*1228 During the taxable year petitioner and its principal creditor, who was its majority stockholder, mutually waived the restrictions as to payment of dividends contained in a written contract executed by them prior to May 1, 1936, and petitioner, thereupon, declared and paid a dividend of $30,000. Held, such waiver deprives petitioner of any credit under section 26(c)(1), Revenue Act of 1936.
*1110 This proceeding involves an income tax deficiency of $5,659.99, representing a surtax on undistributed profits for 1936. The sole issue is whether petitioner is entitled to a credit of $42,780.27 under section 26(c)(1) of the Revenue Act of 1936, because of a contract restricting the payment of dividends.
FINDINGS OF FACT.
Petitioner is an Arkansas corporation, organized on or about January 1, 1932, with its principal place of business at Blytheville, Arkansas. It acquired the coca cola bottling business previously conducted by J. A. Leech by issuing $10,000 of its capital stock to him and executing a demand promissory note for $45,884.50 in his*1229 favor dated January 1, 1932, with interest at 6 percent. Since the organization of the petitioner, its capital stock has been continuously held by J. A. Leech, 94 shares, A. F. Leech, wife of J. A. Leech, 5 shares, and H. H. Brooks, 1 share. The stockholders were also the directors and officers of petitioner, J. A. Leech being president and treasurer, H. H. Brooks, vice president, and A. F. Leech, secretary.
*1111 The minutes of the meeting of the stockholders and the directors on January 1, 1932, contain resolutions which recite the acquisition of the business formerly conducted by J. A. Leech, individually, provide for the consummation of the transaction by the giving of proper evidence of indebtedness for the deferred payments, and provide, by duly adopted resolutions, that "his [J. A. Leech] debt to be paid prior to the payment of any dividend."
During 1932 J. A. Leech advanced $40,000, $4,374.70, and $3,906.65 to petitioner on the dates and for the purposes hereinafter set forth. These advances were credited by petitioner to J. A. Leech's account on its books, which account had a credit balance of $55,884.50 at the time of the first advance of $40,000. Each of*1230 said loans bore interest at 6 percent. Cash payments to J. A. Leech were debited to this account and interest charged on the loans was credited thereto. This account, up to December 31, 1936, shows debit entries for cash payments to J. A. Leech totaling $87,431.50; credit entries, principally interest and the above three advances, totaling $74,327.27; and a credit balance at December 31, 1936 of $42,780.27.
Prior to May 1, 1936, the petitioner, as party of the first part, and J. A. Leech, as party of the second part, executed a written agreement, the pertinent portions of which are as follows:
On January 1, 1932, it became necessary to incorporate first party for the protection of the business then owned by second party. At that time second party owned the entire business and sold same to first party, consisting of a franchise, plant building, machinery, bottles, cases, delivery equipment and other such property. At that time it was agreed between the parties hereto and the stockholders of first party that the property sold by second party to first party was of the true value of $55,884.50, which amount was set up on the books of the Company as being due second party the same*1231 to draw six per cent interest from that date until paid. On May 6, 1932, second party, acting for first party, purchased the Pemiscot Coca-Cola Bottling Company of Caruthersville, Missouri, for the sum of $90,000.00, $40,000.00 of the purchase price being paid in cash and the remainder evidenced by promissory notes. First party borrowed the sum of $40,000.00 of second party to make the down payment, and agreed to pay him six per cent interest thereon from that date until paid. On May 24, 1932, second party loaned first party $4,374.70 and on August 27, 1932, loaned it $3,906.65, to pay on notes given for the purchase of Pemiscot Coca-Cola Bottling Company. The amounts were loaned under the same agreement that first party would pay six per cent interest thereon from date until paid.
In making the various advances and loans to first party by second party it was understood and agreed by and between the parties and with the stockholders of first party that second party would be paid his debt as promptly as convenient and possible and before the payment of any dividends. Such an arrangement was set up in the minutes of the stockholders' meeting held January 1, 1932.
It has also*1232 been agreed and understood by and between the parties that it has been and will be necessary to enlarge the present buildings, to install new *1112 machinery and to make other improvements, and therefore it will be necessary to create and build up a surplus known as an expansion and building fund.
It is therefore agreed and understood by and between the parties hereto that the sums hereinbefore described as being due to second party will be repaid to him with annual interest at six per cent from the respective dates of the loans and advancements; that the principal and interest will be repaid to second party before the payment of any dividends; that the expansion and building fund herein mentioned may and will be created from time to time as the parties hereto may direct.
Although the above agreement bears date of June 18, 1932, it was not actually executed on that date. The agreement was executed during 1934, probably in September of that year.
