SHAKEN v. COMMISSIONER OF INTERNAL REVENUE

Respondent determined income tax deficiencies against petitioners as follows: Docket No. Year Deficiency 39823 ...................... 1948 ........................ $4,911.84 45116 ...................... 1949 ........................ 780.04 The sole issue is whether certain withdrawals by petitioners from Victor International Corporation in 1948 and 1949 constituted loans or taxable dividends to the extent of $13,583.16 in 1948 and $2,936.90 in 1949.

FINDINGS OF FACT.

Some of the facts were stipulated and they are hereby found.

Petitioners are husband and wife. They reside in Mount Vernon, New York. Their joint returns for the calendar years 1948 and 1949 were filed with the collector of internal revenue for the second New York district.

Victor Shaken, hereinafter referred to as petitioner, was the sole stockholder of Victor International Corporation, hereinafter sometimes referred to as the corporation, which was organized on August 6, 1946, under the laws of the State of New York and was engaged in the business of import and export, with its office at 225 Broadway, New York City. The corporation's income tax returns were filed on the basis of a fiscal year ending March 31.

Prior to August 6, 1946, petitioner operated an importing and exporting business as a sole proprietor under the trade name of Victor Importing Company. Petitioner's attorney, John Tullman, advised petitioner to do business in a corporate form because excess profits taxes had been eliminated and there was "a great deal more elbow room" in corporate activities than had existed theretofore. On or about August 6, 1946, petitioner transferred to Victor International Corporation all of his interest in Victor Importing Company in return for 3 shares of the corporation's capital stock.

At all times during the corporate existence of Victor International Corporation, petitioner was the sole stockholder, petitioner and his wife were the only directors, petitioner was president and treasurer, and his wife was vice president and secretary. Petitioner was also the primary manager who made and executed the corporation's policies. Petitioner's wife was never a stockholder of the corporation.

