1943 U.S. Tax Ct. LEXIS 176">*176 Decisions will be entered for petitioners.
Assignability of Construction Contract -- Recognition of Separate Corporate Entity. -- Petitioners are husband and wife, residing in Texas. On December 30, 1935, the husband entered into a contract with the State of Texas to construct a certain building, and thereafter he proceeded with the work until July 1, 1936, on which date petitioners organized a Texas corporation to which the contract was assigned in consideration of its assumption of all losses and liabilities. Petitioners made gifts of 32 shares of the corporation's stock, out of a total of 100 shares, to each of their three minor children. The corporation performed the contract and earned profits, on which it paid the tax due. The corporation also distributed the balance of its net earnings as dividends, and each stockholder reported and paid tax on his distributive share. Held, the contract was not for personal services of such character as to render it nonassignable under Texas law, and the profits earned by the corporation constituted income taxable to it, not to petitioners; held, further, on the facts, the corporate entity may not be disregarded in determining1943 U.S. Tax Ct. LEXIS 176">*177 tax liability.
1 T.C. 1000">*1000 Respondent determined a deficiency in income tax of each petitioner for the year 1936 in the amount of $ 17,692.08. The principal issue is whether respondent erred in including in the taxable income of petitioners, as community income, the total profit realized from construction of the State of Texas Building at Dallas, Texas, the construction work having been performed in part by petitioner, P. O'B. Montgomery, individually, and, after assignment of the contract, in part by a corporation known as P. O'B. Montgomery, Inc.
FINDINGS OF FACT.
Petitioners are, and during the taxable year were, husband and wife, living together and residing at Dallas, Texas. Each filed a separate income tax return for the year 1936 with the collector of internal revenue for the second district of Texas.
During the years 1936 and 1937, petitioners had three living children as follows: William Slack Montgomery, approximate age at July 1, 1936, 17 or 18; Philip O'B. Montgomery, Jr., approximate age at 1 T.C. 1000">*1001 same date, 16 or 17; Frances1943 U.S. Tax Ct. LEXIS 176">*178 Montgomery, approximate age at same date, 14 or 15.
Under date of December 30, 1935, petitioner P. O'B. Montgomery entered into a contract with the State of Texas, acting by and through the State Board of Control, whereby petitioner agreed to provide all material and perform all work for the construction of the State of Texas Building at the Texas Centennial Central Exposition, Dallas, Texas, for a base bid price of $ 993,000. The contract provided that the exterior of the building was to be completed on or before June 6, 1936, and that the entire contract was to be completed within eight months from its date. The contract further provided, among other things, as follows: "The said parties for themselves, their heirs, successors, executors, administrators, and assigns, do hereby agree to the full performance of the covenants herein contained."
Thereafter, petitioner P. O'B. Montgomery began work under the above contract and proceeded with such work until July 1, 1936, on which date he and his wife, Frances H. Montgomery, and C. E. Montgomery executed articles of incorporation under the laws of Texas for the organization of a corporation known as "P. O'B. Montgomery, Incorporated," 1943 U.S. Tax Ct. LEXIS 176">*179 hereinafter called the corporation. The corporation was organized for the purpose of contracting for the construction and repair of buildings, and was to exist for a term of 50 years. It was to have 3 directors, the incorporators being appointed as such for the first year. The amount of the capital stock was $ 1,000, divided into three shares of class A voting stock and 97 shares of class B nonvoting stock, all shares of the par value of $ 10. The capital stock, fully paid in on July 1, 1936, was subscribed by the following persons:
| P. O'B. Montgomery | 2 shares class A |
| Frances Montgomery | 1 share class A |
| C. E. Montgomery | 1 share class B |
| P. O'B. Montgomery, Jr | 32 shares class B |
| William Slack Montgomery | 32 shares class B |
| Frances Hench Montgomery | 32 shares class B |
The articles of incorporation were approved on July 8, 1936, and were certified as the charter of the corporation on the following day by the Secretary of State of the State of Texas.
On July 1, 1936, P. O'B. Montgomery executed an assignment of the contract above mentioned to the corporation in consideration of the assumption by the corporation "of all losses and liabilities" that might thereafter arise in1943 U.S. Tax Ct. LEXIS 176">*180 connection with the performance of the contract. The assignment further recited that if it should be held for any reason that the contract could not be assigned, then the instrument should be construed as an assignment of all profits and proceeds which might thereafter arise from the contract, in consideration of the assumption 1 T.C. 1000">*1002 by the corporation of all losses. The corporation thereafter completed the contract. The corporation adopted bylaws and kept books of account and minutes of the meetings of its board of directors. Construction of the State of Texas Building was completed by the corporation about September 1936.
