1928 BTA LEXIS 3841">*3841 Noninterest-bearing demand promissory notes, bona fide paid in for treasury stock, included in invested capital in an amount equal to their actual cash value at the time turned in for stock.
11 B.T.A. 248">*248 These proceedings, involving income and excess profits taxes for the years 1919, 1920, and 1921 in the respective amounts of $2,310.46, $22,177.98, and $26,349.67, were consolidated at the hearing on agreement of the parties. The petitioner alleges that the Commissioner erred in disallowing as invested capital during the taxable periods, noninterest-bearing demand promissory notes of a total face and cash value of $500,000 bona fide paid in on December 6, 1919, and April 15, 1920, for treasury common stock.
The Commissioner's answer to the petitioner under Docket No. 14387 was amended at the hearing by alleging that certain salaries paid by the petitioner in 1920 and 1921 to officers and employees were unreasonable for the service performed to the extent that they exceeded 11 B.T.A. 248">*249 the amounts he specified. Subsequently, on motion by counsel for the1928 BTA LEXIS 3841">*3842 respondent, the amendment to the answer was stricken from the record.
FINDINGS OF FACT.
The petitioner is an Oregon corporation and is engaged in the manufacture of bed room and dining room furniture at Portland.
During the taxable periods the authorized capital stock of the taxpayer was $300,000, divided into 3,000 shares of a par value of $100 each, of which prior to the first sale of stock hereinafter mentioned F. S. Doernbecher, the then president and general manager, held 2,500 shares, and H. A. Green, the present president and general manager, and Bruno John, the present production manager, held 250 shares each. The stock held by John was fully paid. Green owed Doernbecher approximately $27,000 on his holdings purchased in 1916 for about $75,000. In connection with the transaction about to be consummated whereby additional shares of stock were to be acquired from Doernbecher, Green, under date of December 5, 1919, assigned his 250 shares to the former and the petitioner thereafter issued a new certificate to the assignee. This was done in order that the transaction might be covered by one agreement and Green's interest in the stock was full recognized and taken into1928 BTA LEXIS 3841">*3843 account in the settlement.
On December 6, 1919, the petitioner purchased 688 shares of its common stock from Doernbecher for $250,000 (approximately $363 per share), and in payment gave Doernbecher cash or Liberty bonds of an equal value. On the same day the petitioner sold 688 shares of the stock so acquired to H. A. Green, Bruno John, E. S. Beach, and B. D. Randall, employees of the petitioner, receiving in full payment therefor the following noninterest-bearing promissory notes of the parties, dated December 6, 1919, and payable on demand and issued the following stock certificates:
| Buyer | Certificate | Shares | Note |
| E. S. Beach | 171 | 50 | $18,168.60 |
| B. D. Randall | 172 | 25 | 9,084.30 |
| Bruno John | 173 | 306 | 111,191.90 |
| H. A. Green | 174 | 307 | 111,555.20 |
| Total | 250,000.00 |
On April 15, 1920, the petitioner acquired from the same source for the same amount and by the same method of payment 684 shares of its common stock, and on the same day sold it to the same parties, who, in full payment therefor gave their notes dated April 15, 1920, 11 B.T.A. 248">*250 bearing no interest and payable on demand as follows, and received the following stock certificates:
| Buyer | Certificate | Shares | Note |
| H. A. Green | 179 | 305 | $111,353.71 |
| Bruno John | 180 | 306 | 111,353.71 |
| E. S. Beach | 181 | 49 | 18,195.05 |
| B. D. Randall | 182 | 24 | 9,097.53 |
1928 BTA LEXIS 3841">*3844 At the times these transactions took place the respective buyers were conducting negotiations with Doernbecher for the purchase of all of his holdings in the petitioner corporation. The terms of the contract of purchase were tentatively agreed upon in 1919 and the early part of 1920. Due principally to the weak physical condition of Doernbecher, however, the contract was not reduced to writing until December 1, 1920. At the request of the respective makers of the notes the stock certificates for the aforementioned sales were issued to F. S. Doernbecher, Trustee, and were held by him as trustee for the owners pending their purchase from him under a written contract of his remaining stock in the corporation. Neither Doernbecher nor the petitioner retained a lien of any kind on the stock. Each certificate for stock sold by the petitioner bore an endorsement that the stock was fully paid and nonassessable.
