*3261 1. A corporation in 1905 acquired a business and in addition to stock issued to former owners it agreed to pay them "a sum equal to 12 1/2% of the net profits" throughout its existence. Held sums so paid in 1920, 1921 and 1922 were not deductible as ordinary and necessary expenses.
2. The disallowance of such deductions in computing net income does not carry with it the necessity of including the amount thereof in invested capital.
*365 These proceedings result from determinations of deficiencies in income and profits taxes as follows: for 1920, $7,444.98; for 1921, $1,667.73; for 1922, $3,533.84.
Petitioner alleges error with reference to the following issues: (1) deductions have been disallowed of payments to George La Monte and George M. La Monte made in accordance with an agreement made on or about January 30, 1905, as follows: in 1920, $17,304.11; in 1921, $7,360.89; in 1922, $28,270.73; (2) in event such disallowance was not erroneous, then respondent erred in failing to include *366 the said payments in invested capital for*3262 each of the taxable years; (3) respondent erred in reducing invested capital for 1920 and 1921 by prior years' income and profits taxes. This issue was abandoned at the hearing.
Upon motion duly made and granted the appeals were consolidated for purposes of hearing and decision.
FINDINGS OF FACT.
Petitioner is a New Jersey corporation with its principal office at New York, N.Y., and is engaged in the manufacture and sale of safety paper. It was formerly known as The Kingsland Paper Mills.
Prior to 1904, George La Monte & Son, a New York corporation, and The Kingsland Paper Mills, a New Jersey corporation, were separately engaged in the manufacture of safety paper. They were competitors. The La Monte concern had been in business since about 1850, when George La Monte had originated the safety paper. The Kingsland corporation started in business a good many years later and manufactured a paper known as "Bankers' Safety Paper." In 1904 the proposition was conceived to merge the two corporations. Pending an outcome of the ensuing negotiations the products of both corporations were handled from their joint account during a period of about one year by the "Hudson Trading*3263 Company." In January, 1905, the stockholders of George La Monte & Son were George La Monte and his son, George M. La Monte, and the stockholders of The Kingsland Paper Mills were John Howe, W. L. Sergeant, and Thomas J. O'Neil.
The following agreement was entered into:
THIS AGREEMENT, made this 30th day of January Nineteen hundred and five, between GEORGE LA MONTE & SON, a corporation organized under the laws of the State of New York, party of the first part, THE KINGSLAND PAPER MILLS, a corporation organized under the laws of the State of New Jersey, party of the second part, GEORGE LA MONTE and GEORGE M. LA MONTE, parties of the third part, and WILIAM L. SERGEANT, THOMAS J. O'NEILL and JOHN HOWE, parties of the fourth part, witnesseth, that the said parties hereto do hereby mutually covenant and agree to and with each other as follows, viz:
The party of the second part agrees forthwith to amend its certificate of incorporation by increasing its authorized capital to the sum of $342,800. and to issue $42,800. as special stock to La Monte & Son and to issue one-half of the balance total capital common stock ($150,000. in amount) to the parties of the third part in equal*3264 amounts the balance of common stock $150,000., shall be issued to the parties of the fourth part in equal amounts. All the outstanding certificates of stock, which are now held by the parties of the fourth part hereto, shall be surrendered. The capital of Three hundred and forty two thousand eight hundred dollars, to be issued as above mentioned, shall be provided and paid as follows, viz:
*367 (1) The entire manufacturing plant of the party of the first part, including all its machinery, fixtures, tools, trade-marks, designs, lease-hold interests in real estate, and good will of the safety and other paper business now carried on by it, shall be transferred and conveyed to the said party of the second part at a valuation of $167,800.; the manufacturing plant of the party of the second part, including all machinery, fixtures, tools, trade-marks, designs, good will of business and real estate, shall be estimated and taken at $125,000.
