*1025 1. SECTION 104(b). - In determining whether accumulations are beyond the reasonable needs of a business, section 104(b), Revenue Act of 1932, sets up a practical rather than a theoretical test, and it is erroneous to compute a surplus based on cost of assets which are useful to the business only to the extent of their lower market value.
2. EVIDENCE, INTERESTED WITNESS. - Testimony of a witness that the corporation which took over the business and assets of a partnership of which he was a member was formed in order to limit liability of the partners and to remove danger of liquidation of the partnership in the event of death of a partner, and that tax benefits were not considered, may not be disregarded in view of the impressiveness of the witness and the fact that his testimony was reasonable and not inconsistent with but was corroborated by other evidence.
3. SECTION 104(a). - The petitioner-corporation had been engaged in the tobacco business for many years. It required a large amount of liquid capital to purchase and process tobacco and to finance its customers. It carried among its assets a substantial amount of securities, and due to a decline in business its holdingso*1026 of securities increased. During the taxable year, and for several years prior thereto, it had sustained losses in its business operations but had income in the form of dividends and interest on its securities. The surplus at the close of the taxable year, based on cost of securities, was over $2,000,000, but, on the basis of market value of securities, the surplus was negligible. The corporation paid no dividends and the officers of the corporation honestly believed that all of the capital and surplus would be required for the proper conduct of its tobacco business as soon as the business recovered from the effects of the depression which began in 1929. The capital available in the taxable year was no greater than at the time of organization ten years before, when the business experienced its most prosperous years. Held, that the petitioner was not availed of in the taxable year for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.
*512 The Commissioner determined a deficiency of $94,377.32 for the calendar year 1932. The petitioner reported a net loss of $4,637.33 on its return for the year and the Commissioner did not change that figure. He determined the deficiency by holding that the petitioner was subject to tax under the provisions of section 104 of the Revenue Act of 1932, and added to income dividends of $189,141.96 and interest on United States obligations of $4,250. None of these figures are in dispute in this proceeding. The sole issue is whether or not section 104 applies.
FINDINGS OF FACT.
The petitioner is a corporation which filed its income tax return for the calendar year 1932 with the collector of internal revenue for the second district of New York.
The business of the petitioner had its origin prior to the Civil War. C. H. Spitzner established it. Later, his two sons joined him in the business. Thereafter the business was conducted under the name of C. H. Spitzner & Son. One son died in 1895, C. H. Spitzner retired at that time, and George W. Spitzner, the remaining son, began to operate the business as a sole proprietorship. Carl O. Kienbusch was a*1028 grandson of C. H. Spitzner and a nephew of George W. Spitzner. Shortly after he graduated from college in 1906 he was employed in the business and he continued in the business up to the time of the hearing in this proceeding. He and George W. Spitzner formed a partnership on January 1, 1918, which operated the business until December 31, 1921. The two partners shared the profits equally, although Spitzner contributed about twice as much capital as Kienbusch.
Kienbusch had a number of discussions with his attorney between 1918 and 1921 in regard to the advisability of incorporating the business. The business was a hazardous one and Kienbusch was concerned about the fact that his entire fortune was risked in the business. Spitzner was about 57 years of age and was not in good health. Kienbusch knew that the partnership would be dissolved by Spitzner's death and his executors would have a right to withdraw and would probably withdraw his capital from the business. Kienbusch felt that it was desirable from his standpoint to form a corporation. *513 Spitzner was opposed to the incorporation, but finally consented. The partners decided that the capital of the petitioner*1029 should be $4,000,000. The assets of the partnership at that time were not worth $4,000,000. Spitzner contributed to the partnership, just prior to the incorporation, stocks and bonds of the value of $109,750. Kienbusch contributed stocks, bonds, and cash of the value of $606,133.04. Kienbush paid the larger amount and made that amount as large as he could afford to make it, so that his interest, and, therefore, his share in the profits of the corporation to be formed, would be as near 50 percent as he could make it. The petitioner was organized on December 29, 1921, and on January 3, 1922, it acquired all of the assets of the partnership, subject to the liabilities of the partnership, in exchange for 37,100 shares of its capital stock. Twenty thousand seven hundred of the shares were issued to Spitzner and 16,400 were issued to Kienbusch. The remaining authorized shares were not issued at that time, but were issued pro rata as a stock dividend at the close of the year. Thereafter and throughout 1932 Spitzner owned 21,918 shares, Kienbusch owned 17,682 shares, and the remaining 400 shares were owned by Kienbusch as trustee and by members of his family.
The business consists*1030 of buying and selling leaf tobacco, and packing, curing, raising, manufacturing, and dealing in tobacco and tobacco products. The business is seasonal, hazardous, and subject to violent fluctuations from year to year. It is affected by the quality of each tobacco crop and by changes in general business conditions. The petitioner raises tobacco on its own and on rented farms. It purchases tobacco from farmers. It owns warehouses located in the totacco growing centers, where it gathers, treats, grades, and packs the product. It frequently makes loans to farmers, to aid them in producing their crops, and it also advances a part of the purchase price to them prior to the delivery of a crop. The warehousing and processing necessary to make a crop ready for sale to customers consumes about a year of time. Frequently crops are in the petitioner's hands for much longer periods. The petitioner sells tobacco to cigar manufacturers, tobacco jobbers, and brokers throughout the country. Most of its sales are made through salesmen, either its own or those of noncompeting firms, and through brokers. Customers are given credit for long periods of time. The petitioner also follows the custom, *1031 common in the trade, of assisting its customers financially by making them loans and by investing in their capital stock.
