that under this issue it is entitled to deduct, under section 23(a)(1)(A) of the Internal Revenue Code, the damages determined by the New York courts in the amount of $270,767.25, plus the unexplained addition of $20 actually paid by petitioner, or a total deduction under this issue of $270,787.25, or, in alternative, that it is entitled to deduct the entire payment which petitioner was compelled to pay Steinbugler with respect to the 1,200 shares, plus the excess of the amount which petitioner was compelled to pay for the 300 shares over the fair market value of the said 300 shares at the date when the decision became final, namely, January 14, 1943.

The respondent contends that the total payment made by petitioner on January 25, 1943, of $270,787.25 (exclusive of the interest of $113,834.62 which the respondent allowed, and exclusive of the court costs of $3,392.10, and exclusive of the $116,366.75 which Steinbugler owed petitioner) was a capital expenditure for the purchase of its own stock and under section 24 of the Internal Revenue Code was not deductible.

The material provisions of the Internal Revenue Code relied upon by the parties are set forth in the margin.

SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(a) EXPENSES.—(1) TRADE OR BUSINESS EXPENSES.—(A) In General.— All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; * * *SEC. 24. ITEMS NOT DEDUCTIBLE.(a) GENERAL RULE.— In computing net income no deduction shall in any case be allowed in respect of—(2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate;(3) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

We do not find ourselves in entire agreement with either petitioner or respondent. As has already been stated, petitioner in its return took a deduction of $308,909 as ‘Judgment awarded in litigation‘ and explained this deduction as growing out of an employment arrangement with Steinbugler, and it relied on United States Steel Corporation, 2 T.C. 430, to support the deduction. On the other hand, the Commissioner contends that the transaction was not an employment arrangement at all, but simply a sale by Steinbugler of his stock to petitioner, and that petitioner could have no gain or loss in this repurchase of its stock; that its payment of the Steinbugler judgment, exclusive of the interest, was simply a capital expenditure and none of it is deductible. It, of course, requires no citation of authority to establish the principle that ordinarily a taxpayer has no gain or loss in the mere purchase of property. We think, however, the Commissioner is wrong in contending that the transactions narrated in our findings of fact under this issue were entirely a capital transaction and did not constitute in part an employment arrangement between Steinbugler and petitioner. We think they did. It seems clear to us that the original sale and delivery of the stock to Steingbugler and the reacquisition of the stock by petitioner were both essential elements of an employment contract between petitioner and Steinbugler, as repeatedly urged by the latter in the New York litigation, which view was sustained in all essential respects by the New York courts. But, while this is true, we do not agree with petitioner that the situation with which we have to deal is entirely similar to the one which existed in the United States Steel Corporation case, upon which petitioner so strongly relies.

In the United States Steel Corporation case there was a subscription plan under which the corporation's employees could make application to purchase a limited number of shares of the corporation's stock and make deferred monthly payments thereon from wages, and the corporation on its part agreed to make certain credits to the employees' stock purchase accounts equaling the dividend payments on the corporation's common stock and other annual credits in the form of special benefits as additional compensation, which credits and delivery of the stock were specifically conditioned upon the employee remaining in the corporation's service until the stock was fully paid for in the manner provided in the stock purchase agreement. Under such a plan we held that the credits to the employees' stock purchase accounts measured by dividends on the corporation's common stock and other special accounts were additional compensation paid to employees during the taxable year and were deductible by the corporation under section 23(a). We have no similar facts here. It is clear that in the United States Steel Corporation case the employee did not become a stockholder in the corporation until the purchase price was completed under the plan. All the so-called dividens which were credited to the employees' purchase account were not dividends at all, but were simply additional payments to the employee for his services, measured by the dividen rate paid by the corporation on its common stock.

