*555 Petitioner was incorporated in 1908 for the purpose of operating a chain of grocery stores. Very little of its profits has over been distributed to its sole stockholder in the form of dividends. During recent years a large part of its surplus profits has been invested in bonds and stocks, which suffered a large decline in market value during the fiscal year ended January 31, 1931. During that fiscal year, and for a number of years prior thereto, the petitioner loaned to its sole stockholder large amounts of money upon which no interest has been paid to the petitioner. Held that for the fiscal year ended January 31, 1931, the corporation is liable to tax under section 104 of the Revenue Act of 1928.
*163 This is a proceeding for the redetermination of a deficiency in income tax for the fiscal year ended January 31, 1931, of $477,360.68. The petitioner alleges that the respondent erred in holding it liable to tax under section 104 of the Revenue Act of 1928, and also that section*556 104 is unconstitutional.
FINDINGS OF FACT.
The petitioner was incorporated under the laws of the State of New Jersey in 1908 for the purpose of operating a chain of grocery stores. Its authorized capital stock was $5,000, divided into 50 shares of a par value of $100 each. All of the shares were beneficially owned by Henry Kohl. At the time of incorporation the business consisted of three stores. They were all operated upon a "cash and carry" basis. The business prospered and with the profits, all of which were retained in the business, additional stores were acquired. In 1911 there was an amendment to the charter and the capital stock was increased to $200,000, all of which was beneficially owned by Kohl. The capitalization of the company has never been increased from that amount and Kohl and always beneficially owned all of the shares of stock. The annual net profits of the business, as shown by petitioner's books of account for the fiscal years ended January 31, 1923, to January 31, 1931, have always been in excess of $500,000. *164 The net profits for the last four fiscal years above referred to were as follows:
| January 31, 1928 | $818,043.54 |
| January 31, 1929 | 870,144.92 |
| January 31, 1930 | 806,507.32 |
| January 31, 1931 | 786,466.98 |
*557 During the same period petitioner paid a salary to Henry Kohl of $2,000 per week. The number of stores operated at the end of each of the fiscal years ending in 1928, 1929, 1930, and 1931 were 715, 782, 799, and 815, respectively.
For many years the petitioner has contemplated greatly expanding the number of stores operated. For a time it negotiated for the purchase of stores in Paterson, New Jersey, and also for stores in New York City proper, and for a large chain of stores in Brooklyn, New York. The petitioner has not, however, made the contemplated expansions because in the opinion of the petitioner's president, Henry Kohl, the stores could not be purchased at what he regarded as a fair price.
For a long period of years the surplus profits of the business have been invested in stocks and bonds. At the end of the fiscal year January 31, 1931, the petitioner owned shares of stock in 58 industrial corporations, 24 public utilities, 18 insurance companies, 16 investment trusts, and 24 banks, and the bonds of many companies. The surplus was thus invested in order to obtain a greater return therefrom than would have been obtained from bank deposits and with the thought in*558 mind of realizing cash thereon for the purpose of expanding its chain of grocery stores at any time desired.