The petitioner has always kept its books and made its income tax returns on an accrual basis of accounting. Its assets and liabilities *514 at its inception on January 3, 1922, and on December 31, 1932, as shown by its books were as follows:
| Jan. 3, 1922 | Dec. 31, 1932 | |
| ASSETS | ||
| Cash | $136,956.39 | $434,102.75 |
| Securities | 692,217.04 | 2,237,068.00 |
| Notes and loans receivable | 133,990.29 | 186,481.11 |
| Accounts receivable | 1,292,881.45 | 206,826.40 |
| Inventories | 1,237,914.94 | 258,994.82 |
| Advances to agents and farmers | 133,794.86 | 29,061.70 |
| Investments in stock of tobacco companies | 537,300.00 | 676,803.00 |
| Mortgages receivable | 19,500.00 | 43,937.50 |
| Fixed assets (less reserve for depreciation) | 297,219.00 | 146,995.00 |
| Total | 4,481,773.97 | 4,220,270.28 |
| LIABILITIES | ||
| Accounts payable | $562,273.97 | $219,952.16 |
| Unearned interest | 9,500.00 | |
| Notes payable | 200,000.00 | |
| Capital stock | 3,710,000.00 | 4,000,000.00 |
| Surplus | 318.12 | |
| Total | 4,481,773.97 | 4,220,270.28 |
The gross sales of the partnership just prior to incorporation had amounted to*1032 from $2,000,000 to $3,000,000 per year. It realized gross profits from sales in the amounts of $627,583.29 in 1920 and $283,272.76 in 1921, and received income from interest, rents, and dividends in those years of $87,773.22 and $100,085.09. The following table shows the petitioner's gross sales, net income, profit or loss from operations, dividends received, interest received, book surplus, dividends paid, and the book value of its securities other than those of tobacco companies.
| Year | Gross sales | Net income | Profit or loss from operations | Dividends received | Interest received | Book surplus | Dividends paid | Book value of securities other than those of tobacco companies |
| 1922 | $3,006,582.60 | $405,209.99 | $289,035.37 | $59,053.34 | $99,340.78 | $185,951.88 | $60,000 | $788,045.00 |
| 1923 | 2,135,040.43 | 314,499.72 | 185,272.85 | 83,357.09 | 79,325.21 | 505,106.87 | 80,000 | 1,139,904.00 |
| 1924 | 1,977,797.60 | 107,192.42 | 1 51,872.70 | 83,436.90 | 72,321.39 | 698,152.07 | 40,000 | 1,091,903.00 |
| 1925 | 1,067,394.26 | 120,580.67 | 1 92,484.97 | 93,567.02 | 99,740.34 | 942,963.86 | 40,000 | 1,774,390.00 |
| 1926 | 926,037.33 | 315,995.40 | 12,564.42 | 143,089.81 | 93,598.20 | 1,236,531.35 | 80,000 | 2,538,494.00 |
| 1927 | 1,428,801.96 | 314,784.54 | 10,346.74 | 232,380.56 | 71,911.09 | 2,145,566.90 | 120,000 | 4,039,647.00 |
| 1928 | 1,799,180.21 | 468,277.10 | 44,518.55 | 243,633.87 | 64,934.87 | 3,595,219.87 | 120,000 | 5,350,840.00 |
| 1929 | 1,617,869.55 | 395,286.87 | 12,011.54 | 278,828.71 | 72,832.21 | 3,219,921.83 | 80,000 | 5,927,385.00 |
| 1930 | 869,901.29 | 216,485.56 | 1 126,097.96 | 279,163.19 | 40,159.43 | 1,718,916.24 | 40,000 | 4,127,078.00 |
| 1931 | 976,364.53 | 203,270.13 | 1 78,301.29 | 251,651.80 | 35,119.31 | 179,868.92 | 2,736,877.50 | |
| 1932 | 557,649.18 | 198,954.14 | 1 82,371.51 | 194,941.47 | 48,397.26 | 318.12 | 2,237,068.00 |
The petitioner's investments in stocks of tobacco companies, as shown by its books at the close of the years, was highest in 1927, when it amounted to $869,552. It was lowest in 1932. Loans payable by customers as of the end of each year from 1922 up to and including 1926 averaged over a million dollars a year. For other *515 years they ranged from $490,000 to the 1932 figure shown above. Accounts receivable at the close of 1922 and at the close of 1924 were about $950,000. As of the close of the years 1923 and 1925 and subsequent years, accounts receivable have ranged from a low of $63,886.79 at the close of 1927 to a high of $300,588.11 at the close of 1928. Advances to agents and farmers for tobacco purchases as of the close of the years 1922 to 1931, inclusive, ranged from $80,707.17 in 1923 to $2,682.72 in 1931. Balance sheets at the close of the years showed notes payable in only three years - $300,000 at the close of 1922, $100,000 at the close of 1927, and $350,000 at the close of 1929. Accounts payable as of the close of the years 1922 to 1931, inclusive, ranged from $361,254.88 for 1924 to $478,051.92 for 1928. The petitioner received rents*1034 in each year. They amounted to $4,000 or less in the first years and ranged from about $22,000 to $27,000 a year beginning in 1925. The petitioner sustained losses from the sale of securities in 1927, 1930, and 1931. The loss in the latter year was the largest, $27,177.15. The petitioner realized relatively small profits from the sale of securities in 1925, 1929, and 1932. It realized a profit of $66,442.46 from the sale of securities in 1926 and a profit of $120,426.37 from the sale of securities in 1928.
The decline in the petitioner's business from 1922 to 1933 was due in part to severe damage from rain in 1923, to an unusually poor crop in 1924, to an unfortunate reduction in the number of acres under production by the petitioner in 1925, to a cooperative movement among farmers beginning in those years and coming to a close a few years later, and to the business depression which began in the fall of 1929.
