*979 The petitioner corporation was organized to take over the cartoon business of an individual. One object of conducting the business in corporate form was to put the individual on a salary basis and thereby attempt to curb his lavish expenditures and another - which would follow if the first was accomplished - was to accumulate sufficient capital to meet certain contingencies which, if they materialized, would require considerable sums of money. The surplus accumulated in the two taxable years, 1926 and 1927, was not unreasonable to meet the possible needs of the business. Held, that petitioner was neither formed nor availed of in 1926 and 1927 for the purpose of permitting its stockholders to escape surtax and section 220 of the Revenue Act of 1926 does not apply.
*211 The respondent, upon audit of petitioner's income tax returns for 1926 and 1927, disallowed certain salary deductions and applied section 220 of the Revenue Act of 1926, thereby determining a deficiency of $58,872.43*980 for 1926 and $58,101.89 for 1927. The petition filed questions the validity of section 220, alleges error in respondent's application of it to the petitioner, and alleges error in the disallowance of salaries. At the hearing counsel for petitioner waived the salary issues and stated that the only point at issue is whether petitioner is subject to section 220. The salary adjustments will not be further noticed.
FINDINGS OF FACT.
Petitioner is a New York corporation, organized on December 31, 1925. It was organized to take over a business previously conducted under the firm name of Fisher & Fisher. The firm consisted of Harry C. Fisher, generally known as "Bud" Fisher, the originator of the "Mutt and Jeff" cartoons, his father, A. A. Fisher, and his mother, Nellie G. Fisher.
On January 1, 1921, Harry C. Fisher entered into a contract, hereinafter more fully described, wherein he agreed to furnish to the Bell Syndicate, Inc., drawings for the Mutt and Jeff cartoons for sale and distribution to newspapers. This contract he assigned to the firm of Fisher & Fisher, and in January 1926 it was assigned to the petitioner. In the taxable years Harry C. Fisher did not make any*981 of the drawings for the cartoons.
*212 During the existence of the firm Harry C. Fisher had drawn freely upon it for funds to meet his personal expenditures. In the latter part of 1925 he indulged in what is described in the record as a spending orgy. His withdrawals from the firm in 1925 amounted to almost $140,000. This liberal spending by Fisher was disturbing to his father and mother and to Charles E. Kelley, who was actively in charge of the firm's operations. Kelley is a lawyer, a member of the New York Bar, and he has been actively engaged in the practice of law for more than twenty-eight years. Kelley became acquainted with Harry C. Fisher and his parents about 1915 and thereafter represented them in some of their legal and business affairs. In 1917, when Harry C. Fisher entered a military camp, Kelley organized two corporations to take over Fisher's business and thereafter he was employed by the three Fishers, on a salary basis, to manage their business affairs. Kelley owned no stock in the petitioner, but was a director and its secretary. The salary theretofore paid to him by the Fishers or the firm was thereafter paid by petitioner. Kelley was the active*982 manager of petitioner.
In 1925 Kelley conceived the idea of organizing a corporation to taken over the Mutt and Jeff cartoon business. The primary objects of having a corporation take over the business were, first, to attempt to control Fisher's spending by putting him on a salary and securing his promise to live within it, and, second, to thus accumulate funds for use in the business as hereinafter explained. Harry C. Fisher was opposed to the formation of a corporation, and Kelley personally advanced the necessary funds for its incorporation. It was not until about January 10, 1926, that Fisher gave his consent to having the corporation, the petitioner here, take over the cartoon business. The only asset of petitioner at the time of its creation was $1,000 cash paid in by Kelley. When Fisher finally consented to having the petitioner take over the cartoon business, certain income-producing contracts, including one with the Bell Syndicate, were transferred to it. Neither Harry C. Fisher nor his parents paid in to the corporation any cash or property other than the contracts pertaining to the cartoon business. Petitioner's total capital stock consisted of 100 shares, of which*983 98 shares were issued to Harry C. Fisher, 1 share to A. A. Fisher, and 1 share to Nellie G. Fisher. Upon the death of A. A. Fisher in December 1926, his share was acquired by Harry C. Fisher. There were no other changes in stockholdings in the taxable years.
