*75 Decisions will be entered under Rule 50.
1. In June 1943, petitioner and his associates acquired all the outstanding shares of stock of The Read House Company, petitioner acquiring one-half the corporate stock. During the taxable years 1944 and 1945, the corporation made to its former stockholders substantial payments of principal and interest on its second mortgage which arose out of the cancelation of the shares of corporate stock not purchased by petitioner and his associates. Respondent determined that the payments to the extent of $ 37,808.85 in 1944 and $ 41,481.98 in 1945, were income to petitioner based on the theory that the payments made by the corporation were in effect a part of the purchase price to be paid for the corporation's stock by petitioner and the other acquiring stockholders. Held, these payments are not taxable to petitioner as dividends under the provisions of section 115 (a) and (g) of the Internal Revenue Code. No part of the indebtedness which the corporation owed on its second mortgage was petitioner's indebtedness or was incurred in his behalf. Consequently, the payments made were not made in his behalf or for his account.
2. Held, that*76 petitioner omitted from his 1944 return more than 25 per centum of his gross income for that year. Consequently, the 5-year statute of limitations provided in section 275 (c) of the Code is applicable and the statute of limitations does not bar the deficiency determined for 1944.
*14 The respondent has determined deficiencies in petitioner's income tax as follows:
| Year | Docket No. | Amount of |
| deficiency | ||
| 1944 | 28554 | $ 14,934.98 |
| 1945 | 23491 | 20,116.08 |
The proceedings have been consolidated.
Certain adjustments*77 as made by the respondent to the net income as reported by petitioner on his returns are not contested. Two issues are raised by the pleadings. The first issue relates to both taxable years. Were the payments made during 1944 and 1945 by The Read House Company to the holders of its second mortgage indebtedness taxable to the petitioner as essentially the equivalent of a dividend? Petitioner contends that respondent erred in determining in respect to the year 1944 that:
(a) It is held that payments were made by the corporation. The Read House Company, on the principal and interest, in the respective amounts of $ 89,176.07 and $ 21,792.50, of outstanding obligations incurred for the benefit of you and your associates; that, of the total payment of $ 110,968.57, the amount of $ 35,350.87 is nontaxable; and, that the balance of $ 75,617.70 represents dividends taxable in full, 50% of which is taxable to you.
Petitioner contends that respondent erred in determining in respect to the year 1945 that:
(a) Payment on principal and of interest made by Read House Company, Chattanooga, Tennessee, all of the outstanding capital stock of which is owned by you and your associates, on *78 an obligation incurred for the benefit of you and your associates, is held to be income taxable to you as follows: *15
| Payment on -- principal | $ 65,583.65 |
| interest | 17,580.30 |
| Total payment | $ 83,163.95 |
| 645/1290ths taxable to you | $ 41,581.98 |
The second issue relates only to the year 1944. The deficiency determined against petitioner is barred by the statute of limitations unless the exception provided by section 275 (c) is applicable. The question involved is whether the exception exists as provided by the statute.
FINDINGS OF FACT.
Some of the facts have been stipulated and are found as stipulated.
Petitioner Ray Edenfield during 1943 and the taxable years under consideration was engaged in the electrical contracting business in Nashville, Tennessee. He was also interested in several other businesses. Petitioner filed his individual Federal income tax returns with the collector of internal revenue at Nashville. Petitioner's income tax returns were prepared on a cash basis.
Some time in the latter part of March or April 1943, A. D. Noe, Jr., who at that time was a resident and hotel operator of Jackson, Tennessee, contacted the petitioner relative*79 to interesting him in joining in the purchase of The Read House. The Read House, one of the leading hotels in Chattanooga, Tennessee, was owned and operated by The Read House Company, a corporation organized under the laws of the State of Tennessee.
