*2390 1. Under the terms of a contract of sale, profits over and above the amount distributed in 1921 were so contingent that they should not be included in petitioner's income for 1921.
2. Where the actual facts show that petitioner received no dividends from a company, although book entries indicated that he did, the facts will control.
3. Negligence penalty asserted for 1920 disallowed where it appears that petitioner followed the same course as a reasonable and an ordinarily prudent man would follow.
4. Negligence penalty asserted for 1921 approved where evidence fails to rebut the determination of respondent.
*1373 This proceeding is for the redetermination of deficiencies asserted by respondent in the amounts of $300.79 for 1920, and $27,635.60 for 1921. A negligence penalty of 5 per cent was asserted by respondent for each year in the respective amounts of $15,04 and $1,381.78, in accordance with the provisions of section 250(b) of the Revenue Acts of 1918 and 1921.
The petitioner asserts error by respondent in the following particulars:
*2391 1. The respondent has determined that the petitioner derived $78,975, in 1921 from Nakom Oil & Gas Company stock, formerly Mo-Kan Oil & Gas Company, when, as a matter of fact, he received $52,975, from that source in 1921, and no greater amount accrued to him in that year.
2. The respondent undertakes to impose a tax on the petitioner by reason of a distribution of Evans-Smith Drug Company upon 320 shares of the stock of that corporation, which passed to petitioner's name from Sallie Van Evans, Walter O. Evans, James E. Gibson and E. W. Zea, when as a matter of fact this petitioner realized no gain from such distribution and is not taxable by reason of it by authority of the 16th Amendment to the Constitution.
3. The respondent undertakes to impose a penalty of 5 per cent with interest at 1 per cent per month on the total amount of the alleged deficiency for both the year 1920 and the year 1921 on the ground that the taxpayer was negligent in returning certain items of income, and in this the petitioner says the respondent erred and the petitioner was not negligent in returning such items or either of them.
4. The respondent undertakes to impose a penalty upon the entire*2392 amount of the alleged deficiency for the year 1921, including both that part of it arising from alleged negligence and that part arising from an honest difference of opinion as to the legal effect of the disclosed facts in connection with which no negligence is charged or existed, and in this the petitioner says the respondent erred because, even if it should be held that the petitioner was negligent in making his return of certain items, the penalty should not be imposed upon any deficiency arising from other items concerning which the petitioner was not negligent and that to do so would be so arbitrary and capricious and so unreasonable and would produce such inequality and injustice as to offend the 5th Amendment to the Constitution of the United States.
FINDINGS OF FACT.
Prior to 1920 the Nakom Oil & Gas Co., a Missouri corporation, acquired a one-half interest in certain oil and gas leases. The other one-half interest was owned by the Mid-Kansas Oil & Gas Co. The latter company operated the properties, drilled additional wells, and *1374 charged one-half of the expenses thereof against the Nakom Company. The Nakom Company never realized a profit from the operations*2393 which were carried on jointly by the two companies.
In 1920 Wallace Good, J. V. Holmes, and the petitioner, owning all of the 184 shares of the capital stock of the Nakom Company, entered into negotiations with Albert R. Jones, looking forward to the assignment of the one-half interest of the Nakom Company in the said leases to Jones for a consideration of $550,000. On December 4, 1920, the stockholders and Jones entered into a written agreement whereby the stockholders contracted to sell, assign, and transfer to Jones the one-half interest held by the Nakom Company in the aforesaid oil and gas leases. Jones agreed to pay $25,000 with the execution of the instrument, an additional $75,000 upon the assignment of the interest and property in said leases and to pay the balance of the $550,000 purchase price in three equal installments. The stockholders agreed to furnish Jones with abstracts showing good title satisfactory to him within 10 days from the date of the agreement.
On January 8, 1921, two separate agreements were entered into by the same parties modifying to a certain extent the prior agreement; the occasion for the new agreement being that the stockholders had failed*2394 to furnish Jones with abstracts showing good title to their interests in said leases. One of these agreements related to and modified the time when the second payment of $75,000 was to have been made by Jones. The effect of the one agreement was to extend the time of and modify the terms of payments under the contract of December 4, 1920, so that Jones was to pay the First National Bank of Kansas City, Mo., upon the vendees depositing therein the assignments covering the undivided one-half interest in the said leases. Concurrently therewith the stockholders agreed, in the alternative, to sell Jones all the stock of the Nakom Oil & Gas Co. for $550,000, subject to the payment of the company's outstanding obligations, in lieu of the assignment of the undivided one-half interest in the leases.
