1939 BTA LEXIS 889">*889 In 1934 suit was brought against petitioner and its common stockholders by the owner of its preferred stock, alleging that the property and income of petitioner were being diverted and misapplied by its common stockholders. In the same year a contract was executed by the preferred stockholder, the common stockholders, and petitioner in settlement of this suit, which provided for the periodic retirement of the preferred stock and further provided that petitioner should declare no dividends on its common stock until the preferred stock was retired as provided for in the contract. The preferred stock was retired as so provided, but at the end of the taxable year there was still outstanding $20,000 of such stock. Held, petitioner was restricted from paying dividends by such contract and entitled to credit as provided by section 26(c)(1), Revenue Act of 1936, as to surtax on undistributed profits.
40 B.T.A. 161">*162 This proceeding involves a deficiency in petitioner's income tax liability for the year 1936 determined by respondent in the sum1939 BTA LEXIS 889">*890 of $7,574.01. With the exception of certain small items not here at issue, this deficiency results from respondent's elimination of a credit for income undistributable under contracts restricting dividend payments and his computation of surtax on undistributed net income.
FINDINGS OF FACT.
Petitioner is a corporation, organized under the laws of the State of Washington and engaged principally in the business of transportation, with its office in Spokane, Washington. Practically all of its common stock was, at all times pertinent, owned by H. S. Hawley and Eva K. Hawley, and other members of their family. All of its preferred stock was owned by one I. M. Hunley. The amount of such preferred stock outstanding in 1934 was of the par value of $85,850.
In May 1934 Hunley brought suit against petitioner and its common stockholders and directors, including the Hawleys, alleging among other things, the following:
(a) That there were accumulated unpaid dividends upon his preferred stock in the sum of $17,000.
(b) That the corporation was being managed and operated for the sole and exclusive interest of H. S. Hawley and his wife, and that they were appropriating, diverting, 1939 BTA LEXIS 889">*891 and misapplying to H. S. Hawley and his family all of the earnings of the corporation.
(c) That a common stock dividend had been declared, absorbing and diverting to H. S. Hawley and his family the surplus of the corporation in 1929.
(d) That money of the corporation had been used to the extent of $15,000 to purchase one-half of the stock of another corporation, which had been taken in the name of a son of H. S. Hawley.
(e) That H. S. Hawley was diverting earnings of the corporation by paying himself an exorbitant salary.
(f) That H. S. Hawley was diverting earnings and assets of the corporation by causing it to pay rental upon a building owned by him individually.
40 B.T.A. 161">*163 (g) That H. S. Hawley had paid cash dividends to himself and members of his family while giving stock dividends to other stockholders.
On September 13, 1934, a written contract was executed between Hunley, as party of the first part, H. S. Hawley and Eva Hawley, as parties of the second part, and the petitioner as party of the third part, the purpose of which was to settle the pending litigation. The provisions of such settlement agreement may be summarized as follows:
(a) The dividend rate1939 BTA LEXIS 889">*892 on petitioner's preferred stock owned by Hunley was reduced from 7 1/2 percent to 5 1/2 percent and was payable monthly.
(b) The second parties (Hawleys) in case the petitioner was unable to pay dividends, had a right to advance the same.
(c) The petitioner was given the right to retire any part of the preferred stock at any time, but agreed that there would be retired, on or before July 10, 1939, stock of the par value of $25,000.
(d) Hunley agreed that if stock of the value of $25,000 was retired on or before July 10, 1939, he would surrender $10,000 par value as a bonus.
(e) The Hawleys and petitioner agreed in any event to retire stock in accordance with net earnings, if any, to be calculated from July 1, 1934, as soon as the net earnings could be ascertained. The term "net earnings" was defined.
(f) H. S. Hawley had the right personally to pay the sums which the petitioner became obligated to pay in retirement of the stock, in which case he would become the owner of the stock.
(g) Commencing July 10, 1940, the petitioner agreed to retire in 10 equal annual installments stock which remained outstanding after July 10, 1939, and dividends on the preferred stock1939 BTA LEXIS 889">*893 were to be continued. The contract provided: "No dividends shall be paid to common stockholders until said preferred stock and the dividends thereon have been retired or purchased as herein specified."
(h) The petitioner and the Hawleys agreed to have the books of the corporation audited yearly and to furnish to Hunley a copy of the audit, but Hunley was given the privilege of himself auditing the books. The petitioner agreed to practice rigid economies in operation and avoid useless indebtedness and excessive salaries.