Petitioner and his wife maintained running "loan accounts" with the corporation. Petitioner's loan account on the books of the corporation can be summarized as follows: Period Explanation Amount Explanation Amount debited credited Aug. 1, 1946, Total withdrawals $1,248.61 Balance at .... $2,563.68 to Dec. 31, Balance (due ..... 1,315.07 beginning of 1946. petitioner) period ---------- ---------- Total ....... $2,563.68 Total ..... $2,563.68 ========== ========== Jan. 1, 1947, Total withdrawals $3,373.48 Balance at .... $1,315.07 to Mar. 31, beginning of 1947. period Balance (due ..... 291.59 Salaries ...... 2,350.00 petitioner) transferred to loan account. ---------- ---------- Total ....... $3,665.07 Total ..... $3,665.07 ========== ========== Apr. 1, 1947, Total withdrawals $2,513.61 Balance at .... $291.59 to Dec. 31, beginning of 1947. period Balance (due 2,222.02 the corporation) Dec. 31, 1947. ---------- ---------- Total ....... $2,513.61 Total ..... $2,513.61 ========== ========== Jan. 1, 1948, Balance at ....... $2,222.02 Salaries ...... $2,880.00 to Mar. 31, beginning of transferred 1948. period. to loan account. Total ....... 663.68 Balance (due 5.70 withdrawals the corporation) Mar. 31, 1948. ---------- ---------- Total ....... $2.885.70 Total ..... $2,885.70 ========== ========== Apr. 1, 1948, Balance at ....... $5.70 Petitioner's $2,736.50 to Dec. 31, beginning of cash, payments 1948. period. for the corporation's account. Total withdrawals 20,103.26 Total of 692.05 salary checks deposited Cash .......... 307.95 Balance (due 16,372.46 the corporation) Dec. 31, 1948. ---------- ---------- Total ....... $20,108.96 Total ..... $20,108.96 ========== ========== Jan. 1, 1949, Balance at ....... $16,372.46 Total of $516.00 to Mar. 31, beginning of salary checks 1949. period. deposited Cash .......... 484.00 Total withdrawals 10,397.05 Petitioner's 9,584.70 personal check Salaries ...... 2,880.00 transferred to loan account. Balance (due 13,304.81 the corporation) Mar. 31, 1949. ---------- ---------- Total ....... $26,769.51 Total ..... $26,769.51 ========== ========== Apr. 1, 1949, Balance at ....... $13,304.81 Total of $351.75 to Dec. 31, beginning of salary checks 1949. period. deposited Cash .......... 648.25 Total withdrawals 1,581.30 Balance (due 13,886.11 the corporation) Dec. 31, 1949. ---------- ---------- Total ....... $14,886.11 Total ..... $14,886.11 ========== ========== Jan. 1, 1950, Balance at ....... $13,886.11 Balance (due $14,244.11 to Mar. 31, beginning of the 1950. period. corporation) Mar. 31, 1950. Total withdrawals 358.00 ---------- ---------- Total ....... $14,244.11 Total ..... $14,244.11 Petitioner made the following withdrawals from his loan account prior to January 1, 1948: Date Explanation Amount Sept. 10, 1946 Collector of Internal Revenue ............... $292.00 Oct. 18, 1946 V. Shaken-Equitable Life .................... 449.70 Oct. 18, 1946 Dr. Sidney Harris ........................... 150.00 Dec. 9, 1946 Thomas N. Barr .............................. 35.00 Dec. 21, 1946 Dr. Sidney Harris ........................... 100.00 Dec. 18, 1946 Bloomingdale Bros ........................... 21.91 Dec. 6, 1946 Dr. Sidney Harris ........................... 100.00 Dec. 24, 1946 S. Legget ................................... 50.00 Dec. 24, 1946 Madie Williams .............................. 50.00 Dec. 21, 1946 B. Francis .................................. 25.00 Dec. 24, 1946 Ethel Lappner ............................... 50.00 Dec. 20, 1946 Ethel Novick ................................ 50.00 Jan. 14, 1947 Collector of Internal Revenue ............... 500.00 Jan. 31, 1947 Dr. Sidney Harris ........................... 100.00 Jan. 30, 1947 Louis Schwartz .............................. 50.00 Feb. 10, 1947 Beth Hamedresh Hogedet ...................... 4.80 Feb. 1, 1947 Mrs. Harold Freeston ........................ 30.00 Mar. 31, 1947 V. Shaken ................................... 2,563.68 Apr. 7, 1947 State Tax Commission ........................ 151.41 Apr. 30, 1947 Ethel Novick ................................ 200.00 Apr. 5, 1947 Young' Merchandise Corp ..................... 10.00 Apr. 19, 1947 M. Hoffman Son ............................ 325.00 Apr. 23, 1947 S. Harris ................................... 100.00 May 17, 1947 Bonwit Teller ............................... 107.05 June 14, 1947 S. H. Harris ................................ 201.00 June 30, 1947 Additional withholding tax .................. 470.00 July 8, 1947 Louis Schwartz .............................. 350.00 Sept. 22, 1947 Victor Shaken ............................... 324.15 Oct. 10, 1947 L. Schwartz ................................. 50.00 Nov. 15, 1947 Abercrombie Fitch ......................... 125.00 Dec. 24, 1947 Sallye Legget ............................... 50.00 Dec. 24, 1947 Ethel Lappner ............................... 50.00 --------- Total ................................. $7,135.70 Petitioner's withdrawals from the loan account during 1948 were as follows: Date Corporation Payee Amount check No. Mar. 8, 1948 3794 Collector of Internal Revenue .. $547.80 Mar. 9, 1948 115.88 Apr. 3, 1948 3874 S. Harold Harris ............... 10.00 Apr. 9, 1948 3891 State Tax Commission ........... 251.94 Apr. 29, 1948 3943 Ethel Lappner .................. 50.00 Mar. 31, 1948 Abercrombie Fitch ............ 145.00 June 2, 1948 4173 Prestige Appliances ............ 478.50 June 30, 1948 4002 Steven's Buick ................. 100.00 July 8, 1948 J. F. Stobey ................... 319.25 Aug. 19, 1948 4295 V. Shaken ...................... 7,900.00 Aug. 23, 1948 4305 Collector of Internal Revenue .. 1,661.07 Aug. 27, 1948 4320 V. Shaken ...................... 8,300.00 Aug. 24, 1948 4307 Ethel Lappner .................. 25.00 Sept. 11, 1948 Ralph Scarinzi ................. 200.00 Oct. 11, 1948 4392 Equitable Life ................. 337.50 Sept. 25, 1948 4598 Ralph Scarinizi [sic] .......... 200.00 Oct. 25, 1948 4599 Ralph Scarinzi ................. 125.00 --------- Total ..................... $20,766.94

