Dill Mfg. Co. v. Commissioner , 39 B.T.A. 1023 ( 1939 )

THE DILL MANUFACTURING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Dill Mfg. Co. v. Commissioner

Docket No. 89583.

United States Board of Tax Appeals

39 B.T.A. 1023; 1939 BTA LEXIS 944;

May 24, 1939, Promulgated

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">*944 1. Petitioner was a manufacturing corporation, organized in 1909. Because of dissension between its majority and minority stockholders, it acquired the stockholdings of the latter in 1932. This stock was immediately retired and the stated capital reduced. As a part of the consideration for this stock, petitioner transferred to the stockholders United States bonds, having a face value of $200,000, which had cost petitioner $202,687.51, and a then market value of $170,562.50. The contract for the acquisition of the minority stock provided for the payment of $188,000 in assets of the petitioner, of which the sum of $176,000 was to be payable by delivery of United States bonds in a face value of $200,000. Held, the transaction constituted a partial liquidation and the transfer of the United States bonds was a distribution in kind upon which no gain or loss was sustained by the petitioner.

2. Respondent failed to sustain his burden here of establishing that petitioner, a manufacturing and not a holding company, was "formed or availed of [during the taxable year] for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting">*945 its gains and profits to accumulate instead of being divided or distributed," and petitioner is, therefore, not subject to the tax which respondent, in this proceeding, affirmatively alleges is due under section 104 of the Revenue Act of 1932.

F. E. Gleach, Esq., and H. A. Mihills, C.P.A., for the petitioner.

Elmer L. Corbin, Esq., H. D. Thomas, Esq., and A. D. King, Esq., for the respondent.

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LEECH

">*1023 Respondent determined a deficiency of $4,992.92 in petitioner's income tax for the fiscal year ending November 30, 1932. The deficiency arose, primarily, from the disallowance of a deduction of $32,125.01, taken by petitioner on its return for that year, which was alleged to constitute a loss sustained on its disposition of United States bonds. Subsequent to the filing of the petition and answer in this proceeding, respondent, by amended answer, asked an increase of the deficiency in the amount of $105,087.02, because of his proposed imposition of the 50 percent penalty of petitioner's net income for that year, under the provisions of section 104 of the Revenue Act of 1932. Respondent affirmatively alleges that petitioner was availed">*946 of, during the tax year, for the purpose of preventing the imposition of surtax upon its shareholders through the medium of permitting its gains and profits to accumulate beyond the reasonable needs of its business.

">*1024 FINDINGS OF FACT.

Petitioner was organized in 1909 under the laws of Ohio. Its authorized and issued stock was 50 shares of a par value of $100. It was organized by three men for the manufacture of dust caps for automobile tire valves. These men have always directed the activities of the company and now own, as they did originally, all of its capital stock. From the date of its organization, petitioner was successful. But, due to its extremely limited capital, its organizers pursued the policy of investing its earnings in additional plant facilities to take care of the increase in its business. In 1925, as a result of competition, it became necessary for petitioner to expand the scope of its manufacture. Therefore, it undertook the manufacture of the entire automobile tire valve.

This change and expansion necessitated a heavy financial outlay for plant facilities, since the machines used in this additional operation were different from those">*947 it had formerly used. At this time, petitioner's accumulated surplus was approximately $382,000, but almost all of it was invested in plant, equipment, and inventory. In order to secure the essential funds for this necessary change and expansion in operations, in 1925, petitioner procured an investment in the company by a syndicate headed by A. C. Ernst and R. V. Mitchell (hereinafter called the syndicate).

