*985 DIVIDENDS OR DEDUCTIONS FROM GROSS INCOME. - In connection with a reorganization of petitioner's financial structure, two individuals who owned practically all petitioner's capital stock exchanged their old stock for all the preferred stock, all of the series A special common stock and 70 percent of the series B common stock of the new setup, the remaining 30 percent of the B stock going to certain employees. Series A stockholders were to receive a dividend annually from income of certain segregated assets, which assets were to be gradually liquidated and used as a sinking fund to eventually retire the series A stock. Petitioner agreed to pay the two individuals 6 percent on the total amount it had collected from the liquidation of the segregated assets up to beginning of tax year, until such time as property of a value equal to the liquidated assets should be assigned to them. Held, such payments constituted dividends within the meaning of section 115(a) of the Act of 1928, rather than either interest or expenses under section 23 of the same act.
*168 This proceeding was brought to redetermine a deficiency in income tax for the calendar year 1929 in the amount of $1,426.38. The single error assigned in the petition is as follows:
The Commissioner erred in determining that certain money paid by the taxpayer to its two sole Special Class A Common Stockholders was a dividend and not reasonable consideration for said stockholders forbearing to compel the taxpayer to redeem their stock in accordance with the resolution of the directors and the provisions of the certificate of incorporation.
FINDINGS OF FACT.
Petitioner is a New Jersey corporation, with its principal office at Jamesburg, New Jersey. Its business is that of dealing in lumber and coal, etc. It was incorporated in 1914 with an authorized capital stock of 5,000 shares of common of the par value of $100 each, of which only 3,500 shares had been issued. On December 30, 1924, petitioner's issued and outstanding capital stock was owned by the following individuals:
| Joseph M. Perrine | 2,993 shares |
| Samuel E. Perrine | 500 shares |
| Daniel B. Malan | 3 1/2 shares |
| Jacob Wyckoff | 3 1/2 shares |
*987 The Perrine brothers desired gradually to retire from the business and eventually to transfer their ownership to Malan and Wyckoff, who were old and trusted employees of the company. They sought some means whereby the stock to be purchased progressively by *169 Malan and Wyckoff would derive its earnings from the active operation of petitioner, unhampered by the burden of certain assets, consisting of notes, bonds, mortgages, and book accounts, which were considered more or less "frozen." On December 30, 1924, petitioner therefore reorganized its financial structure by increasing its capital stock from $500,000 to $700,000 divided into 7,000 shares of $100 each. Three classes of stock were created: $350,000 of series A special common stock, $300,000 of series B common stock, and $50,000 of preferred stock. The preferred stock was 8 percent cumulative, but did not participate in the assets set aside to retire the series A special common stock. The series B stock was the ordinary stock of the corporation and its earnings were dependent on the success of petitioner's business. It alone carried voting rights and participated in the management of the corporation.
On December 30, 1924, petitioner*988 executed and filed with the Secretary of State of the State of New Jersey a "Certificate of Increase of Capital Stock", which provided in part as follows:
B. The Series A Special Common Stock may be issued as and when the Board of Directors may determine and shall entitle the holders thereof to receive out of the surplus or net earnings of each fiscal year, and the corporation shall be bound to pay thereon, a non-cumulative dividend equal in amount to all of the earnings received by said Corporation upon all Notes, Bonds, Mortgages and Book Accounts, of the said Corporation as more particularly described, enumerated and set forth in a schedule made up and filed with the Treasurer of this Corporation and set forth at length in the minutes of the said Corporation, to be paid as and when declared by the Board of Directors, but at least once in every year.
The said Series A. Special Common Stock of the said Corporation shall not in any manner participate in any other of the earnings of the said Company and the remainder of the Assets or net earnings shall, in the discretion of the Board of Directors, be distributed as dividends, after the payment of dividends on Preferred*989 Stock as hereinbefore set forth, to and among the holders of Series B Common Stock as and when the Board shall determine.
