*195 Decision will be entered under Rule 50.
Petitioner Jesse Johnson was engaged in business as an independent building contractor. He helped organize two corporations whose purpose was the development of rental housing projects. Petitioner acquired all their outstanding common stock and controlled their activities. He entered into contracts with his wholly owned corporations to construct their housing projects. Although the contracts were amended during and after the construction period to provide increases in the amounts payable to petitioner, his total construction costs were in excess of the amounts provided by the amended contracts. Part of such excess costs was due to the use of materials of a higher quality than that required by the contract specifications; part was due to bad weather and the inability to get materials during the construction period. Petitioners deducted the unreimbursed excess construction costs as losses on their returns for 1947, 1948, and 1949. Respondent disallowed such deductions. Held, there was no arm's-length relationship between petitioner and his wholly owned corporations, and losses purportedly sustained by him under contracts with such*196 corporations are nondeductible as losses but are contributions to the capital of the corporations.
*107 This proceeding involves deficiencies in income tax determined against petitioners, as follows:
| Year | Deficiency |
| 1947 | $ 1,632.30 |
| 1948 | 1,727.22 |
| 1949 | 6,166.62 |
| 1950 | 3,186.94 |
*108 The sole issue to be decided is whether petitioners are entitled to deduct as losses under section 23 (e) of the 1939 Code amounts expended by petitioner Jesse Johnson*197 in excess of the prices provided by amended construction contracts entered into by him with his wholly owned corporations.
Respondent concedes that if such amounts are not deductible as losses, then they must be added to the basis of petitioner's stock in such corporations and that the deficiency for 1949 must be reduced to reflect a resulting decrease in capital gains realized by petitioner in that year on the sale of his stock in one of such corporations.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found and are incorporated herein by this reference.
Jesse Johnson (hereinafter referred to as petitioner) and Virginia D. Johnson are husband and wife, residing in Arlington, Virginia. They filed joint income tax returns for the calendar years 1947 to 1950, inclusive, with the collector of internal revenue for the district of Virginia.
Petitioner has been engaged in the construction industry since 1927. In 1938, he and another individual established their own brick and stone contracting business. They built many large apartment buildings and housing developments in and around Washington, D. C., until they discontinued activities in 1943. Thereafter, *198 petitioner, individually, was engaged in the construction of houses for sale and for rent.
In 1946, petitioner and three other individuals organized Frederick Courts, Inc., under the laws of Virginia. They transferred real estate, having a cost price of $ 57,000, to the corporation and each became the owner of 25 per cent of the corporation's capital stock. Frederick Courts, Inc., proceeded with plans for the construction of an apartment development, to be financed by a loan insured by the Federal Housing Administration. On May 26, 1947, petitioner purchased the stock of the other three stockholders in the corporation and continued with the development of the property by himself.
In order to qualify for Federal Housing Administration insurance, the corporation's charter was amended to provide for two classes of stock, common and preferred. As amended, it further provided, in part, as follows:
4. * * * The shares of capital stock shall have the following preferences and restrictions:
(a) The holders of the preferred stock shall be entitled to receive, when and as declared by the board of directors, noncumulative dividends at the rate of *109 five cents (5 cents) per share *199 per annum, before any sum or sums shall be set apart for or applied to the purchase or redemption of the preferred stock and before any dividend or other distribution shall be declared, set apart, paid or made in respect of the common stock.
(b) The net earnings of the corporation, after providing therefrom dividends on preferred stock and all reserves hereinafter required, may be applied each year in payment of dividends to stockholders.