The petitioner at all times has inventoried its securities at market at the close of each year. The increase or decrease resulting from the inventory was entered on its books and used in the computation of the book surplus at the close of each year. This practice*1035 was adopted and followed so that the true worth of the corporation might be known to the stockholders, to creditors, and to the agencies which furnish credit information. The practice resulted in a write-up for each year up to and including 1928, and in a write-down for the remaining years up to and including 1932. The securities were carried on the books at the close of 1932 at a value which was $1,978,777.76 below their cost.
The petitioner had at all times followed the practice of inventorying its real estate and equipment at the close of each year at an amount which it determined to be the fair market value of those assets. This resulted in a write-up for 1922 and a write-down for all subsequent years. The change for each year was reflected in the surplus for that year. This practice was adopted and followed so *516 that the true worth of the corporation might be known to its stockholders, to creditors, and to the agencies which furnish credit information. The corporation also deducted depreciation on its depreciable assets. These fixed assets were carried on the books at the close of 1932 at a figure which was $128,750 below the cost of those assets adjusted for*1036 depreciation.
The changes in book value of the securities, real estate, and equipment resulting from the practice of inventorying those assets, described in the two preceding paragraphs, were not reflected in the computation of income shown on the income tax returns filed by the petitioner. The petitioner was not permitted under the revenue acts and regulations to inventory those assets in computing its taxable income.
The petitioner reduced its dividend payments in 1930 and paid no dividends in 1931 and 1932 because it sustained losses from operations in those years and because of the sharp decline in the market value of its securities in those years. Its officers believed that business conditions would improve, the corporation might reasonably be expected to again have gross sales of about $3,000,000, and as business improved the corporation would need all of its assets for use in its operations.
Spitzner and Kienbusch occasionally borrowed money from and loaned money to the corporation. Interest was paid on all such loans. Loans to the corporation far exceeded loans from the corporation. Kienbusch was indebted to the corporation in the amount of $18,000 at the close*1037 of 1932 and wished to have the corporation declare a dividend sufficient to enable him to pay off the loan. He sought legal advice and was informed by his attorney that, since the corporation had insufficient surplus to permit the distribution of any dividend without impairing the capital stock, it would violate the laws of New York to pay any dividend.
The petitioner was not a mere holding or investment company.
The gains and profits of the petitioner had not been permitted to accumulate beyond the reasonable needs of the business in 1932.
The petitioner was not formed or availed of during 1932 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.
OPINION.
MURDOCK: Section 104 is entitled "Accumulation of Surplus to Evade Surtaxes." The provisions of the section impose a tax of 50 percent of the net income of the corporation. That tax is in addition to the tax imposed by section 13, and the net income includes dividends *517 and interest on certain obligations of the United States, which items are not normally taxed to corporations*1038 but are subject to tax in the hands of an individual owner. The following quotations are from paragraphs (a) and (b) of the section:
(a) If any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, * * *
(b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax.
The Commissioner has held that the petitioner is liable under section 104. In such cases he sometimes makes a categorical determination under (b). Here he has not made a categorical determination that the petitioner is a mere holding or investment company, or that its gains or profits have been permitted to accumulate beyond the reasonable needs of the business. Nevertheless, we shall consider whether or not (b) applies. The facts show conclusively that the petitioner was not a mere holding or investment company. It regularly carried*1039 on a business. It did nothing else. The character of the business was quite different from that of a mere holding or investment company. Furthermore, the fact that the gains or profits were not permitted to accumulate beyond the reasonable needs of the business is clear from the record. The Commissioner has made his determination on the basis of conditions as they existed at the close of the taxable year. The books of the corporation at the close of 1932 showed a surplus of $318.12. The corporation, in computing that surplus, valued its securities and fixed assets at market. The Commissioner does not contend that the values used by the petitioner were other than the correct fair market values of the assets in question. It had followed the practice of inventorying those assets at market during its entire existence, and for all purposes other than the computation of its taxable net income. However, it was not allowed to use inventories of those assets in computing its taxable net income and it did not use the inventories for that purpose, but used cost. Sec. 22(c); Regulation 77, art. 105. The Commissioner, by using the cost of the securities and the cost less depreciation*1040 of the fixed assets, has computed a surplus of somewhat more than $2,000,000 at the close of 1932. It is unnecessary, for the purpose of paragraph (b), to determine whether or not a surplus of that amount was "beyond the reasonable needs of the business", since no such surplus was available for the needs of the business. The paragraph sets up a practical test rather than a theoretical one. Was there an accumulation "beyond the reasonable needs of the business?" The assets would *518 be useful to the business only to the extent of their actual market values. The fact that they cost a greater amount would not benefit the business. Thus the surplus based upon cost, as computed by the Commissioner, was not available for the reasonable needs of the business. It did not actually exist and could not have been used in the business. Business men and bankers, worthy of those names, would not have regarded it as a surplus. The accumulation of surplus which the petitioner actually had for use in the business amounted to only $318.12. That small surplus did not represent an accumulation of gains or profits beyond the reasonable needs of the business within the meaning of paragraph*1041 (b).