In case of liquidation, dissolution or distribution of the Assets of the Corporation the holders of Series A. Special Common Stock shall receive and the Corporation shall pay to them the total amount collected from the sale, collection or other liquidation of all Promissory Notes, Bonds and Mortgages and Book Accounts as mentioned in paragraph "B", and no part or portion of any of the other assets of the said corporation. All the other Assets of said corporation upon such liquidation, dissolution or distribution to be applied, paid to and distributed to the holders of Preferred Stock to the par amount thereof and accumulated unpaid dividends and the balance ratably among all the holders of Series B. stock without preference.
C. The corporation shall set up a Sinking Fund and all receipts on account of principal of the Bonds and Mortgages, Notes and Book Accounts mentioned in the above paragraph designated "B", shall be retained in said Sinking Fund until in the opinion of the Board of Directors of the said Corporation it is most for the best interest of*990 the said Corporation to retire all or any portion of its Series A Special Common Stock. Upon such determination to retire any or all of its Series A. Special Common Stock, the same shall be redeemed by the Board of Directors from said Sinking Fund, at par. * * *
D. *170 All income derived by the corporation from the said Sinking Fund by interest or other means shall be applied to the payment of dividends of the said Series A Special Common Stock. [Emphasis supplied.]
Certificates of series A common stock were duly issued to Joseph M. and Samuel E. Perrine and, among other things, embodied the following provision:
This certificate entitles the holder thereof to receive, and the company is bound to pay, to and amongst the holders of all the Series A. Stock issued and outstanding, the total proceeds and profits received by said Company by interest or otherwise from all Bonds and Mortgages, Notes and Book Accounts, as set aside and segregated by the Schedule in the minutes of said Company for the purpose of this stock, to be paid as and when the Board of Directors shall determine, but at least once in each year. This stock is subject to redemption as set forth in the*991 Certificate of Incorporation and has no voting power and in the event of dissolution, liquidation or other distribution of the assets of the said Company is entitled to receive all of the proceeds of the sale, distribution, collection or other liquidation of all of the Bonds and Mortgages, Promissory Notes and Book Accounts mentioned in the Certificate of Incorporation in the Paragraph relating to Series A. and as more particularly described in the Schedule set forth in the minutes and in the possession of the Treasurer of the said Perrine & Buckelew, Incorporated, and in no other of the Assets of said Company.
A schedule of the notes, bonds, mortgages, and book accounts which were segregated and set apart from the general assets to do used in the ultimate redemption of the series A special common stock, which schedule was filed with petitioner's treasurer on December 30, 1924, is summarized as follows:
| 82 notes, totaling | $48,894.58 |
| 60 bonds and mortgages, totaling | 90,169.27 |
| 172 books accounts, totaling | 77,236.15 |
| Grand total | 216,300.00 |
Of the authorized $700,000 of new stock, only $228,500 of series A special common stock, $250,000 of series B common, and*992 all the preferred, were issued, as follows:
| Stockholder | Series A | Series B | Preferred |
| Joseph M. Perrine | 213,000 | 125,000 | 40,000 |
| Samuel E. Perrine | 15,500 | 50,000 | 10,000 |
| Daniel B. Malan | 50,000 | ||
| Jacob Wyckoff | 25,000 | ||
| Total | 228,500 | 250,000 | 50,000 |
The minutes of the regular meeting of petitioner's board of directors held December 29, 1925, provide in part that:
On motion made by Mr. Malan and seconded by Mr. Wyckoff, it was decided that instead of yearly payments of the money collected from Series (A) mortgages, notes and accounts, that we pay to the holders of this stock and retire the (A) stock in blocks of $1,000 or more as soon as any of the mortgages, notes or accounts are paid. This motion was carried.
*171 Malan and Wyckoff gradually assumed the management of the petitioner's business. No sinking fund was ever created, and none of the so-called series A special common stock certificates were ever retired. During the years 1925, 1926, 1927, and 1928 amounts representing 6 percent of any liquidation of the segregated assets were paid to the two class A stockholders, the Perrine brothers. These amounts are not here in question.
