*3002 Capital stock of the petitioner, a corporation, paid to its officers and directors in 1923, held to have been paid for services in promoting the corporation in 1919, and is not a proper deduction from income of 1923 under section 214 of the Revenue Act of 1921.
*1015 This is a proceeding for the redetermination of a deficiency in income taxes for the year 1923 in the amount of $5,312.50.
The following errors are assigned:
(1) The respondent erroneously determined the taxable net income of petitioner for 1923 to be $97,176.05, whereas it was not more than $54,696.05;
*1016 (2) The respondent erroneously disallowed as a deduction from petitioner's income the amount of $42,500 paid to officers as compensation;
(3) The respondent erroneously treated the said sum of $42,500, paid and distributed to officers of petitioner in its capital stock, as an addition to capital and as a capital expenditure;
(4) The respondent erred in failing to treat said amount of $42,500 as an item of expense accrued and paid by petitioner within the year*3003 1923; and
(5) The respondent erred in assessing income tax at the rate of 12 1/2 per cent, amounting to $5,312.50 upon the sum of $42,500.
FINDINGS OF FACT.
On November 12, 1919, eight individuals, John S. McDonald, Henry Van Aalderen, Glendon A. Richards, Frederick W. Hinyan, Charles E. Norton, Edwin F. Cool, M. Thomas Ward, and Frank J. Cook, met and drew up articles of incorporation, to be known as Guarantee Bond & Mortgage Co. of Grand Rapids. Two of these parties, Ward and McDonald, were lawyers. On November 17, 1919, the articles were filed with the Secretary of State of the State of Delaware, and the petitioner came into existence. The authorized capital stock of petitioner was $2,500,000, divided into 250,000 shares of stock of a par value of $10 each. Of this number of shares, 150,000 were preferred stock and 100,000 were common stock. Petitioner started business with a capital paid in of $1,000.
On November 21, 1919, the first meeting of the stockholders of petitioner was held and the following resolution was adopted:
Upon motion duly made and seconded, it was resolved that the directors be and they hereby are authorized to issue the common capital stock*3004 of this company to the aggregate of twenty-five thousand (25,000) for services performed, labor done, or any of such considerations as they shall from time to time deem advisable.
On the same date the first directors' meeting was held, at which the following resolution was passed:
Resolved that the president and secretary be and they are hereby authorized and directed to issue to the order of Charles E. Norton, 9,000 shares of fully paid capital stock of this company, and to M. Thomas Ward, 9,000 shares of fully paid capital stock of this company, and to Henry Van Aalderen, 1,000 shares of fully paid capital stock of this company, and to John S. McDonald, 1,000 shares of fully paid capital stock of this company, and to Frederick W. Hinyan, 1,000 shares of fully paid capital stock of this company, and to Christian Gallmeyer, 1,000 shares of fully paid capital stock of this company, and to Glendon A. Richards, 1,000 shares of fully paid capital stock of this company, and to Frank J. Cook, 1,000 shares of fully paid capital stock of this company, and to Edwin F. Cool, 1,000 shares of fully paid capital stock of this company, which stock is to be issued for services rendered by the*3005 parties in organizing, *1017 incorporating and getting the company upon a sound, financial basis, and the Board of Directors do hereby determine that the said services so rendered are worth to this company, the sum of $250,000. Unanimously carried.
Prior to November 21, 1919, the petitioner had no assets other than the $1,000 paid into it for stock, and no business had been obtained. It was not at that time upon a sound financial basis. The corporation had simply been organized and the incorporation papers filed. The stock referred to in the resolution of November 21, 1919, was issued in the names of the parties specified, but was not delivered to them. On November 25, 1919, petitioner made application to the Michigan Securities Commission for permission to sell its stock. This application contained the following statement:
Twenty-five thousand shares of the common stock are to be given to the promoters of the company for the promotion for the service rendered and in lieu of all other compensation.
The 25,000 shares of common stock were ordered to be placed in escrow with the State Treasurer until the time petitioner should be earning 6 per cent net upon all of*3006 its outstanding stock. The Commission reserved the right at any time it deemed expedient or necessary for the protection of the stockholders of the company to order all or any portion of the 25,000 shares returned to the treasury of petitioner for its use and benefit.
