Docket No. 109088.

1 T.C. 457 (1943)


United States Tax Court.

Promulgated January 15, 1943.

Attorney(s) appearing for the Case

Frank J. Albus, Esq., for the petitioner.

John D. Kiley, Esq., for the respondent.

The respondent has determined against petitioner income tax deficiencies for the calendar years 1937, 1938, and 1939 in the amounts of $569.06, $1,980, and $1,980, respectively, and an excess profits tax deficiency in the amount of $360 for 1937.

The only issue presented is whether the payments on corporate debentures were interest on indebtedness or dividends on stock.


Substantially all the facts are stipulated and are hereby found accordingly. Those facts hereafter appearing which are not from the stipulation are facts found from the record made at the hearing.

Petitioner is an Indiana corporation, organized in 1907 and reorganized in 1930, and has its principal place of business in Marion, Indiana. It is engaged in a retail furniture business. Its income tax returns for the calendar years 1937, 1938, and 1939 were prepared from books kept on the accrual basis, the taxable profit on installment sales being computed on the installment basis, and were filed with the collector of internal revenue at Indianapolis, Indiana.

On January 1, 1937, the petitioner had authorized as capital stock 1,500 shares of common stock at no par value and 3,000 shares of preferred stock at $100 par value, of which 1,110 shares of common stock and 1,124 shares of preferred stock had been issued and were outstanding. Roy F. Kelley, individually, owned 567 shares of common stock and 628 shares of preferred stock, and, as trustee for Mabel K. Ronald, he owned 543 shares of common stock and 496 shares of preferred stock. Mabel K. Ronald, who died May 30, 1940, was a sister of Roy F. Kelley.

During the month of January 1937 Roy F. Kelley transferred the 628 shares of preferred stock and 171 of the common shares owned by him in his own right; 50 shares of preferred to Mabel K. Ronald, as trustee for her daughters, Ruth Stevens Korper and Mary Louise Stogsdill; 289 shares of preferred to Mabel K. Ronald as trustee for Ruth Stevens Korper; 289 shares of preferred to Mabel K. Ronald as trustee for Mary Louise Stogsdill; and the 171 shares of common stock to his wife, Birdena Kelley. It was provided in the above three trusts, however, that Birdena Kelley should receive the income from the 628 shares of preferred stock during her lifetime.

On January 11, 1937, a special meeting of the board of directors of the petitioner corporation was held and a plan of recapitalization was adopted. Following that meeting and on the same date the shareholders of the corporation held a special meeting and approved the resolution adopted by the board of directors. Under this resolution the authorized issue of 1,500 shares of common stock of no par value was changed to 1,500 shares of common stock with a par value of $100 per share and then increased to 6,000 shares. The resolution also authorized the issue of "income debenture bonds" aggregating the sum of $250,000, bearing interest at the rate of 8 per cent per annum, and the execution of a trust agreement setting forth the terms and conditions upon which said debenture bonds were issued and the power and duties of the trustees. Under the resolution the income debenture bonds would be offered by the trustees in exchange for the issued and outstanding 1,124 shares of the preferred stock on the basis of $102 in face value of debentures for each share of said preferred stock; and, for the purpose of raising additional capital to expand the business of the corporation "in the field of finance", the trustees were to offer any and all unissued debenture bonds for sale at face value to the shareholders of the corporation. The directors meeting was attended by the three directors, Mabel K. Ronald, Roy F. Kelley, and Mary Louise Stogsdill, and the holders of the entire capital stock of the corporation, Mabel K. Ronald and Roy F. Kelley, were present at the meeting of the shareholders.

The trust indenture dated January 1, 1937, was entered into by the petitioner corporation through its president, Mabel K. Ronald, and secretary, Roy F. Kelley, with the trustees, Mabel K. Ronald and Roy F. Kelley. None of the income debenture bonds were issued prior to July 1, 1937. On that date Roy F. Kelley, as trustee for Mabel K. Ronald, delivered to the petitioner 496 shares of preferred stock, and coincidental therewith there were delivered to Roy F. Kelley, as trustee for Mabel K. Ronald, $50,592 face amount of the said bonds. On the same date, Mabel K. Ronald, as trustee for Ruth Stevens Korper and Mary Louise Stogsdill, delivered to the petitioner 628 shares of preferred stock, and coincidental therewith there were delivered to Mabel K. Ronald, as trustee for the same beneficiaries, $64,056 face amount of the income debenture bonds. On July 1, 1937, Mabel K. Ronald and Birdena Kelley subscribed for $24,408 and $10,944, respectively, of the said bonds. These amounts were carried against them in open accounts on the books of the petitioner and were later wiped out by the credit of dividends received by them on common stock. In the case of Mabel K. Ronald the dividends so credited were on the common stock held for her by Roy F. Kelley, as trustee, while in the case of Birdena Kelley the said dividends were on the 171 shares of common stock which had been transferred to her by Roy F. Kelley in January of 1937.

