*2458 1. INVESTED CAPITAL. - The paid-in capital of petitioner corporation may not be reduced until such time as the outstanding stock shares have been returned to the corporation or acquired by it so that said shares can be canceled and the stock retired. In this case 61 shares of the outstanding stock representing paid-in capital were acquired prior to the beginning of each of the taxable periods here involved and such 61 shares must be considered as having been retired and canceled prior to the beginning of the taxable years here under consideration. (Art. 862, Reg. 45 and 62.)
2. Id. - The earned surplus of a corporation may not be reduced for the purposes of invested capital on account of an account receivable until such time as said account shall have been found to be worthless and uncollectible either in full or in part.
3. SPECIAL ASSESSMENT. - The fact that in one year the volume of deductible repairs was such an unusual amount as to result in a net loss for that year can not be taken to establish an abnormality of income in other years and the whole record in this case has been found insufficient to warrant the granting of special assessment for the two years 1919*2459 and 1921.
*152 The respondent determined deficiencies in income and profits taxes against the petitioner for the year 1919 in the amount of $2,684.41 and for the year 1921 in the amount of $6,194.19.
The petitioner alleges errors as follows: (1) That in computing invested capital the respondent eliminated in each year the amount of $37,944.73 representing a debt owing the petitioner and carried on its books as an account receivable; (2) that for the year 1919 the respondent reduced invested capital by the effective average of Federal income and profits taxes for the year 1918, and (3) that the respondent refused to grant special assessment for each of said years.
The two appeals were consolidated for trial and decision.
*153 FINDINGS OF FACT.
The petitioner is an Alabama corporation with its principal place of business at Mobile, and has, since its organization in 1907, been engaged in the operation of a fleet of towing vessels in and around the port of Mobile.
From the organization of the*2460 petitioner until some time in the year 1915, H. T. Hartwell was the secretary-treasurer of the petitioner and was also a stockholder owning and/or controlling, for at least a portion of the period, a majority interest in the outstanding capital stock of the petitioner. Hartwell was during all of this time the active business manager of the petitioner's business. Early during the period between 1907 and 1915 Hartwell began borrowing the funds of the petitioner had hypothecating its credit for his own personal benefit. During this period other stockholders and some knowledge of Hartwell's transactions but did not take any action in respect to the same until during 1915.
In the year 1915 the paid-in capital stock of the petitioner was $38,400, represented by 384 shares of stock of the par value of $100 each. Of this outstanding capital stock Hartwell was the record owner of 199 shares, a majority of all the stock then issued and outstanding. When in 1915 the minority stockholders began a check-up of Hartwell's transactions they found that at various times in previous years he had withdrawn and still held company funds in the aggregate amount of $32,705.65, and that at that time*2461 he had hypothecated the company's credit at several of the local banks in amounts aggregating, with interest, $28,746.95. These latter amounts the company then assumed and later paid. The minority stockholders then prevailed upon Hartwell to sever all his official connection with the corporation and to assign to it all his right, title and interest in and to the 199 shares of stock held of record by him, together with all his right, title and interest to all other property which he then held, if any, to secure to the corporation the repayment of the sum of $61,452.60 and said sum was thereupon entered upon the books of the corporation as an account receivable owing by said Hartwell.
Following this action the corporation found that, of the 199 shares standing of record in the name of said Hartwell, the Merchants National Bank of Mobile held 34 shares; the Bank of Mobile, 34 shares; the First National Bank of Lakeland, Fla., 60 shares; the Peoples Bank of Mobile, 45 shares; the First National Bank of Mobile, 25 shares, totaling 198 shares. The record is silent as to the other one share standing in the name of Hartwell, and for the purpose of this action we find that the said one*2462 share was then in 1915 acquired and received by the petitioner.
*154 Each of the above-named banks claimed that they severally were entitled to hold the shares of stock as above enumerated either as owners or as having liens thereon prior to the claimed liens of the petitioner and thereupon a number of suits were started in the state courts by the petitioner to recover possession of the 198 shares above described. As a result of such litigation the Merchants National Bank of Mobile and the First National Bank of Mobile were adjudged to be either the owners or entitled to the possession of the 68 shares held by them and that the petitioner could not recover the same. In the action brought against the First National Bank of Lakeland, Fla., final decision was rendered on May 30, 1918, decreeing that the petitioner was entitled to recover the possession of the said 60 shares, and as a result of other suits the petitioner recovered the 25 shares held by the First National Bank of Mobile in the year 1922, and in 1924 petitioner likewise recovered possession of the 45 shares held by the Peoples Bank of Mobile.
