*777 1. In settlement of a controversy between them as to the ownership of 248 of the 250 shares of outstanding stock of a corporation, petitioner Mann purchased the stock from his wife for $165,000 in bonds to be issued by the corporation for that purpose, the bonds to bear 5 percent interest and be payable at the rate of $6,000, principal and interest, semiannually. The corporation assumed Mann's debt and in 1928 paid his wife $9,200 to apply against principal and interest on the bonds. The account of petitioner Mann on the corporate books was charged with the amount of the payments and credited with a dividend of a like sum. Held, under the circumstances, that of the amount of the bonds only the sum of $9,200 constituted a taxable dividend to Mann in 1928.
2. The amount paid in the same way by the corporation for petitioner Mann in the year 1929 included interest in the amount of $7,853.44. Held, petitioner Mann is entitled to a deduction for the interest so paid. Held, further, the deduction allowed by respondent to petitioner Bismarck Tribune Co. for the payment of the interest was not proper.
3. The respondent's action in disallowing a portion of legal fees*778 and expenses of the Bismarck Tribune Co. on the ground that they represented personal expenses of petitioner Mann incurred in litigation instituted by him was not error.
*281 These proceedings involve the redetermination of deficiencies in income tax in the amounts of $27,497.04 and $764.56 for 1928 and 1929, respectively, in the case of petitioner Mann and in like tax in the amount of $1,190.27 for 1929 in the case of the Bismarck *282 Tribune Co. The issues are (1) whether there should be included in the gross income of petitioner Mann for 1928 the sum of $165,000 as a dividend of bonds issued by the Bismarck Tribune Co.; (2) whether the respondent erred in disallowing as a deduction from petitioner Mann's income for 1929 the sum of $7,853.44 for interest on indebtedness to the Bismarck Tribune Co.; and (3) whether the Bismarck Tribune Co. is entitled to deduct as an ordinary and necessary business expense in 1929 the additional amount of $2,150 for legal expenses. In his answer to the amendment made*779 to the petition the respondent raises the additional question of whether he correctly allowed the sum of $7,853.44 as a deduction from gross income of the Bismarck Tribune Co. in 1929 as interest on bonds. The cases were consolidated for hearing and report.
FINDINGS OF FACT.
In 1917 petitioner Mann and his wife, Beatrice Mann, purchased the assets of the Bismarck Tribune Co. from two individuals. Until the incorporation of the Bismarck Tribune Co. on January 19, 1918, under the laws of North Dakota with a capital of $25,000, consisting of 250 shares of common stock of a par value of $100 each, the individuals operated the business for their joint account. In February 1918 petitioner Mann was elected president and his wife secretary and treasurer of the corporation. At that time or prior thereto, 248 shares of the corporation's stock were issued in favor of petitioner Mann, and one share each to Beatrice Mann and Minnie Coulter, sister of Beatrice Mann. The stockholdings remained the same until July 1, 1920, when 248 shares of the corporation's capital stock were issued in favor of Beatrice Mann and one share each in favor of petitioner Mann and Minnie Coulter. The stock*780 certificates were not detached from the stock book. The stockholders were the members of the board of directors of the corporation.
In October 1927 Beatrice Mann appeared at the office of the corporation with F. E. Leuhe, an accountant, and after receiving the corporation's books in compliance with her request, removed from the stock book the certificates issued in her and Minnie Coulter's favor. These stockholders then called a special meeting of the corporation's board of directors on November 1, 1927. Prior to the date set for the meeting petitioner Mann instituted an equity suit against his wife and F. E. Leuhe for the purpose of enjoining them from disposing of the 248 shares of stock outstanding in the name of Beatrice Mann and interfering with the operation of the business of the corporation and for determining that petitioner Mann was the rightful owner of the stock. The court issued a temporary restraining order pending a decision on the issues involved in the complaint.
