Doan Sav. & Loan Co. v. Commissioner

*772 This proceeding is for the redetermination of deficiencies in income tax for the years 1920 and 1921 in the amounts of $354.19 and $1,828.80, respectively, resulting from the disallowance of claims for abatement. The issues are: (1) Whether the petitioner was exempt from taxation during said years as a domestic building and loan association, under the provisions of section 231(4) of the Revenue Acts of 1918 and 1921, and (2) if not so exempt, whether certain amounts should be included in the computation of net income for each of said years, as representing dividends on stock.

*773 By amended answer filed April 7, 1927, the respondent alleged that the petitioner, in determining its net taxable income for the year 1920, deducted the amount*3461 of $41,493.95, which represented dividends paid on stock; that the petitioner's net taxable income for said year was $49,785.53, instead of $8,291.58, the amount shown on the petitioner's return and in the deficiency letter; and that the correct tax liability of the petitioner for said year is $4,503.58 instead of $354.19.

With respect to the year 1921, the respondent alleged in said amended answer that the petitioner, in determining its net taxable income for said year, deducted the amount of $47,092.37, which represented dividends paid on stock; that the petitioner's net taxable income for said year was $68,688.80, instead of $21,596.43, the amount shown on the petitioner's return and in the deficiency letter; and that the correct tax liability of the petitioner for said year is $7,985.78 instead of $1,828.80.

FINDINGS OF FACT.

The petitioner is a corporation organized under the laws of Ohio, relating to building and loan associations, with its principal office at Cleveland. It was organized December 9, 1912, with an authorized capital stock of $500,000, divided into 5,000 shares of $100 each, and in January, 1914, its capital stock was increased to $5,000,000, divided*3462 into 50,000 shares of $100 each.

During the years involved herein, the petitioner carried on its business under the supervision of, and made annual reports to, the Inspector of Building and Loan Associations of the State of Ohio.

As shown by its articles of incorporation, the petitioner was formed "for the purpose of raising money to be loaned to its members and others on Real Estate security, to buy and build homes, and for such other purposes as are authorized by law."

During the years 1920 and 1921, the petitioner derived its funds from four principal sources, which, together with the amounts received therefrom on the respective dates material here, were as follows:

During the years involved, the petitioner paid interest on deposits at the rate of 5 per cent per annum, and dividends of 7 per cent on paid up and running stock. Loans made for home purposes were repayable *774 in 165 monthly installments, *3463 each of 1 per cent of the amount of the loan. There was no fixed rate of interest charged on loans, but the monthly repayment plan provided for the return of the principal plus an amount equal to an annual rate of 7.98 per cent of the amount borrowed. No bonuses were charged borrowers.

The payment of dividends was governed by the petitioner's by-laws, which provided:

Sec. 24. Such dividends as the Board may declare shall be divided among the members in proportion to the amount of money deposited on stock by each, and the length of time the same has been on deposit with the Company, less the withdrawals.

The matter of withdrawals was governed by the following provision of the by-laws:

Sec. 21. Members and special depositors whose stock or deposits are not pledged to this company, may, at the discretion of the Executive Board, upon written application to the Secretary, withdraw all or any part of their stock, credits or deposits, at any time without previous notice, * * * and the liability to further dues, and the right to dividends on stock credits and interest on special deposits shall cease with any application to withdraw. All persons withdrawing shall be entitled*3464 to receive the amount of all credits at the time of the application to withdraw, less any member's share of the Company's loss in excess of the reserve fund * * *.

During the year 1920, the petitioner made 50 loans, amounting to $349,450, one of which was made to an individual who was not a stockholder. The individuals and firms to whom the remaining 49 loans were made subscribed for 43 shares of the petitioner's capital stock having a par value of $4,300. Among these borrowers were 9 individuals or firms who obtained more than one loan, and each of whom subscribed for only one share of stock.

The following loans, made during the year 1920, were not for the purpose of acquiring, improving or building homes for occupancy by members of the petitioner, but were loans on homes for investment or other purposes, including one loan to a non-member:

*3465 *775 The loans made to members during the years 1920 for investment purposes and to one nonmember amounted to more than 68.06 per cent of the total loans made during that year.

During the year 1921, the petitioner made 50 loans, amounting to $409,900, three of which were made to firms who were not stockholders of the petitioner. The following loans made during 1921 were not for the purpose of acquiring, improving or building homes for occupancy by members of the petitioner, but were loans on homes for investment or other purposes, including three loans to two nonmembers:

*3466 *776 Total loans made to borrowers (stockholders and nonstockholders) during the year 1921 for purposes of investment amounted to more than 49.1 per cent of the total loans made during that year.