At a meeting of the board of directors of P. O'B. Montgomery, Inc., a dividend of $ 390 per share was declared on both class A and class B stock, payable in cash on December 21, 1936. The dividends payable on the class B stock held in the names of the three minor children of petitioners in the total amount of $ 37,440, were paid by check of the corporation. The check was made payable to the order of P. O'B. Montgomery, as trustee for each of the three children named, and was deposited by petitioner in his personal bank account carried in the name of 1943 U.S. Tax Ct. LEXIS 176">*181 "Philip Montgomery," which was separate from his business account.
Petitioner did not use for his individual purpose the dividends which he held as trustee for his minor children, but on December 30 and 31, 1936, used the money to purchase for them 600 shares of preferred and common stocks of other corporations at a total cost of $ 40,360. The difference between the amount of the dividends belonging to the children and the total purchase price of these stocks was paid by petitioner out of his own funds, and for such advancement he was later reimbursed. Petitioner had these stocks issued in his own name because he was then unable to comply with certain requirements as to proof of trusteeship.
On January 30, 1937, both petitioners joined in the execution of a declaration of trust, under notarial seal of the same date, wherein it was acknowledged that each of the three minor children above mentioned was the owner of 32 shares of class B stock of P. O'B. Montgomery, Inc., and that the stocks purchased with the children's dividends of the latter corporation were held in trust for them, and that neither of these petitioners had any personal ownership interest in such stocks.
An account1943 U.S. Tax Ct. LEXIS 176">*182 entitled "Income and Disbursements, P. O'B. Montgomery, Trustee" was kept for the years 1936-1940, inclusive, in which were recorded all transactions relating to trust corpus and income. After removal of the disabilities of petitioners' two sons, an accounting was made to them, on or about December 30, 1940, of their interests in the trust account in the amount of $ 43,497.57. Since the daughter had not attained her majority at that time, her interest was retained in the account.
At a meeting of the board of directors of P. O'B. Montgomery, Inc., held on June 19, 1937, a dividend of $ 289 per share was declared on all the corporation's stock, payable in cash on June 21, 1937. The dividends 1 T.C. 1000">*1003 payable on class B stock held in the names of the three minor children in the total amount of $ 27,744 were paid by check of the corporation to the order of "P. O'B. Montgomery, Trustee" and this check was deposited in the same bank account as the first dividend check.
The corporation filed an income and excess profits tax return for its fiscal year ended June 30, 1937, showing normal tax net income of $ 78,567.95, dividends paid credit of $ 67,900, and total tax due of $ 10,628.18, 1943 U.S. Tax Ct. LEXIS 176">*183 which tax was subsequently paid.
Each of the three minor children of the petitioners filed an individual income tax return for the calendar year 1936, reporting dividends received from P. O'B. Montgomery, Inc., in the amount of $ 12,480, and showing total tax thereon of $ 850.80. For the calendar year 1937 each of the minor children filed an individual income tax return showing dividends received from domestic corporations in the amount of $ 10,004.67 and total tax thereon of $ 588.47. The taxes shown under such returns were duly paid. The dividends reported in the returns for 1937 included the dividends declared in that year by the corporation here involved, and also dividends received on the stocks of the other corporations hereinabove referred to.
Petitioners filed separate individual income tax returns for the calendar year 1936, in which each reported dividends received from P. O'B. Montgomery, Inc., in the amount of $ 1,170.
Throughout the life of the corporation P. O'B. Montgomery was its president and general manager, and his wife, Frances H. Montgomery, was secretary. The officers received no compensation for their services.
After assignment of the contract above mentioned1943 U.S. Tax Ct. LEXIS 176">*184 to the corporation there was no change in the personnel employed, and the turnover of employees was about the same as before the assignment. The intervention of the corporation did not materially change the duties performed by P. O'B. Montgomery in connection with the construction of the building, except that prior to July 1, 1936, he acted in his own behalf as an individual, and after that date he acted in behalf of the corporation, as its president and general manager. The corporation was dissolved on October 5, 1938. In addition to completion of the State of Texas Building, the corporation submitted unsuccessful bids on two or three other construction jobs during 1936 and 1937.
