*1194 Petitioner, a corporation on the accrual basis, held demand promissory notes of its stockholders representing net withdrawals for personal use. The notes were executed with the mutual understanding that no interest would be charged or paid thereon. Held, petitioner is not required to accrue interest on said notes as income.
*339 This proceeding involves a redetermination of deficiencies in income tax asserted against petitioner for the calendar years 1934 and 1935 in the respective amounts of $599.27 and $2,366.55.
The question for consideration is whether the Commissioner erred in including in petitioner's gross income the sum of $13,717.79 for the calendar year 1934 and $14,071.29 for the calendar year 1935, representing interest on certain notes executed and delivered to petitioner by its stockholders for amounts withdrawn from the corporation for personal use.
Petitioner assails other additions to income made by the respondent which are either waived or conceded. These will be*1195 adjusted under Rule 50.
FINDINGS OF FACT.
In January 1900 the petitioner, a corporation, was organized under the laws of the State of Kentucky, with its principal office in Lexington, Kentucky. It filed its income tax returns in the district of Kentucky. Its books were kept and its returns made on the accrual basis.
*340 Prior to incorporation, and after 1895, the business was conducted as a partnership consisting of Alfred Combs and his six sons. They were engaged in the lumber and contracting business in the city of Lexington, Kentucky, where the corporation is now doing business. During this time when a partner needed money for his personal use he withdrew it from the firm, and the amount so withdrawn was charged to him on the partnership books and carried as an open account without interest.
Upon incorporation, the partners became stockholders, officers, and directors. All of the stock has been continuously held and owned by Alfred Combs, his sons, and grandchildren. With the exception of Mrs. Morrison, daughter of Thomas A. Combs, the officers and directors devoted practically all their time to the business of the corporation. They occupied the general*1196 offices of the corporation, were in daily contact with each other, and had frequent conferences and discussions concerning the conduct of the business. Formal stockholders' meetings were seldom held or made a matter of record.
After incorporation and continuing through 1934 and 1935, by mutual consent, the officers and directors continued to withdraw from the corporation amounts for their own personal use. The amounts so withdrawn were charged against the person receiving them on the company's books. Each account was credited with dividends paid by the corporation and with such other amounts as to which the individual was entitled to receive credit. These several accounts with the officers and directors were carried as open accounts without interest until January 1, 1920, when, upon suggestion of I. N. Combs, vice president and general manager, it was decided to close the open accounts at the end of each year by taking a promissory note for the balance due from each. The taking of notes to balance the accounts at the end of each year was for the purpose of avoiding any dispute that might later arise between the corporation and an interested party. By securing notes for the*1197 amounts due from those making withdrawals the petitioner sought to avoid the necessity, if a dispute should arise, of proving from its books over a long period of years the amounts due and owing from each. If the charges during the year exceeded the credits during the year, the difference was added to the face amount of the old note; if the credits during the year exceeded the charges during the year, the difference was deducted from the face amount of the old note and the account so adjusted was represented by a new note executed by the party owing the same and the old note was canceled.
The notes were demand notes on printed forms and provided for 6 percent interest from date. All the parties were assured by I. N. Combs, when the notes were first presented to them for execution, that while the notes provided for interest, no interest would be charged or *341 collected, and the notes were executed and renewed from year to year with that understanding. The provision as to interest was not stricken from the printed forms. In no case was interest charged, collected, or received on the open accounts or notes, or included in the new notes. All the accounts and notes were*1198 handled in the same way from the time the business was started. After this controversy arose a new form of note was used which contained no provision as to interest.
Alfred Combs, the father, died in 1933, leaving no estate. No interest was claimed, paid, or collected on the father's note.
Bill Combs, one of the brothers, died in 1933. In proving its claim against his estate petitioner neither claimed nor collected interest on his note. The same was true as to Thomas A. Combs, another brother, who died in 1935. I. N. Combs, Jr., son of I. N. Combs, had executed his note to the corporation for $2,236, representing withdrawals made by him. This note was paid and no interest was claimed, paid, or collected thereon. S. S. Combs was insolvent during the years 1934, 1935, and 1936.