Nevertheless the Commissioner has determined that section 104 applies. He has wiped out the net loss for the year by adding dividends and a relatively small amount of interest from Government obligations, which are only taxable to the petitioner in case section 104 applies. The Board must decide whether or not the petitioner was formed or availed of in 1932 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains or profits to accumulate instead of being divided or distributed. The determination of the Commissioner is presumed to be correct, and the petitioner was required "to show its hand." ; certiorari denied, . It has made what appears to be a complete disclosure of the facts. The test is the state of mind of those persons responsible for the formation and operation of the petitioner. Even though the effect of the formation and operation of the corporation may have been to avoid surtaxes, still section*1042 104 does not apply unless the purpose, the intention of the participants, was to prevent the imposition of surtaxes upon themselves by permitting the gains and profits of the corporation to accumulate instead of distributing them. ; affd., ; certiorari denied, . was formed for the purpose mentioned in section 104(a). In order was formed for the purpose mentioned in section 104(c). In order to reach that conclusion they have to argue that the testimony of the principal witness should be disbelieved. They point to the fact that the two partners paid in dividend-bearing securities, and to certain other circumstances. Self-serving declarations of interested witnesses are not necessarily determinative. Yet such testimony can not be waved aside merely because of its character. If it comes from witnesses who are impressive, if it is reasonable, if it is not inconsistent with other evidence in the case, and if it is corroborated by other evidence, it is important evidence. The reasons for the incorporation *519 of this petitioner at the close of 1920 are clear from the*1043 testimony of Kienbusch, and they were wholly unrelated to a purpose of preventing the imposition of a surtax upon shareholders.
Kienbusch had been active in the business for a number of years. He had become an equal partner with Spitzner. A large part of the responsibility for the successful conduct of the business rested upon him. His entire fortune of about $1,000,000 was risked in the business as long as the partnership continued. He wanted to limit his liability from the business. He was apprehensive about the health of his partner. That partner had contributed about two-thirds of the capital of the partnership. Kienbusch realized that in case of Spitzner's death his personal representatives, in a proper administration of his estate, would probably withdraw his property from the hazardous business of the partnership. Kienbusch, having all of these things in mind, sought to organize the corporation. Spitzner opposed the change, largely for sentimental reasons, but finally succumbed to his partner's persistent urging. The petitioner was formed and thus the purposes which Kienbusch had in mind were accomplished, i.e., to limit his liability and to remove the danger of*1044 liquidation which might result from the death of Spitzner. Kienbusch testified that tax benefits were not considered or discussed and the evidence corroborates his statement. Therefore, we have no hesitation in concluding that section 104 may not be invoked by reason of the purpose leading to the formation of the petitioner.
A somewhat more difficult question is whether the petitioner was availed of during the year 1932 for the purpose described in section 104. Although the petitioner sustained a loss from the operation of its business in that year, it had gains and profits in the form of dividends and interest from its securities, and it permitted those to accumulate, instead of dividing or distributing them. Had the individual stockholders owned those securities during 1932, those gains would have been subject to surtaxes in their hands and, obviously, the intervention of the corporation prevented the imposition of surtaxes upon the shareholders. But the same would be true of any corporation which received any dividends. Yet Congress did not intend to impose the severe penalty of section 104 upon all such corporations. For example, the provisions of that section were*1045 never intended to apply to a corporation which limited its activities to some branch of agriculture, manufacture, or merchandising and made normal distributions. ; affd., . However, the stockholders of that kind of a corporation might bring their corporation under the lash of section 104 by diverting it from its normal business activities and intentionally using it during any taxable year for the purpose of *520 preventing the imposition of surtax upon themselves through the medium of permitting its gains and profits to accumulate instead of being divided. The question here narrows to this, Does the fact that the petitioner accumulated its tax exempt gains from dividends and interest, instead of distributing them, show a purpose on the part of its shareholders to prevent the imposition of the surtax upon themselves?
The incorporators of the petitioner believed, when they organized it, that it would need capital of at least $4,000,000 to successfully conduct its tobacco business. Kienbusch contributed as much as he could. Although their interests in the partnership had been*1046 equal, and although Kienbusch wanted his interest in the corporation to be as near a 50 percent interest as he could make it, nevertheless Spitzner also contributed over $100,000 to the business just before the formation of the corporation. The property contributed by Kienbusch had previously been held as collateral for a loan used in the business. Earnings of the first year were capitalized in order to give the corporation $4,000,000 capital. These and other circumstances indicate that the stockholders believed that $4,000,000 was needed in the business. That amount was used during 1922. The actual capital available for use in the business in 1932 was still approximately $4,000,000.
The business of the corporation in 1932 was not what it had been in 1922. It had fallen off very badly. But the petitioner never slackened its efforts to make a success of the tobacco business. Kienbusch, in his testimony, gave what he regarded as the principal reasons for the decline in sales and profits. The factors upon which he blamed the slump were of a temporary character, and he expressed confidence that the business would recover, would again have gross sales of $3,000,000, and would*1047 again need all of its available funds. The opinions which he expressed as to the future possibilities and needs of the business were honestly held by him and were not unreasonable. The respondent says he was an "incorrigible optimist." He may have been, but, if so, his optimism rather negatives the purpose described in section 104. All of the assets, including all gains and profits accumulated up to the end of 1932, would be necessary and desirable for the successful conduct of the business in case it should again expand to a volume equivalent to that of 1922.
Certainly there was good reason for the failure of the corporation to declare any dividend in 1932. Operations were conducted at a loss in that year and in prior years. The value of the assets had materially declined. The officers hoped and expected to continue in business. Capital available for business purposes would have been impaired by any distribution at that time. The financial standing *521 of the petitioner during the trying times through which it was passing was precarious. The addition of any avoidable strain would have been unwise. The failure to declare dividends in 1932 may not fairly be taken*1048 as an indication of a purpose on the part of the shareholders to avoid surtaxes.