The chief source of income of petitioner was the contract between Harry C. Fisher and the Bell Syndicate, Inc., entered into January 3, 1921, for a period of three years ending August 7, 1924. It was extended by two endorsements to August 7, 1930. The second *213 endorsement, dated December 3, 1926, recites that, "The within contract having been assigned by the party of the second part [Harry C. Fisher] to Fisher and Fisher, Inc., it is hereby agreed [by] and between the respective parties to the within contract that the same shall be and it is hereby extended for the further term of three (3) years ending August 7, 1930, * * *." This endorsement was signed: "The Bell Syndicate, Inc., by John N. Wheeler, Pres." and "Harry C. Fisher." Under the contract Fisher agreed to furnish exclusively to the Bell Syndicate, Inc., the Mutt and Jeff cartoons for sale and distribution to newspapers throughout the world. The*984 Bell Syndicate, Inc., on its part agreed to pay Fisher a guaranteed minimum of $3,000 per week. The maximum to be paid was to be computed at 75 percent of the Bell Syndicate's gross sales of the cartoons up to $4,700 per week, against which the $3,000 guaranteed minimum was to be applied, plus 50 percent of gross sales in excess of $4,700 per week. After January 1, 1926, the Bell Syndicate, Inc., made the contract payments to petitioner, making total payments of $199,176.82 in 1926 and $205,199.85 in 1927.
At the time the Bell Syndicate contract was assigned to petitioner notice of the assignment was given to the syndicate. Wheeler, president of the syndicate, advised petitioner's secretary, Kelley, at that time that his company would not renew the contract when it expired in 1927 unless the petitioner corporation had substance and financial reponsibility. The Bell Syndicate, Inc., at that time had three active competitors who from time to time attempted to secure the distribution rights to the Mutt and Jeff cartoons, but none of them offered terms as favorable as the Bell Syndicate, Inc. It was provided in the agreement with the Bell Syndicate, Inc., that, in the event the*985 syndicate failed to meet any of the terms of the contract, or in the event that Wheeler severed his connection with the syndicate, Harry C. Fisher could at his option take over all contracts between the syndicate and its newspaper customers and complete the performance of them. At the time of its organization petitioner was not in a position to take over the sale and distribution of the Mutt and Jeff cartoons. The distribution of a feature having as wide a field of publication as those cartoons had in the taxable years requires an extensive establishment. It requires facilities for making proofs and mats, the distribution of the mats on scheduled dates to the hundreds of newspapers publishing the feature, and facilities for collection from the newspapers, many of which were slow in remitting. Petitioner had none of these facilities. It was the practice of the Bell Syndicate, Inc., in accordance with its contract, to pay the petitioner each week the $3,000 guaranteed weekly *214 minimum, regardless of its collection from the newspapers. In the event that it became necessary for the petitioner to take over the distribution of the cartoons under any of the contingencies above*986 outlined, substantial capital would be required. In order to be prepared to take over the sale and distribution of the cartoons should the occasion arise, it was advisable for petitioner to accumulate a surplus.
