*1188 1. The petitioner, a corporation, purchased assets of another corporation, giving in part payment 7,500 shares of its 7 percent cumulative preferred stock. Simultaneously with the sale the petitioner agreed to repurchase from the selling corporation, at future annual dates, the preferred stock "at par, plus accrued and unpaid dividends." Held, upon the petitioner's repurchase of the stock, under this agreement, the amount paid for each share in excess of its par value represented a part of the purchase price and not interest due upon a corporate obligation.
2. Held, payments made by the petitioner to its president to compromise a suit and secure his release from a controverted contract of employment, under the facts shown, are capital expenditures and not business expenses.
*68 The respondent has asserted an income tax deficiency of $9,145.97 against the petitioner for the fiscal year ended June 30, 1926. In arriving at the determination the petitioner alleges the respondent erred*1189 by rejecting its claim for deductions from gross income of amounts of $33,250 and $4,600, paid on account of interest and salaries respectively. In its amended petition the petitioner asks that it be allowed an additional deduction from the gross income for 1926 of $238,460 representing payment made in stock for services rendered by one of its officials. The respondent has conceded the petitioner's right to deduct the $4,600 salary item.
FINDINGS OF FACT.
The petitioner is a Delaware corporation engaged in the manufacture of cottonseed products, with principal place of business at Memphis, Tennessee. It was incorporated August 12, 1924.
In July 1925, the petitioner purchased most of the assets of the Phoenix Cotton Oil Co., a Tennessee corporation, hereinafter referred to as the "Phoenix Co.," for the consideration of $500,000 in cash and $750,000 in 7 percent cumulative preferred stock of the petitioner at its par value of $100 per share. Coupled with the sales agreement, and as one of its conditions, was an offer made by the petitioner and accepted by the Phoenix Co., reading as follows:
This company will cause to be purchased at par, plus any accrued and unpaid dividends*1190 on or before five years from date of issue, and in any event, at the rate of $150,000 par value per year, preferred stock issued under the terms of this agreement and will give satisfactory security to be agreed upon, guaranteeing the fulfillment of this agreement.
To satisfy the guarantee requirement of this repurchase proposal, the parties agreed that $1,800,000 of the Phoenix Co.'s bonds (to be acquired by the petitioner in the process of the sale) should be impounded in the Bank of Commerce & Trust Co. of Memphis, Tennessee, and so held pending the complete repurchase of the stock.
A short time after the completion of the sale of the Phoenix Co.'s assets to the petitioner, internal strife in the management of petitioner's affairs developed, which gave rise to much litigation and culminated in the appointment of a Federal receiver for its business on September 6, 1925. The Federal receiver was in control of petitioner's business on April 1, 1926, which was the first of the five annual dates when it was bound to repurchase its preferred stock from the Phoenix Co. under its contract. The receiver, in recognition of the petitioner's contractual obligations as aforesaid, purchased*1191 1,500 shares of the preferred stock in question by paying to the aforesaid bank, as trustee, $150,000, representing the face value of the shares, and an additional sum of $33,250 for accrued dividends to date upon the entire issue.
*69 In its income tax return for the fiscal year ended June 30, 1926, the petitioner claimed as a deduction from its gross income for that period, the sum of $33,250 which its receiver paid in the circumstances hereinabove set out, upon the theory that the payment should be treated as interest paid upon indebtedness. The respondent disallowed the deduction.
At the first meeting of the petitioner's board of directors held after its incorporation on August 18, 1924, that body adopted bylaws for the corporation and took certain steps towards employing a president. The bylaws, as adopted, contained the following provision respecting officers, to wit:
There shall be an Executive Committee of seven persons, who may or may not be members of the Board of Directors, * * *
* * *
The officers of the corporation shall be chosen by the Directors and shall be a president, five vice-presidents, a secretary and treasurer. * * *
* * *
The salaries*1192 of all officers and agents of the corporation shall be fixed by the Executive Committee.
* * * Any officer elected or appointed by the Board of Directors may be removed at any time by the affirmative vote of a majority of the whole Board of Directors.
Relative to their consideration of the question of compensation for the president of the corporation, the minutes of the meeting show the following:
It being suggested to the meeting that there is some misunderstanding about the amount of compensation to be paid Mr. Cornish, as President, upon motion of Mr. Hunter Jones, Mr. E. Rice and Mr. Alston Boyd were named as a committee to interview Mr. Cornish relative to this matter.
