*815 Prior to 1935 petitioner operated its business under a line of credit established with the Northwestern Bank. During that period it had been petitioner's custom to divide and distribute substantially all of its earnings between its general manager and its stockholders. In 1935 the bank advised petitioner that so long as these withdrawals continued it would be required to reduce its loans and no further credit would be extended. In November 1935, at the insistence of the bank, petitioner, its general manager, and its stockholders executed a written agreement providing that so long as the bank extended a line of credit to petitioner and so long as it was indebted to the bank no withdrawals from the corporate funds for compensation or dividends would be permitted in excess of amounts stipulated. In reliance thereon the bank extended credit to petitioner and throughout the taxable periods petitioner was indebted to the bank. Held, the agreement did not prohibit petitioner from paying taxable stock dividends and it is not entitled to the credit provided for in section 26(c)(1) of the Revenue Act of 1936.
*821 The respondent determined deficiencies in income tax for the calendar year 1936 and for the period from January 1 to June 30, 1937, in the amounts of $6,084.15 and $112.39, respectively, and a deficiency in excess profits tax for 1936 in the amount of $81.40, the latter of which is not contested. The issue is whether in computing the surtax on undistributed profits imposed under section 14 of the Revenue Act of 1936 petitioner is entitled, under section 26(c)(1), to a credit against its adjusted net income by reason of a contract restricting the payment of dividends.
FINDINGS OF FACT.
Petitioner is a Washington corporation, with its principal office in St. Paul, Minnesota. It filed its income tax returns for 1936 and for the period from January 1 to June 30, 1937, with the collector of internal revenue at St. Paul, Minnesota.
Petitioner is engaged in the business of treating cedar poles and other forest products, which is done at two plants, one at St. Paul and the other at Newport, Washington. During the taxable periods ending on December 31, 1936, and June 30, 1937, petitioner kept its books and filed its income*817 tax returns on the accrual basis. In the early part of 1930 petitioner's business was owned by Lillian S. Clark, who had acquired it in November 1929 upon the death of her husband. *822 In 1930 Mrs. Clark sold the business to Ambrose Brothers of Seattle, Washington, from whom she reacquired it in February 1933, since which time she has been the principal stockholder. During 1931 and 1932 the company had been losing money and when Mrs. Clark reacquired ownership its affairs were in serious condition. Its sales had fallen off, its inventory was depleted, it had but little cash, and it was without bank credit. Following the reacquisition, M. H. Sperry was employed by petitioner as general manager. Mrs. Clark lived in California. Sperry was employed under a contract providing for an annual salary of $7,500 plus 50 percent of the net earnings. In 1933 petitioner's business began to show some improvement. Its volume of sales grew steadily and by 1935 was approximately three times that of 1932. Sperry is still in active charge of petitioner's business affairs and since July 1937 has been its president.
During 1935, up to December 30, the petitioner's authorized capital*818 stock consisted of 1,000 shares of common stock of the par value of $100 per share, all of which was outstanding and held as follows: Lillian S. Clark, 847 shares; Grace C. Pyle, daughter of Lillian S. Clark, 150 shares; E. G. Pyle, 1 share; E. M. Hays, 1 share; and M.H. Sperry, 1 share. The shares held by E.G. Pyle, Hays, and Sperry were held by them as directors' qualifying shares, the beneficial ownership being in Lillian S. Clark.
From 1933 until 1935, petitioner's business was operated under a line of credit established with the Northwestern National Bank & Trust Co. of Minneapolis, hereinafter referred to as the Northwestern Bank. Although its business had continued to improve, the petitioner in 1935 found itself without sufficient funds to purchase materials in such quantities as were necessary to handle its business. This condition was due to the fact that more capital was needed to take care of the expanding sales and the further fact that in each year all net earnings were being taken out of the business, one-half by Sperry as compensation under his contract of employment and one-half by Mrs. Clark and Mrs. Pyle in the form of dividends. In 1935 Clarence E. Hill, vice*819 president of the Northwestern Bank, advised petitioner that so long as that state of affairs continued the bank would not allow any further extension of credit, and, furthermore, would insist that existing bank loans be paid, and that the only conditions under which the bank would make any further loans were that annual withdrawals for salaries to officers and for dividends to shareholders be limited to a total of $12,000, and further that Sperry, or whoever was responsible for the active direction of the petitioner's affairs, would be required to have a personal investment at stake in the enterprise. Another bank in St. Paul with which negotiations for credit were undertaken laid down substantially the same terms.