In the instant case there is no doubt but that Steinbugler became a stockholder of petitioner in 1915 and 1916, when he acquired his original 100 shares of stock from petitioner. The stock certificates actually issued in Steinbugler's name and were delivered to him. When in 1922 petitioner declared a stock dividend of 1,400 per cent, Steinbugler received a new certificate, for 1,500 shares of petitioner's stock, to take the place of his original certificates for 100 shares. It is true that Steinbugler and petitioner's 3 other employees who were permitted to acquire stock were permitted to acquire it on very advantageous terms, the main feature of which was they were permitted to pay for it out of future dividends, without personal obligation to pay for it out of other funds. But they were stockholders nevertheless, and when dividends were paid by the corporation, dividends were paid on their stock as well as on the rest of the outstanding stock of the corporation, and they were true dividends. To the extent these dividends were applied as payments on the purchase price of the stock here in question, they were payments made by Steinbugler, because the dividends on his stock were undoubtedly his own property. Steinbugler was, under the original purchase agreement, to apply all his dividends on the purchase price of the stock, exclusive of that purchased for cash. Later this agreement was changed so as to require him to pay only one-half of his dividends towards the purchase price of the stock. Just how much of these dividends to Steinbugler was applied on the purchase price of his stock we do not know, nor is it important that we know. We do not have Steinbugler before us as a taxpayer and we have no issue to determine as to the cost basis of his stock or when or how he was taxable on the gains which he had from the transactions. Cf. though, Joseph W. Frazer, 4 T.C. 1152; affd., 152 Fed.(2d) 282.

Since we have held that the arrangement between Steinbugler and petitioner was an employment contract between them, despite its dissimilarity to the United States Steel Corporation case, upon which petitioner so strongly relies, the question is, as we view it, how much of the $387,134 principal of the judgment in favor of Steinbugler which petitioner had to pay is it entitled to deduct in the year of payment as additional compensation to Steinbugler. It is clear that petitioner is not entitled to deduct the full amount of $308,909 which it originally claimed on its return. As we have already stated, petitioner no longer contends that it is entitled to deduct that much Petitioner's main contention now is:

The cash payment of $270,787.25, representing the principal of the judgement (after the deduction of the amount owing by Steinbugler to Petitioner), which Petitioner was required to pay to Steinbugler pursuant to the final decision of the Court of Appeals of New York, constitutes additional compensation to Steinbugler or damages arising out of an employment contract and is an ordinary and necessary expense incurred by Petitioner in carrying on its trade or business. As such it is deductible in computing Petitioner's taxable income for the year 1943, the year in which the judgment became final.

It seems to us that another view would be that petitioner, in its settlement of the principal amount of the judgement of $387,134, acquired from Steinbugler property, namely 1,500 shares of petitioner's common stock, which had a value of $115.36 per share or a total of $173,040. Subtracting this $173,040 from the principal of the judgment, $387,134, which petitioner satisfied, leaves $214,094 for which petitioner received no offsetting asset, and it seems reasonable to hold that at least this much of the payment which petitioner made in 1943 represented additional compensation to Steinbugler for his services over the years which intervened between the time when Steinbugler purchased his stock and when he resigned from petitioner's service in 1936. It was not possible until 1943 to determine what amount petitioner would have to pay as a result of the litigation. It was in 1943 that petitioner paid the amount of the judgment, and it is for that year that petitioner is entitled to a deduction resulting from the payment of the judgment, although not in the entire amount which it claimed. Cf. Electric Storage Battery Co., 39 B.T.A. 121. We hold that petitioner is entitled to a deduction in 1943 of at least $214,094 on account of the payment of this Steinbugler judgment and that amount should be used as a deduction in a recomputation under Rule 50, instead of the $308,909 which petitioner claimed on its return for that year. The fact that such additional compensation is for services rendered by Steinbugler in prior years is not material. Lucas v. Ox Fibre Brush Co., 281 U.S. 115; Hudson Motor Car Co. v. United States, 3 Fed.Supp. 834.

In view of our holding that petitioner is entitled to deduct the above mentioned amount of $214,094 in 1943, it is apparent that petitioner has no net income for 1943 and, therefore, it becomes unnecessary to consider adjustments (a) and (c) for 1943.

