*1348 1. Petitioner realized no gain upon the purchase of its own stock. National Home Owners Service Corporation,39 B.T.A. 735">39 B.T.A. 735, followed.
2. Petitioner was not in receipt of income to the extent it was freed from its obligation to declare dividends on preferred stock repurchased. Houghton & Dutton Co.,26 B.T.A. 52">26 B.T.A. 52, followed.
3. Amounts recovered in the taxable year upon debts previously charged off as worthless must be included in the income of the taxable year.
4. Petitioner is not liable under section 102 of the Revenue Act of 1934, not having permitted its gains and profits for 1935 to accumulate in order to avoid imposition of surtax upon its shareholders.
*356 These consolidated proceedings are brought to redetermine deficiencies in income taxes for 1934 and 1935 in the respective amounts of $1,618.80 and $35,258.27, and excess profits taxes for the latter year in the amount of $163.48. The proceedings were further consolidated, for hearing, with Rollin C. Reynolds, Docket*1349 Nos. 97718 and 98015, decided this day. The submitted issues are (1) whether petitioner realized taxable gain upon the purchase of shares of its own stock and certain contracts relating thereto in 1935, (2) whether petitioner derived income in 1934 from the recovery of amounts previously charged off as bad debts, and (3) whether petitioner was availed of in 1935 for the purpose of preventing the imposition of the surtax on its shareholders through the medium of permitting gains and profits to accumulate instead of distributing them, under section 102 of the Revenue Act of 1934.
*357 FINDINGS OF FACT.
Petitioner is a corporation, organized in 1920 under the laws of the State of New York. Its income tax returns for the years here involved were filed with the collector of internal revenue for the fourteenth district of New York, at Albany, New York. It is engaged in the wholesale and retail furniture business at Troy, New York.
Petitioner's capitalization consists of 10,000 shares of cumulative 8 percent preferred stock of a par value of $100 per share and 10,000 shares of common stock having a par value of $1 per share. Its stock has always been issued and dealt with*1350 in units, each unit consisting of one share of perferred and one share of common stock.
Upon incorporation, petitioner took over the assets of a furniture business previously conducted as a sole proprietorship by Rollin C. Reynolds. In consideration for that transfer, the company issued its stock therefor pursuant to a bill of sale from Reynolds and agreed to assume, among others, any tax liability incurred by Reynolds in his conduct of the business prior to incorporation. This stock was originally issued, at Reynolds' direction, as follows:
| Preferred stock | Common stock | |
| Rollin C. Reynolds | 4,000 shares | 3,999 shares |
| Grace S. Reynolds | 6,000 shares | 5,998 shares |
Reynolds was elected president and Grace S. Reynolds, his wife, vice president of the company. Shortly thereafter petitioner transferred 1,460 units to certain employees at $100 per unit. The stock so transferred consisted partly of stock which had originally been issued to Reynolds and partly of stock which he had acquired from his wife. The employees were afforded an opportunity to buy this stock in the company through written agreements providing for the issuance of the stock in their names, *1351 the application of dividends declared thereon for the purchase price of the stock, and the delivery of the stock endorsed in blank to Reynolds as collateral security for the payment of the price.
From 1920 to 1929, inclusive, petitioner declared and paid 8 percent dividends on its preferred stock. No dividends were declared from 1930 to 1935, inclusive. On December 30, 1936, the preferred dividends due in 1930 were declared and paid in part.
After the original sale of 1,460 units of stock to employees, Reynolds sold 600 additional units to employees in 1923, 1924, and 1925 at the same price and on the same terms. Whenever an employee desired to sell his stock back to Reynolds, Reynolds repurchased it at $100 per unit, whether or not he was obligated to do so under the *358 original agreement of sale. By June 1, 1935, Reynolds had thus reacquired 1,340 units, and at that time he held contracts of sale of 420 units, upon which was unpaid the total amount of $12,971.62.