*283 During the pendency of the equity suit petitioner Mann was advised by his counsel that the controversy with his wife could be more advantageously concluded by a property settlement in*781 a divorce action than in the equity suit. Acting on such advice, petitioner Mann instituted divorce proceedings against his wife, who filed a cross bill. When the equity suit was called for trial, counsel for the parties, at the suggestion of the presiding judge, discussed the question of a compromise settlement, with the result that an informal agreement was reached for entry in the action. On February 15, 1928, the agreement was redrafted under the title of, and filed as a stipulation in, the divorce suit. Petitioner Mann did not contest the cross bill of his wife, and on February 16, 1928, the stipulation was made a part of the judgment of the court awarding a divorce to Beatrice Mann. The equity suit was then dismissed by stipulation of the interested parties. Beatrice Mann never made a claim for alimony. The stipulation provided that:
The plaintiff [petitioner Mann] is to pay to the fependant [Beatrice Mann] the sum of One Hundred Sixty-five Thousand Dollars in bonds of the Bismarck Tribune Company, a corporation, running to The Northern & Dakota Trust, a trust company, as trustee, which bonds are to provide for interest at the rate of five per cent per annum from*782 the 15th day of February, 1928, and the payment of such bonds and interest shall be amortized to provide for the payment of Six Thousand Dollars, principal and interest, on the 1st day of July and the 1st day of January each year until the full amount thereof, together with interest on the principal at the rate of five per cent per annum, payable annually, has been paid, the intent hereof being to so provide that the plaintiff shall not be compelled t0 pay more than the sum of Twelve Thousand Dollars, including interest, in any one year, and shall not be compelled to pay more than five per cent interest per annum on deferred or other payments. Such bond issue shall be secured first mortgage on all the real and personal property of said Company. It is further stipulated and agreed that the first bond shall be due and payable on the 1st day of July, 1928, and the next bond for a like amount shall be due and payable on the 1st day of Jan. 1929, and the balance of said bonds in the sum of Six Thousand Dollars each shall be payable semi-annually on the 1st day of July and the 1st day of January thereafter until the full amount of said bond issue, to gether with interest, has been paid, *783 it being understood that the last bond shall be in such amount as may at that time be due and owing under the amortization plan hereinbefore referred to.
* * *
* * * The bonds hereinbefore referred to shall be delivered to the defendant on or before the 15th day of March, 1928, and the plaintiff shall pay to the defendant on Monday of each week from and after this date until the delivery of said bonds the sum of Two Hundred Dollars and the amount of the total of such weekly payments in this paragraph provided for shall be endorsed as a payment upon the bond to be due July 1, 1928.
The document also provided for prepayment of the bonds in whole or in part on any interest payment date; for the transfer and delivery of specified personal and real property to Beatrice Mann; for the *284 entry of judgment against petitioner Mann for $165,000, less any weekly payments made on account, for the 248 shares of stock in the event of default in delivery of the bonds; and for the delivery of such stock and the certificate held by Minnie Coulter with a waiver of all claims to the stock and property of the corporation.
On March 1, 1928, the capital stock of the Bismarck Tribune*784 Co. was reissued provisionally to enable the corporation to authorize the bond issue, petitioner Mann receiving a certificate for 248 shares and Frank C. Ellsworth and Archie O. Johnson, employees of the corporation, each receiving a certificate for one share to qualify them to serve on the board of directors. These stockholders, as directors of the corporation, met on the same day and adopted a resolution, which, after reciting, among other things, that Beatrice Mann and Minnie Coulter had relinquished and assigned to petitioner Mann all of their interest in the capital stock of the corporation; that Beatrice Mann had assigned her stock to petitioner Mann under the property settlement filed in the divorce suit; that the settlement agreement provides for the delivery by petitioner Mann to Beatrice Mann of bonds of the corporation in the face amount of $165,000, bearing interest at the rate of 5 percent per annum, amortized so as to provide for the payment of $6,000 principal and interest semiannually; that the intent and purpose of the decree of the court which heard the divorce suit was to place the "entire capital stock of said corporation in the hands of the said George D. Mann, *785 and in lieu of her [Beatrice Mann] previous interest in the capital stock of said corporation, and in lieu of alimony, suit money, counsel fees, costs, and all other rights which she might otherwise have, to substitute in the hands of said Beatrice Mann the bonds of this company in the principal sum of $165,000 and interest as hereinbefore set out * * * it being the intent and purpose of said substitution to give to the said George D. Mann the full and active control and ownership of the entire capital stock of said corporation", provides:
Now, Therefore, in order that the intent and purpose of said decree and the contract of the parties approved thereby may be consummated, and in order that the said Beatrice Mann may be empowered to carry out the terms and conditions of said decree upon her imposed, it is hereby resolved that this corporation assume the payment of the obligation of $165,000.00 ashereinbefore set out, and upon the terms and conditions hereinbefore referred to, and that the said obligation be taken into the books of this corporation as a liability thereof, and that the book value of the outstanding common stock of said corporation be adjusted by the proper officers*786 of this corporation to reflect the obligation thus assumed.