Pursuant to the terms of this agreement petitioner retired preferred stock of the par value of $25,850 in 1934, $10,000 in 1935, and $20,000 in 1936, and obtained the surrender from Hunley, as a bonus, of preferred stock of the par value of $10,000. There was outstanding on December 31, 1936, preferred stock of the par value of $20,000. This latter amount was retired by petitioner by August 31, 1937.
40 B.T.A. 161">*164 As of December 31, 1936, the balance sheet of petitioner showed assets and liabilities as follows:
| Assets | |
| Cash | $25,213.01 |
| Notes receivable | 40.00 |
| Accounts receivable | 11,561.61 |
| Inventories | 8,932.42 |
| Licenses | 2,506.22 |
| Buildings, machinery and equipment, furniture and fixtures, delivery equipment, etc., less reserves, for depreciation | 103,872.66 |
| Land | 9,650.00 |
| Franchise | 127,552.25 |
| Due from officers and employees | 31,457.41 |
| Deposit on light | 35.00 |
| Total | 320,820.58 |
| Liabilities | |
| Notes payable | $7,239.35 |
| Accounts payable | 10,542.67 |
| Taxes accrued | 5,053.46 |
| Other expenses accrued | 4,164.05 |
| Outstanding tickets | 3,501.19 |
| Federal income tax | 6,785.51 |
| Preferred stock | 20,000.00 |
| Common stock | 200,000.00 |
| Surplus | 63,534.35 |
| Total | 320,820.58 |
1939 BTA LEXIS 889">*894 OPINION.
KERN: The ultimate question involved in this proceeding is whetherr petitioner is entitled to a credit provided in section 26(c)(1) of the Revenue Act of 1936, set out in the margin hereof, 1 relating to contracts restricting dividends, in an amount equal to or in excess of $37,878.05 representing the undistributed net income of petitioner determined by respondent to be taxable under section 14 of that act.
The contract described in1939 BTA LEXIS 889">*895 our findings of fact, to which petitioner was a party, is a written contract executed by petitioner corporation prior to May 1, 1936, which expressly dealt with the payment of dividends and operated as a legal restriction upon petitioner as to amounts which it could distribute as dividends on its common stock so long as any of its preferred stock remained unretired pursuant to the contract. (See art. 26-2(b), Regulations 94.) Respondent insists, however, that, since petitioner had an excess of $25,000 cash on hand at the end of 1936 and could, therefore, have retired the remaining outstanding $20,000 par value of preferred stock and thus have removed any contract restrictions on the payment of dividends on its common stock, petitioner is not entitled to such a credit.
The short answer to respondent's contention is that petitioner did not retire its remaining outstanding preferred stock during the taxable year and was under no legal obligation so to do. Therefore, it 40 B.T.A. 161">*165 could not distribute any amount as dividends without violating the express provision of the contract and was entitled to a credit in the amount of its adjusted net income pursuant to the provisions of section1939 BTA LEXIS 889">*896 26(c)(1) of the Act of 1936.
In this proceeding we are not called upon the decide nor do we decide a question which might be presented if a corporation, with cash and liquid assets greatly in excess of both its current obligations and its secured obligations which were by written contract to be retired before the payment of dividends, delayed the retirement of such securities for an unreasonable length of time for the purpose of obtaining the credit provided for by section 26(c)(1) of the Act of 1936. Such was not the case here. In this case petitioner's balance sheet attached to its 1936 income tax return showed as of the end of the taxable year current assets as follows:
| Cash | $25,213.01 |
| Notes receivable | 40.00 |
| Amounts receivable | 11,561.61 |
It showed current liabilities (exclusive of taxes) as follows:
| Notes payable | $7,239.35 |
| Accounts payable | 10,542.67 |
It is obvious that petitioner's liquid assets were insufficient to pay its current liabilities and at the same time retire all of its preferred stock outstanding. It had retired all of its preferred stock except this amount even before it was called upon to make such retirements by the1939 BTA LEXIS 889">*897 terms of the contract. It retired preferred stock of a par value of $25,000 in 1934, of $10,000 in 1935, and of $20,000 in 1936, and in 1937 it retired the balance outstanding of a par value of $20,000.
On these facts we hold for petitioner.
Decision will be entered under Rule 50.
Footnotes
1. (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. ↩