Jones, subsequently, exercised his right of election, and elected to purchase by taking all the stock. Thereafter a fourth agreement covering this same transaction was entered into by the same parties. The terms of this agreement were as follows (Exhibit 1, herein, refers to agreement of January 8, 1921, modifying and extending the original contract of December 4, 1920):
THIS AGREEMENT, *2395 made and entered into on this 9th day of April, 1921, by and between John T. Kennedy, Wallace Good, and J. V. Holmes, all of Kansas City, Missouri, parties of the first part, and Albert R. Jones, of Mission Hills, Johnson County, Kansas, party of the second part:
WITNESSETH: That whereas, on the 8th day of January, 1921, the parties of the first part, in behalf of Nakom Oil and Gas Company and the stockholders of the Nakom Oil and Gas Company, entered into a certain contract and agreement in writing with Albert R. Jones, party of the second part, covering the *1375 purchase and sale of certain oil and gas mining leases belonging to Nakom Oil and Gas Company or the capital stock of said Nakom Oil and Gas Company, for a consideration of Five hundred fifty thousand dollars ($550,000.00), a copy of which contract and agreement is attached hereto and marked "Exhibit 1"; and,
WHEREAS, the party of the second part has paid to first parties the sum of Twenty-five thousand dollars ($25,000.00) and has paid to the First National Bank of Kansas City, Missouri, under the terms of Exhibit 1, the sum of Seventy-five thousand dollars ($75,000.00) as provided by the terms of Exhibit 1, *2396 and has also paid to said bank One hundred fifty thousand dollars ($150,000.00) on February 10, 1921, and One hundred fifty thousand dollars ($150,000.00) on March 10, 1921, making a total of Three hundred seventy-five thousand dollars ($375,000.00) of said consideration, which said party of the second part has to said bank; and,
WHEREAS, party of the second part has elected to purchase the stock of Nakom Oil and Gas Company in lieu of purchasing the property of said corporation by assignment, and the parties of the first part have agreed to protect the said party of the second part against all obligations of the company in the manner hereinafter set out; and,
WHEREAS, parties of the first part represent and guarantee that all obligations of the Nakom Oil and Gas Company have been paid except taxes and except current operating expenses and,
WHEREAS, the amount of taxes, both Federal and State general and special, which the Nakom Oil and Gas Company shall be required to pay for all years up to and including 1920, has not been determined;
NOW, THEREFORE, in consideration of the premises and One Dollar ($1.00) and other good and valuable considerations, in hand paid by the party*2397 of the second part, receipt of which is hereby acknowledged, by the parties of the first part, it is understood and agreed by and between the parties hereto as follows:
I.Party of the second part shall, upon the execution of this agreement, notify the First National Bank of Kansas City, Missouri, in writing, that he elects to purchase the stock of Nakom Oil and Gas Company under the terms of Exhibit 1, and instruct said bank to pay the Three hundred seventy-five thousand dollars ($375,000.00) now in said bank, and placed therein by the party of the second part, to J. V. Holmes, Trustee, for the stockholders of Nakom Oil and Gas Company, as provided by the terms of Exhibit 1, and party of the second part shall be entitled to receive all the capital stock of Nakom Oil and Gas Company in accordance with the terms of Exhibit 1.
II.The balance of the consideration of Five hundred fifty thousand dollars ($550,000.00), said balance being one hundred fifty thousand dollars ($150,000.00), shall be retained by the party of the second part until such time as it shall have been finally determind the amount of all Federal taxes, of whatsoever nature, which the Nakom Oil and Gas Company*2398 shall be required to pay for all years prior to and including the year 1921, except any taxes which may become due on account of profits received from the operation of the leasehold properties of said company after October 1, 1920. And the said sum of One hundred fifty thousand dollars ($150,000.00), or so much thereof as may be necessary for that purpose, shall be applied by the said party of the second *1376 part in the payment of such of said taxes, with interest and penalty, as shall finally be determined to be due, and in the payment of any and all State taxes, of whatsoever nature, that may be finally determined to be due from said Nakom Oil and Gas Company for any period up to January 1, 1921; and in the payment of any and all other obligations of Nakom Oil and Gas Company, of whatsoever nature, which may have been incurred prior to October 1, 1920; and any expense incurred by the said party of the second part, or the Nakom Oil and Gas Company, in the maintenance of said company, or the dissolution thereof, in the event said corporation is dissolved.
III.In the event party of the second part should cause to be transferred to himself, by assignment or otherwise, *2399 all of the assets of Nakom Oil and Gas Company, and dissolve the corporation, any and all taxes which may be finally determined to be due the Federal Government, by reason of such transfer and assignment, shall be paid out of and from the said One hundred fifty thousand dollars ($150,000.00) retained by the party of the second part.
IV.In the event the taxes and obligations herein referred to do not amount to One hundred fifty thousand dollars ($150,000.00), and there remains in the hands of the party of the second part after the payment of such taxes and obligations any portion of the said One hundred fifty thousand dollars ($150,000.00), then the balance thereof remaining shall be paid by the party of the second part to J. V. Holmes, Trustee; provided, however, that party of the second part shall not be required to make such payment until the expiration of six (6) months from the date such balance shall have been determined, and in no event shall he be required to pay such balance prior to March 31, 1922. The party of the second part agrees to pay to the parties of the first part interest on the said One hundred fifty thousand dollars ($150,000.00) at the rate of five (5) *2400 per cent per annum, payable annually, so long as the same remains in his hands, it being understood that interest shall be paid only on such portion of said sum as remains in his hands.
V.In the event said taxes and obligations are in excess of the amount of One hundred fifty thousand dollars ($150,000.00) and the party of the second part, or Nakom Oil and Gas Company, is required to pay any such excess, parties of the first part will reimburse party of the second part for any such excess, and said parties of the first part do hereby, severally and jointly, agree to indemnify, protect and hold harmless party of the second part from any and all loss which said party of the second part may sustain by reason of any such excess, and also agree to indemnify, protect and hold harmless said party of the second part from any loss he may sustain by reason of any tax which he personally may be required to pay on account of a transfer of the assets of the Nakom Oil and Gas Company to party of the second part, as referred to herein.