The amount of the investment of this corporation in securities had grown tremendously from its early days up to the period here involved. But the reason for that change is also satisfactorily explained in this record. As the business of the corporation declined, a smaller and smaller portion of its capital was used for operating purposes. Common sense required that the inactive funds be employed as profitably as they might be. So it is not surprising that they were invested in income producing securities. The corporation had to be ready at all times to take full advantage of a good crop and of any increased demand for its products due to a return of better times. The investments were generally in high grade, listed securities. The assets were thus retained in as liquid form as could be, ready for prompt use in the business either as collateral or by conversion into cash when, as, and if the part of that business which had been lost was recovered.
The books of the corporatioin at the close of 1931 showed a surplus of $179,868.92, and at the close of prior years showed surpluses in much larger*1049 amounts. The question of whether or not the corporation was availed of in those years to avoid surtaxes on the shareholders is not the question for decision here. Nevertheless, the situation in those years may be scrutinized in an effort to determine whether or not a purpose of the kind described in section 104 existed in the year 1932. A large part of the book surplus shown in prior years represented the write-up resulting from the annual inventory of securities at market. The surplus in some of those years may have been beyond the reasonable needs of the business. However, the Commissioner never attempted to apply section 104, or its counterpart in earlier acts, to the income of this petitioner for any of those years. Dividends in substantial amounts were paid in most of those years. The large book surplus of these years had disappeared prior to 1932. Although the facts relating to those prior years do not show that the corporation was never availed of for the purpose of preventing the imposition of the surtax, that circumstance is not important, since the conclusion can not be drawn from those facts that the shareholders in 1932 had a purpose to avail of the petitioner to*1050 avoid surtaxes.
The two principal stockholders of the petitioner had been indebted to it at times for small amounts of money. When so indebted, they were charged with and they paid interest on the indebtednesses. But for the most part and in much larger amounts the corporation was *522 indebted to those stockholders for advances made by them to meet the needs of the business. Interest was paid on those advances. Thus, this is not a case where the principal stockholders have withdrawn funds of the corporation through loans so that they might have the use of the accumulations and, at the same time, save surtaxes by not receiving the dividends and interest directly.
Kienbusch, the treasurer, was indebted to the corporation in the amount of $18,000 at the close of 1932. This loan to him was necessitated by conditions in his own finances brought on by the depression. He did not like to be indebted to the corporation and sought legal advice to learn whether or not the corporation might declare a dividend sufficient to enable him to discharge this indebtedness. He was advised that, inasmuch as the books of the corporation showed insufficient surplus, a dividend could not*1051 be paid and any distribution would impair capital, rendering the officers and directors liable civilly and criminally for their actioin. These circumstances have some tendency to negative a purpose to avoid surtaxes.
The explanation of the investments of this petitioner in the stock and securities of other tobacco companies and of its loans to those companies leads inescapably to the conclusion that those investments and loans were incidental to and reasonably necessary in the successful conduct of the tobacco business of the petitioner. Most of the purchases were made by the partnership before the organization of the petitioner. They not only led to sales of tobacco to those particular companies, but they led indirectly to sales to other companies. Some of them were made in the hope of sales and profits which never materialized. But it may not be inferred from that unfortunate circumstance that the investments were unrelated to the business of the petitioner or that they indicate a purpose to evade surtaxes. The loans and the purchases were made to assist customers financially, to promote sales, or for both purposes.
The parties have filed rather lengthy briefs which indicate*1052 that they have carefully considered the mass of detailed facts and figures in this record. This discussion would be unduly prolonged were it to include comments on every point made by the parties. But our failure to mention any particular point in this opinion may not be taken as an indication that some point or argument made has not been carefully considered. It does seem proper, however, to make special mention of three of the cases cited by the respondent. The Board held in , and in , that the corporation there was availed of within the year for the purpose described in the statute, despite the fact that in each case the corporation would not have had any surplus had its securities been valued at market. The differences between those cases and the present case are marked. Each of those corporations was a mere holding or *523 investment company. Neither had any business like that of the petitioner in this case. The activities of those corporations up to and including the taxable year involved were indicative of purposes on the part of the shareholders to avail of the corporations*1053 to prevent the imposition of the surtax upon the shareholders. Here the activities of the petitioner for a similar period indicate an absence of such a purpose. Purpose is the test, and those cases are not authority one way or the other for decision of the present proceeding. The facts in the case of , in some respects parallel the facts in the present case. However, the decision of the Board in that case was reversed, , and, to the extent that the facts are parallel, that case now supports the contention of the petitioner in this case.
Reviewed by the Board.
Decision will be entered for the petitioner.
HARRON, dissenting: I respectfully dissent from the majority opinion. Certain agreed facts, together with detailed schedules of the financial history of the petitioner corporation from 1922 to 1932, inclusive, have been filed in this proceeding and provide the ground for the dissenting opinion.
The petitioner reported, for the year 1932, no income tax liability. It had realized a net loss from its tobacco business in 1932 in the amount of $56,089.29. It had received*1054 net income from investments in the amount of $255,043.43, but it appears that, dividends being deductible under section 23(p) of the Revenue Act of 1932 and interest on obligations of the United States being not taxable, these were not includable in taxable net income under ordinary circumstances. The Commissioner, pursuant to the provisions of section 104(c), has determined that the petitioner had a net income for the year 1932 since, under subsection (c), dividends and interest would be includable in the net income of a corporation which came within the other provisions of section 104. In his notice of deficiency the Commissioner states:
After careful consideration of your Federal income tax return and all other available information, the Bureau holds that your corporation is subject to taxation under the provisions of section 104 of the Revenue Act of 1932.