The capital stock of The Read House Company consisted of 1,755 shares of Class A stock and 5,354 shares of Class B stock, or a total of 7,109 shares. All the shares of stock were owned by the estate of Samuel R. Read, which estate was being administered by the American Trust & Banking Company of Chattanooga, together with J. D. L. McPheeters and Edmond Smartt. The administrators desired to sell the stock in The Read House Company. Sufficient cash was desired in order to pay estate taxes due by the estate. The administrators made several efforts to sell the stock but they were unsuccessful in finding any prospective buyer. Subsequently, in the spring of 1943, the petitioner, Noe, and Tom Florida, the latter a mortgage and business banker in Osceola, Arkansas, entered into negotiations for the purchase of The Read House property or the stock of The Read House Company. The petitioner was interested in purchasing a one-half interest*80 in the property provided his liability therefor did not exceed $ 100,000. The reason for limiting his liability to that amount was that a liability in excess of that amount might interfere with his making bond for performance of contracts sometimes necessary in his electrical contracting business.
*16 In order to reach a definite agreement regarding the purchase of the property, petitioner, Noe, and Florida met representatives of the Read estate on several occasions to discuss provisions of the proposed transaction. As a result of extensive negotiations, a written offer to sell the entire capital stock of 7,109 shares of The Read House Company dated May 28, 1943, was submitted to the prospective purchasers, who refused to accept it. Petitioner objected to the provision which required that all corporate profits should be applied to the payment of the second mortgage and also to certain other features. After more negotiations, a second written offer dated June 10, 1943, for the sale of the stock of The Read House Company was submitted by the prospective purchasers. On June 17, 1943, the administrators and heirs of the Read estate accepted the offer. Under this contract petitioner*81 and his associates offered to purchase "all of said shares of stock of the said The Read House Company, or the number of shares remaining after the retirement contemplated herein if said retirement is completed prior to the consummation of this agreement, for the sum of $ 185,000.00 cash net to the Administrators." It was further provided in the contract that a second mortgage deed of trust should be executed by The Read House Company covering all real estate and tangible personalty of the company in the amount of $ 581,990 net to the administrators in purchase and retirement of the shares of stock not purchased by petitioner and his associates. The contract further provided that petitioner and his associates were to pledge their stock to secure the second mortgage indebtedness created, or to be created, by The Read House Company. Also contained in the contract were provisions limiting the salaries and dividends to be paid by the company.
On June 22, 1943, the board of directors of the company held a special meeting at which a resolution was adopted authorizing an amendment to the corporate charter to decrease the par value of its capital stock from $ 100 to $ 25 per share, and *82 authorizing the issuance of corporate bonds not in excess of $ 700,000 to be secured by a second mortgage trust deed on the corporate assets for the purpose of purchasing its corporate stock. At a special meeting of the stockholders held immediately after the directors meeting, the stockholders ratified and approved the recommendations made by the directors.
At an adjourned meeting of the board of directors held on June 29, 1943, resignations of all directors which had previously been submitted, with the exception of E. H. Lawman, were accepted and their successors, namely, E. H. Lawman, petitioner, and his associates were elected directors and officers of the corporation. The chairman announced that the reduction in the par value of the stock had been accomplished. At the meeting, E. H. Lawman, on behalf of the administrators of the Read estate, made the following offer:
*17 Chattanooga, Tennessee
June 29, 1943
To The Board of Directors of
The Read House Company:
We, the undersigned, Administrators with the Will Annexed of the Estate of Samuel R. Read, do hereby offer to exchange for retirement 5354 shares of Class "B" stock, and 465 shares of Class "A" stock of The Read*83 House Company, for $ 581,990.00 of The Read House Company's notes, said notes to be secured by a Second Mortgage on the real estate, equipment, fixtures, furnishings, etc. in accordance with the terms and conditions as set forth in the attached unexecuted Deed of Trust.