The five largest loans made by the petitioner which remained unpaid during 1920, and the purposes of said loans, were as follows:

The five largest loans made by the petitioner which remained unpaid during 1921, and the purposes of said loans, were as follows:

All loans made during the years 1920 and 1921, for purposes other than that of enabling the petitioner's members to acquire homes, were made from surplus funds not required at the time for*3467 home purposes. At all times, applications for home loans were given precedence over applications for other loans, and the petitioner at no time refused an application for a home loan if the security offered was satisfactory to its officers.

At January 15, 1921, there were 605 stockholders, including borrowing and nonborrowing members of the petitioner, 208 borrowers and 1,124 depositors.

At January 15, 1922, there were 650 stockholders, including borrowing and nonborrowing members of the petitioner, 192 borrowers and 1,082 depositors. The petitioner owned real estate and a 99-year lease on an office building. Its income from rentals amounted to $7,939.08 for the calendar year 1920, and $10,769 for the calendar year 1921.

The petitioner claimed as a deduction in its income-tax return for the year 1920 the amount of $67,365.63 on account of interest paid in that year, which amount was made up of the following items:

*777 The petitioner claimed as a deduction in its income-tax return for the year 1921 the amount*3468 of $66,924.34 on account of interest paid during said year, which amount was made up of the following items:

Accounts of savings depositors were not subject to be drawn upon by check or draft, but deposits could be withdrawn upon presentation by the depositor of his pass book. The petitioner carried no checking or commercial accounts of any kind, discounted no bills of exchange or notes, sold no mortgages or other securities, made no loans on personal credit, and did not engage in underwriting.

OPINION.

TRAMMELL: The first issue for consideration is whether the petitioner was exempt from taxation for the years 1920 and 1921. The Revenue Act of 1918, in effect during the calendar year 1920, provides in section 231(4) that "domestic building and loan associations" shall be exempt from taxation. The Revenue Act of 1921, which is controlling for that year, provides in the same numbered section that "domestic building and loan associations*3469 substantially all the business of which is confined to making loans to members" shall be exempt from taxation.

The petitioner claims exemption from all tax liability for said years under said Acts, which claim the respondent has denied. Unless the petitioner was a domestic building and loan association, as that term is used in the Act last mentioned, it will be unnecessary to determine whether during the year 1921 substantially all of its business was confined to making loans to members. Thus, the issue as to both years is resolved into a single preliminary question, namely, was the petitioner during 1920 and 1921 a domestic building and loan association within the meaning of said Acts?

Congress has exempted such associations from taxation without defining the term, or providing any rule by which to determine generally whether particular associations came within the exemption. We must assume, therefore, that the term was used in its commonly understood and generally accepted meaning, particularly in view of the fact that the authorities universally recognize that building and loan associations possess certain definite and peculiar characteristics.

*3470 *778 An essential attribute of a building and loan association is mutuality, and hence its business must be confined substantially to its own members. ; . But the mutuality essential to such an association must include not only a mutuality of right with respect to the control of the association and a mutuality with respect to the assets of the association, but its primary design must be that of an instrumentality of mutual helpfulness among its members in saving and borrowing for home owning. ; affd. ; .

It is generally recognized that one of the purposes of such an association is to make loans to its members to enable them to build or acquire property for their own occupancy or use. If a corporation does not substantially meet such generally recognized requirements, it is not such a building and loan association as is contemplated by the statute, regardless of what name it may have or how it may be designated or classified by the state*3471 statute under which it was organized.

On this point, the facts here show that during 1920, the petitioner made 50 loans, amounting to $349,450, one of which was made to a nonmember. Of the 49 loans made to members, according to the petitioner's evidence, 29 loans amounting to $233,850 were made for investment purposes, and, including the loan made to the nonstockholder constituted more than 68 per cent of the total loans made in that year. The testimony did not explain the purposes of the loans, except that they were for investment in buildings. This standing alone might be interpreted as meaning investments in property to be occupied by the borrowers, but when considered in connection with all the facts of record, we conclude that the buildings in which the investments were made were not to be used or occupied by the borrowers.

This view is supported by the fact that one stockholder obtained a loan of $24,000 for investment in a building to be leased to the Government for use as a post-office building. Three other stockholders obtained 16 separate loans for investment in as many different buildings. Also, other loans were made to building contractors. Not one of these*3472 borrowers owned more than one share of stock, having a par value of $100. One borrower secured 8 loans in 1920 of the total amount of $49,850 on 8 separate pieces of property; another secured 5 loans amounting in the aggregate to $65,000. The loans averaged from approximately $6,000 to $8,000 each, and of the total loans made by the petitioner in 1920, less than 32 per cent was made for the purpose of enabling its members to acquire homes or other property for their own occupancy.