VI.It is the purpose and intent of this agreement that parties of the first part will hold party of the second part and Nakom Oil and Gas Company harmless*2401 from any and all taxes of whatsoever nature now due or hereafter to become due *1377 against Nakom Oil and Gas Company for all prior years up to and including 1921, except any taxes which may become due on a account of profits received from the operation of the leasehold properties of said company, after October 1, 1920, including any and all taxes which may be required to be paid on account of any transfer of the assets of Nakom Oil and Gas Company to party of the second part, and including any obligations of Nakom Oil and Gas Company incurred prior to October 1, 1920; and that party of the second part shall retain One hundred fifty thousand dollars ($150,000.00) of the agreed consideration of Five hundred fifty thousand dollars ($550,000.00) for the capital stock of the Nakom Oil and Gas Company, until such time as said taxes and obligations shall have been paid, and that such portion of said One hundred fifty thousand dollars ($150,000.00) as may be necessary for that purpose may be applied in the payment thereof, and the balance remaining after such payment, if any, shall be paid to J. V. Holmes, Trustee, as provided by the terms of Exhibit 1.
All of the terms, conditions*2402 and obligations hereof shall extend to and be binding upon the parties hereto, their heirs, representatives, administrators and executors.
In accordance with the terms of the agreement of April 9, 1921, the capital stock was transferred to Jones, and Holmes, as trustee, deposited, on the 11th of April, $376,002.75, being the payments made to the First National Bank of Kansas City, Missouri, by Jones under the terms of the agreement between the parties. On April 12, 1921, Holmes deposited $25,000, representing the down payment made by Jones upon the execution of the first agreement. The last deposit, covering the balance of the purchase price, was made on June 7, 1922, in the amount of $151,312.13. No written agreement or declaration of trust was entered into between Holmes and the other two stockholders with respect to these funds, but a meeting was held at which they discussed the plan that Holmes should follow in liquidating the Nakom Company's debts and in distributing the remainder.
At or about the time Holmes, as trustee, received the first payment from Jones it was determined that the largest amount which could probably be divided among the shareholders was $1,630 per*2403 share. This amount was arrived at in part through advices that the taxes of the Nakom Oil & Gas Co. might amount to as much as $140,000. It was agreed by the stockholders that the trustee should distribute $1,630 per share, making a total distribution of $299,920, and that, if the remainder of the purchase price should thereafter prove to be insufficient to liquidate the debts and expenses which had been or would thereafter be incurred, each of the said stockholders would reimburse Holmes, as trustee, in the amount of their pro rata share of the deficit. Holmes, as trustee, prior to paying the $1,630 per share, secured an indemnity agreement to this effect from each of the stockholders.
The agreement of April 9, 1921, provided that Jones should pay the debts and liabilities of the Nakom Company out of the $150,000 retained, but the terms of the agreement in this regard were ignored *1378 by both parties since Holmes, as trustee, paid the debts, taxes, and expenses out of the $401,002.75 received from Jones. The record of the liquidation of the Nakom Company's debts and the distribution to stockholders of the residue are contained in the bank book and the check book of*2404 Holmes, as trustee. The first check drawn by the trustee was dated April 12, 1921, was payable to the Nakom Oil & Gas Co. in the amount of $90,356.65, and was used by that company to pay its bills, notes and accounts then due. Expenses which were thereafter incurred by the trustees were paid from the funds held in trust. These expenses included such items as accountant fees, attorney fees, payments to shorthand reporters, Federal taxes, expenses incident to a trip to Washington relative to the corporation's taxes and other similar expenses. The various checks given by the trustee were for the sole purpose of liquidating the debts of the Nakom Oil & Gas Co. and for the distribution of the remainder of the purchase price to and among the stockholders of the said company. National Bank of Kansas City, in the amount of $34,268.40. The National Bank of Kansas City, in the amount of $34,268.40. The check, although made payable to the bank, was a portion of the distribution payable to Kennedy on the 32 1/2 shares which he owned in the Nakom Company. On the same date the trustee issued check No. 19 to Houston, Fible & Co., brokers, in the amount of $18,706.60, constituting the remaining*2405 portion of Kennedy's share in the said distribution. No other distribution was received by Kennedy during 1921 upon his stock in the Nakom Oil & Gas Co. The first and last checks to stockholders covering this distribution in 1921 were drawn by the trustee between April 12 and April 30, 1921.
During the summer and fall of 1921 Holmes, as trustee, took up the question of Federal taxes with the Treasury Department in Washington. Due to allowances secured for discovery value and depletion, the Federal taxes were reduced in a considerable amount, so that Holmes paid the collector $1,032.24 as Federal taxes for 1918, 1919, and 1920.
In June, 1922, upon receipt of the balance of the purchase price, the trustee made a second distribution to the Nakom Company's stockholders in the amount of $800 per share. Kennedy received his portion of this distribution in two checks, one for $4,000, and one for $22,000. The dates for the first and last checks issued to stockholders for this distribution were June 7, and July 31, 1922, respectively. On June 19, 1922, the trustee issued a check to Kennedy for $500, in payment for services rendered by Kennedy in connection with the liquidation of*2406 the Nakom Oil & Gas Co.