On or about June 5, 1940, petitioners each filed a gift tax return reporting the gift to each of their children of 32 shares of stock of P. O'B. Montgomery, Inc. The returns disclosed no gift tax due. These returns were filed at the request of and upon the basis of valuation contended for by an internal revenue agent. Petitioners contended that such basis was erroneous, and further that no gift tax returns were required.
1 T.C. 1000">*1004 OPINION.
The deficiencies involved in these proceedings result in their1943 U.S. Tax Ct. LEXIS 176">*185 entirety from respondent's action in including in the community income of petitioners the total profits realized from the construction of the State of Texas Building, completed in September 1936. The profit derived from the construction contract up to July 1, 1936, in the amount of $ 86,009.59 was reported by petitioners as community income, but respondent held that the balance of the profit in the amount of $ 78,567.95, derived after July 1, 1936, and reported by the corporation, P. O'B. Montgomery, Inc., in its return for the taxable year ended June 30, 1937, also constituted community income of petitioners for their taxable year ended December 31, 1936. There is no dispute as to the amount of the total profits so derived and reported. The sole issue for decision is whether or not respondent correctly included in petitioners' income the profit realized from the contract after its assignment to the corporation on July 1, 1936.
Respondent seeks to have us sustain the deficiencies determined by him upon a number of related grounds. First, he says that because the contract was for personal services it was nonassignable, and under the doctrine of ,1943 U.S. Tax Ct. LEXIS 176">*186 and similar decisions, the profit reported by the corporation was first the income of petitioners and taxable to them. Respondent's position on this point is untenable for two reasons: the contract was not for personal services of such character as to render it nonassignable in the absence of restriction by express statutory provision or rule of public policy, and there is no suggestion of any such restriction in this case. . Furthermore, assignment of the contract was expressly authorized by the provision which bound assignees to the full performance of its covenants. , and authorities cited. In the second place, the income in controversy was not earned by the assignor and assigned without consideration, as in ; nor did it represent merely a right, vested in the assignor to receive income from property, prior to assignment without consideration, as in , involving assignments of trust1943 U.S. Tax Ct. LEXIS 176">*187 income. The income before us here arose from performance of the contract by the corporation subsequent to assignment for a valuable consideration. Such income is taxable to the assignee. ; affd., . Cf. .
Respondent also argues that the petitioners can find no refuge from tax liability in the existence of the corporation for the reason that at most it was nothing more than a conduit through which payments due 1 T.C. 1000">*1005 on the construction contract of December 30, 1935, were made to petitioner P. O'B. Montgomery. In substance, respondent contends, therefore, that the corporate entity should be disregarded and that the profits and income realized by the corporation from completion of the construction work after assignment of the contract to it on July 1, 1936, should be taxed to petitioners. This contention, in our opinion, can not be sustained Authorities cited by respondent are not applicable under the facts of this proceeding, as will appear from our further discussion below.
Before passing to a consideration1943 U.S. Tax Ct. LEXIS 176">*188 of corporate entity in the determination of tax liability, we may point out a fatal defect in the premise upon which respondent's argument in part is based, namely, that the corporation was in fact used as a conduit through which payments were made to P. O'B. Montgomery. The fact is clearly shown by the record that all payments on the contract after July 1, 1936, were made to the corporation, and, to the extent of 97 percent of the profits, ultimately went in the form of dividends to stockholders other than petitioners.
The decisions of the courts on the question of when, to what extent, and under what circumstances corporate entity may be disregarded for tax purposes are too numerous for detailed analysis here. We shall refer only to those establishing principles most clearly applicable under the present facts.
It is the recognized rule that corporations generally are to be treated as taxable entities separate and distinct from their stockholders, and it is only in exceptional circumstances that such distinction can be disregarded. . The corporate entity may not be disregarded where the corporation serves legitimate1943 U.S. Tax Ct. LEXIS 176">*189 business purposes, even including the reduction of tax liability. , modifying on another point, .