(2) The excess above the amount of $292,800. consisting of the value of the plants and other matters above designated, consisting of $50,000. shall be made up as follows: - An inventory and valuation shall be made of all stock and materials*3265 on hand, manufactured and in process of manufacture, also raw materials, and the value thereof shall be agreed upon and fixed by all the parties hereto, or if they fail to agree then by disinterested appraisers, and the balance necessary to make up the full amount of capital of $342,800. shall be paid by the said parties of the third and fourth part in equal portions, for the purpose of providing working capital. Should more capital be required than $50,000. above mentioned the capital shall be furnished by the parties of the third and fourth parts equally either in cash or accepted merchandise.
The following mentioned property, now held in the name of said Kingsland Paper Mills, but not used in its business, is to be transferred to the parties of the fourth part, and is not comprehended within this agreement; the same is described as follows:
(1) Mortgage for $2,000 made by Masonic Lodge.
(2) $550 worth of stock of U.S. Metal Engraving Co. of East Newark. Also cash notes & Bills receivable and stock and raw materials goods in process and manufactured and all property except the manufacturing plant and tools & above mentioned.
The corporate name of said party of the second*3266 part shall be changed to GEORGE LA MONTE & SON by amendment of the certificate of incorporation.
The by-laws of the party of the second part shall also, at the same time, or as soon as practicable thereafter, be changed so that the same shall be in the form shown by the draft thereof hereto annexed, marked "Schedule A."
Immediately upon change of the name and by-laws and the giving of the Bills of Sale by the parties hereto the party of the second part shall make a contract with GEORGE LA MONTE and GEORGE M. LA MONTE to pay them each year during the corporate existence, a sum equal to 12 and one-half per cent of the net profits of the business for each year before any dividends shall be declared less such amount as shall be paid upon the special stock issued to the said GEORGE LA MONTE and GEORGE M. LA MONTE. The said contract shall be also ratified and assented to by all the stock-holders personally and shall be binding upon them their personal representatives and assigns as owners of stock held by them respectively.
The parties of the third and fourth parts shall agree in writing with said last named company that none of them shall for a period of 40 years, engage (except*3267 as members of said company), either directly or indirectly, in the manufacture or sale of safety paper in any part of the United States, Canada, Mexico, such parts of South America as may be specified, Great Britain, Ireland, France and Germany, Sweden, or in any other place in which said parties of the first part of second part have heretofore or shall hereafter manufacture or sell safety paper. Provided however, if said company shall at any time practically suspend or discontinue the manufacture or sale of safety paper, for any cause, such restriction shall no longer bind any of the said parties of the third or fourth parts.
*368 The Board of Directors of said Company shall consist of six stockholders thereof, of whom three shall be persons who are now stockholders in said party of the first part, or such persons as they or their successors in ownership of the stock hereafter to be issued as above provided (amounting to $150,000.) shall nominate; the remaining three shall be persons who are now the stockholders in said party of the second part, or such persons as they or their successors in ownership of said $150,000. worth of stock hereafter to be issued to them as above*3268 provided, shall nominate.
The Board of Directors shall elect the following officers to serve for one year and until their successors are elected; President, George M. La Monte, Vicepresident George La Monte, Treasurer William L. Sergeant, Secretary, Thomas J. O'Neill, John Howe, Superintendent of Nutley Mill.
The Board of Directors shall also appoint the following named persons to be the first members of the Executive Committee: viz: George M. La Monte and William L. Sergeant.
It is agreed that the Executive Committee shall at all times be composed of two persons, one of whom shall be such person as is now a stockholder in said party of the first aprt, and the other shall be a person who is now a stockholder in said party of the second part; or such committee may consist of such other persons or person as shall be nominated by the representatives of the present stockholders of said parties of the first and second part respectively, each having the right to nominate one member of said committee.
The President salary shall $300be per month, and that of the Secretary and Treasurer and Superintendent Nutley Mill each $100. per month, subject to change by the Executive Committee*3269 or Board of Directors.
That the existing Contracts of the parties of the first part and the parties of the second part for sale of safety paper shall be carried out by the parties of the second party. Also contracts with Margaret and Joseph Kingsland Jr.
