*1503 1. A purchase in 1934 by a corporation, which was not in existence in 1913, of one-tenth of its outstanding shares for a price in excess of one-tenth of its paid-in capital, held to absorb accumulated earnings and profits in the amount of such excess.
2. A distribution in 1935 in an amount greater than the earnings and profits acquired after exhaustion by distribution in 1934, held, to the extent of such excess, not taxable as a dividend, but properly chargeable to capital account. Foster v. United States,303 U.S. 118">303 U.S. 118, distinguished.
*439 The Commissioner determined a deficiency of $1,086.30 in petitioner's income tax for 1935 by increasing income from dividends. Petitioner contends that the increase represents amounts not distributed to him out of earnings or profits because earnings and profits had been exhausted by an earlier purchase of shares.
*440 FINDINGS OF FACT.
Petitioner, a minor residing at Toronto, Ontario, is the ward of Amilius Jarvis, Jr., appointed guardian of his person and property*1504 on October 23, 1934, by the Surrogate Court for York County, Ontario. He is the beneficiary of a trust, created on July 10, 1928, by his grandparents, Edward Goodrich Acheson and Margaret M. Acheson, who transferred to the Power City Bank (now Power City Trust Co.) of New York, as trustee, 90 shares of the Acheson Corporation, directing that the trustee receive the income, apply it to petitioner's support during minority, pay it to him thereafter for life, and distribute corpus on his death as he should direct by will, or in case of intestacy to his successors at law. The trust instrument defined corpus to include any shares received in place of the Acheson Corporation shares upon an exchange.
On April 1, 1935, the trustee received a dividend of $630 on the 90 shares of Acheson Corporation. It sold 4 of the shares on May 10, and during the remainder of the year received cash distributions, pursuant to dividend declarations, aggregating $4,158.10 on the remaining 86. It paid or credited the $4,788.10 so received to petitioner. On May 18, 1935, it received from the Acheson Corporation 86 preferred shares of Acheson Graphite Corporation, of a value of $110 each or $9,460, pursuant*1505 to a resolution of the Acheson Corporation's board of directors of May 14, 1935, that 9,000 preferred shares of Acheson Graphite Corporation be distributed "as a partial liquidation of the Corporation." These shares the trustee held as corpus.
The Acheson Corporation was organized in 1915 and issued its authorized capital stock of $1,000,000, represented by 10,000 shares, to Edward G. Acheson in consideration of securities transferred to it; it assumed obligations of $200,800. The value of the securities was $2,112,299.66, but was stated on the corporation's books to be $1,327,300. The Acheson Corporation's earnings and profits from its inception to December 31, 1934, amounted to $5,137,990.15, as computed to reflect a 1926 charge-off of $600,913.21, notes of the Acheson Oildag Co. During this period it paid dividends of $3,664,100 and properly made additional charges of $25,737.48 against earned surplus. On June 20, 1934, it charged $1,060,000 against surplus after acquiring 1,000 of its own shares for $1,160,000. It earnings and profits for 1935 amounted to $561,462.47, of which $206,589.79 was allocable to the period January 1 to May 14, and $349,183.56 to the period May*1506 14 to December 27, date of the last distribution of the year. During the former period it distributed among its shareholders $63,000 pursuant to dividend declarations, and during the latter it so distributed $435,150. It also distributed 9,000 preferred shares of Acheson Graphite Corporation of a total value of $990,000, pursuant to the aforesaid *441 resolution of May 14, 1935. Of these shares it owned 8,950 on July 10, 1928, and purchased 50 thereafter with the proceeds of sales of other securities held by it on that date. The cash and shares received by the trustee of petitioner's trust in 1935 were the proportionate parts of these distributions to which the Acheson Corporation shares held in trust entitled the holder. Of the 9,000 shares of Acheson Corporation, outstanding from May 14 to December 27, 1935, the Power City Trust Co. held 366 as trustee under five trusts; the Franklin Trust Co. held 800 as trustee under one trust; the Guaranty Trust Co. held 4,800 as trustee under six trusts; Margaret M. Acheson, Edward G. Acheson, Jr., and William G. Heiner, held 80 as trustees under five trusts; and Margaret M. Acheson individually held 2,954.
