*1246 The taxpayer, engaged in the business of making and certifying abstracts of title, agreed with a title insurance company that in consideration of the latter's guaranteeing its title searches, it would deposit an amount equal to 5 percent of its income from title searches in a special reserve to cover possible losses arising out of those searches. Amounts so deposited in the taxable year are held:
(1) to be includable in taxable income because the subsequent use of or restrictions on income after receipt do not affect its taxability, (George Hyatt,36 B.T.A. 121">36 B.T.A. 121, followed);
(2) not to entitle the taxpayer to a credit under section 26(c)(1) of the Revenue Act of 1936, because the agreement with the insurance company did not restrict the payment of dividends under the conditions existing through the taxable year.
*5 This is a proceeding to redetermine a deficiency in income tax of $499.85 for the calendar year 1936. Petitioner asks a finding also that it has overpaid its normal tax for the calendar year 1936 to the extent of*1247 $375.33. Two issues are presented: (1) Whether petitioner may exclude from taxable income, sums placed by it pursuant to contract in a special reserve account to pay losses arising out of its title searches; and (2) whether petitioner is entitled to a credit, under section 26(c)(1) of the Revenue Act of 1936, on the ground that it could not distribute dividends without violating a written contract.
FINDINGS OF FACT.
Petitioner is a corporation organized under the laws of the State of New York and engaged in the business of searching titles to real estate, public documents, and records, and in making and selling abstracts of these searches. It carries on business in Erie and Monroe Counties, and counties adjacent thereto, all these being located in the State of New York. It kept its books and made its return on the accrual basis.
On April 29, 1935, it entered into a written contract with New York Title Insurance Co. (sometimes referred to hereinafter as "the Insurance Company"). This contract was in force throughout the taxable year, and the material provisions read as follows:
NOW, THEREFORE, it is agreed
I
That the Abstract Company [petitioner] shall make and*1248 issue searches and abstracts in the County of Erie, New York, and in the County of Monroe, New *6 York, certified in the manner and form of the certificates attached hereto or in such other form as may be hereafter mutually approved by the contracting parties. * * *
II
That all such certificates and abstracts affecting premises situated in said County of Erie, New York, and in the County of Monroe, New York, if so desired, shall be guaranteed by the Abstract Company and issued in its name and shall be guaranteed by the Insurance Company.
* * *
IV
It is further agreed that as compensation for the guaranty of the Insurance Company, as herein provided, an amount equal to 5% of the gross abstract income on the searches and certificates issued and affecting premises situated in the County of Erie, New York, under and pursuant to this agreement, as well as of the gross abstract income of searches and certificates issued and affecting premises situated in the County of Monroe, New York, whether or not guaranteed by the Insurance Company, during each month, shall be paid in cash in monthly installments to the Insurance Company on or before the 15th day of the succeeding*1249 month.
V
It is further agreed that an additional amount equal to 5% of said monthly gross abstract income, both in the County of Erie, New York, and the County of Monroe, New York, is to be deposited in cash on or before the 15th day of the succeeding month in the name of the "Monroe Abstract Corporation, Reserve Account", in a depository or depositories, to be designated by the contracting parties hereto. The sums so deposited and the increment thereof, and any additions thereto, shall be maintained as a reserve fund and shall be kept separate and apart from the general funds or other reserve or special accounts of the Abstract Company and shall be kept and maintained as a fund to pay losses arising out of the liability of the Abstract Company on the searches or abstracts issued under and pursuant to this agreement. This fund, or any part thereof, shall not be withdrawn except to pay losses arising on searches and certificates issued under this agreement, or except by the joint consent of the contracting parties, it being understood and agreed that no withdrawal of funds from said account or accounts, either for the payment of losses or otherwise, shall be made except upon*1250 countersignature of the Insurance Company. It is agreed, however, that at the termination of the agreement or at any time thereafter, the Abstract Company may, by depositing with the Insurance Company a Surety Bond, in form approved by the said Insurance Company and equal in amount to the then accumulated reserve, withdraw the then existing reserve, which bond shall be by a Company approved by the Insurance Company. This reserve is established as additional protection to the Insurance Company, and as part of the consideration for the guaranty of the Insurance Company.
