*3175 Interest paid by petitioner held to be proper deductions on individual returns.
*871 This is a proceeding for the redetermination of income taxes for the calendar years 1918 and 1919, for which the Commissioner has determined deficiencies of $18,978.75 and $17,820.63, respectively. Each deficiency represents a portion of a jeopardy assessment made for each of the years 1918 and 1919, for which claims in abatement, accompanied by proper bonds, were filed and the balance of the assessments paid. It is alleged that the Commissioner erred either (1) in refusing to allow a deduction of $28,000 in each taxable year for interest paid on indebtedness, or (2) in his failure and refusal to reduce taxable dividends received, under the provisions of the third paragraph of section 330 of the Revenue Act of 1918, by the sum of $28,000.
FINDINGS OF FACT.
Arthur Letts died on May 18, 1923. For more than 25 years prior thereto he was a resident of the City of Los Angeles, State of California. The petitioners were duly appointed*3176 executors of the estate of Arthur Letts, deceased, on June 13, 1923, by the Superior Court in and for the County of Los Angeles, and are now acting in such capacity.
From some time prior to the year 1900 until June 10, 1919, Arthur Letts owned and operated, as sole proprietor, a business known as "The Broadway Department Store," located at Fourth and Broadway, Los Angeles. At all times he maintained two independent sets of books, one for the store in which all assets, liabilities and transactions of the store business were recorded, and one personal set in which personal assets, liabilities and transactions, separate from the store business, were entered. On or about June 10, 1919, the Broadway Department Store was incorporated under the laws of California to take over the assets and business of the store conducted theretofore by Letts as sole proprietor.
*872 On February 2, 1912, Arthur Letts, as lessee, leased from James Moses of Trenton, N.J., as lessor, the land at Fourth and Broadwaw. Los Angeles, for a term of years beginning February 1, 1913, and ending January 31, 1961. The lease, hereinafter called the Moses lease, provided that Letts should remove the old*3177 building then on the land and construct thereon a new building, and that Moses, at the option of Letts, should lend to Letts a sum of money not exceeding $400,000, to be used in the construction of the new building, said loan to be made in the manner and upon the terms specified and to be evidenced by negotiable promissory notes executed by Letts. Paragraph 12 of the lease provided, in part, as follows:
The lessee shall not assign this lease, until after the new building hereinbefore provided to be constructed on said premises has been completed, and any moneys borrowed by he Lessee from the Lessor as hereinbefore provided have been repaid: PROVIDED, HOWEVER, that said Lessee, at any time after the execution of this lease and before the completion of said building and repayment of said loan, may assign this lease to a business corporation, provided said corporation has been duly organized under the laws of the state of California and at the time of the making of said assignment and the acceptance of the same by said corporation the Lessee herein named, to-wit, Arthur Letts, is the owner of a majority of the subscribed capital stock of said corporation. Should any such assignment*3178 be made to such corporation, the same shall be evidenced in writing duly executed and acknowledged before a Notary Public by the Lessee and duly recorded in the Recorder's Office in the County of Los Angeles, State of California, and in any such assignment the said corporation shall expressly accept and assume all of the obligations contained in this lease to be kept and performed by the Lessee. And upon any such assignment being made to such corporation in the manner above provided the Lessee shall thereby and thereafter he released and forever discharged from all obligations thereafter accruing hereunder, excepting, of course, such obligations as attach to such Lessee by reason of his ownership of shares of stock in the Corporation accepting such assignment under the laws of the State of California pertaining to individual liability of the stockholders of corporations; and excepting also the obligation of said Arthur Letts to repay to the Lessor all moneys borrowed from the Lessor, by the said Arthur Letts, as Lessee, under the terms of this lease; the intention being that no assignment of this lease nor the acceptance thereof by said corporation shall in any manner affect or diminish*3179 the personal liability of the said Arthur Letts for the payment of the promissory notes hereinbefore provided to be executed and delivered to said Lessor by said Lessee for all moneys borrowed from said Lessor by said Lessee hereunder.
Said lease was duly recorded in Book No. 83 of Leases, page 225, records of Los Angeles County.
Arthur Letts exercised his option under the lease to borrow, and did borrow, from James Moses the total sum of $400,000, in four equal installments, for which he personally executed, as maker, four negotiable promissory notes payable to James Moses, on the dates and in the amounts, respectively, as follows:
| Nov. 1, 1914 | $100,000 |
| Feb. 15, 1915 | 100,000 |
| Apr. 1, 1915 | 100,000 |
| Nov. 20, 1915 | 100,000 |
| Total | 400,000 |
*873 The several installments of the loan, hereinafter called the Moses loan, were entered upon the personal books of Arthur Letts as notes payable at or about the dates of receipt thereof and the execution of the notes therefor, as set forth above, and were not entered as a liability upon the books of the Broadway Department Store then or at any other time.