The account of Holmes, trustee, was closed out in 1925 by checks to Holmes, Kennedy, and Good for services in liquidating the corporation. Holmes received a total sum of $5,000 in payment for his *1379 services in the liquidation, part of which had been paid prior to June, 1925. Kennedy in February, 1925, received $557.50 in payment for his services in connection with the liquidation, the $57.50 representing interest which had accumulated while the funds were in the bank.
Early in 1915 the petitioner acquired 750 shares of the capital stock of the Evans-Smith Drug Co., a wholesale drug house in Kansas City. By the summer of 1915 his holdings in the drug company amounted to 880 shares, which he continued to hold throughout the taxable years in question. The Evans-Smith Co. sold entirely to retailers and carried in the neighborhood of 60,000 items of drugs and pharmaceuticals. The company was capitalized at $150,000, the par value of each share being $100, but the normal investment in the business was approximately $450,000 due to stocks of drugs and merchandise on hand and accounts carried on the company's books.
Prior to 1920 the petitioner*2407 decided, due to the steadily diminishing profits, that it would be advisable to close out the wholesale drug business. He desired to do so in 1919, but his plans were rejected by the other stockholders. In 1920 Kennedy, together with one of the employes of the drug company, made an investigation of the storage and warehouse business as conducted in northern and eastern cities. They called on brokers engaged in this line of business and went over storage and warehouse plants in Minneapolis, Detroit, Buffalo, New York, Cleveland, Chicago, and other places. As a result of this trip, Kennedy decided to organize a new corporation for the storage and warehouse business, which would require an investment of not more than $50,000.
Upon placing his proposition before the stockholders some of them agreed to continue with Kennedy in the storage and warehouse business, while others refused to do so and desired to liquidate their interests. The stockholders who desired to liquidate and the amount of their stock in the drug company were as follows:
| Shares | |
| Sally Van Evans | 250 |
| Walter O. Evans | 50 |
| J. E. Gibson | 10 |
| E. W. Zea | 10 |
| Total | 320 |
In keeping with his proposal*2408 to discontinue the wholesale drug business and operate a storage and warehouse business, Kennedy as president of the Evans-Smith Co., on August 23, 1920, entered into an agreement with the Mutual Drug Co. of Cleveland, Ohio, whereby the latter company agreed to purchase the entire stock of goods, wares, and merchandise owned by the Evans-Smith Co. on September 15, 1920, subject, however, to certain terms and conditions therein *1380 contained which are not here material. Some of the merchandise carried by the Evans-Smith Co. could not be handled by the Mutual Drug Co., due to conditions imposed by manufacturers or for other reasons. It was necessary, therefore, to dispose of these commodities by sale or by returning them to the manufacturer wherever this was possible. In selling this merchandise, which included the pharmaceuticals, the Evans-Smith Co. wrote its customers, and also competing firms, advising them of their intention of going out of business and that certain specified stocks then on hand were for sale at the lowest market prices. The remaining merchandise, which consisted of odds and ends, was offered to the public at retail. The fixtures and equipment rejected*2409 by the Mutual Drug Co. were disposed of at any price which could be obtained. The Mutual Company, in addition to merchandise and fixtures, secured a list of the customers of the Evans-Smith Co.
The storage and warehouse business was to be conducted in a new building which petitioner had built for that purpose, and in the latter part of December, 1920, the building was taken over for the purpose of beginning the business of the John T. Kennedy Sales Co.
The stockholders who refused to go into the new business venture agreed to accept the book value of their stock. This value was to be determined as soon as the inventory was taken, the various accounts collected, and the business of the Evans-Smith Co. would up. At the time of moving into the new building it was impossible to determine the book value of this stock since the wholesale drug business had not been completely transferred and closed out. On January 15, 1921, conditions were such that it was still impossible to determine the book value of the stock. Some of the stockholders who wanted to liquidate their stock were pressing Kennedy, as president, for their money, and he promised them that, if the drug company was*2410 unable to determine the book value of their stock in the next two or three days, he would pay them.
One of these stockholders, Walter O. Evans, had a note at the bank for $12,000, with his stock as security, and the bank was pressing him for payment. Kennedy promised him that the company would take up the note, and on January 17, 1921, the Evans-Smith Drug Co. drew a check payable to Kennedy in the amount of $12,500, which he endorsed over to Evans. After taking up the note and releasing the stock as collateral security, the stock was transferred on the books to petitioner's account, and Kennedy was charged with the par value of the stock.
On January 25, 1921, the book value of the stock having in the meanwhile been determined, the company issued its check to James Gibson for $3,032.10, which represented his portion of the surplus and undivided profits, plus the par value of 10 shares of stock that *1381 he owned. On the same date a check in a similar amount was issued to E. W. Zea, representing his portion of the surplus and undivided profits, plus the par value of his 10 shares of stock. On January 29, 1921, the company paid Walter O. Evans $2,660.50, being the balance*2411 due him, as surplus and undivided profits, plus the par value of his 50 shares of stock. All of these checks were charged against the petitioner's account on the books of the company, and thereafter his account was credited with the dividends declared out of surplus and undivided profits at the directors' meeting of January 29, 1921.
The checks issued to the retiring stockholders for the book value of their stock were endorsed by the payees and bear the stamp of the banks cashing the checks.