When the Acheson Corporation*1507 distributed the Acheson Graphite Corporation shares on May 14, 1935, it had an accumulated earned surplus of $531,742.46, computed to reflect the charge-off of the Oildag notes in 1926 and the charge of $1,060,000 to surplus in 1934. Computed without these adjustments, its earned surplus was then $2,192,655.67.
The Acheson Corporation keeps its books and prepares its income tax returns on an accrual basis.
1. When Edward G. Acheson died on July 6, 1931, he was the owner of 1,080 shares of the Acheson Corporation, which shares had a value of $1,194.99 each. His executors, Margaret M. Acheson, Edward G. Acheson, Jr., and William Graham Heiner, distributed 80 of the shares among five trusts to which they had been bequeathed. Estate taxes of $1,029,884.44 plus interest were assessed against the estate, which for tax purposes comprised funds of this and other trusts created on July 10, 1928, and besides the Acheson Corporation shares the trustees had available other assets of a value of less than $125,000. To raise funds for payment of estate tax, they offered on April 20, 1934, to sell the remaining 1,000 Acheson shares to the Acheson Corporation for $1,160 a share. The offer*1508 was immediately accepted by a directors' resolution. The board then consisted of ten directors, of whom three were also executors of the estate. Of the purchase price of $1,160,000, $70,000 was paid on May 28; $405,000 on June 20; and for the remaining $685,000, notes dated June 12, 1934, were given. Simultaneously the executors delivered to the corporation a certificate for the shares endorsed in blank. The certificate was canceled; none of the shares was ever reissued. To make the initial payments for the shares, the Acheson Corporation borrowed $350,000 from Margaret M. Acheson, and by May 1, 1935, had paid off the notes with the proceeds of loans and sales of securities. A directors' resolution to purchase 40 or less additional shares from trusts was also adopted on April 20, 1934, but no action followed.
Upon the corporation's acquisition of the 1,000 shares, $100,000, or par value, was charged to a newly opened account "Treasury *442 Stock" and $1,060,000 was charged to surplus with the journal notation, "It is the purpose of the Acheson Corporation to treat this as unissued or Treasury stock." At the same time the corporation's treasurer stated on an information*1509 report to the United States Corporation Co. of Dover, Delaware, in respect thereof, "Stock to be retired from issue by Acheson Corporation, who purchased the same." The same notation appears on the stock ledger by entry dated June 20, 1934. The "Treasury Stock" account was closed on May 8, 1935, and the "Capital Stock" account was debited $100,000 with the journal notation, "To give effect to reduction of capital pursuant to certificate filed April 8th, 1935." The series of recorded steps was ratified or authorized by a directors' resolution of March 12, 1935. On the same date the directors resolved that the corporation's capital stock be reduced to $900,000, consisting of 9,000 $100 par value shares, and that its certificate of incorporation be so amended. There has been no other redemption or modification of the corporate structure.
2. Among the securities originally acquired by the Acheson Corporation in exchange for its shares were 1,000 shares of Acheson Oildag Co. to which was assigned a book value of $10,000. These shares represented Oildag's entire capital stock of $100,000, and had been issued to Edward G. Acheson when Oildag was incorporated in 1908. Oildag's purpose*1510 was to develop and market "Oildag", a concentration of deflocculated graphite and oil, to be used as a lubricant, and "Aquadag", a concentration of deflocculated graphite and water. In 1916 it was decided to introduce "Oildag ready-for-use", known as R.F.U., a product consisting of petroleum and two-tenths of 1 percent deflocculated graphite. The new product was not commercially successful, and by 1926 Oildag had sustained operating losses in excess of $500,000. For every year of the period 1918-1926 its total expenses exceeded its gross sales. In 1920 its books showed a deficit of $95,546.27, and the deficit steadily and rapidly increased.
Between January 2, 1916, and September 30, 1925, the Acheson Corporation advanced an aggregate of $469,461.69 to Oildag for its operations, and charged interest of $131,452.52. During this period Oildag paid to the Acheson Corporation negligible amounts. September 30, 1925, the Acheson Corporation segregated the advances and interest, totaling $600,914.21, took demand notes from Oildag, credited the amount to Oildag's current account, and charged it to a "refunding notes receivable" account. Thereafter the Acheson Corporation made further*1511 advances of $56,800 which were charged to the current account, and both these and the notes were shown on Oildag's balance sheet of July 31, 1926, as liabilities. The balance sheet showed a deficit of $529,588.81. Inventories, plant, furniture, *443 and equipment, constituting all the tangible assets of Oildag, were carried at $190,638.47, but no more than $40,000 could have been realized from their liquidation. Oildag also had cash, $3,821.96; accounts and notes receivable, $34,451.60; "deferred expense", $6,255.64. The notes or credits of $600,914.21 were worthless to the Acheson Corporation in 1926.