From the notice of deficiency it is evident that the Commissioner based his determination upon the conclusion that the petitioner had run afoul of the provisions of section 104 generally, although the determination was not based upon section 104(b) specifically. After the hearing in this proceeding the respondent asked*1055 that this Board find as a fact that the petitioner had violated section 104(b); namely, that its gains and profits were permitted to accumulate beyond the *524 reasonable needs of the business in the taxable year. The respondent contends that petitioner was formed for the purpose of escaping surtax on its shareholders; that the petitioner was availed of to escape surtax of its shareholders; and that gains and profits of petitioner were permitted to accumulate beyond the reasonable needs of its business. There is, therefore, the question in this proceeding whether the facts show that in the taxable year 1932 that petitioner permitted its gains or profits to accumulate beyond the reasonable needs of the business. This question is a fact question. If the facts show such circumstance as is covered by subsection (b), the statute regards this as prima facie evidence of a purpose to escape surtax and the burden is upon the petitioner to introduce evidence to overcome such prima facie evidence. The majority view concludes that the evidence does not show a state of mind in the two chief stockholders of petitioner to operate their corporation so as to prevent the imposition of surtaxes*1056 upon themselves. It is always difficult to obtain the admission of the interdicted purpose, but the facts relating to the financial history of the corporation in question, the fair needs of the business, and the conduct of its officers may disclose the interdicted purpose.
There are several questions, one of which is, Were the gains and profits of petitioner permitted to accumulate beyond the reasonable needs of the business in 1932 and does the evidence show that petitioner has overcome the prima facie evidence of a purpose to escape surtax? It is the view of this dissenting opinion that the evidence shows that the gains and profits of petitioner were permitted to accumulate beyond the reasonable needs of its tobacco business and that there is not sufficient evidence to overcome the prima facie evidence of a purpose to escape surtax. The following discussion of the evidence is believed to support this conclusion.
At the close of 1932 the petitioner had the following assets, excluding investments in securities: Cash, $434,102.75; notes and loans receivable, $186,481.11; accounts receivable, $206,826.40; inventories, $258,994.82; advances to agents and farmers, $29,061.70; *1057 investments in stock of tobacco companies, $676,803. Its only current liability was accounts payable in the amount of $219,952.16. Petitioner had followed a practice of "writing down" the asset values of investments to the current market prices at the end of the fiscal year, so that at the end of 1932 securities and mortgages which had a cost value of $4,936,586.26, had a book value of $2,237,068. On the basis of the book value of the petitioner's investments, petitioner showed a surplus of only $318.12. There is no evidence, other than the book value adopted by petitioner, of the value of securities in the taxable year. It has not been found as a fact that the value of the securities in 1932 was the book value. It is petitioner's contention that no dividend *525 could have been declared in 1932 because there was no substantial surplus upon its books, so that to have paid a dividend would have impaired capital. It is a question of fact whether payment of a dividend in the taxable year would have impaired capital. In effect petitioner argues that its earnings were "impounded" on account of the shrinkage of its security values at the end of the taxable year. This argument*1058 of petitioner must be weighed against the financial record of the company, which shows that in over 10 years the petitioner accumulated $2,577,759.63 from dividends, net income from operations of the tobacco business, and net profit from the sales of securities. This amount is a net amount excluding a total of $660,000 dividends declared and paid by petitioner over the 10-year period. It appears that these accumulated earnings were invested from year to year in the purchase of more dividend-producing securities, for the cost value of petitioner's investments increased over the 10 years in the amount of $3,663,483.15. The following schedule shows this.
| 1922-1932, inclusive. | |
| Dividends from investments | $2,389,116.93 |
| Net income from operations, less losses | 671,419.61 |
| Net profit from the sales of securities, less losses | 177,223.09 |
| Total | 3,237,759.63 |
| Less: Dividends paid by petitioner | 660,000.00 |
| Net earnings and gains | 2,577,759.63 |
| Cost of investments, end of 1932 | 4,936,586.26 |
| Cost of investments, end of 1922 | 1,273,103.11 |
| Increase in investments, 10 years | 3,663,483.15 |
The following schedule from comparative balance sheets of petitioner, excluding*1059 a stock dividend paid in 1922 in the amount of $290,000, shows that the petitioner had an earned surplus at the end of 1932 in the amount of $2,107,845.88.
| Period | Assets | Net earnings | Earned surplus | Dividends paid and declared |
| 1-3-22 | $4,481,773.97 | |||
| 12-31-22 | 4,903,402.08 | $405,209.99 | $55,209.99 | $60,000 |
| 12-31-23 | 4,961,018.09 | 314,499.72 | 289,709.71 | 80,000 |
| 12-31-24 | 5,061,406.95 | 107,192.42 | 353,623.17 | 40,000 |
| 12-31-25 | 5,321,733.34 | 120,580.67 | 434,792.14 | 40,000 |
| 12-31-26 | 5,668,409.64 | 315,995.40 | 670,787.54 | 80,000 |
| 12-31-27 | 6,705,878.52 | 314,784.54 | 865,572.08 | 120,000 |
| 12-31-28 | 8,165,271.79 | 468,277.10 | 1,213,849.18 | 120,000 |
| 12-31-29 | 8,059,423.02 | 395,286.87 | 1,529,136.05 | 80,000 |
| 12-31-30 | 6,184,241.72 | 216,485.56 | 1,705,621.61 | 40,000 |
| 12-31-31 | 4,545,523.17 | 203,270.13 | 1,098,891.74 | |
| 12-31-32 | 4,220,270.28 | 198,954.14 | 2,107,845.88 | |
| Total | 3,060,536.54 | 660,000 |
*526 From this we believe that the amount of $318.12 which petitioner contends was its true surplus, was not the true surplus available for dividends, but that the actual earned surplus available for dividends was $2,107,845.88. The securities and fixed assets which*1060 petitioner "wrote-down" were owned by petitioner at the end of the taxable year and no actual reduction in earned surplus was effected during the taxable year, for the assets were not disposed of. Cf. ; affd., ; certiorari denied, ; , affirming ; certiorari denied, ; ; .