For the years prior to 1924 silent motion pictures had been made of the Mutt and Jeff characters. At the height of their popularity the income from these pictures had exceeded the income from newspaper publication of the cartoons. But by 1924 the income from that source had dropped below the cost of production of the pictures and production ceased. It was the opinion of newspapermen and cartoonists that the production of a motion picture, or animated cartoon, version of a newspaper cartoon was necessary for the feature to retain its popularity, and Kelley attempted to secure funds from the Fishers to enable the petitioner to produce a new series of motion pictures. The Fishers refused to go into the venture or to put any money in the petitioner for that purpose, and so Kelley and another individual produced several pictures with capital obtained from other sources. About the time those films were ready for release, the showing of sound pictures commenced and the silent*987 films produced by Kelley and his associates became worthless. In the succeeding years, up to 1928, Kelley continued negotiations with various persons with a view to arranging for the production of a new series of animated cartoons. In 1928 the petitioner actually embarked on the production of animated cartoons, but this venture failed, due to the collapse of the Fox Film Co. Had this project been carried through, it would have required an expenditure of over $100,000 by petitioner. The cost of production of the silent animated cartoons had been from $5,000 to $7,000 for each picture, whereas the production cost of each sound picture ran from $15,000 to $25,000. At least three experimental pictures would be required to determine whether there was any demand. The cost of such experimental films is at least twice that of production after the initial phases of organization and experiments are passed. The production of sound pictures by petitioner would have required several hundred thousand dollars, and this was another reason why it was advisable for petitioner to accumulate a surplus.
The most prominent showing of the Mutt and Jeff cartoons in the newspapers during the years*988 1926 and 1927, and prior thereto, was in the New York World, published in New York City. This newspaper paid the largest amount of any newspaper for the Mutt and *215 Jeff cartoons. In addition to the income, the position of the cartoon in the New York World was of utmost importance, it being regarded as the "New York show window." The Mutt and Jeff cartoons commanded a prominent position in the New York World. It did not appear on the same page with other cartoons. The contract required that it be placed at the top of the sporting page and be the only cartoon on that page. The contract further provided that the Sunday cartoon was to be printed in four colors and was to appear on the front page of the comic section. The position of the Mutt and Jeff cartoons in the New York World enabled the Bell Syndicate to sell the cartoons to newspapers in other cities for substantial sums of money.
It was of the utmost importance to petitioner to maintain the advantageous position of the Mutt and Jeff cartoons in the New York World; to lose this position would materially affect the business with other newspapers throughout the country. It was a fact of common knowledge during*989 the years 1925 and 1926 that the New York World was losing money and that sooner or later there would be a reorganization which would bring in new interests. Kelley, Harry C. Fisher, and Wheeler, president of the Bell Syndicate, frequently discussed the necessity of being on the alert to see that their interests were properly protected in the case of any change of management or ownership of the New York World. One of the reasons for the organization of petitioner was to accumulate money to buy an interest in the New York World when the occasion arose, in order to maintain the position of the cartoons in it. Actually the New York World was later offered for sale and at that time Kelley personally took an active interest in an attempt to acquire an interest in the paper. He appeared before the surrogate and had available funds of over $700,000, but he was unable to complete the purchase. The petitioner was a participant in the pool controlled by Kelley to the extent of $250,000. After the change of management the Mutt and Jeff cartoons were removed from the New York World and the receipts of petitioner from the Bell Syndicate, Inc., have materially declined as a result thereof.
*990 A sum of $200,000 was not an unreasonable amount for petitioner to accumulate for the purpose of meeting the contingencies facing its business in the taxable years.
The salaries of the stockholders of petitioner were as follows:
| 1926 | 1927 | |
| Harry C. Fisher | $52,000 | $52,000 |
| A. A. Fisher | 10,000 | |
| Nellie G. Fisher | 10,000 | 10,000 |
*216 At the close of 1926 Harry C. Fisher had not drawn all of his salary for that year and the petitioner owed him on account thereof the sum of $21,053.05. The firm of Fisher & Fisher had an account on the books of petitioner and at the close of 1926 that account had a debit balance of $44,699.10, that is, the firm owed that amount to the petitioner. In May 1927 Kelley required Harry C. Fisher to make up the debit balance of Fisher & Fisher and at May 31, 1927, Fisher & Fisher had a credit balance on the books of the petitioner in the amount of $3,803.47, and Harry C. Fisher had a credit balance of $7,887.01. By the close of 1927 the account of Fisher & Fisher was again overdrawn and the firm owed petitioner $21,049.42, and Harry C. Fisher owed the petitioner $73,627.27, that amount appearing as a debit balance in his*991 account. The firm of Fisher & Fisher and Harry C. Fisher each had securities of a value in excess of the amounts they owed petitioner.