A similar resolution was adopted by the stockholders of the corporation on the same day. Pursuant to the resolutions the Bismarck *285 Tribune Co. issued as of February 15, 1928, 47 bonds, 46 of the face value of $6,000 each and one of the face value of $395.76, a total of $276,395.76. One of the bonds, typical of the others, reads as follows:
For value received, on the first day of July, 1929, unless sooner retired under privilege hereinafter set out, the Bismarck Tribune Company, a corporation of Bismarck, North Dakota, does hereby promise to pay to the bearer, at the office of the Northern and Dakota Trust Company, Fargo, North Dakota, the sum of
SIX THOUSAND DOLLARS
Without Interest
In the event that this obligation is not paid when due it shall draw interest after due at the rate of five per cent per annum, payable annually.
This bond is one of forty-seven, forty-six in the sum of $6,000.00, payable, one on July 1st, 1928, and one on January 1st, and July 1st, of each year from and including January 1st, 1929, to and including January 1st, 1951, and one in the sum of $395.76, due July 1st, 1951, *787 and which bonds, by the amortization method of payment represents the installments of principal and interest on a total obligation of $165,000.00 of principal, and interest on deferred installments at five per cent per annum, payable annually.
This bond may be retired at any time before its due date by payment of its then present value at the time of payment, said then present value to be determined on the basis of five per cent annual compound discount.
The amortization table showing the method of payment of the principal obligation and interest is set out in full in the trust chattel and real estate mortgage covering and being a first lien on the real and personal property of the Bismarck Tribune Company, which secures this obligation, and said amortization table is hereby made a part hereof.
This bond is made, executed and delivered, pursuant to, and in accordance with, the orders and directions of the decree of the District Court of Burleigh County, North Dakota, duly entered on the 16th day of February, 1928, in the case of George D. Mann vs. Beatrice Mann, and for the uses and purposes therein expressed.
This bond shall not be valid until the certificate of the Trustee*788 endorsed thereon shall have been duly executed by the Trustee.
On February 15, 1928, the stock certificates held by Beatrice Mann and Minnie Coulter were placed in escrow pending the delivery of the bonds. Beatrice Mann declined to accept the bonds when delivery thereof was tendered, on the ground that they were invalid. The trial court held the bonds to be valid. Thereafter the Bismarck Tribune Co. was interpleaded in the case and an appeal taken to the Supreme Court of North Dakota on the bond question. In a decision rendered January 19, 1929, the court sustained the trial court, .
None of the bonds were made payable to or were ever in the physical possession of petitioner Mann. On or about March 12, 1929, the bonds were delivered to Beatrice Mann and the certificate for 248 *286 shares of stock standing in her name and the certificate for one share issued in favor of Minnie Coulter were delivered to petitioner Mann. The certificates were then canceled and placed in the corporation's stock book.
In 1928 the Bismarck Tribune Co. paid the sum of $9,200 to Beatrice Mann in weekly payments*789 of $200 pursuant to the terms of the settlement agreement filed in the divorce action. Like payments were made in 1929 until the delivery of the bonds. The amounts were charged to an account in the corporate books entitled "Beatrice E. Mann, Property Settlement." On December 31, 1928, the corporation opened a new account in its books entitled "Premium on Business Interests - Beatrice E. Mann" and made a debit entry therein of $165,000, with the following explanation: "For any or all rights and interest in the company as per settlement of February 15, 1928." The balancing entry was made in an account entitled "Bonds Payable." On the same date the account under the name of Beatrice E. Mann, property settlement, was balanced by transferring $2,131.25, representing principal retired during the year, as a charge to the bonds payable account, and the balance of $7,068.75 to the corporation's interest account. This allocation of principal and interest was in accordance with the amortization table set forth in the mortgage securing the bonds. On March 12, 1930, the account entitled "Premiums on Business Interests - Beatrice E. Mann" was closed out by transfer to the personal account of*790 petitioner Mann. On the same date petitioner Mann's personal account was charged with $3,534 and $7,853.44 for interest on bonds in 1928 and 1929, respectively. Offsetting entries were made in the corporation's operating surplus account.
