*1151 1. For the purposes of the credit provided by section 26(c)(1) of the Revenue Act of 1936, a corporate bylaw is not a "written contract executed by the corporation."
2. Petitioner may deduct from gross income the actual amount of interest accrued on its indebtedness for the taxable year, despite a deduction of a lesser amount in its return.
*675 This is a proceeding to redetermine deficiencies in income tax of $531.83 and $761.46 for the calendar years 1936 and 1937, respectively. The deficiencies arise out of respondent's disallowance of a credit claimed under section 26(c)(1) of the Revenue Act of 1936 and raise the question of whether, for the purposes of that section, a corporate bylaw is a contract. Petitioner also requests a finding of overpayment because of its erroneous understatement of the amount of a deduction for accrued interest.
FINDINGS OF FACT.
Petitioner is a corporation organized under the laws of the State of Michigan. It is authorized by its articles of incorporation to lease, hold, or improve*1152 real estate. Upon its incorporation on September 6, 1934, it issued 1,000 shares of stock, par value $10, for a conveyance of title to a store and office building located in Detroit, Michigan. The stock, constituting petitioner's entire issue of capital stock, was issued to petitioner's incorporator, Jacob B. Lasky. Lasky, immediately after the incorporation, sold the stock in various amounts to his six children.
At the time of the conveyance, the property was subject to a mortgage payable to the Massachusetts Life Insurance Co., by virtue of which annual principal payments of not less than $8,000 were to be paid, with interest at 6 percent. Under the deed conveying the property *676 to petitioner, petitioner assumed and agreed to pay the mortgage indebtedness.
At the first meeting of stockholders, held October 6, 1934, the following bylaw was adopted:
Until January 2nd, 1942, no dividends shall be paid unto the stockholders of the Company unless the principal of the mortgage indebtedness on the Davison-Joseph Campau property owned by the Corporation shall have been reduced to a sum of not more than Sixty Thousand Dollars ($60,000.00) without the unanimous written*1153 consent of all stockholders of record, this provision as to the dividends in the by-laws not to be amended except by the unanimous written consent of all stockholders of record.
Pursuant to the above bylaw, petitioner's board of directors, at their first meeting on November 7, 1934, took the following action:
Upon motion duly made, seconded and unanimously carried, the following was adopted as the policy of the Board of Directors with reference to the use of all excess income: It is the policy of the Board of Directors adopted in accordance with the wishes of all stockholders of said Company that all proceeds of the Company be devoted toward the payment of maintenance and operating costs, taxes and insurance, then toward the payment of the necessary servicing of the mortgage indebtedness in accordance with the terms of said mortgage, then to set aside a reserve, which reserve shall be maintained in the depositary bank designated by said Board of Directors to be used to reduce the principal of the mortgage indebtedness, and that no dividends shall be paid unto the stockholders of said Company until the principal of the mortgage indebtedness shall have been reduced to a sum of not*1154 more than Sixty Thousand Dollars ($60,000.00).
The bylaw and the resolution pursuant thereto were adopted in order to safeguard the property from foreclosure, and to prevent use of excess income from leases in good years from being used for any purpose save the reduction of the mortgage. Lasky had owned other properties and had lost them through foreclosures which had eventuated from his failure to use the income from the properties to pay off the mortgages, and it was desired to prevent a repetition of those occurrences.
As of December 31, 1936, the principal balance due on the mortgage was $111,000 and as of December 31, 1937, the principal balance due on the mortgage was $103,000. The mortgage indebtedness has always been in excess of $60,000.
Petitioner claimed credit, under the Revenue Act of 1936, section 26(c)(1), for all of the adjusted net income, $5,573.79, in computing undistributed net income subject to surtax, as provided in section 14 of that act.
Petitioner's income tax return for 1936 was stated, in the questionnaire provided for that purpose, to have been filed on the cash basis. In the questionnaire attached to the 1937 return, the answer to the question*1155 as to the accounting basis was left blank. Petitioner's books were kept on the accrual basis and always have been, and all its other *677 income tax returns have been filed on the accrual basis. It was the intention of those in charge of petitioner to file on the accrual basis for 1936 and 1937 and the returns were so filed. The statement in the one questionnaire was made in error, and the omission on the other was inadvertent.
