#### SILVERTOWN MOTOR CO. v. THE UNITED STATES

[No. E-75.

*Decided May 3, 1926]*

*On the Proofs*

*Income mid excess-profits taxes; deduction for ivitlidrawul.*— Where the controlling stockholder of a corporation causes to be withdrawn therefrom a sum of money over and above all credits due him, applies said sum to his personal debts and thereafter becomes insolvent, and the corporation is unable to collect the same, it is not a loss deductible from gross income within the meaning of section 234 (a) (4) and (5), revenue act of February 24, 1919, 40 Stat. 1057, 1078.

*The Reporter's*statement of the case:

*Mr. Joseph W. Bucle*for the plaintiff.

*Mr. Alexander H. McCormick,*with whom was *Mr. Assistant Attorney General Herman J. Galloway,*for the defendant.

The court made special findings of fact, as follows:

I. The plaintiff, Silvertown Motor Co. (Inc.), is a New York corporation with its principal office in Elmira, N. Y. The LaFrance Garage Co. was a New York corporation engaged during 1919 in the general garage business, and during the first nine months of 1919 acted as agents and distributors for the Studebaker and Chevrolet automobiles in Elmira, N. Y., and Williamsport, Pa.; and for the Studebaker and Dodge automobiles in Binghamton, N. Y. On or about November 30, 1921, the plaintiff merged the LaFrance Garage Co., under the provisions of section 15 of the stock *172corporation law of the State of New York, and, as a result thereof, acquired and became possessed of all estate, property, rights, and franchises of the LaFrance Garage Co.

II. The LaFrance Garage Co., in accordance with the revenue act of 1918, made a return to the Commissioner of Internal Revenue of its income for the calendar year 1919, showing a net taxable income of $1,344.59, which said net income did not include the sum of $39,230.62, being an amount over and above all credits for salary, dividends, and other credits shown on its books as having been withdrawn by Coleman T. LaFrance, its president and principal stockholder, between September 15, 1919, and December 31, 1919, which said sum was taken as a loss or deduction in computing said net income.

III. Upon a reexamination of the tax return for 1919, the Commissioner of Internal Revenue refused to allow said sum of $39,230.62 as a deduction in computing taxable income, alleging and claiming that this amount represented a dividend to said Coleman T. LaFrance; and also made certain other minor adjustments of income to which the plaintiff herein does not object, and determined the net taxable income of the LaFrance Garage Co. for the year 1919 to be $41,513.62; and made an assessment of additional income and profits tax based on such amended income in the sum of $14,756.27, which sum plaintiff was required to pay and did pay under protest on or about November 2, 1923.

IY. On or about November 29,1923, plaintiff filed a claim for the refund of said additional tax with the Commissioner of Internal Revenue, claiming that the amount of $39,230.62 withdrawn by Coleman T. LaFrance represented a deductible expense or loss from gross income.

V. On September 15, 1919; the board of directors of the LaFrance Garage Co. passed a resolution fixing the salary of Coleman T. LaFrance at $12,000 for 1919, while on the books of the LaFrance Garage Co., Coleman T. LaFrance was credited with only $2,300 for salary for that year. The Commissioner of Internal Revenue subsequently allowed as a deduction in computing net income for the year 1919 an additional $9,700 as salary for Coleman T. LaFrance, and *173on or about May 22, 1924, allowed and recommended the refund of $4,462 of plaintiff’s claim for refund, which sum was subsequently paid to the plaintiff, and, at the same time, the Commissioner of Internal Revenue rejected tire balance of plaintiff’s claim and refused to refund the balance of $10,265.97, this being the tax on the $29,530.62 balance of the Coleman T. LaFrance account which the Commissioner of Internal Revenue refused to allow as a deduction in computing net income.

YI. For several years prior to September 15, 1919, the principa. 1 owners of the capital stock of the LaFrance Garage Co. were A. Ward LaFrance and Coleman T. LaFrance. During this period the garage company enjoyed a profitable and growing business. A. Ward LaFrance was president of the company until 1917, when he became interested in another venture and gave up active management of the company, although retaining his stock interest. Thereafter Coleman T. LaFrance was elected president, which office he retained until after December 31, 1919.

On or about September 15, 1919, Coleman T. LaFrance purchased from A. Ward LaFrance, and from certain other minority holders, their common and preferred stock, so that from and after September 15, 1919, and during the balance of the year Coleman T. LaFrance owned $32,400 par value of common stock and $1,400 par value of preferred stock of the LaFrance Garage Co., out of a total of $32,400 par value of common stock and $12,400 of preferred, authorized, and outstanding.

From September 15, 1919, to the end of the year the company was managed by a board of three directors selected and controlled by Coleman T. LaFrance. These directors, other than Coleman T. LaFrance, did not own any of the stock of said company, and it does not appear that they even held qualifying shares.

