*2680 1. Where under a composition agreement of creditors it is provided that all sums paid shall be treated as interest, but upon the payment of sums totaling 45 per cent of the principal sum due all further obligations to pay either principal or interest shall be discharged, petitioner's accrual of interest may not exceed the total amount it is obligated under the contract to pay.
2. The amount paid to employees in the year 1924 as additional compensation for services rendered allowed as a deduction from gross income.
*1315 These proceedings, which were consolidated for hearing and decision, involve the redetermination of a deficiency of $22,746.33 in income and excess-profits taxes for the year 1921, and deficiencies of $6,008.03 and $1,025 in income taxes for the years 1922 and 1924, respectively. The issues are (1) whether certain amounts are deductible from gross income in 1921 and 1922 as interest accrued upon indebtedness; (2) whether a net loss sustained in 1921 should be allowed as a deduction from net income for the year 1922, and (3) *2681 whether there should be allowed as a deduction from gross income for 1924 the sum of $2,026.10 as additional compensation paid to employees.
FINDINGS OF FACT.
The petitioner is a California corporation with principal offices at San Francisco. During the years 1921 and 1922 it kept its books and made its returns on the accrual basis.
On March 27, 1915, when the petitioner was in financial difficulties and some of its creditors were demanding payment of their claims, the petitioner entered into a written agreement with its creditors, whose claims aggregated $924,350.36, and Wm. R. Pentz, as trustee, for the liquidation of the indebtedness. The pertinent provisions of the instrument read as follows:
FIRST: That the said debtor shall within 30 days from this date cause to be delivered to Wm. R. Pentz, who is hereinafter called the trusteeThe whole of its capital stock, save and except five (5) shares thereof which shall be and remain one (1) share in the name of each of its directors, and shall cause to be vested in said trustee for the purposes of this agreement full and complete title to said stock so delivered with all powers incident thereto;
SECOND: That the said trustee*2682 shall have the power to nominate, and from time to time to substitute by writing addressed to the Board of Directors of the debtor, a person who shall be elected Treasurer of said debtor, and who shall receive and control all of the funds received by said debtor from whatever source derived, and shall disburse such of said funds as may be necessary to safely and economically conduct and carry on said business and shall turn over and deliver to said trustee the remainder of said funds, which shall from time to time, and whenever there is sufficient in his hands for that purpose, be by said trustee distributed pro rata among the undersigned creditors;
* * *
FIFTH: *1316 That the full amount of the claims and demands of the undersigned creditors as hereinbelow placed opposite their respective names shall be paid on or before five (5) years from the date hereof;
SIXTH: That each and all of said acts and payments shall be done and made promptly at maturity, and so to this condition, time is hereby made of the essence of this agreement, so that in case of default or miscarriage regarding said acts and payments the whole of said original indebtedness, together with interest thereon, *2683 is hereby renewed and revived, save and except such portion thereof as may have been theretofore received thereon from said trustee, as hereinabove set forth:
HEREBY AGREE one with another and with the said debtor upon the conditions aforesaid, to waive, any and all claim for interest now due or to become due upon their several claims and demands, and to extend, and they do hereby extend, for a period of five (5) years from the date hereof, the time of payment of the principal thereof, being the amounts hereunto set opposite their respective names, provided, however, that they shall receive and credit upon said principal such amounts as may be disbursed to them by said trustee, as hereinabove set forth. But in case of a breach of any of said conditions then these presents shall be void and of no effect, except as an acknowledgment and renewal of said original claims and demands, and interest thereon, sufficient to prevent the bar of any statute of limitations of the State of California, and which statute and the pleading thereof as a defense to the recovery of any of said claims or demands is hereby expressly and irrevocably waived by said debtor, it being the intention of this*2684 agreement to suspend the operation of such statute of limitations while this agreement remains in force.
At the time the agreement was entered into, Ada Johnson, a stockholder of petitioner and one of its creditors in the amount of $139,969.40, was liable for the payment of a portion of the claims of petitioner's creditors. By the terms of an agreement dated March 27, 1915, between Ada Johnson, Wm. R. Pentz and petitioner's creditors, the former, in consideration of the discharge of her liability under the claims, agreed to assign all of her property, including her claim against petitioner, less certain exemptions, to Wm. R. Pentz, in trust, with power, among others, to collect the revenue therefrom and convert the property into money and distribute the net proceds ratably among petitioner's creditors in liquidation of their claims against the petitioner.
The claims of the creditors were not liquidated in full within the five-year period provided for in the agreement, and as a consequence, the parties to the instrument entered into a further agreement on January 3, 1921, the pertinent provisions of which are:
That the said trustee shall have the power to nominate, and from*2685 time to time to substitute by writing addressed to the Board of Directors of the debtor, a person who shall be elected Treasurer of said debtor, and who shall receive and control all of the funds received by said debtor from whatever source derived, and shall disburse such of said funds as may be necessary to safely and economically conduct and carry on said business and shall turn over and deliver to said trustee the remainder of said funds, which shall from time to time, and whenever there is sufficient in his hands for that purpose, be by said trustee, distributed pro rata among the undersigned creditors and *1317 Wm. R. Pentz, trustee for the creditors of Ada Johnson under a certain indenture entered into between the undersigned creditors and said Ada Johnson on March 27th, 1915;
That an amount shall be paid on the claims and demands of each of the undersigned creditors and on the claim and demand of Ada Johnson (now held by Wm. R. Pentz as trustee for the creditors of said Ada Johnson) on or before three years from the date hereof, by or for the debtor, which amount so paid, together with all payments received since March 27th, 1915, from the debtor or Ada Johnson or*2686 Wm. R. Pentz as trustee for either of them on said claims and demands, shall equal forty-five (45) per cent, of the amount of the present principal of each of said claims and demands.