*779 The petitioner accepted savings deposits from the general public, upon which it paid interest at the rate of 5 per cent per annum, and, together with other funds, loaned this money to its members and others upon a repayment plan which netted the equivalent of interest at the rate of 7.98 per cent per annum. At the end of 1920 the petitioner had approximately 605 stockholders, 208 borrowers, and 1,124 depositors.

There was, during the year 1920, to a very material extent a lack of mutuality between the stockholders of the petitioner, on the one hand, and the borrowers and depositors, on the other.

During 1921, the petitioner made 50 loans amounting to $409,900, three of which were made*3473 to two borrowers who were not stockholders. Of the 50 loans, 12 were made to members and nonmembers for investment in business property, amounting to a total of $149,100, and 9 loans were made to members for investment in houses to be occupied as homes by others, amounting to a total of $52,400, or a total of 21 loans for investment purposes in the amount of $201,500. Less than 51 per cent of the 1921 loans were made to members for the purpose of enabling them to become owners of their own homes. At the end of 1921, the petitioner had approximately 650 stockholders, including borrowing and nonborrowing members, 192 borrowers and 1,082 depositors. What has been said above with reference to the lack of mutuality in 1920 applies in only slightly less degree to 1921.

From the record before us, it appears that during the two years involved, an average of more than 58 per cent of the petitioner's loans were commercial loans made for precisely the same purpose as loans made by commercial mortgage companies, whose incomes are subject to tax. The petitioner's loans referred to above were made for the sole purpose of earning profits for distribution amoung its stockholders, and not for*3474 the purpose of enabling its members to acquire property for their own use. And it further appears that its profits were derived in large part from the funds of savings depositors who were not members of the petitioner. The petitioner also owned real estate, from which it derived rents to the amount of $7,939.08 in 1920 and $10,769 in 1921.

As stated by the court in the Lilley case, supra, it is not thought that the making of loans to nonmembers, or borrowing from nonmembers or receiving deposits, so long as such transactions are simply incidental to the primary purpose of operating a mutual building association, would defeat the exemption, but here, upon a consideration of all facts, it is our opinion that there was a lack of the essential elements of a building and loan association as generally recognized.

*780 The determination of the respondent on the first issue is, therefore, approved.

The conclusion reached above requires that we now consider the second issue, which relates to deductions of certain amounts claimed by the petitioner as interest, but which the respondent contends represents dividends on stock.

In its tax return for 1920, the petitioner*3475 deducted from income the total amount of $67,365.63 on account of interest paid during that year. This deduction included the amount of $41,493.95, which was in fact paid to the stockholders of the petitioner as dividends on paid-up and running stock. The petitioner also deducted in its 1921 return the amount of $66,924.34, which included $47,092.37 paid to its stockholders in that year as dividends on stock. While admitting that said amounts represent dividends paid in the respective years, the petitioner contends that the deductions should be allowed either as a business expense or as interest paid on borrowed money, because of the fact that all amounts paid in by the stockholders on paid-up or running stock could be withdrawn by them at any time.

This contention of the petitioner can not be sustained. Ordinarily, interest is compensation paid for the use of money borrowed, while dividends represent that part of the earnings paid to the stockholder on his investment which is risked in the enterprise. A creditor may subject to the payment of interest not only the earnings of a corporation but may proceed against the capital assets to satisfy a just demand, while a stockholder*3476 is entitled to dividends only if and when there are net earnings subject to distribution.

The petitioner's by-laws, which governed the matter of withdrawals, provided that, "All persons withdrawing shall be entitled to receive the amount of all credits at the time of the application to withdraw, less any member's share of the company's loss in excess of the reserve fund."

Under these circumstances, it is our opinion that amounts paid in by members of the petitioner on paid-up or running stock were subject to the hazards of the business up to the date of any application to withdraw, and dividends paid thereon are not allowable deductions as interest or business expenses.

The deficiencies herein, having been determined by the respondent on the basis of the allowance of the deductions mentioned, which he now alleges were erroneous, should be redetermined by adding to income for 1920 the amount of $41,493.95 and for the year 1921 the amount of $47,092.37.

Reviewed by the Board.

Judgment will be entered under Rule 50.

TRUSSELL and MILLIKEN dissent.