*993 Up to December 31, 1928, petitioner had collected as principal from the liquidation of the segregated assets the amount of $162,687.08. These collections were mingled with the other corporate assets. In view of a prospective extended European trip and for other reasons, Joseph M. Perrine had demanded a settlement from petitioner. Wyckoff, its secretary and a director, submitted the following written proposal, which was agreed to by all stockholders:
There is due to Joseph M. Perrine and Samuel E. Perrine, the amount of $162,687.08 money collected from the series (A) accounts receivable, notes, bonds & mortgages and stock, set aside on Dec. 31st. 1924, to represent the series (A) stock of Perrine & Buckelew, Inc. In order that this may be paid to them, it is agreed by the undersigned that they will assign the following described assets to pay to Joseph M. Perrine his 426/457th portion and Samuel E. Perrine his 31/457th portion of the above named sum and they accept for this purpose the following bonds & mortgages as per list attached, amounting to $78,723.37 and the following pieces of real estate from which they are to receive from each parcel of land and premises the amount*994 set for each, as per list following herewith:
[Here follows a list of the securities and real estate to be assigned.]
These assets are hereby guaranteed for the amounts listed $162,687.08
Accepted:
For PERRINE & BUCKELEW, INC.
JOS. M. PERRINESAMUEL E. PERRINE
DANIEL B. MALAN
JACOB WYCKOFF
JOS. M. PERRINESAMUEL E. PERRINE
No such assignment of assets was actually made prior to the close of the year 1929. As shown by its balance sheet, the corporation, as at December 31, 1929, had:
| Cash and receivables | $338,098.96 |
| Inventories | 108,674.31 |
| Investments | 173,784.56 |
| Capital assets (land, buildings, etc.) | 125,538.56 |
| 746,096.39 | |
| Liabilities totaling | $110,956.24 |
| Surplus | 106,640.15 |
| Capital stock | 528,500.00 |
| 746,096.39 |
The petitioner did not desire to make the assignment above referred to immediately, as it would have weakened its financial statement *172 for credit purposes, and definitely agreed to pay 6 percent per annum of $162,687.08 until such time as the assignment was made.
Petitioner's balance sheet, both at the beginning and end of its taxable year 1929, reflects the series A special common stock as a part of its capital*995 stock liability, but does not reflect the item of $162,687.08 as a liability. The item of $162,687.08 does not appear on those balance sheets at all.
The respondent attached to his deficiency notice a statement which is in part as follows:
So-called interest on Class A stock amounting to $9,967.10 disallowed and considered to be Dividends. This Class A Stock was issued in 1924 with certain specific mortgages, investments, etc., as being especially set apart from the other assets of the corporation and to be considered as securing said Class A. Stock. When these securities were converted into cash from time to time the money was not used to liquidate the stock but was retained in the business for general business purposes. The company construes this as a loan on which they should pay interest to the two holders of this stock.
It is held, however, that the stock is simply a form of Preferred Stock, and payments on which must be called Dividends.
OPINION.
BLACK: Did the respondent err in disallowing as a deduction from gross income the item of $9,967.10?
Petitioner in its brief argues "That the so-called special common stock - Series A Certificates were not Certificates*996 of stock in fact but were in effect certificates of a restricted indebtedness" and further contends "That the payments in controversy made to the holders of the Series A Certificates were not dividends but a consideration for forbearing to enforce a legal right." Respondent contends that these contested payments were dividends paid to the holders of the corporation's special class A common stock.
Our problem is to determine whether the payments were dividends as defined in section 115(a) of the Revenue Act of 1928, or deductions from gross income under either paragraph (a) or (b) of section 23 of the same act. These statutory provisions are set forth in the margin. 1 Whether these payments are dividends or deductions *173 as either expenses or interest depends upon whether the Perrines received such payments in the capacity of shareholders or as creditors of the corporation.
*997 The question whether certain payments made by other corporations were dividends or deductions from gross income within sections 115 and 23, respectively, of the Revenue Act of 1928, and similar provisions of other revenue acts, has often been the subject of controversy before the Board and the courts. We do not deem it necessary to discuss the numerous decisions dealing with the subject. Suffice it to say that in each of the cases to which we have been cited, the decision turned on the peculiar facts and the construction given to the particular document or documents there in question. We approach the problem here presented in the same way.
It is perfectly clear that prior to the reorganization of petitioner's financial structure on December 30, 1924, the Perrine brothers were stockholders and not creditors of the petitioner. Except for the qualifying shares held by Malan and Wyckoff, Joseph and Samuel Perrine were the sole stockholders, owning six sevenths and one seventh of the stock, respectively.