Petitioner, on December 10, 1937, filed articles of amendment of its articles of incorporation with the Secretary of State of Indiana, which showed the total number of shares of its capital stock to be 3,000 shares of preferred stock having a par value of $100 each and 6,000 shares of common stock having a par value of $100 each.

On December 15, 1937, 1,110 outstanding shares of common stock of the petitioner were owned, 396 shares by Roy F. Kelley; 171 shares by Birdena Kelley; and 543 shares by Roy F. Kelley, as trustee for Mabel K. Ronald. A cash dividend of $55 per share was paid on 1,110 shares on December 15, 1937, after which a common stock dividend of 3 ½ shares for each share of common stock held was declared and paid by petitioner.

During the periods of July 1 to December 31, 1937; January 1 to December 30, 1938; and January 1 to December 31, 1939, the petitioner had outstanding "income debenture bonds" of the face amount of $150,000, in respect of which $6,000, $12,000, and $12,000 for each period, respectively, were set up on the books of petitioner as accrued interest thereon. The amounts so accrued were paid and were claimed by petitioner as deductions in computing its taxable net income for the respective calendar years 1937, 1938, and 1939. These deductions were disallowed by the respondent.

On the petitioner's books the "income debentures" were referred to as "stocks," "bonds," and "notes." Charges were entered in an account which was headed "accrued interest, income debentures." The petitioner in its capital stock tax returns for 1938 and 1939 listed "debenture" and "debenture notes," respectively, as capital stock. They were not reflected as indebtedness in the balance sheets appearing in the income and excess profits tax returns filed by petitioner for 1937, 1938, and 1939, but appear under the heading "Capital Stock: Debenture Notes." The board of directors annually adopted corporate resolutions authorizing the payment of "interest" on the "income debenture bonds" or "debenture notes." On most of the checks, drawn for the "interest" on the "income debentures" to the holders thereof, the nature of payment was described to be for "Interest, income debenture stock."

On January 1, 1937, the assets of petitioner totaled $963,807.57 and its liabilities exclusive of common and preferred stock totaled $75,817.74. On December 31, 1937, its total assets were $982,221.08 and its total liabilities exclusive of common stock and the debentures were $46,158.19.

The trust indenture set out the form of debenture to be issued, which was substantially followed, and the debentures in controversy, in so far as material, read as follows:

THE JOHN KELLEY COMPANY, an Indiana corporation, for value received, promises to pay to the bearer on the 31st day of December, 1956, the sum of ONE THOUSAND DOLLARS ($1,000) in lawful money of the United States of America at the office of the Company in Marion, Indiana, and to pay interest thereon in like lawful money, out of the net income of the Company, at the rate of 8% per annum, payable annually on the 31st day of December of each year, at the office of the Company in Marion, Indiana, on presentation of this Debenture for endorsement of payment thereon, conditioned, however, upon the net income of the Company being sufficient during any interest period to pay the amount due as interest, in accord with the terms and provisions hereof. The interest on this Income Debenture shall not be cumulative.

* * * * * * *

If any of the events of default specified in the trust agreement shall occur, all debentures outstanding hereunder may be declared to be due and payable in the manner and with the effect provided in the trust agreement.

In the payment of their claims, all creditors, other than the stockholders of the Company, shall rank superior to the holders of this income debenture, but all holders of this income debenture shall rank pari passu with each other and superior to the stockholders of the corporation with respect to their share stock.

Article IV of the trust indenture set forth "Default and Remedies," and the first two sections thereof designated "default" as follows:

Section 1. If one or more of the following events of default happen, viz; (a) if default be made in the punctual payment of any installment of interest on any outstanding debenture or debentures or (b) if default be made in the observance or performance of any of the terms of said debentures or of this Trust Agreement, and any such last named default shall continue for a period of two (2) years after written notice thereof shall have been given to the Company by the Trustees (whose duty it shall be to give such notice at the request in writing of at least twenty-five per cent (25%) in principal amount of the debentures at the time outstanding hereunder), then and in every such case, the Trustees may, and upon the written request of the holders of twenty-five per cent (25%) in principal amount of the debentures then outstanding hereunder shall declare the principal of all debentures then outstanding hereunder to be due and payable immediately, and upon any such declaration the same shall become immediately due and payable, anything in this Trust Agreement or in said debentures contained to the contrary notwithstanding.

