Hatcher v. Commissioner

*632 This proceeding is brought to redetermine the deficiencies in income tax of J. S. Hatcher and A. Barnett for the year 1922 in the sums of $566.14 and $12,912.08, respectively. The cases involve the same question and were consolidated for hearing and decision. the petitioners allege that the respondent erred in adding to income the sums of $17,242.55 and $67,295.23, respectively, as alleged dividends received by them in the taxable year.

FINDINGS OF FACT.

On January 1, 1902, a corporation known as the Barnett Lumber Co. was organized under the laws of the State of Nebraska, under a *633 20-year charter, with capital stock of $100,000, divided into 1,000 shares of the par value of $100 each. Prior to May 19, 1919, Albert Barnett (known in this proceeding as A. Barnett) owned 488 1/3 shares and B. M. Frees owned 511 2/3 shares thereof.

On January 1, 1907, a corporation known as the J. S. Hatcher Co. was organized under the laws of the State of Nebraska, under a 25-year charter, with capital*2618 stock of $100,000 divided into 1,000 shares of the par value of $100 each. Prior to May 19, 1919, J. S. Hatcher, A. Barnett, and B. M. Frees each owned 333 1/3 shares thereof.

On January 3, 1907, a corporation known as the Warren Lumber Co. was organized under the laws of the State of Colorado, under a 20-year charter, with capital stock of $100,000 divided into 1,000 shares of the par value of $100 each. Prior to May 1, 1919, U. J. Warren, A. Barnett, and B. M. Frees each owned 333 1/3 shares thereof.

Prior to May 19, 1919, the petitioner, A. Barnett, and B. M. Frees had an understanding that in the event either stockholder desired to withdraw from the Barnett Lumber Co. the other would purchase his stock therein. The record discloses no reference to a similar agreement, as between Barnett and Frees, controlling the disposition of their respective holdings of stock in the other two corporations. Sometime prior to January 1, 1919, the health of Frees became impaired and he indicated his desire to withdraw from all three corporations. Accordingly, he entered into the following contracts with Barnett under date of May 19, 1919.

MCCOOK, NEBR., May 19, 1919.

Agreement*2619 for sale of Stock.

This agreement made this 19th day of May, 1919, in triplicate, between B. M. Frees of San Diego, California, party of the first part and A. Barnett, of McCook, Nebraska, party of the second part, witnesseth: - that the party of the first part in consideration of the covenants to be performed by the party of the second part, agrees to sell to said party of the second part Stock as hereinafter described, and subject to the following conditions.

Five Hundred Eleven and two-thirds Shares of the Capital stock of the Barnett Lumber Company, McCook, Nebraska. A dividend of thirty per cent on said Capital Stock to be paid January 2nd, 1921. A dividend of thirty per cent on said Capital Stock to be paid January 2nd, 1922. After the said mentioned dividends have been declared and paid the said party of the second part agrees to pay to said party of the first part one hundred five and 69/100 Dollars per share for said stock amounting in all to Fifty Four Thousand Seventy Eight and 5/100 Dollars.

Also three hundred thirty three and one-third shares of the capital stock of J. S. Hatcher & Company, of McCook, Nebraska, on the following conditions. A dividend of seven*2620 per cent on the capital stock of said company is to be declared and paid January 2nd, 1921. A dividend of seven per cent on the *634 said capital stock is to be paid January 2nd, 1922. After the above described dividends have been declared and paid said party of the second part is to pay to the said party of the first part One Hundred and 90/100 Dollars per share for said stock, amounting in all to thirty three thousand six hundred thirty three and 33/100 Dollars.

Also, three hundred thirty three and one-third shares of the capital stock of the Warren Lumber Company of Fort Morgan, Colorado, subject to the following conditions. A dividend of sixty five per cent on the Capital Stock of the said company to be declared and paid January 2nd, 1921. A dividend of sixty five per cent to be declared and paid January 2nd, 1922, and after the above described dividends have been declared and paid the said party of the second part agrees to pay to the said party of the first part One Hundred Seven and 35/100 Dollars per share for said Capital Stock, amounting to Thirty five Thousand Seven Hundred Eighty three and 33/100 Dollars.

Also, one hundred and ninety shares of the capital*2621 stock of L. W. Cox & Company, of Scottsbluff, Nebraska, subject to the following conditions. A dividend of seventy per cent on Capital Stock to be declared and paid January 2nd, 1921. A dividend of seventy per cent on Capital Stock to be declared and paid January 2nd, 1922. After the above mentioned dividends have been declared and paid said party of the first part agrees to pay to the said party of the second part One Hundred Forty One and 51/100 Dollars per share for said Capital Stock, amounting to Twenty Six thousand eight hundred eighty six and 90/100 Dollars.