(c) The preferred stock at any time outstanding may be redeemed by the corporation at par and dividends declared thereon, but unpaid to the date of such redemption, provided, however, that such stock shall be so redeemed, upon, but in no event before, the termination of any contract of mortgage insurance covering any indebtedness of the corporation * * *
(d) Anything to the contrary herein notwithstanding, no dividends shall be paid upon any of the capital stock of the corporation (except with the consent of the holders of a majority of the shares of each class of stock then outstanding until all amortization payments due under the mortgage insured by the Federal Housing Commissioner have been paid, and until a reserve fund for replacements is first*200 established and maintained by the allocation to such reserve fund in a separate account with the mortgagee (or in the case of a deed of trust with the beneficiary) or in a safe and responsible depository designated by the mortgagee, commencing on the date of the first payment toward amortization of the principal of the mortgage insured by the Commissioner unless a later date is approved in writing by the holders of the preferred stock, of an amount equal to five hundred nine and 75/100 dollars ($ 509.75) and a like amount monthly thereafter. Such fund, whether in the form of a cash deposit or invested in obligations of, or fully guaranteed as to principal and interest by the United States of America, shall at all times be under the control of the mortgagee. Disbursements from such fund, whether for the purpose of effecting replacements of structural elements, furnishings and mechanical equipment of the projects or for any other purpose, may be made only after receiving the consent in writing of the holders of the preferred stock.
(e) In the event of any default by the corporation, as hereinafter defined, and during the period of such default, the holders of the preferred stock, *201 voting as a class, shall be entitled to remove all existing directors of the corporation, and to elect new directors in their stead: Provided, however, that one of said directors shall be the owner or holder of one or more shares of common stock. When such default or defaults shall have been cured, the right to elect directors shall again vest in the holders of the common stock.
* * * *
10. The corporation shall not, without prior approval of the holders of a majority of the shares of preferred stock, * * * (a) assign, transfer, dispose of or encumber any real or personal property, including rents, except as specifically permitted by the terms of the mortgage, (b) remodel, reconstruct, demolish or subtract from the premises constituting the project and subject to such mortgage, (c) permit the occupancy of any of the dwelling accommodations of the corporation except at or below the rents fixed by the schedule of rentals provided hereinafter, (d) consolidate or merge the corporation into or with any other corporation; go into voluntary liquidation; carry into effect any plan or reorganization of the corporation; redeem or cancel any of its shares of preferred stock, or effect any changes*202 whatsoever in its capital stock, alter or amend the certificate of incorporation or fail to establish and maintain reserves as set forth in this certificate of incorporation.
*110 11. (a) The happening of any of the following events shall constitute a default within the meaning of that word as used in this certificate: (1) the failure of the corporation to have dismissed within thirty days after commencement, any receivership, bankruptcy or other form of liquidation instituted by or against the corporation; (2) the failure of the corporation to pay the principal, interest, or any other payment due on any note, bond, or other obligation executed by it, as called for by the terms of such instrument, (3) the failure of the corporation to establish and maintain the reserve fund for replacements as provided in Article 4, Section (d) hereof, or the use of such fund except as permitted in said section; (4) the failure of the corporation, continuing for a period of fifteen days, to perform any of the covenants, conditions or provisions required by it to be performed by this certificate, the by-laws of the corporation, the mortgage, or any contract to which the corporation and the Commissioner*203 shall be parties, or fail to carry out in full the terms of any agreement whereby the loan covered by the insured mortgage is to be advanced or the project is to be constructed and operated.
* * * *
12. * * * (a) (1) Dwelling accommodations of the corporation shall be rented at a maximum average rental per room per month fixed by the board of directors of the corporation and approved by the holders of the preferred stock. * * *
(b) In the event rents are regulated throughout the United States and its possessions by any agency of the United States Government expressly established for purposes of controlling maximum rents, other than the Federal Housing Commissioner, the regulation and restriction provided for in Article 12, paragraph (a) will not be required. * * *
* * * *
(d) The corporation, its property, equipment, buildings, plans, offices, apparatus, devices, books, contracts, records, documents and other papers shall be subject to examination and inspection at any reasonable time by the Commissioner [Federal Housing Administrator]; * * *
(e) The corporation shall furnish the Commissioner [Federal Housing Administrator] within 60 days following the end of each fiscal year a complete*204 annual financial report.