American Trust & Banking Company
By E. H. Lawman, Vice President
Edmond Smartt
J. D. L. McPheetersAdministrators with the Will Annexed of the Estate of Samuel R. Read.
Acceptance of the offer was made by the following resolution:
RESOLVED That the foregoing offer be accepted and that a copy of said Deed of Trust and a copy of one of the 37 notes described therein be spread of record in an appendix, as part of the minutes of this meeting, and that said exchange for retirement be made from the capital surplus of this corporation; * * *
On June 29, 1943, The Read House Company executed the deed of trust and 37 notes bearing interest at 4 1/2 per cent and in the total amount of $ 581,990. These were delivered to the administrators as consideration for the purchase of the 5,819 shares of company stock held by the administrators. As additional security for their performance of the contract, petitioner and his associates*84 pledged with the administrators of the Read estate the 1,290 shares of stock of The Read House Company owned by them. As of this time these 1,290 shares of stock represented all the outstanding shares of stock of the company. These shares of stock were held as follows:
| Name of stockholder | Number of shares |
| Tom Florida | 322 1/2 |
| A. D. Noe, Jr | 322 1/2 |
| Ray Edenfield | 645 |
Petitioner paid $ 100,000 for his 645 shares of stock. The purchase price paid by petitioner and his associates for the 1,290 shares of stock was $ 185,000.
The reduction in par value of the company stock from $ 100 to $ 25 was for the purpose of creating a capital surplus. The surrender of stock as reflected by the books of the company converted capital and capital surplus into a mortgage payable in the amount of $ 581,990 and did not affect earned surplus of the company. The contract of sale between the administrators and petitioner, Noe, and Florida did expressly provide that 25 per cent of the corporate profit should be reserved and applied to payment of the second mortgage debt. During *18 the taxable years The Read House Company made payments on the second mortgage indebtedness to the administrators*85 of the Read estate as follows:
| Year | Principal | Interest | Total |
| 1944 | $ 89,176.07 | $ 21,792.50 | $ 110,968.57 |
| 1945 | 65,583.65 | 17,580.30 | 83,163.95 |
In 1944, The Read House Company had accumulated earnings and profits available for distribution in the amount of $ 75,617.70. The payments made by the company during 1944 on the principal and interest exceeded this amount, but since only $ 75,617.70 represented earnings and profits, the Commissioner determined that one-half of this amount was taxable income to petitioner (who held one-half the stock of the company) as being essentially equivalent to the distribution of dividends on the stock of the company. During 1945, the net income of the company exceeded the $ 83,163.95 paid on principal and interest on the indebtedness. The Commissioner determined that one-half thereof, or $ 41,581.98, was taxable during 1945 to the petitioner as being essentially equivalent to a distribution of a dividend by the company.
In auditing The Read House Company's tax return for the year 1944, the revenue agent disallowed the interest payment made by the corporation to the administrators of the Read estate on the second mortgage notes in the*86 amount of $ 21,792.60 on the theory that such payment was not interest but dividends paid to the corporation's then three stockholders, one of whom was petitioner. The petitioner has been allowed in the deficiency notice an additional deduction of $ 10,896.25 for interest paid, which deduction was not claimed by petitioner on his tax return.
In the deficiency notice for the year 1945, the Commissioner added to petitioner's net income $ 41,581.98 as a distribution from The Read House Company being essentially the equivalent of a dividend. Among other adjustments to petitioner's net income for 1945 respondent allowed an additional deduction of $ 17,580.30 for interest paid on the indebtedness.
Petitioner contends that on his 1944 income tax return he reported gross income of $ 758,004.18 from his sole proprietorship, Edenfield Electric Co., while respondent contends that petitioner reported from the business a gross income of $ 18,127.46. In addition to the gross income from the Edenfield Electric Co. petitioner reported on his 1944 tax return gross income of $ 18,070.25. Thus it is contended by respondent that the total amount of gross income which petitioner *19 reported *87 on his return for 1944 was $ 36,197.71. The following schedule was attached to and incorporated in petitioner's income tax return for the year 1944:
| Edenfield Electric Co. | ||
| Year -- 1944 | ||
| Gross Receipts | $ 793,029.73 | |
| Less: | ||
| Labor | $ 714,812.79 | |
| Material | 35,025.55 | |
| Other cost | 25,063.93 | 774,902.27 |
| Gross Profit | $ 18,127.46 | |
| Less Operating Expenses: | ||
| Interest and discount | $ 971.64 | |
| General expenses | 11,635.58 | |
| Taxes | 1,567.12 | |
| Insurance | 423.35 | |
| Trucks & auto expense | 2,898.68 | |
| Misc. expense | 1,885.30 | |
| Donations | 1,207.50 | |
| Dues and license | 696.77 | |
| Depreciation | 3,075.14 | 24,361.08 |
| Net Loss | 6,233.62 |
On his individual income tax return (Form 1040) filed for the year 1944, petitioner reported a gross income in the amount of $ 36,197.71, of which $ 18,127.46 was reported as earned from Edenfield Electric Co. Petitioner omitted from his return of 1944, $ 13,560.60 "profits on jobs." The Commissioner has added this amount to the net income reported by petitioner on his return and in his petition, petitioner does not assign this action of respondent as error.