The net income of petitioner for 1932 was $198,954.14. From this fact it is extremely doubtful that petitioner would have had to sell any securities to pay dividends in 1932, as petitioner contends. This income was derived from dividends and interest on investments totaling $255,043.43, from which is deducted the year's loss from the tobacco business of $56,089.29. Since the investments which produced the income represent in themselves accumulated earnings and gains of prior years, it is obvious that the earnings for the taxable year were earnings from accumulated surplus. It is also apparent that the*1061 petitioner corporation from the time of its organization in 1922 did not require in its tobacco business any of the earned surplus or any of the invested capital which it kept in dividend and interest-bearing securities, the cost value of which steadily increased from year to year. There is no evidence that petitioner sold any substantial amount of its securities so as to put its earned surplus in liquid, usable form. A smaller and smaller portion of its capital was used each year for operating expenses and the amount of capital invested in securities increased. It is this evident nonuse of capital invested so largely in securities that gives rise to respondent's claim that petitioner was a holding company and gives importance to the circumstance that the two chief stockholders, Spitzner and Kienbusch, contributed to the partnership, just prior to the incorporation of petitioner, stocks and bonds of values of $109,750 and $606,133.04, respectively, increasing investments in securities and real estate to $1,546,236, compared to the amount of about $500,000 which the partnership previously carried. Kienbusch's contribution represented his entire wealth with the exception of property*1062 valued at about $120,000. These contributions relieved the two individuals of surtax liabilities on income from dividends thereafter paid to and accumulated by petitioner. Cf. ; affd., ; certiorari denied, .
Petitioner claims that the transfer of securities to it by its two chief stockholders, at the end of 1921, was necessary to provide additional capital for the tobacco business. The evidence shows that in *527 1922, when petitioner did its largest business, the cost of sales of tobacco was in the sum of $2,423,590, which is approximately only two-thirds of the capital of petitioner. Thus, in 1922 there was no evident need for capital in excess of $3,710,000, which would have been the capital of petitioner if the chief stockholders had not made a contribution of securities in the amount of $606,133. Further, the record shows that in 1922 petitioner had more liquid capital than it needed in carrying on the tobacco business in the year of its largest business. Petitioner at the end of 1922 had loaned $800,000 to a concern, S. Rupin, Inc., a corporation in which petitioner*1063 owned 50 percent of the outstanding stock. The explanation of loans to tobacco concerns is that such loans were effective in developing and maintaining petitioner's business. However, the record shows that from 1922 to 1932 petitioner made no sales of tobacco to S. Rupin, Inc. Therefore, it is a fair conclusion that the Rupin loan was not made to develop petitioner's business, but as investment in an associated company of a surplus of capital which petitioner did not need in its own tobacco business. It also indicates that petitioner did not need the additional income-producing capital at the date of the formation of petitioner out of the assets of the chief stockholders. The transfer of income-producing securities to a corporation, without proof of the need of such additional assets in the conduct of business, is proof of a purpose on the part of the transferors to use the corporation to avoid payment of surtaxes on their own income. Cf. ; certiorari denied, . Further, in the period 1922 to 1932 the petitioner loaned funds to one of its chief stockholders, Kienbusch, *1064 in the years when petitioner paid no dividends, which is further indication that the petitioner was accumulating earnings and gains beyond its reasonable needs.
The following schedule shows the steady increase of investments in stocks and bonds from accumulated earnings and gains:
| Period | Actual cost of stocks, bonds, and mortgages received |
| 1-3-22 | $1,249,017.04 |
| 12-31-22 | 1,273,103.11 |
| 12-31-23 | 1,506,807.84 |
| 12-31-24 | 1,579,676.10 |
| 12-31-25 | $2,069,270.28 |
| 12-31-26 | 2,841,051.19 |
| 12-31-27 | 3,666,204.18 |
| 12-31-28 | 3,801,020.31 |
| 12-31-29 | $4,987,501.22 |
| 12-31-30 | 4,831,685.37 |
| 12-31-31 | 4,957,415.32 |
| 12-31-32 | 4,936,586.26 |
The explanation given by one of petitioner's chief stockholders for the steady accumulation of earnings is that it was conserving its working capital for use at such time as improved and increased tobacco business would require; that it was hoped and expected that the petitioner's tobacco business would eventually return to an annual *528 volume of $3,000,000, which would require working capital of about $4,000,000. This explanation is also an argument advanced against the respondent's contention that the petitioner corporation had become*1065 a holding company even though it engaged in a tobacco business.
Whether or not the managers of petitioner were optimists, it is evident that a volume of business at $3,000,000 a year was not normal. In one year only, 1922, did gross sales reach that amount. Since the question involved relates to what working capital is necessary for the reasonable needs of the business, the year 1922 is not the normal year to take to test what amount of capital the reasonable needs of the tobacco business requires. The following schedule shows the size of petitioner's business during its life.
| Period | Gross sales | Cost of sales | Inventory |
| 12-31-22 | $3,006,582.60 | $2,423,590.83 | $953,135.34 |
| 12-31-23 | 2,135,040.43 | 1,638,462.89 | 1,192,489.80 |
| 12-31-24 | 1,977,797.60 | 1,831,599.92 | 616,220.34 |
| 12-31-25 | 1,067,394.26 | 942,226.30 | 388,854.58 |
| 12-31-26 | 926,037.33 | 708,339.24 | 279,837.01 |
| 12-31-27 | 1,428,801.96 | 1,167,308.85 | 664,358.41 |
| 12-31-28 | 1,799,180.21 | 1,456,846.33 | 496,027.15 |
| 12-31-29 | 1,617,869.55 | 1,330,406.62 | 358,134.11 |
| 12-31-30 | 869,901.29 | 796,820.16 | 648,883.30 |
| 12-31-31 | 976,364.53 | 870,134.69 | 294,330.63 |
| 12-31-32 | 557,649.18 | 482,495.62 | 258,994.82 |
In*1066 the year 1922, when petitioner's volume of business amounted to $3,000,000, the working capital of the business was $3,490,557.08. From 1927 to 1932 the business of petitioner has never required working capital in excess of $1,900,000. The following table shows the actual working capital in use in each year. It is computed from petitioner's comparative balance sheets by excluding from total assets the book values of the investments in securities and mortgages.
