*906 Petitioner exchanged its capital stock for securities having a fair market value in excess of the par value of its stock, plus indebtedness assumed. The fair market value of the securities represented actual cost thereof to petitioner. Computed on such basis, petitioner had an operating deficit at the close of the taxable year 1934. Held, petitioner was not "formed" for the purpose of enabling its shareholders to escape tax, and, since petitioner had no accumulation of "gains and profits" but an impairment of paid-in capital, it was not "availed of" for such purpose in the taxable year and is not subject to the tax imposed by section 104 of the Revenue Act of 1932, as amended.
*150 This is a proceeding for the redetermination of a deficiency in income tax for the fiscal year ended October 31, 1934, in the amount of $39,715.83. Petitioner assigned seven errors in its petition, as amended, but they may be briefly summarized as alleging in substance that respondent erred "in holding that*907 the petitioner was subject *151 to the tax imposed by Section 104 of the Revenue Act of 1932." The errors alleged were denied by respondent. The facts were stipulated in part, and established in part by oral and documentary evidence.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the State of Texas on November 4, 1929. The stated purpose for which the petitioner was organized was:
* * * to subscribe for, purchase, invest in, hold, own, assign, pledge and otherwise deal in and dispose of shares of capital stock bonds, mortgages, debentures, notes and other securities, obligations, contracts and evidences of indebtedness of foreign or domestic corporations, as permitted under the laws of Texas, and to have and perform all powers necessary or incidental to the conduct of such business.
The stockholders, the amounts subscribed, and the number of shares owned at the time of the organization of the petitioner were as follows:
| Stockholder | Amount subscribed | Amount paid |
| W. S. Farish, Sr | $255,000 | $255,000 |
| Libbie Rice Farish | 94,700 | 94,700 |
| W. S. Farish, Jr | 75,000 | 75,000 |
| Martha Botts Farish | 75,000 | 75,000 |
| B. L. Block | 100 | 100 |
| B. D. Haltom | $100 | $100 |
| W. N. Finnegan, Jr | 100 | 100 |
| Total | 500,000 | 500,000 |
*908 There was no change in stockholdings of the petitioner between the date of its organization and the end of its taxable year 1934, except on August 10, 1933, one share was transferred by Libbie Rice Farish to S. P. Farish, and on February 5, 1934, one share was transferred from B. D. Haltom to Hines H. Baker as qualifying shares. W. S. Farish, Jr., and Martha Botts Farish are the son and daughter, respectively, spectively, of W. S. Farish, Sr., and his wife, Libbie Rice Farish.
The capital stock of the petitioner at the time of its incorporation on November 4, 1929, and at the time of the hearing, was $500,000. In consideration for the issuance of its capital stock, securities of a fair market value of $1,245,875 were transferred to the petitioner by Farish and his wife, and the petitioner assumed liabilities in the amount of $618,084.65. The stocks transferred by Farish and wife to the petitioner represented only a small proportion of the stocks and bonds owned by them. Their gross estate, the stocks and bonds owned by them and their liabilities as of September 1, 1929, were as follows:
| Gross estates | $28,061,057.15 |
| Stocks and bonds | 26,796,630.73 |
| Liabilities | 7,989,469.75 |
*909 *152 In 1930 Farish and his wife received dividends on stocks of domestic corporations in the amount of $356,656.16, while petitioner during its fiscal year 1930 received like dividends of $74,912.67; in 1931 petitioner's stockholders received in such dividends $312,735.05, and petitioner received $66,078.80; in 1932 the stockholders received $275,624.63 and petitioner received $41,172.02.
On July 26, 1930, Farish and his wife contributed 14,905 shares of stock of the South Texas Cotton Oil Co. to the petitioner as capital surplus, the cost thereof to them being $248,835.75, which was the amount credited to capital surplus by the petitioner. The fair market value thereof on the above date was $670,725.
The petitioner kept its books and made its income tax returns on the basis of a fiscal year ending October 31.
At the time of its formation, W. S. Farish was president of the Humble Oil & Refining Co., and later he became chairman of the board of directors of the Standard Oil Co. of New Jersey.
