*718 A corporation increased its common capital stock and distributed a stock dividend. Two years later it made a further increase, reclassified all but 4 percent of the stock as preferred, and distributed a preferred stock dividend. The corporation, beginning two years after the second increase, was required to redeem or purchase for retirement each year out of surplus or net profits, after payment of dividends on the preferred stock, an amount of such preferred stock in par value equal to 5 percent of the largest amount in par value ever outstanding. The evidence disclosed that the increases were made not to disguise later distributions of cash dividends, but for legitimate business purposes, namely, in order to satisfy the demand of banks for a larger capitalization in order to obtain unsecured short term loans necessary for the operation of the business, and in order to satisfy the request of a stockholder anticipating retirement from active participation in the business that the larger portion of the stockholders' investments be placed in preferred stock. Held, that amounts distributed in redemption of the preferred stock were not to be treated as taxable dividends under section*719 115(g), Revenue Act of 1928.
*700 The Commissioner determined a deficiency of $2,889.73 in the petitioner's income tax for 1931. The petitioner raises the only issue in the case by the following assignment of error:
In determining the taxable net income of the petitioner for the year 1931, the Commissioner failed to include as income the profit arising from the sale of 215 1/2 shares of the preferred stock of Bernuth Lembcke Co. Inc., but ruled the entire proceeds of same to be a dividend in the ordinary course of business and taxable at legal surtax rates.
*701 FINDINGS OF FACT.
The petitioner is an individual. He was a stockholder in 1931 of the Bernuth Lembcke Co. He was also its treasurer and secretary until he retired. That corporation was engaged in the business of buying creosote oil abroad for cash, transporting it, and selling it in the United States, principally to railroads.
The business was incorporated in 1907 with capital stock of $200,000. Its name was changed and the par value and type of its shares were changed, but*720 the total par value of the outstanding capital stock remained the same until January 21, 1927, at which time the capital stock consisted of 2,000 shares of common stock. A stock dividend of 8,000 shares of common stock was declared and paid to the stockholders of record on January 21, 1927. The capital stock of the company was reclassified on March 22, 1929. A preferred stock dividend of $1,100,000, represented by 11,000 shares, each having a par value of $100, was declared and paid on March 22, 1929. The stock dividend of January 21, 1927, and the stock dividend of March 22, 1929, were both declared out of earned surplus. The following table shows the holdings on the dates above mentioned:
| Shares held | |||||
| Name | January 21, 1927 | March 22, 1929 | After March 22, 1929 | ||
| Common | Common | Preferred | Common | Preferred | |
| O. M. Bernuth | 618 | 309 | 2,781 | 309 | 6,180 |
| Adeline E. Bernuth | 618 | 309 | 2,781 | 309 | 6,180 |
| George A. Lembcke | 431 | 215 1/2 | 1,939 1/2 | 215 1/2 | 4,310 |
| Molly S. Lembcke | 333 | 166 1/2 | 1,498 1/2 | 166 1/2 | 3,330 |
| Total | 2,000 | 1,000 | 9,000 | 1,000 | 20,000 |
A "Certificate of Increase of Capital Stock and Number of*721 Shares and Classification and Reclassification of Shares" provided that the preferred stock should have 6 percent cumulative dividends and that:
On or before the first day of January, 1931 and annually on or before the first day of January in each year thereafter (until all the Preferred Stock of the Corporation shall have been retired) the Corporation, from and out of its surplus or net profits remaining after the full dividends on the Preferred Stock for all past quarterly dividend periods shall have been paid, shall acquire by redemption or purchase its preferred Stock for retirement up to an amount thereof in par value equal to at least five per cent. (5%) of the largest amount in par value of such Preferred Stock which shall ever have been issued and outstanding.
The directors were free to determine the time and manner of acquiring the stock but they could not pay more than the redemption price, *702 plus accrued dividends. If the acquisitions fell behind, the deficiency was to be made up out of surplus and net profits before any dividend was to be paid on or set apart for other stock. Preferred stock could also be redeemed in whole or in part at any dividend paying*722 date upon thirty days' notice and the payment of par and accrued dividends.