These withdrawals were all charged to a corporate account labeled "Loans Receivable — Victor Shaken." The stubs of checks numbered 4295, 4305, and 4320 contained the following notations:

Check No. Notation

4295 ............................ V. Shaken (loan) 4305 ............................ Collector of Internal Revenue a/c Victor Shaken 1945 Ass. 4320 ............................ V. Shaken loan

The word "loan" on the stub of the check numbered 4320 is in pencil and was inserted a day or two after the check was drawn or possibly at the end of the month when the corporation's accountant asked petitioner about such things.

In the summer of 1948 there were a number of unsubstantiated claims against the corporation. These claims arose from the contentions of some of the corporation's customers in the Far East that defective merchandise had been shipped to them. Two lawsuits had been commenced against the corporation: One in Bombay, India, for $9,600, and another by a Kirk Klein in the New York Supreme Court in New York City for $19,000. These suits were still pending at the time of the hearing in the present proceeding.

The merchandise involved in these claims had been purchased by the corporation from other suppliers and sold by it to customers in the Far East. In petitioner's business, if merchandise became damaged in transit, the corporation had a claim against the carrier and such claim was turned over to the insurance underwriters. If the merchandise was defective before transit, the corporation had a claim against the supplier. When Kirk Klein asserted his claim in court, the corporation's supplier, the Cotton Processing Corporation, was joined as third party defendant. Only four or five times during the life of the corporation was it unable to collect from third parties the amount of the claims asserted against it.

During the summer of 1948 petitioner conferred with his lawyer and accountant over what to do about the Far East claims which were then unsubstantiated and did not appear on the corporation's books as liabilities. The corporation maintained only one bank account, which was at the Irving Trust Company in New York City. The corporation had overseas agents to whom commissions were owed, and these commissions were listed as liabilities on the corporation's balance sheets. Petitioner was anxious to maintain the corporation's overseas contacts.

With the sums advanced to petitioner by corporate check on August 19 and August 27, 1948, petitioner bought high grade securities outright without margin on the New York Stock Exchange. He kept these securities in a safe-deposit vault and continued to own them unencumbered and unpledged until after the corporation was liquidated in June 1950.

The debit balance of $16,372.46 in petitioner's loan account as of December 31, 1948, was reduced to $13,304.81 by March 31, 1949. On March 31, 1949, which was the close of the fiscal year of the corporation, petitioner made and delivered to the corporation his promissory note dated that day, in the amount of $13,304.81, payable on demand to the order of Victor International Corporation, without interest, at Irving Trust Company, 225 Broadway, New York, New York. The same amount was also reflected as a corporate asset in the item "loans receivable" on the corporation's March 31, 1949, balance sheet.

From the time petitioner executed the promissory note until the dissolution of the corporation in 1950, the note was kept in the corporation's strongbox and the corporation's accountant knew about it. When the corporation was liquidated, the note was canceled by having petitioner's signature torn off. Petitioner was solvent throughout the period between August 1948 and June 1950, and he was able to repay the sum represented by the promissory note at any time. After the large advances were made to petitioner in August 1948, the corporation did not curtail any of its normal activities and was prepared to do every kind of business it had done before 1948.

At the time the corporation made the advances to petitioner in 1948, petitioner knew that there was a distinction between capital gain rates and ordinary income rates, and that dividends were taxed as ordinary income.

