Court Opinion

ID: 4624643
Source: CourtListenerOpinion
Date Created: 2020-11-21 02:55:35.379955+00
Date Added: 2024-06-11T07:56:34.349183
License: Public Domain

W. O. Covey, Inc. v. Commissioner.W. O. Covey, Inc. v. CommissionerDocket No. 4518-67.United States Tax CourtT.C. Memo 1969-273; 1969 Tax Ct. Memo LEXIS 24; 28 T.C.M. (CCH) 1379; T.C.M. (RIA) 69273; December 15, 1969, Filed Robert W. Tunnell, Race St., P.O. Box 151, Georgetown, Del., for the petitioner. Bert W. Hunt for the respondent.  SCOTTMemorandum Findings of Fact and Opinion SCOTT, Judge: Respondent determined deficiencies in petitioner's income taxes for the fiscal years ended March 31, 1963 and March 31, 1964, in the amounts of $1,820 and $931.36, respectively. The issue for decision is whether petitioner is entitled to deduct as interest, payments made in 1963 and 1964 to Julia E. Covey with respect to an instrument in the form of a demand note which petitioner gave to Julia E. Covey on January 2, 1958, in exchange for 240 shares of petitioner's common stock. Findings of Fact Some of the facts have been stipulated and are found accordingly. W. O. Covey, Inc. (hereinafter referred to as petitioner) is a Delaware corporation with its principal place of business at the date of the filing of the petition in this case in Seaford, Delaware. Petitioner filed its Federal corporate income tax returns for its fiscal years ending March 31, 1963 and March 31, 1964, on an accrual method of accounting. These returns were filed with the district director of*26  internal revenue, Wilmington, Delaware. Petitioner was incorporated as a successor to the business of a sole proprietorship engaged in food distribution which was founded in 1923 by William O. Covey, Sr. The incorporation of the business was in 1935 shortly after the death of William O. Covey, Sr. Of petitioner's authorized 1,000 shares of no par value stock, only 720 were issued. Of the 720 issued shares, 240 were issued to Julia E. Covey, 240 to her son, William O. Covey, Jr., 220 to her daughter, Lucile C. Hitchens, and 20 to her son-in-law, Norris H. Hitchens. From 1935 until January 2, 1958, there was no change in petitioner's stockholders or the number of shares held by each. Julia E. Covey exchanged her 240 shares of stock for an instrument in the form of a demand note dated January 2, 1958. At the time of this exchange on January 2, 1958, Julia E. Covey was 76 years old. The minutes of a meeting of petitioner's board of directors, held January 2, 1958, read as follows: A meeting of the Board of Directors of W. O. Covey, Inc. was held in the office of the corporation in Seaford, Delaware, at 7:30 P.M. on January 2, 1958. The following directors were present: William*27  O. Covey, Jr. Julia E. Covey Norris H. Hitchens Lucile C. Hitchens After some discussion it was decided by the directors and agreed upon by Julia Covey that she would sell back to the corporation the 240 shares of common stock that she owns of W. O. Covey, Inc. The price agreed upon was $70,000.00 and Mrs. Covey agreed to accept a note in that amount from the Corporation. It was also agreed that approximately $3,000.00 per year would be paid on the principal of the note plus interest on the unpaid balance at 5% rate.  1380 It was also agreed that Mrs. Covey's salary remain the same. There being no further business, the meeting adjourned. (Signed) Lucile C. Hitchens, Secretary On January 2, 1958, the only directors of petitioner were those listed in the minutes as being present at the meeting of the board of directors. Julia E. Covey's basis in her 240 shares of stock was $24,398.08 and the approximate fair market value of the stock on January 2, 1958, was $70,000. On January 2, 1958, the officers of petitioner were: PresidentW. O. Covey, Jr.Vice PresidentJulia E. CoveySecretaryLucile C. HitchensTreasurerNorris H. HitchensJulia*28  E. Covey had been vice president of petitioner since July 6, 1935, and continued as vice president until August 17, 1961. She was a member of the board of directors from January 20, 1936, until August 17, 1961. From January 2, 1958, until June 1, 1961, she received a yearly salary as vice president in the amount of $2,400. Dividends were paid by petitioner as follows: Fiscal year ending March 31Amount1951$ 15,000195220,000195315,000195415,000195515,000195615,000195715,000196818,000No dividends were paid after the fiscal year 1957 until the fiscal year ending March 31, 1968. The instrument given by petitioner to Julia E. Covey was on a printed form which contained the provisions customary to a demand note which provides for confession of judgment. The instrument was executed as follows: Witness our hands and seals the day and year aforesaid. WITNESS: W. O. Covey, Inc. (Seal)  W. O. Covey, Jr., Pres. (Seal)  Norris Hitchens, Treas. (Seal) The note contained no restriction on transferability. Julia