Prior to December 30, 1936, the petitioner had paid no dividends. The minutes of a special meeting of its board of directors on the latter date show that at that meeting the only business considered by the directors was "the*1233 apparent necessity of the corporation declaring and paying a dividend, due to the newly enacted Federal Income Tax law, which puts a penalty or a surtax on undistributed profits." The minutes further recite, in part:
A general discussion was entered into by all present. The action of both the board and the stockholders at previous meetings in instructing that no dividend payments were to be made until J. A. Leech was paid in full and until the new building and machinery were fully paid for, was discussed at length. J. A. Leech also brought to the attention of those present that he has the corporation's contract that no dividends are to be paid until his account is paid in full.
He, however, after much discussion, advised that it was his opinion that the former actions of the board and stockholders should be ignored and that the corporation should pay a dividend to avoid a heavy tax penalty.
J. A. Leech advised that he had discussed this matter very fully with the corporation's attorney Cecil Shane, and the corporation's auditor James A. Matthews, and that it was also their opinion a dividend should be paid. Those present were advised of the fact that all of the year's net*1234 profit must be paid out in dividends [sic ] or the corporation would be taxed on all profits that were not paid out. J. A. Leech advised, however it was his opinion that income taxes and his debt could be deducted from the profits before paying a dividend.
H. H. Brooks stated the 1936 profits would, in his opinion, amount to $80,000.00. With J. A. Leech's account approximately $40,000.00 and income taxes approximately $10,000.00, Mr. Brooks stated there would be $30,000.00 left for dividend purposes. Objection was immediately raised to paying this much cash dividend, as it was thought that all available cash and bonds would be needed to pay for the new building and machinery.
J. A. Leech then stated he was firmly of the opinion that this dividend should be paid at once and offered to take H.O.L.C. bonds, owned by the corporation, as part payment of his dividend. After discussion, it was moved, seconded and unanimously ordered that a $30,000.00 dividend be paid today, of which $9,850.00 should be paid in cash, and $20,150.00 in H.O.L.C. bonds.
In computing the deficiency respondent determined petitioner's adjusted net income as $66,270.20. He disallowed the claimed*1235 credit of *1113 $42,780.27, but allowed a dividends paid credit of $30,000, which left undistributed net income of $36,270.20 subject to surtax.
OPINION.
ARNOLD: Section 26(c)(1), Revenue Act of 1936, set forth in the margin, 1 controls the issue presented, i.e., whether petitioner is entitled to the credit therein granted. The section was designed by Congress as a "special tax exemption" and is to be strictly construed. ; ; affd., . It does not afford relief to all corporations having contracts restricting the payment of dividends, but only those which fall within the terms of the section.
*1236 We have found as a fact that petitioner executed a written contract prior to May 1, 1936. That contract contained a provision which expressly dealt with the payment of dividends. It is provided therein that the principal and interest on loans and advancements made by J. A. Leech to the petitioner "will be repaid * * * before the payment of any dividends."
However, it appears from the evidence adduced that the principal creditor of the petitioner, who owned 94 percent of its capital stock, deliberately and intentionally waived the contract restrictions as to the payment of dividends for the taxable year. Furthermore, it should be noted that for all practical purposes the corporation was the alter ego of Leech, as he and his wife owned 99 percent of the corporation's stock. The minutes of the directors' meeting of December 30, 1936, show that a $30,000 dividend was declared and paid with full knowledge and after much discussion of the contract restrictions. The minutes show that J. A. Leech advised that the former actions of the board and stockholders in observing the restriction should be ignored and a dividend paid in order to avoid a heavy tax penalty. He advised the*1237 directors that petitioner's attorney and its auditor were of the same opinion. Leech further advised that income taxes and the amount of his debt could be deducted from current earnings and profits before the dividend was paid. The record shows that this procedure was followed *1114 and that the difference, after allowing for income taxes and the debt to Leech, was declared and paid as a dividend on December 30, 1936.
Thus it appears that the contract which restricted petitioner from paying dividends was completely disregarded by the debtor corporation, with the consent and upon the insistence of the creditor for whose benefit the contract was executed. The question naturally arises whether the credit provided under section 26(c)(1) should be allowed in view of the mutual waiver of the contract provisions as to payment of dividends in 1936. The waiver was not restricted to the $30,000 later paid as dividends. Petitioner could have paid out as dividends any funds available for distribution without violating the provisions of the written contract. The credit was provided for by Congress as a special tax exemption from the surtaxes imposed on undistributed profits, *1238 , where, because of contract restrictions, the corporation was prohibited from distributing its earnings and profits.
In our opinion, under the particular facts herein effect should be given for tax purposes to the things done by the contracting parties, and their waiver of the contract restrictions for the taxable year 1936 deprives petitioner of a credit under section 26(c)(1).
Reviewed by the Board.
Decision will be entered for the respondent.
ARUNDELL and SMITH dissent.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
In the case of a corporation the following credits 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. ↩