It was not intended, either by the corporation or by the parties executing the notes, that interest should be charged, collected, or paid. No interest on the notes was accrued on petitioner's books as interest receivable. The face amounts of the notes were carried on petitioner's books as assets of the corporation.
In their individual income tax returns no deduction for interest was claimed*1199 by any of the stockholders on their notes held by the corporation.
The indebtedness of the interested parties and respondent's method of determining the amount of the deficiencies appear from the following tabulation taken from the deficiency notice (the amounts are not disputed):
| Indebtedness | ||||
| Number of shares | January 1, 1934 | January 1, 1935 | January 1, 1936 | |
| Alfred Combs | 0 | $19,846.64 | $19,846.64 | $19,846.64 |
| I. N. Combs | 1,018 | 69,281.39 | 72,062.13 | 73,638.52 |
| James H. Combs | 933 | 94,365.17 | 97,568.98 | 99,750.31 |
| S. S. Combs | 900 | 58,734.77 | 60,775.34 | 60,775.34 |
| Bill Combs | 660 | 26,404.88 | ||
| Thos. A. Combs | 800 | 24,889.67 | 25,610.97 | 25,610.97 |
| I. N. Combs, Jr | 3 | 2,236.00 | 2,236.00 | 2,236.00 |
| Totals | 4,314 | $295,758.52 | $278,100.06 | $281,858.08 |
| Less: | ||||
| Alfred Combs' account | 19,846.64 | 19,846.64 | 19,846.64 | |
| Bill Combs' account | 26,404.88 | |||
| Thos. A. Combs' account | 24,889.67 | 25,610.97 | 25,610.97 | |
| Total | $71,141.19 | $45,457.61 | $45,457.61 | |
| Balance | $224,617.33 | $232,642.45 | $236,400.47 | |
| Average advances | $228,629.89 | $234,521.46 | ||
| Interest 6% of advances | $13,717.79 | $14,071.29 |
*342 OPINION.
ARNOLD: We have found*1200 as a fact that it was not the intention of the parties that interest should be paid or collected on the amounts withdrawn for personal use. No interest was in fact paid or collected on the amounts withdrawn from the time the business first started as a partnership in 1895. This method of handling withdrawals continued after incorporation to and including the years before us. In 1920 when notes were first given it was understood by the makers and the corporation that no interest was to be paid or collected on the notes, and those subsequently given were executed and delivered with that understanding. The purpose of taking notes to balance the accounts at the end of each year was to avoid the inconvenience and difficulty, should a dispute arise, of making proof of the amount due from the books over a period of years. The old notes were canceled when new ones were given, and no interest on the old notes was paid or collected, and none carried forward and included in the renewals. No interest was paid or collected on those discharged by other than renewal notes. While the interest provision was not stricken from the face of the notes, the evidence clearly shows that this provision*1201 was considered immaterial and that no liability for interest was intended or created. Interest was not accrued on petitioner's books at any time. The notes were executed and delivered by those making withdrawals and accepted by petitioner with the understanding that no interest was to be paid or collected.
Respondent objected to the introduction of evidence to the effect that no interest was to be charged or collected, on the ground that as the notes on their face provided for interest, such evidence had the effect of varying the terms of a written instrument by parol, and cites authorities in support of that general principle.
We have held that the general rule contended for by the respondent does not apply in tax proceedings where the Commissioner was not a party to the instrument or in privity with the parties. ; ; ; . See also *1202 ; ; affd., .
This Board and the courts are not rigidly bound by formal written documents in determining questions in the field of taxation, since it is the substances and the realities of the transaction that must govern. ; While the notes here given formally provided for interest, it is clearly established by the evidence *343 that the parties intended that no interest should be charged or paid. In pursuance of such intention no interest was in fact paid and no interest was ever accrued by petitioner on its books. As no liability for interest was ever created, the respondent erred in including the interest in controversy in petitioner's gross income.
In so deciding we have considered various cases cited by the respondent, including *1203 ; ; ; , and others. In these cases a liability existed. Here no liability was created. The important factor in this case is succinctly stated in , wherein it is said: "When the right to receive an amount becomes fixed, the right accrues." Here, the right to receive never came into existence because the parties never intended to create any liability for interest by the giving or by the acceptance of notes.
Decision will be entered under Rule 50.