The stock journal of the Evans-Smith Drug Co. contains the following entries relative to these transactions:
| January 17, 1921 | |||
| W. O. Evans, | Cert. #98 | $5,000.00 | |
| John T. Kennedy | Cert. #112 | $5,000.00 | |
| 50 shares | |||
| January 25, 1921 | |||
| Jas. E. Gibson, | Cert.#100 | 1,000.00 | |
| John T. Kennedy, | Cert.#113 | 1,000.00 | |
| 10 shares | |||
| January 26, 1921 | |||
| E. W. Zea, | Cert. #75 | 1,000.00 | |
| John T. Kennedy, | Cert.#114 | 1,000.00 | |
| 10 shares | |||
| January 26, 1921 | |||
| Mrs. H. W. Evans, | Cert. #96 - 100 sh | 10,000.00 | |
| Mrs. H. W. Evans, | Cert. #70 - 50 sh | 5,000.00 | |
| Mrs. H. W. Evans, | Cert. #73 - 36 1/2 sh | 3,650.00 | |
| Mrs. H. W. Evans, | Cert. #71 - 50 sh | 5,000.00 | |
| Mrs. H. W. Evans, | Cert. #60 - 13 1/2 sh | 1,350.00 | |
| John T. Kennedy, | Cert. #115 | 25,000.00 |
*2412 Subsequently, petitioner decided against his original plan to organize a new corporation, and on January 29, 1921, at a stockholders' meeting, it was voted to change the name to the John T. Kennedy Sales Co., and a resolution to amend the Evans-Smith Co.'s charter was adopted without a dissenting vote. The resolution to amend reads as follows:
RESOLVED: That Article Seventh of the Articles of Association of this corporation as originally executed, filed and recorded, be and the same is now hereby amended so as to read:
"SEVENTH: The purposes for which this corporation is formed are to buy, sell, manufacture and generally deal in drugs, chemicals, paints, oils, toilet *1382 articles, druggists sundries and other merchandise, and to act as factors, brokers and selling agents therefore, and to do all acts and things reasonable and necessary for the conduct of the business or in connection therewith."
The minutes of the meeting of the board of directors held on January 29, 1921, contains the report of the treasurer of the Evans-Smith Drug Co., showing its financial condition and that the surplus and undivided profits of the company were as follows:
| Profits earned druing the year 1920 | $98,016.56 | |
| Profits earned during year 1919, carried to surplus | $11,412.49 | |
| Profits earned during year 1918, carried to surplus | ||
| Profits earned during year 1917, carried to surplus | 10,512.84 | |
| Profits earned during year 1916, carried to surplus | 20,690.11 | |
| Profits earned during year 1915, carried to surplus | 21,161.20 | |
| Profits earned during year 1914, carried to surplus | ||
| Profits earned between March 1, 1913, and | ||
| Dec. 31, 1913, carried to surplus | ||
| Profits earned prior to March 1, 1913, carried to | ||
| surplus | 173,064.26 |
*2413 After hearing this report of the treasurer the board of directors adopted the following resolution:
RESOLVED: That there be and there is now declared out of the profits and surplus of this company, dividends upon the capital stock of the corporation issued and outstanding for the full aggregate amount of the accumulation as here reported by the treasurer, the said amount to be properly allocated to the several respective years in which said profits were earned, the aggregate amount of said dividends to be paid in cash on or before March 1st, 1921.
On February 17, 1921, the "John T. Kennedy Sales Company, Seccessors to Evans Smith Drug Company," issued its check to Sally Van Evans in the amount of $75,802.50, representing her portion of the surplus and undivided profits, plus the par value of 250 shares of stock which she owned. This stock had been turned in to the company and transferred on the books to John T. Kennedy on January 26, 1921.
Under date of February 28, 1921, the stock journal of the Drug Company, which continued to be used by its successor, the John T. Kennedy Sales Co., shows that Certificate No. 1 was issued to petitioner in the amount of 1,200 shares of*2414 stock, and that between that date and January 15, 1923, there were five certificates of stock of the Evans-Smith Drug Co. turned in and replaced with new certificates of stock in the John T. Kennedy Sales Co.
On January 15, 1923, the capital stock of the John T. Kennedy Sales Co. was reduced to $50,000 and new certificates of stock were issued to the stockholders. This decrease was duly authorized at a meeting of the stockholders and by a certificate issued by the Secretary of State on January 17, 1923. The decrease is recorded in the stock journal by the following entries:
| 15th | ||
| John T. Kennedy | $ 82,200.00 | |
| A. H. Simson | 3,000.00 | |
| Thos. F. Kennedy | 9,900.00 | |
| J. M. Price | 4,900.00 | |
| To capital stock | $100,000.00 | |
| Reduce capital stock as per minutes of Jan. 15, 1923. | ||
| John T. Kennedy | 37,700.00 | |
| A. H. Simson | 12,000.00 | |
| J. M. Price | 100.00 | |
| T. F. Kennedy | 100.00 | |
| Rees Turpin | 100.00 | |
| John T. Kennedy No. 1 | 37,700.00 | |
| A. H. Simson 2 | 12,000.00 | |
| J. M. Price 4 | 100.00 | |
| T. F. Kennedy 3 | 100.00 | |
| Rees Turpin 5 | 100.00 | |
| Reissue of new stock. |
*1383 The petitioner's returns for 1920 and 1921 were prepared for him by Frederick A. Smith, who had*2415 likewise prepared his returns for prior years. Kennedy had no personal books of account, was unfamiliar with bookkeeping methods, and relied on the records of others and personal memoranda for information in reporting his income. Smith made up the return from personal memoranda and statements from the records of others that Kennedy turned over to him. For each year Kennedy procured a statement from his brokers, Houston, Fible & Co., of Kansas City, for income-tax purposes, which he turned over to Smith. Petitioner signed the returns as prepared by Smith, believing them to be true and correct. The return for 1920 states that petitioner is on the cash receipts and disbursements basis in reporting income, but the 1921 return fails to state the basis upon which income was reported.