Upon making the arrangements and adjustments with Hartwell in 1915*2463 the petitioner found that said Hartwell had in an open account on petitioner's books a credit balance of $464.18 which amount was immediately applied in reducing the total of the Hartwell account of $61,452.60. In 1917 Hartwell negotiated a sale of one of petitioner's towboats and for his services in relation to said sale the petitioner allowed him a commission of $5,000, $3,000 of which the petitioner paid to Hartwell in cash; the remaining $2,000 was credited against the account then standing on petitioner's books, thus reducing the total thereof to $58,988.42.
In 1916 the petitioner undertook steps to enforce its lien against the 199 shares of stock then standing in the name of Hartwell by offering the same for sale at public auction and at such sale the petitioner bid $2,000 for said stock and thereupon credited Hartwell's account with the said sum of $2,000.
In 1918 the petitioner found that Hartwell had a note then held by outside parties upon which the amount of principal and interest then due and unpaid was $10,603.81, and petitioner thereupon negotiated the purchase of said note for said amount and paid to the holders thereof the said sum of $10,603.81. Through the*2464 purchase of this note the petitioner acquired the collateral held by the former owners of said note as follows: A note dated August 7, 1915, made by the Bailey Reeder Co., payable four months after date in the amount of $4,100 and interest thereon; also a note dated August 10, 1911, made by J. T. Cothron, payable four years after date for the sum of $7,000 less a credit for payment thereon of $2,000, leaving a balance due of $5,000 plus interest to be reckoned at date of payment; also 15 shares of the capital stock of the Turner-Hartwell *155 Dock Co., a corporation, and an agreement on the part of Hartwell to turn over as further collateral two bonds of $1,000 each of the said Turner-Hartwell Dock Co., if any when issued. In May, 1918, the Cothron note, with interest thereon, was paid to the petitioner in the amount of $5,647.50, which amount was then credited against the Hartwell note, which had been purchased by the petitioner for $10,603.84, thus reducing the cost of the said Hartwell note to $4,956.31. The said Hartwell note was entered at cost upon the books of the petitioner in the notes receivable account and was there carried until 1922. The 15 shares of stock of*2465 the Turner-Hartwell Dock Co. were held by the petitioner until 1922, when it was disposed of by sale for a consideration of $26,000, and the proceeds thereof were then credited upon the Hartwell account. The above-mentioned Bailey Reeder Co. note of $4,100 proved to be worthless and the two bonds of the Turner-Hartwell Dock Co. were never issued and petitioner was never able to make any further realizations upon the collateral acquired with the said Hartwell note for which it had paid $10,603.81.
As a result of the suit against the First National Bank of Mobile the petitioner in 1922 acquired the right of possession of the 25 shares of petitioner's stock up to that time held by the said First National Bank and thereupon undertook to exercise its lien upon said 25 shares by offering the same for sale at public auction, at which sale petitioner bid $7,500 for said stock. The proceeds of this sale were applied by petitioner as follows: $6,453.63 in discharge of principal and interest of Hartwell's note which had been purchased by petitioner for $10,603.81, and the balance of $7,500, namely, $1,046.37, was credited upon the Hartwell account. As a result of the suit against the Peoples*2466 Bank of Mobile the petitioner in 1924 acquired the right of possession of the 45 shares up to that time held by the said Peoples Bank and thereupon undertook again to enforce its lien against the said 45 shares by offering the same for sale at public auction and at said sale the petitioner bid for said shares the sum of $9,000, and thereupon credited the said amount upon the said Hartwell account. The said Hartwell account as it appeared upon petitioner's books was thus reduced to $20,942.50 and of this balance $20,941.50 was charged off as a bad debt in 1924, leaving a debit balance in said account of $1.