Account of these transactions, the petitioner, at the direction of its president, made the following journal entries as of December 6, 1919, and April 15, 1920, respectively:
| 6 | Treasury stock |
| F. S. Doernbecher | |
| Notes receivable, miscellaneous. | |
| Treasury stock. | |
| 15 | Treasury stock |
| F. S. Doernbecher | |
| Notes receivable, miscellaneous. | |
| Treasury stock. | |
| December, 1919 | ||
| Purchase of stock per minutes of Dec. 5, 1919 | $250,000 | |
| $250,000 | ||
| Notes as follows in full payment of purchase of | 250,000 | 250,000 |
| Treasury stock. Demand-No interest. | ||
| H. A. Green $111,555.20 | ||
| Bruno John 111,191.90 | ||
| E. S. Beach 18,168.60 | ||
| B. D. Randall 9,084.30 | ||
| April, 1920 | ||
| Purchase of stock per minutes of Apr. 14, 1920 | 250,000 | |
| 250,000 | ||
| H. A. Green $111,353.71 | ||
| E. S. Beach 18,195.05 | 250,000 | 250,000 |
| Bruno John 111,353.71 | ||
| B.D. Randall 9,097.53 | ||
| Notes given in full payment for treasury stock. |
On December 1, 1920, the four notes totaling $54,545.48 given by Randall and Beach on December 6, 1919, and April 15, 1920, for stock were canceled and replaced by noninterest-bearing demand notes of Green and John for $27,272.74 each.
Subsequently, as of December 1, 1920, stock certificates Nos. 184 and 185 were issued to H. A. Green and Bruno John for 688 and 687 11 B.T.A. 248">*251 shares, respectively, in exchange for the certificates issued for the stock purchased by the various parties on December 16, 1919, and April 15, 1920, including certificates for one share each issued to Green, Randall, 1928 BTA LEXIS 3841">*3846 and Beach on December 6, 1919. The stock was purchased by the petitioner for the express purpose of selling it to the respective makers of the notes, the advice of counsel for and opinion of Doernbecher being that the sales should be made through the petitioner instead of by direct dealings between Doernbecher and the respective buyers. The notes were used by the petitioner in preparing financial statements on which to obtain credit.
In 1919 and 1920 the assets of the petitioner, excluding good will of a large value, were approximately $1,750,000. Its current indebtedness during that period was of a negligible amount. No cash dividends were paid in the years 1919, 1920, and 1921. Some time subsequent to 1920 the capital stock was increased from $300,000 to $2,000,000 by the declaration of a stock dividend.
At the time the notes were paid in to petitioner for its stock in December, 1919, Green's assets consisted of 250 shares of petitioner's stock acquired by him in 1916, on which he still owed $27,000. John's worth, outside of his interest in petitioner's stock, approximated $50,000, and Beach's wealth was $2,500, represented by cash on hand. The fair market value of the1928 BTA LEXIS 3841">*3847 shares of stock owned by Green and John at this time was not less than $363 per share. In April, 1920, when additional notes were given by Green, John, Beach, and Randall, the net worth of the first three persons was not less than what it was in December, 1919.
The actual cash value of the notes at the time paid in for stock in December, 1919, was $175,000, and the actual cash value of the notes paid in for additional shares of stock in April, 1920, was $175,000.
In computing the petitioner's invested capital for the taxable periods the Commissioner disallowed the notes received for treasury stock and reduced the account as follows: 1919, $17,808.49; 1920, $178,278.69 and $250,000; and 1921, $500,000. The petitioner filed its return on the calendar year basis.
OPINION.
ARUNDELL: Section 326(a) of the Revenue Acts of 1918 and 1921 provides that the term "invested capital" means the "actual cash value of tangible property, * * * bona fide paid in for stock or shares, at the time of such payment." By the terms of section 325(a) of the same Acts, notes are tangible property.
We are satisfied that the promissory notes were bona fide paid in for stock and need not discuss1928 BTA LEXIS 3841">*3848 that phase of the issue. To establish the value of the notes at the time they were paid in for stock petitioner relies primarily on the testimony of J. C. Ainsworth, president 11 B.T.A. 248">*252 of the United States National Bank of Portland, Oreg., who was familiar with the financial affairs of the petitioner, as well as of Green and John. We quote from his testimony somewhat at length:
Q. If that corporation had made a demand on Mr. John and Mr. Green for the payment of these notes would your bank have considered loaning them a sufficient amount to take up the notes?
A. We agreed to find the money for them. I don't think our own bank could have loaned that sum.
Q. Did you ask Mr. Green and Mr. John for a financial statement?
A. No.Q. Do You know what property either of them had outside of this stock of the Doernbecher Manufacturing Company?
A. No. Q. You didn't? A. We didn't care.Q. Now, this loan that you would have made to these two gentlemen, what collateral would you have asked for that loan?
A. We would have loaned it on their - on that same stock based on our knowledge of their ability to successfully operate the business.