IN WITNESS WHEREOF, we have hereunto set our hands and seals the date first above mentioned.
In the presence of -
GEO. LA MONTE & SON. GEO. LA MONTE per GEO. M. LA MONTE. GEO. M. LA MONTE.KINGSLAND PAPER MILLS.
JOHN HOWE, Pres.
JOHN HOWE.
WM. L. SERGEANT.THOMAS J. O'NEILL.
Under date of January 31, 1905, the directors of petitioner passed the following resolution:
Whereas, the total amount of the capital stock of this company amounting to $30,000 was originally issued to and is now held by William L. Sergeant, Thomas J. O'Neil and John Howe in equal portions, 100 shares being held by each: And
Whereas, the present cash value of the net assets of this Company largely exceeds the said sum of $30,000 and in the judgment of the Board of Directors the real estate, manufacturing plant, tools, machinery, good-will, trade-marks, contracts and all other assets (except the merchandise now on hand, *3270 manufactured and in process of manufacture, cash book, accounts, bills and notes receivable and other intangible assets), are worth at this time in cash at least the sum of $125,000 over and above the liabilities of the Company: And
*369 Whereas, it is proposed to increase the authorized capital of this Company from $30,000 to $342,800 (of which $42,800 is to be special stock, to be issued in accordance with the proposed amendment to the Certificate of Incorporation and by-laws)
Therefore, Be it Resolved, that this company declare and it does hereby declare a stock dividend to the present stockholders based upon such present value of the net assets of the company represented by said real estate manufacturing plant, tools, machinery, good-will, trade-marks, contracts and all other assets (except the merchandise now on hand, manufactured and in process of manufacture, cash and other excepted items above stated) over and above the total original stock issue of $30,000, sufficient to make the total issue of stock (including said $30,000 originally issued) issued for said real estate manufacturing plant, tools, machinery, good-will, trade-marks, contracts, and other assets (with*3271 the exceptions above stated), amount in value to $125,000 (1250 shares). The said excepted property, consisting of merchandise now on hand, manufactured and in process of manufacture, cash book accounts, bills, and notes receivable and other intangible assets, shall be inventoried at the proper valuations and after payment therefrom of the present indebtedness of the company stock shall be issued at par to the present stockholders, in equal proportions for the value thereof, up to the further sum of $25,000, if the value of such residue shall amount to that sum; but if it shall not amount to that sum, the balance necessary to make up the said sum of $25,000 is to be paid in cash to the Company.
The total stock issued to the present stockholders representing the total net assets of the company, will then amount to $150,000 in amount (1500) which shall include the present issue of $30,000. The said new stock shall be issued as soon as the authorized capital of the company shall be increased as above stated. The present issue of $30,000 shall be surrendered to the Company and cancelled.
This resolution is in pursuance of, and for the purpose of carrying out the provisions of*3272 a contract made between this company and George La Monte & Son a corporation and George La Monte, George M. La Monte, William L. Sergeant, John Howe, and Thomas J. O'Neil, so far as it relates to the stock which is contemplated by said contract to be issued to and held by the present stockholders of this company.
On motion the meeting then adjourned.
THOS. J. O'NEIL, Secretary.
Under date of January 31, 1905, the stockholders of The Kingsland Paper Mills approved the above contract and assented to the following amendments to the certificate of incorporation:
The name which we have assumed to designate such corporation and to be used in its business and dealings is George La Monte & Son.
The total authorized capital stock of this corporation is $342,800, divided into 3428 shares of the par value of $100 each; of said amount $42,800 shall be issued as special stock, the same to be entitled to no interest in the capital stock of the corporation and to have no voting powers but to be entitled to receive dividends not exceeding 8 per cent per annum in accordance with the provisions of the by-laws; the balance of $300,000 to be issued as general or common stock.