Pursuant to its agreement to pay any Federal income tax assessed upon Reynolds in respect of his earnings from the business prior to its incorporation, petitioner had reimbursed Reynolds for an additional*1352 tax assessed against him in 1925 for the taxable year 1920 in the amount of $247,079.38. As a result of a suit for refund brought by Reynolds in petitioner's interest, recovery of the tax thus paid was had to the extent of $117,135.22 plus interest, pursuant to a judgment rendered on September 1, 1934, by the District Court of the United States for the Northern District of New York in a case entitled Reynoldsv. Durey. On June 1, 1935, at a directors' meeting, Reynolds turned over to petitioner a check for $136,575.52, representing the amount of the judgment plus interest, less counsel fees.
Petitioner's directors as of June 1, 1935, were Reynolds, Mrs. Reynolds, and William H. Prentice. At the meeting held on that day Mrs. Reynolds suggested that, inasmuch as the corporate funds had been increased because of the tax refund, consideration should be given to the reduction of the outstanding capital stock, and called attention to the provisions of the certificate of incorporation authorizing redemption of the preferred stock at 110. It was her idea that, because of present financial conditions, employees who had agreed in better times to buy stock of petitioner at $100*1353 per unit might want to surrender their stock to petitioner at the same price, and that this privilege should be extended to Reynolds, who had already reacquired 1,340 units from employees. But the following resolution was adopted:
WHEREAS Mr. Reynolds has heretofore sold to employees of the corporation at $100 per unit 2,010 units of 1 share of preferred and 1 share of common stock pursuant to contracts providing for payment for such stock out of the dividends thereon, and acting with regard for the interests of the corporation has since repurchased 1,340 of such units at the same price of $100 per unit and has been ready to repurchase the remaining 670 of such units if and when desired by the holders thereof; and
WHEREAS employees still holding 250 of such units have fully paid therefor, and employees holding 420 of such units have paid $29,028.38 on account of the purchase price thereof and have still to pay $12,971.62 thereon; and
WHEREAS, in the judgment of the board of directors, the outstanding capital stock of this corporation should be reduced and the first opportunity to surrender stock should be offered to employees and to Mr. Reynolds in respect of the stock which*1354 he has personally reacquired from employees as above set forth:
RESOLVED that this corporation offer to such employees as are stockholders and to Mr. Reynolds in respect of the stock acquired by him from employees that, upon surrender and delivery of certificates for such stock, this corporation *359 will pay therefor the sum of $100 per unit of 1 share of preferred and 1 share of common stock, such price to be paid in cash where no part of the original purchase price of such stock remains unpaid, and where part of the purchase price of such stock remains unpaid, such price to be paid to such extent by the cancellation of the liability for such remaining payment and in cash to the extent that payment has heretofore been made on account of the purchase price of such stock:
RESOLVED, upon the assignment by Mr. Reynolds to this corporation of the contracts with employees for the purchase of said 420 units of stock in respect of which payment has not yet been completed, that this corporation pay to Mr. Reynolds therefor the sum of $12,971.62, representing the remaining liability of the purchasers of such stock and take over and assume the rights and obligations which Mr. Reynolds*1355 has had and to which he has been subject in respect of such stock purchase contracts; * * *
Thereupon Reynolds transferred to petitioner the 1,340 units of stock which he had previously reacquired from employees and assigned to petitioner his contracts of sale to employees of 420 units of stock, there being still unpaid on such contracts a total of $12,971.62. Petitioner paid for the stock and contracts by crediting Reynolds' account on its books with the sum of $146,971.62 ($134,000 for the stock plus $12,971.62 covering the unpaid balance on the contracts).
Although in 1934 the company had formally reduced the par value of its common stock in order to permit of the charging off of good will, it did not cause its authorized capital stock to be reduced upon the above acquisition of its own shares in 1935, nor did it amend its certificate of incorporation in any other respect. The transaction was reflected on its balance sheet by changing the 1934 figures for preferred stock and common stock outstanding from $1,000,000 and $10,000, respectively, to $866,000 and $8,660, respectively.