The board of directors of the Bernuth Lembcke Co. adopted a resolution on March 17, 1931, which was in part as follows:
The President stated that this corporation was required on or before the first day of January, 1931, in accordance with its certificate of incorporation as amended, to retire, either by redemption or purchase, an amount equal to 5% of the largest amount in par value of its preferred stock which had ever been issued and outstanding. He further stated that the largest amount of par value of such preferred stock was $2,000,000 and that accordingly the company was required to redeem a minimum of $100,000 par value of such stock; that none had been purchased and that accordingly the same must be by redemption. He further stated that there was sufficient surplus after the payment of all dividends on the preferred stock to make such redemption.
After consideration and discussion and on motion duly made and seconded the following resolutions were unanimously adopted:
RESOLVED that this corporation redeem out of surplus on April 1, 1931, at par and accrued dividends 1000 shares of its preferred*723 stock, such redemption being made pro rata, from the respective holders of such preferred stock as nearly as may be; and that the proper officers of this corporation notify holders of record of such preferred stock of such redemption, specifying the respective amounts to be so redeemed.
FURTHER RESOLVED that upon presentation of said stock the proper officers of this corporation be and they hereby are authorized to pay the par value thereof plus accrued dividends to April 1, 1931.
The President further stated that after making provision for dividends on preferred stock payable on January 1, 1931, and for the redemption of 1000 shares of the preferred stock on April 1, 1931, whih accrued dividends to such date, there remains sufficient surplus to declare a dividend on the balance of preferred stock outstanding for the balance of the year.
On motion duly made and seconded the following resolution was unanimously adopted:
RESOLVED that a dividend on the preferred stock of this company of 1 1/2% payable on each of the following dates, viz.: April 1, July 1 and October 1, 1931, to stockholders of record on such respective dates, be and the same hereby is declared.
Two hundred*724 and fifty shares of preferred stock held by the petitioner were redeemed pursuant to the resolution of March 17, 1931. The company distributed to him $21,550 in cash on April 1, 1931. The company had at that time earnings or profits accumulated after February 28, 1913, in excess of the total distributions made pursuant to the resolution of March 17, 1931. The next change in the outstanding capital stock of the corporation was the purchase from the petitioner of 1,077 shares by the corporation in 1934.
*703 The petitioner, in his income tax return for 1931, reported a capital gain of $5,140.32 from the redemption of the 215 1/2 shares of preferred stock of the Bernuth Lembcke Co. The Commissioner, in determining the deficiency, eliminated the capital gain reported and included in income $21,550 as dividends. He explained that he held the distribution to be essentially equivalent to a dividend and the entire amount received was taxable as a dividend and no part of it was taxable as capital gain.
A cargo of creosote oil cost between $350,000 and $400,000. Customers of the company did not always make prompt payment and the company sometimes borrowed from banks on three*725 months' paper as its needs required. The bank loans to the Bernuth Lembcke Co. were made on its unsecured notes and sometimes amounted to as much as $250,000 or $300,000.
The gross sales, gross profit from trading, interest paid, surplus and undivided profits, and cash dividends as shown by the returns 1 for the various years, were as follows:
| Year | Gross sales | Gross profit from | Interest paid | Surplus and | Cash dividend |
| trade | undividend | ||||
| profits, | |||||
| December 31 | |||||
| 1923 | $ 5,503,112.17 | $335,994.43 | $8,853.02 | $955,134.67 | $36,000 |
| 1924 | 7,775,638.68 | 1,141,688.40 | 55,905.04 | 1,104,447.88 | 36,000 |
| 1925 | 6,752,671.72 | 471,019.87 | 61,458.97 | 996,257.71 | 54,000 |
| 1926 | 6,105,713.44 | 407,577.63 | 48,594.42 | 1,132,561.79 | |
| 1927 | 9,759,001.01 | 618,537.48 | 38,282.18 | 636,752.47 | 54,000 |
| 1928 | 8,230,709.63 | 537,789.67 | 18,381.71 | 1,782,531.67 | 100,000 |
| 1929 | 6,205,285.04 | 453,387.60 | 42,812.08 | 1,736,502.65 | 230,000 |
| 1930 | 4,785,150.69 | 318,103.19 | 27,558.56 | 1,321,997.68 | 420,000 |
| 1931 | 2,261,746.61 | 205,693.96 | 11,506.76 | 892,786.34 | 117,000 |
*726 The redemption on April 1, 1931, of the 215 1/2 shares of preferred stock of the Bernuth Lembcke Co. held by the petitioner was not at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend.
