*2184 1. Certain individuals engaged in the business of shipbuilding as partners organized a corporation to construct vessels under contracts with the Emergency Fleet Corporation which required a showing of financial responsibility by contractors. In order to avoid the delay incident to an appraisal of assets by the State Corporation Commissioner and the Federal Capital Issues Committee, and after consultation with, and approval of their plan by, those officials, they borrowed the amount of the authorized capital stock on their individual notes, which was deposited to the credit of the new corporation and the latter received certificates of deposit for the full amount, and upon representation that the funds had been paid for the stock and would be used bona fide for the purchase of the partnership assets, and real estate and bonds owned by two of the partners, the Corporation Commissioner immediately authorized the issuance of the entire stock for cash. The corporation took over the assets and liabilities of the partnership and acquired from the partners, in exchange for the greater part of the certificates of deposit, the real estate and bonds, which were conveyed and deposited in trust*2185 for its benefit. Held, that the stock was not issued in exchange for the partnership assets and that the amount of cash deposited to the credit of the corporation was bona fide paid in for stock within section 326(a)(1), Revenue Act of 1918.
2. Held, further, that the fact that the stockholders agreed that the individuals who transferred the real estate and bonds to the corporation in exchange for certificates of deposit should receive the income therefrom, and, after dissolution, should receive the property itself if not required for corporate obligations and that such assets were merely held in trust for the use and benefit of the corporation and were not directly used in the business did not take them out of the category of assets within the reach of creditors and at risk in the business.
*6 This proceeding involves deficiencies of $44,700.95 and of $82,201.40 in profits taxes for the fiscal years ended June 30, 1919 and 1920, respectively. Petitioner attacks the Commissioner's exclusion from invested capital*2186 of $850,000 alleged to have been paid in for shares.
FINDINGS OF FACT.
Petitioner is a California corporation with principal place of business at Wilmington, Calif. It was organized on July 26, 1918, for the purpose of constructing ships for the United States Shipping Board Emergency Fleet Corporation. Prior to its organization a partnership of the same name, composed of Harry Chandler, his nephew, Ralph J. Chandler, General M. H. Sherman, his son, R. P. Sherman, and nephew, Eugene P. Clark, had been engaged since June, 1917, in constructing two vessels for the Emergency Fleet Corporation. Early in 1918 the Fleet Corporation entered into negotiations with the partnership for prospective contracts of construction involving $8,000,000. The Fleet Corporation required a well financed corporation. Contracts for shipbuilding were refused in many instances to firms which could not show adequate financial responsibility, and for the purpose of obtaining these contracts the five partners organized petitioner. The prospective contracts were on the so-called lump-sum basis, with provision for a bonus or penalty of $1,000 a day for completion of the ship before or after the date fixed. *2187 Speed in execution was indispensable, since the Government required the ships for the transportation of troops.
Petitioner's articles of incorporation provided for 10,000 shares of the par value of $100. For organization purposes $1,000,000 was borrowed on July 30, 1918, from the Farmers & Merchants National Bank of Los Angeles on four notes of $250,000 each, each of which was signed by one of the partners. General Sherman and Harry Chandler, the only two financially responsible for such amounts, each signed one and endorsed the other three. The loan, which was intended for the purchase of petitioner's stock, was divided into four parts to comply with a provision of the National Banking Act limiting a loan to one party to 10 per cent of the lending bank's capital and surplus, which in the case of the Farmers & Merchants National Bank was $2,500,000.