Upon the issue of the new shares referred to in our findings of fact, did the Perrines become creditors of the petitioner by reason of the receipt by them of the series A special*998 common stock certificates? We think not. In his opening statement, counsel for petitioner said: "It is admitted by the petitioner it called the certificates stock certificates, and treated them as such on its books." Of course, it is well settled that the name given to an instrument is not conclusive evidence of its character. ; . But it is equally well settled that the terms used and the treatment accorded to the instrument by its creator can not be lightly set aside. ; ; ; affd., ; certiorari denied, .
In , the question was whether certain payments by a bank to certain of its depositors were dividends or interest. The question arose under an act of Congress passed in 1864 (13 Stat. L. 283), as amended in 1866 (14 Stat. L. 138), which provided that there should be levied and collected a tax*999 of 5 percent on all dividends, with a proviso "That the annual or semiannual interest allowed or paid to the depositors in savings banks or savings institutions shall not be considered as dividends." The entire opinion of Mr. Chief Justice Waite, holding the payments to be dividends, is as follows:
A distinction is expressly recognized in the act of Congress between interest and dividends, and the Circuit Court decided that the payments to the depositors *174 were for dividends. The question is whether this decision was correct.
We think it was. The depositors contracted not for a rate of interest to be paid upon their deposits, but for a share of the profits of the business in which their money was, by agreement, to be employed. It is true that the profits of the company were principally to be derived from interest upon loans made, but they were none the less on that account profits. The interest received for the loan of each deposit was not kept by itself, and paid to the depositors after deducting a charge to cover expenses, but all was placed in a common fund, and when the net result of the business was ascertained, that was divided among the several contributors*1000 according to the value of their contributions. Such a division clearly produces a dividend according to the common understanding of that term. The parties themselves so understood it, for they gave it that name in the contracts, executed when the depositors made their deposits. They stipulated for the payment of dividends and not interest.
It is true that the holders of the series A certificates alone were to share in the profits of certain segregated assets belonging to the corporation, and, in case of liquidation, in the proceeds from the sale of the assets themselves. But we fail to see wherein this fact would make the holders thereof creditors of the corporation. The payment were not to be made until declared by petitioner's board of directors, and were to be paid out of "proceeds and profits received by said company by interest or otherwise from all bonds and mortgages, notes and accounts set aside and segregated", etc. Petitioner's segregated assets were subject to the claims of its general creditors as much as were its remaining assets. These assets were kept in the business at the risk of the business. Each certificate of class A common stock specifically provided*1001 that it was a part of the issue of petitioner's capital stock "amounting in all to Seven Hundred Thousand Dollars ($700,000.00), par value, authorized by the Certificate of Incorporation of the company, as amended, dated December 30, 1924, and filed in the office of the Secretary of State of the State of New Jersey." We are, therefore, of the opinion and so hold that such series A certificates were certificates of petitioner's authorized capital stock and not, as petitioner contends, certificates of a restricted indebtedness.
We now turn to the document executed on December 31, 1928, shown in our findings of fact. Was it in effect a declaration by petitioner of a dividend in kind to the extent of $162,687.08? We think not. There was no resolution by petitioner's board of directors to that effect. But what is more important perhaps, is the fact that no assignment of the assets mentioned in that document has ever been made. Petitioner continued to use the assets therein mentioned in its business. It did not recognize this amount of $162,687.08 as a liability on its books of account. With reference to the failure of the corporation to actually assign these assets of an agreed*1002 value of $162,687.08 to its stockholders, the Perrines, at *175 the time the agreement was entered into, petitioner's witness, Jacob Wyckoff, testified as follows:
Q. Was there any conversation at that time as to when the actual assignment of these assets was to be made or any conversation in regard to the actual assignment?
A. Yes. Q. What? A. They were supposed to be assigned at that time. Q. Well, why weren't they?A. Well, they weren't assigned because we didn't want to take them out of our place.
Q. Well, what happened. You didn't want to take them out of your statement?
A. Then Mr. Perrine says - "If you don't do this, I should be compensated for it," so we agreed to pay him the equivalent of 6 per cent on the $162,000 until such time as the actual assignment was made.