Petitioner kept its books on the accrual basis, but reported income from sales on the installment*1356 basis. Each year it charged off a number of accounts receivable as bad debts. Its practice when recoveries were made in later years in respect of accounts which had previously been charged off as uncollectible was to include in income for the year of recovery only such portion of the recovery as represented sented previously unrealized profit. The balance was not taken into income until a later year, when either recovery should be made in full or further attempts thereat abandoned. Thus, if on an account of $500 previously charged off as worthless, $200 were recovered in the taxable year, only a percentage of that recovery, (usually about 44 percent), or $88 would be reported as taxable income. When hope of further recoveries was abandoned, the balance of $112 would be taken into income through the process of crediting bad debts, debiting the debtor's account, and including in income the portion of the account representing cost to petitioner. The result was that ultimately the whole recovery was reported in income, but in two different *360 years. The following table indicates the workings of this system on the books of petitioner:
| Accounts Receivable Credit Balances | ||||
| Year | Increase or (decrease) for year | Percentage applied | Amount reported as installment income | Amount not reported as income |
| 1924 | 8,412.85 | 0.47343 | 3,982.90 | 4,429.95 |
| 1925 | (76.70) | .4617 | (35.41) | (41.29) |
| 1928 | 1,921.78 | .4520 | 868.64 | 1,053.14 |
| 1929 | 583.62 | .4478 | 261.34 | 322.28 |
| 1930 | (260.16) | .4490 | (116.81) | (143.35) |
| 1931 | 3,059.54 | .4466 | 1,366.35 | 1,693.19 |
| 1932 | 653.04 | .4591 | 299.81 | 353.23 |
| 1933 | (110.05) | .4252 | (46.79) | (63.26) |
| 1934 | 207.79 | None | None | 207.79 |
| Total | 14,391.71 | 6,580.03 | 7,811.68 |
*1357 The "percentage applied" represents the average percentage of profits on sales.
Respondent has included the total amount of recoveries not reported as income in the year of the particular recovery, $7,811.68, in petitioner's taxable income for 1934.
Petitioner's stock, as of 1934 and 1935, was held as follows (figures represent units):
| Year | Grace S. Reynolds | Rollin C. Reynolds | Employees | Petitioner | Total |
| 1934 | 5,151 | 4,079 | 770 | 10,000 | |
| 1935 | 5,151 | 2,789 | 720 | 1,340 | 10,000 |
The dividends paid by petitioner (all being on its preferred stock) and the years in which they accrued are shown by the following table:
| Dividends paid to - | ||||
| Year paid | R. C. Reynolds | G. S. Reynolds | All other stockholders | Total |
| 1921 | $27,112 | $41,208 | $11,680 | $80,000 |
| 1922 | 27,592 | 41,208 | 11,200 | 80,000 |
| 1923 | 26,552 | 41,208 | 12,240 | 80,000 |
| 1924 | 23,552 | 41,208 | 15,240 | 80,000 |
| 1925 | 23,112 | 41,208 | 15,680 | 80,000 |
| 1926 | 23,512 | 41,208 | 15,280 | 80,000 |
| 1927 | 24,112 | 41,208 | 14,680 | 80,000 |
| 1928 | 24,752 | 41,208 | 14,040 | 80,000 |
| 1929 | 25,312 | 41,208 | 13,480 | 80,000 |
| 1936 | 8,367 | 15,453 | 1,710 | 25,530 |
| 1937 | 5,578 | 10,302 | 1,100 | 16,980 |
*1358 *361 Profit and loss statements of petitioner from 1930, the first year in which dividends were passed, to 1934, inclusive, are as follows: 1930, loss, $326.66; 1931, loss, $697.58; 1932, loss, $33,473.37; 1933, loss, $24,586.87; 1934, loss, $2,611.93.
For 1935 petitioner's books show a net profit of $19,631.53. Of this amount, $19,444.30 is the excess of the interest received on the tax refund as a result of the judgment in Reynolds v. Durey, supra, over counsel fees and other expenses of suit.
Petitioner's net earnings in 1936 and 1937 were $13,259.64 and $15,923.94, respectively. In those years, dividends of $25,530 and $16,980, respectively, were declared and paid.