The following shows the cost, fair market value, and depreciation in value of the stocks and bonds owned by petitioner on the dates indicated:
| Date | Cost | Fair market value | Depreciation |
| July 12, 1930 | $2,138,072.61 | $2,053,722.93 | $84,349.68 |
| Oct. 31, 1930 | 2,205,803.13 | 1,948,769.39 | 257,033.74 |
| Oct. 31, 1931 | 1,997,806.01 | 1,108,459.53 | 889,346.48 |
| Oct. 31, 1932 | 1,553,357.09 | 836,127.58 | 717,229.51 |
| Oct. 31. 1933 | 2,146,534.39 | 1,961,156.22 | 185,378.17 |
| Oct. 31, 1934 | 1,946,513.64 | 1,942,750.94 | 3,762.70 |
*910 At the time the stocks and bonds were transferred to petitioner in exchange for its capital stock, they were held by brokers as collateral security on indebtedness of Farish and his wife. The indebtedness assumed by petitioner was a portion of this indebtedness. The brokers required Farish to guarantee petitioner's accounts at the time of its organization in 1929, and such guarantee was in force up to and including petitioner's taxable year 1934. Petitioner's indebtedness to brokers on the dates indicated was as follows:
| November 4, 1929 | $618,084.65 |
| October 31, 1930 | 1,421,241.03 |
| October 31, 1931 | 1,294,312.25 |
| October 31, 1932 | $1,250,513.74 |
| October 31, 1933 | 1,560,124.19 |
| October 31, 1934 | 1,341,609.73 |
The net payment by petitioner on its indebtedness to brokers during the taxable year 1934 was $219,114.46.
*153 The following is a statement of petitioner's income for the fiscal year 1934 as shown by its books:
| Income: | ||
| Dividends received | $86,155.31 | |
| Gains on turnover | 57,343.00 | |
| Interest received | 1,415.27 | |
| Miscellaneous | 13.90 | |
| Total income | 144,927.48 | |
| Expenses: | ||
| Interest paid | $25,469.08 | |
| Losses on turnover | 37,468.52 | |
| Miscellaneous | 1,858.22 | |
| Total expenses | 64,795.82 | |
| Net income | 80,131.66 |
*911 In the fiscal years 1930, 1931, and 1932 petitioner's losses on turnover exceeded its gains on turnover in the amounts of $27,808.72, $76,794.46, and $195,441.29, respectively. In the fiscal years 1933 and 1934 gains exceeded losses on turnover in the amounts of $11,980.31 and $19,874.48, respectively.
As shown by its books, petitioner had no earned surplus at the beginning of the fiscal year 1930. During that year it sustained an operating loss of $20,731.74. At the beginning of the fiscal year 1931 petitioner had a deficit of $21,271.74; it sustained an operating loss during the year of $37,382.73 and at the end of the year had a deficit of $58,654.47. At the beginning of the fiscal year 1932 petitioner's deficit was $58,654.47; it sustained a loss during that year of $186,216.84 and had a deficit at the end of the year of $244,871.31. At the beginning of the fiscal year 1933 petitioner had a deficit of $245,063.18; it realized net income during the year of $38,701.69 and had a deficit at the end of the year of $206,361.49. At the beginning of the taxable year 1934 petitioner had a deficit of $206,361.49; it derived net income during the year of $80,131.66 and at the end*912 of the year had a net deficit in the amount of $126,229.83.
Petitioner's balance sheets, at the dates indicated, disclosed the following:
| Assets | Liabilities | ||||
| Oct. 31, 1934 | Nov. 4, 1929 (date of organization) | Nov. 4, 1929 | |||
| Cash in bank | $40,875.27 | W. S. Farish, Sr | $56,053.17 | ||
| Accounts receivable | 41,670.27 | Brokers | 1,341,609.73 | 618,084.65 | |
| Stocks and bonds | 1,835,061.74 | $708,466.69 | Capital stock | 500,000.00 | 500,000.00 |
| Pro rata cost of items acquired 11-4-29 for capital stock | 111,451.90 | 409,617.96 | Capital surplus | 257,663.52 | |
| Fixed assets | 37.41 | Earned surplus (deficit) | (126,229.83) | ||
| Total | 2,029,096.59 | 1,118,084.65 | Total | 2,029,096.59 | 1,118,084.65 |
*154 In opening petitioner's books of account, the cost of securities received for its capital stock was set up in two accounts in the total amount of $1,118,084.65, in order to facilitate the making of petitioner's income tax returns. One of such accounts was designated "Stocks and Bonds", showing a debit of $708,466.69 representing cost of the securities to the transferors, and the other was called "Proration of Capital Stock", in the amount of $409,617.96. *913 The brokers were credited for the indebtedness assumed by petitioner in the aggregate amount of $618,084.65, and capital stock was credited in the amount of $500,000.