On August 9, 1926, the Acheson Corporation's board of directors resolved that the "refunding notes receivable" account be charged off as a bad debt, the notes being "deemed by this Board uncollectible"; and $600,913.21 was charged against surplus and a nominal value of $1 was assigned the notes in the asset account. The charge-off was reflected in the consolidated income tax return of the Acheson Corporation and its subsidiaries for 1926, but "did not affect the taxable income shown." The Commissioner made no adjustment with respect thereto. Oildag continued the sale*1512 of products, but refrained from expenditures to promote sales of R.F.U.; it is still engaged in business operations, and no proceeding for its liquidation or dissolution has ever been commenced. The sale of R.F.U. was discontinued in 1935; sales of aquadag, concentrated oildag, and other products by Oildag totaled $125,755.31 and yielded a profit of $13,348.25 in that year. After the charge-off by the Acheson Corporation in 1926, Oildag removed the amount of the notes from its liabilities, which had previously always exceeded its assets, and its books indicated a surplus of between $37,000 and $57,000 until 1933, when there was a deficit of $8,000. It has never paid a dividend, but its books show profits ranging from about $6,000 to $44,000 for each of the years 1934-1940.
OPINION.
STERNHAGEN: 1. Petitioner contends that the later 1935 dividends were traceable in part to Acheson Corporation's capital and paid-in surplus because its accumulated earnings had been exhausted by prior distributions. The circumstances of the 1934 distribution were as follows:
The Acheson Corporation was organized in 1915, with a capital stock of $1,000,000, represented by 10,000 shares, all*1513 of which were issued to Edward G. Acheson. It began with a paid-in surplus of $911,499.66. Petitioner insists that the distribution of $1,160,000 in June 1934 served to reduce by $1,060,000 the accumulated earnings, so that distributions of $63,000 cash and of $990,000 in shares of the Graphite Corporation on or before May 14, 1935, completely exhausted the total of undistributed profits which had accumulated since inception. The 1934 distribution, however, was not a dividend. It was paid by the corporation to redeem 1,000 shares of its *444 own $100 par value stock and represented payment of $1,160 per share, the agreed price. During the remainder of 1935 the corporation declared dividends of $435,150. Between May 14 and December 27, 1935, date of the last dividend, the corporation's earnings amounted to only $349,183.56. Petitioner takes the position that "the cash distributions during that period totalling $435,150 were taxable as dividends to the stockholders of Acheson Corporation only to the extent of $349,183.56, being 82.74 per cent thereof."
Thus stated, the facts are exactly comparable with those in *1514 , except that here the existence of the corporation, and hence of its accumulated earnings, began in 1915, and the date of March 1, 1913, has no relevance. Were it not for that difference of fact there would be nothing to do but hold the 1935 distributions taxable, as the Foster case so clearly did.
But the difference is crucial. The 1913 date lay at every point in the Court's consideration of the Foster case. It permeates the entire reasoning of the opinion, and therefore the decision must be limited to cases involving pre-1913 earnings. It was said that the prior stock purchase was properly chargeable to capital account consisting of pre-1913 earnings and left post-1913 earnings unimpaired and available for distribution as a dividend in the later year. A tax on such a dividend was what Congress plainly intended to impose and it was not to be defeated by the bookkeeping device of charging it to pre-1913 earnings, which by earlier judicial decision had been held to be nontaxable capital. Cf. *1515 .
The present case involves no opportunity to escape a tax by a bookkeeping device. No doubt in this case all earnings and profits are taxable when distributed, no matter by what method or what label and no matter what the accounting, The Acheson Corporation has but one "capital account" and that account consists of the original amount received for its capital stock, comprising both the par value and the paid-in surplus, ; . Any distributions properly chargeable to those funds are distributions of capital and not dividends, provided that distributions are first charged against earnings or profits and more particularly the most recently accumulated earnings or profits, as section 115 of the Revenue Act of 1934 prescribes, . There is no pre-1913 source of tax-free distributions.