We next consider as one issue adjustments (a) and (b) for 1942. The facts as to these adjustments are set forth in our findings. These facts in substance show that in the litigation with Steinbugler petitioner was not endeavoring to acquire any capital asset. It was not defending the title to any stock which it already owned. On the contrary, it was strenuously resisting the suit of Steinbugler, a former employee, in the regular course of its business. The very essence of this litigation was Steinbugler's effort to enforce an employment contract to repurchase the stock at a price which Steinbugler thought he was entitled to receive. Petitioner contested both its obligation to repurchase and the amounts asked for by Steinbugler. Title to the stock was involved only incidentally. The fact that petitioner was the loser in this litigation and was forced to acquire the stock against its will and pay the judgment which Steinbugler obtained against it does not, in our opinion, impair its right to deduct the litigation expenses of that suit. We hold hold that the amounts expended by petitioner in 1942 for legal fees and litigation expenses, all in connection with the Steinbugler litigation, are deductible in 1942 under section 23(a)(1)(A), supra. Cf. Kornhauser v. United States, 276 U.S. 145; Welch v. Helvering, 290 U.S. 111.

Capital Stock Tax Issues.

The issues under this main division are whether the respondent erred in making adjustment (c) for 1942 and adjustment (d) for 1943, which adjustments we have set out in our opening statement. The facts concerning these issues are fully stated in our findings and need not be repeated here. Ordinarily, in view of our holding under the Steinbugler litigation issues that petitioner is entitled to deduct $214,094 in 1943, which leaves petitioner without any net income for that year, it would not be necessary to consider adjustment (d) for 1943. However, it is believed that a consideration of this issue will aid in the solution of the issue relative to adjustment (c) for 1942.

Relative to the amount of $202.50 which the respondent added to petitioner's income under adjustment (c) for 1942, petitioner contends that the proper way to treat this item is to disallow $202.50 of the $2,702.50 allowed for 1941. We express no opinion as to what should be done for 1941, as that year is not before us. Cf. Baltimore Transfer Co., 8 T.C. 1. In Athens Roller Mills, Inc. v. Commissioner, 136 Fed.(2d) 125, the Circuit Court of Appeals for the Sixth Circuit, among other things, said:

The income taxing Statutes contemplate that tax liability is to be determined for annual periods on the basis of facts existing at the end of each such period. Under this plan, items deducted from gross income in one year and recovered in a later year become gross income in the year of recovery. The concept of the taxing statutes is violated if items of either gross income or deductions for different years are commingled. Burnet v. Sanford & Brooks Co., 282 U.S. 359.

In the instant proceeding the $202.50 which was allowed as a deduction in 1941 as part of the deduction of $2,702.50 allowed for that year was in no sense ‘recovered‘ by petitioner in 1942. No refund of $202.50 was collected by petitioner in that year. The respondent was, therefore, in error in adding the amount of $202.50 to petitioner's income for the year 1942.

Relative to the disallowance of the amount of $2,498.75 for 1942 and the additional allowance of the same amount for 1943, we approve the respondent's determination. Petitioner kept its books and filed its returns upon the accrual basis. It did not accrue its capital stock tax liability until the calendar year in which the capital stock tax period ended and payment was made. This was error, as it was in effect placing these items on a cash basis. We have consistently held (except where a taxpayer treated its capital stock tax liability on a monthly accrual basis, as was done in Atlantic Coast Line Railroad Co., 4 T.C. 140, and was not done in the instant case) that the capital stock tax liability accrues at the beginning of the capital stock tax period rather than at its close. Bowman Hotel Corporation, 24 B.T.A. 1193, 1208 (issue No. 4); Continental Baking Corporation v. Helvering, 77 Fed.(2d) 119; T. H. Symington & Son, Inc., 35 B.T.A. 711, 750 (issue No. 6); and Louisiana Delta Hardwood Lumber Co., 7 T.C. 994 (issue No. 2).

Section 102 Issues.