The $1,000,000 was deposited to petitioner's credit at the bank, certificates of deposit therefor were issued, and upon representation to the State's Corporation Commissioner that said funds had been paid for the shares and would be used for the bona fide purchase *7 by the corporation of the partnership's assets, certain*2188 real estate and bonds, a temporary permit for the issuance of the shares for cash was immediately granted in accordance with section 359 of the California Civil Code, which provides that no corporation shall issue stocks or bonds except for money paid, labor done, or property actually received. On the following day, July 31, 1918, the formal permit was granted. The shares were issued for $1,000,000 cash, as follows:
| Shares | Par value | |
| Ralph J. Chandler | 1 | $100 |
| M. H. Sherman | 1 | 100 |
| M. L. Baden | 1 | 100 |
| R. P. Sherman | 1 | 100 |
| Eugene P. Clark | 1 | 100 |
| V. F. McClellan | 1 | 100 |
| E. N. Martin | 1 | $100 |
| Harry Chandler | 2,498 1/4 | 249,825 |
| Ralph J. Chandler | 2,498 1/4 | 249,825 |
| M. H. Sherman | 1,665 1/2 | 166,550 |
| R. P. Sherman | 1,665 1/2 | 166,550 |
| Eugene P. Clark | 1,665 1/2 | 66,550 |
For $850,000 of the certificates of deposit petitioner acquired, from Harry Chandler and General Sherman, Liberty bonds of $300,000 and real estate which was reasonably worth $550,000. It also took over the assets and liabilities of the partnership. All these assets and liabilities were entered in petitioner's books, October 1, 1918. The Liberty bonds, of which $177,000 had belonged*2189 to Chandler and $123,000 to Sherman, were placed in trust with the Farmers & Merchants National Bank of Los Angeles on August 10, 1918, to be used for the credit and benefit of petitioner and subject to its order. The real estate, a portion of which had belonged to General Sherman and the remainder to corporations owned by Harry Chandler, his wife and children, was deeded in trust to the Title Insurance & Trust Company, part on August 10 and part on August 28, 1918, for like purposes and subject to petitioner's instructions. It is not unusual in Los Angeles for corporations to make such trust agreements in the conduct of their business. The entire interests in the capital assets of the partnership was owned by General Sherman and Harry Chandler.
Petitioner's shares were not issued for assets because an appraisal of value, likely to consume months, was required by the Corporation Commissioner and Capital Issues Committee prior to the granting of a permit for issuance of the shares, and such a delay might have resulted in a loss of the Government contracts. After informal discussions by the incorporators' counsel with said commissioner and a representative of the committee, it*2190 was decided that the most expeditious manner of proceeding would be to pay cash for the shares, if the money could be raised, and then buy the assets with the cash, provided a supplementary statement of the assets were filed. This statement was filed, and the commissioner and committee were both satisfied with the arrangement.
*8 At the time of organization there was an understanding between the parties that General Sherman and Harry Chandler would receive the income from the Liberty bonds and the real estate after the manner of preferred shareholders, and upon dissolution of the corporation would receive back said assets in case such income and assets were not required to meet the obligations of petitioner which held the equitable title thereto. Escrow instructions, ratified by all petitioner's shareholders and accepted by the Title Insurance & Trust Company on November 2, 1918, after reciting that said real estate was then held in trust for the use and benefit of petitioner and that receipts for the Liberty bonds and a promissory note for $150,000 executed by petitioner's stockholders in its favor were therewith delivered to it, directed that said properties be held - *2191 for the benefit of said Ralph J. Chandler Shipbuilding Company, unless and until you are authorized to convey or otherwise dispose of said property or any part thereof by an order in writing signed by the holders of at least 60% of the capital stock of said Ralph J. Chandler Shipbuilding Company.
An agreement drafted by the Title Insurance & Trust Company and signed November 1, 1918, by said shareholders recited that it was their intention to assure to those shareholders by whom said properties were transferred a return thereof or of cash paid in by them, "and to assure to the owners of the capital stock of said company any profits accruing to said corporation with the exceptions hereinafter stated." It then directed inter alia that upon distribution of the capital assets, by dissolution of the corporation or otherwise, the real estate should be returned to the respective grantors and the Liberty bonds to those whose names were endorsed on the reverse side of the receipts, and that:
4. The joint note described in said Escrow Instructions, in the sum of One Hundred Fifty Thousand Dollars ($150,000.00) is to be canceled if still unpaid; and if paid, so much of said One Hundred, *2192 fifty Thousand Dollars ($150,000.00) as has been paid is to be returned to the person or persons holding the receipt for said payment, or payments, and the balance, if any, is to be canceled.
5. In the event that it should be deemed expedient by all of the persons whose signatures are hereto attached that any or all of the real, personal or mixed property hereinbefore described should be replaced by cash or other real, personal or mixed property of equal value, then the said property shall be released in substitution for said other properties or cash, in accordance with the written instructions of all of the signers hereof.
6. Any profits that may accrue to the said Ralph J. Chandler Shipbuilding Company from the ownership of the above described real property shall not inure to said corporation, but shall be owned by and paid to the person or persons to whom said real property is to be returned and reconveyed.