E. Covey from the time the note was issued in 1958 until her death in February 1967, made no demand upon petitioner to*29  pay any part of the principal of the note and received no such payment. Petitioner each year paid $3,500 to Julia E. Covey which it denominated as interest at the rate of 5 percent per annum on the $70,000 note. Norris H. Hitchens was executor of the estate of Julia E. Covey. No demand was made upon petitioner to pay any part of the principal of the $70,000 during the settling of the estate and no such payment was made. Julia E. Covey in her will left the residue of her estate which included the instrument in question to her granddaughter, Julia L. Hitchens, who has made no demands on petitioner to pay any part of the $70,000 principal. Julia L. Hitchens is the daughter of Norris H. Hitchens. On January 28, 1968, a new instrument was issued to Julia L. Hitchens. This instrument was also in the form of a demand note, given under seal, bearing 5 percent interest per annum, and providing for confession of judgment. There was no restriction on transferability of the new instrument. In September 1968, petitioner made a payment of $5,000 as its first payment on the principal of $70,000 to show "good faith." There was a closely knit family relationship between the members of the Covey*30  family. At the time of the transaction concerning the exchange of stock by Julia E. Covey for the instrument dated January 2, 1958, and during the years which followed, there was never any dissension between Julia E. Covey and her children nor between her and her son-in-law, Norris H. Hitchens. W. O. Covey, Jr., died on July 9, 1963. Lucile C. Hitchens died prior to December 1966. Norris H. Hitchens has a life estate and Julia L. Hitchens has a remainder interest in the 220 shares held by Lucile C. Hitchens prior to her death. On August 17, 1967, Julia L. Hitchens was elected as a director of petitioner and 1381 has continued from that time to serve as a member of the board. She was elected secretary of petitioner on October 25, 1966, and has continued to serve in that capacity. The following tables show the balance sheets and profit and loss statements of petitioner for the years 1959 through 1968:  *10 Profit and Loss Statement, 1964-196819641965196619671968Sales (net)$2,790,155$3,269,923$3,481,157$3,913,681$3,922,182Cost of goods soldInventory--Beginning235,094290,941306,327336,422406,451Purchases2,455,3832,852,1623,042,1313,460,0083,357,079Freight 5,57610,3735,0744,0448,571Total2,696,0533,153,4763,353,5323,800,4743,772,101Inventory--Ending 290,941306,327336,422406,451401,132Cost of goods sold 2,405,1122,847,1493,017,1103,394,0233,370,969Gross profit on sales385,043422,774464,047519,658551,213Other income:Purchase discount15,88318,44124,85828,38332,565Dividends438497365279216Rent900900900900825Interest 2900000Total other income 17,51119,83826,12329,56233,606Total income402,554442,612490,170549,220584,819Expenses:Operating expense371,469397,503436,801490,117530,472Officers' life insurance2,4032,6843,1093,2333,359Contributions1,0081,5001,5001,55073Interest3,5003,5003,6456,0719,562Employees' profit sharing plan12,08718,18819,96723,62722,939Less endorsed note 00000Total expenses 390,467423,375465,072524,598566,045Net income beforeFederal taxes12,08719,23725,09824,62218,414Federal income taxes 4,0204,6636,4106,6113,775Net income8,06714,57m18,68818,01114,639*31  1382 *10 Balance Sheet, 1959-196319591960196119621963AssetsCurrent assetsCash$ 26,190$ 20,076$ 52,451$ 18,240$ 46,519Accounts receivable81,11279,561113,656117,678126,159Inventory141,510160,578197,358164,539235,094Investments (at cost)10,65010,65010,65010,65010,650U.S. Government bonds49,00049,00049,00049,00049,000Cash surrender value of life insurance8,4759,73810,73611,74512,774Advance on commissions 00000Total current assets$316,937$329,603$433,851$371,852$480,196Fixed assetsLand1,5001,5001,5001,5001,500Bldg., fixtures and equip. 7,8116,6856,3805,0363,815Total fixed assets 9,3118,1857,8806,5365,315Total assets $326,248$337,788$441,731$378,388$485,511LiabilitiesCurrent liabilitiesAccounts payable63,93560,474141,826$ 49,768$116,944Payroll taxes2,8104,0183,9343,6924,356Notes payable--bank3,0009,0004,00000Accrued commissions and salaries6,19823,06333,74033,69241,848Profit sharing trust16,94413,83213,49719,74520,294Federal income tax7,0004,6014,4446,0558,071Loanspayable--officers and others 20,0155,35215,21230,12840,092Total current liabilities$119,902$120,340$216,653$143,080$231,605Long-term liabilitiesNotes payableRedemption of stock70,00070,00070,00070,00070,000Officers00000Employees' profit sharing 00000Total long-term liabilities 70,00070,00070,00070,00070,000Total liabilities189,902190,340286,653213,080301,605Shareholders' EquityCapital assigned to common stock--1,000 authorized, no par value--720 outstand- ing, 240 treasury