On June 11, 1947, petitioner exchanged his 500 shares of common stock in Frederick Courts, Inc., for an equal number of shares in that corporation; such new shares, however, providing for the restrictions and limitations of its amended charter. At a meeting of the stockholders of Frederick Courts, Inc., held June 10, 1947, petitioner, as the sole stockholder, elected certain people who were employed by him in his construction business as officers and directors of the corporation.
On June 18, 1947, petitioner informed a meeting of the board of directors of the corporation that a loan in the amount of $ 1,256,000 had been arranged, subject to insurance by the Federal Housing Administration, for the purpose of erecting an apartment house project. On June 24, 1947, the Federal Housing Administration purchased 100 shares of preferred stock from the corporation at $ 1 per share, in *111 accordance with the requirements of that agency where loans were in excess of $ 200,000.
On June 24, 1947, Jesse Johnson, Contractor, and Frederick Courts, Inc., by Jesse Johnson, President, entered into a construction contract on Federal Housing Administration Form No. 2442-W, *205 whereby petitioner committed himself to construct an apartment project for the corporation for a consideration of $ 1,163,640. The contract provided in "Article 4 -- Schedule of Payments" that applications for payment were to be filed and payments were to be made monthly, but that the "Contractor shall only be entitled to payment in the amount approved by the Lender and the Federal Housing Commissioner with respect to said application." It was further provided that:
whenever it is provided in this Contract that the approval of, or the certificate or order from the Architect shall be received either as a condition precedent to any action being taken or not taken, as the case may be, or as a prerequisite to the exercise by the parties hereto of any right or rights hereunder, including the right to receive payment under this Contract, the Commissioner or the Lender may require that such approval and such certificate or order shall, before being effective, be accompanied by the written approval of the Commissioner and the Lender or their duly authorized representatives.
Petitioner was required to furnish an indemnity agreement in an amount equal to 10 per cent of the contract price.
*206 The minutes of the corporation state that, on January 9, 1948, petitioner informed a meeting of the corporation's board of directors that "improvements in materials used and changes in the plans as originally approved by F. H. A. resulted in increased cost of construction and would also provide increased income from apartments." Petitioner stated that the officers of the corporation had applied for an increase in the amount of its insured mortgage and read a portion of a letter, written by the Federal Housing Administration, granting an increase in the amount of $ 102,100. The board of directors then authorized the officers of the corporation to amend the construction contract with petitioner to increase the total consideration from $ 1,163,640 to $ 1,263,640.
At a meeting of the board of directors of Frederick Courts, Inc., held on July 26, 1948, after the construction of the apartment project was completed, petitioner presented a bill of $ 50,000 for extras to the corporation. The following resolution was unanimously carried by the board of directors:
Resolved, that the bill of Jesse Johnson, Builder & Developer, dated July 15, 1948, in the amount of $ 50,000.00, for extra work*207 in connection with the construction of Frederick Courts Apartments (change in plans of building #5, converting basement space to office space in building #3, and building three-car garage) is hereby approved and the officers of this corporation are authorized to make payments on account of this bill when funds are available.
*112 The construction contract price was thus increased from the previously amended amount of $ 1,263,640 to $ 1,313,640. All or most of this $ 50,000 was paid to petitioner by 1950.
Petitioner's cost of performing the construction contract amounted to $ 1,444,275.15, which was $ 130,635.15 in excess of the $ 1,313,640 amount provided for by the amended contract. Part of such excessive costs was attributable to bad weather, rising labor costs, and the inability to get materials during the construction period. Petitioner claimed the $ 130,635.15 in excess construction costs as an ordinary loss on his returns for 1947 and 1948, in the respective amounts of $ 13,878.82 and $ 116,756.33.