The said above described payments for stock amounting to One hundred fifty thousand three hundred Eighty one and 61/100 Dollars are to be paid by promissory notes signed by A. Barnett and dated January 3rd, 1922, with interest at six per cent per annum. Said notes are to be dated at McCook, Nebraska, and payable to B. M. Frees at 2700 2nd St., San Diego, California.

One for thirty thousand dollars due on or before January 3rd, 1923; one for thirty thousand dollars due on or before January 3rd, 1924; one for thirty thousand dollars due on or before January 3rd, 1925; one for thirty thousand dollars due on or before*2622 January 3rd, 1926; and one note for thirty thousand three hundred eighty one and 61/100 Dollars, dated at McCook, Nebraska, January 3rd, 1922, and payable on or before January 3rd, 1927, to B. M. Frees, at 2700 2nd St., San Diego, California, with interest at six per cent per annum from date until paid.

It is agreed between the party of the first part and the party of the second part that the above described Stocks, together with copy of this contract, are to be placed escrow at the First National Bank, of McCook, Nebraska, to be held by them and delivered to said party of the second part on his complying with the terms of the contract, and on his delivering to said Bank the notes as above described.

This contract to be binding upon the parties hereto, their heirs, executors, administrators and assigns.

Witness our hands and seals this 19th day of May, 1919.

,

Party of the First Part

(Witness, Party of the First Part)

Party of the Second Part

(Witness, Party of the Second Part)

*635 Shortly after the execution of the above contract Barnett entered into contracts with*2623 Warren and Hatcher, whereby he would become the owner of an equal amount of capital stock in the Warren Lumber Co. and J. S. Hatcher Co., respectively, upon the withdrawal of Frees from those corporations. Frees died in May, 1920, and thereafter the transactions were carried on with his personal representatives.

The stock certificates representing the stock owned by Frees in the three corporations were signed in blank on the date of the above contract and, with the contract, were placed in escrow in the First National Bank at McCook, Nebr. On January 2, 1922, the last so-called dividend was paid and notes were executed pursuant to the terms of the contract of May 19, 1919. The notes aggregated $80,000, less than the amount then contractually due, Frees having withdrawn or borrowed more than the amount of the dividends set forth in the agreement. Thereupon the stock certificates representing the capital stock of Frees as set forth in the said contract were canceled and new certificates issued to the remaining stockholders in proportion to their respective interests.

The terms of the agreement of May 19, 1919, were complied with in substance, although payments by bookkeeping*2624 intries or otherwise were anticipated in some instances.

Frees utilized the Barnett Lumber Co. as a vehicle for carrying on some of his personal transactions. He borrowed money from that corporation and dealt with the Warren and Hatcher Co. by means of entries on the books of the Barnett Co.

From May 19, 1919, until January 2, 1921, no payments were made to Frees under the contract of May 19, 1919, but he was paid interest at the rate of 6 per cent from January 1, 1919, on the amounts of his investment in the several corporations. Likewise, he was charged interest on his borrowings or withdrawals from the Barnett Company and indirectly through that company from the two other corporations.

The dividends paid to Frees by the three corporations were made from the surplus funds of those companies and practically consumed his share of such funds. No corresponding dividends were declared to the other stockholders in those corporations. Payments of the dividend and interest charges contemplated by the contract of May 19, 1919, were made by appropriate bookkeeping entries on the books of the three corporations. All transactions under that contract were carried on through the*2625 three corporations and payments to Frees made thereunder were effected by the corporations either by direct payments, borrowings or withdrawals reflected in proper entries on the books of those corporations.

*636 The personal account of Frees on the books of the Barnett Lumber Co. shows the following debit balances:

During 1922 that account was closed by reason of the credits made to it representing the so-called dividends from surplus declared and paid by the three corporations.

In the year 1922 the amount charged to surplus by the Barnett Lumber Co., together with one-half of the amount so charged by the Hatcher and Warren Co., aggregated $69,193.49. Later it was discovered that $3,796.52 of this sum had been paid from surplus accumulated prior to February 28, 1913, and one-half of that amount, or $1,898.26, was deducted from the said surplus charges, leaving the sum of $67,295.23, which was considered by the respondent as income of A. Barnett. Similarly the respondent found that the surplus account of the J. S. Hatcher Co. had been charged with an aggregate*2626 of $19,140.81, representing a so-called taxable dividend to Hatcher, but $3,796 thereof had been paid from surplus accumulated prior to February 28, 1913, and one-half of that amount, or $1,898.26, was deducted from the above surplus, leaving the sum of $17,242.45 which was considered by the respondent as income to the said Hatcher.

