*782 Petitioner is a corporation the stock of which was held 40% by S, and the balance by members of S's family. Prior to 1936 it was indebted on its note in the sum of $424,000 to a trust company which also held reclamation district bonds which were a first lien on petitioner's property. Petitioner's note was secured by a deed of trust under which petitioner was prohibited from paying dividends so long as the note was outstanding. Around January 1, 1936, the trust company agreed to rebate to petitioner a part of the interest called for by the note and bonds, in return for the personal guarantee by S of the note and bonds. In a written agreement executed by petitioner and S it was recited that S was willing to do this on condition that petitioner pay no dividends whatsoever until the note and bonds were paid, and petitioner agreed to pay out no money whatsoever as dividends until said obligations were paid. The note was paid in September 1936, but the bonds were not paid during the year. Held, petitioner is entitled by the agreement of January 1, 1936, to a credit under section 26(c)(1), Revenue Act of 1936, in the computation of its surtax on undistributed income for the year*783 1936.
*1049 This case comes up on respondent's determination of a deficiency for the year 1936 in income tax of $64,233.19 and in excess profits tax of $1,816.01, of which $62,235.58 is still in controversy. The question raised is whether petitioner is entitled to any credit against its undistributed adjusted net income under section 26(c)(1) or 26(c)(2) of the Revenue Act of 1936 by reason of three certain agreements, two executed January 1, 1933, and the third on January 1, 1936. The facts are as follows:
FINDINGS OF FACT.
Petitioner is a corporation, organized under the laws of California on or about January 7, 1933. Upon its incorporation it issued all of its capital stock to Ashby O. Stewart and Mary W., his wife, jointly. Petitioner filed its income tax return with the collector of internal revenue for the first district of California. Petitioner was organized by A. O. Stewart to take over certain lands in Reclamation District 2062 which had been previously owned and operated by the California Irrigated Farms, a corporation.
A. O. Stewart*784 had been a stockholder of the California Irrigated Farms. In 1928 or 1929 he traded his interest in that corporation to John Drum for the latter's interest in another corporation. Drum thereafter managed the California Irrigated Farms. At the time of this transaction, Drum and Stewart were endorsers on a note held by the Security First National Bank of Los Angeles which was originally in the amount of $800,000 but had been reduced to around five or six hundred thousand dollars. After the transaction between Stewart and Drum, Stewart remained an endorser on the note, while Drum sought to refinance their indebtedness. In 1932 Drum became heavily involved and the American Trust Co., which then held the note, notified Stewart that it would look to him to pay the indebtedness. *1050 After negotiations between Stewart and the American Trust Co., it was agreed that property owned by the California Irrigated Farms should be conveyed to petitioner, and a new note was given by petitioner to the American Trust Co. which also was endorsed by Stewart.
The note is dated January 1, 1933, and reads as follows:
$424,000. San Francisco, California, January 1, 1933.
FOR VALUE RECEIVED, *785 RECLAIMED ISLAND LANDS COMPANY (hereinafter called the "Company"), a California corporation, acknowledges itself indebted and hereby promises to pay to the order of AMERICAN TRUST COMPANY, at its head office in San Francisco, California, the principal sum of four hundred twenty-four thousand dollars ($424,000) on the first day of January, 1943, in lawful money of the United States of America, together with interest thereon, in like money, from date hereof until payment of said principal sum, at the rate of five (5) per cent per annum, payable semi-annually on the first day of January and the first day of July in each year, first interest payment to be made July 1, 1933.
This note is secured by a deed of trust of even date herewith executed by the Company to American Securities Company, as Trustee, for the benefit of American Trust Company, as beneficiary.
IN WITNESS WHEREOF, the Company has caused this note to be signed in its corporate name by its president or vice-president and its corporate seal to be hereunto affixed and attested by its secretary or assistant secretary as of the first day of January, 1933.
