*787 Petitioner is a closely held corporation, all of its capital stock having been issued to four brothers who paid in $100,000 in cash and transferred to the petitioner certain oil properties estimated to be woth approximately $7,000,000, subject to the condition that the corporation would indemnify and save harmless the transferors against loss or damage arising out of any litigation or other cause resulting from their former ownership of the properties. Entries were made on the petitioner's books to show a paid-in surplus equal in amount to the estimated value of the properties. The petitioner having been called upon to reimburse one of the stockholders under this agreement of indemnity for the sums paid out by him in settlement of a suit involving title to and an accounting for a royalty interest which was included in the properties transferred to the corporation upon its organization, it is held the amount of the reimbursement does not constitute a loss or a deductible expense and the respondent did not err in refusing to allow such payment to be deducted from the petitioner's income for the taxable year.
*1062 This proceeding is for the redetermination of a deficiency in income tax for the year 1930 in the amount of $17,810.43. A single issue is presented, whether the respondent erred in disallowing a deduction of $145,515.43 from income for the taxable year, representing the sum of $437.58 paid as expenses of lawsuits and the amount of $145,077.85 paid by petitioner to one of its stockholders in reimbursement of the sums paid by him in settlement of litigation which involved title to and an accounting for an oil royalty interest turned over to the petitioner corporation by such stockholder at the date of its organization.
FINDINGS OF FACT.
Petitioner was incorporated under the laws of the State of Delaware in December 1915 and began to do business in the State of Oklahoma in January 1916. The corporation's authorized capital stock of $100,000 was issued as follows:
| Shares | |
| B. B. Jones | 435 |
| M. Jones | 434 |
| E. L. Jones | 78 |
| R. L. Jones | 47 |
| Harry Ekdahl | 3 |
| J. E. Thrift | 3 |
The shares of stock issued to Ekdahl and Thrift were*789 qualifying shares. The four stockholders first listed above were brothers and Ekdahl was their brother-in-law.
The Jones brothers had been engaged as individuals in the oil business and owned in varying amounts certain valuable oil properties situated in Oklahoma, consisting of leases, mining rights, and royalty interests which they purposes to convey to the petitioner corporation in accordance with the following resolution of the board of directors passed at its organization meeting:
Be it resolved, First: That the Bermont Oil Company accepts the proposition of Messrs. B. B. Jones, M. Jones, R. L. Jones and E. L. Jones, wherein in exchange for the capital stock of this corporation they offer:
(1) To transfer to the company certain mining rights, leases and royalty interests subject to certain conditions; and,
(2) To pay to this company the sum of One Hundred Thousand ($100,000.00) Dollars as a fund for immediate development and operating expense.
These properties were particularly described in schedules attached to the minutes of the corporation, and it was further provided that the owners thereof would sell to the corporation upon open account the equipment and certain*790 property upon the lands described in the leases and elsewhere, the property to be inventoried and priced as the same was listed and valued upon the books of the respective sellers as of January 1, 1916.
*1063 Pursuant to this resolution B. B. Jones and M. Jones paid in to the corporation in cash $50,000 apiece, making a total of $100,000 to be used as a fund with which to operate, and the four brothers transferred to the petitioner the above described oil properties, which were estimated to be worth approximately $7,000,000. The "certain conditions" mentioned in the above-quoted resolution refer to an oral agreement between the parties that the corporation would indemnify and save harmless each and all of the contributing stockholders against loss or damage arising out of any litigation or other cause resulting from their former ownership of any of the properties. Entries were made on the books of the corporation to show a paid-in surplus equal to the estimated value of the properties. The distribution of stock was not in proportion to the contributions made in cash and property by the four Jones brothers.
Included in the list of properties thus turned over to the petitioner*791 by B. B. Jones was his title to the lessor's share or royalty interest in a property described as the southwest quarter of the southwest quarter of section 3, township 17 north, range 7 east, commonly known and hereinafter referred to as the George Tucker allotment. This property had been acquired by B. B. Jones on September 14, 1912, from one Thomas B. Slick, the immediate assignee of M. B. Leonard, and Leonard had acquired title at a guardianship sale on or about February 9, 1912, from one C. K. Leslie, guardian of George Tucker. The transfer to the petitioner of his royalty interest in the George Tucker allotment was made by B. B. Jones by assignment dated January 22, 1916, conveying all his right, title, and interest in and to the lessor's share or royalty interest provided by certain named oil and gas mining leases, subject to the terms and conditions thereof, together with all royalty and proceeds of royalty accrued or accruing to him as assignor since January 1, 1916. This assignment was recorded in Creek County, Oklahoma, December 18, 1917, and recorded in Tulsa County, Oklahoma, August 9, 1929. B. B. Jones had received the royalty payments from the date of his purchase*792 to January 1, 1916, after which date the royalties were received by the petitioner until November 30, 1917, when the royalty interest in the George Tucker allotment was conveyed with other properties by assignment from the petitioner to the Prairie Oil & Gas Co. On the last mentioned date B. B. Jones executed a deed conveying certain real estate to the Prairie Oil & Gas Co., which deed included the George Tucker allotment.