stock73,17973,17973,17973,17973,179Retained earnings 133,167144,269151,899162,129180,727Total206,346217,448225,078235,308253,906Less treasury stock 70,00070,00070,00070,00070,000Total shareholders' equity-- capital 136,346147,448155,078165,308183,906Total liability and capital $326,248$337,788$441,731$378,388$485,511*32  *10 Balance Sheet, 1964-196819641965196619671968AssetsCurrent assetsCash$ 57,688$ 60,012$ 63,528$ 47,034$ 51,682Accounts receivable143,736165,423204,735214,620193,951Inventory290,941306,327336,422406,451401,132Investments (at cost)10,65010,6505,6505,6505,650U.S. Government bonds00000Cash surrender value of life insurance8,5789,23013,24217,30520,926Advance on commissions 001,50000Total current assets$511,593$551,642$625,077$691,060$673,341Fixed assetsLand1,5001,5001,5001,5001,500Bldg., Fixtures and equip. 2,8143,95411,06511,96221,542Total fixed assets 4,3145,45412,56513,46223,042Total assets $515,907$557,096$637,642$704,522$696,383LiabilitiesCurrent liabilitiesAccounts payable147,187150,916158,564188,682157,042Payroll taxes3,4707,2525,0604,4234,605Notes payable--bank000026,000Accrued commissions and salaries25,36127,69140,78437,52020,017Profit sharing trust12,08718,18819,96723,62722,939Federal income tax4,0204,6636,4106,6113,775Loans payable--officers and others 46,40756,43792,20956,93750,023Total current liabilities238,532265,147322,994317,800284,401Long-term liabilitiesNotes payableRedemption of stock70,00070,00070,00070,00070,000Officers00050,00050,000Employees' profit sharing 000025,000Total long-term liabilities 70,00070,00070,000120,000145,000Total liabilities308,532335,147392,994437,800429,401Shareholders' EquityCapital assigned to common stock--1,000 authorized, no par value--720 outstand- ing, 240 treasury stock73,17973,17973,17973,17973,179Retained earnings 204,196218,770241,469263,543263,803Total277,375291,949314,648336,722336,982Less treasury stock 70,00070,00070,00070,00070,000Total shareholders' equity--Capital 207,375221,949244,648266,722266,982Total liability and capital $515,907$557,096$637,642$704,522$696,383*33  1384 Proft and Loss Statement, 1959-196319591960196119621963Sales (net)$2,022,559$2,076,500$2,297,429$2,561,922$2,602,270Cost of goods soldInventory--Beginning119,716141,509160,578197,358164,539Purchases1,735,7591,795,4242,009,0542,156,1902,257,176Freight 8,80510,0088,8274,4336,871Total1,864,2801,946,9412,178,4592,357,9812,428,586Inventory--Ending 141,510160,578197,358164,539235,094Cost of goods sold 1,722,7701,786,3631,981,1012,193,4422,193,492Gross profit on sales299,789290,137316,328368,480408,778Other income:Purchase discounts9,83516,26111,76613,36614,940Dividends315415370415430Rent720720720765900Interest 1,6302,3209401,4951,380Total other income 12,50019,71613,79616,04117,650Total income312,289309,853330,124384,521426,428Expenses:Operating expense266,700274,464300,166340,778374,168Officers' life insurance1,0781,0751,2258031,141Contributions1,2001,0001,2001,0701,075Interest3,8004,1265392,3793,574Employees' profit sharing plan16,94413,83113,49719,74520,829Less endorsed note 0917000Total expenses 289,722295,413316,627364,775400,787Net income beforeFederal taxes22,56714,44013,49719,74625,641Federal income taxes 7,0004,6014,4436,0568,071Net income15,5679,8399,05413,69017,570*34  1385 Petitioner in each of its fiscal years ended March 31, 1963, and March 31, 1964, claimed a deduction for the amount of $3,500 paid to Julia E. Covey with respect to the $70,000 instrument as interest paid. Respondent in his notice of deficiency disallowed these claimed deductions. Ultimate Finding of Fact  Payment of $3,500 made by petitioner in each of its fiscal years ended March 31, 1963, and March 31, 1964, with respect to the instrument issued to Julia E. Covey on January 2, 1958, is not interest paid on an indebtedness so as to be deductible under section 163, I.R.C. 1954. 1Opinion Petitioner contends that the yearly payments of $3,500 to Julia E. Covey in connection with the instrument originally issued to her in 1958 in exchange for her certificate of 240 shares of petitioner's stock are deductible under section 163(a) which provides for the allowance of a deduction for all "interest paid or accrued within the taxable year on indebtedness." We must therefore decide whether*35  the transaction which occurred on January 2, 1958, did in fact create a bona fide debt of petitioner to Julia E. Covey within the meaning of section 163. The substance of the economic relationship, rather than the form in which a transaction is cast, determines the incidents of Federal income taxation.  Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935), and Edwin C. Hollenbeck, 50 T.C. 740">50 T.C. 740 (1968), on appeal (C.A. 9, Nov. 18, 1968). The instrument issued to Julia E. Covey was in the form of a demand note. There is nothing in the record to indicate that Julia E. Covey could not have enforced payment of the note in a court of law or could not have assigned the note for value. We will therefore assume that under State law and in form the instrument created a valid indebtedness of petitioner to Julia E. Covey. This assumption does not, however, answer the question of whether this instrument should be treated as creating a bona fide debt for purposes of taxation. The form of the instrument or its validity under State law does not control its treatment for Federal tax purposes. *36 United States v. Snyder Brothers Company, 367 F. 2d 980 (C.A. 5, 1966). All the surrounding circumstances at the time of the issuance of an instrument and the subsequent treatment of the transaction by the parties must be examined to determine whether for tax purposes there was an "indebtedness." Ambassador Apartments, Inc., 50 T.C. 236">50 T.C. 236 (1968), affirmed per curiam 406 F. 2d 288 (C.A. 2, 1969). Cases dealing with whether an instrument in form evidencing an indebtedness does in substance create an indebtedness by the maker arise from many diverse factual situations. In many such cases funds advanced by shareholders to corporations in return for an instrument in the form of a note or bond are determined by the Commissioner to be in substance capital contributions to the corporation. In determining whether there is in fact an indebtedness of the corporation to the shareholder, all of the surrounding facts are considered. One of the primary facts to be determined is whether there is an unconditional intent to repay the amount of the claimed indebtedness*37  in all events. Without such an intent to repay, there can be no indebtedness. In Edwin C. Hollenbeck, supra, at 747, we stated: The debt-equity inquiry is essentially the same in all areas. The precise determination to be made - is there more than one class of stock, are notes bona fide indebtedness, etc., varies from case to case, but the basic standards remain the same in all cases where the respondent seeks to reclassify debt or equity. The test is whether the form in which the taxpayer has cast the transaction has substantial economic reality. * * * The instrument which was issued on January 2, 1958, to Julia E. Covey was in exchange for all her common stock in petitioner. Respondent makes an extended argument that the transaction did not amount to a redemption of stock within the definition of sections 302(a) and 317(b). 2 1386 Petitioner does not contend that the transaction was a distribution in redemption of the stock of Julia E. Covey within the meaning of these sections, apparently for the reason which respondent points out, that Julia E. Covey remained an officer and director of petitioner for several years after the transaction of January 2, 1958. *38 *39  Since Julia E. Covery remained an officer and director of petitioner for several years after January 2, 1958, it is obvious that under the attribution provisions, she is considered to own the stock owned by her son and her daughter. After the exchange of her common stock for the instrument dated January 2, 1958, she would be considered as owning, under the attribution provision, over 95 percent of petitioner's common stock. Petitioner takes the simple position that the transaction of January 2, 1958, constituted a purchase by the corporation of the stock of Julia E. Covey just as much as if cash had been paid for the stock. Upon consideration of all the facts here present, we agree with respondent that the instrument issued to Julia E. Covey on January 2, 1958, though in the form of a demand note, did not actually create a debtor-creditor relationship between Julia E. Covey and petitioner from the standpoint of economic reality but more nearly resembled an exchange of common stock for a form of preferred stock. The financial situation of petitioner was such that regular yearly payments could have been made on the principal, but the note could not have been paid on demand without*40  greatly curtailing petitioner's ability to carry on its operations. In fact, in its brief, petitioner states: In 1958 when the $70,000.00 note was given to Mrs. Covey the petitioner enjoyed a line of credit at the bank of only fifteen or twenty thousand dollars. According to the testimony of Mr. Hitchens (T. p. 23) the company has never been in a position, since 1958, to pay off the $70,000.00 obligation. * * * In order to clearly point out the desperate working capital position of the petitioner a document entitled "Working Capital Position of W. O. Covey, Inc. as of March 31, 1959 through 1968" was prepared and put in evidence as Petitioner's Exhibit No. 9. * * * Petitioner then pointed out that Julia E. Covey did not need the cash and had sufficient funds from the $3,500 she was collecting annually from petitioner under the designation of "interest" plus other assets to live comfortably. The substance of petitioner's