RECLAIMED ISLAND LANDS COMPANY
Attest
[Signed] By A. O. STEWART, *786 President
W. A. RABBETT, Secretary
The note was secured by a deed of trust bearing the same date but not executed until June 29, 1933, by petitioner, the American Securities Co. as trustee, and the American Trust Co. The deed of trust was put in evidence and is incorporated here by reference. Its paragraph V, section 5(a) and (b) provides as follows:
(a) The Company covenants and agrees that while said promissory note shall be unpaid, it will not pay any dividends upon its capital stock or make any distribution of any kind to its stockholders.
(b) The Company covenants that on or before the 15th day of January of each year while any of the principal or interest of said promissory note shall be unpaid, commencing with January 15th, 1934, it will pay to the Trustee the entire net receipts of the Company during the next preceding calendar year. All amounts so paid by the Company to the Trustee shall be forthwith applied by it in reduction of the principal amount of said promissory note; provided, however, that the Trustee, in its discretion, may apply any or all such amounts to the payment of any other obligation of the Company hereunder. The net receipts of the Company*787 during each such year shall be determined by deducting from the gross receipts of the Company from all sources during such year all expenses (exclusive of depreciation) incident to the operation and maintenance of the Company and its properties during such year (fixed in accordance with standard accounting practice), including therein taxes, reclamation district and other assessments, interest on said promissory note, insurance, reasonable and proper charges for repairs, maintenance and farming operations *1051 of the Company, overhead and expenses of supervision and salaries of officers of the Company; provided, however, that the total charges for overhead and supervision and salaries of officers shall not, without the written consent of the Trustee, exceed the sum of Three thousand (3000) dollars for any calendar year.
At the same time that the deed of trust was executed a collateral agreement was entered into between petitioner, Stewart, the American Securities Corporation, and the American Trust Co., which was put in evidence and is incorporated here by reference. This agreement provided for certain additional rights to the trust company which are not deemed material*788 to the issues herein.
The American Trust Co., at the time the above agreement was executed, owned bonds which had been issued by Reclamation District 2062 in the amount of $380,000. These bonds were a first lien on the lands within the district, including the lands covered by the deed of trust. The American Trust co. owned these bonds until January 1937, when they were sold. In the years 1933 and 1934 petitioner's operations were confined to the sale and operation of its farm lands, and its books disclose a net operating loss in each of those years. Petitioner continued with such activities in 1935 and 1936, but it also bought and sold securities in those years. Petitioner realized capital gains on the sale of joint stock land bank bonds in 1935 in the amount of $126,501.44. Its taxable net income for the year 1935 was $99,924.90.
In the latter part of December 1935 an agreement was negotiated between petitioner, A. O. Stewart, and the American Trust Co., and executed on January 1, 1936. It was put in evidence and is incorporated here by reference. Under it petitioner and Stewart collectively agreed to pay to the American Trust Co. on its execution $100,000, to be credited*789 on the principal of a note in the face amount of $424,000. It was further provided that, if petitioner and Stewart should pay the trust company at least $100,000 each year after 1936, the trust company would pay the petitioner by way of rebate two-fifths of the interest on the bonds of the Reclamation District and on the note.