The returns for 1920 and 1921 failed to report any profits from trading in stocks on margin through Houston, Fible & Co., although during these years his brokerage account was active. Upon audit by a revenue agent, respondent determined that petitioner had realized a profit of $5,832.60 for the two years, and allocated $2,849 thereof to 1920 and the remainder to 1921. Petitioner reported net income*2416 in 1920 in the amount of $10,048.44, which was increased by respondent to $12,897.44. This increase resulted in the determination of a deficiency for 1920 in the amount of $300.79, to which was added $15.04, representing the 5 per cent negligence penalty provided for by section 250(b) of the Revenue Act of 1918. The petitioner has paid the deficiency asserted for 1920, but denies any liability for the penalty imposed for negligence in reporting income.
In his return for 1921 petitioner reported income from the Nakom Oil & Gas Co. transaction as $30,358, reporting the cost of his *1384 interest as $19,642, and the amount received as $50,000. The $50,000 item was computed for Kennedy by Samuel Turner who was vice president of the Nakom Company and was reputed to be somewhat of an expert in tax matters. In arriving at his income for 1921, Kennedy asked Turner to compute his profit from the Nakon Company transaction, inasmuch as the latter was familiar with all the details thereof. A few days thereafter Turner handed petitioner a piece of paper showing that he made approximately $1,550 per share, and advised him to report his profits as $50,000. In preparing petitioner's*2417 return Smith reported this income as profits derived from the sale of "oil leases." The respondent accepted the cost reported by petitioner, but increased the profits by determining that the sale of his Nakom Company stock was a completed transaction in 1921 and that all the profits therefrom should be reported as income for 1921.
The petitioner's 1921 return reported ordinary dividends in the amount of $12,019.50 and liquidating dividends from the Evans-Smith Drug Co. in the amount of $58,276.43. A revenue agent determined upon a field audit that petitioner had received $243,860.29 in 1921 from the Drug Company, but that $138,451.40 thereof was applicable to accumulations prior to March 1, 1913. The difference, amounting to $105,408.89, was determined to be ordinary dividends subject to surtax. The respondent further found that interest had been overstated in the amount of $728.07, and that petitioner had realized a profit from sales of stock of $12,022.20 instead of a loss of $22,420.40 as reported. This latter adjustment included the profit as computed by respondent on the sale of petitioner's stock in the Nakom Company.
On the basis of these and other adjustments, respondent*2418 increased petitioner's total net income for 1921 from $38,153.43, as reported, to $117,257.36, determined a deficiency of $27,635.60 for that year and added a penalty of 5 per cent for negligence as provided in section 250(b) of the Revenue Act of 1921.
The petitioner accepted the determination of the respondent as to a portion of the deficiency for 1921 and paid the collector $4,290.83. In this proceeding he disputes so much of the deficiency as results from including the $26,000 item as income in 1921 and the correctness of the inclusion of $28,106.38, distributed on the 320 shares of stock which were transferred to him in January, 1921. He denies liability for any penalty for negligence in reporting his income for 1920 or 1921.
OPINION.
MORRIS: The first issue to be determined is whether the profit derived by petitioner from the sale of the capital stock of the Nakom *1385 Oil & Gas Co. constituted income to him in 1921 or should be divided between the years 1921 and 1922 as and when petitioner received his portion of the said profit. The cost of the stock to the petitioner and the amount received from the sale are agreed upon by the parties. The question is*2419 whether all the profit should be reported as income for 1921, or part in 1921 and part in 1922.
The problem presented must be determined in the light of the legal consequences which flowed from the agreement of April 9, 1921, the acts of the parties in carrying out the terms of that agreement, and the method used by petitioner in reporting income in his returns. Briefly stated, the contention of the petitioner is that, since he received only $52,975 from the sale of his stock in 1921, he should report only that amount, less the cost of such stock to him, in his 1921 return.
The terms of the agreement show a sale of stock for $550,000, but out of this sum the vendors were to pay all the obligations of the Nakom Oil & Gas Co. Until the obligations and liabilities of that company were liquidated the purchaser was entitled to and did retain $150,000 of the purchase price. It was further agreed that, in the event that the sum so retained proved insufficient to liquidate the outstanding obligations of the Nakom Company, the vendors would indemnify the vendee as to any such excess. It was also agreed by the parties that if any balance was due the vendors, it should in no event be*2420 paid prior to March 31, 1922.
In view of the conditions which were known to exist in April, 1921, the stockholders were fearful that the sum of $299,920, which was distributed during that month, might represent more than the amount of their profits. It was, therefore, agreed prior to the receipt of their portion of the distribution that, should the company's obligations exceed the balance retained by the trustee, plus the sum retained by the purchaser, they would indemnify the trustee proportionately to the distributions received from him. Subsequent developments were favorable to the stockholders and the trustee was able to liquidate the obligations from the sum which he had retained in his hands, so that in 1922, upon payment of the balance of the purchase price by the vendee, Holmes was able to distribute an additional amount to the stockholders.