The amount of $127,790.35 representing the difference between the fair market value of $1,245,875 of the securities received for capital stock and $1,118,084.65, representing the cost at which they were recorded on petitioner's books, could properly have been set up as paid-in surplus, but the full amount was not so recorded.
Petitioner was not formed, nor, during the taxable year, availed of for the purpose of preventing the imposition of any internal revenue tax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.
OPINION.
HILL: Section 104 of the Revenue Act of 1932, as amended by section 214 of the National Industrial Recovery Act, 48 Stat. 195, 207, applicable to petitioner's taxable year ended October 31, 1934, provides that if any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of any internal revenue tax upon the shareholders through the medium of permitting*914 its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for the taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof; and the fact that any corporation is a mere holding or investment company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape internal revenue tax.
For the purposes of this section it is further provided that net income shall include dividend deductions and interest on certain obligations of the United States which would be subject to tax in the hands of an individual owner, but that the tax imposed shall not apply if all the shareholders of the corporation include, at the time of filing their returns, in their gross income their entire distributive shares of the net income of the corporation for such year.
The first question for consideration is whether or not petitioner corporation was "formed" for the purpose proscribed by the statute. *155 W. S. Farish, Sr., was the principal stockholder of the petitioner. The balance of its stock*915 was owned by his wife, son, and daughter, with the exception of qualifying shares. At the time of the organization of petitioner, Farish and his wife owned an aggregate gross estate in excess of $28,000,000, embracing stocks and bonds in excess of $26,000,000. They transferred to the corporation in exchange for its capital stock securities of a fair market value of only $1,245,875, which was less than 5 percent of the securities owned by them.
In 1930 Farish and his wife received dividends from domestic corporations in the amount of $356,656.16, while petitioner during its fiscal year 1930 received like dividends of $74,912.67; in 1931 petitioner's stockholders received in such dividends $312,735.05, and petitioner received $66,078.80; in 1932 the stockholders received $275,624.63 and petitioner received $41,172.02. If the petitioner corporation had been formed for the purpose of enabling its stockholders to escape tax through the medium of permitting its gains and profits to accumulate instead of being distributed as dividends, it would seem reasonable to assume that Farish and his wife would have transferred a much larger portion of their income-producing securities to the*916 corporation.
Apparently respondent does not seriously urge the contention that petitioner was "formed" for the purpose of saving its stockholders from tax through the accumulation of gains and profits, but rather that it was "availed of" for such purpose in the taxable year, and was "formed" primarily for the purpose of registering tax losses.
Respondent in his brief asserts that on November 7, 1929, three days after petitioner was organized, Farish transferred certain securities to the corporation, which transfer was characterized as a sale, for the purpose of registering losses in the sum of approximately $788,000 on the individual income tax returns of himself and wife, and that they thereby escaped an enormous tax. Respondent further states:
It is realized that this precipitous utilization of the petitioner corporation to avoid surtax by registering tax losses does not in itself bring the petitioner under the scope of Section 104. While it is almost conclusive proof that the petitioner was formed to escape surtax of its stockholders, the principal medium or the method chosen to escape tax of its stockholders was by the method of registering losses rather*917 than through the medium of non-distribution of profits as prescribed by Section 104.
Even if we should assume that the petitioner corporation was originally formed for the purpose of registering tax losses through sales of securities to it by its stockholders, and also was used for such purpose, as contended by respondent, this would not in any event bring petitioner within the provisions of section 104, which imposes a penalty for avoiding tax only through the accumulation of the corporation's gains and profits.
*156 Farish testified that he did not organize petitioner for the purpose of avoiding tax; that his primary purpose was to establish an enterprise that would continue to function after his death, one that in time would become free of debt and to which he could make gifts from time to time for the purpose of increasing its value; that he and his wife expected to make petitioner executor of their respective wills, and trustee of trusts for the benefit of their children. Also, he hoped that his son, who was then in college, would become active in petitioner's affairs, and this son did become treasurer of the petitioner in 1935 after he left college. Secondary*918 reasons for the organization of the corporation were (1) to simplify the transfer of assets of Farish and his wife after their deaths, in that there would result the transfer of the stock of only one corporation instead of the securities of a large number of corporations organized under the laws of various states, and (2) to concentrate management in one company.