On January 2, 1936, petitioner and Stewart executed an agreement dated the previous day, which was put in evidence and is incorporated here by reference. This agreement reads as follows:
WITNESSETH:
THAT, WHEREAS, the First Party on January 1, 1933, made, executed and delivered to the American Trust Company, a corporation, a promissory note in the sum of Four Hundred Twenty-four Thousand Dollars ($424,000.00), securing deed of trust on certain lands situate in San Joaquin County, California, on said note and deed of trust there is due to the said American Trust Company as of January 1, 1936, the sum of Four Hundred Twenty-four Thousand Dollars ($424,000.00) together with five per cent. (5%) interest from July 1, 1935; and
*1052 WHEREAS, said First Party is desirous of obtaining certain deductions and concessions in regard to the interest on*790 said note and the interest on certain bonds of Reclamation District 2062 held by the said American Trust Company, which said deductions and concessions said American Trust Company has expressed its willingness to make upon condition that certain payments be made by First Party and that the Party of the Second Part hereto will continue to guarantee the payment of said note and will guarantee the faithful performance of all of the provisions, obligations and conditions of a certain refunding agreement dated January 1, 1933, between the First Party and the American Trust Company and will also guarantee the payments of bonds of Reclamation District 2062 held and owned by said American Trust Company, of the total par value of Three Hundred Eighty Thousand Dollars ($380,000.00); and
WHEREAS, the said Second Party is willing to grarantee said note and said bonds as required by the said American Trust Company, so as to enable the First Party to receive the deductions and concessions above referred to, upon condition that the First Party hereto shall use all of its net proceeds from whatever source received to retire first its indebtedness to the American Trust Company, and, second, to retire*791 the bonds of Reclamation District 2062, which are a lien against the lands of said First Party within the borders of said district; and that it pay no dividends whatsoever to its stockholders until the indebtedness to said American Trust Company is paid and said bonds have either been purchased from said American Trust Company or retired in such a manner as to save said Second Party harmless; and
WHEREAS, the parties hereto are about to make and enter into an agreement to be dated January 1, 1936, with the American Trust Company for the purpose of carrying into effect the foregoing objects, and pursuant thereto the Party of the Second Part has endorsed the said note and will agree to continue thereon as an endorser and guarantor, and will guarantee the provisions of the Refunding Agreement above described and will also guarantee the payment of the bonds of Reclamation District 2062 as above described; and the said American Trust Company has agreed to reduce the interest on said promissory note by rebating two-fifths thereof;
NOW, THEREFORE, in consideration of the premises and of the execution by the Party of the Second Part hereto of the aforesaid agreement, to be dated January 1, 1936, as*792 a party thereto, and in consideration of his continuing as an endorser on said note and guarantying the same and the payments agreed to be made thereon, and guarantying repayment of the bonds aforesaid, the Party of the First Part has, and by these presents does, covenant and agree with the Party of the Second Part that it will apply all of the net proceeds of its operations and investments of every nature and kind received by or accruing to it from any and every source whatever and from date hereof, to the payment of that certain note hereinbefore described to the American Trust Company, together with the interest thereon and to the retirement of the deed of trust securing the same, and to the payment and retirement of the bonded indebtedness of Reclamation District 2062.
Said Party of the First Part does further covenant and agree that it will pay no money out whatsoever as dividends to its stockholders until the indebtedness above described shall have been retired in full and the Second Party released from all further liability in connection with said indebtedness and said bonds. And the said First Party does further covenant and agree to save the Second Party entirely harmless*793 by reason of said endorsement and guaranty provided for as aforesaid.
*1053 During the year 1936 petitioner purchased and sold stocks and bonds on which it realized capital gains in excess of $395,000, $338,417.75 of which was realized prior to September 16, 1936, the date when the note was paid. These securities were purchased through brokers. The purchases were financed by loans from the Bank of America, which were in almost all cases guaranteed by Stewart. The securities purchased were delivered to the Bank of America for the account of petitioner and were pledged as collateral on the loans made by the bank. As securities were sold, the Bank of America would apply the cost of them against the amount realized from the sale and the difference between the cost and proceeds would be paid by the bank to petitioner. Notes made by petitioner and endorsed by Stewart were given to the bank for each day's purchase of securities, but Stewart did not guarantee all the notes of petitioner so given, for in cases where Government bonds were purchased he was not asked to do so. As of December 31, 1936, the amount of these loans was $1,594,899.75. Checks payable to petitioner on*794 these sales of securities were deposited in its bank account with the Bank of America, California-Montgomery Branch. Petitioner had only one other bank account during the year 1936, an account at Tracy with the America, Trust Co., from which no disbursements were ever made. Funds deposited in this account were collections from farming operations and from purchasers for lands sold by petitioner. These deposits included returns of capital on the sale of lands, as well as profits. From time to time as funds accumulated in the Tracy account they were transferred to petitioner's account with the Bank of America. Petitioner prepared profit and loss statements monthly, the final profit and loss statement for the year being prepared as soon after December 31 as possible. Petitioner's income tax return for 1936 shows gross income of $455,660.96 and net income of $355,034.10. Respondent has made adjustments which are not in question here resulting in a determination that petitioner's net income for 1936 was in the sum of $370,167.50. Respondent has also determined that petitioner's undistributed adjusted net income for that year was $303,588.13. Petitioner does not question this determination.