OPINION.
The principal issue in these proceedings is whether*88 certain amounts paid during the years 1944 and 1945 by The Read HouseCompany, a Tennessee corporation, on a second mortgage indebtedness payable to the American Trust & Banking Company, Edmond Smartt, and J. D. L. McPheeters, administrators with the will annexed of the estate of Samuel R. Read, deceased, were taxable to petitioner as being essentially the equivalent of dividends constructively received by him. The second issue is whether petitioner omitted on his tax return for the year 1944, 25 per cent of his gross income so as to bring into effect the 5-year period of limitation provided by section 275 (c) of the Code.
*20 First Issue.
Relying on the authority of section 115 of the Code, the applicable portions being set forth in the margin, 1*89 respondent determined that petitioner received income in the form of dividends from The Read House Company 2 to the extent of $ 37,808.85 during 1944 and $ 41,581.98 during 1945.
At the outset it should be remembered that we do not have before us as a petitioner The Read HouseCompany, a Tennessee corporation, and do not have to determine whether the interest it paid in each of the years 1944 and 1945 to the Read estate, the holder of the second mortgage indebtedness, was deductible as interest by the corporation. We pass no judgment as to that because it is not an issue before us.
The question which we have to determine is whether the second mortgage indebtedness upon which the payments were made was the indebtedness of petitioner and his two associates, Noe and Florida. If it were, then, of course, when The Read House Company made the payments on the indebtedness they would be payments made on petitioner's indebtedness and the tax consequences would be as the Commissioner has determined. It requires no citation of authorities that such would be taxable income to petitioner if the payments were made to discharge his indebtedness. We think, however, that*90 it is entirely clear that the indebtedness was not the indebtedness of petitioner and his two associates and never was their indebtedness. The creditor was the Read estate and the debtor was the corporation, and petitioner and his two associates were merely the stockholders of the corporation which owed the debt. Under such state of facts it requires no citation of authorities to establish that payments on the debt did not result in dividends to petitioner. We are entirely convinced by the evidence before us, through stipulation and through testimony, and by the entire record that the payments in question were not essentially a dividend taxable to petitioner. In the instant case, the petitioner did *21 not at any time purchase or own the stock which was retired. The stock was never transferred to him and he never assumed any personal liability for the mortgage. Neither petitioner nor his two associates signed the notes which were secured by the second mortgage. It is true they put up their 1,290 shares of stock in the corporation as additional security for the second mortgage but that was merely giving the corporation of which they were then the sole stockholders the benefit*91 of the use of their collateral. The mortgage indebtedness was in no sense their indebtedness. It was the corporation's indebtedness. The corporation purchased the stock directly from the Read estate. The evidence indicates that petitioner and his associates were interested in buying all the outstanding shares of corporate stock and that they intended to invest not more than $ 200,000. In order to obtain the $ 185,000 offered in cash (no other purchasers had been willing to pay as much) the administrators of the Read estate and their attorneys worked out the arrangement whereby second mortgage notes amounting to $ 581,990 were accepted from the corporation in exchange for the shares of stock not sold to petitioner and his associates and these shares were immediately retired. Petitioner and Tom Florida both testified that they did not participate in planning this arrangement, and, in fact, all they did was to accept the plan as it was offered to them.
