*2533 DEDUCTIONS - NET LOSS. - Upon the evidence, held that the total of amounts paid by petitioner during the fiscal year 1925 in satisfaction of a judgment rendered against it in that year and expenses incident to the litigation represented a loss incurred as an incident of business regularly carried on, and was properly to be carried forward as a net loss and deducted from income over the years 1926 and 1927.
*1069 This is an appeal from a determination of deficiencies in income taxes for the fiscal years ended February 28, 1926 and 1927, of $195.81 and $2,068.37, respectively.
Petitioner alleges error in that the amounts of a judgment and the expenses relative thereto aggregating $25,256.78 have not been allowed as deductions from income in 1925, and a resulting net loss has not been carried forward to 1926 and 1927.
FINDINGS OF FACT.
The petitioner is a New York corporation engaged in the manufacture of stone-working machinery, with its principal office at Long Island City.
Prior to the organization of the petitioner*2534 the business was conducted by Willard Franklin Meyers. Prior to 1915 Meyers employed *1070 one Morris Simons as general manager, upon a weekly-wage basis. In 1915, acting upon the advice of Simons, Meyers caused the petitioner to be organized, with an authorized capital stock of 1,000 shares of $100,000 par value, and he then became and has since continued to be the principal stockholder of the petitioner. The petitioner took over the business formerly conducted by Meyers. Simons was allowed to purchase 60 shares of the stock of the petitioner for $1,500 cash and his notes for the balance of the par value as an inducement to secure his best personal efforts in the business.
On April 30, 1915, petitioner and Simons executed a contract providing for the latter's employment for a term of three years at a stated salary. On the same date they executed a separate contract as follows:
MEMORANDUM OF AGREEMENT made this 30th day of April in the year One Thousand Nine Hundred Fifteen, by and between WILLARD F. MEYERS MACHINE COMPANY, INC., party of the first part, and MORRIS SIMONS, party of the second part,
WHEREAS, the party of the first part is a corporation having capital*2535 stock wherein the party of the second part has invested Six Thousand ($6,000) Dollars at par, and
WHEREAS, the party of the second part is in the employ of the party of the first part, and the parties hereto deem it mutually desirable that in the event of the relations of employer and employe between the parties hereto coming to an end that the party of the second part should not continue while in the employ of another, to retain possession of the said stock with the privileges which the same may confer.
NOW THIS AGREEMENT WITNESSETH, that for and in consideration of the premises and the sum of One ($1) Dollar each to the other in hand paid, receipt whereof is hereby acknowledged, the parties hereto have agreed and stipulated as follows:
That in the event of the severance of the relations of employer and employe aforesaid, between the parties to this agreement the party of the first part shall buy and the party of the second part shall sell, at par, the Six Thousand ($6,000) Dollars of stock aforesaid and any other additional stock which the party of the second part may have acquired.
The party of the second part will sell to none other than the party of the first part unless*2536 the owners of the majority in interest of the stock of the party of the first part shall claim a preference on the same terms, which the parties hereto agree to admit if exercised before the time herein fixed for purchase, by the party of the first part, shall have expired.
The party of the second part shall have ninety (90) days from the actual date of the severance of the relations as aforesaid, or in the event of such severance by the act or notice of the party of the first part, within ninety (90) days of such act or notice within which to purchase said stock at the aforesaid price. Interest at the rate of six (6%) per cent per annum during the part of said ninety (90) days required to exercise the said option shall be allowed the party of the second part and paid by the party of the first part on the par value of the shares hereby required to be purchased and sold.
*1071 In the event of failure or refusal by the party of the first part to carry out its contract hereunder for the purchase of said stock of the party of the second part, the party of the second part may at once bring the necessary legal proceedings to enforce this contract; and in connection therewith, *2537 he may sell his stock at public sale after giving the party of the first part ten (10) days' notice of the time and place of sale at the best price obtainable and bring suit for the difference, if any, as liquidated damages.
Any unpaid note of the party of the second part given in connection with the purchase of stock by him, may be used as cash to the amount for which the in the repurchase of stock under this agreement.
IN WITNESS WHEREOF, the party of the second part has hereunto set his hand, and the party of the first part has caused the same to be signed by its President and attested by a member of the Board of Directors and caused its corporate seal to be hereunto affixed the day and year first above written.