At the time of this investment, the petitioner was reorganized and recapitalized by the cancellation of its original stock and the issuance of 50,000 shares of common stock, without par value. Of these 50,000 shares, 38,890 were issued to the original stockholders for the 50 shares then held by them. The balance, 11,110 shares, was issued to the syndicate for $200,000 cash. The original stockholders then sold to the syndicate 13,880 shares of the 38,890 shares issued to them, whereupon the original stockholders owned 25,010 shares and the syndicate 24,990 shares of the total of 50,000 shares issued. The original stockholders, in their income tax returns for 1925, reported their gains upon their sales of stock to the syndicate and paid the income tax thereon.

The additional">*948 capital thus obtained by petitioner was invested in the facilities needed for the change and expansion of the manufacturing plant. These funds were inadequate, since the cost of the changes was in excess of $750,000. The necessary additional funds were provided through loans from banks and from the earnings of the petitioner in subsequent years.

This expansion proved successful. The corporate earnings had decreased steadily from a high of $94,082.74 in 1921, to $31,299 in 1924. They increased in 1925 to $166,137.40; in 1926 to $104,265.62; and in 1927 to $106,283.79. During these last three years, no dividends ">*1025 were paid and the earnings were used to defray the additional cost of the expansion program over and above the amount invested by the syndicate and the bank loans for that purpose. From 1928 through 1933, dividends were paid by petitioner, as follows:

1928	$40,000.00
1929	50,000.00
1930	50,000.00
1931	$50,000.00
1932	48,152.98
1933	106,441.40

During this same period, petitioner's net earnings were:

1928	$153,706.90
1929	107,318.51
1930	90,757.90
1931	$245,816.10
1932	210,174.03
1933	283,427.34

The">*949 balance sheet of the petitioner for the years indicated follows:

	1931	1932	1933
Assets
Cash	$149,554.23	$343,959.08	$162,126.86
Notes receivable	13,790.88	31,818.94	46,088.46
Accounts receivable	110,279.03	88,057.28	120,221.88
Less: Reserve for bad debts	(10,000.00)	(20,000.00)	(20,000.00)
U.S. Gov't. claims
Inventories	350,131.81	311,770.65	409,765.97
Investments: (nontaxable) U.S. Obligations	320,071.41	93,774.42	342,796.09
Other investments:
Preferred stock (treasury)		47,727.00	79,897.50
Deferred charges:
Insurance	1,695.76	2,296.21	1,802.99
Taxes	77.42	605.43	7,097.80
Other
Plant and equipment	656,916.25	660,868.21	519,450.38
Less: Reserve for depreciation	(316,707.29)	(353,723.58)	(239,755.99)
Patents	1.00	1.00	1.00
Deposits in closed banks			111,214.72
Less: Reserve			(96,257.14)
Deposits and other investments	6,754.22	6,378.32	6,031.16
Associated Co. account	56,417.51	58,093.85	48,317.77
Misc. accounts receivable	1,355.63	1,681.78	1,625.17
Total assets	1,340,337.86	1,273,308.59	1,500,424.62
Liabilities
Notes payable
Accounts payable	$39,914.38	$50,516.36	$68,396.66
Accrued expense:
Interest
Dividends payable	12,500.00	11,467.00	71,689.50
Taxes	3,501.52	3,080.52	10,206.51
Other	250.00	801.39	334.60
Reserve for contingencies	17,000.00	17,000.00	31,955.58
Reserve for Federal tax	29,679.59	23,100.00	41,000.00
Reserve for loss	37,872.31	44,553.42	30,683.31
Reserve for depreciation
Preferred stock		425,000.00	399,700.00
Common stock	700,000.00	100,000.00	100,000.00
Surplus	499,620.06	597,789.90	746,458.46
Surplus - capital
Total liabilities	1,340,337.86	1,273,308.59	1,500,424.62