The only dividends the petitioner has ever paid to its sole stockholder up to January 31, 1931, were a dividend of $25,000 in 1917, and a dividend of a like amount in 1918. Petitioner had, however, advanced money to its sole stockholder to an amount of $394,100 to January 26, 1925. These advances were made on notes bearing interest at 6 percent per annum, although no interest has ever been charged or paid thereon. After January 26, 1925, the petitioner also loaned to its sole stockholder additional amounts on demand notes bearing no interest, and the aggregate amount of the loans to the petitioner up to January 31, 1931, totaled $610,000. During the fiscal year ended January 31, 1931, the petitioner loaned to its sole stockholder, without interest, $140,000, $40,000 of which amount was to enable Kohl to acquire a house in Florida and $100,000 to enable him to make a personal charitable contribution of that amount to a Y.W.C.A. A considerable portion of the loans made to the petitioner was canceled by dividends declared by the petitioner after January 31, 1931, although*559 the outstanding loans to the *165 petitioner on April 23, 1936, still stood at $424,000. The balance sheets of the petitioner for the fiscal years ended January 31, 1928, to January 31, 1931, inclusive, show as follows:
| Fiscal years ended - | ||||
| 1/31/28 | 1/31/29 | 1/31/30 | 1/31/31 | |
| ASSETS | ||||
| Cash | $659,734.40 | $890,397.59 | $1,332,332.28 | $1,405,961.04 |
| Notes receivable | 424,100.00 | 460,000.00 | 470,000.00 | 610,000.00 |
| Accounts receivable | 1,888.82 | 3,975.19 | 26,816.37 | 3,220.85 |
| Inventories | 2,615,057.67 | 2,917,716.55 | 3,189,396.72 | 2,812,939.16 |
| Mortgage | 59,000.00 | 59,000.00 | 59,000.00 | 59,000.00 |
| Bonds | 256,114.76 | 96,820.30 | 59,435.00 | 313,391.27 |
| Stocks | 2,169,687.62 | 2,318,074.13 | 2,720,283.07 | 2,676,061.47 |
| Other | 6,236.39 | 7,425.08 | 10,150.89 | 20,686.18 |
| Deferred | 33,338.64 | 25,685.23 | 31,875.79 | 29,687.74 |
| Permanent | 1,542,129.60 | 1,501,193.83 | 1,345,976.63 | 1,177,489.43 |
| Total | 7,767,287.90 | 8,280,287.90 | 9,245,266.75 | 9,108,437.14 |
| LIABILITIES | ||||
| Notes payable and | ||||
| mortgages | 1,008,750.00 | 700,000.00 | 790,000.00 | |
| Accounts payable | 258,889.61 | 270,318.54 | 371,121.96 | 269,140.49 |
| Accrued | 7,742.15 | 7,385.56 | 19,757.11 | 7,411.70 |
| Reserve income tax | 93,933.45 | 72,035.56 | 52,592.97 | 51,330.42 |
| Reserve insurance | 417,797.77 | 491,032.34 | 565,970.45 | 641,588.99 |
| Capital stock and | ||||
| surplus | 5,980,174.92 | 6,739,515.90 | 7,445,824.26 | 8,138,965.54 |
| Total | 7,767,287.90 | 8,280,287.90 | 9,245,266.75 | 9,108,437.14 |
*560 The fair market value of the securities owned on January 31, 1931, was $2,125,434.50 as against their cost of $2,989,452.74.
The petitioner was availed of during the fiscal year ended January 31, 1931, for the purpose of preventing the imposition of the surtax upon its sole stockholder "through the medium of permitting its gains and profits to accumulate instead of being divided or distributed."
OPINION.
SMITH: The first question presented by this proceeding is whether the petitioner is liable to tax under section 104 of the Revenue Act of 1928 upon its profits for the fiscal year ended January 31, 1931. That section, so far as material to this proceeding, is as follows:
(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, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 13 and shall be computed, *561 collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax.
(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.
*166 In his deficiency notice the respondent stated:
After careful consideration of your protest dated July 19, 1932 and subsequent information furnished this office, the Bureau approves the revenue agent's conclusion that in accordance with the provisions of section 104 of the Revenue Act of 1928 your company has permitted its gains and profits to accumulate beyond the reasonable needs of the business instead of being distributed, which is construed as prima facie evidence of a purpose to prevent imposition of surtax upon its stockholders.
Does the evidence overcome this prima facie presumption? And, if so, was the petitioner "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*562 of being divided or distributed", during the taxable year?
The petitioner was organized for the purpose of operating a chain of grocery stores. For a number of years after its organization the profits of the business were used in extending the chain. At some time prior to 1922 the petitioner began to invest a portion of its surplus profits in the purchase of bonds and stocks. Its balance sheet at January 31, 1922, shows its investment in bonds and stocks at $490,000 and $130,710, respectively. Its holdings of securities in subsequent years greatly increased. There was also, up to 1929, a very large increase in the market value of the securities acquired. Since 1929 the petitioner has not greatly expanded its grocery business. Its profits have been large but they have not been paid over to its sole stockholder in the form of dividends. Most of them have been invested in securities.