Parkwood, Inc., was organized and incorporated under the laws of the State of Virginia in October 1947, for the purpose of constructing and renting an apartment project. *208 All of the capital stock issued by Parkwood, Inc. (50 shares), was purchased by petitioner for $ 500. Petitioner was president and a member of the board of directors. Three individuals who were employed by petitioner in his construction business, as office manager, secretary, and bookkeeper, respectively, also acted as officers and members of the board of directors of Parkwood, Inc.
On the basis of Federal Housing Administration insured mortgages, Parkwood, Inc., borrowed $ 1,772,000 in a series of nine loans to construct its apartment project. The Federal Housing Administration held no preferred or other kind of stock in Parkwood, Inc., since none of such loans was in excess of $ 200,000.
Petitioner entered into contracts with Parkwood, Inc., to construct 221 apartment units for the sum of $ 1,662,200. Construction began in December 1947 and was completed in February 1949. On March 10, 1949, petitioner, by letter to Parkwood, Inc., stated that though the aggregate amount of the construction contracts was $ 1,662,200, he found "the cost of constructing same (exclusive of office overhead and any profit) amounted to approximately $ 1,770,000.00." Further, he wrote that his "loss" *209 in excess of $ 100,000 was "due in part to furnishing materials of a superior quality to that called for by the plans and specifications." Petitioner also attributed his excess costs to the fact that only 221 apartments were constructed, whereas it had originally been anticipated that a total of 516 would be built. He then requested the board of directors to increase the contract price by allowing a 5 per cent increase ($ 83,110) over and above the contract price and, in addition, that he be repaid $ 13,262.80, representing the cost of surfacing the streets with asphalt. On March 15, 1949, the board of directors of Parkwood, Inc., adopted the following resolution:
Resolved, that the contracts with Jesse Johnson dated February 11, 1948 and July 27, 1948 aggregating $ 1,662,200.00, be increased by 5% or $ 83,110.00, and *113 that Jesse Johnson be repaid for street surfacing in the amount of $ 13,262.80; and further, that payment for this increased cost be made as and when funds are available.
The construction contract price was thus increased from $ 1,662,200 to $ 1,758,572.80. Parkwood, Inc., entered the amount of $ 96,372.80 in its accounts payable ledger as a credit due*210 petitioner. Petitioner filed an amended return for the year 1948 to report $ 94,832.65 of the $ 96,372.80 increase in the contract price as income for that year.
Petitioner's cost of performing said construction contract, as amended, amounted to $ 1,774,194.12 and was $ 15,621.32 in excess of the amount due him under the amended contract. This excess was claimed as a net ordinary loss.
As a result of his inability to obtain immediate reimbursement for the excess costs incurred in the construction of the Frederick Courts, Inc., and Parkwood, Inc., projects, petitioner was financially pressed and unable to meet his bills as they came due. On April 12, 1949, for a total consideration of $ 225,000, petitioner sold his entire 50 shares of stock in Parkwood, Inc., and assigned two accounts receivable due him from that corporation, in the amounts of $ 96,372.80 and $ 4,696.63, respectively. Parkwood, Inc., made a series of payments on these accounts and the purchaser was paid in full by October 15, 1950. Petitioner reported that $ 123,330.57 of the $ 225,000 total consideration was the selling price of the 50 shares of stock and reported a long-term capital gain thereon, computed as*211 follows:
| Gross sales price | 1 $ 123,330.57 | |
| Less: | ||
| Cost | $ 500.00 | |
| Expense of sale | 24,200.00 | 24,700.00 |
| Profit | $ 98,630.57 | |
| 50 per cent taken into account | $ 49,315.28 |
Respondent determined that petitioner had realized no deductible losses from the performance of construction contracts entered into by him with his wholly owned corporations.
OPINION.