">*950 The valve manufactured by petitioner contained a metal stem. Metal stem valves underwent numerous alterations because of changes in wheel design. This not only adversely affected petitioner's sales from 1925 to 1932, but also bred the necessity for numerous changes in manufacturing machinery, and caused obsolescence of existing equipment. A large portion of such equipment of petitioner had to be replaced. Further expansion was occasioned ">*1026 by patent research and investigations of the changes in valve designs, to enable petitioner to keep pace with the various modifications demanded by its customers. Competition was keen. The Firestone Tire & Rubber Co., which had been trying to make its own valves with metal stems purchased from petitioner, turned its business over to the Bridgeport Brass Co. in 1931. The latter, and another big competitor of petitioner, A. Schroeder & Sons Co., had a competitive advantage over petitioner in having their own brass mills, while petitioner was required to buy its brass from outsiders. Petitioner used large quantities of brass and copper. The market for these materials fluctuated. Petitioner's purchases of them, in some years, aggregated">*951 as much as $300,000. To secure these metals at an advantageous price, it was necessary for petitioner to make commitments in advance and to maintain a substantial amount in cash and liquid securities in order to take advantage of fluctuations in the market. In this connection, it had been its practice to invest considerable sums of cash on hand in United States bonds instead of depositing these funds in banks. The interest return from this investment was comparable to or exceeded the interest returns paid on bank deposits in the community in which petitioner was located, and such investment was safer. The sums thus invested in United States bonds, which began in 1919 with an investment of $10,635.70, varied from a low in 1924 of $906.44 to a high of $342,796.09 in 1933.

Subsequent to 1925 and the investment by the syndicate in petitioner's business, and prior to 1930, it became evident that further expansion and diversification of the manufacturing operations of petitioner were necessary if it was to continue, securely, as an independent concern. In its efforts to thus compensate for its actual and expected loss of the valve business, petitioner spent a substantial amount of">*952 time and money in the investigation, patenting, perfecting, manufacturing, and sale of new products. In 1929 and 1930 experiments were conducted with a permanent wave machine, which proved unsuccessful and cost petitioner $150,000. In 1932, a device for patching tires was developed, which proved successful. Other products investigated included a tire inflation device and cake mixer. These efforts, as well as others in the same category, all required the use of a comparatively large amount of cash, particularly since it had been the experience of the organizers of petitioner, who continued as its active operating heads, that these expenditures were, in most cases, substantially in excess of their estimated cost. Further, as matters existed in 1932, the granting of certain patent applications would have resulted in the need for large capital outlays for the production of new articles.

Beginning in 1930, petitioner began to suffer competition from a type of automobile tire valve that was made with a rubber stem ">*1027 instead of a metal one. One of petitioner's customers, a large tire company, began making these valves itself, which indicated that it, as well as other companies, ">*953 would thereafter buy from petitioner only a small brass insert for the valve instead of the entire unit. The metal stem business declined. It thus became necessary for petitioner to install entirely new equipment for the rubber stem valves. During the years from 1932 to 1937, machinery costing the petitioner $87,858.36 for the making of the metal stem valves was scrapped. During the same period, new rubber stem equipment was bought, costing petitioner $134,725.94.

Petitioner was handicapped by insufficient plant space because of the installation of new equipment. In 1929, it bought land upon which to erect a new plant which was then estimated to cost $450,000. The cost of moving to the new plant and loss of business from such transfer will exceed the cost of the new construction. It negotiated with the Nickel Plate Railroad Co. for a railroad switch therefor. In the tax year, petitioner set up a reserve for this renewal and expansion of its plant facilities. In the fiscal year ending in 1933, petitioner purchased United States bonds with $320,000. These bonds, in the amount of $204,591.08, were placed in this reserve fund and the balance was held for inventory purchases. ">*954 The plans for new construction were interrupted by the 1929 financial crash, and the petitioner, though still owning and paying taxes on the land upon which the new plant is to be erected, is still awaiting an appropriate time to begin construction.

The consistent policy of petitioner's operating group, consisting of its organizers, was to secure the financial and economic independence of petitioner. In doing so, the earnings in excess of the dividends paid were retained.