In so far as *1516 ; , and , recognize the later distribution as attributable to pre-1913 earnings, they are at variance with the Foster decision and must be regarded as to that extent *445 overruled. But they are not overruled in so far as the dividend is attributed to post-1913 earnings. The 1934 transaction was a stock purchase by the corporation and pro tanto a liquidation - a reduction of capital by one-tenth. Thus of the $1,160,000 paid out by the corporation, $100,000 is properly chargeable to capital stock account, $91,149.97 (as petitioner now admits) to paid-in surplus, and the rest of the $1,160,000 to accumulated earnings, and profits. Presumably the distribution of the last named earnings and profits was properly taxed in 1934 to the recipients. There is nothing in the statute to justify the belief that Congress intended to treat the 1935 distribution as from the same source and hence taxable again. Section 115 quite clearly indicates the contrary. How much was left in earned surplus immediately after the distribution in 1934 does*1517 not appear (although it does appear that no January 1, 1935, the earnings were $388,152.67). The corporation had further earnings in 1935; and it is not disputed that the 1935 distributions must in each instance be applied to the most recently accumulated earnings and treated by the shareholders as taxable dividends. After earnings and profits are thus exhausted, the remaining distributions must be regarded as properly chargeable to capital account and received by the shareholder not as a dividend, but as return of capital, with resulting gain or loss, depending on his basis. In this way the shareholders are taxed at one time or another upon all dividends - that is, distributions out of earnings or profits - and only after such earnings and profits have been exhausted is a shareholder recognized as recovering his capital.
2. In his computation of the earned surplus distributed in June 1934, petitioner adopts the figure which results from the write-off in 1926 of the $600,914.21 principal and interest of the debt owed to it by the Oildage Co. Respondent contends that the 1926 write-off was improper, that the surplus in 1934 was that much greater, and was therefore not exhausted*1518 by the 1934 distribution. The ground for respondent's position is that the advances made by the Acheson Corporation to Oildag from 1916 to 1926 were not loans, but were contributions to capital which served to increase the cost of the Acheson Corporation's investment in Oildag's shares, and as such were not susceptible of a surplus adjustment until the shares were finally disposed of.
The evidence shows that during the period of the advances, although the Oildag venture was not fruitful, both the parties and all concerned regarded the advances as loans and accounted for them as such. There is nothing from which it could be reasonably inferred that beneath the outward signs of a debt was a conception of additional contributions to Oildag's capital. Bona fides is not in doubt. Certainly the corporation had the right to create such debts. *446 The fact that the lender was a shareholder of the borrower is not enough to stamp the advances as contributions, ; .
The evidence, as shown by the findings, establishes that in 1926 the judgment of the directors that the amount was uncollectible*1519 was well founded. The Acheson Corporation properly charged it off and thus reduced its surplus. In this proceeding affecting 1935 it is not necessary to determine whether the entire debt was first ascertained to be worthless in 1926, as it would be if the issue were the corporation's right to a deduction in 1926. The issue here would be the same, irrespective of a write-off by the corporation each year of its advances. We are to say whether the surplus at the time of the stock purchase in 1934 used up earnings; and if the advances to Oildag were properly charged off in any prior year, the effect is to reduce the distributable earnings, and, as shown by the findings, to use them up. Since the $600,914.21 was a worthless credit long before 1934, it was properly eliminated from surplus and should not be restored for present purposes.
This is just as true of so much of the amount as represented interest ($131,452.52) as it is of the principal ($469,461.69), for the interest debt was as worthless as the principal. Even if, as respondent suggests, the interest debt was not in 1926 the proper subject of a tax deduction, that would not require its inclusion in the surplus of 1934.
*1520 It is held that the 1934 expenditure of $1,160,000 must be treated as using up $100,000 of capital stock, $91,149.97 of paid-in surplus, and the rest, earnings and profits. The 1935 dividends are to be applied against the most recently accumulated earnings and profits, and after all earnings and profits are thus used up the rest of the 1935 dividends is chargeable to capital account and not taxable as a dividend to the distributee shareholder.
Reviewed by the Board.
Decision will be entered under Rule 50.