In April, 1921, it appears, therefore, that it was uncertain and highly improbable that the vendors would realize more than the amount which had been distributed during that month. Their belief in this regard was evidenced by the indemnity agreements, which provided that they would protect and hold harmless the trustee with respect*2421 to the distribution which he had made, and that they would protect and hold harmless the purchaser of the stock in the event *1386 that the outstanding obligations of the Nakom Oil & Gas Co. proved to be in excess of the amount retained by the purchaser.
It is an undisputed fact in this case that the petitioner received but $52,975 from the sale of his stock in 1921. The theory upon which respondent rests his contention is that the sale was a closed and completed transaction in 1921, and he cites in support thereof our decisions in Parish-Watson & Co.,2 B.T.A. 851">2 B.T.A. 851; Estate of Jeremiah Roberts Downing,12 B.T.A. 1180">12 B.T.A. 1180; and Old Colony Trust Co., Executor,12 B.T.A. 1334">12 B.T.A. 1334. In each of these cases the sales were made under a deferred payment plan which called for the unconditional payment of stated sums on specified dates. In each of these cases the dates of the deferred payments and the amounts thereof were unconditionally provided for and the only thing that remained to be done was the payment of the remainder of the purchase price. In the Downing case the future payments were evidenced by a promissory note, but in the*2422 other two cases the contracts constituted the evidence of the promise to pay.
These cases in our opinion are distinguishable from the present case in that the property acquired was considered to have a readily realizable market value. In this case the prospects of additional profits, after the distribution in April, 1921, were contingent, and continued so until the liquidation of the Nakom Company's obligations. In our opinion the facts herein are more analogous to the facts in Maro Brownfield,8 B.T.A. 1164">8 B.T.A. 1164, wherein we held that the conditions which the parties had annexed to their agreement were such that the additional amount might never be paid, that the additional sum was paid in the following year, but that the petitioner being on the cash receipts and disbursements basis should return the amount in the year in which it was received. Cf. Emily Allen Elfreth,15 B.T.A. 147">15 B.T.A. 147.
This brings us to the question of the basis upon which petitioner reported his income. Section 212(b) of the Revenue Act of 1921 provides that a taxpayer shall compute income upon the basis of the annual accounting period regularly employed in keeping his books, but*2423 that if no such method of accounting is employed, the computation shall be made so as to clearly reflect his income. The record is silent as to the method used by the petitioner in computing income for 1921, but it clearly appears from his return for 1920 that he computed income for that year on the cash receipts and disbursements basis, and his testimony shows that he relied to a great extent upon the records of others and maintained no personal books of account. In a similar situation we stated, in John A. Brander,3 B.T.A. 231">3 B.T.A. 231, 235, that where a petitioner was without records it may generally be concluded that the cash method is being used. And in John T. Morris,15 B.T.A. 260">15 B.T.A. 260, 263, we said, "In the absence of evidence *1387 as to the basis used in accounting and in making his return, we assume that the petitioner was on the cash receipts basis."
In view of the foregoing it is our opinion that the respondent erred in including the $26,000 received by the petitioner in 1922 as income to him in 1921. In this disposition of the question it becomes unnecessary to pass upon the contention presented by respondent that Holmes was petitioner's*2424 agent and that receipt by Holmes constituted receipt by Kennedy.
The second question presented by the pleadings is whether the respondent erred in including in petitioner's income for 1921 an amount distributed on 320 shares of capital stock of the Evans-Smith Drug Co. The petitioner contends that under the facts he realized no income therefrom. The respondent contends that, since the 320 shares had been transferred to petitioner at the time the dividend was declared, petitioner received "dividends" as defined by section 201(a) of the Revenue Act of 1921. No question is raised as to the amount itself but only as to the propriety of including such amount in petitioner's income.
Since the issue must be decided upon the facts set forth in our findings, a short resume thereof will be helpful in arriving at a solution. The petitioner together with certain other stockholders decided to discontinue the wholesale drug business and embark in the warehouse and storage business. Four stockholders refused to continue in the new enterprise and desired to liquidate their interests. The business, merchandise, furniture, fixtures, etc., of the drug company were sold to another drug concern, *2425 and the wholesale drug business operated by the Evans-Smith Drug Co. was discontinued.
Upon the refusal of the four stockholders to continue their investment in the new enterprise, the petitioner made arrangements with them whereby they were to receive the book value for their stock. One of the stockholders secured a substantial advancement from the company on his 50 shares of stock prior to the determination of its book value, and the stock was transferred on the stock journal to Kennedy. Subsequently, this stockholder received from the company the balance due him in liquidation of his interest. Two of the stockholders received checks from the company in full payment for their interests on the same date that their stock was transferred to Kennedy. The fourth stockholder turned in her stock and it was transferred to Kennedy on January 26, making up the 320 shares in question. Thereafter, she received payment in the full amount of the book value of her interest. All of the checks issued by the company in payment for these stockholders' interests were charged on its books against Kennedy.