The syndicate members had expected larger dividend returns, but realized the soundness of the policy of the operating group if petitioner was to continue secure, as an independent manufacturing company. However, the syndicate group desired to sell the business or to merge it with a bigger concern, in which event it could be operated as a branch of the larger business. The operating group opposed this, since it had been so successful and represented their life work.

As a result of this dissension, a plan was formulated by the operating group to buy the syndicate holdings and retire that stock. This plan culminated in an offer by the operating group to the members of the syndicate, providing for the acquisition">*955 of the stockholdings of the latter by petitioner. It was originally intended that the members of the operating group sell the syndicate ten additional shares of common stock, that the charter of petitioner be amended to authorize the issuance of 4,250 shares of preferred stock, with a ">*1028 par value of $100, and that the 25,000 shares of common stock then held by the syndicate be acquired by petitioner in exchange for this preferred stock and $188,000, in cash. Because of the inability of petitioner to raise that sum in cash, the plan, as evidenced by the written proposal, provided for the delivery by petitioner to the syndicate of $12,000 cash and United States bonds, owned by petitioner, with a par value of $200,000, which had a then market value of $176,000. Under this plan, the 25,000 shares of common stock acquired from the syndicate were to be retired and the stated capital of petitioner reduced from $700,000 to $100,000. The offer of the operating group was accepted, with slight modification, the transaction was carried out, and the 25,000 shares of common stock thus acquired by petitioner were retired and its stated capital thus reduced.

The petitioner agreed">*956 to retire the preferred stock thus received by the syndicate members within five years, at an annual minimum rate. This preferred stock issue was so used to avoid jeopardizing the financial and business position of the petitioner. The United States bonds which petitioner delivered to the syndicate cost it $202,687.51. When their transfer to the syndicate was consummated, their market value had decreased to $170,562.50, which was below the amount at which the syndicate was to accept them. However, in view of the agreement, upon receipt of these bonds, petitioner was credited in the amount of $176,000 on account of its $188,000 obligation. In its return for the taxable fiscal year, petitioner deducted as a loss upon its disposition of these bonds the difference between their cost to it and the market price of the bonds on the date of the transfer to the syndicate.

The three organizers and officers of the petitioner who are now the owners of all of its stock received the same salaries for the fiscal years ending in 1931, 1932, and 1933, which were, respectively, $15,000, $14,625, and $13,500.

The preferred stock of a par value of $425,000, issued by petitioner in 1932 to the">*957 syndicate as part of the consideration in the acquisition of the common stock of the syndicate, was all retired by the year 1937. During the fiscal year 1932, $47,727 was expended by petitioner on this account.

The shareholders of petitioner paid less surtax for the taxable year than they would have been obliged to pay if the earnings of petitioner for that year had been distributed to them.

Respondent has not sustained his burden of establishing that petitioner was "formed or availed of [during 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."

">*1029 OPINION.

LEECH: In the first issue, respondent bases his disallowance of a deduction for loss on the United States bonds on that part of Regulations 77, article 71, which reads as follows: "* * * No gain or loss is realized by a corporation from the mere distribution of its assets in kind in partial or complete liquidation, however they may be appreciated or depreciated in value since their acquisition * * *."

">*958 Similar regulations, with slight differences in wording immaterial here, have been in force since the Revenue Act of 1918. Because such regulations had long been in force without change in the law, Regulations 69, article 548, the prototype of and substantially similar for present purposes to the quoted regulations, was held to be valid in , although there it was found no distribution in kind on dissolution occurred. See also . A like conclusion of validity was reached in . In that case, a bank, in competition with the petitioner bank, acquired all of petitioner's outstanding stock through a nominee, and turned it over to the latter. Petitioner thereupon conveyed all of its assets to the competing bank, then the sole stockholder, and dissolved. The stock was surrendered for cancellation. It was held on the basis of the same regulation that the petitioner had realized no gain or loss when it distributed its assets to its sole stockholder in complete liquidation.