* * *
VII
It is represented by the Abstract Company that its capital funds and reserve, at the present time, amount in total to $38,000.00, and it is further agreed by the Abstract Company that these funds will be maintained in an amount at least equal to $38,000.00. It is covenanted and agreed by the Abstract Company, as part of the consideration for this agreement, that it will maintain *7 its capital funds and reserve in the amount named and any depreciation of its capital funds and reserves below said amount, shall, under a provision of the By-Laws of the Abstract Company duly adopted by the Board*1251 of Directors of the Abstract Company at a meeting of the same held on April 29th., 1935 and under the terms of this agreement, prohibit the said Company from paying any cash dividend on its stock. It is hereby further covenanted and agreed by the Abstract Company that of its capital funds, the sum of $15,000.00 at least, will be kept liquid in the form of cash or investments in United States or State of New York bonds. This covenant is made as part of the consideration for the guaranty of the Insurance Company and for this agreement.
* * *
Petitioner's capital, surplus, and reserves at the beginning of 1936, as disclosed by the balance sheet, were as follows:
| Capital | $40,100.00 |
| Surplus | 303.07 |
| Securities valuation reserve | 1,533.75 |
| Reserves for contingencies | 10,027.72 |
| Total | 51,964.54 |
These items at the end of 1936 were as follows:
| Capital | $48,150.00 |
| Surplus | 1,087.56 |
| Securities valuation reserve | 1,533.75 |
| Reserves for contingencies | 15,686.74 |
| Total | 66,458.05 |
The items "reserves for contingencies" were the deposits made under the contract with the Insurance Co.
At the beginning of 1936, petitioner had cash on hand in the amount*1252 of $25,118.71, and at the end of 1936 this figure stood at $34,092.
During 1936, petitioner deposited in the Liberty Bank of Buffalo and in the Rochester Trust & Safe Deposit Co. a total of $3,411.93, in accordance with the provisions of the above agreement.
At the beginning of 1936, petitioner had not only a surplus of $303.07, but an additional reserve of $1,337.66 beyond the amount required by the contract to be deposited during 1935. Its total reserve, beyond the requirements of the contract, at the end of 1936, thus amounted to $1,640.73.
Petitioner has paid a normal tax of $375.33 on account of the amount deposited pursuant to the contract during 1936. On April 12, 1938, petitioner claimed a refund of tax in the amount of $375.33.
OPINION.
LEECH: Petitioner contends, first, that the sum of $3,411.93 which it deposited in 1936 pursuant to the terms of its contract with the Insurance Co., is not subject to the normal tax on corporate incomes and, second, that it is entitled to a credit of $3,411.93 under *8 section 26(c)(1) of the Revenue Act of 1936, 1 on the ground that it had entered into a contract restricting the payment of dividends within the meaning*1253 of that section.
The essence of petitioner's position on the first point is that the amount it had to deposit in certain banks pursuant to the agreement with the Insurance Co. does not constitute income because it was not realized gain since petitioner did not then have unlimited*1254 control of the fund.
The agreement required petitioner to deposit an amount equal to 5 percent of its monthly income derived from its business of making abstracts of title. The fund comprising the aggregate of these deposits was to be held only for the payment of losses arising out of the liability of petitioner on searches and abstracts issued under the agreement. The countersignature of the Insurance Co. was required for any withdrawals. The fund was to remain on deposit until the termination of the agreement, but at any time thereafter petitioner might withdraw the reserve, provided it first deposited with the Insurance Co. a surety bond equal in amount to the then existing reserve.
It should be noted that petitioner is not required to deposit 5 percent of its monthly gross income in this reserve account, but an amount equal to that percentage. In other words, petitioner may satisfy the contract by a use of existing surplus or capital or by borrowing the necessary amount. It should further be noted that we are not concerned here with moneys actually used to pay losses, but only with moneys deposited, pursuant to agreement, against the payment of losses sustained in*1255 the future.