The following*3273 agreement was entered into:
THIS AGREEMENT made this sixth day of February in the year nineteen hundred and five by and between GEORGE LA MONTE & SON, a corporation of the *370 State of New Jersey, party of the first part and GEORGE LA MONTE and GEORGE M. LA MONTE parties of the second party, WITNESSETH.
For and in consideration of the sale of certain property by GEORGE LA MONTE AND SON a corporation of the State of New York to the party of the first part the party of the first part hereby agrees with the parties of the second part, their representatives and assigns that it will pay them during the existence of the said first party a sum equal to twelve and one-half per cent of the net profits of said first party, less the amount paid on the special stock of the party of the first part, by the party of the first part. The said payments herein contemplated to be made, shall be made at the times that the said first party shall pay dividends on its stock.
IN WITNESS WHEREOF, the party of the first part has set its seal the day and year first above written.
GEO. LA MONTE & SON.By GEO. M. LA MONTE Pt.
In the presence of -
THOS. J. O'NEIL.The assets were transferred*3274 to petitioner by the following conveyance:
This agreement made this 1st day of February in the year one thousand nine hundred and five by and between George La Monte & Son a corporation of the State of New York, party of the first part and George La Monte & Son, a corporation of the State of New Jersey party of the second part. Witnesseth the parties of the first part for and in consideration of the issue of certain stock of the party of the second part consisting of $125,000, common stock and $42,800 special stock to George La Monte, and George M. La Monte and the making of a certain agreement by second party with said persons to hereby sell, convey and assign to the second party the entire manufacturing plant of the first party, including all its machinery, fixtures, trade-marks, designs, good will of the safety and other paper business, now owned and carried on by first party, interest in leases, and contracts and real estate and generally all property of whatever kind and nature now owned by the said first party herein except merchandise, cash bills and notes, outstanding accounts for merchandise.
The capital stock was issued by petitioner as follows:
| Common stock issued to- | Shares | So-called special stock issued to- | Shares |
| George La Monte and | |||
| George M. La Monte | 1,500 | George La Monte | 143 |
| William L. Sergeant | 500 | Caroline La Monte (his daughter) | 143 |
| Thomas J. O'Neill | 500 | George M. La Monte | 142 |
| John Howe | 500 | ||
| Total | 3,000 | Total | 428 |
*3275 The common stock is still held 50 per cent by the La Monte family and 50 per cent by the group of Sergeant, O'Neill and Howe.
At a stockholders' meeting on February 6, 1905, the following directors were elected: George La Monte, George M. La Monte, C. B. La Monte, William L. Sergeant, Thomas J. O'Neill, and John Howe.
At a directors' meeting on February 6, 1905, the following officers were elected: president, George M. La Monte; vice president, George *371 La Monte; secretary, Thomas J. O'Neil; treasurer, William L. Sergeant; superintendent, John Howe.
Included in the revised by-laws of petitioner which were adopted at the stockholders' meeting on February 6, 1905, were the following provisions:
VIII.The total amount of the capital stock of this company is $342,800. The number of shares is 3,428. The par value is $100. Of this amount $42,800 shall be special stock and the balance common stock. Said special stock shall entitle holders to receive in each year a dividend of 8 per cent per annum quarterly before any dividend shall be set apart or paid on the general or common stock. This said dividend to be paid only out of 12 and one-half per cent of the net*3276 profits of the company, and if 12 and one-half per cent of the net profits in any year or period of dividends shall not be sufficient to pay 8 per cent per annum on this special stock then such dividend shall be paid thereon as 12 and one-half per cent of the net profits of a year or period of payment of dividends will suffice to pay. Holders of special stock shall have no power to vote nor shall they be entitled to notice of any meeting of stockholders of the company. They shall not be entitled to share in the distribution of the assets of this company in the event of the dissolution or other termination of this company, shall have no right whatever except to receive dividends as herein provided.