We must decide whether petitioner may properly deduct as losses under section 23 (e) of the Internal Revenue Code of 19391 amounts expended by him in excess of the prices provided *114 by construction contracts which he entered into with his wholly owned corporations. Petitioner is an individual with many years of experience in the construction business; and, during the years here in issue, he was actively engaged as a building contractor. He was also the sole common stockholder, president, and member of the boards of directors of two corporations engaged in the development of rental housing projects. *212
Petitioner's investment in these corporations was small in relation to the total sums required to accomplish their objectives. Although not specifically set out in the record, it appears that his investment in Frederick Courts, Inc., was less than $ 100,000. As for Parkwood, Inc., petitioner paid a total of $ 500 for his stock in that corporation. The two housing projects were to be financed principally by Federal Housing Administration insured loans of $ 1,256,000 and $ 1,772,000, respectively.
Petitioner, in his capacity as an independent housing contractor, entered into contracts with each of the corporations to construct their projects for the sums of $ 1,163,640 and $ 1,662,200, respectively. *213 However, in each project his costs proved to be in excess of the contract price. Frederick Courts, Inc., obtained an additional Federal Housing Administration insured loan of $ 102,100, and amended petitioner's contract to provide for the payment of an additional $ 100,000 to him. After petitioner had completed work on the project, he presented a $ 50,000 bill for extras to the corporation and was voted this sum, payment to be made "when funds are available." All or most of this $ 50,000 was paid to petitioner by 1950. After petitioner had completed the Parkwood, Inc., project, he informed that corporation that his costs exceeded the contract price by over $ 100,000, "due in part to furnishing materials of a superior quality to that called for by the plans and specifications." He was voted an additional $ 96,372.80, payment to be made "when funds are available."
Despite these increases in the contract prices, petitioner still had unreimbursed costs on the Frederick Courts, Inc., and Parkwood, Inc., projects in the respective amounts of $ 130,635.15 and $ 15,621.32. He contends that these amounts should be deductible as losses under section 23 (e), arguing that the contracts were*214 entered into with the intent to realize a profit, that a substantial part of the excess costs was due to bad weather conditions and material shortages which provided no economic benefit to the corporations, and further, that the corporations were unable to reimburse him for these excess costs.
Petitioner and respondent agree that section 24 (b) (1) has no application in the instant case inasmuch as no "sale or exchange of property" occurred here. However, that section is not exclusive in the disallowance of losses between related taxpayers. If "good faith and *115 finality" are lacking in a transaction between related taxpayers, purported losses must be disallowed even though not specifically covered by section 24 (b) (1). Crown Cork International Corporation, 4 T. C. 19 (1944), affd. 149 F. 2d 968 (C. A. 3, 1945).
The burden of proof is on the taxpayer to establish a deductible loss. Burnet v. Houston, 283 U.S. 223">283 U.S. 223 (1931). Moreover, transactions between a sole stockholder and his wholly owned corporation are subject to special scrutiny. We do not mean to imply that all losses incurred*215 by taxpayers in dealings with their wholly owned corporations are nondeductible because of the difficulty or impossibility of maintaining an arm's-length relationship. But where, as in the instant case, the record clearly shows that a taxpayer did not maintain an arm's-length relationship in his dealings with his wholly owned corporation, his purported losses must be disallowed.
The profit motive appears to have been a very minor element in these construction contracts, if present at all. The record herein clearly indicates that petitioner voluntarily supplied materials of a better grade than called for by the contract specifications. This was done not to benefit himself as an individual contractor but, rather, to benefit himself in his capacity as sole stockholder of the corporations. Excess expenditures caused by the use of such materials produced no economic loss since petitioner realized offsetting benefits through the increase in value of his common stock in the two corporations.
In Higgins v. Smith, 308 U.S. 473">308 U.S. 473 (1940), the Supreme Court disallowed a loss claimed by a sole stockholder when he sold securities to his wholly owned corporation*216 at a price less than his basis. The Court pointed out that the transfer was executed as a tax-minimizing device and that the taxpayer retained domination and control over the securities even after the transfer, stating at page 476:
Indeed this domination and control is so obvious in a wholly owned corporation as to require a peremptory instruction [to a jury] that no loss in the statutory sense could occur upon a sale by a taxpayer to such an entity.