No appropriate resolutions were passed by the several corporations authorizing the payment of the dividends provided for in the contract of May 19, 1919, or of the interest paid to Frees on the amounts invested therein by him. Dividends of 20 per cent and 10 per cent on the capital stock of the Barnett Co. and the Hatcher Co., respectively, were declared on January 3, 1921, and January 17, 1921. Such action was in the period during which the Frees estate received 6 per cent interest on his investment in the several businesses as represented by the capital stock originally owned by Frees.

OPINION.

VAN FOSSAN: The sole issue in this proceeding is whether or not the amounts paid to the personal representative of B. M. Frees during the year 1922 by the Barnett Lumber Co., the J. S. Hatcher Lumber Co., and the Warren Lumber Co. out of the surplus*2627 of those corporations, in proportion to Frees' interests therein, constitute dividends taxable to Barnett and Hatcher because made and used for their benefit.

On its face the contract of May 19, 1919, was a personal agreement between B. M. Frees and A. Barnett for the sale of certain *637 stock by the former to the latter. That contract, however, contains provisions impossible of fulfillment without recourse to the rights and powers of the makers as stockholders and officers of the corporations mentioned therein. In order to arrive at a correct interpretation and application thereof it is proper that we consider the relationship of the parties to the contract and other pertinent facts and circumstances which may throw light on the underlying purpose and intention.

The evidence shows clearly that Frees desired and intended to withdraw from the Barnett, Hatcher, Warren, and Cox companies his full interest therein. The value of that interest was to be determined by adding his proportionate share of the surplus to the par value of the stock and was to be paid to him in installments. The value of the interest of the remaining stockholders in those corporations after his*2628 withdrawal remained the same as before. In order to effect such purpose Frees and Barnett entered into the contract of May 19, 1919, as embodying the plan by which it could be accomplished most effectively. Other interested stockholders of the corporations mentioned therein acquiesced in the arrangements and assisted in carrying them out. Certain intracorporate informalities in procedure were cured by the agreement, express and implied, of all stockholders.

Dividend distributions were made neither ratably nor by the proper and usual methods governing corporate actions. We have held, however, that such irregularities will not affect the taxable status of those benefited thereby unless the rights of third persons are impaired (), and that by unanimous agreement among the stockholders of the corporation the profits may be divided and distributed other than ratably among the stockholders. (.)

While the contract of May 19, 1919, in its terms was a personal one between Frees and Barnett, yet it is apparent that it was utilized, and probably intended, as a means of acquiring on behalf*2629 of the several corporations the interest in them owned by Frees. Shortly after May 19, 1919, Barnet entered into contracts with Warren and Hatcher in accord with that purpose. The bookkeeping entries show that the corporations paid to Frees the approximate amount of his proportion of the surplus on hand on January 1, 1919. During the period from January 1, 1919, to January 1, 1922, Frees and his personal representatives borrowed and received advances of considerable sums from the several corporations. During 1922 the several corporations completed the payments from surplus as contemplated by the contract of May 19, 1919, and later the *638 deferred purchase money notes were paid in full to the Frees estate. So far as the record shows, all payments for Frees' stock in the corporation were made from the funds of those companies. The cancellation of the old Frees' stock certificates and the issuance of new certificates to the remaining stockholders in the three corporations did not serve to increase the value of their holdings. Each stockholder merely owned more shares of stock, worth in the aggregate, however, the same as before the disposal of the Frees stock.

Whatever*2630 gain or profit from this transaction was derived accrued to Frees or to his estate. In their capacity as stockholders in the corporations, Barnett and Hatcher received no taxable dividends therefrom under the contract of May 19, 1919, or through Frees' withdrawal from the companies. Their financial status was not changed. They held a larger proportionate interest in a small aggregate of assets. They neither gained nor lost by the transaction.

In our opinion, the method employed to accomplish Frees' withdrawal from the Barnett Lumber Co., the J. S. Hatcher Lumber Co., and the Warren Lumber Co. did not result in taxable gain to the petitioners.

Reviewed by the Board.

Decision will be entered under Rule 50.