This provision, however, is subject to the conditions that if at any time after the principal of said debentures shall have been so declared due and payable, and before any judgment or decree for the payment of monies due shall have been entered, all arrears of interest upon all the debentures shall have been duly paid and all defaults shall have been made good, and all the stipulations of said debentures and of this Trust Agreement shall have been fully performed by the Company, then, and in every such case, the holders of a majority in principal amount of the debentures then outstanding, by written notice to the Company and to the Trustees, may waive such default and its consequence and rescind such declaration; but no such waiver or rescission shall extend to or affect any subsequent default or impair any right consequent thereon.

Section 2. The company covenants that (a) in case default shall be made in the punctual payment of any installment of interest on any outstanding debenture or debentures and such default shall have continued for a period of two (2) years; or (b) in case default shall be made in the payment of the principal of any such debenture or debentures when the same shall become payable, whether upon maturity or upon call or declaration as provided in this Trust Agreement, then upon demand of the Trustees the Company will pay to the Trustees for the benefit of the holders of the debentures issued hereunder and then outstanding, the whole amount which then shall have become due and payable on all such debentures then outstanding and in addition thereto such further amount as shall be sufficient to cover the costs and expenses of collection, including a reasonable compensation to the Trustees, their agents, attorneys and counsel, and any expenses or liability incurred by the Trustees hereunder. In case the Company shall fail forth-with to pay such amount on such demand, the Trustees in their own names and as Trustees of an express trust shall be entitled and empowered to institute such action or proceeding at law or in equity, as may be advised by counsel, for the collection of the sums so due and unpaid and may prosecute any such action or proceeding to judgment or final decree and may enforce any such judgment or decree in the manner provided by law.

The trust indenture provided certain procedure to be followed by the trustees and debenture holders in enforcing payment of the interest and principal, in case of default by the petitioner. In one provision the petitioner pledged that all of its property was free of mortgage and no lien or any other encumbrance would be placed upon it as long as any of the debentures were outstanding. It was also provided that the debentures were subordinate to the claims of petitioner's creditors but had priority over the claims of the stockholders. The holders of the debentures were not given the right to participate in the management of the business.


TURNER, Judge:

If the debentures have created an indebtedness the payments to the holders thereof are interest and deductible as expense, but if they are in fact capital stock the payments are dividends and not deductible.

Similar questions have been before this tribunal and other courts, and with each one it was necessary to consider all of the facts and circumstances in the particular case in order to determine if the relationship was that of a stock ownership or of debtor and creditor. In some cases the determining characteristic has been one factor, while in other cases it has been another. No one factor is necessarily controlling. Commissioner v. Schmoll Fils, Associated, Inc., 110 Fed. (2d) 611 (C.C.A., 2d Cir., 1940).

The determining factors are usually listed as the name given to the certificates, the presence or absence of maturity date, the source of the payments, the right to enforce the payment of principal and interest, participation in management, status equal to or inferior to that of regular corporate creditors, and intent of the parties. Applying the test of these determining characteristics, we conclude petitioner should prevail.

Though at different times the petitioner might have called the "debentures" "stock," at all times the payments thereon, whether on the books, in the minutes, or in the income tax returns, were referred to as "interest." It is true that the interest was to be paid out of "net income," but that in itself is not decisive. H.R. DeMilt Co., 7 B. T. A. 7. In the event of default the trustees and debenture holders were entitled to declare, in a designated process, the debentures immediately due and payable and to institute suit thereon. The fact that the debentures were subordinated to the rights of all creditors but were prior to those of the stockholders is not of itself conclusive against their classification as indebtedness. O. P. P. Holding Corporation, 30 B. T. A. 337; affd., 76 Fed. (2d) 11 (C. C. A., 2d Cir.). The debenture holder did not have the right to participate in the management of the corporation. It is apparent that the holders of the preferred stock, in exchanging the stock for "20 year 8% income debentures," preferred the debtor-creditor status of debenture holders to that of stockholders, and stockholders have the right to change to the creditor-debtor basis, though the reason may be purely personal to the parties concerned. Commissioner v. Proctor Shop, Inc., 82 Fed. (2d) 792 (C. C. A., 9th Cir.), affirming 30 B. T. A. 721.

In computing the surtax on undistributed profits the respondent increased the dividend paid credit claimed by petitioner in the returns for the years 1937, 1938, and 1939 in the amounts of $6,000, $12,000, and $12,000, respectively, by reason of having determined the said amounts were dividends and not interest. The dividend paid credit as to each of the years should be reduced by a corresponding amount.

Decision will be entered under Rule 50.


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