VII. Coleman T. LaFrance obtained a portion of the money for the purpose of said stock by borrowing on short-term notes approximately $50,000 from the First National Bank and the City National Bank of Binghamton, N. Y., and placing as collateral for these loans his entire holdings of the capital stock of the LaFrance Garage Co. These loans *174had been negotiated by his attorney, Charles K. Stewardt, who had arranged to turn over the Dodge agency and Bing-hamton building in part liquidation of the loans, and to secure a longer-term loan from the West Branch National Bank of Williamsport, Pa. These arrangements could not be carried out as planned and the Binghamton banks called upon Coleman T. LaFrance to take up the loans.

Between September 15, 1919, and December 30,1919, Coleman T. LaFrance, at sacrifice prices, turned assets of the company into cash and withdrew from the company, and applied to the payment of his personal debts a sum indicated on the books as $39,230.62, over and above all credits to his account for salary, dividends, or any other credits due him from the corporation.

VIII. During the period from September 15, 1919, to December 31, 1919, A. Ward LaFrance was a personal indorser on certain of the direct notes or loans of the LaFrance Garage Co., which aggregated $36,000, to the Second National Bank of Elmira, N. Y., and $14,000 to the West Branch National Bank of Williamsport, Pa., from which indorsement he had not been relieved when he sold his stock to Coleman T. LaFrance.

The Second National Bank of Elmira and A. Ward La-France, upon discovering that Coleman T. LaFrance was withdrawing large sums of money from the LaFrance Garage Co., which he was using for his own personal uses and purposes, notified Coleman T. LaFrance and later the Binghamton banks that the withdrawals must cease, and when Coleman T. LaFrance continued to make further withdrawals, on December 30,1919, in order that they might protect their loans and the interests of the creditors and stockholders of the company, they compelled Coleman T. La-France to turn over the business of said LaFrance Garage Co. to them; and A. Ward LaFrance at the same time took up and paid the balance of $14,646 then due to the Bingham-ton banks on Coleman T. LaFrance’s personal loan.

From December 30, 1919, until the LaFrance Garage Co. was merged with the plaintiff herein, its business was managed and controlled by the directors nominated by said bank and A. Ward LaFrance, and during this period the *175organization of the company was disrupted and there was great confusion in the bookkeeping methods of the company, particularly at the end of the year 1919.

IX. The amounts withdrawn by Coleman T. LaFrance were not charged on the company’s books to surplus account, but were carried on the company’s books as an account receivable from Coleman T. LaFrance; there was no setting aside of these amounts from the profits of the company, and there was no formal declaration by the directors or stockholders of the company of a dividend for such amounts. In the case of all dividends of the LaFrance Garage Co. prior to September 15,1919, there had been a formal declaration of such dividends by the board of directors. On the books of the LaFrance Garage Co. the surplus or profits account was never debited and the account of Coleman T. LaFrance was never credited with any of the amounts so withdrawn. Nothing was done to show any intent on the part of either Coleman T. LaFrance or the company to consider the withdrawals as dividends or distributions of profits. Coleman T. LaFrance did not report on his 1919 income tax return the amounts withdrawn by him as a dividend.

X. Coleman T. LaFrance was compelled by the new directors of the company to turn over all his available property to apply on his indebtedness to the company, and on December 31, 1919, and thereafter he was insolvent.

The new directors of the company, upon taking over its management, determined to charge off as a loss the amount of $39,362 carried on the books of the company as an account receivable against Coleman T. LaFrance, and they so charged it off in the early part of the calendar year 1920.

The court decided that plaintiff was not entitled to recover.

DowNey, Judge,

delivered the opinion of the court:

The plaintiff seeks to recover an alleged erroneous assessment against the LaFrance Garage Có. of corporate income and excess-profits taxes for the calendar year 1919, which by reason of a merger with said company the plaintiff was compelled to and did pay, under protest, on November 2, 1923.

*176In 1920 the LaFranee Garage Co. made a tax return showing a net taxable income for the year 1919 of $1,344.59, which did not include $39,230.62 which had been drawn out between September 15, 1919, and November 30, 1919, by Coleman T. LaFranee, who was then the president of the company and the owner of all of its common stock.

To enable him to buy all the common stovk of the company Avhich he did not already own Coleman T. LaFranee borrowed a large sum of money, hypothecated the stock of the company, and then began systematically to convert assets of the company into cash, which between September 15 and November 30 of 1919 he withdrew to the amount of $39,230.62 in excess of all credit due him and used in the payment of his individual indebtedness. This sum was thereafter added by the Commissioner of Internal Revenue to the income of the said LaFranee Garage Co. for the' year 1919, and an additional tax of $14,756.27 was assessed, which the plaintiff, having in the meantime merged with said company, was compelled to and did pay. By reason of a credit determined to be due Coleman T. LaFranee on account of salary a refund of $4,462 was allowed and paid, and by reason thereof and a small conceded item of $28.30 the amount claimed is reduced to $10,265.97.