The balance sheet of petitioner as of February 1, 1905, drawn from the books was as follows:
| Dr. | Cr. | |
| LaMonte mill plant, etc | $167,800.00 | |
| Kingsland Mill plant, etc | 125,000.00 | |
| LaMonte millstock inventory | 26,863.48 | |
| Kingsland millstock inventory | 21,261.28 | |
| Cash | 3,738.72 | |
| Capital Stock: | ||
| Common | $300,000.00 | |
| Preferred | 42,800.00 | |
| George LaMonte & Son (New York) | 1,863.48 | |
| 344,663.48 | 344,663.48 |
The net profits according to the books of the corporation*3277 were as follows (petitioner changed to a calendar year basis in 1905):
| Year | Geo. LaMonte & Son, | |
| New York corporation | Petitioner | |
| Fiscal year ended Jan. 31, 1902 | $34,235.57 | $10,200.80 |
| Fiscal year ended Jan. 31, 1903 | 75,211.65 | 20,901.24 |
| Fiscal year ended Jan. 31, 1904 | 39,445.39 | 66,613.71 |
| Fiscal year ended Jan. 31, 1905 | 44,420.87 | 75,513.70 |
| Period ended Dec. 31, 1905 | 118,869.06 | |
| Calendar year 1906 | 144,646.49 | |
| Calendar year 1907 | 159,536.29 | |
| Calendar year 1908 | 116,352.02 | |
| Calendar year 1909 | 139,528.51 |
*372 The above includes the profits of the "Hudson Trading Company."
Payments to the La Montes in compliance with the agreement of February 6, 1905, after deducting amounts paid to the holders of the "special stock" amounted as follows:
| Year | Amount |
| 1905 | $11,434.64 |
| 1906 | 14,646.49 |
| 1907 | 16,518.04 |
| 1908 | 9,807.49 |
| 1909 | 13,392.05 |
| 1910 | 14,824.75 |
| 1911 | $16,529.91 |
| 1912 | 24,717.51 |
| 1913 | 28,507.08 |
| 1914 | 15,961.92 |
| 1915 | 5,765.66 |
| 1916 | 18,776.84 |
| 1917 | $5,286.28 |
| 1918 | 19,098.83 |
| 1919 | 8,040.88 |
| 1920 | 17,304.11 |
| Total | 240,612.48 |
As of January 1st, 1920, the total of such payments amounted to $223,308.37.
*3278 Prior to the death of George La Monte, the remainders of the one-eighth shares of the net profits, after deducting the distributions to the holders of the special stock, were, by agreement between George M. and George La Monte, paid by petitioner, two-thirds thereof to George La Monte and one-third to George M. La Monte.
The La Monte family has always retained the proprietary interests in the agreement of February 6, 1905. The respective interests therein have been the subject of transfers from time to time between members of the family by will or agreements, without relation to the individual holdings of the special stock.
The following agreement was executed:
WHEREAS, an agreement dated February 6th, 1905, was heretofore made by and between GEORGE LAMONTE & SON, a New Jersey corporation, as party of the first part (hereinafter called the "Company") and the undersigned, GEORGE LAMONTE and GEORGE M. LAMONTE, as parties of the second part, in and by which said Company agreed that it would pay to the undersigned, their representatives and assigns, during the existence of said Company, a sum equal to twelve and one-half per cent. (12 1/2%) of the net profits of said Company, *3279 less the amount paid on its special stock; and
WHEREAS, said special stock consists of four hundred and twenty-eight (428) shares of the par value of $100 each, and has been and is owned and held as follows: George LaMonte one hundred and forty-three (143) shares, George M. LaMonte one hundred and forty-two (142) shares, and Caroline B. LaMonte one hundred and forty-three (143) shares; and
WHEREAS, under the by-laws of said Company said special stock is entitled to dividends at the rate of eight per cent. (8%) per annum; and
WHEREAS, it was and is the understanding of the undersigned, that all amounts paid to the undersigned under said agreement of February 6th, 1905, over and above the dividends on the special stock held by them, should be divided between them in the proportion of two-thirds (2/3) to said George LaMonte and one-third (1/3) to said George M. LaMonte;
Now, THEREFORE, THIS AGREEMENT WITNESSETH, that for and in consideration of the premises and of the sum of One dollar by each of the parties to the other *373 in hand paid, the receipt of which is hereby acknowledged, the parties hereto do hereby agree to and do ratify and confirm the aforesaid understanding.