">*959 Distributions in complete or partial liquidation result in no gain or loss to the distributing corporation. , affirming ; ; affd., ; ; .

Was the transfer of cash, preferred stock, the United States bonds to the syndicate, in exchange for 25,000 shares of common stock in petitioner, a distribution in partial liquidation of petitioner?

The original intention of the parties may have been that the petitioner should acquire the syndicate's common stock with its preferred stock and cash. However, that intention was abandoned. It was not carried out. Petitioner did not, in fact, do that, and the fact controls the tax incidence here. ; ; ">*960 ; ; affd., . The plan, finally adopted and executed, obligated the petitioner to deliver to the syndicate, preferred stock, cash, and United States bonds. The obligation to deliver United States bonds was not a debt payable in money. It could not have been satisfied except ">*1030 by the transfer of those bonds, assets of the petitioner. See

The position of petitioner is that since it had no intention to liquidate any portion of its business in the acquisition of this stock interest, no liquidation occurred. However, absence of intent does not contradict the statutory status of liquidation if, in fact, a liquidation occurred, by the cancellation or redemption of capital stock. ; .

Here a partial liquidation actually occurred. The capitalization of petitioner was reduced from $700,000 to $100,000. The 25,000 shares of common stock, so reacquired, were not held in petitioner's">*961 treasury for resale but were canceled and retired. The authorized capital stock of petitioner was reduced from 50,000 to 25,000 shares. Cf. .

It follows that petitioner suffered no allowable loss by the distribution of the United States bonds as a part consideration for 25,000 shares of its outstanding common stock.

The second issue is raised by the affirmative allegation in respondent's amended answer that petitioner is subject to the 50 percent penalty of net income for the taxable year, under section 104 of the Revenue Act of 1932, and the consequent request for an increase in the deficiency of $4,992.92, as determined, to the sum of $110,079.94.

Respondent supports this allegation on the ground that petitioner was "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." Respondent has the burden of proof. Rule 32 of the Board's Rules of Practice; ">*962 .

It may be conceded that the shareholders of petitioner would have been obliged to pay surtaxes in a larger amount if more of petitioner's gains and profits had been distributed during the taxable year. "But the taxes under these statutory provisions 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 the imposition of surtaxes, the tax may not be imposed." ; affd., ; certiorari denied, .

True, the proscribed purpose may be evidenced in many ways. See ; certiorari denied, ; . But the contested tax is "highly penal" and thus "While the plain intent of such a statute must be ">*1031 given full effect, ">*963 it should be strictly construed and should not be extended to cover cases which do not fall within its letter."

Since the respondent has the burden of proof and petitioner is not a holding company, no presumption of the existence of the proscribed purpose may be indulged here until it be established by the weight of the evidence that there was an unnecessary accumulation of gains and profits. Moreover, respondent is limited to the contention, as he admits, that petitioner "was availed of" during the taxable year, for the prohibited purpose. The respondent argues that the record sustains his burden of establishing that in the taxable year petitioner permitted its gains and profits to accumulate beyond the reasonable needs of its business and that the consequent presumption of the existence of the penalized purpose has not been overcome. See .

The question of what are reasonable or unreasonable needs of business is always one of fact. The answer is rarely easy to find. However, the law does not require that "a business should remain static; ">*964 it must be assumed that any business shall have the right to grow." A fortiori, a corporation certainly must have the untrammeled right, within reasonable limits, to financially protect itself and its shareholders.

Justice Holmes once said "A page of history is worth a volume of logic." . Thus, the economic history of the country and this company is both pertinent and illuminating. So, particularly where, as here, the petitioner is not a holding company but is engaged in a manufacturing business, which is so obviously hazardous from a business viewpoint, we will hesitate before substituting our judgment upon the reasonableness of the corporate accumulations, for that of the directors. See .