By resolution adopted at the first meeting of its directors, *3180 held on June 10, 1919, the corporation authorized and directed its officers to purchase from Arthur Letts the Moses lease and all the property and assets of the business owned and operated by Arthur Letts as the Broadway Department Store, and in consideration thereof to issue to Arthur Letts, or his nominees, its entire capital stock of 50,000 shares, par value $100 each. The resolution further provided:
All of said property to be purchased subject to the liabilities against said business as the same existed on January 1st, 1919, consisting of local accounts, eastern accounts, concessions, exchanges, miscellaneous, delivery equipment reserve, fixture reserve, building reserve and bonus account, amounting to the sum of $740,766.70, as shown by said books of account; with the understanding that this corporation shall assume and agree to pay said liabilities; it being understood that the items carried on said books as "Fixture Reserve," "Building Reserve" and "Delivery Equipment Reserve" are not in fact liabilities that must be paid, but are deductions in the value of these assets, as carried in said books, allowed on account of depreciation; it being understood also that the James*3181 Moses property at the southwest corner of Broadway and Fourth Street, including the leasehold interest of Arthur Letts under the Moses long term lease, is subject to a mortgage of $400,000.00; but that the said Arthur Letts, in assigning said lease to this corporation, will promise and agree to protect the said leasehold interest and this corporation free and harmless from the lien of said mortgage.
Subject also to all changes that may have taken place in said assets in the usual and ordinary conduct of said business since January 1st, 1919; it being understood that said business since said date has been conducted at a profit and that no changes other than the usual and ordinary purchases and sales of merchandise have been made.
On motion duly made, seconded and carried, the meeting adjourned.
(Signed) W. H. B. KILNER,
Secretary.
APPROVED:
(Signed) ARTHUR LETTS,
President.
By agreement dated August 19, 1919, Arthur Letts sold, transferred and assigned to the corporation all the assets and property *874 of the business conducted by him under the name of the Broadway Department Store and also the Moses lease, a formal and separate written assignment*3182 of the lease being executed simultaneously with the agreement, in consideration of $5,000,000 therewith paid in the form of 50,000 shares of the capital stock of the corporation, of $100 par value each, issued to Arthur Letts and his nominees. The 50,000 shares of stock were issued on August 18, 1919, 49,996 shares to Arthur Letts, and upon his order, one share to Harry Philp, one share to W. H. B. Kilner, one share to Arthur Strasburger and one share to Arthur Letts, Jr. Said stockholdings were thereafter changed from time to time in 1919 and 1920, but a majority of the stock was held at all times during said years by Arthur Letts. Said agreement of sale, transfer and assignment was expressly made -
SUBJECT, HOWEVER, to the liabilities against said business as the same existed on January 1st, 1919, consisting of local accounts, eastern accounts, concessions, exchanges, miscellaneous, delivery equipment reserve, fixture reserve, building reserve and bonus account, amounting to the sum of $740,766.70 as shown by the books of account of said business; and it is agreed that the second party hereto shall, and said second party does hereby, assume and agree to pay said liabilities.
*3183 IT IS FURTHER UNDERSTOOD AND AGREED that the James Moses property at the southwest corner of Broadway and Fourth Street, including the leasehold interest of the first party under the long term lease above referred to, is subject to a mortage of $400,000.00; but the first party hereto promises and agrees to protect the said leasehold interest and the second party hereto free and harmless from the lien of said mortgage.
IT IS FURTHER AGREED that the foregoing assignment is made subject to all changes that may have taken place in the assets of said business in the usual and ordinary conduct thereof since January 1st, 1919.
IN WITNESS WHEREOF, the first party has signed his name hereto and the second party has caused its corporate name and seal to be hereunto affixed by its President and Secretary thereunto duly authorized by a resolution of its Board of Directors, on the day and year first above written.
(Signed) ARTHUR LETTS
THE BROADWAY DEPARTMENT STORE,
By (Signed) ARTHUR LETTS, President.
W. H. B. KILNER, Secretary.
(SEAL.)
On August 19, 1919, simultaneously with the execution of the above-mentioned agreement, a formal and separate written assignment*3184 of the Moses lease, incorporating therein that portion of paragraph 12 of the Moses lease hereinabove set forth, was executed by Arthur Letts and accepted by the Broadway Department Store, a corporation, in the following terms, exclusive of the recital clauses:
NOW, THEREFORE, for a valuable consideration delivered by the second party to the first party, the receipt of which is hereby acknowledged, the said first party hereby sells, transfers and assigns to the second party, all of his right, title and interest in, to and under the lease hereinbefore particularly described, *875 and the second party accepts said assignment of said lease and expressly accepts and assumes all of the obligations contained in said lease to be kept and performed by the first party hereto, as lessee under said lease.