The meeting took a recess while the committee interviewed Mr. Cornish. The meeting then reconvened and the committee reported that Mr. Cornish understood that he was to receive a salary of $25,000 a year, with a bonus of 2 1/2% of the net operating income of the corporation; also a stock bonus of 5% of the preferred stock and 5% of the common stock issued by the corporation in payment for the properties purchased by it. On motion of Mr. Adams, seconded by Mr. Boyd and unanimously carried, it was ordered*1193 that a contract for the services of Mr. Cornish for a period of five years, in keeping with his understanding of his compensation as outlined, be prepared and executed.
Mr. I. H. Fleming having resigned as a director, the Board by a unanimous vote elected Mr. Ed Cornish as a director in his place and stead.
Mr. Cornish, as President, thereupon came into the meeting and took the chair.
Although the record fails to show that the above suggested contract with Cornish was ever "prepared and executed" as directed in the above resolutions, or that, if so, it was approved by the executive committee, it does show that Cornish served as president from and after the date of the above meeting until some time in 1926, and that some time about September 6, 1926, dissatisfaction arose among the *70 stockholders over his management of its business and an attempt was made to force him out of that office. In September 1925 intervention of a Federal receiver, hereinbefore mentioned, ended Cornish's management of petitioner's business and the receiver operated the business until the following June, when all disputes were settled and the property was returned to the stockholders.
*1194 One of the chief causes of petitioner's troubles in the management, of its business was attributable to the fact that its stockholders were divided into rival camps known as the "east" and "west" side groups. Cornish was of the "west" side group and insisted upon remaining in the office of president under what he declared to be a five-year contract of employment entered into at the meeting of the board of directors on August 18, 1925. After some negotiations for a settlement with Cornish, which included a proposal to purchase all of the stock held by his group, a special meeting of petitioner's stockholders was held on June 22, 1926, to consider the question. At this meeting it was announced that Cornish had expressed his willingness to waive any further rights under his contract, provided the meeting should confirm the issuance to him of 2,000 shares of preferred and 3,846 shares of common stock of the petitioner; and that such action be concurred in by its board of directors. Thereupon the minutes of this meeting show action was taken as follows:
The Chairman stated that the Board of Directors at a meeting held on June 15, 1926, had adopted a Resolution approving the acceptance*1195 of the proposition of Mr. Cornish, and this action of the directos had been taken at the same meeting at which other transactions had been authorized, calculated and intended to facilitate the company financing its requirements, and taking it out of the hands of the Receiver.
A motion was then duly made and seconded to adopt the following resolution:
BE IT RESOLVED, That the adjustment of the controversies existing between Mr. Cornish and this Company, referred to at this meeting, and heretofore approved and authorized by the directors of this company at a meeting held on June 15, 1926, be and the same hereby is in all respects ratified and approved as and for the corporate act of this corporation, and that the directors and officers of the corporation are hereby authorized to execute an agreement with Mr. Cornish covering such adjustment, and to take such other proceedings, and execute such documents as may be necessary to terminate all litigation now pending between Mr. Cornish and the corporation, or now being conducted against Mr. Cornish by any stockholder or stockholders for the benefit of the corporation, or other stockholders similarly situated.
BE IT FURTHER RESOLVED, *1196 That the issuance of common and preferred stock in the amounts hereinbefore set forth, to Mr. Cornish be and the same is hereby approved, and that any amount issued in excess thereof shall be returned to the corporation for cancellation.
*71 BE IT FURTHER RESOLVED, That inasmuch as through the services performed by Mr. Cornish, and in consideration of the adjustment with Mr. Cornish as aforesaid, the said Two Thousand (2000) shares of preferred stock, and Thirty-Eight Hundred and Forty-Six (3846) shares of common stock be and they are hereby declared to be issued as fully paid and non-assessable.
The motion having been put to a vote, was declared carried unanimously. It was then moved to adopt the following resolution:
BE IT FURTHER RESOLVED, That in any other suit growing out of the said litigation wherein the corporation is either complainant or defendant, the attorneys appearing for the corporation are authorized and instructed to dismiss and/or consent to the dismissal of the said suit and that all prior provisions in these minutes to the contrary be and the same are hereby set aside and a copy of this be sent to each of the said attorneys under the seal of this*1197 corporation.