Petitioner's balance sheets for the years 1933 to 1936, inclusive, are shown in the following table:
| 1933 | 1934 | 1935 | 1936 | |
| Assets: | ||||
| Cash | $46,887.83 | $28,390.56 | $77,036.21 | $91,814.67 |
| Inventory | 228,606.42 | 229,183.08 | 235,077.24 | 164,739.73 |
| Receivable from: | ||||
| R. C. Reynolds | 308,508.80 | 383,293.47 | 285,305.83 | 314,677.21 |
| Others: | ||||
| Notes | 2,000.00 | 6,550.00 | 2,000.00 | 2,350.00 |
| Accounts | 420,840.61 | 402,149.98 | 383,297.45 | 349,518.83 |
| Employees | 12,971.62 | 11,661.62 | ||
| Securities | 108,035.07 | 73,514.60 | 113,398.08 | 134,823.78 |
| Real estate | 282,613.72 | 272,530.82 | 262,447.92 | 257,773.64 |
| Equipment | 358.80 | 176.99 | 299.58 | 3,581.53 |
| Prepaid and accrued items | 11,293.06 | 2,169.28 | ||
| Good will | 766,281.23 | |||
| Total | 2,175,425.54 | 1,395,789.50 | 1,374,003.21 | 1,330,941.01 |
| Liabilities: | ||||
| Preferred stock | 1,000,000.00 | 1,000,000.00 | 866,000.00 | 851,000.00 |
| Common stock | 1,000,000.00 | 10,000.00 | 8,660.00 | 8,510.00 |
| Surplus | 59,085.74 | 272,211.82 | 410,318.57 | 398,198.21 |
| Capital and surplus | 2,059,085.74 | 1,282,211.82 | 1,284,978.57 | 1,257,708.21 |
| Payable to: | ||||
| G. S. Reynolds | 85,155.33 | 87,709.98 | 79,364.16 | 74,408.11 |
| Others: | ||||
| Notes | 42,050.00 | 38,125.00 | 36,925.00 | 33,325.00 |
| Accounts | 20,224.28 | 19,657.26 | 20,103.11 | 22,652.88 |
| Unrealized profits on sales | -31,089.81 | -31,914.56 | -47,367.63 | -57,153.19 |
| Total | 2,175,425.54 | 1,395,789.50 | 1,374,003.21 | 1,330,941.01 |
*1359 The following table is an analysis of petitioner's surplus for the years 1934 to 1936, inclusive:
| 1934 | 1935 | 1936 | |
| Surplus on January 1 | $59,085.74 | $272,211.82 | $410,318.75 |
| Net income per year per books | -992.69 | 19,631.53 | 13,259.64 |
| Cash dividends paid during year | -25,530.00 | ||
| Additional Federal income tax for 1920 of R. C. Reynolds recovered | 117,135.22 | ||
| Par value of capital stock reduced | 990,000.00 | ||
| Prepaid rent charged off | -9,600.00 | ||
| Good will charged off | -766,281.23 | ||
| Excess of par value over cost of capital stock of R.C.R., Inc. acquired | 1,340.00 | 150.00 | |
| Surplus on December 31 | 272,211.82 | 410,318.57 | 398,198.21 |
| Computation of Earned Surplus Considering Withdrawals of Reynolds as Loans. | ||
| Earned income per books 1920 - 1934 incl.: | ||
| Profits 1921 - 1929 | $1,134,826.58 | |
| Less losses 1930 - 1934 | 60,460.03 | $1,074,366.55 |
| Restore to that earned income taxes of Reynolds paid by corporation as part consideration for transfer to it of business and charged as expenses against income on books: | ||
| 1919 Federal income tax | $7,125.67 | |
| 1920 Federal income tax | 6,878.71 | |
| New York state tax | 714.93 | |
| 1917 Federal income tax | 1,455.77 | |
| 1918 Federal income tax | 1,353.15 | |
| 1920 Federal income tax | 1,121.03 | 18,649.26 |
| $1,093,015.81 | ||
| Eliminate from earned income refunds on Reynolds' taxes paid by corporation, as part consideration for transfer to it of assets, which refunds were included in income: | ||
| 1919 Federal income tax | $206.82 | |
| 1920 Federal income tax | 20,197.59 | 20,404.41 |
| $1,072,611.40 | ||
| Add 9 mos. depreciation charged against income to which corporation was not entitled in 1920 | 6,621.56 | |
| $1,079,232.96 | ||
| Deduct dividends paid on preferred stock 1921-1929, inc | 720,000.00 | |
| $359,232.96 | ||
| Deduct item of prepaid rent which was lost on giving up lease and charged to Surplus in 1934 | 9,600.00 | |
| $349,632.96 | ||
| Recoveries in 1934 and prior years on account of bad debts charged of | 7,811.68 | |
| Earned surplus as of December 31, 1934, available for dividends, treating prior withdrawals by Reynolds as loans - as respondent does | $357,444.64 |
*1360 *362 By appropriate corporation resolutions and charter amendments, and as indicated on the above table, petitioner reduced the par value of its common stock from $100 to $1 per share in 1934 in order to permit the charging off of good will. The difference between the total reduction of par value and the total of amounts charged off was added to surplus, as indicated in the above balance sheet.