The entire 131 shares of petitioner's capital stock acquired by petitioner as a result of the assignment thereof made by Hartwell in 1915 and the result of litigation during the period 1915 to 1924 were shown upon petitioner's books as retired and canceled in the year 1924.
*156 The balance sheet of the company of December 31, 1918, as revised by the examining revenue agent and excluding the Hartwell account, shows net assets of the company in the amount of $77,865.37, the equivalent of $202 per share for 384 shares. A similar balance sheet as of December 31, 1920, revised*2467 and reconstructed by the examining revenue agent and excluding the Hartwell account, shows net assets of $83,991.23, the equivalent of $218 per share for 384 shares. In 1922 the petitioner's bid for 25 shares then held by the First National Bank of Mobile was $7,500 or $300 per share. In 1924 the petitioner's bid for 45 shares then held by the Peoples Bank was $9,000, the equivalent of $200 per share.
On the books of the petitioner payments for salaries of officers were charged as follows: in 1919, $450 per month, or an aggregate of $5,400; in 1921, $400 per month, or an aggregate of $4,800. The salaries were paid to J. M. Walsh, president and general manager, John A. Dorgan, and R. B. Pope. J. M. Walsh was also president of the Walsh Stevedoring Co., which did a business of much greater volume that did the petitioner and had offices adjacent to those of petitioner. Walsh and John A. Dorgan, who was the active manager of the petitioner's business, were charged with the responsibilities of conducting the business of the petitioner. In addition to general supervision, Walsh engaged business for the petitioner on his trips to New York. Dorgan was the active manager of the business*2468 and devoted his full time to his duties. Pope devoted about 10 per cent of his time to the business. Pope was elected secretary-treasurer in 1920.
The boats operated by the petitioner were required to be kept in repair currently to an extent that would enable operation of them to be continued and, in addition, when opportunity offered to put them in dry dock they were subject to more thorough repairing. It was customary to put the boats in dry dock at least once a year. During the taxable years, in addition to the amounts of actual expenditures for repairs, the petitioner entered upon its books amounts of surplus and/or profit and loss reserves for future expenditures for repairs and maintenance. In 1920 a boat named the Echo was extensively overhauled, including the putting in of some new plates, a new house, a new deck, and a boiler. A period of about seven months was required for the work. The cost of this work and of other work amounting to over $90,000, was capitalized upon the books by charges to the several maintenance reserve accounts. Subsequently, when the return of the petitioner was investigated by a revenue agent, this procedure was reversed in part and*2469 a large part of the expenditure for the work on the Echo was included in the deduction allowed by the respondent for repairs during 1920.
*157 In determining the tax liability for 1920 and the deficiencies for 1919 and 1921, the respondent computed the net income and the excess-profits taxes, as follows:
| 1919 | 1920 | 1921 | |
| Net income disclosed by books | $32,654.46 | $47,021.40 | $25,205.19 |
| Deductions disallowed: | |||
| Income tax | 12,086.04 | ||
| Donations | 695.00 | 615.00 | 165.00 |
| Cost of installing heaters on tugs | 1,200.00 | ||
| 46,635.50 | 56,036.40 | 48,050.19 | |
| Additional deductions allowed: | |||
| Repairs charged to reserves | 64,930.12 | 9,209.80 | |
| Additional depreciation | 628.96 | ||
| Net income | 46,635.50 | 38,211.43 | |
| Loss | 8,893.72 | ||
| After making the above adjustments the | |||
| deductions actually allowed for repairs | |||
| amounted to | 9,682.03 | 75,990.18 | 10,141.80 |
| Gross income from operations | 154,488.10 | 173,169.13 | 181,544.71 |
| Amount of excess profits tax | 12,267.76 | 8,216.21 |
The returns filed by the petitioner reported tax liabilities amounting as follows: for 1919, $5,229.98; for 1920, $16,329.14; for 1921, $5,021.54. Subsequently, an additional tax*2470 for 1919 was assessed; the assessments for 1919 aggregating $12,820.15.
OPINION.