That each and all of said acts and payments shall be done and made promptly, at maturity, and as to this condition, time is hereby made of the essence of this agreement, so that in case of default or miscarriage regarding said acts and payments the whole of said principal indebtedness, together with interest thereon, is hereby renewed and revived, save and except such portion thereof as may have been theretofore received thereon from said trustee, as hereinabove set forth;
HEREBY AGREE one with another and with the said debtor upon the conditions aforesaid, to extend, and they do hereby extend, for a period of three years from the date hereof, the time of payment of the principal and interest upon their several claims and demands. But in case of a breach of any of said conditions then these presents shall be void and of no effect, except as an acknowledgment and renewal of said original claims and demands, and interest thereon, sufficient to prevent the bar of any statute of limitations of the State*2687 of California, and which statute and the pleading thereof as a defense to the recovery of any of said claims and demands is hereby expressly and irrevocably waived by said debtor, it being the intention of this agreement to suspend the operation of such statute of limitations while this agreement remains in force;
AND HEREBY AGREE one with another and with the said debtor, upon the conditions aforesaid that the full amount of said claims and demands of the undersigned, principal and interest, and the claim and demand of Ada Johnson against the debtor assigned to Wm. R. Pentz, Trustee as aforesaid for the undersigned creditors, principal and interest, shall be considered as paid in full and extinguished and discharged upon the payment of said 45 per cent on each of said claims and demands; that all payments heretofore made on said claims and demands by said debtor or Ada Johnson or said Wm. R. Pentz as Trustee for either of them shall be considered as having been made on interest and not on principal; that all future payments herein provided to be made on said claims to make up said 45 per cent shall be paid as and on interest and not as principal.
By June 15, 1922, there had been*2688 paid to Wm. R. Pentz as trustee, and he had distributed to the creditors, pursuant to the terms of the agreement of January 3, 1921, and the agreement between Ada Johnson and the creditors, amounts equivalent to 45 per cent of the principal amount of the indebtedness on January 3, 1921.
In its returns for the years 1921 and 1922 petitioner claimed the respective sums of $124,787.30 and $56,703.80 as deductions for interest on the full amount of the claims of its creditors. The respondent disallowed all of the deductions with the exception of $293.54 for the year 1921.
*1318 For the year 1922 the petitioner claimed as a deduction from net income an alleged net loss for the year 1921. The respondent disallowed the claim in full in view of the fact that his adjustments for the year 1921 resulted in net income instead of a net loss.
During the year 1924 the petitioner, pursuant to a policy established in December, 1923, paid its employees a total of $2,026.10 as additional compensation for services rendered. The amount paid each employee was based upon a small percentage of his salary. The sum paid was not claimed as a deduction from gross income in the return filed*2689 by petitioner for the year 1924. The amount paid each employee was, however, reported to the respondent on Form No. 1096 or No. 1099 as additional compensation paid to its employees.
OPINION.
ARUNDELL: By the agreement of January 3, 1921, petitioner admits a liability to its creditors in the principal sum of $924,350.36, on which it agrees to pay interest. It is provided in the contract that all sums thereafter paid shall be regarded as interest until such time as there has been paid to the creditors a sum which, when added to the amounts theretofore paid, shall equal 45 per cent of the principal sum due, at which time petitioner is to be discharged from all liability to its creditors. This agreement, according to its terms, must be performed within three years from its date and time is of the essence of the contract.
We have not been advised of the sums paid to the creditors between March 27, 1915, and January 3, 1921, nor the amounts thereafter paid, which would be sufficient to make up the 45 per cent. All that we know is that by June 15, 1922, sufficient had been paid to release petitioner from further liability for principal and interest.
If petitioner were on*2690 the cash basis it would be entitled to deduct, in computing its net income, the sums actually paid as interest during the years in which paid, and if it performed under the contract these amounts would be limited to a total of not to exceed 45 per cent of the principal sum due. As its books were kept on the accrual system, it may deduct the interest as it accrues, regardless of when payment is made, but may it deduct an amount greater than its total liability? We do not believe that the accrual system contemplates or that the law permits such a deduction. Nor do we think the fact that the contract must be performed within three years to entitle petitioner to its discharge in the manner set forth should change our conclusions. During 1921 and 1922 it was operating under that contract with its liability limited to an amount not in excess of 45 per cent of the principal sum, and in fact it did fully perform its part of the contract within one and one-half years.
*1319 The petitioner having refrained from giving us the amounts actually paid by it to its creditors either before or subsequent to January 3, 1921, we have no means of determining the extent of its liability during*2691 the years in question and consequently the amount, if any, that it would be entitled to accrue in the respective years 1921 and 1922. The determination of the respondent in this particular will therefore not be disturbed.
Inasmuch as our decision of the first issue will result in net income for the year 1921 instead of a net loss, it follows that the petitioner has no grounds for claiming as a deduction from net income for 1922 a net loss for the prior year.
The respondent is not contesting the reasonableness of the additional compensation paid by the petitioner to its employees in 1924. The sum was actually paid in the taxable year as additional compensation for services rendered and is deductible from gross income as an ordinary and necessary business expense.
For the years 1921 and 1922 judgment will be entered for the respondent. For the year 1924 judgment will be entered under Rule 50.