Referring to Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935), the Court stated, at pages 476 and 477:
If, on the other hand, the Gregory case is viewed as a precedent for the disregard of a transfer of assets without a business purpose but solely to reduce tax liability, it gives support to the natural conclusion that transactions, which do not vary control or change the flow of economic benefits, are to be dismissed from consideration. There is no illusion about the payment of a tax exaction. Each tax, according to a legislative plan, raises funds to carry on government. The purpose here is to tax earnings and profits less expenses and losses. If one or the other factor in any calculation is*217 unreal, it distorts the liability of the particular taxpayer to the detriment or advantage of the entire tax-paying group.
Subsequently, in Crown Cork International Corporation, supra, involving a loss claimed to have been sustained by a corporation on *116 the sale of securities to its wholly owned subsidiary, we applied the following rule, page 23:
Not all transactions between a wholly owned corporation and its parent are to be disregarded. But where either the relationship between the two is such that they are in fact inseparable, so that the individual existence of the two entities is an unsupported fiction and the "finality" of the loss to the combined enterprise is consequently negatived, cf. Interstate Transit Lines v. Commissioner, 319 U.S. 590">319 U.S. 590, or the transaction itself is without a true purpose except that of tax avoidance, so that its effectiveness to "change the flow of economic benefits," its "good faith," as an incident of the conduct of a business, is suspect, cf. Wickwire v. United States (C. C. A., 6th Cir.), 116 Fed. (2d) 679, then taxpayers have failed to*218 show themselves entitled to the benefit of the loss.
In the instant case, petitioner argues that he lacked complete control over the corporations because of the rights and powers of the Federal Housing Administration as guarantor of the corporations' mortgages. However, after an examination of the various agreements entered into it is obvious that petitioner retained complete control over the corporations' activities. The Federal Housing Administration held no stock in Parkwood, Inc., and, as to Frederick Courts, Inc., only if that corporation had defaulted on the payment of its mortgage would the Federal Housing Administration have been given control over its activities. The sole exception appears to be that the Federal Housing Administration had certain powers with respect to the disbursement of the guaranteed loans. This fails to support petitioner's argument, since he received almost the entire amount of such loans and his complaint is that there were not more of them.
The corporations were clearly his alter ego since their officers and directors, elected by him, were all individuals employed by him in his contracting business in various subordinate capacities. When he found*219 that his costs were in excess of the contract price, he caused the corporations to increase the contract price. Frederick Courts, Inc., was able to obtain an additional loan of $ 102,100, and voted petitioner $ 100,000 of this immediately. Subsequently, petitioner was voted $ 50,000 by Frederick Courts, Inc., and $ 96,372.80 by Parkwood, Inc., such sums being payable "when funds are available." Had petitioner wished, he could undoubtedly have caused the corporations to establish additional accounts payable for the remainder of his excess costs which are now before us. Having failed to do so, he must be regarded as having made additional contributions to the capital of each of the corporations, and the amount of the excess costs is to be added to his basis for the stock.
Since the corporations were petitioner's alter ego and the transactions herein were not at arm's length, it is immaterial whether the excess costs were due to the use of more expensive materials than required by the specifications, rising labor costs, or bad weather conditions. *117 We need not determine whether all such expenditures produced true economic benefits to the corporations. For, whatever their*220 economic value, the excess expenditures over the amended contract prices were, on the facts of this case, capital contributions which increased the basis of petitioner's stock. Having determined that such excess costs are capital contributions, it is unnecessary to discuss petitioner's last argument relating to the inability of the corporations to promptly reimburse petitioner for such excess expenditures.
Decision will be entered under Rule 50.
Footnotes
1. Although the two accounts receivable which were assigned totaled $ 101,069.43, the record does not disclose why petitioner did not assign $ 123,930.57 as consideration for the stock, rather than $ 123,330.57.↩
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(e) Losses by Individuals. -- In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise --
(1) if incurred in trade or business; * * *↩