At the meetings of the stockholders and directors on the 29th of January, Kennedy held*2426 1,200 shares of the capital stock. The directors, *1388 by an appropriate resolution, provided that all the surplus and undivided profits accumulated over a long period of years should be distributed in cash on or prior to March 1, 1921. But as the former stockholders had already received their pro rata share of the dividend declared on the 29th, and the payments had been charged on the books against Kennedy, his account was credited with the dividend on 320 shares and a portion of the charge was wiped out leaving a balance against him of $32,000 representing the par value of the 320 shares. This balance was subsequently wiped out and the whole transaction balanced by the reduction in capital stock which occurred in January 1923.
Respondent has determined that petitioner received ordinary dividends from the drug company during 1921 in the amount of $105,408.89, and that these dividends are subject to the surtax. His determination is based on the fact that the dividend was an ordinary dividend and is governed by the provisions of section 201(a) of the Revenue Act of 1921, and he cites our decision in *2427 E. G. Perry,9 B.T.A. 796">9 B.T.A. 796; Deposit Trust & Savings Bank,11 B.T.A. 706">11 B.T.A. 706, and J. S. Rippel,12 B.T.A. 438">12 B.T.A. 438, as supporting his determination.
An examination of the cited cases must lead one to the conclusion that the facts are distinguishable. The Perry case, supra, decided that the dividends were declared in the ordinary manner and that although the business might be liquidated the following day, nevertheless, the dividends previously declared would remain ordinary dividends and could not be considered liquidating dividends. The Deposit Trust & Savings Bank, supra, presents the same situation and the same decision was made. Our question, however, is not whether petitioner received ordinary or liquidating dividends, but whether under the facts petitioner received income.
The facts in the Julius S. Rippel case, supra, are more nearly analogous hereto than either of the other two cited cases. Rippel purchased certain shares of stock from the vendor at the cost price to the vendor, at a time when both parties thought that the regular 4 per cent dividend was about to be declared. Within a few days*2428 after the purchase Rippel received $42,000 in dividends, which he contended was taken into consideration and influenced the price that he paid for the stock, and that this sum should not therefore be considered a dividend to him. It was held that the amount received was a dividend to him and that he was liable for the surtax thereon.
While the facts in the Rippel case and this proceeding are closely analogous, it is immediately apparent that that decision can not be followed here, because petitioner herein never received any portion of the amounts distributed on the 320 shares. The testimony shows that the whole transaction was recorded in petitioner's account primarily because he was the president and principal stockholder. The *1389 checks issued to the former stockholders bear their endorsements, showing that they received sums equivalent to their portion of the distribution, plus the par value of their stock. The fact that the transaction was handled from a bookkeeping standpoint through petitioner's account is immaterial, in view of the actual facts.
We believe that to hold under these circumstances that petitioner should be taxed as receiving income on these*2429 320 shares would be equivalent to making form paramount to substance. Accordingly, it is our opinion that it was error to include any amount representing a distribution on these 320 shares as a part of petitioner's net taxable income.
The third assignment of error relates to the negligence penalty of $15.04 which has been asserted for 1920. Petitioner admitted the deficiency of $300.79, but denies that he was negligent in reporting his income. The penalty is provided for by section 250(b) of the Revenue Act of 1918, which states that where a taxpayer understates his income due to negligence on his part, but without intent to defraud, that there shall be added a penalty of 5 per centum of the total deficiency, plus interest.
The addition of the penalty under the terms of this section is mandatory if respondent finds that a taxpayer has been guilty of negligence. The respondent has found petitioner guilty of negligence and has assessed the penalty in accordance with the law, and the only redress which petitioner has is to prove that he exercised due diligence in reporting his income. The pleadings squarely raise the question of whether petitioner was negligent in reporting*2430 income.
The facts show that petitioner's return was prepared for him by Smith from memoranda which he left with Smith. Included therein was a statement from Houston, Fible & Co., brokers, purporting to show the income or loss which he had sustained during the year. Petitioner procured this statement from his brokers and the testimony shows that the brokers were accustomed to preparing statements for their clients for income-tax purposes. Kennedy had no reason to question or doubt the accuracy of their statement, and it is our opinion that he followed the same course as a reasonable and an ordinarily prudent man would have followed under similar circumstances. It will also be noted that the deficiency for 1920 results from the transferring of certain income from 1921 to that year, the correctness of which was a debatable question in the Bureau itself. It follows therefore that respondent erred in determining under these facts that petitioner was negligent in reporting income for 1920.
The fourth allegation of error relates to the penalty asserted for negligence in reporting income for 1921. The provisions of section 250(b) of the Revenue Act of 1921 are substantially the*2431 same in imposing *1390 the penalty as that of the Revenue Act of 1918, and the pleadings raise the same question of negligence on the part of petitioner.
The facts show that petitioner, in addition to understating his income from trading in stocks on margin, overstated interest paid by $728.07, and admits additional income for the year of approximately $25,000. Petitioner has failed to show that negligence had no part in producing this result and since the determination of respondent is prima facie correct until rebutted by evidence, we approve respondent's determination as to the negligence penalty for 1921.
The petitioner's contention that the negligence penalty should attach only to such part of the deficiency as is directly attributable to negligence is fully met by the provisions of section 250(b) of the Revenue Act of 1921, wherein it is provided that if any part of the deficiency is due to negligence, there shall be added as part of the tax 5 per centum of the "total amount of the deficiency in tax."
Judgment will be entered under Rule 50.