The running loan account maintained with the corporation by petitioner's wife contained the following entries: Date Explanation Amount debited Dec. 31, 1946 Balance (due petitioner) ................... $3,264.91 ========== Mar. 31, 1947 Alice Shaken ............................... $4,514.91 Mar. 31, 1947 Balance (due petitioner) 0 ---------- $4,514.91 ========== Apr. 7, 1947 State Tax Commission ....................... $17.50 June 30, 1947 Additional withholding tax ................. 250.00 Nov. 26, 1947 Saks Co .................................. 123.00 ---------- $390.50 ========== Jan. 1, 1948 Balance .................................... $390.50 Mar. 8, 1948 Collector of Internal Revenue. ............. 2.28 Mar. 31, 1948 Balance (due petitioner) ................... 7.22 ---------- $400.00 ========== Apr. 9, 1948 State Tax Commission ....................... $135.75 ---------- $135.75 ========== Jan. 1, 1949 Balance .................................... $128.53 Mar. 23, 1949 J. Feldstein ............................... 135.00 Mar. 31, 1949 The Telescope Furniture Co. ................ 25.92 Mar. 31, 1949 Balance (due petitioner) ................... 110.55 ---------- $400.00 ========== Aug. 8, 1949 Maybrook Bedding ........................... $92.32 Apr. 13, 1949 The Fair ................................... 60.00 Apr. 15, 1949 State Tax Commission ....................... 198.45 Apr. 27, 1949 Riche Nursery .............................. 146.50 Apr. 9, 1949 Saks-5th Ave ............................... 115.00 May 25, 1949 Jessi Vogel ................................ 37.30 May 25, 1949 Talbott Glass .............................. 33.25 June 3, 1949 Jacques Bodart, Inc ........................ 474.17 July 7, 1949 O'Neil Rug Carpet ........................ 250.00 Aug. 29, 1949 A. Shaken .................................. 3,000.00 Sept. 12, 1949 Marie Nelson ............................... 240.00 Oct. 4, 1949 Equitable Life ............................. 339.75 Oct. 26, 1949 Samuel Shiller ............................. 30.50 Oct. 10, 1949 William Hoffman ............................ 54.00 Nov. 7, 1949 Nursery Furniture .......................... 63.50 Nov. 18, 1949 Riche Nursery .............................. 66.00 Nov. 14, 1949 New York Hospital .......................... 235.73 Dec. 13, 1949 M. Nelson .................................. 120.00 Dec. 19, 1949 M. Nelson .................................. 84.00 ---------- $5,640.47 ========== Jan. 1, 1950 Balance .................................... $5,508.25 Jan. 11, 1950 Lord Taylor .............................. 75.30 ---------- $5,583.55 ========== Apr. 1, 1950 Balance .................................... $5,583.55 Date Explanation Amount credited Aug. 1, 1946 Balance at beginning ...................... $3,264.91 ========== Jan. 1, 1947 Balance .................................... $3,264.91 Mar. 31, 1947 Salaries transferred to loan account. ...... 1,250.00 ---------- $4,514.91 ========== Apr. 1, 1947 Balance .................................... 0 Dec. 31, 1947 Balance (due the corporation). ............. $390.50 ---------- $390.50 ========== Mar. 31, 1948 Salaries transferred to loan account. ...... $400.00 ---------- $400.00 ========== Apr. 1, 1948 Balance .................................... $7.22 Dec. 31, 1948 Balance (due the corporation). ............. 128.53 ---------- $135.75 ========== Mar. 31, 1949 Salaries transferred to loan account. ...... $400.00 ---------- $400.00 ========== Apr. 1, 1949 Balance .................................... $110.55 Sept. 2, 1949 J. Bogart — refund .......................... 21.67 Dec. 31, 1949 Balance (due the corporation). ............. 5,508.25 ---------- $5,640.47 ========== Mar. 31, 1950 Balance (due the corporation). ............. $5,583.55 ---------- $5,583.55 Many of the advances made to petitioner's wife were amounts paid for household furnishings and other items for the home of petitioner and his wife. The $3,000 withdrawal made on August 29, 1949, was apparently never repaid to the corporation or to petitioner, and Alice Shaken never gave the corporation any promissory note for her claimed indebtedness. Alice Shaken was solvent and able at all times to repay the money advanced by the corporation and she agreed to repay it.