Commencing with September 30, 1920, petitioner continued the furniture business theretofore conducted by Reynolds. In 1920 it *363 operated stores in Albany and Troy; in 1921 it also operated stores in Schenectady, Glens Falls, Newburgh, and Poughkeepsie; in 1922 it ceased operation of the stores in Glens Falls, Newburgh, and Poughkeepsie; in 1931 it closed the Albany store; in 1936 it discontinued the Schenectady store; and from 1937 it has operated only the store in Troy. Because its business was diminished by the depression, it had funds from 1930 onward which were temporarily unneeded in its business. The company, believing the loans of these funds to Reynolds would be a good investment, made extensive loans to him from 1930 onward, on which petitioner charged interest*1361 and was paid interest.
The rate of interest varied from approximately 2 1/2 percent to approximately 4 percent.
Reynolds' loan account with petitioner shows the following:
| Year | Principal | Interest | Cash |
| 1930 | $102,611.16 | ||
| 1931 | 126,591.12 | $4,015.25 | |
| 1932 | 116,842.46 | 10,046.73 | |
| 1933 | 45,388.93 | 11,007.50 | |
| 1934 | 74,945.91 | 10,110.09 | |
| 19351 | 53,149.86 | 6,445.32 | |
| 1936 | 40,504.04 | $11,000.00 | |
| 1937 | 23,337.92 | 35,531.55 | |
| 1938 | 14,253.51 | 14,299.19 | |
| 1939 | 13,564.73 | 12,714.82 |
The advances to Reynolds were charged to his account with petitioner and his debit balances were carried as accounts receivable in its balance sheets. Interest was charged him on the debit balances and included in petitioner's*1362 taxable income. He had assets other than his investment in the company in excess of his indebtedness and he intended to repay this indebtedness. It was the policy of the company not to declare and pay dividends unless earned, and to conserve its surplus to protect its financial position during periods of depression and the reasonably expected years of prosperity and expansion to follow.
Petitioner was not a mere holding or investment company and was not organized or availed of in 1935 for the purpose of avoiding surtax on its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided and distributed.
OPINION.
LEECH: The first issue is whether petitioner realized gain upon the acquisition of 1,340 units of its own stock from Reynolds on June 1, *364 1935. Respondent has determined a gain of $72,986.40 on this transaction, apparently, under section 22(a) of the Revenue Act of 1934 and article 22(a) - 16 of Regulations 86. Respondent nowhere indicates how he arrived at the figure of $72,986.40. Presumably, he is taking the position that the fair market value of the stock was considerably higher than the price petitioner*1363 paid for it.
Assuming that such was the case, and that the transaction was not a taxable dividend under section 115(g) of the same act, and was a purchase by petitioner (see Rollin C. Reynolds,44 B.T.A. 342">44 B.T.A. 342, could petitioner have been in receipt of taxable gain on this transaction under the law as it was in 1935?