7. The interest on the hereinbefore mentioned United States Government "Liberty" Bonds of the aggregate par value of three hundred thousand dollars ($300,000.00) shall not belong to or be the property of said Ralph J. Chandler Shipbuilding Company, but is and shall*2193 be the property of the *9 person or persons whose name or names are endorsed on the reverse side of the accompanying receipts for said bonds; and said interest shall be paid to said person or persons when it accrues.
8. Any dividends that may be declared on the capital stock of said Ralph J. Chandler Shipbuilding Company, and any moneys that may accrue as profit from the operations of the Company from sources other than those herein-above described, shall belong to and be paid to the stockholders of said corporation, in proportion to their ownership of stock therein.
No dividends were voted by petitioner from its organization to June 30, 1920. Interest from the Liberty bonds and rents from the real estate were paid to Harry Chandler and General Sherman. Said interest and rents were not included in petitioner's original returns for the fiscal years ended June 30, 1919 and 1920, but were properly included in amended returns. For 1919 and 1920 the interest amounted to $11,687.50 and $12,750, respectively, and the rents to $7,458.90 and $8,479.81, respectively. No part of the capital paid in for the purchase of petitioner's shares was distributed prior to the close of*2194 the fiscal year ended June 30, 1920, nor has any permit for distribution ever been obtained. Petitioner was engaged in business from 1918 to 1921. The trust has never been terminated.
In computing petitioner's tax liability for the taxable years in question the Commissioner excluded from invested capital $300,000, representing the value of the Liberty bonds and $550,000, representing the value of the real estate.
With respect to a 25 per cent ad valorem penalty for the fiscal year 1919, petitioner submitted an offer in compromise of $250, which offer was duly accepted and paid, and is the correct amount of the penalty.
OPINION.
STERNHAGEN: Petitioner contends that the cash payment of $1,000,000 for its 10,000 shares establishes its invested capital under section 326(a)(1) of the Revenue Act of 1918, which provides in part:
That as used in this title the term "invested capital" for any year means * * * (1) actual cash, bona fide paid in for stock or shares * * *.
Respondent concedes that the money was paid in the form alleged, but denies the bona fides of the payment, arguing that the $1,000,000 amounted to no more than a loan which resulted in securing credit; *2195 that in fact petitioner's shares were exchanged for the assets and liabilities of the partnership, and since the stockholders and partners were substantially identical, the incorporation was a reorganization governed by the provisions of section 331 of the Act, which would deny to the corporate assets here a value in excess of their cost of *10 acquisition to the partners. As there in no evidence of such cost, he concludes that his determination should be approved.
The Board has repeatedly had before it questions involving the substantive effect to be given formal acts in which transactions affecting tax liability are clothed, and has followed the principle enunciated by the Supreme Court in United States v. Phellis,257 U.S. 156">257 U.S. 156, that "in such matters what was done, rather than the design and purpose of the participants should be the test." In numerous instances full recognition has been given to formal, though circuitous, steps taken by taxpayers in financial transactions where the results so attained might have been more simply or more directly achieved in another manner. *2196 Anna M. Harkness,1 B.T.A. 127">1 B.T.A. 127; Regal Shoe Co.,1 B.T.A. 896">1 B.T.A. 896; Edward A. Langenback,2 B.T.A. 777">2 B.T.A. 777; W. J. Hunt,5 B.T.A. 356">5 B.T.A. 356; United States Envelope Co.,10 B.T.A. 84">10 B.T.A. 84; Romie C. Jacks,19 B.T.A. 559">19 B.T.A. 559. A situation not unlike that here presented was considered in Minnie C. Brackett, Administratrix,19 B.T.A. 1154">19 B.T.A. 1154, wherein three individuals transferred assets to a newly organized corporation in exchange for its check, which was immediately endorsed and returned to it in payment for shares of its stock. The Board recognized in the transaction a sale of assets from which taxable gain resulted.
In certain instances in which form has been disregarded, the evidence adduced has warranted the conclusion that the steps taken or acts done were never intended to be of substantive effect, but were designed merely as a subterfuge for avoiding taxation. Ready Auto Supply Co.,2 B.T.A. 730">2 B.T.A. 730; Thomas Cronin Co.,8 B.T.A. 429">8 B.T.A. 429; *2197 Coon Auto Co.,8 B.T.A. 763">8 B.T.A. 763; affd., 35 Fed.(2d) 504.
