*77 Decision will be entered for the respondent.
Petitioner is a corporation engaged among other things in the wholesale lumber business, with its principal sales made to building contractors. In this line of business petitioner was required to carry large inventories and to have at all times considerable amounts of accounts receivable on its books. Its own capital and surplus were insufficient to finance this business, considering the size to which it had grown. In 1937 it made a contract with its president by which he agreed to lend to petitioner on an unsecured basis sums of money not in excess of $ 100,000 at any one time and petitioner agreed to pay interest on these sums at the rate of 6 percent per annum and in addition to pay its president semiannually 25 percent of the profits of the business. Held, that the 25 percent of profits paid by petitioner to its president under the terms of this contract in 1939, 1940, and 1941, were not "ordinary" as that term has been construed by the Supreme Court in Deputy v. du Pont, 308 U.S. 488">308 U.S. 488, and are not deductible as "ordinary and necessary" business expenses under section 23 (a), Internal Revenue*78 Code.
*1164 The Commissioner has determined against petitioner deficiencies as follows:
| Declared | |||
| Year | Income tax | value | Excess-profits |
| excess-profits tax | tax | ||
| 1939 | $ 2,504.34 | $ 1,797.38 | |
| 1940 | 6,073.79 | 3,848.60 | $ 3,413.20 |
| 1941 | 6,629.38 | 4,734.67 | 9,748.98 |
The deficiencies are due to adjustments made by the Commissioner to the income as reported by petitioner on its income tax returns for each of the taxable years by his disallowance as deductions of certain financing charges which petitioner had sought to deduct as ordinary and necessary business expenses. The Commissioner explained his disallowance of these financing charges as deductions in the following language in his deficiency notice:
(a) The deduction claimed for payments made to Joseph E. Haenn, in excess of 6 percent on borrowed money, has been disallowed.
It is held that this item is not an ordinary and necessary business expense.
Other adjustments were made by the Commissioner, *79 which are not in dispute. The petitioner by appropriate assignments of error contests the correctness of the Commissioner's disallowance of the financing charge as deductions.
FINDINGS OF FACT.
The petitioner, Geo. J. Haenn, Inc., is a corporation organized and existing under the laws of the State of Pennsylvania. Its place of business is located in the city of Philadelphia. For each of the taxable years in question it filed its income tax return with the collector of internal revenue, Philadelphia, Pennsylvania.
The business of petitioner was originally established by George J. Haenn some 55 years ago as a vehicle for the supply of dunnage to shipping moving to and from the port of Philadelphia. "Dunnage" is the trade designation of loose or rough lumber, such as cordwood and the like, placed in the hold of a vessel to protect the *1165 cargo from water or so stowed as to prevent damage to it from shifting or chafing in the movement of the vessel. The entire operation is described as "ceiling."
In 1924 the business was incorporated under the laws of Pennsylvania, with the style and title of "Geo. J. Haenn, Inc." and with a wholly issued common capital stock of $ 10,000, *80 divided into 100 shares of the par value of $ 100 each, of which George Haenn retained 54 shares and distributed the remainder in small lots amongst four of his employee, two of whom were his sons, Joseph E. Haenn and William F. Haenn. In January of 1939 George J. Haenn continued to hold his original 54 shares, Joseph E. Haenn held 28 shares and William F. Haen and John A. Wiedmann each held 14 shares.
In 1935 George J. Haenn was approaching his eightieth year and was not in good health. The business had prospered, and from it and other ventures in which he had engaged he had amassed considerable wealth, but when his health began to fail he announced to his associates his decision to be longer concerned in the active management of the business and left it to them to determine the future of it. Joseph E. Haenn thereupon took over the management, continuing in the office of president of the corporation with his father as vice president and treasurer, and John A. Wiedmann as secretary. The stockholdings remained the same, George Haenn with 54 shares, Joseph E. Haenn holding 18 shares, and John A. Weidmann and William F. Haenn each having 14 shares. George J. Haenn died in 1940, *81 and, on the distribution of his estate in 1943, Joseph E. Haenn acquired his father's shares under the latter's will.
From 1935 to 1940, when George J. Haenn died, no change had occurred in the ownership of the stock of the corporation. In the interim, however, a marked change had taken place in the character of its business. Toward the end of 1934 and in the forepart of 1935, the coastwise and trans-Atlantic business and shipping at the port of Philadelphia had lessened materially, and the corporation gradually ventured into the field of buying and selling manufactured lumber at wholesale and retail, principally to building contractors. The sources of supply were remote -- on the west coast and in the southern mills -- and the terms of payment were such that the corporation was soon required to resort to borrowing.