Respondent's Regulations 86 were approved on September 6, 1934. Article 22(a) - 16 thereof reads as follows:
Acquisition or disposition by a corporation of its own capital stock. - Whether the acquisition or disposition by a corporation of shares of its own capital stock gives rise to taxable gain or deductible loss depends upon the real nature of the transaction, which is to be ascertained from all its facts and circumstances. The receipt by a corporation of the subscription price of shares of its capital stock upon their original issuance gives rise to neither taxable gain nor deductible loss, whether the subscription or issue price be in excess of, or less than, the par or stated value of such stock.
But where a corporation deals in its own shares as it might in the shares of another corporation, the resulting gain or loss is to be computed*1364 in the same manner as though the corporation were dealing in the shares of another. So also if the corporation receives its own stock as consideration upon the sale of property by it, or in satisfaction of indebtedness to it, the gain or loss resulting is to be computed in the same manner as though the payment had been made in any other property. Any gain derived from such transactions is subject to tax, and any loss sustained is allowable as a deduction where permitted by the provisions of applicable statutes.
Article 22(a)-16 was taken from T.D. 4430, C.B. XIII-1, p. 36, adopted on May 2, 1934.
Prior to this time, respondent's regulations (typified by Regulations 77, art. 66) had read as follows: "A corporation realizes no gain or loss from the purchase or sale of its own stock."
In Helvering v. Reynolds Tobacco Co.,306 U.S. 110">306 U.S. 110, the Court held that the ruling embodied in Regulations 86 could not be retroactively applied to a sale of treasury stock by a corporation in 1929, and used this language:
* * * As the petitioner points out, Congress has, in the Revenue Acts of 1936 and 1938, retained Section 22(a) of the 1928 Act in haec verba.*1365 From this it is argued that Congress has approved the amended regulation. It may be that by the passage of the Revenue Act of 1936 the Treasury was authorized thereafter to apply the regulation in its amended form. But we have no occasion to decide this question, since we are of opinion that the reenactment of the section, without more, does not amount to sanction of retroactive enforcement of the amendment, in the teeth of the former regulation which *365 received Congressional approval, by the passage of successive Revenue Acts including that of 1928.
Relying on this language, we held, in National Home Owners Service Corporation,39 B.T.A. 753">39 B.T.A. 753, that the changed regulations here involved can not be applied to a 1935 transaction, because Congressional approval of the change could not be deemed to have been given in the Revenue Act of 1934, which became law only eight days after the ruling. 2Congress, we said, had given the older rule the force of law, and it must be applied rather than the later one.
This issue is thus controlled by Helvering v.Reynolds Tobacco Co. and National Home*1366 Owners Service Corporation (supra ), and decision thereon is for petitioner.
Respondent, by way of an alternative position, contends that petitioner was in receipt of income in 1935 to the extent it was freed from its obligation to declare dividends on the shares of preferred stock then repurchased. Respondent is foreclosed in this contention by Houghton & Dutton Co.,26 B.T.A. 52">26 B.T.A. 52.
Did petitioner derive income in 1934 through the recoveries on accounts previously charged off as worthless and, if so, in what amount? The record shows that it was petitioner's practice to split a bad debt recovery into two parts, reporting as income in the year of recovery only such portion of the recovery as represented the profit on the sale in question and deferring inclusion of the balance until the year in which further attempts at recovery were abandoned. It is well settled that bad debt recoveries should be reported in full as accrued income in the year of recovery and not deferred or split up. Hartford Hat & Cap Co.,7 B.T.A. 714">7 B.T.A. 714; *1367 Excelsior Printing Co.,16 B.T.A. 886">16 B.T.A. 886; First National Bank of Key West,26 B.T.A. 370">26 B.T.A. 370; Lake View Trust & Savings Bank,27 B.T.A. 290">27 B.T.A. 290; Putnam National Bank v. Commissioner, 50 Fed.(2d) 158; Regulations 86, art. 23(k)-1. Consequently we do not think petitioner's unusual accounting practice is warranted.