In the instant proceeding the meticulous care taken by the petitioner in the issuance of its shares, together with the supporting reasons shown therefor, abundantly sustains its contention that the payment of the $1,000,000 was not a sham or a subterfuge and that the procedure adopted was not merely a scheme to avoid taxation. The acts done were designed to and did result in actual transfers of cash and other property of the incorporators to petitioner. They constituted a compliance with necessary and very real requirements of the Emergency Fleet Corporation's contracting agent, the Federal Capital Issues Committee, and the California Commissioner of Corporations. They were taken only after consultation with representatives of the last two and pursuant to requirements of the first. To hold that the shares were issued in exchange for assets, as respondent contends they were in effect, would deny all weight to the rulings of the Commissioner of Corporations and the Capital Issues Committee, and would set at naught the act of the Emergency Fleet Corporation's agent, who let the contracts only upon*2198 the showing of financial responsibility which the payment of the million *11 dollars and subsequent acts were designed to establish, all matters of substantial importance. It was the incorporator's direct purpose not to exchange shares for assets, because such a method would have required several months for an official valuation, and it was this delay which petitioner sought to and did avoid.
Under such circumstances it can not be held that the method of organization chosen involved vain steps to which substantive effect should now be denied, when such method was deliberately and openly adopted for substantial reasons at the time. Respondent advances as his reason for the disallowance of the $850,000, that the real estate and Liberty bonds, purchased with that amount of the paid-in capital, never became the absolute property of petitioner, but remained for practical purposes under the control of General Sherman and Harry Chandler. He relies for this view on the language and provisions of the stockholders' agreement, which contains instructions for the guidance of the Trust Company. We find nothing in this instrument inconsistent with the ownership by petitioner of the*2199 real estate and bonds prior to a distribution of its assets or such of them as might remain after satisfaction of its creditors' claims. While it directs that rents and interest derived from these assets shall not belong to petitioner, but be paid to Chandler and Sherman, such wording may be reasonably construed as the corporation's authorization to its agent to pay income as received to specified parties. Such directions affirmatively imply ownership; the income, moreover, was reported in petitioner's returns as amended. While petitioner might conceivably have restored the real estate and bonds to Sherman and Chandler to the fraudulent detriment of creditors, it stockholders did not authorize such an act and we may not entertain the assumption that they would. The same reasoning is applicable to the corpus as well as the income of the trust, both of which, being within petitioner's power of disposition, were clearly subject to the claims of its creditors.
It is immaterial that the real estate and bonds were not invested in assets of direct use in shipbuilding, but were held in trust for petitioner's use and benefit. *2200 Norman B. Livermore,11 B.T.A. 428">11 B.T.A. 428. It was necessary for petitioner to acquire sufficient financial responsibility to satisfy the Emergency Fleet Corporation, and this it did. As instruments in securing this credit, the assets represented by the $850,000 disallowed were clearly invested capital. Hewitt Rubber Co.,1 B.T.A. 424">1 B.T.A. 424. And since they were within reach of creditors and at the risk of the business, they are within the purpose of the statutory definition of invested capital. LaBelle Iron Works v. United States,256 U.S. 377">256 U.S. 377.
*12 We have thus disposed of the controversy by holding that cash to the extent of $1,000,000 was paid in for stock or shares as prescribed in section 326, and since the respondent in his determination has eliminated $850,000 of this invested capital, it follows that his determination was incorrect and this amount should be restored. From the argument there appears some ambiguity as to the amount of $150,000 which was permitted by respondent to remain in invested capital. The evidence indicates, although not clearly, that this may properly be included because it represents the note of $150,000. *2201 Hewitt Rubber Co., supra.In argument, however, counsel for both parties seem to adopt the hypothesis that the $150,000 represents the partnership assets, although it appears fairly clear that the assets were not in fact transferred directly by the partnership to the corporation in exchange for the corporation's stock, but in exchange for $150,000 covered by the certificates of deposit. Since the respondent's determination of the deficiency was not, so far as appears, predicated upon section 331, there is no presumption that section 331 applies or that any of the facts contemplated by that section are present. The evidence does not disclose circumstances of such a reorganization or change of ownership as is contemplated by section 331, and we therefore have no reason to disturb the allowance of $150,000 recognized in the respondent's determination.
Judgment will be entered under Rule 50.