In May 1916 litigation arose with respect to the title to the George Tucker allotment, the suit being instituted in the name of George Tucker, by next friend, and B. B. Jones was named as one of the defendants therein. In July 1921, B. B. Jones paid $1,500 in settlement *1064 of the claims against him of the plaintiffs in this suit. Subsequently and on April 9, 1927, George Tucker in his own name filed another suit in the District Court of Creek County, Oklahoma, in which B. B. Jones and the petitioner corporation were included in the defendants named. Tucker alleged that the deed from C. K. Leslie as guardian was fraudulent and void, asked that such deed be canceled, and prayed for an accounting against all of the defendants as to the value of the*793 oil and gas taken from the land. On December 20, 1927, the trial court found the issues in favor of the defendants and against the plaintiff and the plaintiff appealed to the Supreme Court of Oklahoma. In April 1930 the Supreme Court of Oklahoma rendered a decision which reads in part as follows:
This record shows that Bernard B. Jones paid $400.00 for forty acres of the allotment on September 14, 1912, and that he paid $1500.00 to the "next friend" of the plaintiff on July 8, 1921. He received from the land for oil royalties $74,901.24; for gas royalties $406.12 and for gas rental $100.00 up to October 31, 1917 at which time he sold the land to the Prairie Oil and Gas Company along with other land without any division or apportionment of the purchase money. Judgment should be rendered against him and in favor of plaintiff for the amounts he received with interest at the rate of six per cent per annum from the date of receipt thereof less the amounts that he paid with interest thereon at the rate of six per cent per annum from the dates of payment.
This court further held that the guardian's deed to Leonard and all the conveyances from Leonard and his grantees, with the exception*794 of the oil and gas mining leases to the Prairie Oil & Gas Co. and the deed from B. B. Jones to the Prairie Oil & Gas Co. (and the deed covering certain other property not here involved), should be vacated, canceled and set aside; and directed that the trial court should determine the amount received by B. B. Jones from the sale of the land to the Prairie Oil & Gas Co. The judgment of the trial court was reversed and the cause was remanded to the trial court with instructions to render judgment in favor of the plaintiff and against the defendant, Bernard B. Jones, in the amount found due and owing; to vacate, cancel, and set aside the deeds mentioned; to quiet and confirm the title to the land involved in this action in the plaintiff, free and clear of the claims of the defendants, except as stated; to determine the amount received by B. B. Jones from the sale of the land to the Prairie Oil & Gas Co., and to render judgment therefor.
Under date of September 24, 1930, B. B. Jones paid $145,000 in compromise and settlement of all claims of the plaintiff against him, a stipulation and agreement being entered on the record acknowledging receipt of this amount in full satisfaction thereof, *795 which agreement specifically recited that the plaintiff did release and discharge *1065 B. B. Jones, his lessees and assigns, from any and all liability on account of the matters at issue, the judgment rendered therein and to be rendered in pursuance thereof. On September 25, 1930, the trial court entered judgment in accordance with the mandate of the Supreme Court, in which reference is made to the settlement made by B. B. Jones, and which reads in part as follows:
It is further Ordered that the plaintiff, his assignees and attorneys, have received full compensation in accordance with their stipulation and agreements, and that they be and are hereby barred from procuring judgment or asserting any claim or right against the defendant B. B. Jones because of the matters complained of in this cause of action.
Under date of December 31, 1930, petitioner drew its check in favor of B. B. Jones in the sum of $145,077.85 to reimburse him for the payment of $145,000 made under the circumstances above set out and to cover certain costs incurred by B. B. Jones. B. B. Jones endorsed this check "Pay to the order of Bermont Oil Company for credit my account", and turned it over to*796 the petitioner. The petitioner credited the account of B. B. Jones in this amount. This check was never passed through the bank on which it was drawn. B. B. Jones and his brothers frequently used the petitioner as a bank and endorsed checks to the petitioner to be deposited to their credit.
During the year 1930 petitioner paid out the sum of $437.58 as expenses in connection with three other lawsuits involving title to its properties.