Petitioner's balance sheet at the beginning of the taxable year shows cash on hand of $1,332,332.28; notes receivable (Henry Kohl), $470,000; accounts receivable, $26,816.37; bonds, mortgages, and stocks, $2,838,718.07; and other current assets against actual liabilities (exclusive of reserves) *563 of $1,180,879.07. At the end of the taxable year petitioner's belance sheet shows cash, $1,405,961.04; notes receivable (Henry Kohl), $610,000; bonds, mortgages, and stocks, $3,048,452.74; and other current assets against the actual liabilities (exclusive of reserves) of only $276,552.19. Its actual surplus at January 31, 1931, was $7,938,965.54
The petitioner contends that this large surplus was of benefit to it in obtaining credit at banks and in enabling it to purchase merchandise at a low price. It appears, however, that the petitioner's credit had been excellent for many years prior to the taxable year and that it did not obtain loans from banks at a lower rate of interest simply because it had a large investment in bonds and stocks. Manifestly, the amounts invested in bonds and stocks were not used by the petitioner either in the taxable year or for several *167 years prior or subsequent thereto in its grocery business. We find as a fact that the petitioner's accumulation of earnings was far in excess of the "reasonable needs" of the corporate business.
We are also of the opinion that the evidence of record does not rebut the prima facie presumption created by*564 the statute that the accumulation of earnings beyond the "reasonable needs of the business" was for the purpose of preventing the imposition of the surtax upon its sole stockholder. The evidence shows that Henry Kohl, personally, needed some of the profits of the business. Prior to the taxable year he had borrowed from the petitioner $470,000, and, during the taxable year, he borrowed an additional amount of $140,000. No interest was ever charged or paid upon these loans. If the amount borrowed during the taxable year had been distributed as a dividend the petitioner would have been subject to a large surtax upon it. By reason of the failure to pay the $140,000 as a dividend the petitioner escaped surtax upon that amount of income. See .
Upon the evidence before us we have made the finding that the petitioner was "availed of" during the fiscal year ended January 31, 1931, for the purpose of preventing the imposition of the surtax upon its sole stockholder "through the medium of permitting its gains and profits to accumulate instead of being divided or distributed." Cf. *565 ; .
The petitioner contends that: "Section 104 of the Revenue Act of 1928, as construed and applied by the Commissioner of Internal Revenue, or his deputy, to the income of petitioner for the fiscal year ending January 31, 1931, violates rights secured to the petitioner under the Constitution of the United States." It has not, however, advanced any argument in support of this proposition in its brief, and the constitutionality of the provision is sustained upon the authority of ; certiorari denied, ; ; ; .
Reviewed by the Board.
Judgment will be entered for the respondent.
MELLOTT, dissenting: The majority holding, that the act is not unconstitutional, is, in my judgment, correct. I have considerable doubt, however, *566 that the tax and penalty prescribed by it should be assessed and imposed under the facts before us.
*168 The petitioner corporation was not formed for the purpose of preventing the imposition of the surtax upon its shareholders. It was formed many years prior to the enactment of the income tax law and for the purpose, as set out in the prevailing opinion, "of operating a chain of grocery stores."
Was it "availed of" during the taxable year for the inhibited purpose? The respondent contends that it was. In his notice of deficiency it is stated that he "approves the revenue agent's conclusion that * * * [it] * * * permitted its gains and profits to accumulate beyond the reasonable needs of the business." Such determination apparently was made under section 104(b) of the Revenue Act of 1928, which prescribes that such a finding is prima facie evidence of a purpose to evade the surtax.
It may, or may not, be significant that the respondent did not categorically find that petitioner was "availed of" for the interdicted purpose; but such finding must be made by this Board if it is to approve the deficiency. Before we make such finding, however, there should be at least*567 a fair preponderance of the evidence to support it, and I am not satisfied that such requirement has been met.
The prevailing opinion makes reference to three or four facts relied upon as being particularly significant - that the profits, though large, were not paid over to the sole stockholder in the form of dividends but were invested partially in securities; that the surplus increased during the taxable year; and that the sole stockholder borrowed from the petitioner certain sums of money without interest. These are circumstances which should be considered, but I do not think, upon this record, that they are so indicative of the nefarious purpose as to compel the conclusion reached by the majority.