Prior to April 1937 Joseph E. Haenn loaned certain sums of money to petitioner and received interest at the rate of 6 percent per annum thereon. He did not make a charge for or receive additional payments for the use of said moneys by the petitioner during that time. It is stipulated that the sum of $ 53,000 was owing to Joseph E. Haenn for borrowed money by the petitioner*82 prior to 1937. Joseph E. Haenn was unwilling to continue to advance the corporation sums of money, which *1166 he had to borrow from banks by using his own individual collateral, unless he was paid some extra compensation for this financing service over and beyond the 6 percent interest rate which was being paid him. On April 20, 1937, petitioner and its president, Joseph E. Haenn, entered into a written agreement by which Joseph E. Haenn, as party of the first part, agreed to finance petitioner, as party of the second part, in its business in an amount not to exceed $ 100,000. The terms and conditions of this financing are stated in the agreement as follows:
Whereas, said Company has been and now is in need of additional working capital to enable it to carry on its business successfully.
Now, Therefore, in consideration of the mutual covenants and premises hereinafter contained and set forth, it is mutually covenanted and agreed by and between the parties hereto as follows:
1. The party of the first part agrees, upon the execution of this agreement, to lend the Company such amounts or sums as shall from time to time be required to provide it with sufficient funds to assure*83 the continued conduct of its operations. Said loans, inclusive of the indebtedness now subsisting between the said Company and the party of the first part, shall not exceed in the aggregate the amount or sum of $ 100,000.00, shall bear interest at the rate of six per cent. per annum, and shall be due and payable within one year from the date hereof, at the option of the party of the first part, as hereinafter provided.
2. The Company agrees, in consideration of the premises, to pay to the party of the first part, semi-annually, such amount or sum as shall be equivalent to twenty-five per cent. of the net profits realized from the operations of the Company, as and by way of a financing charge for the extension of the aforesaid credit by the party of the first part, and which said amount or sum shall be computed and paid by the Company to the party of the first part before any dividends shall be declared or paid upon the capital stock of the Company now or hereafter issued and outstanding.
3. The parties hereto further agree that this agreement shall be terminable at the option of either of the parties hereto at the expiration of one year from the date hereof, but unless so terminated*84 shall remain and continue in full force and effect for another year, and so on from year to year until so terminated by notice in writing of the intent of either of the parties hereto to discontinue and terminate this agreement.
It has been stipulated that during the period 1937 to 1941, inclusive, Joseph E. Haenn loaned the sum of $ 287,892.83 to the petitioner, in addition to the sum of $ 53,000 owing to Joseph E. Haenn by the petitioner prior to 1937. Of this amount the sum of $ 174,000 was borrowed by Joseph E. Haenn from the Corn Exchange National Bank & Trust Co. of Philadelphia on dates and at interest rates set out in the stipulation. The dates of these borrowings extended from January 27, 1937, to June 10, 1941, and the interest rate which Joseph E. Haenn paid the Corn Exchange National Bank & Trust Co. on such borrowings ranged from 3 1/2 percent charged for the loan on January 27, 1937, to 2 3/4 percent on the loans made in 1940 and 1941. The interest rate did not exceed 3 3/4 percent on any of the loans.
In 1937, pursuant to the provisions of the contract, Joseph E. Haenn *1167 loaned the corporation, including loans made prior to the contract, up to a maximum *85 of $ 138,000. In 1938 the top figures were $ 99,000, and in 1939 they did not exceed $ 81,500. In 1940 they reached $ 106,770.83, and in 1941 they advanced to the peak of $ 174,575.01.
The petitioner repaid Joseph E. Haenn in the following amounts during the period 1939 to 1941, inclusive:
| 1939 | $ 22,230.97 |
| 1940 | 66,500.00 |
| 1941 | 123,161.85 |
| Total | 211,892.82 |
The financing charges which were paid by petitioner to Joseph E. Haenn under the terms of the financing contract were as follows:
| 1937 | $ 3,221.70 |
| 1938 | 2,439.31 |
| 1939 | 15,900.47 |
| 1940 | 30,883.48 |
| 1941 | 37,024.63 |
The petitioner corporation has continuously maintained banking facilities at the Philadelphia National Bank, Philadelphia, since 1924. Joseph E. Haenn has continuously maintained personal banking facilities at the Corn Exchange National Bank & Trust Co., Philadelphia, since 1924.