Q. But you1928 BTA LEXIS 3841">*3849 would have asked for the stock as collateral, wouldn't you, in making the loans?
A. Well, it wouldn't have made any difference as far as we are concerned, because we knew that their ability to earn it was there.
Q. Well, then, wasn't your loan based upon what you thought this stock was worth?
A. Yes, sir. Q. And not their ability to pay independent of this stock?A. No, under other management we would not have loaned this money.
Q. The reason you would have loaned to these men was because you considered the Doernbecher Manufacturing Company stock very valuable, didn't you, under their management?
A. Yes, sir.Q. When you make statements as to the financial condition of Mr. Green and Mr. John, it is based upon what you thought this stock was worth, isn't it?
A. Yes, sir.Q. And not upon their independent ability to pay outside of that?
A. If they hadn't any interest in the plant they wouldn't have had the ability to pay.
Concerning the face value of the notes here in question, Ainsworth testified as follows:
Q. Knowing the financial condition of the corporation and the holdings of Mr. Green and John therein, would you have considered1928 BTA LEXIS 3841">*3850 the notes which they gave to the corporation in payment for this stock worth face value?
A. Yes, sir.Q. Would you have considered the notes of Mr. Green and Mr. John for $250,000 each to the Doernbecher Manufacturing Company good and collectible notes?
A. Yes, subject to a slight discount if they wanted any cash on a loan.
Q. That is, if they wanted to sell them? A. Yes, sir.11 B.T.A. 248">*253 A fair reading of the above testimony convinces us that the opinion of the witness was based on what he believed to be the value of the stock to be acquired by the notes rather than the ability of Green and John to pay those notes, based on their financial responsibility at the time the notes were given, and before these men became the owners of the additional shares.
The Board has recently had before it practically the identical question here raised in the case of the . In our opinion therein we stated as follows:
In considering the value of the notes we must also exclude the value of the stock purchased with the notes and pledged as security for their payment. It would seem evident that a corporation does not increase1928 BTA LEXIS 3841">*3851 the value of its assets or increase its invested capital by increasing its capital stock. Until it receives property of value in exchange for such stock, its assets remain the same. If the corporation issues its stock for notes which in themselves have no value, there is still no increase in the value of the assets. Such value is not increased by pledging the stock so issued as security for the payment of the notes, for the only thing of value which it has received for its stock is such stock. If it does not increase its assets by issuing its own stock to itself, it does not do so when it receives such stock as the only thing of value in payment therefor. The notes can be paid only out of such security and the value of such security can be realized only from the assets already existing. The net worth of the corporation is the same as it was before the transaction took place. Only the amount of the outstanding capital stock has been increased and the effect is the same as that of a stock dividend; it serves to decrease the value of each share but not to increase the value of the assets.
It is said that the corporation could borrow on such collateral notes. The answer is that1928 BTA LEXIS 3841">*3852 it is not borrowing on any value existing in the notes but is borrowing on its own stock. This is only another way of saying that it is borrowing on its own credit, as reflected in the credit value attaching to its stock. To permit the value of the stock so sold and pledged as security for the notes to be used to measure the value of the notes, would be to include in invested capital the value of the assets back of the stock, which have already been once included to the full amount allowed by the statute.
It follows from the foregoing that we must look to something other than the value of the stock to be acquired in determining what, in fact, was the fair market value of the notes when paid in for petitioner's stock. We are satisfied that the notes given in December, 1919, had a value and in our findings of fact we have placed that value at $175,000. In reaching that conclusion consideration was given to the evidence that at the time the notes were executed in December, 1919, Green was the owner of 250 shares of petitioner's stock on which he still owed Doernbecher $27,000; John owned 250 shares of petitioner's stock which was fully paid for and in addition owned property worth1928 BTA LEXIS 3841">*3853 $50,000; Beach's wealth was $2,500, represented by cash on hand. We have found that the shares of stock in the Doernbecher Manufacturing Co. were at that time worth not less than $363 per share.
11 B.T.A. 248">*254 Inasmuch as Green, John, and Beach received for their notes given in December, 1919, shares of stock in petitioner worth not less than $363 per share when received, and throughout the following year, their financial responsibility at the time the notes were given in April, 1920, was not impaired by reason of the earlier obligations and for that reason we believe the additional notes at the time they were paid in in April, 1920, were worth not less than $175,000, as set forth in the findings of fact. It follows from the foregoing that petitioner's invested capital should be increased by $175,000 from December 6, 1919, and by an additional $175,000 from April 15, 1920.
Reviewed by the Board.
Judgment will be entered on 15 days' notice, under Rule 50.