*1312 1. All the stockholders of a corporation by petition addressed to its board of directors authorized and consented to a dividend distribution not in proportion to stockholdings, but in proportions which would result in payments to two stockholders who gave all their time to the business of the corporation in amounts larger than they would have received if the distribution had been pro rata. Held, such dividend distribution was preferential within the meaning of section 27(g), Act of 1936.
2. Held, on the facts, that compensation paid to one of petitioner's officers was unreasonable and excessive.
*539 This proceeding involves an asserted deficiency in income taxes in the amount of $2,565.21 for the taxable year ended April 30, 1937. At the hearing petitioner filed an amended petition, to which respondent filed an answer containing certain affirmative allegations.
The two issues presented are: (1) Whether petitioner is entitled to a dividends paid credit of $10,000 for computing surtax on undistributed profits; and (2) whether petitioner is*1313 entitled to a deduction of $2,255 for compensation paid to its second vice president, Myrtle V. Montgomery.
This second issue arose at the hearing for the first time and was contained in respondent's answer to petitioner's amended petition.
FINDINGS OF FACT.
Petitioner, a corporation organized under the laws of the State of Indiana and engaged in the manufacture of cloth gloves, properly filed its Federal income tax return for the taxable year ended April 30, 1937, and claimed therein a dividends paid credit of $10,000 with respect to a dividend on common stock in the total amount of $10,000 which it paid during the taxable year. It likewise claimed a deduction in the amount of $2,255 for compensation or salary paid to its second vice president, Myrtle V. Montgomery.
In 1934 the common stock, consisting of 100 shares, was held as follows:
| C. Steinhauser | 35 shares |
| Montgomery interests | 35 shares |
| E. Soller | 20 shares |
| J. S. Young | 10 shares |
Soller and Young gave their entire time to the business, as officers of the company, and, in recognition of their services, the stockholders *540 in 1934 petitioned the directors to divide the succeeding year's*1314 profits so that each of the above interests would receive one-fourth of the earnings.
The petition of the stockholders was renewed each succeeding year, and at each meeting of the board of directors the petition was noted on the minutes, although no dividend distribution was made until 1937.
Myrtle V. Montgomery died in February 1937, at which time she was the owner of 17 1/2 shares of the common stock. The other 17 1/2 shares representing the remainder of the 35 shares held by the Montgomery interests were all held by Minnie L. Fuller, the mother of Myrtle V. Montgomery, except for a single share held by J. D. DePrez for the Montgomery interests. Minnie L. Fuller was the administratrix of the daughter's estate. She desired to part with her own stockholdings after her daughter's death, as well as that stock held by the daughter's estate. Parrish Fuller, her son, got in touch with Soller and Young to negotiate for a sale of the stock. In April 1937 an agreement was reached between Soller and Young, on the one hand, and Parrish Fuller, representing Minnie L. Fuller, whereby Soller and Young agreed to purchase the 35 shares for $25,750, with the understanding that Soller and*1315 Young would be entitled to any dividends declared after the date of the agreement. The agreement was not put in writing.
Actually the agreement was carried out and the stock was transferred to Soller and Young in July of 1937, when the last payment was made on the purchase price. Young paid four-sevenths of the purchase price and received four-sevenths of the stock. Soller paid for and received the remaining three-sevenths. The court administering the estate of Myrtle V. Montgomery gave its approval to the sale in July 1937.
When the board of directors met on April 19, 1937, they had knowledge of the agreement between Soller, Young, and Fuller. At their meeting on that date a dividend of $10,000 was declared, reported as follows in the minutes:
On motion of John S. Young, seconded by Edwin Soller, the following resolution was adopted:
Be it resolved that a dividend for the fiscal year of 1936, ending April 30th, 1937, be declared in the sum of Ten Thousand Dollars, ($10,000.00) and paid to Common stockholders as follows:
C. Steinhauser, the sum of $2,500.00John S. Young, the sum of 3,928.57
Edwin Soller the sum of 3,571.43
The board of directors when declaring*1316 these dividends, took into consideration (1) the stockholders' petition, supra, and (2) the oral agreement to purchase the stock then held by Minnie L. Fuller, both as an individual and as administratrix.
*541 Myrtle V. Montgomery had been petitioner's second vice president since 1934. Until the taxable year the petitioner had paid her weekly a salary of $25. At a meeting of the board of directors on May 26, 1936, the salaries of the four officers for the ensuing year were each raised $30 per week. Myrtle V. Montgomery was then living in Colorado, where she continued to reside until summertime when she returned to Shelbyville, Indiana, where petitioner is located. She remained in Shelbyville until her death on February 3, 1937, at which time she was approximately 60 years of age.