The petitioner corporation discounts all bills payable received by it. The accounts receivable on the books of the petitioner are of a nature characterized as current accounts, i. e., of 30, 60, or 90 days duration. During the years 1935 to 1941, inclusive, the petitioner charged off as bad debts from operations the amount*86 of $ 4,499.54.
At no time prior to April 9, 1941, did the petitioner endeavor to obtain credit accommodations at the Philadelphia National Bank, with which it had its banking account for many years. On April 9, 1941, the question of accommodating the petitioner in regard to any credit requisites it might require was discussed for the first time by the petitioner and the Philadelphia National Bank. On April 12, 1941, the bank notified the petitioner that it was "prepared to loan" petitioner" $ 25,000 on an unsecured basis." The petitioner borrowed a total of $ 105,000 from the Philadelphia National Bank during 1941. It retired $ 80,000 thereof during that year, leaving a balance owing to the bank of $ 25,000 at December 31, 1941. The above credit was extended to the petitioner by the bank at an annual rate of interest of 4 percent.
The undivided profits, per books, from the operations of the petitioner for the years 1935 to 1941, inclusive, before the payment of United States income and excess profits tax are as follows: *1168
| 1935 | $ 29,391.27 |
| 1936 | 33,139.38 |
| 1937 | 30,515.99 |
| 1938 | 35,876.77 |
| 1939 | $ 68,385.71 |
| 1940 | 117,027.49 |
| 1941 | 169,343.55 |
The inventory of the *87 petitioner consisted of lumber on hand for operations. The following reflects the yearly amount of inventory per books of the petitioner during the years 1935 to 1941, inclusive:
| 1935 | $ 35,367.91 |
| 1936 | 83,565.66 |
| 1937 | 114,325.90 |
| 1938 | 77,909.43 |
| 1939 | $ 113,218.88 |
| 1940 | 120,026.13 |
| 1941 | 236,964.31 |
Joseph E. Haenn, as president and member of the board of directors of the petitioner, did not at any time prior to April 9, 1941, when credit facilities were opened at the Philadelphia National Bank, attempt to obtain credit accommodations from banks or credit institutions on behalf of the petitioner.
Any part of the stipulated facts not included in the foregoing findings of fact are incorporated herein by reference.
OPINION.
The question we have to decide in this proceeding is whether certain payments which petitioner made to its president, Joseph E. Haenn, in each of the taxable years here involved under the terms of a financing contract entered into in 1937, were deductible as ordinary and necessary business expenses. The amounts of these payments are not in dispute. There is no contention made by either party that the amounts paid under the circumstances detailed in our findings*88 of fact were interest or that they were additional compensation for services rendered by Joseph E. Haenn as president and general manager of petitioner. The salary paid Joseph E. Haenn in each of the taxable years has been allowed as a deduction by the Commissioner and is not in dispute. The Commissioner has disallowed these financing payments as deductions, explaining in his deficiency notice as follows:
(a) The deduction claimed for payments made to Joseph E. Haenn, in excess of 6 percent on borrowed money, has been disallowed.
It is held that this item is not an ordinary and necessary business expense.
The petitioner assigns this action of the Commissioner as error.
The applicable statute is section 23 (a), Internal Revenue Code, printed in the margin. 1
*89 *1169 There seems to be no doubt that the payments which petitioner made to its president, Joseph E. Haenn, as financing charges in each of the taxable years involved in this proceeding were expenditures which were required to be made under the terms of a written contract which had been entered into in 1937 between petitioner and its president. But if it be assumed that these expenditures can be correctly classed as "necessary expenses" within the provision of the statue printed in the margin, can it be said that such expenses were "ordinary" within the meaning of said statute. For such expenditures to be deductible under section 23 (a) of the Internal Revenue Code they must be both ordinary and necessary. In Deputy v. du Pont, 308 U.S. 488">308 U.S. 488, the Supreme Court discussed the meaning of "ordinary" as that word was used in a statute identical in language with the one which is applicable in the instant case. The Supreme Court, among other things, said:
* * * Ordinary has the connotation of normal, usual or customary. To be sure, an expense may be ordinary though it happen but once in the taxpayer's lifetime. Cf. Kornhauser v. United States*90 , supra. Yet the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved. Welch v. Helvering, supra, * * *. Hence, the fact that a particular expense would be an ordinary or common one in the course of one business and so deductible under § 23 (a) does not necessarily make it such in connection with another business. * * * As stated in Welch v. Helvering, supra, "* * * What is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance." One of the extremely relevant circumstances is the nature and scope of the particular business out of which the expense in question accrued. The fact that an obligation to pay has arisen is not sufficient. It is the kind of transaction out of which the obligation arose and its normalcy in the particular business which are crucial and controlling. [Italics supplied.]