Motion was duly seconded and it being put to a vote, was declared carried unanimously.
On the 24th of June 1926 the receivership of petitioner's property and business was terminated, but prior thereto the petitioner adjusted its dispute with Cornish by transferring to him 2,000 shares of preferred and 3,846 shares of its common stock. Record was made of this settlement in petitioner's books by a charge of $238,460 against its property account. Soon after this settlement, the exact month, day, and year not appearing, a syndicate, including some stockholders and outsiders who wished to secure ocntrol of petitioner, purchased from Cornish all of this stock, paying therefor the gross sum of $174,679.25.
In computing its taxable income for 1926, the petitioner took a deduction of $238,460, representing the value of the stock payment to Cornish, as aforesaid, from its gross income for that period, upon the theory that it represented a payment for services rendered. The respondent, in his audit of petitioner's return, rejected that claim for deduction.
OPINION.
LANSDON: Our first issue relates to the petitioner's right to deduct $33,250 from its gross income*1198 for 1926, on the ground that it represents interest paid in that year upon its obligations. The respondent has denied this claim and held that the payment should be attributed to dividends on stock.
The record shows that the petitioner purchased the assets from the Phoenix Co. and, simultaneously therewith, agreed to purchase back the 7,500 shares of its preferred stock at the rate of $150,000 par value per annum "with accrued and unpaid dividends." The offer made and accepted proposed that the petitioner would cause to be purchased at par, plus any accrued and unpaid dividends, $150,000 *72 par value per year of the stock. It will be seen that this offer contemplated future purchases with a formula by which the price paid should be fixed when made. This price was to include the par value of the stock with all accruals for dividends added. This fixing of future dates for execution of the resales precludes any theory of an existing obligation, or obligations, to pay before said dates, upon which interest could accrue in the interim.
The petitioner contends, however, that the parties intended to make provisions in their contract of sale of the Phoenix Co.'s assets to*1199 allow for interest on deferred payments on their purchase price, and that the increase in payments over par was intended to represent such allowance. It therefore argues that, because of that intent, we should at attempt to change the character of this capital outlay in order to give effect to the substance of the transaction.
Assuming that the intent of the selling parties was as contended for by the petitioner, that fact, in our opinion, does not change the character of this expenditure or affect the real substance of what the parties did. They saw fit to divorce completely the purchase and sale of the Phoenix Co.'s assets from the resale of the preferred stock. The first was immediate and conclusive as to all parties, while the latter was wholly executory and binding only on the petitioner. It agreed to buy back the preferred stock at the price fixed, but there was no corresponding commitment on the part of the Phoenix Co. or its stockholders to sell should they change their minds on ay of the terms. Whatever the parties may have intended in the transaction, their contract wholly failed to create any debt against which the petitioner could accrue an interest charge during*1200 the intervening period from date of its execution to the date of the purchase, and we, therefore hold that the respondent correctly rejected the deduction claimed on account of it in the period under review.
Petitioner next contends that it is entitled to deduct $238,460 from its gross income for 1926 as the value of its stock payment made to its president, Cornish, for services rendered and to end litigation and terminate its so-called five-year contract with him.
The record shows that the salary contract with Cornish authorized by petitioner's directors on August 18, 1924, was never executed. Chairman Rice of that board says in his deposition that it was not signed because when they got ready to draw it up they "split upon the proposition of when he (Cornish) was entitled to the five percent."
Cornish actually served as petitioner's president about one year and was paid in excess of $25,000 cash for that service. The stock payment later made was in compromise of Cornish's suit and to get *73 a release from him and his crowd that would get rid of the receiver and give control to the group that was to refinance and rehabilitate its affairs.
In our opinion the stock*1201 expenditures here contended for were in the nature of capital outlays made in the reorganization or rehabilitation of petitioner's business and not expenses incurred in the operation thereof. The record convinces us that Cornish was adequately paid in cash for any and all services ever performed for the petitioner before the receiver took over its management and the petitioner has failed to show any additional services he rendered to it after that time and for which the amount in controversy would be reasonable compensation. Deductions of the character here contended for, to be allowable, must be shown to be reasonable in amount and necessary to the prosecution of the business to which they are attributed, and this the petitioner has failed to show. Its claim for this deduction is therefore denied. ; ; ; ; and *1202 .
Decision will be entered under Rule 50.