There was much evidence tending to support Farish on this point, a detailed discussion of which would unnecessarily prolong this opinion. We have carefully considered all the evidence, as well as the argument on brief of counsel for the respective parties, and it is our opinion that the preponderance of evidence clearly indicates that the actuating motive for the formation of the petitioner corporation was not to enable its shareholders to escape tax through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.
The second and principal question for consideration is whether petitioner was "availed of" for such purpose during the taxable year.
Section 104, and similar provisions contained in section 220 of the Revenue Act of 1926 and prior acts, have been construed by*919 the Board and the courts in numerous cases. For present purposes such discussion need not be repeated here. See, among others, ; affd., ; ; ; affd., ; .
Application of the statute obviously depends upon the existence of "gains and profits" which have been accumulated (instead of being divided or distributed) for the purpose of preventing the imposition of tax upon the shareholders. If petitioner corporation had no accumulated gains or profits to be divided or distributed in the taxable year, it could not have been availed of for the proscribed purpose. As to so much, the parties substantially agree.
Petitioner contends that it had no gains or profits, but an 0perating deficit, whereas respondent holds "that there was not only no deficit, *157 but that there was a constant and substantial accumulation of surplus during the prior years as well as the fiscal year in question. *920 " Thus, solution of the controverted point requires consideration of the radically different methods employed by the parties in their respective computations.
At organization petitioner exchanged its capital stock of the par value of $500,000 for securities having a fair market value of $1,245,875, and assumed indebtedness of the transferors in the amount of $618,084.65. It recorded the stocks and bonds on its books as having a cost to it of $1,118,084.65, which was the aggregate sum of the par value of its capital stock and the indebtedness assumed. The fact that petitioner set up the securities on its books in two assets accounts, namely, "Stocks & Bonds" $708,466.69. which represented cost to the transferors, and "Pro-Ration of Capital Stock" $409,617.96, we think is immaterial. The two accounts showed assets of a total cost of $1,118,084.65, and allocating to the account designated "Stocks & Bonds" an amount equal to the transferors' cost facilitated the making of petitioner's income tax returns, since that was the cost basis to it in computing gain or loss for income tax purposes upon subsequent sales of the securities. The difference between the fair market value of the*921 securities and cost recorded on books might properly have been credited to paid-in surplus, but for reasons not important here this was not done. For convenience of discussion the book cost will in those circumstances be treated as the equivalent of fair market value.
In arriving at the deficit of $126,229.83 shown by its books at the end of the taxable year, petitioner used the book cost above referred to in computing gain or loss on sales of the securities in question, while respondent employed the transferors' cost, which concededly is the statutory basis for computing taxable net income. Since the transferors' cost was less than the fair market value or book cost, petitioners' method of computation tended materially to reduce gains and increase losses over respondent's method, while respondent's basis, as compared with petitioner's, correspondingly increased gains and decreased losses. This directly raises the question whether respondent's method properly may be used in determining whether petitioner, within the meaning of the statute, realized distributable gains and profits, or sustained an operating deficit which impaired its paid-in capital. It is our opinion that*922 such method may not be so used.
Section 112(b)(5) of the Revenue Act of 1932 provides that no gain or loss shall be recognized if property is transferred to a corporation solely in exchange for its stock and immediately after the exchange the transferors are in control of the corporation; and section 113(a)(8) provides that the basis for determining gain or loss in respect of such property in the hands of the corporation shall *158 be the same as it would be in the hands of the transferors. The facts of the present case bring it squarely within these statutory provisions, which require that petitioner's taxable net income be computed on the basis of the transferors' cost of the securities exchanged for its capital stock. This rule was adopted because of the fact that upon the exchange no gain or loss was recognized. The gain derived or loss sustained when computed in such manner, however, does not reflect the true gain or loss as it affects the capital of the corporation. The rule is applicable only in computing taxable net income, that is, the income upon which Congress has levied a tax. Thus, taxable net income is purely a statutory concept, and bears no*923 necessary relation to gains and profits subject to distribution as dividends. Cf. ; ; . It is the actual gain or loss which affects the corporation's capital and determines whether there is earned surplus, or a deficit which impairs the capital. Section 104 itself makes a distinction. The proscribed act is the accumulation of "gains and profits" and not "net income" or "taxable net income." However, the tax provided is 50 percent upon the "net income" as defined in subsection (c).
The cost to a corporation of property exchanged for its capital stock is the fair market value of the stock so exchanged, and where there is no other method of determining the value of the stock, its value is held to be the fair market value of the property exchanged therefor. ;; ; *924 ; .