(Signed) WILLARD F. MEYERS MACHINE CO. INC.
WILLARD F. MEYERS, Pres.
MORRIS SIMONS.
Later, the term of Simons' employment was extended by contract for an additional period of three years.
During 1916 and 1917, simons acquired an additional aggregate of 141 shares of the petitioner's stock, of which 67 shares were issued to him in October, 1917, as his pro rata share of the distribution of a stock dividend.
Simons continued to hold 201 shares of*2538 the stock of petitioner until the spring of 1921, when he voluntarily left the employ of the petitioner, whereupon he made demand upon the petitioner to comply with the agreement of April 30, 1915, above set out, and purchase the 201 shares from him at par. At this time the petitioner was without available cash capital to comply with this demand and its balance sheet reflected a deficit.
Petitioner denied liability to buy more than 60 shares of the stock. Thereupon, Simons instituted suit against petitioner upon the contract of April 30, 1915, and on September 7, 1921, sold his 201 shares of stock at public austion for $7 per share, realizing, after paying the expenses and commissions of the sale, net proceeds of $1,344.71. After trial on the merits on May 21, 22, 1924, judgment against the petitioner was rendered upon a directed verdict in the amount of $21,505.40, which included $135.40 costs.
Shortly thereafter the petitioner effected settlement with Simons on the following basis:
| Due Simons on basis of par value of capital stock | $20,100.00 | |
| Less proceeds of auction sale of stock | 1,344.71 | |
| $18,755.29 | ||
| Due Simons for interest less discount allowed by Simons for cash settlement | 2,328.36 | |
| Due Simons for costs | 135.40 | |
| Net amount due Simons | 21,219.05 | |
| Counterclaims allowed by Simons: | ||
| Simons' account receivable per ledger | $834.55 | |
| Simons' indebtedness on loans of cash | 3,000.00 | |
| $3,834.55 | ||
| Remainder | 17,384.50 | |
| Cash paid by the petitioner to Simons in June, 1924 | 17,384.50 |
*2539 *1072 Legal and accounting expenses incidental to the suit amounted as follows and were billed to the petitioner by the respective parties during the fiscal year ended February 28, 1925:
| Sidney T. Strongin | $86.10 |
| Thomas C. Kadin, Jr | 687.00 |
| Touche, Niven & Co., accountants | 415.00 |
| John J. Pheelan, attorney | 2,849.63 |
| Total | 4,037.73 |
Upon settlement with Simons the petitioner demanded delivery of the certificates for the 201 shares of stock, but Simons refused, declaring that the stock sold was out of his possession and control.
In 1927 Simons presented to the petitioner the stock certificates previously issued to him and which he sold at public auction in 1921, bearing, when presented to the petitioner, assignments dated September 13, 1921, from I. Rosenblum to Simons, and he demanded that the transfer be recorded upon the petitioner's records and new certificate for 201 shares be issued to Simons. This was done and no effort has ever been made by the petitioner to compel Simons to surrender the stock to the petitioner.
The petitioner kept its accounts on the accrual basis and on a fiscal year ended on the last day of February. It rendered income-tax*2540 returns for the fiscal years 1925, 1926, and 1927 in agreement with the books. The liability to Simons for breach of contract was for the first time entered upon the books during the fiscal year 1925 at the time when the judgment was rendered and settlement was made with Simons. In determining the deficiencies the respondent adjusted the returns as follows:
| 1925 | 1926 | 1927 | |
| Losses reported in returns | $25,330.36 | $22,289.95 | $5,421.01 |
| Deductions disallowed: | |||
| Judgment and expenses | 25,256.78 | ||
| Prior-year net loss | 25,330.36 | 22,289.95 | |
| Bad debts | 529.82 | 452.32 | |
| Adjusted net loss | 73.58 | ||
| Adjusted net income | 3,570.23 | 17,321.26 | |
| Credit allowed for net loss | 73.58 |
*1073 The loss claimed in the return for 1925 was arrived at as follows:
| Principal amount due Simons | $18,755.29 |
| Interest (net) paid Simons | 2,463.76 |
| Expenses of suit | 4,037.73 |
| 25,256.78 |
OPINION.