Petitioner's business required the purchase of large amounts of cotton goods during the year. For the fiscal year 1936 these purchases amounted to $136,062.31. Fluctuations in the price of cotton goods had a substantial effect on petitioner's profits, and Myrtle V. Montgomery assisted in the determination of the time to make purchases of cotton goods and the amounts to be purchased. *1317 Meetings for this purpose were held from ten to twelve times during the year, the general situation discussed, and the amounts to be purchased determined. During the time that Myrtle V. Montgomery was in Colorado she had J. D. DePrez sit in her place at these meetings.
The salary of $2,255 paid by petitioner to Myrtle V. Montgomery in the taxable year was unreasonable and excessive.
OPINION.
KERN: The first issue for our decision here is whether petitioner is entitled to a dividends paid credit pursuant to section 27(a) of the Revenue Act of 1936, or whether it is precluded from such credit by virtue of section 27(g) of the same act and article 27(g)-1 of Regulations 94. Both of these sections of the act, together with this article of the regulations, are set out in the margin. 1
*1318 *542 Without considering the question raised by the contract of Young and Soller to purchase the stock in petitioner owned by the so-called Montgomery interests, the factual background may be succinctly restated as follows: The stock in petitioner was owned prior to the taxable year in the following proportions: 35 percent by C. Steinhauser, 35 percent by the Montgomery interests, 20 percent by Soller, and 10 percent by Young. Soller and Young were devoting all of their time to the business of petitioner, as its first vice president and secretary-treasurer, respectively. For several years prior to the taxable year the stockholders of petitioner, in consideration of the services of Young and Soller had adopted a petition addressed to petitioner's directors authorizing and directing them to make a disposition of the net earnings of petitioner in the proportion of 25 percent to Soller, 25 percent to Young, 25 percent to Steinhauser and 25 percent to the Montgomery interests. In the taxable year, Young and Soller having entered into a contract to purchase the shares formerly held by the Montgomery interests, the stockholders' petition was to the effect that the directors should*1319 distribute the net earnings in the proportion of 25 percent to Steinhauser, 25 percent to Young, 25 percent to Soller and 25 percent "to be proportionately divided according to the stock owned, to the owners of the stock formerly owned by H. G. Montgomery." Thereupon, on April 19, 1937, the directors resolved.
* * * that a dividend for the fiscal year of 1936, ending April 30th, 1937, be declared in the sum of Ten Thousand Dollars ($10,000.00) and paid to common stockholders as follows:
| C. Steinhauser, the sum of | $2,500.00 |
| John S. Young, the sum of | 3,928.57 |
| Edwin Soller, the sum of | 3,571.43 |
If the dividend had been distributed pro rata according to the stockholdings in petitioner, it is obvious that Steinhauser's dividend would have been $3,500 instead of $2,500, the amount of his dividend as declared by the board of directors, and also obvious that the dividends to Young and Soller would have been less. Accordingly it is the contention of respondent that the distribution of dividends was preferential and not pro rata and, therefore, petitioner is not entitled to a dividends paid credit.
On the other hand, petitioner contends that the petition of the stockholders*1320 authorizing the payment of the dividend in the amounts declared amounted to an assignment by stockholders other than Young and Soller of future dividends binding on the corporation, that the stockholders are individually taxable on what would have been their pro rata distributions, but that if they chose to accept loss than their pro rata distribution it should be considered that they had assigned any excess to those stockholders receiving more than a pro rata distribution. *543 Accordingly, petitioner contends that Steinhauser should be taxable on a dividend distribution of $3,500 constructively received by him, of which amount he, in effect, assigned $500 to Young and $500 to Soller. The conclusion of petitioner's argument seems to be that the dividend distribution must, therefore, be considered as, in reality, pro rata, and not preferential and that the fact that the actual payment by the corporation to its stockholders was in amounts not pro rata to the stockholdings was only because the corporation recognized, as it was bound to do, the prior assignments by some of its stockholders of part of these pro rata dividend distributions.