In 1928 a corporation known as Cartoonist Court, Inc., was organized, with 100 shares of capital stock, to which Harry C. Fisher transferred his holdings of land and his horse-breeding and racing stables in exchange for its stock. Petitioner acquired, at first 41 1/10 shares of the stock, for which it credited the current account of Cartoonist Court, Inc., with $50,000. Later in 1928 it acquired the balance of the stock, 58 9/10 shares, for which it credited Harry C. Fisher's account in the amount of $71,650. At the close of the years 1928, 1929, and 1930 the indebtedness of Cartoonist Court, Inc., to petitioner was for each year, respectively, $8,476.96, $90,446.16, and $155,425.28. The operating losses of Cartoonist Court, Inc., for 1928, 1929, and 1930 were in round numbers, respectively, $16,000, $65,000, and $85,000. For those years Cartoonist Court, Inc., and petitioner filed consolidated returns.
Petitioner's net income for 1926, before adjustment for salaries made by the respondent, was $92,344.85 and for 1927, before adjustment*992 for salaries made by the respondent, was $103,503.79. Petitioner declared no dividend in 1926 or 1927. Dividends were declared December 31, 1928, and December 31, 1930, in the respective amounts of $40,000 and $50,000.
Petitioner's surplus according to its books, and as reported in its income tax returns, was $92,344.85 at the end of 1926 and $168,848.07 at the end of 1927.
Petitioner was not formed, nor during 1926 and 1927 was it availed of, for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.
*217 OPINION.
ARUNDELL: The respondent, in auditing petitioner's returns for 1926 and 1927, computed the tax under both section 230 of the Revenue Act of 1926 (at the 13 1/2 percent rate) and section 220 (at the 50 percent rate). Petitioner does not question the computation under section 230. It takes issue with the respondent's application to it of section 220, contending that it does not come within the provisions of that section, and that that section is unconstitutional. Subsections (a) and (b) of section 220, which are all we*993 are concerned with here, are set out in the margin. 1
The constitutionality of section 220 of the Revenue Act of 1926, and the corresponding provisions of earlier statutes, has been sustained by all the tribunals*994 that have considered the question. See , affirming ; ; . We follow those decisions on this point.
If the petitioner was either "formed or availed of" for the purpose of preventing imposition of surtaxes on its stockholders, it becomes subject to the additional tax. We are convinced that the petitioner corporation was not formed for the purpose described in the statute. The creation of the petitioner was entirely Kelley's idea, and he carried it through not only without help from the Fishers, but even over the opposition of Harry C. Fisher. Kelley testified at length as to his reasons for organizing the petitioner, and we have set them forth in considerable detail in our findings of fact. A restatement of them is unnecessary here and we need say no more than that on this point, on which Kelley was undoubtedly qualified to testify, we give full credence to his testimony and hold that in so far as the formation of the petitioner*995 is concerned it does not come within section 220.
*218 The question of whether the petitioner was "availed of" to avoid surtaxes is more difficult to decide. The statute lays down as a rule of evidence that permitting gain or profits "to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax." In this connection we have said that the statute does "not contemplate that a business should remain static; it must be assumed that any business shall have the right to grow." In this case the petitioner made no distribution of its profits in 1926 and 1927, but permitted them to accumulate through both years. It was not until the close of 1928 that a dividend was declared. In 1926 the petitioner had a gross income of $201,701.47 and a net of $92,344.85, and this latter figure represented its surplus at the end of the year. For 1927 its gross income and net were, respectively, $209,320.02 and $103,503.78, and its surplus at the end of 1927 was $168,848.07. The evidence is that, had the contingencies facing the business materialized, a sum of $200,000 would*996 have been insufficient to meet them. From this it follows that the profits accumulated were not in excess of the reasonable needs of the business. Consequently, the accumulation of profits does not make out a prima facie case and we must go to other evidence in the record to determine whether the petitioner corporation was availed of to escape surtax.
