*1855 1. One of petitioner's officers contracted to serve petitioner for a number of years at an agreed annual compensation and to place his stock in trust for a term of years. Upon the death of the officer before the termination of the contract, petitioner paid to the officer's estate for a period of time the sums it had agreed to pay the officer. Held that the aggregate of the sums paid to the officer and his estate is not deductible as a loss in the year the contract was terminated by agreement between petitioner and the deceased officer's estate.
2. Under section 206(a)(5) of the Revenue Act of 1926, it is held that in computing a net loss tax-exempt interest should be included in income.
*585 The respondent, disallowing a claimed net loss carried over from 1926, determined a deficiency in income tax for the year 1927 in the amount of $2,888.41.
Petitioner claims that certain payments made under a contract constituted a net loss in 1926 which entirely offset its income for 1927, and that respondent erroneously reduced a 1925 net*1856 loss by the amount of nontaxable interest received in that year, thus depriving petitioner of a part of a net loss which it could otherwise carry forward and deduct in computing 1927 net income. The facts were stipulated.
*586 FINDINGS OF FACT.
Petitioner is a Massachusetts corporation, engaged in the manufacture of steam pumps. Prior to and during the years 1921, 1922, and 1923 it earned large profits.
In 1902 Frank F. Phinney entered petitioner's employ and later became its president, treasurer, and general manager. In 1919 Phinney owned 1,300 shares of petitioner's stock and members of his family owned 369 shares, the total thus owned, 1,669 shares, amounting to 50 per cent of petitioner's capital stock. In that year petitioner and Phinney entered into a contract which recited that petitioner believed that it was for its best interest to keep Phinney's block of 1,300 shares of stock intact, and to retain the services of Phinney as treasurer and general manager as long as possible. In order to accomplish these purposes it was agreed by petitioner and Phinney that his stock was to be turned over to trustees, who were designated and whose powers were enumerated*1857 in a trust agreement attached to the contract, and it was further agreed that Phinney should be employed as treasurer and general manager for a term of five years and also thereafter if elected and able to serve. He was to receive "the same annual salary heretofore received * * * plus an increase of twenty (20) per cent." The petitioner further agreed that:
* * * if and when the said Frank F. Phinney shall cease to act as Treasurer and General Manager for any reason whether this shall occur during or after the five year period aforesaid the said Company will pay to him or in case of his death to his executors, administrators or assigns annually in regular monthly installments the same sum hereinbefore specified to be paid to him as Treasurer and General Manager aforesaid; provided, however, that the said payment shall cease if and when the said Agreement of Trust shall terminate and upon such contingency this Agreement shall become null and void.
Phinney died in March, 1920, and prior to his death petitioner had paid to him the amounts as agreed upon in the contract above mentioned. After Phinney's death petitioner continued to pay the amounts provided for in the contract to*1858 Phinney's estate until the latter part of 1925. In that year petitioner decided that the contract and payments no longer had value to it; that in view of the payments previously made it had fully compensated Phinney and his estate for the consideration of the contract; and that it was inequitable to longer continue the payments. Thereupon negotiations were opened between petitioner, on the one hand, and Phinney's estate or heirs, on the other, which extended into the year 1926. Petitioner offered the representatives of the estate $10,000 in full settlement of all obligations under the contract, which was accepted by the representatives of the estate in 1926 with approval of the *587 probate court. While the negotiations were pending, and until the acceptance of its offer in 1926, petitioner continued to pay to the estate the amounts provided for by the contract.
In its income and profits-tax returns for the years in which payments were made under the contract petitioner deducted the amounts so paid as ordinary and necessary business expenses. Upon audit of the returns the respondent disallowed the claimed deductions, and added the amounts thereof to petitioner's gross*1859 income for each of the taxable years.
The issue as to whether the amounts paid by petitioner in the years 1921, 1922 and 1923 were deductible was decided by the Board in an opinion reported at .
For the calendar year 1927 petitioner reported a net income of $242.90. Respondent increased net income to $23,395.63 by the disallowance of a claimed net loss of $23,152.73.
Petitioner's net loss or net income for each of the years 1925, 1926, and 1927 is as follows:
| 1925 - Net loss, excluding exempt income | $25,709.38 |
| Exempt income | 18,245.00 |
| 1926 - Net income, excluding exempt income | 8,952.88 |
| Exempt income | 14,403.01 |
| 1927 - Net income, excluding deductions claimed | 23,395.63 |
The tax-exempt interest received by petitioner in 1925 and 1926 was interest on obligations of the United States, States, and municipalities.
Respondent reduced petitioner's 1925 net loss by the amount of tax-exempt interest received in that year, thus computing the statutory net loss for 1925 to be $7,464.38.
OPINION.
ARUNDELL: Petitioner claims that if its net losses for 1925 and 1926 are correctly determined and allowed as deductions in computing 1927*1860 income there will be no income in the latter year and consequently no deficiency.
The first claim is that a net loss was sustained in 1926 as the result of payments under the so-called Phinney contract. The error alleged with respect to the disallowance of those payments is as follows:
The respondent Commissioner in error, in computing taxable net income if any for 1927, has failed to take into account several payments made by petitioner under a so-called Phinney contract and under facts hereinafter set forth, said payments being made in 1926 and years prior thereto and creating a net loss for the year 1926 properly deductible in computing net income for 1927.