The corporation's certified public accountant submitted to it monthly statements of the corporation's accounts which included a balance sheet of assets and liabilities at the close of business each month. All of the monthly statements over the period involved show the loans receivable due to the corporation from petitioner and his wife. These financial reports were shown to several of the corporation's suppliers, people who extended credit to the company, and several persons who were thinking of entering the export business. The balance sheets attached to the corporation's Federal income tax returns also show these amounts as loans receivable.

The various claims which had been asserted against Victor International Corporation by its vendees in the Far East were not set forth as liabilities on the balance sheet of the corporation nor was a reserve for contingent liabilities established.

No interest was paid by Victor International Corporation to either petitioner or his wife on any loan payable account, and no interest was paid by either petitioner or his wife to the corporation on any loan receivable account.

The following resolution was adopted at a special meeting of the corporation's stockholders held on March 24, 1950:

A motion was duly made by Victor V. Shaken that the corporation dissolve and all assets be distributed at once to the stockholders [ sic].

A vote being had thereon, the motion was unanimously carried and adopted.

Pursuant to this resolution, Victor International Corporation transferred to petitioner all its assets, subject to all its liabilities, in complete liquidation and redemption of all the capital stock.

In the liquidation, the entire claimed indebtedness of petitioner and his wife both on their loan accounts and on petitioner's promissory demand note was canceled and discharged by treatment of the amount due as a liquidating distribution to petitioner, the sole stockholder. In their joint Federal income tax return for the calendar year 1950, petitioner and his wife reported a long-term capital gain by reason of their treatment of the cancellation of the claimed indebtedness as a liquidating distribution made in complete redemption of petitioner's capital stock in the corporation.

Victor International Corporation was dissolved by Certificate of Dissolution filed in the office of the Secretary of State of New York on June 30, 1950. The corporation also filed with respondent Form 966 together with a certified copy of the resolution for liquidation adopted at the March 24 meeting.

Except for the distribution upon liquidation, the corporation never made any formal dividend declaration.

The balance sheets of Victor International Corporation, as adjusted to give effect to subsequent changes by the Bureau of Internal Revenue, show the following amounts of earned surplus accumulated at the end of its respective fiscal years:

Fiscal year ended Mar. 31 Earned surplus

1947 ........................................... $9,663.03 1948 ........................................... 13,757.21 1949 ........................................... 15,427.73 1950 ........................................... 13,847.77

By the end of fiscal year 1950 petitioner and his wife had withdrawn practically all the capital and surplus invested in the business, as shown as follows: Total assets at Mar. 31, 1950 ........................... $31,817.47 Less: Loans receivable .................................. 21,237.66 ---------- Balance of assets ....................................... $10,579.81 Total liabilities ....................................... 10,360.18 ---------- Balance ................................................. $219.63 Capital and surplus ......................... $21,457.29 Loans receivable ............................ 21,237.66 After the corporate liquidation petitioner operated the business as a sole proprietor under the name of Victor Importing Company. The business was of exactly the same nature as that of the dissolved corporation.

After the liquidation of the corporation, Alice Shaken loaned money to Victor Importing Company. At June 30, 1952, that company owed her the sum of $13,020.29.

In the deficiency notice addressed to petitioners covering the calendar year 1948, respondent explained his adjustment to their income as follows:

(a) It has been determined that cash withdrawals by you in 1948 from Victor International Corporation were not loans but constituted taxable dividends, to the extent of $13,583.16, within the purview of Sections 22 (a) and 115 of the Internal Revenue Code.

The deficiency notice covering the calendar year 1949 referred to a revenue agent's report, dated May 12, 1952, which explained one of respondent's adjustments for that year as follows:

Dividends ....................................... $2,936.90

Cash advances in above amount, from Victor International Corporation, constituted taxable dividends.

Petitioner and his wife, both individually and as officers and directors of Victor International Corporation, regarded the moneys advanced to them by the corporation in 1948 and 1949 as loans and consistently treated them as such.

The withdrawals made by petitioner in 1948 and the payments made to his wife in 1949 were loans and not dividends.

OPINION.