TRUSSELL: The record of this action clearly shows that the Hartwell manipulations of the petitioner's cash and credit for his personal benefit began some years prior to 1915, and that it was known to the other stockholders, and at least outwardly acquiesced in until 1915, when it may be presumed that the other stockholders felt or determined that Hartwell was getting beyond the limit of reason in said manipulations and determined to stop the same, and that they thereupon arrived at an adjustment, accepting the separation of Hartwell from the business of the corporation, the turning over to the corporation of all of his assets, including capital stock of the petitioner company, and setting up the agreed amount of the debt on the corporation's books as an account receivable, and that they properly carried said account forward from year to year as a debt owing to the company, and that it then appeared to the company and its remaining stockholders that the securities and property rights assigned by Hartwell would fully liquidate his indebtedness. Convincing evidence of this is shown by the fact that*2471 in 1917, when Hartwell negotiated a sale of one of the company's tugboats, the company agreed to allow him a commission of $5,000 on the sale and paid him $3,000 of that amount in cash, only crediting $2,000 upon his indebtedness. Much litigation followed in the efforts of the *158 petitioner to acquire possession of the Hartwell stock and other property rights assigned by him to the petitioner and the settlement of this litigation continued until 1924. During this period, as a result of litigation and other settlements made by the petitioner, the petitioner realized recoveries as follows:
| Credit balance in Hartwell's account on petitioner's books (1915) | $464.18 |
| Commission allowed on the sale of tug boat (1917) | 2,000.00 |
| Net cash realized on disposition of Hartwell collateral (1918) | 21,043.00 |
| Total cash recovery | 23,507.18 |
Decrease of capital liabilities were made as follows:
| 1918, 61 shares of petitioner's stock | $6,100.00 |
| 1922, 25 shares of petitioner's stock | 2,500.00 |
| 1924, 45 shares of petitioner's stock | 4,500.00 |
| Total of reduced stock liability | 13,100.00 |
The revenue agent found in his revised balance sheet a book surplus of*2472 December 31, 1918, of $78,565.37. By the liquidation of 131 shares of the company's stock 131/384 of said 1918 surplus was saved to the company and its surviving stockholders in the amount of $26,802.22. These items total $63,409.40. We are, therefore, of the opinion that the Hartwell account as it stood in 1915, in the amount of $61,452.60, has been substantially liquidated in full and therefore that it was a good account receivable during the years 1919 and 1921 for its full amount less the cash recoveries prior to December 31, 1918, in the total of $2,464.18, and further reduced by the proper credits to be made upon said account resulting from the retirement of 61 shares of petitioner's stock.
When, in 1916, petitioner undertook under the state statutory provisions to exercise its lien upon the Hartwell stock it held an auction sale and there bid $2,000 for such stock and thereupon credited the Hartwell account with the said $2,000. Later, it acquired actual physical possession of 61 shares of said stock and, pursuant to article 862 of Regulations 45 and 62, such shares of stock must, for the purpose of invested capital, be regarded as having been retired and canceled prior*2473 to the beginning of the taxable years here under consideration. Hartwell was properly entitled to a credit upon his account for at least the par value of the stock assigned by him and, although no further credit was made by the petitioner, we must now consider that the thing which should have been done was done, and, $2,000 having been credited to the Hartwell account in 1916, there must now be an additional credit of $4,100 on account of the retirement of said 61 shares of stock. Therefore, at the beginning of the year 1919 the Hartwell account *159 must be regarded as having been reduced on account of the retirement of said stock in the amount of $6,100.
In regard to the second issue relating to the reduction of the invested capital for 1919 by the effective average of the income and profits taxes for 1918, it appears that this reduction of invested capital has been made in accordance with the regulations of the Treasury Department existing in that year and, under the provisions of section 1207 of the Revenue Act of 1926, the action of the respondent must be found to have been in accordance with the provisions of law and regulations relating thereto.
With respect to*2474 petitioner's claim for assessment under the provisions of sections 327 and 328 of the Revenue Acts of 1918 and 1921, we have examined the data furnished by the record and have arrived at the conclusion that such facts as shown in reference to salary payments and the unusual deduction for repairs in the year 1920 are not such as to prove an abnormality of income for the years 1919 and 1921, and the claim for special assessment must, therefore, be rejected.
Reviewed by the Board.
Judgment will be entered pursuant to Rule 50.
MARQUETTE, PHILLIPS, and MURDOCK concur in the result only.