Throughout the record there is apparent a difference of opinion between Kelley, the actual, active manager of the petitioner, and Harry C. Fisher, its nominal head and majority stockholder. Kelley, on the one hand, bent every effort toward accumulating a sufficient surplus to meet the several contingencies facing the business and to keep up its earning power. Fisher, on the other hand, did not even want a corporation to take over the business, and after he "adopted the corporation" - using Kelley's words - he apparently saw no need of accumulating any capital, for he proceeded in 1927 to overdraw his account by more than $73,000. In fact his withdrawals appear to have been greater than indicated by this figure, for some of his personal withdrawals were charged against the firm of Fisher & Fisher. In 1926 one item of over $39,000, *997 representing a withdrawal by Harry C. Fisher, was charged to the firm, so that as a matter of fact he was overdrawn at the end of that year instead of having a balance to his credit as shown by the books. Kelley tried to interest the Fishers in producing Mutt and Jeff moving pictures in order to keep up the earning power of the cartoons, but they refused to go in with him on the deal.
If we were to judge the purpose of using the corporation for carrying on the cartoon business by the conduct of Harry C. Fisher, *219 we would be confronted with a difficult task. His conduct in 1925 and during the taxable years indicates no purpose but to spend lavishly. Herein lies the solution to the question before us. Fisher did not appear at the hearing. We know, however, from the evidence in both this case and a prior case involving his own income tax for 1925 (see ) that he was merely the nominal head of the business. He performed no services either for the petitioner or the firm that preceded it. He had no initial investment in it and refused to put any in. His only contact with it was to draw funds from it for his personal use. In this situation*998 the conduct of the individual who in the majority of cases would be the responsible head of the business cannot be taken as establishing the purpose for which the corporation was used. And because of his lack of responsibility we think it not only proper but necessary to determine the true purpose for which the corporation was created and used from the testimony of Kelley, who was its organizer and actual head. Kelley, it is shown by the evidence, has been actively in charge of Fisher's business affairs since about 1917. He knew Fisher's propensity for spending and he knew too the hazards of the cartoon business; he had seen syndicates fail and knew the necessity for the business to be in a position to make its own distribution of cartoons. Kelley's testimony is directly to the point that in organizing the corporation and operating the business through it he had two objectives in view, one of which was to curb Fisher's lavish spending, and the other to provide capital to meet the contingencies of the business. It is a demonstration of his seriousness of purpose that when in 1927 he discovered Fisher's overdraft - part of which had been charged to Fisher & Fisher - he demanded*999 and secured a restoration to the petitioner.
Considerable stress is placed by respondent on the fact that in 1928 petitioner invested in Cartoonist Court, Inc., a corporation organized to take over Harry C. Fisher's real estate and his racing and breeding stables, and that in subsequent years petitioner made substantial advances to that corporation. We have considered these facts, but we do not believe that they reflect the purpose for which petitioner was operated in 1926 and 1927.
We accordingly conclude that petitioner was not formed nor, during 1926 and 1927, availed of for the purpose of permitting its stockholders to escape surtax.
Reviewed by the Board.
Decision will be entered under Rule 50.
*220 VAN FOSSAN, dissenting: I am unable to agree with the prevailing opinion. In my judgment the petitioner has not furnished evidence sufficient to demonstrate that the surplus was not more than was reasonably necessary for the needs of the business. The burden of proof rested on petitioner. I do not believe he has discharged it.