*823 Shortly thereafter Sperry advised Mrs. Clark of the situation and she came east to discuss the matter and decide what should be done. After holding several conferences with an attorney and with the officers of the bank, she and Sperry advised the bank's vice president that the bank's terms for further extension of credit to the petitioner would be met. Pursuant thereto the interested parties entered into the following contract:
MEMORANDUM OF AGREEMENT
*820 November 18th, 1935.
THIS AGREEMENT made this day between VALENTINE CLARK CORPORATION, as first party, LILLIAN S. CLARK, as second party, and M. H. SPERRY, as third party, WITNESSETH That
WHEREAS, second party owns a large majority of the outstanding stock of said Valentine Clark Corporation and is the president of said corporation, and
WHEREAS, third party is the general manager of said corporation and employed under a contract fixing his compensation at a fixed salary plus a one-half interest in the annual net earnings of the corporation, and
WHEREAS, all three parties hereto are interested in procuring a bank line of credit of $25,000.00 for the corporation and the Northwestern National Bank and Trust Company of Minneapolis has promised to extend such a line of credit ($12,500.00 on open line and $12,500.00 secured by assignment of corporate accounts receivable) upon certain conditions,
Now, THEREFORE, in consideration of these premises and of the mutual agreements herein contained, the parties hereto mutually agree, each with the others, as follows:
1. Second party agrees that so long as such line of credit is made available to first party by said bank and/or so*821 long as any indebtedness of first party exists in favor of said bank on account of loans made under said line of credit, she will not make or permit withdrawals from the corporate funds to herself or any members of her family by way of salaries, dividends, loans or advances in excess of $6000.00 per year (which last mentioned amount, however, may be paid to her and/or any member of her family as she may designate in monthly instalments). This agreement shall become effective as of January 1st, 1936 and between that date and the date of this memorandum any such withdrawals by second party and/or any member of her family shall not exceed the sum of $700.00 per month for the months of November and December, 1935.
2. Third party agrees that so long as such line of credit is made available to first party by said bank, and/or so long as any indebtedness of first party exists in favor of said bank on account of loans made under said line of credit, he will not make withdrawals or accept payment from said corporation on account of compensation other than as follows:
(a) With regard to his salary now fixed at $7500.00 per year, he will not draw out in cash more than $6000.00 per year, *822 which may be paid to him in monthly instalments. The balance of said fixed salary shall remain as an obligation of first party to him and shall be evidenced either as a credit to him on the corporate books or by a corporate note to be given to him.
(b) With regard to his right to additional compensation to the extent of one-half of the annual net earnings of first party, he shall not withdraw any such amounts to which he may be or become entitled but the same *824 shall remain as a corporate obligation to him to be evidenced either by credits to him on the corporate books or by a corporate note or notes to be given to him.
This agreement shall become effective as of January 1st, 1936; and between that date and the date of this memorandum third party shall be entitled to withdraw the full unpaid instalments of his said fixed salary for 1935, but shall not withdraw any amounts to which he may be entitled as his share of the corporate earnings for 1935.
3. First party assents to and approves the foregoing agreements and provisions; and further agrees that it will make and keep proper corporate records of any and all amounts for which it may from time to time be obligated*823 to third party for compensation owing to him on account of such amounts by way of fixed salary and/or his share in corporate earnings which he has failed to withdraw in accordance with the foregoing provisions. First party further agrees that it will evidence its said obligations to third party, as they may from time to time accrue, at his option by credit entries in his favor upon its corporate records or by corporate notes to be given to him and said obligations shall bear interest at the rate of 5% per annum. In case of insolvency or bankruptcy proceedings, any such obligation owing from first party to third party, however evidenced, shall become immediately due and payable.
VALENTINE CLARK CORPORATION,
[Signed] BY LILLIAN S. CLARK
Its President
And GRACE C. PYLE
Its Treasurer
LILLIAN S. CLARK
M. H. SPERRYThe undersigned, Grace C. Pyle, owner of 150 shares of stock of Valentine Clark Corporation, herewith and hereby assents to and approves the foregoing agreement.
[Signed] GRACE C. PYLE
Dated November 18, 1935.