argument is that Julia E. Covey did not, at the time the note was issued or at any time thereafter, intend that any portion of the $70,000 face amount of the so-called demand note be paid to her unless the financial position of petitioner was such that it could*41  be paid with no inconvenience to petitioner. Since petitioner could not make such payment at any time after January 2, 1958, without substantially curtailing its operation, Julia E. Covey made no request for any payment. The inference from the record is unmistakable that it was the intent of Julia E. Covey, as well as the other officers of petitioner, that the investment which Julia E. Covey had in the corporation would not actually be taken out of the corporation but that Julia E. Covey would receive yearly payments which would be denominated "interest" whether or not any corporate dividends were declared to the other stockholders. The minutes of January 2, 1958, referred to payments of $3,000 annually on "principal" of the "note." However, the fact that no such payments were made or sought leaves the clear inference that it was never intended that such payments be made if petitioner had a more pressing need for use of its funds. Petitioner contends that there were several business reasons why petitioner desired to purchase the stock of Julia E. Covey. It contends that William O. Covey, Jr., and Norris H. Hitchens were carrying the major work of the corporation and that their percentage*42  interest was increased when the corporation purchased the stock of Julia E. Covey; that Julia E. Covey was 1387 growing older and might have given her stock to a person who would not have petitioner's interest at heart; that the other stockholders of petitioner desired to ease Julia E. Covey out of petitioner without hurting her feelings; and that her stock could be held as treasury stock in the event it was desired to issue the stock to key employees. None of these so-called business reasons, when analyzed, is a business reason from the standpoint of the corporate petitioner. The logical way for William O. Covey, Jr., and Norris H. Hitchens to have increased their stock interest would have been for them to have personally purchased the stock of Julia E. Covey. Certainly, more havoc might have been wrought had Julia E. Covey given the so-called note to an outsider who would have enforced its collection than had she given her common stock to an outsider who would not have had a controlling interest. The fact is that Julia E. Covey did remain an officer and director after the transaction of January 2, 1958. Also the facts show that there was unissued stock of petitioner which could*43  have been used to distribute to key employees and none of that stock or the stock previously held by Julia E. Covey has been so used. The fact that no payment was made on the "principal" of the "note" to Julia E. Covey or to her estate supports the inference from other facts in the record that the intent at the time of the transaction was that no payment was to be made on the note unless the circumstances of the business were such that petitioner had funds for which it had no need in its business. The clear inference is that there was not an unconditional intention to pay the so-called indebtedness and that in economic reality Julia E. Covey retained an equity interest in petitioner after the exchange of January 2, 1958. The fact that shortly before the trial of this case a payment on the so-called note was made to show "good faith" is not persuasive that during the years here in issue the instrument dated January 2, 1958, evidenced a bona fide debt of petitioner. The payment of $3,500 in each of the years here in issue by petitioner to Julia E. Covey was in the nature of a dividend on preferred stock and not interest on a loan. Decision will be entered for respondent.  Footnotes1. All references are to the Internal Revenue Code of 1954.↩2. SEC. 302. DISTRIBUTIONS IN REDEMPTION OF STOCK. (a) General Rule. - If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph (1), (2), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock. (b) Redemptions Treated as Exchanges. - (1) Redemptions not equivalent to dividends. - Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend. * * * (3) Termination of shareholder's interest. - Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder. * * * (c) Constructive Ownership of Stock. - (1) In general. - Except as provided in paragraph (2) of this subsection, section 318(a) shall apply in determining the ownership of stock for purposes of this section. (2) For determining termination of interest. - (A) In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if - (i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor, * * * Sec. 317(b)↩ Redemption of Stock. - For purposes of this part, stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.