The Bismarck Tribune Co. earned profits prior to 1928, but paid no dividends. The corporation's operating surplus account had a credit balance on January 1, 1928, of $118,990.66. At the same time the corporation had a credit balance of $78,856.50, in an account entitled "Capital Surplus", consisting of $35,566.50 for membership in the Associated Press and $43,290 for circulation structure. The corporation never paid any dividends in cash and no dividends were credited to the personal account of petitioner Mann until March 12, 1930, when it was credited with $9,200 and $14,800 for 1928 and 1929 dividends, respectively, and the operating surplus account was charged with like amounts. After March 12, 1930, dividends were periodically credited to petitioner Mann's account and used to retire the bonds.
On March 24, 1931, petitioner Mann executed in favor of and delivered to the Bismarck Tribune Co. a 6 percent interest-bearing demand note for*791 $151,557.79, such sum being the principal amount *287 of the bonds then outstanding. No security was given for payment of the note. The minutes of the meetings of the board of directors of the corporation make no reference to a loan made to petitioner Mann. The balance sheet appearing in the 1928 income tax return of the Bismarck Tribune Co. discloses no loans receivable from petitioner Mann as of the close of that year. Its accounts receivable at that time were stated to be $33,349.07. The income tax return of petitioner Mann for 1928 does not disclose the payment of any interest on loans from the Bismarck Tribune Co.
The Bismarck Tribune Co. kept its books and filed its income tax returns on the accrual basis of accounting.
In its return for 1929 the Bismarck Tribune Co. deducted the sum of $7,932.38 as legal expenses. The amount of $1,458.65 represents attorney fees and expenses incurred in legal questions involving only the corporation, and the remaining amount of $6,473.73 covers fees and expenses charged by two firms of attorneys for representing petitioner Mann in the equity suit and both petitioners in the divorce action, and for services rendered the corporation*792 in connection with the bond issue. The corporation charged $500 of the amount to the personal account of petitioner Mann. The respondent disallowed $2,650 of the amount claimed, on the ground that such portion of the charges constituted personal expenses of petitioner Mann.
OPINION.
SEAWELL: The contention of petitioner Mann is that the record proves a sale of the stock by his former wife to the corporation and a purchase of the stock by him from it. He admits a liability to the corporation for the purchase price of the stock and an obligation to the Government to pay a tax on the dividend credited to him to retire the debt. The position of the respondent is that the present value of $165,000 of the bonds was a distribution from the corporation's surplus and constituted a taxable dividend in 1928, the year the bonds were delivered and the stock transaction was closed.
There is an abundance of evidence in the record showing that the transaction was concluded without any thought being given to the question of from whom petitioner Mann was buying the stock or the effect the transaction would have on his income tax liability. His chief concern was to obtain control of the*793 corporation through stock ownership and the best means open to him were utilized to accomplish that end. In 1930 he contended before the Commissioner in protests prepared by counsel employed for that purpose that he purchased the stock from his wife. While there is evidence tending to support Mann's present position, we think the whole record *288 sustains the conclusion that Beatrice Mann was the seller of the stock to him.
The real purpose of the equity suit was to determine ownership of the 248 shares of stock outstanding in the name of Beatrice Mann and the conferences had between the parties to the suit at the time the case was called for trial centered around the value of her interest in the corporation, represented by the stock, and the sale of the stock to petitioner Mann. The corporation was not a party to the suit and did not intervene in the divorce action until after the trial court had entered its judgment, and then only for the purpose of determining the validity of the bonds in the appellate court. The corporation was not a party to the settlement agreement filed in the divorce suit, and no subrogation agreement was ever entered into. Both the settlement*794 agreement and the resolutions adopted by the directors and stockholders of the corporation authorizing the issuance of the bonds show an assignment of the stock to petitioner Mann rather than to the corporation. It does not appear that an adjusting entry was ever made in the capital stock account of the corporation to show a retirement of the stock such as would have been necessary under good accounting practice if the corporation had purchased the stock. The stipulation entered in the divorce suit clearly shows a liability on the part of petitioner Mann to pay the bonds for the stock, and to make weekly payments of $200 on account pending delivery of the securities. We conclude that the transaction resulted in a purchase of the stock by petitioner Mann from his wife.