To further conform with the condition that Sperry acquire a personal investment in the enterprise, and for other reasons, Sperry, *824 Mrs. Clark, and Mrs. Pyle, on November 23, 1935, signed another written contract which provided, among other things, that Mrs. Clark and Mrs. Pyle would cause petitioner's capital structure to be revised on or before January 1, 1936, so as to authorize 1,500 shares of preferred stock of the par value of $100 each and so as to reduce and authorize common stock to 200 shares without par value; that 250 shares of the preferred stock so authorized would be issued to the L. S. Clark Corporation or its nominee (Mrs. Clark owned all the stock of L. S. Clark Corporation) in exchange for certain real estate owned by that company, that 150 shares of the preferred stock would be issued to Mrs. Pyle, and the remainder to Mrs. Clark; that of the 200 shares of authorized common stock, 50 shares would be issued to Mrs. Clark, 50 shares to Mrs. Pyle, and 100 shares to Sperry; that upon accomplishment of the foregoing, Sperry's 1933 contract of employment should be terminated and he would be given a new *825 contract running seven years beginning January 1, 1936, and providing for a minimum annual salary of $6,000, and that Mrs. Clark and Sperry would also execute an agreement modifying that*825 certain contract under date of November 18, 1935, between them and the Valentine-Clark Corporation insofar as might be necessary to give effect to the provisions governing Sperry's future employment.
The changes thus provided for in petitioner's capital structure were completed not later than December 30, 1935, and the new stock was issued on that date. Instead of being issued as set out in the contract of November 23, 1935, it was issued in such amounts and to such parties as hereinafter set forth. Of the 1,500 shares of preferred stock, 1,312 1/2 shares were issued to Mrs. Clark and the remaining 187 1/2 shares to Mrs. Pyle, and they were the owners thereof during the taxable years. Of the 200 shares of common stock, 85 shares were issued to Mrs. Clark, 15 to Mrs. Pyle, and 100 to Sperry, and the common stock was so held until August 20, 1936. From that date until June 30, 1937, the said 200 shares were held as follows: 20 shares by Mrs. Clark, 30 shares by Mrs. Pyle, 50 shares by Mrs. Clark and Mrs. Pyle as joint tenants, and 100 shares by Sperry.
At the beginning of 1935, petitioner's borrowings at the Northwestern Bank amounted to $23,000. At the insistence of the bank*826 these loans had been reduced to $7,500 by November 1935. After petitioner delivered to the bank copies of the two contracts above described, the bank opened a line of credit for petitioner. It did so in reliance upon the terms and conditions set forth in those contracts. By the end of November 1935 petitioner's loans at the Northwestern Bank amounted to $12,500; on January 1, 1936, to $21,500; on January 1, 1937, to $61,000; and on June 30, 1937, to $36,000. The highest amount of such indebtedness between January 1, 1936, and June 30, 1937, inclusive, was $71,400, in February 1937, and the lowest amount was $11,759, in June 1936. Between January 1, 1936, and June 30, 1937, the line of credit was continuously available to petitioner and during that period petitioner was continuously indebted to the bank. At no time during that period was petitioner able to make payment in full of its indebtedness to the bank without adversely affecting its business and competitive position.
In November 1936 petitioner requested the Northwestern Bank for permission to pay dividends and salaries in excess of the limits specified in the contract of November 18, 1935. Such permission was denied*827 as to dividends, but the bank gave its approval to the payment of a $2,500 bonus to Sperry and such bonus was paid.
In June 1937 petitioner requested the bank, first orally and then by letter, for permission to pay dividends in excess of the limits prescribed *826 in the contract of November 18, 1935. The bank, first orally and then by letter, gave petitioner permission to pay a dividend on its common stock of $5,000 in cash and $15,000 in petitioner's notes, on condition that such notes be subordinate to all bank loans and on the further condition that the notes mature not earlier than two years from date. A dividend was declared and paid as thus permitted.
Petitioner's balance sheets dated December 31, 1936, and June 30, 1937, show earned surplus in the respective amounts of $25,905.33 and $28,966.36.
OPINION.