*795 Payments were made by petitioner on its note to the American Trust Co. as follows: $100,000 on December 31, 1935, coincident with the execution of the agreement between petitioner, Stewart, and the American Trust Co. on January 1, 1936; February 11, 1936, $100,000; April 30, 1936, $13,663.16; July 29, 1936, $14,362.75; August 6, 1936, $100,000; September 16, 1936, $95,974.09. The last payment of September 16, 1936, paid the note in full. The total amount paid during the year 1936 was $324,000.
*1054 These payments were made from time to time as a substantial round sum accumulated in petitioner's hands, the decision of payment being made by Stewart, as president, and one Rabbett, the secretary and treasurer of petitioner. The board of directors of petitioner during the year 1936 did not specifically authorize any payments of principal on the note of $424,000, but the contract under which payments were made was so authorized.
During the whole of the year 1936 the bonds of Reclamation District 2062 remained outstanding and in the hands of the American Trust Co. but were not in default in respect of either principal or interest. During the year 1936 the stock of petitioner*796 was owned as follows:
| A. O. Stewart and Mary W. Stewart, jointly | 4,000 |
| Mary Keuchler | 2,000 |
| Henry M. Kuechler, Jr. | 1,000 |
| Sue Kuechler | 1,000 |
| Sally Kuechler | 1,000 |
Mary Kuechler and Henry M. Kuechler, Jr., were the daughter and son-in-low, respectively, of A. O. Stewart; and Sue and Sally Kuechler were his grandchildren. During the year 1936 Sue and Sally Kuechler were three and two years of age, respectively.
OPINION.
KERN: Petitioner contends that by virtue of the several contracts executed by it prior to May 1, 1936, which are described in our findings, it is entitled to the benefit of section 26(c)(1) and (2) 1 of the Revenue Act of 1936 in the computation of its surtax on undistributed income for that year. Thus there are raised several issues with regard to the application of each of these subsections to each of the various contracts involved. Since we are of the opinion that *1055 the contract between petitioner and A. O. Stewart dated January 1, 1936, entitles petitioner to the benefit of section 26(c)(1), it is unnecessary to consider the contentions advanced by the parties with regard to the other contracts or section 26(c)(2).
*797 The pertinent parts of this contract are as follows:
WHEREAS, the said Second Party is willing to guarantee said note and said bonds as required by the said American Trust Company, so as to enable the First Party to receive the deductions and concessions above referred to, upon condition that the First Party hereto shall use all of its net proceeds from whatever source received to retire first its indebtedness to the American Trust Company, and, second, to retire the bonds of Reclamation District 2062, which are a lien against the lands of said First Party within the borders of said district; and that it pay no dividends whatsoever to its stockholders until the indebtedness to said American Trust Company is paid and said bonds have either been purchased from said American Trust Company or retired in such a manner as to save said Second Party harmless; and
* * *
NOW, THEREFORE, in consideration of the premises and of the execution by the Party of the Second Part hereto of the aforesaid agreement, to be dated January 1, 1936, as a party thereto, and in consideration of his continuing as an endorser on said note and guaranteeing the same and the payments agreed to be made thereon, *798 and guaranteeing repayment of the bonds aforesaid, the Party of the First Part has, and by these presents does, covenant and agree with the Party of the Second Part that it will apply all of the net proceeds of its operations and investments of every nature and kind received by or accruing to it from any and every source whatever and from date hereof, to the payment of that certain note hereinbefore described to the American Trust Company, together with the interest thereon and to the retirement of the deed of trust securing the same, and to the payment and retirement of the bonded indebtedness of Reclamation District 2062.
Said Party of the First Part does further covenant and agree that it will pay no money out whatsoever as dividends to its stockholders until the indebtedness above described shall have been retired in full and the Second Party released from all further liability in connection with said indebtedness and said bonds. And the said First Party does further covenant and agree to save the Second Party entirely harmless by reason of said endorsement and guaranty provided for as aforesaid.