The amount thus withdrawn by Coleman T. LaFranee was not charged to him as a dividend; there was no action by the directors authorizing its payment as a dividend, although dividends had theretofore been declared by resolution of the board of directors, and he made no return of it as a dividend in his individual income tax return, but it was carried on the books of the company as an account receivable against Coleman T. LaFranee. Banking interests and his brother, who was obligated on paper of the company, compelled him to turn over such property as he had to the company, and at the end of the year 1919 another board of directors designated by these interests took control of the affairs of the company. No suit was instituted to recover from Coleman T. LaFranee any part of this remaining indebtedness, but it was recognized that at the end of the year 1919 he was wholly insolvent, and at some time in the early *177part of the year 1920 this account against him was by the new directors'charged off as a bad debt.

The situation may be clarified by disposing of the contention that the amount in question was paid to Coleman T. LaFrance as dividends. While it is true that there might have been a pajunent of dividends without a formal declaration by the board of directors, and there are authorities construing payments made as dividends, although not expressly so made, there is nothing in this transaction in any manner even tending to justify a construction of the payment in question as dividends.

The contention is that by reason of these withdrawals by Coleman T. LaFrance the company suffered a loss which under the revenue act of 1918 was deductible in computing net income for purposes of income and profits taxes for the year 1919. On this phase of the case the defendant suggests that no effort was made to collect this sum from any person other than Coleman T. LaFrance and contends that the loss can not be considered as for the year 1919 because not charged off until some time in the early part of the year 1920.

Aside from this question, which perhaps we need not determine, one of more substantial merit seems to present itself. Can a transaction such as this, in any event, serve to relieve from the payment of taxes otherwise due? And the answer must involve consideration of something broader than the mere interpretation of words.

The statute contemplates that in computing the net income of a corporation certain deductions may be made, among them “ Losses sustained during the taxable year and not compensated for by insurance or otherwise,” and “ Debts ascertained to be worthless and charged off within the taxable year.” A transaction such as this is hardly to be characterized as a “ loss ” within the above provision, but rather does it indicate the creation of a debt ascertained to be worthless and charged, off, and if to be measured and tested solely by the words of the statute it measures up thereto unless it be otherwise because not in fact charged off within the calendar year.

*178But the statute is undoubtedly intended to deal equitably with corporate transactions and to recognize that back of the corporate entity are the real parties in interest — the stockholders. In determining- the basis of taxation all or gross income is first to be ascertained, but, in fairness, deductions are to be allowed to the end that net income, the final basis for the assessment of the tax, be ascertained. But its ascertainment is evidently to be based on legitimate considerations operating fairly to both parties. Has a loss occurred not in some manner compensated for or have the directors extended a credit which, by reason of the subsequent insolvency of the debtor becomes a “ worthless debt,” the law permits a deduction in arriving at net income, but it certainly contemplates that from legitimate transactions legitimate results shall be deduced and not that a corporation and its sole stockholder who is its president and in fact its board of directors shall so illegitimately manipulate its affairs as to relieve from taxation a large part of its assets otherwise taxable.

The transaction can only be given the effect claimed, if at all, upon the theory of the entity of the corporation as distinct from the stockholders. That theory is so generally recognized in the cases as well as the text books that it must be deemed beyond the pale of disputation, but both classes of authorities deal with the corporation as in the exercise of its legitimate functions. It ordinarily evidences a community of interests belonging ultimately to a number of stockholders, and the division among a number of stockholders furnishes basis for the theory that the combining of these separate interests by incorporation creates a separate entity. But after all it is but a fiction necessarily resorted to in most cases to permit the working out of the legitimate purposes of the corporation.

In *United States*v. *Milwaukee Refrigerator Transit Co.,*in the Circuit Court for the Eastern District of Wisconsin (142 Fed. 247) Justice Sanborn reviews at length the origin, purposes, and departures from this theory of a corporation as a separate legal entity and finally announces this conclusion:

*179“ If any general rule can be laid down, in the present state of authority, it is that a corporation will be looked upon as a legal entity as a general rule, and until sufficient reason to the contrary appears; but when the notion of legal entity is used to defeat public convenience, justify wrong, protect fraud, or defend crime, the law will regard the corporation as an association of persons.”

Whether the transaction under review be regarded as a loan of corporate assets to a stockholder or as an appropriation of corporate assets by an officer of the corporation and their application to the payment of individual debts, it was wrong, but upon an even broader ground it must be condemned because, if to be regarded as legitimate for the purposes here sought, it must result that one thus owning-all the stock of a corporation and absolutely controlling its affairs with the aid of dummy directors of his own creation, can, through the medium of such a transaction and resort to the theory of a separate corporate entity relieve absolutely from taxation a large sum of money otherwise taxable. We are so convinced that upon this theory alone the transaction can not be made to serve the purpose for which it is invoked that we do not discuss the other question referred to above.

We are not unmindful of the fact that another corporation was called upon to pay this tax, but that fact can not change the necessary conclusion. If equities were to be weighed the conclusion must be unchanged, for the only reasonable inference is that those interested as incorporators and officers of the plaintiff company must have been fully conversant with the situation.

We find no right in the plaintiff to recover, and therefore dismiss its petition.

Graham, *J-udge;*Hat, *Judge;*Booth, *Judge;*and Campbell, *Chief*Justice, concur.