| Period | Working capital, excluding investments in stocks, bonds, mortgages |
| 12-31-22 | $3,490,557.08 |
| 12-31-23 | 3,221,313.09 |
| 12-31-24 | 3,109,201.95 |
| 12-31-25 | 2,698,541.34 |
| 12-31-26 | $2,198,364.64 |
| 12-31-27 | 1,713,429.52 |
| 12-31-28 | 1,900,130.79 |
| 12-31-29 | 1,274,886.02 |
| 12-31-30 | $1,220,511.72 |
| 12-31-31 | 1,188,380.67 |
| 12-31-32 | 1,262,461.78 |
From the above, it seems evident that petitioner's normal business did not require maintaining a surplus of earnings that would assure a working capital of $4,000,000 a year. There is little substance in the argument of petitioner that it was accumulating earnings to meet the anticipated needs of its business. *1067 The petitioner had substantially no liabilities. In the 10-year period there is no evidence of efforts to increase business to a size that would require use of the *529 large accumulation of earnings. Cf. ; affd., ; certiorari denied, . In the taxable year 1932 there was a substantial accumulation of earnings that had been turned back into income-producing securities, which had increased during 10 years to a cost value of $4,936,586. The petitioner was in a liquid position. No evidence having been introduced to prove the value of securities at less than cost, it should be held that petitioner had an earned surplus of $2,107,845.88. The evidence does not show that there were reasonable needs for any further accumulation of earnings by preserving the entire net earnings of the taxable year. Cf. The earnings for 1932 could as well have been distributed as held for future investment or distribution. Petitioner's turnover of business has been far below its invested capital.
It should be found as a fact that petitioner permitted*1068 its gains to accumulate beyond the reasonable needs of the business in 1932. It should further be held that petitioner has not introduced evidence to overcome the prima facie evidence of a purpose to avoid surtax. The analysis of the surplus account of petitioner gives strong support to respondent's contention that it had become a holding company. In every year since 1924 net income received from investments has far exceeded net income from operations, and capital used in operations has steadily been less than capital converted into investments. The following schedule shows this fact and greatly weakens petitioner's argument that the conduct of its operations was solely to further the tobacco business.
| Year | Net income from tobacco operations | Net income other than operations | Net income | Dividends paid |
| 1922 | $351,336.18 | $53,873.81 | $405,209.99 | $60,000 |
| 1923 | 250,238.59 | 64,261.13 | 314,499.72 | 80,000 |
| 1924 | (loss) 12,082.41 | 119,274.83 | 107,192.42 | 40,000 |
| 1925 | (loss) 46,652.77 | 167,233.44 | 120,580.67 | 40,000 |
| 1926 | 45,201.67 | 270,793.73 | 315,995.40 | 80,000 |
| 1927 | 59,433.95 | 255,350.59 | 314,784.54 | 120,000 |
| 1928 | 101,801.49 | 366,475.61 | 468,277.10 | 120,000 |
| 1929 | 87,407.46 | 307,879.41 | 395,286.87 | 80,000 |
| 1930 | (loss) 73,175.77 | 289,661.33 | 216,485.56 | 40,000 |
| 1931 | (loss) 35,999.49 | 239,269.62 | 203,270.13 | |
| 1932 | (loss) 56,089.29 | 255,043.43 | 198,954.14 | |
| Total | 671,419.61 | 2,389,116.93 | 3,060,536.54 | 660,000 |
*1069 Petitioner claims that because of the shrinkage in values of its assets it had no surplus out of which to pay dividends in 1932 and that to do so would have been in violation of section 58 of the New York State Stock Corporation Law and section 164 of the Penal Law. Petitioner relies on certain advice given him by an attorney. This attorney appeared as a witness. His testimony, on cross-examination, shows that his opinion was given without examining *530 the books of the corporation and without knowledge of whether payment of a dividend would have impaired capital. He admitted that, where there is a close corporation and no creditors (the petitioner had only $220,000 current liabilities and $434,000 in cash), and the stockholders agree to the distribution, it is inconceivable that there could be "injury" from payment of a dividend and hence no penalty under the New York statute for distributing dividends. There is no evidence in this proceeding that the security assets of petitioner were in fact of the book value in 1932 ascribed to them by petitioner in its own "write-down" of values. Nor is there any evidence that the value of the security investments was less than*1070 cost. The surplus of $318.12 for 1932 is a result of bookkeeping and creates nothing. As stated in , "mere bookkeeping entries cannot preclude the government from collecting its revenues, nor are such entries conclusive upon the taxpayer." It is exceedingly doubtful whether payment of a dividend would have impaired capital and consequently doubt that there was any statutory bar against payment of a dividend by petitioner in 1929. In an issue of this kind, claimed shrinkage of values in assets as a bar to paying dividends is a fact to be proved, and that fact apparently has not been proved here.
In conclusion, it is the opinion of this dissenting view that the penalty prescribed by section 104 should be imposed upon the petitioner.
Footnotes
1. Loss. ↩