The substance of the agreement between petitioner, mann and his wife is that she was to receive for her and her sister's stock, a total of 249 shares, the sum of $165,000, with interest at 5 percent per annum, payable, principal and interest, at the rate of $6,000 semiannually, unless the demand were satisfied by a cash payment of the principal amount. Petitioner Mann did not have the funds necessary to close the*795 deal by a cash payment and, accordingly, he caused the corporation to authorize a bond issue in the amount of $165,000, payable in accordance with the terms of the agreement with his wife.
In the final analysis the corporation did nothing more than agree to pay petitioner Mann's obligation as it matured. Neither this promise to pay nor the issuance of the bonds evidencing the promise affected the corporation's surplus, for there was at all times an implied promise on the part of petitioner Mann to reimburse the corporation for all payments it made to liquidate the bonds. He acknowledged such a liability when the question became important. Each payment made by the corporation was on behalf of, and chargeable to, petitioner Mann. In 1928 the corporation paid *289 Beatrice Mann $9,200 to apply against principal and interest on the bonds upon their acceptance by her. This sum was charged to petitioner Mann and a like sum was credited to him as a dividend. Of the sum of $165,000 in question, only $9,200 constitutes a taxable dividend to Mann. See *796 . Cf. ; .
Of the amount of $12,000 paid by the Bismarck Tribune Co. in 1929 to retire its bonds, $7,853.44 represented interest on unpaid principal. This sum was charged to petitioner Mann's personal account in March 1930. He claims that the sum is deductible as interest on indebtedness incurred in the purchase of the stock. Looking through to the ultimate facts we agree with this contention of petitioner. The deferred debt upon which the interest was paid was the debt of petitioner Mann, and through his arrangement with the corporation petitioner Mann paid the interest. We hold the respondent was in error in refusing to allow the amount as a deduction for interest paid by petitioner Mann.
The same amount was claimed by the corporation and allowed by the respondent as interest on the bonds. The respondent now contends that he should not have allowed the deduction on the ground that the bonds do not bear interest.
The bonds do contain a provision that they are without interest, but other documents must be considered to determine the*797 real facts. The clear intent of the settlement agreement between petitioner Mann and his wife was that she should receive for her and her sister's stock, bonds of the Bismarck Tribune Co. of the face amount of $165,000, payable, principal and interest at 5 percent per annum, at the rate of $6,000 semiannually. This definite understanding is set forth in the resolutions adopted by the directors and stockholders of the corporation authorizing the bond issue. The amortization table in the mortgage executed on all of the corporation's real and personal property to secure payment of the bonds is made a part of the bonds by reference. This table shows the amount of principal and interest liquidated by payment of the bonds as they mature, and provides a method for computing different sums in case of prepayment of any bond. The mortgage also provides that the total amount of the bonds represents principal of $165,000 and interest at the rate of 5 percent per annum, payable semiannually, on unpaid balances. The bonds and mortgage disclose a purpose to pay the principal sum of $165,000, with interest, on the terms specified. The evidence is against a holding that the obligation incurred*798 was $276,395.76, without interest, payable $6,000 semiannually. The corporation could have reached the same result by issuing one bond for $165,000, at 5 percent interest, payable, principal and interest, at the rate of $6,000 semiannually. As we have held above, the deferred *290 debt upon which the interest accumulated was the debt of petitioner Mann. Payment of that interest in the way and manner shown by the evidence was payment by Mann and not by the Bismarck Tribune Co. Accordingly, we hold that the allowance of the deduction to the Bismarck Tribune Co. was not proper.
The sum of $7,932.38 was claimed by the Bismarck Tribune Co. as a deduction in 1929 for legal fees and expenses. The respondent disallowed $2,650 as representing personal expenses of petitioner Mann. The corporation contends that the respondent should not have disallowed in excess of $500, the amount allocated and charged to petitioner Mann on the corporate books.
Of the fees in question, $1,950 was charged in 1929 for representing petitioner Mann in the equity suit and $5,000 constitutes the fee charged by counsel for representing the individual and the corporation in the divorce suit and services*799 performed in connection with the bond issue. The corporation was not a party to the equity suit and was not an intervener in the divorce action until after a decree had been entered and then only for the purpose of obtaining a decision by the appellate court on the question of whether or not the bonds were valid. The primary purpose of both proceedings was a settlement of the disagreements between Mann and his wife. The corporation had only a remote interest in the outcome of the litigation. The respondent's action in disallowing $2,650 of the legal fees and expenses as not being an ordinary and necessary expense of the Bismarck Tribune Co. is sustained. .
Decision will be entered under Rule 50.