The general proposition that amounts deposited in a reserve to cover contingent liabilities may not be deducted until such liabilities become fixed, is well settled. ; ; .
But petitioner argues that the tax effect is different where the deposits are made pursuant to a restrictive agreement like the present one, citing ; ; petition to *9 review dismissed, ; ; ; ; and .
These cases are not in point. In all of them the use of the contested amounts by the recipient was limited by a trust imposed by agreement of the payor with the*1256 payee. Here no such trust existed. The restriction imposed by the contract went not to the imcome itself but only to its equivalent, and existed by virtue of petitioner's contract with the Insurance Co. and not with the payor of the income. The use to which income is put after its receipt does not affect its taxability when received. ; ; certiorari denied, ; .
The petitioner is foreclosed in its first position. .
Accordingly, we conclude that petitioner has not overpaid its tax in so far as that income was imposed on earnings in the amounts deposited pursuant to the agreement with the Insurance Co., for the reason that such amounts were properly includable in taxable income.
The second issue requires the consideration of the contract. Does it expressly prohibit the payment of dividends under the conditions obtaining during the taxable year? Such a prohibition is a stated condition precedent to the application of section 26(c)(1), *1257 supra.
It may be conceded at the outset that petitioner may not use the amounts it deposits under the agreement for any purpose except to pay losses, and that, by the agreement, dividends are forbidden if capital funds and reserve fall below $38,000 or if, out of those capital funds, there is not, at least, $15,000 in cash on hand, or its equivalent. However, we are unable to follow petitioner in its contention that this contract prohibited the payment of dividends by the petitioner during the taxable year. Throughout that period the capital funds, reserves, and cash on hand were well over the amounts specified.
The agreement provided for the deposit of a reserve against losses, and such incidental restrictions as there are on the use of the deposit and the maintenance of sufficient capital and liquid assets are only for the purpose of assuring the maintenance of that reserve and the proper conduct of petitioner's business. There is nothing in the agreement to prevent petitioner from paying dividends out of its existing surplus if the guarantee deposit, the capital, and the cash on hand were in the required amounts.
Petitioner, as shown by its balance sheet, in the taxable*1258 year had an actual surplus in excess of $16,000. Its claim that only $1,640.73 of this was "free surplus" available for payment of dividends, is based upon the fact that it has, voluntarily and not by reason of a *10 contract restriction, charged the required guarantee deposits on its books to its earnings. It merely adopted this business policy instead of recording a use of a portion of its comparatively large cash capital for this purpose. The reserve did not represent an actual liability but a mere guarantee. If capital were used to make the deposit it would represent the employment of that capital in a specific business use and no depletion would result. Only in case of payments actually made from the reserve would surplus be called upon to restore the deficit. Petitioner's voluntary method of keeping its accounts can not affect the facts here upon which the prohibition against dividend payments rested. Cf. . None of them existed.
Section 26(c)(1) is a credit provision and petitioner must bring itself strictly within the terms of the statute to have the benefit of the credit therein provided. *1259 . We do not think it has done so or that it is entitled to the credit provided in that section.
Petitioner makes a final contention which is so vague that it does not form an issue in the case. It argues that the free surplus esisting from prior years may not be used to cut down the amount of credit to which petitioner is entitled under section 26(c)(1), and that this section should be so construed as to avoid questions of constitutionality. With the latter proposition we agree, but we are unable to find that respondent has anywhere taken the position with which petitioner charges him. He has merely disallowed the credit in toto, and we have concluded that he did so properly.
Decision will be entered for the respondent.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
In the case of a corporation the following eredits shall be allowed to the extent provided in the various sections imposing tax -
(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
(1) PROHIBITION ON PAYMENT OF DIVIDENDS. - An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. If a corporation would be entitled to a credit under this paragraph because of a contract provision and also to one or more credits because of other contract provisions, only the largest of such credits shall be allowed, and for such purpose if two or more credits are equal in amount only one shall be taken into account. ↩