*3280 IN WITNESS WHEREOF, the said George LaMonte and said George M. LaMonte have hereunto set their hands and seals this 4th day of April, 1912, this agreement being executed in duplicate.
GEO. LAMONTE [SEAL] GEO. M. LAMONTE. [SEAL]In the presence of -
DEWITT V. WEED.
It has been the settled practice of the petitioner for a great many years to charge to profit and loss account the payments made in accordance with the agreement of February 6, 1905.
Subsequent to December 31, 1909, the following resolution was passed at a meeting of the board of directors of the petitioner:
RESOLVED, that the profits of the business of the company for the six months ending December 31, 1909, without deducting the salaries voted at this meeting be ascertained, and that twelve and one-half percent thereof be set apart, and that out of the sum so set apart there be paid to the holders of the special stock of this company, the semi-annual dividend of four per cent, and the balance be paid to Messrs. George LaMonte and George M. LaMonte, pursuant to the terms of the agreement heretofore made dated February 6, 1905, and that said payment be made as of December 31, 1909, and charged as*3281 an expense of the business of the company for the year 1909.
During the taxable years the payments made by petitioner and disallowed by respondent as deductions were as follows: 1920, $17,304.11; 1921, $7,360.89; 1922, $28,270.73.
OPINION.
STERNHAGEN: The issue in this proceeding arises entirely out of the agreement of February 6, 1905, which was made in conformity with the provisions of the original quadrilateral agreement of January 30, 1905, by which the ownership of the business of the two corporations was rearranged. This agreement was that the petitioner would pay to George La Monte and George M. La Monte throughout petitioner's existence "a sum equal to 12 1/2% of the net profits * * * less the amount paid on the special stock." These sums were $17,304.11 for 1920, $7,360.89 for 1921, and $28,270.73 for 1922.
The petitioner deducted these sums in the years in question as "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business," Revenue Acts 1918 and 1921, section 234(a)(1), and the Commissioner has disallowed the deductions. It is not contended that the payments were for services or for any other current consideration, *3282 but only that they were made *374 pursuant to the contractual obligation of 1905. For this reason alone petitioner urges their deductibility.
We are of opinion that this was not an expense of carrying on business but was a division of the profits after such expenses had been paid and accounted for. It was a method whereby the persons named were to share specially in the fruits of the enterprise. While the method was unusual in that it was not like that of either a stockholder or an employee, this does not require that the language of the statute should be interpreted beyond its ordinary meaning so as to provide for their deduction.
Were this a proportionate distribution among stockholders it would not be deductible, but would be taxed first to the corporation and later (except for normal tax) to the stockholders. Here there was a distribution of earnings upon an adopted basis other than proportionate stockholdings, taxable no less as profits even though the statute provides no such credit as that given expressly to stockholders in respect of dividends.
*3283 , certiorari denied , is somewhat similar. A "grubstake" agreement between a corporation and an individual resulting in a sharing of profits from a contract for manufacturing munitions was held by the Circuit Court of Appeals, Third Circuit, to provide no deduction to the corporation of the share paid to the individual in determining its taxable net income from munitions. As in that case, it seems to us that the tax here was imposed upon the corporation between the time its "net profits" were earned and the time they were distributed either under its resolution to stockholders or under the contract to these individuals.
Petitioner urges in that event that the amounts should go into invested capital. This does not follow. The items which make up invested capital are specified in section 326. They include only cash or property paid in to the corporation for stock or by way of surplus. and no such property exists here. These payments added nothing by way of capital to the corporation above what was already in. There is no such relation between taxable net income and*3284 statutory invested capital that the disallowance of a deduction under section 234 carries with it the increase of invested capital under section 326.
Reviewed by the Board.
Judgment will be entered for the respondent.