*1321 A sufficient answer to petitioner's contention is that the right of the stockholders to the dividends actually declared and paid arose from the declaration of such dividends by petitioner's board of directors and not by reason of any petition by stockholders. ; . In spite of petitioner's ingenious argument, the fact stands out that no assignments of future dividends were executed by petitioner's stockholders. In this vital respect the instant proceeding differs from the cases of , and , relied upon by petitioner, in each of which there was actually an assignment by a stockholder of a corporation to one not a stockholder of future pro rata dividends. Here all that was actually done was that all the shareholders of the corporation authorized a preference in the distribution of the dividend, something which is expressly stated in the quoted article of Regulations 94, to in no way qualify the limitation imposed upon the granting of the dividends paid credit by section 27(g). *1322 See also Report of Committee on Ways and Means on the 1938 Revenue Bill, H. Rept. No. 1860. The fact that stockholders of a corporation authorize or approve a preferential dividend distribution does not make it any less a preferential distribution. . To hold, as petitioner would have us hold, that, where all the stockholders of a corporation assent to and authorize a preferential dividend distribution, such a distribution will not be considered as preferential within the meaning of section 27(g), would necessitate our adding to that section the clause "or unless all of the stockholders assent to such distribution." This, it goes without saying, is a matter proper only to the legislative branch of government. In view of the fact that a section similar to section 27(g) was included in the Acts of 1938 and 1940 after the promulgation of article 27(g)-1 of Regulations 94, we must conclude that Congress did not intend any such exception to be read into this section.
For the proposition that the petition of the stockholders was binding on the corporation and constituted an equitable assignment, petitioner relies*1323 heavily on . The fact that in that case there was a formal and binding contract with regard to dividend payments, to which not only the stockholders but also the corporation were parties, and to which reference was made in the stock certificates themselves, is sufficient to distinguish that case from the instant proceeding, in which the stockholders' petition, in so far as the corporation is concerned, is unilateral. It should also be pointed out that in that case the ultimate issue was a question of equity jurisdiction; there was no declaration of a dividend by the board of directors, and the case in no was involved a construction of the pertinent sections of the revenue act. The cases of , and , also cited by petitioner, are even less in point.
We conclude that, where a dividend is declared by a corporation and is paid by it to all of its stockholders, not in proportion to their stockholdings, but in preferential*1324 amounts called for in the declaration of dividends, the stockholders take such dividend by virtue of the corporate resolution declaring it, even though they have by a petition assented to and authorized the declaration of dividends in such preferential amounts; that such a dividend distribution is preferential within the meaning of section 27(g) of the Revenue Act of 1936; and that by the terms of that section the corporation is not entitled to a dividends paid credit.
The other issue raised by the pleadings in this proceeding is as to the reasonableness of a salary paid to Myrtle V. Montgomery, deduction for which was claimed by petitioner in the amount of $2,255. Since this issue was first raised by respondent at the hearing, the burden of proof is upon respondent. Rule 32, Rules of Practice before the United States Board of Tax Appeals. On the strength of the testimony elicited by respondent at the hearing in relation to Myrtle V. Montgomery's activities and residence during the taxable year, we are of the opinion that the amount paid to her and deducted by petitioner in its return was unreasonable and excessive. *1325 Although petitioner asserts that she was acting in her capacity of second vice president when conferring on the cotton sales, it must be borne in mind that she was also one of petitioner's principal stockholders. She did nothing, according to the evidence, except sit in, or have J. D. DePrez sit in for her, on the conferences pertaining to future purchases of cotton. As we pointed out in , these services are not unusual nor unexpected from a principal stockholder, and do not merit the salary paid her by the petitioner. The deduction for salary is therefore disallowed.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 27. CORPORATION CREDIT FOR DIVIDENDS PAID.
(a) DIVIDENDS PAID CREDIT IN GENERAL. - For the purposes of this title, the dividends paid credit shall be the amount of dividends paid during the taxable year.
* * *
(g) PREFERENTIAL DIVIDENDS. - No dividends paid credit shall be allowed with respect to any distribution unless the distribution is pro rata, equal in amount, and with no preference to any share of stock as compared with other shares of the same class.
ART. 27(g)-1. Preferential distributions.↩ - Section 27(g) imposes a limitation upon the general rule that a corporation is entitled to a dividends paid credit with respect to all dividends which it actually pays during the taxable year. Before a corporation may be entitled to any dividends paid credit with respect to a distribution, regardless of the medium in which the distribution is made, every shareholder of the class of stock with respect to which the distribution is made must be treated the same as every other shareholder of that class. The limitation imposed by the Act is unqualified and the existence of a preference is sufficient to prohibit allowance of the dividends paid credit regardless of the fact (1) that such preference is authorized by all the shareholder of the corporation, or (2) that the part of the distribution received by the shareholder benefited by the preference is taxable to him as a dividend. A corporation will not be entitled to a dividends paid credit with respect to any distribution upon a class of stock if there is distributed to any shareholder of such class (in proportion to the number of shares held by him) more or less than his pro rata part of the distribution as compared with the distribution made to any other shareholder of the same class. The disallowance of the dividends paid credit, where any preference or inequality in fact exists, extends to the entire amount of the distribution and not merely to a part of such distribution.