It is respondent's contention, first, that the covenanting clause of the contract*799 did not prohibit the petitioner from paying dividends other than cash dividends. In construing a contract it is the intention of the parties which is of paramount importance, and in ascertaining that intention it is proper to consider the contract as a whole. Meridian & Thirteenth Realty Co.,44 B.T.A. 865">44 B.T.A. 865. When the entire contract is read, and considered in the light of the purpose intended to be achieved by the parties, the prior engagement of the petitioner, as shown by the deed of trust dated January 1, 1933, and the fact that no dividend of any kind was paid by petitioner in the taxable year, it is evident that the parties intended an absolute prohibition against the payment of dividends by petitioner so long as Stewart *1056 was liable as guarantor of its note and the reclamation district bonds which were a first lien upon petitioner's assets. This prohibition was insisted upon by Stewart before he assumed the contingent personal liability as such guarantor, and the obvious purpose of his insistence was to prevent petitioner from making any distribution which would affect its financial condition or weaken its ability to fulfill the primary obligation*800 on its part to the trust company upon which he had assumed a secondary liability. Such an intent or purpose would have been frustrated by permitting the petitioner to make dividend distributions in the medium of notes or bonds or distributions in kind. Respondent admits that petitioner could not have distributed a taxable stock dividend during the year 1936. We conclude that any other form of dividend was also intended by the parties to the contract of January 1, 1936, (petitioner and Stewart) to be prohibited and was prohibited thereby during the taxable year.
In the second place, respondent contends that the agreement in question did not constitute a written contract within the meaning of section 26(c)(1) in that A. O. Stewart was not a creditor of petitioner and only contracts executed directly between a corporation and its creditor in respect to an indebtedness owed by the corporation to such creditor will entitle the corporation to a credit under this section. As authority for this proposition respondent relies upon certain language used by the court in *801 Helvering v. Northwest Steel Rolling Mills,311 U.S. 46">311 U.S. 46, and in our own opinions in Thibaut & Walker Co.,42 B.T.A. 29">42 B.T.A. 29; Henry Mill & Timber Co.,43 B.T.A. 1073">43 B.T.A. 1073; Metal Specialty Co.,43 B.T.A. 891">43 B.T.A. 891; and Lehigh Structural Steel Co.,44 B.T.A. 422">44 B.T.A. 422, reversed 127 Fed.(2d) 67. Respondent calls particular attention to the use of the phrase "routine contracts dealing with ordinary debts" in that paragraph of the Court's opinion in the Northwest Steel Rolling Mills case, which is as follows:
That the language used in section 26(c)(1) does not authorize a credit for statutorily prohibited dividends is further supported by a consideration of section 26(c)(2). By this section, a credit is allowed to corporations contractually obligated to set earnings aside for the payment of debts. That this section referred to routine contracts dealing with ordinary debts and not to statutory obligations is obvious - yet the words used to indicate that the section had reference only to a "written contract executed by the corporation" are identical with those used in section 26(c)(1). There is no reason*802 to believe that Congress intended that a broader meaning be attached to these words as used in section 26(c)(1) than attached to them under the necessary limitations of 26(c)(2).