TURNER: The question here is whether in determining undistributed net income for the purpose of computing the surtax on undistributed profits the petitioner is entitled to a credit under section 26(c)(1) of the Revenue Act of 1936. In that section it is provided that a credit shall be allowed in "An amount equal to the excess of the adjusted net income*828 over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends." With the consent of the bank and under the provisions of the contract of November 18, 1935, the petitioner made certain distributions to its stockholders and to Sperry, its manager, and has claimed credit under section 26(c)(1) in respect of profits not distributed, on the ground that it could not have distributed any further sums as dividends during the taxable years here involved without violating the provisions of the said contract. Holding that the contract did not prohibit the payment of further dividends, the respondent has disallowed the credits so claimed by petitioner.
The contract was in writing, it was executed by the petitioner prior to May 1, 1936, and it did expressly deal with the payment of dividends, but, says the respondent, it does not meet the test of the statute. He claims (1), citing *829 ; ; ; and , that this contract is between petitioner, its officers, and stockholders, whereas the statute contemplates a contract between the corporation and its creditors; (2) that the contract did not bar the payment of dividends to Sperry, who under the agreement with the bank was to become a stockholder and did so become a stockholder prior to January 1, 1936; and (3) that even though the contract did bar the payment of cash dividends, it still does not meet the test of the statute in that it did not bar the payment of dividends in forms other than cash.
The first two claims of the respondent are not, in our opinion, *827 well taken and the cases cited are not controlling. The contract here was not merely an agreement between members of the corporate family, which could have been changed by them at any time, as the respondent contends; its purpose was to establish a needed line of credit with the bank and it was designed to benefit and protect the bank by*830 restricting the distribution of profits so long as the line of credit should be available to the petitioner and so long as the petitioner should be indebted to the bank under the line of credit. The facts show that the line of credit contemplated by the contract was extended by the bank to the petitioner throughout the taxable periods here in question and during those periods the petitioner was indebted to the bank for substantial sums. The written contract was not executed by the bank, it is true, but it was executed by the petitioner as required by the statute and upon advancement of money to petitioner the bank had definite and substantial enforceable rights under the contract. Except to the extent specified in the contract or consented to by the bank, the petitioner could not, without violating the provisions of said contract, have made disbursements in cash or other property to its stockholders or to Sperry as its manager, so as to deplete or diminish the funds or property otherwise available for use in the business.
This leaves for consideration the final contention of the respondent, that the contract did not bar the payment of dividends in forms other than cash. Under*831 section 27(e) of the Revenue Act of 1936. a dividends paid credit is provided in the case of taxable stock dividends to the extent of the fair market value of the stock distributed. We think it apparent therefore that a contract which bars the payment of dividends in cash or other property but permits the payment of dividends in the form of taxable stock dividends is not such a contract as was contemplated by section 26(c)(1), supra. . The contract in the instant case specifically restricts withdrawals from corporate funds. The facts surrounding the making of the contract and the entering into of supplemental agreements convince us that the only thought was that except to the extent allowed by the agreement the corporate funds and properties should remain in the corporation and be available for corporate operations and that there was no thought of restricting the payment of dividends in stock, taxable or otherwise. In fact, it was contemplated that stock should be issued under some plan so as to give Sperry a proprietary interest. This was finally worked out by a rearrangement of the stock structure. Prior to the agreement the*832 authorized stock of the corporation was in the form of common stock and was limited to 1,000 shares, all of which was issued and owned by Lillian S. Clark and Grace C. Pyle. As worked *828 out to meet the desires of the bank, the stock became 1,500 shares of preferred and 200 shares of common. The preferred stock was issued 1,312 1/2 shares to Mrs. Clark and 187 1/2 shares to Mrs. Pyle, while the 200 shares of common stock were issued 85 shares to Mrs. Clark, 15 shares to Mrs. Pyle, and 100 shares to Sperry, and, except for some shifting of the common shares as between Mrs. Clark and Mrs. Pyle on August 20, 1936, the above described distribution of stock continued throughout the year 1936 and the taxable period January 1 to June 30, 1937. We find nothing in the contract of November 18, 1935, nor in the intention of the parties thereto, including the bank, which would have prohibited the payment of stock dividends, taxable or otherwise, during the taxable periods before us, and under such circumstances it can not be said that the petitioner could not have distributed taxable stock dividends during those periods without violating a provision of the said contract. *833 Compare ; ; and . The action of the respondent in disallowing the credits claimed by petitioner is accordingly sustained.
Decision will be entered under Rule 50.