TRUSSELL: This appeal presents but one question, whether the amount paid in the fiscal year 1925 under a judgment rendered against petitioner in that year, together with amounts representing legal expenses incident thereto, and incurred in that year, constitute proper*2541 deductions from income as losses incurred in the regular operation of a trade or business and subject to be carried forward under section 206 of the Revenue Act of 1924 as net loss deductions from income of the two succeeding fiscal years, or, in fact, are amounts paid as incidents of a capital transaction representing dealings by petitioner in respect to its own stock and consequently not giving rise to taxable gain or deductible loss.
Petitioner treated the total of these sums as a net loss and deducted it over the fiscal years 1925 to 1927, inclusive, and the correctness of respondent's action in disallowing the credit taken for 1926 and 1927 is here in issue.
The record shows that this petitioner, by contract of April 30, 1915, employed one Simons as its general manager for a period of three years, this period being extended by a later contract for an additional three years. On the same date petitioner, by contract with Simons, which witnessed the fact that the latter had purchased and then owned $6,000 par value stock of petitioner, bound itself, in the event that Simons left its employ, to buy at par its stock then owned or which might later be acquired by the latter, *2542 or in the event that it did not care to acquire his stock, that same should be sold at auction, in which event it would be obligated to pay a sum equal to its par value less the amount realized on the auction sale if sold at less than par.
Within the succeeding six years Simons acquired additional stock of petitioner and at the end of that period he left petitioner's employ and called upon the latter under its contract to take all of such stock, 201 shares, at its par value of $20,100 and, upon its refusal to do so, brought suit upon the contract, sold the stock at auction, and was given judgment in the suit for $21,370.09, the sum due as liquidated by the contract provisions and the sale made, together with court costs of $135.40.
Respondent argues that had petitioner elected to take the stock under the contract the transaction would not have given rise to loss *1074 or gain subject to reflection in income. He contends that the sums eventually paid were for breach of a contract to carry out such capital transaction and consequently the same rule must be applied to the amounts expended.
We can not agree with this theory. Petitioner's tax liability must be determined*2543 upon the basis of what was done and not on the basis of something which it must be admitted petitioner did not do. It is not indicated that the contract of April 30, 1915, in respect to Simons' stockholdings was executed to secure a purchaser for petitioner's stock. The language of that contract and the circumstances of its execution indicate that its purpose was to secure the services of this individual with an interest in the business which would be reflected in the character of service rendered, and the positive testimony of petitioner's president is to this effect. In other words, the liability assumed by the petitioner to buy its stock at par and the alternative liability assumed to reimburse Simons for any amount by which an auction sale of the stock might fail to realize its par value, were liabilities assumed in securing the services of this individual and to stimulate and increase his effectiveness in the rendering of that service, which would be reflected by an increased prosperity in the business. By the contract petitioner was given an option to do either of two things - purchase the stock at par, or pay an amount measured by the par value of the stock and its sale*2544 price at auction. Had petitioner elected to purchase the stock it is quite evident that the transaction would not have given rise to loss or gain. It would in that event have merely retired at par 201 shares of its stock. But we are not concerned with the question of the result of something which was not done. The fact that such transaction would have been a capital one can not fix as the same in character the transaction which petitioner actually carried out in electing to assume the alternative liability, expecially when an analysis of this transaction shows that as a result of the payment in question petitioner neither secured an addition to his asset account nor reduced the amount of its liabilities represented by outstanding stock.
As we see it, petitioner was given the option under the contract to either make a capital transaction by acquiring its stock or to realize a loss in the payment of an amount which the terms of the contract provided a method for liquidating. Petitioner elected not to acquire this stock, but to assume the loss, and its liability to make this payment being one incurred in securing the services of a general manager for the business, we must hold*2545 that it is a loss incurred in the "operation of a trade or business regularly carried on" and consequently a net loss to be carried forward and deducted over the *1075 two succeeding fiscal years under section 206 of the Revenue Act of 1924. Respondent was in error in disallowing the credits taken by petitioner on account of this loss in the fiscal years 1926 and 1927.
Judgment will be entered pursuant to Rule 50.