The attitude of petitioner toward its earlier gains and profits may have a bearing upon the reasonableness of the accumulation existing in the tax year. See ; and ">*965 But respondent points to the large corporate surplus account of petitioner in the tax year as constituting "accumulated gains and profits" under the act. However, the greater part of this surplus is the result of accumulations over many years and represents physical plant and improved manufacturing facilities by which the petitioner has been enabled to sustain and increase its income upon which it has already paid income tax.

Little benefit can be obtained by repeating the evidence here. That the plant and production facilities represented by such a large part of petitioner's accumulations were actually used in its business ">*1032 can scarcely be doubted. Nor, in view of the evidence, does it seem any less certain that they were reasonably needed in the business.

The Board has said in , that:

* * * No corporation which is actively engaged in business is to be subjected to the penalty of the statute unless and until it permits its course of conduct to be diverted from its normal business interests by a purpose to save its stockholders from surtax.

">*966 Respondent argues that the liquidation of the syndicate common stock was planned when the syndicate bought that stock in 1925; that this was a diversion from its ordinary business interests for the purpose of saving surtax to its stockholders and that this procedure can be repeated and thus deprive the Government of its taxes unless the penalty is imposed here. The answer is that the existence of no such plan is disclosed. In fact, we are convinced the plan to liquidate was born when the liquidation occurred as the result of the petitioner's then pressing and reasonable business need.

At the close of the fiscal year ended in 1931, petitioner had cash on hand in the amount of $149,554.23, and Government bonds which cost it $320,071.41. During the fiscal year ended in 1932, here involved, it realized net earnings of $210,174.03. At the close of the latter year, it had cash on hand in the amount of $343,959.08 and United States bonds which cost it $93,774.42. During this year it had expended about $200,000 in liquidating the common stock interest of the syndicate, and, in addition thereto, it had paid dividends for that year in the amount of $48,152.98.

">*967 Investments in securities of outside companies may be evidence that the funds thus used were not reasonably necessary in a corporate business. See . But such an investment is a far cry from the purchase of Government bonds here. Such investment, per se, is not evidence in the present circumstances of the absence of reasonable necessity for the retention of the funds thus used. Nor is that conclusion affected by the facts that the preferred stock was being acquired by petitioner at a price under par and retired, that its earnings for the taxable year, in the amount of $47,727, were used in that acquisition and that the entire preferred issue was retired before maturity. The amount of these investments in Government bonds, just as the cash on hand, is their only value as evidence in the present situation.

More might be said. But, in the face of this record, the conclusion seems inescapable that petitioner has not "[permitted] its course of conduct to be diverted from its normal business interest by a purpose to save its stockholders from surtax." ">*968

">*1033 The consistently conservative policy of petitioner's management was merely continued through the tax year. It is not disclosed that the petitioner loaned money to its shareholders either with or without interest. See ; affd., ; certiorari denied, ; ; and Not only that, but the salaries of its officers were actually reduced for the taxable year. The petitioner constituted the life work of its operating officers. They had built it and were proud of it. The protection of the economic and financial independence of that work was scarcely less warranted as a business purpose than if petitioner had been an individual.

The issue of preferred stock with the obligation to retire it within five years evidenced a debt. ; ">*969 ; ; affd., . And this record, at most, does not establish that the liquidation of the syndicate stock by the partial use of that preferred stock, under the circumstances here, was not required by a reasonable business necessity. Cf. ; .

The dividend policy of petitioner may have been conservative. The company was successful. However, on the whole record, it certainly has not been established that petitioner, during the taxable year, permitted its gains and profits to accumulate beyond the reasonable needs of its business. And, even if it had been so established, we believe the same record conclusively overcomes any presumption that such accumulations and the failure to distribute them as dividends were permitted "for the purpose of preventing the imposition of the surtax upon [petitioner's] * * * shareholders." It follows that the contested penalty proposed under section 104 of the Revenue Act of 1932, falls.

">*970 Decision will be entered under Rule 50.