The cost to petitioner of the securities acquired in exchange for its capital stock was not less than $1,118,084.65, the cost entered on its books. If petitioner thereafter had sold such securities for $1,118,084.65, it would neither have derived a gain nor sustained a loss in fact, and its paid-in capital would have remained the same in amount, the form merely being changed from an investment in securities to cash. Under the statute it would have realized taxable gain in the amount of $409,617.96, or the difference between the transferors' cost and the sales price, because it acquired the securities in a tax-free exchange. However, if petitioner has distributed such statutory taxable income to its stockholders, it would not have been a distribution out of "gains and profits" but a liquidating dividend which, to that extent, would have invaded its paid-in capital.
Surplus is the amount of net assets over liabilities, including capital stock. *925 ; ; . Conversely, a deficit is the excess of the liabilities, including capital stock, over the assets.
*159 At the close of the taxable year 1934 petitioner had total assets of $2,029,096.59. It total liabilities, including capital stock and paid-in surplus, amounted to $2,155,326.42. The operating deficit, therefore, after deducting the current gains and profits, was $126,229.83, and measured the extent to which its paid-in capital had been invaded. Although the petitioner's books showed net income of $80,131.66 for the fiscal year 1934, there could be no accumulated earnings or profits until the operating deficit was made good.
It is well settled that an impairment of capital or paid-in surplus resulting from operating losses must be restored before any earnings can be available for distribution to the stockholders. ;*926 ; ; ; ; .
Where a corporation, actively engaged in business, has no accumlation of distributable gains or profits but an operating deficit, as in this case, we think it can not be said that its failure to distribute a portion of its paid-in capital equal to its net income computed under section 104 constitutes an availing of the corporation for the purpose of preventing the imposition of tax upon its shareholders.
Petitioner legitimately required the use of considerable capital in the operation of its business, which capital in large part was borrowed. The gains and profits derived in the taxable year were not beyond its reasonable business needs, and did not in any event constitute an accumulation, although not distributed for the reason that, coincident with receipt, they became capital, restoring impairment to that extent.
In *927 , affirming , the corporation was created to take over and hold its sole stockholder's half of the stock of another corporation, which subsequently declared a dividend and credited half of the amount thereof on its books to the taxpayer corporation. The latter corporation paid no dividends but loaned the money to its sole stockholder. It was held that the corporation was both formed and availed of for the purpose described in section 104. That case is clearly distinguishable on the facts from the instant proceeding.
In ; ; and , there were accumulations of gains and profits in the taxable years involved which were not absorbed by operating losses, but which it was claimed by petitioners in those cases were entirely wiped out by diminution of the value of capital assets. The Board held in those cases that a mere diminution in value of capital assets in an amount greater than the total of the gains and profits did not prevent the applicability of*928 section *160 104, supra. These cases are distinguishable from the instant proceeding in that neither of them involved an impairment of paid-in capital as the result of an operating deficit which precluded distribution of current earnings as dividends.
The ground last above mentioned also distinguishes . In that case the Board found as a fact ( that the petitioner corporation was availed of during the taxable year ended January 31, 1931, for the purpose of preventing the imposition of the surtax upon its sole stockholder "through the medium of permitting its gains and profits to accumulate instead of being divided or distributed", and the Supreme Court held that there was ample evidence to support the findings of the Board. At January 31, 1931, the corporation held stocks and bonds valued at $2,989,452.74, an increase during the year of $209,734.67. There was no need of accumulating any part of the year's earnings for the purpose of financing its business. At the close of the taxable year it had on hand cash in excess of all its liabilities, other than capital and reserves, *929 in the amount of $1,136,820.55. Its paid-in capital had not been impaired by an operating deficit nor through depreciation in value of its capital assets. Its actual surplus, consisting apparently of earned surplus, was $7,938,965.54.
In the case at bar, the petitioner corporation did not have sufficient capital to meet the reasonable needs of its business; it operated largely on borrowed capital and at the close of the taxable year, after deducting current gains and profits, it had an actual operating deficit of $126,229.83, which to that extent impaired its paid-in capital.
For the reasons indicated above we hold that the present petitioner was neither "formed" nor, in the taxable year, "availed of" for the purpose recited in section 104, supra, and, therefore, is not subject to the tax imposed by that section.
Reviewed by the Board.
Judgment will be entered for the petitioner.
STERNHAGEN, VAN FOSSAN, MURDOCK, TURNER, HARRON, and KERN dissent.