MCMAHON, dissenting: The "gains or profits" of the petitioner in question here were "permitted*1000 to accumulate beyond the reasonable needs of the business; and hence we have prima facie evidence of a purpose to escape the surtax." Sec. 220(b), supra. No evidence has been presented which is adequate to overcome the prima facie evidence or the defense thereby established for the respondent. Obviously, a prima facie showing of this character cannot be overcome by the very same evidence which, under the very same subsection of the statute, establishes it. Furthermore, in addition to this prima facie evidence, there likewise appears from the majority report other evidence which supports the position of the respondent in this respect. To illustrate: Harry C. Fisher, who at all times in question here owned at least 98 percent of the petitioner's stock, at the outset did not consider the formation of petitioner necessary, and after its incorporation he did not consider the accumulation of the surplus in question necessary; the corporation conducted its business successfully during the years in question without the stockholders ever paying in any cash to the corporation for its stock; at the end of 1927 Harry C. Fisher owed the petitioner $73,627.27 and his account*1001 was, in reality, also heavily overdrawn in 1926; none of the surplus was ever actually used for any of the alleged purposes for which it was accumulated; and it was actually used, promptly after 1927, for wholly different purposes and primarily, if not exclusively, to the personal advantage of Harry C. Fisher.
All of the foregoing applies to the accumulations of surplus by petitioner (1) in the unsuccessful attempt to curb the extravagant expenditures of Harry C. Fisher, (2) in the unsuccessful attempt to make a capital investment in a minority interest in the New York World, and (3) in the attempt at preparation to meet imaginary contingencies, which might have arisen if the Bell Syndicate, Inc., had breached its contract or if Wheeler, its president, had severed his connection with it. There is no showing of a breach of contract on the part of the Bell Syndicate, Inc., or that such breach was ever imminent. The only showing made in this respect is to the contrary. The same is true of Wheeler's severance of his connection with the Bell Syndicate, Inc. There is no adequate showing that the accumulation of surplus in question would have been necessary *221 or adequate*1002 if contingencies had arisen because of a breach of contract by the Bell Syndicate, Inc., or Wheeler's severance of his connection with it. There is some showing that they would not have been necessary or adequate if either or both events had occurred to create contingencies.
In connection with what is said herein, see the dissent in . See also .
It is well settled that a corporation is an entity, distinct, separate, and apart from its stockholders and each of them, even where it is almost wholly owned and completely controlled by a single stockholder, as petitioner was by Harry C. Fisher. , and cases cited therein. Hence the personal affairs and business of Harry C. Fisher were not those of the corporation. To the extent that the corporation participated in his personal affairs and business it stepped out of its own business. Its business, as actually carried on, at all the times material here, was that of furnishing to the Bell Syndicate, Inc., exclusively, drawings for the Mutt and Jeff cartoons*1003 for sale and distribution, by the latter, to newspapers. While Harry C. Fisher was the originator of these cartoons, he did not even make any of the drawings for them in the years before us. To the extent that the petitioner corporation participated in an unsuccessful attempt to curb Harry C. Fisher's extravagant personal expenditures by accumulating its surplus, and this is the underlying, controlling reason why "the gains or profits" were "permitted to accumulate", it was concerned with his personal affairs and business and was not confined to its own business; and hence what it did in this respect was "beyond the reasonable needs of the business" and "is prima facie evidence of a purpose to escape the surtax", under applicable provisions of the statute. It is unnecessary to pass upon the question as to whether what petitioner did in these respects was ultra vires. That it was "beyond the reasonable needs of the business" is sufficient to establish a prima facie case for the respondent, without other grounds; but, as heretofore indicated, there are other grounds.
I also find it unnecessary to pass on the question as to whether the petitioner was "formed" for the*1004 purpose denounced by the statute. To sustain respondent's position in these respects it is sufficient that it was "availed of" for that purpose; and the inescapable conclusion is that it was thus "availed of." Sec. 220(a), supra.
Since this prima facie case for respondent has not been overcome, as heretofore stated, I can not agree with the majority in so far as they hold that any of the "additional" taxes in question herein, as specified in section 220(b), supra, are not to be imposed.
Footnotes
1. Sec. 220. (a) If any corporation however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 230 of this title and shall (except as provided in subdivision (d) of this section) be computed, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax.
(b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie↩ evidence of a purpose to escape the surtax.