Thomas Ward and Charles E. Norton did not receive the 9,000 shares each as provided in the resolution. It was thought that the services they were rendering and had rendered, and the condition of the business did not warrant the issuance to them of that amount of stock and each voluntarily agreed to receive 4,000 fewer shares.
In a letter of February 28, 1921, addressed to the Michigan Securities Commission, the petitioner stated with regard to the shares relinquished by Norton and Ward:
Mr. Ward and Mr. Norton have voluntarily released the 8,000 shares to the company without any obligation on the part of the company. This will simply make our promotion stock that much less.
On July 27, 1922, petitioner made application to the Michigan Securities Commission for release of the remaining 17,000 shares of the stock, stating that the petitioner had been paying in excess of 7 per cent on its preferred stock and*3007 in excess of 6 per cent on its common stock.
The 17,000 shares of stock were released by the Commission on February 1, 1923, as it found that the conditions of the escrow had been met.
The petitioner during the first three years of its existence was in the general commercial and financing business. It made construction loans and operated an abstract of title and title guarantee business. Petitioner bought second mortgages, and contracts, and *1018 title notes on automobiles, trucks and various kinds of equipment. It was necessary to appraise the property involved and to watch closely to see that it was kept up and that the equity was paid up. In some cases it was necessary to replevin automobiles. The business of the petitioner could not have been conducted successfully without the careful attention of its officers and directors. All the officers and directors were consulted about contemplated second mortgage loans.
The officers of the petitioner from 1919 to 1923 were:
Henry Van Aalderen, president.
John S. McDonald, vice president.
Frank Hinyan, vice president.
Charles E. Norton, secretary.
Christian Gallmeyer, treasurer.
The directors of petitioner*3008 were.
Henry Van Aalderen,
Frederick W. Hinyan,
Edwin F. Coll,
Glendon A. Richards,
John S. McDonald,
Charles E. Norton,
Frank J. Cook,
M. Thomas Ward,Van Aalderen, who devoted all his time to the business, received an annual salary of $7,500. None of the other officers and directors received any stated compensation up to 1923, except the treasurer, who received $600 during 1922. Each member of the board of directors who made appraisals received $2.50 for each appraisal. Stock of petitioner was sold by Norton, who received a commission therefor. Ward was the attorney for the petitioner and was paid $2 for each title that he guaranteed. This fee went to pay an assistant to Ward who did the work on the abstracts. In March, 1923, Ward was voted a salary of $1,500 per year.
There were eight concerns organized and doing a business similar to that of petitioner in Grand Rapids. These concerns were unsuccessful. Throughout the State of Michigan there were about 130 such businesses, but only about 20 or 30 survived. The petitioner survived becaused its operating costs were low, due partly to the fact that the most of the officers and directors received no compensation*3009 during the first three years of petitioner's existence.
Directors' meetings were often held at the lunch hour and much of the discussion of the business of petitioner was done by telephone.
The by-laws of petitioner provide in part:
The Directors, as such, shall not receive any stated salaries. By resolution of the Board a fixed sum and expenses, if any, may be allowed for attendance at any regular or special meeting of the Board; provided, however, that nothing herein contained shall be construed to preclude any Director from serving the company in any other capacity and receiving the usual compensation therefor.
*1019 At a directors' meeting held on January 19, 1922, a resolution was passed providing that each director should receive $5 for every attendance at a directors' meeting.