Separate entity may be disregarded where the corporation performs no useful business function but is merely the agent or alter ego of its stockholder. ; . These cases, however, were decided upon the peculiar situations presented, and may not be regarded as laying down a general rule. . It has also been held that corporate form may be disregarded when stock ownership has been resorted to, not for the purpose of participating in the affairs of the corporation in the normal and usual manner, but for the purpose of controlling the corporation so that it may be used as a mere agency, tool, or instrumentality. , and1943 U.S. Tax Ct. LEXIS 176">*190 authorities cited. And a corporate entity will 1 T.C. 1000">*1006 be ignored where the corporation has no actuality or substance, but is a mere subterfuge to disguise the true character of a transaction. .
In , the Court stated that a taxpayer is free to do business as an individual, or to carry on his business in corporate form, if he prefers, although in , the Court, by way of limiting the application of this rule, pointed out that the Government may not be required to acquiesce in the taxpayer's election of the form of doing business where it is determined to be unreal or a sham, and in such case may sustain or disregard the effect of the fiction as best serves the purpose of the tax statute. Obviously, the latter decision was not intended to recognize unrestrained discretion in the Commissioner, but only where the form of doing business was unreal or a sham.
In , we denied the Commissioner's contention1943 U.S. Tax Ct. LEXIS 176">*191 that the corporation should be treated as a separate and distinct entity and allowed a deduction claimed by the taxpayer, where it was shown that the corporation existed in name only; that it had no funds or properties except such as were furnished by the taxpayer in the ordinary course of operations; that it was never formally organized and never functioned as a corporation; that it had no paid-in capital and no shares of stock were issued; and that the taxpayer conducted the business as its own both prior and subsequent to the issuance of the corporation's charter. On the other hand, in , where both corporations were real in form and substance and carried on legitimate business operations, the Court refused to disregard corporate entity and allow a deduction of the prior corporation's losses, notwithstanding both corporations had substantially the same stockholders.
Applying the rationale of the foregoing decisions, we find nothing in the facts and circumstances of the proceedings at bar to justify disregarding the separate entity of the corporation in determining tax liability. It was both de 1943 U.S. Tax Ct. LEXIS 176">*192 jure and de facto a real corporation; it was organized in strict compliance with Texas law and was recognized as a corporation by Texas authorities. It had paid-in capital and issued shares of stock, had a board of directors and officers through whom it functioned, and otherwise carried on business operations in the usual and normal manner. These factors establish a corporate entity which must be recognized for tax purposes. , affirming .
We find nothing in the picture to sustain the contention that this corporation had no actuality or substance, or was a mere subterfuge to disguise the true character of a transaction only for the purpose of 1 T.C. 1000">*1007 avoiding taxes, as in In that case the Court pointed out that a taxpayer has a legal right to decrease or altogether avoid tax liability by any means which the law permits, and this has been the rule since ; but, apart from the tax motive, it was held that what1943 U.S. Tax Ct. LEXIS 176">*193 was done did not constitute a nontaxable reorganization because it had no relation to the business of either corporation. The new corporation was without substance; it served no business or corporate purpose.
In contrast, we briefly summarize the facts of the instant case. Petitioners obviously desired, for reasons not specifically disclosed, to make gifts to their three minor children. They organized a corporation and transferred to it the construction contract of December 30, 1935, in consideration of the corporation's agreement to complete performance and to assume all losses and liabilities. The corporation had capital stock divided into 100 shares, of which petitioners gave 96 shares in equal amounts to their children. The children being minors, the stock was held for them by their father, as trustee. This fact is of no materiality, since the record establishes the bona fides of the trust beyond doubt. The corporation completed the construction work and earned profits. Such profits constituted income taxable to the corporation, which it reported and on which it paid the tax due. The corporation distributed the balance of its net earnings as dividends, and each stockholder1943 U.S. Tax Ct. LEXIS 176">*194 reported his share and paid the tax thereon. Petitioners made a gift tax return in which they reported the gifts of stock to their children, and there is no question here of any deficiency in gift tax.
It is apparent, of course, that petitioners might have made their gifts in other forms, but, since they were made by means which the law permits, petitioners are not subject to legal censure therefor and tax liability must be determined on the basis of what was actually done.
Petitioners on brief make the alternative contentions that, if respondent's determinations should be approved in theory, then the net profits reported by the corporation in its return should be reduced by the amounts paid to petitioners as dividends, and further that the total amount of taxes paid by the corporation and by the other stockholders on their dividends should be credited against the additional tax liability of petitioners. In view of the conclusions reached above, it is unnecessary to consider those matters here.
The deficiencies determined by respondent are disapproved. Cf.
Decisions will be entered for petitioners.