Joseph M. Perrine testified to substantially the same effect. It seems to us that this oral agreement supplementing the written document of December 31, 1928, fell short of making the Perrines creditors of the corporation to the extent of $162,687.08.
It is well settled that the declaration of a dividend creates the relationship of debtor and creditor (*1003 ), and where cash dividends declared are retained by agreement with the stockholders deferring payment until there is sufficient working capital in the treasury of the corporation, the relationship is one of debtor and creditor and interest paid to the stockholders is deductible as interest (). But, as has already been pointed out, we have in the instant case no declaration of a dividend in kind amounting to the sum of $162,687.08, and no satisfactory evidence to show that the corporation became a debtor to its stockholders, the Perrines, for that amount. It seems to us that, giving full effect to the written agreement of December 31, 1928, and the oral testimony supplementary thereto, it simply shows that the Perrines agreed to remain series A common stockholders awhile longer, until such time as it would be convenient and expedient for the corporation to transfer to them the $162,687.08 in property in liquidation of their class A common stock, and in the meanwhile they should be paid dividends of 6 percent of $162,687.08. No showing is made that the*1004 $9,967.10 in issue in this proceeding was not paid out of earned profits of the corporation, and considering all the evidence we see no justification for treating the amount as anything other than a dividend. Nor can we treat the amount as a business expense incurred as petitioner contends, "as reasonable consideration for said stockholders' forbearing to compel the taxpayer to redeem their stock in accordance with the resolution of the directors and the *176 provisions of the certificate of incorporation." Dividends, such as we hold the $9,967.10 here in question to be, are not deductible as business expenses.
At the most, the agreement of December 31, 1928, and the oral agreement supplementary thereto, gave the stockholders, the Perrines, the right to demand that the corporation redeem their class A common stock by transferring to them the $162,687.08 property. This was apparently at the election of the Perrines. However, it has been held that a provision that stock is redeemable at the election of the stockholders upon notice does not create a debt. *1005 .
Neither a provision for optional redemption within a period of years nor a subsequent contract will take a payment out of the class of dividends and cause it to be deductible. ; .
The payments in issue here were not business expenses, and petitioner's contention in that respect is denied. For reasons already stated, we sustain the Commissioner.
Reviewed by the Board.
Decision will be entered for the respondent.
LEECH and TURNER dissent.
VAN FOSSAN, dissenting: I am unable to concur in the conclusion of the majority. The question in the case is whether or not certain payments were deductible business expenses of the petitioner. I believe the case turns on the agreement of December 31, 1928, and the subsequent transactions. By this agreement, after reciting that the amounts were due, the petitioner agreed to assign listed assets aggregating the amount of the claim. For corporate credit reasons, the*1006 assignment was not made, but the petitioner thereupon collaterally agreed to pay 6 percent on the sum due until such assignment should be made. The payment of 6 percent so made during 1929 give rise to the present controversy. The petitioner deducted them as interest paid. The respondent held them to be dividends.
By the agreement of December 31, 1928, the amount owned by the corporation to the Perrines was fixed and it was agreed assets should be assigned in payment. There would seem to be little doubt that the Perrines could have compelled specific performance of this agreement. The subsequent or collateral agreement to pay 6 percent on the principal amount so long as the petitioner withheld the assets and failed to make the agreed assignment was a new obligation. By *177 it the petitioner agreed to pay for the privilege of retaining the assets. Whether this new relationship was a loan of the $162,687.08 or a loan of the assets, it is not necessary to decide, but it seems clear to me the payment of the 6 percent for the use thereof was a proper business expense. The agreement to pay was absolute and was not related to the earnings on the assets or stock. It is*1007 only by an artificial and strained construction that it could be so related to the series A stock as to hold it to be dividends.
SMITH agrees with this dissent.
Footnotes
1. SEC. 115. DISTRIBUTIONS BY CORPORATION.
(a) Definition of dividend. - The term "dividend" when used in this title (except in section 203(a)(4) and section 208(c)(1), relating to insurance companies) means any distribution made by a corporation to its shareholders, whether in money or in other property, out of its earnings or profits accumulated after February 28, 1913.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. - 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; * * *
(b) Interests.↩ - All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed by the taxpayer) the interest upon which is wholly exempt from taxation under this title.