In its 1937 return, petitioner deducted $5,911.30 for interest accrued on the mortgage. One of the items making up this total was interest accrued for the period from October 1 to December 31, 1937; on the return this was erroneously stated as $1,030. The correct amount was $1,545. Petitioner asks a finding of the resulting overpayment.
OPINION.
LEECH: The two issues submitted are: (1) Whether petitioner is entitled to any credit under the Revenue Act of 1936, section 26(c)(1), 1 the amount of the credit not being contested, and (2) whether petitioner is entitled to deduct from gross income for the taxable year the actual amount of interest accrued on its indebtedness in that year, despite a deduction of a lesser amount on its return for*1156 the year.
The inquiry upon which decision of the first issue rests is whether the bylaw of the petitioner, quoted in the findings of fact, supported by the quoted resolution of the directors, is "a written contract executed by the corporation" within the meaning of section*1157 26(c)(1) of the Revenue Act of 1936.
This provision grants credits, under certain conditions. As such, it is to be strictly construed. ; , affirming .
A bylaw of a corporation may be defined as a rule or regulation established by the corporation as one of the incidents of its existence, for its internal government or for the government of its officers or members in the management of its affairs as among themselves. . The general rule is that a proper bylaw may operate as a contract and thus bind the shareholders in their relations with each other and with the corporation. *678 ; ; ; ; *1158 ; ; . It has been held to be "in effect" a contract between the different members of a corporation. ; . The shareholders may thus be bound in their relations with the corporation and with each other by a reliance upon the existence of that law or declared policies of the corporation. But a bylaw seems to us to lack the essence of a formal contract in that it is "adopted" and not "executed." There is only one party, the corporation, acting through its stockholders, to the adoption of the law and the declaration of its policy. It thus becomes a part of the fundamental law of the corporation.
In the Crane-Johnson case, supra, the Circuit Court, in affirming , said:
We are here considering a tax law, and the question is not whether for any purpose a charter or a state law may be treated as a contract, but rather whether they together may be considered a written contract executed by the corporation*1159 within the meaning of Section 26(c)(1) of the Revenue Act of 1936. * * * Clearly, this provision relates to a corporate undertaking to discharge a certain obligation out of earnings, and not to any statutory provisions. * * * [Emphasis supplied.]
We think that any contract existing here by virtue of the bylaw was in the nature of an implied contract, which arose, not from any statutory obligation, it is true, but from a similar obligation imposed by the "law" of the corporation. But, there was no "written contract executed by the corporation" within the meaning of the cited section, preventing the payment of dividends.
In our judgment, the wording of the resolution of the board of directors supports this conclusion in that it declared the "policy" of the corporation in reference to the payment of dividends. ; .
The second issue arises from the respondent's refusal to allow petitioner to correct an error made on its 1937 return in its potition.
Respondent's position on this point is not clear. He contends that petitioner*1160 employs a nonpermissible "hybrid" system of accounting, that there is a conflict in the evidence respecting the facts of the accounting system actually used, and that under these circumstances, the Commissioner's determination should be sustained and that petitioner should not be allowed to rectify its mistake.
We think that the only "conflict" in the evidence has been satisfactorily explained by petitioner's bookkeeper and accountant, who testified from the books that petitioner's books have always been kept on an accrual basis, that its returns, which he prepared, were always *679 filed on an accrual basis, and that the statement in the questionnaire on the 1936 return, that it was filed on the cash basis, and the omission to make any statement on the 1937 return, were erroneous and inadvertent. We have found that both returns were filed on the accrual basis.
It is to be noted, furthermore, that respondent has raised no objection whatever to the balance of the deduction taken for interest accrued on the mortgage, which amounts to $5,911.30.
We do not think his objections to the correction of the error are well founded. *1161 ; ; . Accordingly, we find an overpayment of tax to the extent represented by petitioner's understatement of its deduction for mortgage interest accrued. Therefore,
Decision will be entered under Rule 50.
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. ↩