However, respondent is seeking to throw into one year all the recoveries that have not yet been reported. The rule is that recoveries must be fully reported in the year they occur. (See authorities last cited.) Our findings are that only $207.79 was recovered in 1934 on worthless debts and not then reported. To add to this amount recoveries which were made in earlier years and properly so reportable would be to correct the mistakes of past years by incorrectly computing the income of the taxable year. This was expressly forbidden in Nicollet Associates, Inc.,37 B.T.A. 350">37 B.T.A. 350. We hold that petitioner's 1934 income should be increased on account of recoveries of worthless debts only to the extent of $207.79.
*366 The third question is whether petitioner is liable for the addition of surtax*1368 upon 1935 net income proposed under the provisions of section 102 of the Revenue Act of 1934. 3 Obviously, the petitioner was not organized for the purpose prohibited by that section. Was it availed of for that purpose in 1935? It was not "a mere holding or investment company." Did the "gains and profits" of the company for 1935, which it accumulated and did not distribute, exceed "the reasonable needs of the business"? These are questions of fact - the first being the ultimate issue.
*1369 The findings of fact include our computation of surplus of the petitioner, which gives effect to Rollin C. Reynolds, supra, and thus treats petitioner's advances to Reynolds as loans. It also includes all of the presently contested recoveries on account of bad debts charged off. The amount of this surplus at January 1, 1935, $357,444.64, is not controlling, but is a circumstance to be considered in determining whether the accumulation of the gains and profits for 1935 was reasonably justified by the needs of the business. Corporate Investment Co.,40 B.T.A. 1156">40 B.T.A. 1156.
It is true that this surplus was substantial and that all of it was represented by loans to Reynolds. But Reynolds was not the sole stockholder. He was not even a majority stockholder. Cf. Helvering v. National Grocery Co.,304 U.S. 382">304 U.S. 382; Chicago Stock Yards Co.,41 B.T.A. 590">41 B.T.A. 590. The loans were amply secured and bore interest at a rate of from about 2 1/2 to approximately 4 percent, which was paid. *1370 Cecil B. deMille Productions, Inc.,31 B.T.A. 1161">31 B.T.A. 1161; affd., 90 Fed.(2d) 12; certiorari denied, 302 U.S. 713">302 U.S. 713; Dill Manufacturing Co.,39 B.T.A. 1023">39 B.T.A. 1023. See Rollin C. Reynolds, supra.The surplus had been accumulated in years prior to 1930, during which period dividends were regularly paid. In each of the years following, until 1935, the petitioner suffered losses. Its business was contracted by the necessary discontinuance of several of its stores. It was a wholesaler and retailer of furniture. In view of that situation, the use of caution was surely warranted in the distribution, at least, of the first *367 earnings after the five years of consecutive losses. And what were those earnings for 1935 which were not distributed and which must support the imposition of this tax?
In the deficiency notice the respondent determined the net income of petitioner for that year, on which the surtax was there proposed, to be $98,491.16. The computation of that income there disclosed was as follows:
| ADJUSTMENTS TO NET INCOME. | ||
| Net income as disclosed by return | $20,380.53 | |
| Unallowable deductions and additional income: | ||
| (a) Bad accounts collected | $2,833.24 | |
| (b) Repairs | 1,228.88 | |
| (c) Excessive depreciation | 3,011.82 | |
| (d) Capital gain | 72,986.40 | 80,060.34 |
| Total | $100,440.87 | |
| Nontaxable income and additional deduction: | ||
| (e) Installment profits | $1,037.41 | |
| (f) Treasury bond interest | 162.30 | |
| (g) Capital stock tax | 750.00 | 1,949.71 |
| Net income adjusted | $98,491.16 |
*1371 There is apparently no controversy as to any other item appearing in this computation except capital gain in the amount of $72,986.40, which the respondent states in his deficiency notice represented "Profit realized on transfer of stock under the provisions of section 22 and article 22(a)-16 of the Revenue Act of 1934." But we have already held that petitioner realized no such gain in that transaction. Eliminating that item in the computation of the respondent in his deficiency notice would leave, according to that notice, $25,504.76 as the adjusted net income of the petitioner for 1935. This computation, of course, would be reduced by $749.17 if the net profit as shown by the books of the company, and appearing in the findings of fact, were used instead of the net income disclosed in the return of the petitioner.