The books of petitioner showed assets and liabilities at December 31, 1920, 1921, 1922, and 1923, as follows:
| DECEMBER 31, 1920. | |||
| Assets | Liabilities | ||
| Old National Bank | $1,375.02 | Mortgages payable | $45,303.07 |
| Notes receivable | 1,900.00 | Accounts payable | 7,600.00 |
| Contracts, etc., receivable | 388,870.96 | Unearned discounts | 28,847.20 |
| Abstract department | 50,000.00 | Common stock issued (par) | 495,020.00 |
| Office equipment | 971.45 | Preferred stock issued | 347,910.00 |
| Commission on sales of stock | 85,277.50 | Surplus | 8,592.62 |
| Bonus on common stock | 362,377.96 | ||
| Capital stock in escrow | 42,500.00 | ||
| Total | 933,272.89 | Total | 933,272.89 |
| DECEMBER 31, 1921. | |
| Assets | |
| Accounts receivable | $1,740.89 |
| Notes receivable | 950.00 |
| Contracts, etc., receivable | 583,834.77 |
| Abstracts Department | 150,000.00 |
| Office equipment | 907.34 |
| Commission on sale of stock | 12,087.50 |
| Bonus on common stock | 435,330.00 |
| Capital stock in escrow | 42,500.00 |
| Stock subscriptions unpaid | 7,582.50 |
| Total | 1,234,933.00 |
| DECEMBER 31, 1921. | |
| Liabilities | |
| Insurance on cars | $270.62 |
| Notes payable | 15,000.00 |
| Mortgages payable | 60,648.37 |
| Unearned discount | 52,515.47 |
| Capital stock subscriptions | 11,937.50 |
| Common stock issued (par) | 587,280.00 |
| Preferred stock issued | 467,800.00 |
| Surplus | 16,041.99 |
| Old National Bank (overdraft) | 23,439.05 |
| Total | 1,234,933.00 |
| DECEMBER 31, 1922. | |
| Assets | |
| Cash on hand | $50.00 |
| Notes receivable | 2,450.00 |
| Accounts receivable | 381.95 |
| Contracts, etc., receivable | 965,860.51 |
| Prepaid insurance | 37.35 |
| Office furniture and fixtures | 1,115.38 |
| Abstract department | 150,000.00 |
| Stock subscriptions | 43,328.56 |
| Commission on sales of stock | 87,822.50 |
| Bonus on common stock | 522,457.50 |
| Capital stock in escrow | 42,500.00 |
| Total | 1,816,003.75 |
| DECEMBER 31, 1922. | |
| Liabilities | |
| Notes payable | $65,000.00 |
| Accounts payable | 5,808.84 |
| Old National Bank (overdraft) | 10,766.78 |
| Mortgages payable | 106,243.72 |
| Unearned discount | 71,194.36 |
| Capital stock subscription | 70,850.00 |
| Preferred stock | 723,710.00 |
| Common stock | 738,510.00 |
| Surplus | 23,920.05 |
| Total | 1,816,003.75 |
| DECEMBER 31, 1923. | |
| Assets | |
| Notes receivable | $114,009.26 |
| Accounts receivable | 229.46 |
| Contracts, etc. receivable | 1,034,120.13 |
| Office furniture and fixtures | 1,066.81 |
| Abstract department | 150,000.00 |
| Building improvements | 6,786.80 |
| Stock subscriptions | 23,848.00 |
| Commission on sales of stock | 120,225.00 |
| Bonus on common stock | 554,850.00 |
| Surplus | 17,594.39 |
| Total | 2,022,729.85 |
| DECEMBER 31, 1923. | |
| Liabilities | |
| Accounts payable | $64,909.51 |
| Old National Bank (overdraft) | 15,965.83 |
| Mortgages payable | 136,645.72 |
| Unearned discount | 77,733.79 |
| Capital stock subscribed | 35,425.00 |
| Preferred stock | 881,660.00 |
| Common stock | 810,390.00 |
| Total | 2,022,729.85 |
*1020 The petitioner, in its return for 1923, claimed as a deduction for salaries paid its officers, the amount of $42,500 paid in capital stock during that year. The respondent held that the payment of this stock was organization expenses and the amount of $42,500 was restored to income.
The return of the petitioner was submitted on the accrual basis.
OPINION.
SIEFKIN: The petitioner contends that the amount of $42,500 paid to its officers and directors in*3012 1923 in its capital stock constituted compensation to such officers and claimed it as a deductible expense in the return for the year 1923. The respondent does not dispute the value of the stock paid, but he treated it as promotion stock and restored the amount of $42,500 to income of petitioner for the year 1923.