Respondent urges that the language used in these cases makes clear "that a provision restricting the payment of dividends must be contained in a contract entered into by a corporation with its creditor in respect of its indebtedness to said creditor, in order to permit allowance of credit under section 26(c)(1)." Respondent's regulations *1057 (Art. 26-2(b), Regulations 94) provide that this credit "is allowable only with respect to a written contract executed by the corporation prior to May 1, 1936, which expressly deals with the payment of dividends and operates as a legal restriction upon the corporation as to the amounts which it can distribute within the taxable year as dividends." The argument here advanced by respondent would, in effect, change his own regulation by adding another condition to the allowance of this credit, so that the regulation would read that the credit "is allowable only with respect to a written contract executed by the corporation with its creditor or creditors * * *. *803 "
With this contention as applied to the facts of the instant case, we can not agree. The phrase "routine contracts dealing with ordinary debts" used by the Supreme Court in the Northwest Steel Rolling Mills case was used by it in antithesis to the words "statutory obligations" and therefore the "statutory obligations" were what the Court had in mind as the opposite of "routine contracts dealing with ordinary debts," or as unusual contracts not dealing with ordinary debts. In the instant proceeding the debt of petitioner to the trust company is an ordinary debt and this is true of the obligation under the reclamation district bonds, even if this obligation is one in rem. It is also true that a contract which has as its purpose the safeguarding of a guarantor of an obligation is not an unusual contract and by reason of its subject matter necessarily deals with the debt guaranteed. Neither of these propositions is questioned by respondent, who is merely insisting that because the contract is made by the corporation with the guarantor instead of with the creditor it does not fulfill the requirements of the statute. We can find no justification for this contention in the statute, *804 in respondent's own regulations, or in the decided cases, and, therefore, conclude that a written contract executed by and between a corporation and the guarantor of its debts and obligations prohibiting the payment of dividends by the corporation during the existence of the guarantor's secondary liability on such debts and obligations, is such a contract as to entitle the corporation to credit under section 26(c)(1) of the Revenue Act of 1936.
Respondent's third contention was made in connection with the contention which we have just considered. It may be paraphrased as follows: Petitioner was the principal stockholder of petitioner and exercised a controlling influence on its affairs; at any time he could have relieved the petitioner of any restriction on the distribution of dividends; and, therefore, the restriction on the distribution of dividends by petitioner must be considered as self-imposed and as similar to "intramural," "unilateral" "agreements of the stockholders inter sese" "which the corporation, through its stockholders, could * * * revoke" within the meaning of Thibaut & Walker*1058 Co., supra; *805 Henry Mill & Timber Co., supra;Metal Specialty Co., supra; and Lehigh Structural Steel Co., supra.
We can not agree with this argument. While Stewart dominated the affairs of petitioner during the taxable year, his domination arose by reason of personal ability and the confidence of the other stockholders, and not by reason of his ownership of the majority of petitioner's stock. If, for any reason, difficulties arose between him and his son-in-law and daughter, his domination of the petitioner would be at an end. As the guarantor of petitioner's obligations, he was interested in providing for the payment of these obligations at the earliest moment. While he was motivated to become guarantor by reason of being the principal stockholder of petitioner, he was motivated to exact the contract from petitioner prohibiting it from paying dividends by reason of his undertaking to act as guarantor, and for the purpose of protecting himself as such guarantor. Therefore, the contract dated January 1, 1936, was executed by the corporation with Stewart qua guarantor and not qua stockholder. As guarantor his interests were no longer*806 identical to those of the corporation and the other stockholders. Having insisted upon the execution of this contract and being a minority stockholder, there was little likelihood that Stewart would relieve petitioner of any restrictions on the distribution of its earnings. If he did waive the restrictions of the contract, it would, of course, follow that the petitioner would lose any credit by virtue of the contract. Coca Cola Bottling Co., Inc., of Blytheville, Arkansas,44 B.T.A. 1110">44 B.T.A. 1110.
We conclude that a written contract executed prior to May 1, 1936, by and between a corporation and the guarantor of the obligations of the corporation, prohibiting the payment of dividends by the corporation so long as the obligations are unsatisfied, is a contract which will permit a credit under section 26(c)(1), even though the guarantor is a stockholder of the corporation.
Decision will be entered for the petitioner.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax -
* * *
(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
(1) PROHIBITION ON PAYMENT OF DIVIDENDS. - An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. if a corporation would be entitled to a credit under this paragraph because of a contract provision, and also to one or more credits because of other contract provisions, only the largest of such credits shall be allowed, and for such purpose if two or more credits are equal in amount only one shall be taken into account.
(2) DISPOSITION OF PROFITS OF TAXABLE YEAR. - An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. For the purposes of this paragraph a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word "debt" does not include a debt incurred after April 30, 1936. ↩