As set out in our opening statement, the respondent determined that petitioner was subject to the surtax computed at the rates prescribed by section 102 of the Internal Revenue Code for the calendar years 1942 and 1943. In view of our holdings relative to the Steinbugler litigation issues, it is apparent that petitioner had no net income for 1943 and could not be subject to any surtax for that year. We need, therefore, consider only whether the respondent erred in determining that petitioner was subject to the surtax for the calendar year 1942. The applicable statute (sec. 102, I.R.C.) is set forth in the margin.

SEC. 102. SURTAX ON CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS.(a) IMPOSITION OF TAX.— There shall be levied, collected, and paid for each taxable year (in addition to other taxes imposed by this chapter) upon the net income of every corporation (other than a personal holding company as defined in section 501 or a foreign personal holding company as defined in Supplement P) if such corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation, through the medium of permitting earnings or profits to accumulate instead of being divided or distributed, a surtax equal to the sum of the following:(b) PRIMA FACIE EVIDENCE.— The fact that any corporation is a mere holding or investment company shall be prima facie evidence of a purpose to avoid surtax upon shareholders.(c) EVIDENCE DETERMINATIVE OF PURPOSE.— The fact that the earnings or profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon shareholders unless the corporation by the clear preponderance of the evidence shall prove to the contrary.

The respondent did not determine, and he does not contend, that petitioner was ‘formed‘ for the prohibited purpose. He did determine and he does contend that petitioner was ‘availed of‘ for that purpose. It may also be noted that the respondent did not determine, nor does he contend, that petitioner was ‘a mere holding or investment company‘ as that term is used in section 102(b). It is clear, of course, that the petitioner is not a mere holding or investment company, but is a very active business enterprise, with a large volume of business. It was formed in 1909, long before there was any surtax on the income of corporations, for the purpose of engaging in the business of selling coal on a commission basis for various coal mines, financing the accounts, and collecting from its customers, and it was engaged continuously in that business up to and including the taxable years here in question.

Large amounts of cash were required by petitioner in carrying on its business. To get this cash petitioner frequently had to borrow large sums of money. The respondent determined and contends that during the calendar year 1942 petitioner permitted its earnings or profits ‘to accumulate beyond the reasonable needs of the business,‘ as that phrase is used in section 102(c) of the code. By virtue of section 102(c), the accumulation of earnings or profits beyond reasonable needs is determinative of a purpose to prevent the imposition of the surtax upon the shareholders, unless the corporation by a clear preponderance of evidence proves to the contrary. See Whitney Chain & Mfg. Co., 3 T.C. 1109; affd., 149 Fed.(2d) 936.

Whether petitioner during the taxable year 1942 permitted its earnings or profits ‘to accumulate beyond the reasonable needs of the business‘ and whether petitioner was ‘availed of‘ for the prohibited purpose are questions of fact, to be determined from all the evidence. See secs. 19.102-2 and 19.102-3 of Regulations 111. See also Helvering v. National Grocery Co., 304 U.S. 282; Helvering v. Chicago Stock Yards Co., 318 U.S. 693; Cecil B. DeMille, 31 B.T.A. 1161; affd., 90 Fed.(2d) 12; certiorari denied, 302 U.S. 713; and Lion Clothing Co., 8 T.C. 1181.

We do not deem it necessary to enter into a lengthy repetition of the facts, which are fully set forth under this issue in our findings of fact, and on the basis of such facts we think petitioner has met its burden of proof. From those facts we are well convinced that petitioner's failure to pay dividends in 1942 was not due to any intent or purpose of preventing the imposition of the surtax upon its shareholders, but, on the contrary, was due to a necessity which it, in good faith, believed existed for conserving its cash to meet the reasonable needs of its business, particularly in view of the Steinbugler litigation then pending and not yet finally decided and the legal and accounting advice which it had received from reputable sources that it could not in that year lawfully pay dividends under the laws of the State of New York.

We decide this issue in favor of petitioner.

Reviewed by the Court.

Decision will be entered under Rule 50.