The respondent offered no evidence, except a statement of the cost and market value of the securities, prepared from the books of the company, and the income tax returns of the petitioner and its sole stockholder. The petitioner produced several witnesses. At the risk of unduly extending this discussion, I feel impelled to make reference to some of the facts established by the evidence.
The treasurer of the company, who had been associated with the sole stockholder for more*568 than 30 years, stated that, in her opinion, the surplus was not in excess of the reasonable needs of the business. She testified that to carry on the business, to buy the large quantities of merchandise required, and to pay the other expenses of the business, required a large surplus and that even with the large surplus on hand, there were times when the company was short of cash and had to borrow temporarily from the banks in order to pay the invoices of incoming merchandise.
*169 Kohl, the sole stockholder, when asked why he kept all of the earnings of the company in the business instead of drawing them out, stated, "I needed them in the business - always needed them in the business. I never had any too much money." He also stated that he always tried to hold the corporation ready at all times to buy, if necessary, a whole year's supply of merchandise, if he thought that it could make money by doing so. When asked if, in his judgment, it was necessary for it to be continuously in the position of purchasing supplies in such quantity, he answered: "Well, the more money you have got, the cheaper you can buy and the more independent you are and the more you are recognized*569 - and everything depends upon your statement, see?" It had been the policy of the business since its establishment "to keep in the statement and in the business every possible dollar and let them accumulate for the benefit of the business." From the very beginning the sole stockholder had followed the policy of living simply, drawing only enough salary to live on and confining his expenditures outside of the business to his living expenses. In its first year the company operated three stores; in 1912, 57; in 1915, 171; in 1918, 268; in 1923, 388; and, as shown in the findings above, in 1928, 715, and in 1931, 815. This growth corresponded in a general way with the ambition of the sole stockholder, one witness telling us that when he had 3 stores his ambition was to have 10; when he had 10, his ambition was to have 50; when he had 50, then to have 100, then 500, then 1,000, etc. With this idea in mind the warehouses, garages, bakery, and other facilities of the petitioner were expanded accordingly and such facilities now have sufficient capacity to take care of twice the number of stores which it owned during the taxable year.
Kohl further testified that before 1930 he had considered*570 the purchase of a chain of stores in Paterson, New Jersey. During that year he also carried on negotiations with the owner of some 500 or 600 stores for their purchase. This was a business of from $5,000,000 to $6,000,000. While the stores were not actually purchased during the taxable year, the fact that such purchase was contemplated is a significant circumstance which should be considered by this Board in passing upon the question at issue.
Petitioner sold approximately $20,000,000 worth of merchandise during the taxable year, and, by taking advantage of its discounts, earned almost a half million dollars. Its pay roll and rents alone amounted to $4,000,000 a year. During the taxable year it paid Federal income taxes of $103,616.60. If it and its officers had wished to avoid paying Federal taxes, a method far more efficacious than accumulating "an unreasonable surplus" could have been adopted. *170 For instance, it could have sold some of its securities, which had depreciated in value more than a million dollars, deducted its loss, and thus not only could have saved on its income tax for that year, but in addition could have adjusted its surplus and earnings so*571 that its books would show an actual loss for the taxable year instead of a gain or profit.
The petitioner paid its sole stockholder more than $100,000 a year as a salary. This was reported by him in his income tax return and tax was paid accordingly. It was ample for his ordinary living expenses and there was apparently no good reason why he should pay out any more of the earnings of the corporation to himself. He paid a surtax of more than $8,000 on his salary and a total tax of more than $11,000 for each of the four years 1928 to 1931, inclusive.
William J. Field, president of a large bank, testified that in his opinion the capital and surplus of petitioner was not in excess of the reasonable needs of the business, pointing out that at that time "we were starting on a panic and panic conditions. No one could foretell the future at that time. The National Grocery Co. had a turn-over of over six to eight times its capital in the volume of business it did in those years * * *. They had experienced in previous years rather large losses on inventory and felt they should keep a considerable working capital and surplus to meet any additional losses they might encounter." He*572 also pointed out that the accumulation in surplus invested in securities enabled it to show a better credit statement and to borrow whenever it wished at low rates of interest. Frank C. Ferguson, another bank president, testified to substantially the same effect.