IN WITNESS WHEREOF, the first party has signed his name hereto and the second party has caused its corporate name and seal to be hereunto affixed by its President and Secretary thereunto duly authorized by a resolution of its Board of Directors, on the day and year first above written.
(Signed) ARTHUR LETTS
THE BROADWAY DEPARTMENT STORE,
(CORPORATE SEAL.) By (Signed) ARTHUR*3185 LETTS, President.
By (Signed) W. H. B. KILNER, Secretary.
Said assignment of lease was duly recorded in Book No. 126 of Leases, page 103, records of Los Angeles County.
In accordance with the aforementioned resolution, agreement and assignment the corporation acquired the Broadway Department Store business and assets and the Moses lease, and assumed and agreed to pay all the liabilities of the store as of January 1, 1919, as shown by its books of account in the amount of $740,766.70. The said Moses loan was not shown on the store's books of account as a liability at January 1, 1919, or any other time, and was not included in the specified amount of the liabilities of the store in the sum of $740,766.70, and was not included in its inventory of accounts. The Moses loan was not entered or shown upon the books of the corporation as a liability at any time. There appeared upon the books of the store business as of January 1, 1919, as a liability, the amount of $1,476,780 due to Arthur Letts for money advanced by him for the new building, which sum was paid to him at the time of incorporation of the Broadway Department Store by the issuance of capital stock to him.
*3186 During the year 1918 Arthur Letts paid out of his personal funds, by personal check upon his personal bank account, the sum of $28,000 as interest upon the Moses loan. During the year 1919 Arthur Letts paid out of his personal funds, by personal check upon his personal bank account, the sum of $28,000 as interest upon the Moses loan. In the year 1920 Arthur Letts paid out of his personal funds, by personal check upon his personal bank account, the interest on the Moses loan and likewise paid out of his personal funds the sum of $400,000 to James Moses in full payment of the Moses loan.
The net income of the Broadway Department Store for the year 1918 was in excess of 20 per cent of its statutory invested capital and the said net income was reported and taxed as the income of a corporation under the provisions of section 330 of the Revenue Act of 1918. During the calendar year 1918 Arthur Letts withdrew profits from the Broadway Department Store in the total sum of $120,000 and returned said sum as dividends on his amended individual *876 return of net income for the said year 1918, in accordance with the third paragraph of section 330 of the Revenue Act of 1918.
Also, *3187 pursuant to the provisions of the third paragraph of section 330 of the Revenue Act of 1918, the income of the Broadway Department Store from January 1, 1919, to June 10, 1919, the date of incorporation of the store, was reported as the income of a corporation.
OPINION.
VAN FOSSAN: The respondent contends that the Moses loan was an obligation or liability of the Broadway Department Store in 1918 and 1919, and was assumed by the corporation upon the transfer of the business and the assignment of the Moses lease in 1919. Since the business reported its income and was taxed as a corporation in 1918 and 1919, it is contended that interest upon the loan for those years is an expense of the business and deductible from its income, and is not an allowable deduction from the individual income of Arthur Letts, even though he paid the interest out of his personal funds.
The facts are clear and uncontroverted. They are set forth in our findings and it is unnecessary to repeat them here. There is nothing whatever, in this record, to support the position of the respondent. The loan clearly was the personal and primary obligation of Arthur Letts and was at no time assumed, accepted*3188 or acknowledged as a liability by the Broadway Department Store, either before or after incorporation. Indeed the lender, James Moses, expressly provided that any assignment of the lease should not diminish or in any manner affect the liability of Letts on the loan, and it is doubtful that Letts could have been relieved of his personal liability on the loan without the express consent of Moses. Certain it is that the mere assignment of the Moses lease did not relieve Letts of his personal obligation and liability on the loan and substitute therefor the obligation and liability of the assignee. Letts paid the interest on the loan for 1918, 1919, and 1920, and also the principal amount of the loan, out of his personal funds. The amounts of interest so paid for the taxable years 1918 and 1919 are allowable deductions from the individual income of Arthur Letts for the respective years, under section 214(a)(2) of the Revenue Act of 1918. Clearly, the respondent erred in refusing to allow the deductions.
It is unnecessary to consider the alternative issue raised by the pleadings.
The deficiency, or deficiencies, if any, shall be redetermined in accordance with this opinion and*3189 findings of fact.
Judgment will be entered under Rule 50.