Under this alleged error we understand petitioner's contention to be that the aggregate of the payments made under the contract *588 from the time it was entered into in 1919 until its cancellation in 1926 should be allowed as a deduction in the latter year, the result of which will be a loss for 1926 and that such loss is a net loss.
The amount paid Phinney for services during his lifetime was deductible as an ordinary and necessary expense at that time and obviously such amount is not again deductible as*1861 a loss in a later year. If any of the amounts paid to Phinney were attributable to his agreement to place his stock in trust, such amounts constituted distributions to a stockholder and were not deductible then or at any future time. Following Phinney's death, petitioner continued to pay certain amounts to his estate, which was then the beneficial owner of the trusteed stock. Those payments were distributions to a stockholder and were not made, as claimed, for the acquisition of any asset which was lost when the payments ceased. In the case reported at , involving this same taxpayer, we held that the amounts paid to the Phinney estate in the years 1921 to 1923 were not deductible either as expenses or losses. It was perhaps unnecessary to go as far as we did in that report in holding that the amounts paid were capital expenditures, but even if we so regard them in this case, we are still of the opinion that no deductible loss is shown. The termination of the contract released the petitioner from an obligation to pay annual sums to Phinney's estate and this would seem to be a benefit to petitioner rather than a loss. Moreover, as pointed out in the previous*1862 case, one of the objects of the agreement was to secure unified control of petitioner's stock, and it does not appear that by the termination of the contract there was lost to petitioner the benefits that it originally hoped to derive from such control.
The next issue - urged only in the event we hold against the petitioner on the first - is whether respondent erroneously increased income for 1925 by the amount of tax-exempt interest in determining the amount of net loss. For the year 1925 petitioner claims to have sustained a net loss of $25,709.38. This amount respondent reduced to $7,464.38 by including tax-exempt interest in gross income. For the year 1926 petitioner's net income - excluding the claimed loss under the Phinney contract and exempt income - was $8,952.88, which was more than sufficient to absorb the 1925 net loss, hence the respondent found that there was no net loss remaining from 1925 to be carried over to 1927.
The respondent's computation is based on the following provisions of the Revenue Act of 1926:
Sec. 206. (a) As used in this section the term "net loss" means the excess of the deductions allowed by section 214 or 234 over the gross income, with*1863 the following exceptions and limitations:
* * *
*589 (5) There shall be included in computing gross income the amount of interest received free from tax under this title * * *.
The same provisions appear in the Revenue Act of 1924, and similar provisions are contained in the Revenue Acts of 1918 and 1921. The propriety of including nontaxable interest in income in determining net losses under the 1921 Act was before us in , and , in both of which cases we sustained the respondent in his use of the method followed in this case.
Petitioner contends that the quoted provision of the statute is unconstitutional and cites , as controlling. In that case the court held that section 245(a) of the Revenue Act of 1921 was unconstitutional in requiring that the deduction from gross income of 4 per cent of the mean of the reserve funds be reduced by the amount of tax-exempt interest. Since then the court has held valid sections 214(a) and 234(a) of the same revenue act, which provide that the*1864 amount of interest deductible from gross income shall be reduced by the amount of interest paid to purchase or carry securities, the income of which is tax-exempt. See , and .
Taxable income as defined in the several revenue acts is determined on a basis of a twelve-month period, except in particular circumstances not necessary to discuss here. A departure from this rule was inaugurated by the so-called net loss provision of the Revenue Act of 1918, and continued in subsequent revenue acts. This provision of the several acts is not open to all taxpayers, but only those who come within its terms, and the loss to be carried forward must be measured by the terms of the statute, and not otherwise. A glance at the provisions of section 206(a) of the Revenue Act of 1926, 1 with which we are concerned here discloses a very detailed *590 plan of determining a loss that may be carried forward into another year. We see no reason why Congress in granting this particular boon may not limit it so that the loss to be carried forward is an actual and*1865 true loss, and not an artificial one which arises from the exclusion of certain non-taxable income.
*1866 Reviewed by the Board.
Decision will be entered for the respondent.
Footnotes
1. SEC. 206. (a) As used in this section the term "net loss" means the excess of the deductions allowed by section 214 or 234 over the gross income, with the following exceptions and limitations:
(1) Deductions otherwise allowed by law not attributable to the operation of a trade or business regularly carried on by the taxpayer shall be allowed only to the extent of the amount of the gross income not derived from such trade or business;
(2) In the case of a taxpayer other than a corporation, deductions for capital losses otherwise allowed by law shall be allowed only to the extent of the capital gains;
(3) The deduction for depletion shall not exceed the amount which would be allowable if computed without reference to discovery value, or to paragraph (2) of subdivision (c) of section 204;
(4) The deduction provided for in paragraph (6) of subdivision (a) of section 234 of amounts received as dividends shall not be allowed;
(5) There shall be included in computing gross income the amount of interest received free from tax under this title, decreased by the amount of interest paid or accrued which is not allowed as a deduction by paragraph (2) of subdivision (a) of section 214 or by paragraph (2) of subdivision (a) of section 234. ↩