Another circumstance worthy of more than passing consideration is the fact that petitioner's real estate holdings, as well as its stocks and bonds, had materially depreciated in value. This depreciation, though it had not been reflected in the balance sheet, was nevertheless a very real thing. The stocks and bonds had depreciated more than $900,000. The merchandise inventory, due to the general decline, had decreased approximately a quarter of a million dollars, while the fair market value of the real estate had a shrinkage in value, over and above the depreciation charged off, amounting to approximately $125,000.
Being concerned, as we are, with actualities - a rule which certainly should be applied when we are passing upon the applicability of a penal statute such as we have before us, and regardless of the fact that the books of the company reflected an addition to surplus, the above evidence clearly shows that*573 during the taxable period before us there was no unreasonable accumulation of gains and profits.
*171 Congress was very careful to limit this highly penal statute to corporations which were formed or availed of for the purpose of avoiding the imposition of surtax upon the shareholders. In the first case which came before this Board under the section as originally enacted (; affd., ; certiorari denied, ), both this Board and the Circuit Court upon appeal properly stressed the importance of establishing by the evidence the unlawful purpose. It was there pointed out that if such unlawful purpose was shown to exist, then it was immaterial whether the accumulation be large or small. The ultimate question before us, then, is, was there a purpose to enable the shareholder to escape surtaxes. The test, said the Second Circuit Court of Appeals in
The inquiry as to whether there has been an accumulation of surplus beyond the reasonable needs of the business is not determinative of the ultimate question to be decided. Even if the evidence be sufficient to show that there was an unreasonable accumulation - which, however, I do not believe has been shown in this case - this merely raises a rebuttable presumption of the existence of the crucial purpose. Such presumption is overcome by the evidence in this case which shows an absence of such purpose. The corporation merely continued its long established practice of "ploughing its earnings back into the business." Indubitably it had in the earlier years no "purpose of preventing the imposition of the surtax upon its shareholders", for there was no surtax to escape. There had been no "sudden change of policy, coincident with large increases in the surtax rates, (which) might * * * betray a purpose to accumulate against*575 a season more propitious for distribution." (
In (on appeal to the 9th Circuit), the facts made a much stronger case for the respondent than the facts before us here; but it was pointed out that the taxes and penalties prescribed by the section "are not imposed because of effects; avoidance per se is not prohibited. It is the purpose, the intention motivating a course of conduct which is made controlling by the very words of the statute. Unless the purpose was to prevent *172 the imposition of surtaxes, the tax may not be imposed." This language was recently quoted and reaffirmed by the Board in , and in the very last case which we decided under this section, Almours Securities, Inc., 35 B.T.A. No. 11, the Board said, "There must be such an intent on the part of those who were responsible for the organization of the corporation, or for the conduct of its operations." In the DeMille case it was pointed out that the proof went well beyond mere denial*576 of prohibited intent and showed affirmatively a plan necessitating the accumulation of earnings and "the end to which they might ultimately be used." The same, or stronger, language might be used here.
No case has come before the courts or this Board where a corporation engaged in a mercantile or industrial activity, organized prior to the enactment of the income tax law and which has consistently followed the policy of "ploughing its earnings back into the business", has ever been required to pay the tax and penalty imposed by the section in question. In practically every case in which such penalty has been imposed, a large portion of the corporation's assets had been conveyed to it at the time of its formation, or at a later time, by the principal stockholder or stockholders, or the corporation was "a mere holding company." Typical cases are the following:
This being a "fact case", it is with some reluctance that I reach a conclusion at variance with that of the Member who heard the testimony of the witnesses and had the advantage of observing their manner and demeanor while testifying; but I feel that the evidence is not sufficient to justify the imposition of the penalty and accordingly I dissent.
STERNHAGEN, ARUNDELL, *578 MURDOCK, LEECH, ARNOLD, and DISNEY agree with this dissent.