While it is of course true that the expenditures which the taxpayer sought to deduct as ordinary and necessary business expenses in the Deputy v. du Pont case, supra, were entirely different from those which the taxpayer*91 seeks to deduct in the instant case, nevertheless what the Supreme Court said with reference to the meaning of the term "ordinary" as used in the statute is equally applicable here. Doubtless it is entirely "ordinary" for taxpayers engaged in petitioner's line of business to borrow money and pay interest thereon. The money which petitioner's president loaned petitioner was borrowed by him from the bank with which he individually did business, by placing with the bank his own personal collateral. He borrowed this money on a secured basis at an annual rate of interest not in excess of 3 3/4 percent and loaned it to petitioner on an unsecured basis at the rate of 6 percent per annum. The Commissioner has allowed petitioner a deduction of the full amount of interest which it paid on these loans. That deduction is not involved in this proceeding.
*1170 But were the financing charges of $ 15,900.47, $ 30,883.48, and $ 37,024.63 which petitioner paid to its president in 1939, 1940, and 1941, respectively, "ordinary" expenses within the meaning of the statute? We think we must answer that question in the negative, in view of the interpretation which the Supreme Court gave the word*92 "ordinary" in Deputy v. du Pont, supra.It would be difficult for us to believe that a corporation which was doing as profitable a business as petitioner was doing in 1939, 1940, and 1941, the taxable years which are before us, and was in as strong a financial position as it was in those years would ordinarily in an arm's length transaction agree to pay to a lender of money, in addition to the legal rate of interest provided by law, an additional financing charge of 25 percent of its annual net profits. Such agreement under such circumstances would be extraordinary, we think.
Petitioner argues that, in deciding whether these financing charges were ordinary and necessary, we must look to the conditions which prevailed in the year 1937 when petitioner entered into the contract and not in later years when petitioner's business had grown and it was making large profits. On this point petitioner cites Austin v. United States, 28 Fed. (2d) 677. But in weighing this argument it should be borne in mind that the contract in the instant case contained a provision that:
3. The parties hereto further agree that this agreement*93 shall be terminable at the option of either of the parties hereto at the expiration of one year from the date hereof, but unless so terminated shall remain and continue in full force and effect for another year, and so on from year to year until so terminated by notice in writing of the intent of either of the parties hereto to discontinue and terminate this agreement.
Clearly, under the foregoing provisions of the financing contract petitioner might have brought it to an end in any of the taxable years by giving the required written notice to the lender beforehand. In this important respect the facts are distinguishable from those which were present in Austin v. United States, supra.
Among the cases relied on by petitioner in support of its contention that these financing charges are deductible as ordinary and necessary business expenses are La Monte & Son v. Commissioner, 32 Fed. (2d) 220, and Monroe Sand & Gravel Co., 36 B. T. A. 747. We think these cases are distinguishable on their facts. In La Monte & Son the agreement in question provided that a percentage of net profits*94 should be paid stockholders as partial consideration for a consolidation agreement which brought into the business assets in excess of those owned and contributed by other stockholders. The agreement provided for a permanent charge on the profits of the business ahead of dividends to *1171 the other stockholders and the court held, reversing the Board at 13 B. T. A. 365, that the payments made to the two La Monte stockholders under the terms of the agreement were deductible as ordinary and necessary business expenses. In Monroe Sand & Gravel Co. the nondeductibility of the financing charges paid to two of the stockholders of the taxpayer was raised by affirmative allegations in the Commissioner's answer. We held that, having raised the question of the deductibility of these items by affirmative allegations in his answer, the burden of proof to sustain these affirmative allegations was on the Commissioner, and that he had not sustained it. We therefore held for the taxpayer on that particular issue.
The nondeductibility of the items involved in the instant case was not raised by the Commissioner by affirmative allegations contained in his answer, *95 but, on the contrary, they were disallowed in his determination of the deficiency. The burden of proof is therefore on the petitioner to show that the Commissioner committed error in his disallowance of the items in question. For reasons we have already stated, we hold that petitioner has not sustained this burden of proof.
Decision will be entered for the respondent.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) In general. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; * * *↩