At the hearing three of the officers of petitioner who were present at the time the stock was authorized to be paid testified that the intention was to pay the stock to the officers and directors for services rendered subsequent to organization in putting petitioner upon a sound financial basis. They testified that up to the time the resolution was adopted petitioner was not upon a sound financial basis, that Norton and Ward had done all the preliminary work of organizing the corporation, that such service was not worth more than $300 to $500, and that the placing of the petitioner on a sound financial basis was done by all the directors from 1919 to 1923, for which they received the $42,500 in stock, and that such amount is deductible under section 214(a)(1) of the Revenue Act of 1921, which provides as follows:
SEC. 214. (a) That in computing net income there shall*3013 be allowed as deductions:
(1) All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; * * *
However, the various transactions of the petitioner tend to indicate that this stock was intended to be issued for services rendered in organizing and incorporating the petitioner.
The evidence discloses that the petitioner placed the stock in question in escrow with the Michigan Securities Commission in 1919.
The only part of the Michigan statute regulating investment companies (Act. 46, Compiled Laws of Michigan, 1915, p. 4237, sec. 11952) which provides for placing of stock in escrow, is as follows:
SEC. 8. The said commission shall have power to demand from any investment company seeking to come under the provisions of this act any further information other than such investment company is required to furnish under the provisions *1021 of this act which shall be necessary to the end that the commission may be put in possession of all facts and information necessary to qualify it to properly pass upon*3014 all questions that may come before it. It may make or have made under its direction a detailed examination of such investment company's property, business and affairs, which examination shall be at the expense of such investment company, it may cause an appraisal to be made at the expense of said investment company of the property of said investment company, including the value of patents, good will, promotion and intangible assets, and it may fix the amount of stocks, bonds and securities that shall be issued by any corporation, foreign or domestic, in payment for property, patents, good will, promotion and intangible assets at the value it shall find the same to be worth and may require that such stocks and securities so issued for such property, patents, good will, promotion and intangible assets shall be deposited in escrow under such terms as said commission may prescribe. And said commission may withhold its license to sell such stock, bonds, and securities if such corporation has issued stocks, bonds and securities in payment for property, patents, good will, promotion and intagible assets in excess of their value as found by said commission or if said stocks, bonds and*3015 securities are not deposited in escrow according to the terms fixed by such commission until such stocks, bonds and securities issued in payment for property, patents, good will, promotion and intangible assets in excess of the value so found by said commission have been surrendered to such corporation and cancelled by it, and until the said stock has been deposited in escrow under the terms prescribed by said commission. (Italics supplied.)
We do not believe that the officers and directors of petitioner would have deposited the stock in escrow with the Michigan Securities Commission unless their intention at the time was to issue the stock for promotion compensation. However, even if this amount were paid as compensation for services, we are unable to determine the deduction to be allowed, since petitioner has failed to show that the salaries were reasonable for the year 1923.
In , we said:
We are not impressed by the petitioner's argument that the question of reasonableness is not involved in this proceeding, because it was not the ground upon which the Commissioner disallowed the additional salaries for 1922 and 1923, and because*3016 it was not pleaded in the respondent's answer to the petition herein. In our opinion, regardless of the pleadings, the law makes this question an issue here. In every instance in which we have allowed additional salaries for a given taxable year on account of services rendered in previous years, we have held that the combined regular and additional salaries for such year were no more than reasonable compensation for services rendered. ; ; . We have also disallowed such additional compensation where reasonableness had not been shown. . Upon the record here we are unable to determine that the total deductions claimed on account of salaries for the years 1922 and 1923 were reasonable compensation for the services rendered.
*1022 In the , we said:
Petitioner avers that if the additional salary deductions are not allowed for the year 1918 the same certainly constitutes*3017 a deductible item from income for the year 1919, when the salaries were actually paid. It may be that such additional salaries paid in 1919, when added to the regular salaries paid in 1919, constitute a reasonable compensation for personal services actually rendered in that year, but we have no evidence before us concerning the salaries paid, services performed, or the volume or character of business done during the year 1919, and we are, accordingly, without the necessary facts to determine the issue for that year.
The action of the respondent is upheld.
Judgment will be entered for the respondent.