The 215 1/2 shares of preferred stock had been held by the taxpayer for more than two years at the time they were redeemed. The amount distributed to the petitioner in the redemption of the 215 1/2 shares of stock was distributed in partial liquidation of the corporation
OPINION.
MURDOCK: The Commissioner has applied section 115(g) of the Revenue Act of 1928, which provides:
If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the *704 distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable*727 dividend.
The petitioner concedes that if the distribution in question was at such time and in such manner as to make it essentially equivalent to the distribution of a taxable dividend, then the amount distributed represented in its entirety a distribution of earnings or profits accumulated after February 28, 1913. He contends, however, that sections 115(c) and (h) apply, that is, that the distribution and redemption of the preferred stock was in partial liquidation of the corporation, since the term "amounts distributed in partial liquidation" is defined in subsection (h) as a distribution by a corporation in complete cancellation or redemption of a part of its stock. Undoubtedly the distribution in question was in complete cancellation or redemption of the 215 1/2 shares of stock owned by the petitioner. Subsection (c) provides that amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The parties have agreed that if the petitioner's contention is correct, the gain determined under section 111 was $8,788.09 and all of it is recognized for tax purposes. The respondent does not contend that it would*728 not be taxable as capital gain.
The Commissioner has determined that the distribution was at such time and in such manner as to make it essentially equivalent to the distribution of a taxable dividend. It was, therefore, encumbent upon the petitioner to produce sufficient evidence to overcome the presumption of correctness which attaches to the Commissioner's determination. He sketched, by his evidence, the history of the corporation in so far as changes in its capital structure were concerned. The details of the issuance and redemption of the particular stock in question appeared as a part of that evidence. Thus far there is no dispute between the parties.
The only witness for the petitioner was Oscar M. Bernuth. He had been interested in the business of the corporation since 1898 and was president of the corporation during the period most important to this proceeding. He gave several reasons for the increase in the capital stock which took place in 1927 and also for the increase in capital stock and the change from common to preferred stock which was made in 1929. Some of his reasons are not clear or persuasive, particularly when viewed in the light of other evidence*729 in the case. However, two of his reasons are not without force. The corporation was forced by the necessities of its business to borrow a considerable amount of money from banks on its short term unsecured paper. *705 The banks making these loans preferred that the corporation should have a larger capitalization and felt that the credit which they extended to the corporation would be better secured if such an increase were made. The witness stated that this was one of the reasons for the increase in 1927 and also one of the reasons for the increase in 1929. Another reason which he gave us was that the petitioner had expressed a desire to retire from active participation in the business and in anticipation of this retirement, which actually took place in 1931, had requested that a larger portion of the investment of the stockholders in the corporation be placed in preferred stock. These two reasons can not be disregarded. They indicate that the stock dividends of 1927 and 1929 were declared for legitimate business purposes rather than to disguise the later distribution of cash dividends. The redemption in 1931 was no part of a plan to distribute cash dividends in avoidance*730 of tax. The redemption was at par. The amount distributed was relatively small. Neither the time nor the manner of the redemption indicates an ordinary dividend. Cf. ; affd., . It was a true partial liquidation.
Decision will be entered under Rule 50.
Footnotes
1. The returns for years prior to 1928 were separate returns of the Bernuth Lembcke Co. Thereafter the returns were consolidated returns. ↩