Petitioner kept its accounts on the basis of cash receipts and disbursements. In its return of income for 1930 petitioner claimed a deduction in the total amount of $145,515.43 for "damages account lawsuit and expenses of lawsuit." This amount was disallowed in full by the respondent.
B. B. Jones reported no taxable income in his income tax return for the year 1930.
OPINION.
MATTHEWS: The petitioner has been a closely held corporation since the date of its incorporation, all of its capital stock (except six qualifying shares) having been issued to the four Jones brothers, who were engaged in the oil business in the State of Oklahoma, in the amounts set out in our findings. Upon its organization these brothers conveyed to the petitioner*797 certain leases, mining rights, and royalty interests and paid in cash to the petitioner the sum of $100,000, in exchange for all the capital stock, the properties being transferred subject to the condition that the petitioner would indemnify the save harmless each and all of the contributing stcokholders *1066 against loss or damage arising out of litigation in connection with these properties which had belonged to them. Such an agreement was entered into by the parties for the reason that the stockholders anticipated that attacks were likely to be made on the titles to some of the properties transferred, and that suits might be instituted asking for an accounting for all income and profits derived from the properties during the period of claim of ownership under color of title. In other words, the properties were conveyed to the petitioner subject to any claims which might arise on account of questionable titles and it was understood and agreed that the petitioner would reimburse the transferors for any amounts required to be paid by them on account of their prior ownership of the properties.
It is to be noted that petitioner did not make any payment in money for these*798 properties and that its capital stock was not distributed in proportion to the contributions in cash and property made to it by the stockholders. The entire cash contribution of $100,000 was paid in by B. B. Jones and M. Jones in equal amounts of $50,000. An examination of the schedules listing the properties discloses that these two individuals respectively owned approximately three fourths and one fourth of the transferred properties, E. L. Jones and R. L. Jones together owning only about 1 percent thereof. Entries were made on the petitioner's books to show a paid-in surplus in an amount equal to the estimated value of the properties, which was in excess of $7,000,000.
When the petitioner accepted the proposition of the transferors to convey to it these oil properties, subject to the condition that they would be reimbursed by the petitioner for any payments they might have to make as a result of their prior ownership or claim of ownership of the properties, we are of the opinion that a valid agreement was entered into under which the petitioner was legally bound to reimburse B. B. Jones for the sums paid out by him in settlement of the litigation instituted by George Tucker, *799 under the circumstances described above. It does not follow, however, that such payment constitutes an allowable deduction from income of the petitioner for the year in which the payment was made. On the contrary this transaction would seem to come clearly within the well settled principle that the cost of property or the cost of defending or perfecting title to property is not a deductible expense. Ordinarily such outlays, whether in the form of legal fees or compromise payments, are capital expenditures and should be added to the cost of the property. , affirmed on this issue, ; ; affd., ; *1067 ; and cases cited therein. Certainly the amount paid by the petitioner in the instant case to reimburse B. B. Jones for the sums paid by him, as hereinabove set out, is not an ordinary and necessary expense incurred in carrying on the petitioner's business, nor does it constitute a loss of the corporation which may be deducted under the provisions of the revenue laws. *800 The respondent did not err in disallowing the deduction claimed on account of this item. See, in this connection, , where the Circuit Court of Appeals for the Second Circuit held that attorney fees paid out by the taxpayer in a suit involving the taxpayer's right to his deceased brother's estate, under the terms of his grandfather's will, should not be treated as capital expenditures or business expenses, saying: "expenses of this sort must fall within those general costs of protecting one's property for which the statute makes no allowance."
Counsel for the petitioner have argued that no question would have been raised with respect to allowing the deduction claimed herein if the validity of the agreement of indemnity had not been challenged by the respondent. It is pointed out by the petitioner that the deduction was disallowed on the ground that the judgment obtained against the stockholder was not an obligation of the petitioner corporation. Witnesses for the petitioner testified that the sum of $145,000 was paid by B. B. Jones out of his own funds on deposit in the State of Oklahoma in order that a prompt and advantageous*801 settlement of the plaintiff's claims might be effected, and the petitioner subsequently credited the account of B. B. Jones on its books in the amount of $145,077.85. We consider this point entirely immaterial and our conclusion would be the same if the corporation had originally made the payment in question direct to the plaintiff, George Tucker.
We do not know the nature of the litigation involving other properties of the petitioner but we do know that entries were made on the books to show payments aggregating $437.58 as expenses on account of three other lawsuits. Nothing is contained in the record to indicate that the petitioner is entitled to a deduction on account of these expenses.
The respondent's determination is sustained.
Reviewed by the Board.
Judgment will be entered for the respondent.