However, on brief, respondent shifts his position. He contends that there became available for distribution to shareholders in 1935 the following items:
| Net income per books | $19,631.53 |
| Principal amount (interest excluded) of R. C. Reynolds taxes theretofore charged to accumulated surplus | 117,135.22 |
| Total | 136,776.75 |
Analyzing this statement, *1372 $19,444.30 of the "net income per books" consisted of the excess of interest on the tax refund over counsel fees and other expenses of suit.
*368 The tax refund of $117,135.22 was a recovery of part of the cost of capital assets to petitioner. Petitioner had agreed, as part of the consideration for the transfer to it of Reynolds' assets, to assume the tax liability imposed on Reynolds in respect of his conduct of the business prior to incorporation. When the recovery of part of the amount thus paid occurred in 1935, it was merely a partial restoration of that capital cost and did not affect surplus. Having been paid out as a capital item, it was not income upon its recovery. See Burnet v. Logan,283 U.S. 404">283 U.S. 404; Jamieson Associates, Inc.,37 B.T.A. 92">37 B.T.A. 92. Regardless of the manner in which the petitioner treated this item on its books when paid, in our computation of surplus appearing in the findings of fact, neither the payment nor restoration of part of this item is reflected in the surplus account. This, we think, is proper. The entire income for 1935, therefore, as computed in the deficiency notice, is $25,504.76, upon which the proposed*1373 imposition of surtax must rest, and as computed by respondent on brief, by using the net income as shown by the books of the company, it is $749.17 less.
The comparatively little savings to the stockholders to be expected by the accumulation of this relatively small amount of income, contradicts rather than supports the existence of the condemned purpose in failing to distribute it in view of the record here. See Cecil B. deMille Productions, Inc., and Dill Manufacturing Co., supra. Particularly is this so, in view of the fact that in 1936 and 1937, when petitioner continued to realize income, and in greater amounts, dividends were promptly declared and paid.
Moreover, of this total income of the petitioner for 1935, approximately $19,400 consisted of the excess of interest on the refund over counsel fees and other expenses of the suit therefor. The balance of about five or six thousand dollars, was all of the operating income.
The policy of the company was not to declare and pay dividends unless currently earned and to conserve surplus to protect its financial position during the periods of depression and the reasonably expected years of prosperity*1374 and expansion to follow. That policy was followed consistently by the company from its inception through 1934. In the face of this record, we will not say that the accumulation of gains and profits for 1935 was an accumulation not reasonably justified. Cf. Trico Securities Co.,41 B.T.A. 306">41 B.T.A. 306. And if it were unnecessary, we think any presumption that such accumulation was "for the purpose of preventing the imposition of the surtax upon its shareholders" has been definitely overcome. Corporate Investment Co., supra.Respondent is reversed on this issue.
Decision will be entered under Rule 50.
Footnotes
1. Of this sum $134,000 represents the price of 1,340 units (consisting of one share of preferred and one share of common) of the capital stock of R. C. Reynolds, Inc., which it purchased from R. C. Reynolds in 1935; and $12,971.62 represents the unpaid balance in 1935 on 420 units of the capital stock of R. C. Reynolds, Inc., previously sold to employees thereof by R. C. Reynolds, which he assigned to the corporation in 1935 for $12,971.62. ↩
2. Revenue Act of 1934 was approved May 10, 1934. ↩
3. SEC. 102. SURTAX ON CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS.
(a) IMPOSITION OF TAX. - There shall be levied, collected, and paid for each taxable year upon the adjusted net income of every corporation (other than a personal holding company as defined in section 351) if such corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation, through the medium of permitting gains and profits to accumulate instead of being divided or distributed, a surtax equal to the sum of the following:
(1) 25 per centum of the amount of the adjusted net income not in excess of $100,000, plus
(2) 35 per centum of the amount of the adjusted net income in excess of $100,000.
(b) PRIMA FACIE EVIDENCE. - The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to avoid surtax. ↩