As to the first issue we hold for the petitioner.
Second Issue.
This issue, as we have already stated, involves the statute of limitations. Respondent concedes that the statute of limitations has run as to the deficiency determined*92 for the year 1944 unless petitioner omitted from his return for that year 25 per centum of his gross income. Respondent alleges that petitioner did so omit 25 per centum of his gross income for that year and, therefore, the 5-year statute of limitations applies. The applicable statute is printed in the margin. 3 The respondent, in alleging that the statute of limitations had not run as to the year 1944, makes the following affirmative allegations in his answer:
5. The petitioner in his individual income tax return for the calendar year 1944, filed with the Collector of Internal Revenue for the District of Tennessee, reported total gross income in the sum of $ 36,197.71, and a net loss in the sum of $ 122.84.
*22 6. Petitioner's correct total gross income for the taxable year 1944 is in the sum of $ 87,577.25.
7. The sum of $ 51,369.54, omitted from gross income and properly includible therein, is in excess of 25 per cent of the amount of gross income reported in the said return.
8. Under the provisions of Section 275 (c) of the Internal Revenue Code, the tax for the year 1944 may be assessed, or a proceeding in Court for the collection of such tax may be begun without assessment*93 at any time within five years after the return was filed.
As we have noted in our Findings of Fact, respondent has computed that petitioner reported gross income on his return for 1944 of $ 36,197.71. This $ 36,197.71 was composed of $ 18,127.46 gross income from petitioner's business of Edenfield Electric Co. and $ 18,070.25 from other sources. We have found as a fact that petitioner reported as gross income for 1944, $ 36,197.71.
Petitioner claims $ 758,004.18 gross income was reported from his business of Edenfield Electric Co. Of course, *94 if he is correct as to that, then clearly section 275 (c) does not have any application. But it seems to us that petitioner confuses gross receipts with gross income and obviously the two are not the same. The expenses in question constitute a part of the cost of operations of the Edenfield Electric Co. and, as such, these expenses are to be deducted from gross receipts in arriving at gross income. The Internal Revenue Code authorizes no deduction for cost of goods sold or cost of operation but such costs must be deducted in arriving at gross income. Cf. Lela Sullenger, 11 T.C. 1076">11 T. C. 1076; Joe W. Scales, 18 T. C. 1263. When this fact is kept in mind, we fail to see where the Commissioner is in error when he alleges that the total gross income reported by petitioner on his return for 1944 was $ 36,197.71; one-fourth of this amount is $ 9,049.43.
The Commissioner in his determination of the deficiency has determined that the petitioner omitted from his return the following items of income:
| (a) Additional income | $ 37,808.85 |
| (b) Pro rata profit on jobs | 13,560.69 |
| Total gross income omitted | $ 51,369.54 |
We have*95 held against the Commissioner as to item (a), $ 37,808.85, in our decision of Issue 1. Therefore, petitioner omitted no such amount from his gross income. Petitioner assigned no error as to item (b), $ 13,560.69. Therefore, that adjustment stands as the Commissioner has made it. It follows that petitioner has omitted from his gross income for 1944, $ 13,560.69. This is in excess of 25 per centum of the gross income reported on his return for 1944 and the 5-year statute of limitations provided by section 275 (c) is applicable. Assessment of *23 the deficiency determined by respondent for the year 1944 is not barred by the statute of limitations.
On this second issue the Commissioner is sustained.
Decisions will be entered under Rule 50.
Footnotes
1. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
(a) Definition of Dividend. -- The term "dividend" when used in this chapter * * * means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. * * *
* * * *
(g) Redemption of Stock. --
(1) In General. -- If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.↩
2. The Read House Company is hereinafter sometimes referred to as the company, and at other times as the corporation.↩
3. SEC. 275. PERIOD OF LIMITATION UPON ASSESSMENT AND COLLECTION.
Except as provided in section 276 --
* * * *
(c) Omission from Gross Income. -- If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed.↩