Opinion
Docket No. 58597.
1957-02-4
LEO PERLMAN AND SIMA PERLMAN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Alfred S. Pellard, Esq., for the petitioners. Rutheled B. Wolter, Esq., for the respondent.
Alfred S. Pellard, Esq., for the petitioners. Rutheled B. Wolter, Esq., for the respondent.
Petitioner was an officer and a substantial stockholder of an insurance company. The company's financial condition was precarious. In 1950 petitioner canceled the company's indebtedness to him for unpaid portions of his 1943-1947 salary. Held, the cancellation constituted a contribution to capital and was not deductible under section 23(a) or (e), I.R.C. 1939.
The Commissioner determined a deficiency in income tax for 1950 in the amount of $11,072.78. The question for decision is whether the cancellation of indebtedness by an employee-stockholder in 1950 on account of accrued but unpaid compensation for prior years is deductible by him under section 23(a) or (e), Internal Revenue Code of 1939, or whether the cancellation represents a contribution to the capital of the employer corporation and therefore is not deductible.
FINDINGS OF FACT.
The facts stipulated by the parties are incorporated herein by reference as part of these findings.
Petitioners, husband and wife, are and were residents of Mount Vernon, New York, during 1950. They filed their joint income tax return for 1950 with the then collector of internal revenue for the third district of New York. Petitioner Leo Perlman will hereinafter be referred to as petitioner.
Trade Union Accident and Health Association of America, subsequently known as Union Casualty Co., and now known as Union Casualty & Life Insurance Company, was organized in 1943. It will hereinafter be referred to as the company. Petitioner was one of the organizers of the company. He invested most of the capital he then possessed, and became a director and executive vice president. His duties were general management of the company. The company was a New York corporation, engaged in writing health and accident insurance; it did not commence to write life insurance until after 1950. Throughout the period in controversy petitioner owned between 20 per cent and 23.75 per cent of the outstanding stock. Paul Backer, another stockholder-officer who was active in the affairs of the company, owned 5 per cent of the outstanding stock and his wife, Julia Backer, owned from 15 per cent to 20 per cent of such stock. In addition, petitioner and the Backers together indirectly controlled from 2.5 per cent of the stock (as of January 26, 1946) to 8.75 per cent of the stock (as of December 29, 1950), one-half of such indirect control being attributable to petitioner and the other one-half to the Backers.
In 1943 a contract was entered into between petitioner and the company whereby he was employed for a period of 5 years commencing March 24, 1943, at an annual salary of $7,500. Provision was made for automatic renewal, and the contract was in fact renewed for an additional period of 5 years.
The company was organized with minimum capital and paid-in surplus; it did not do much business at the beginning; and petitioner therefore agreed to the demand of the directors that he withdraw only a part of his salary. During the years 1943-1947, the amounts of compensation payable to petitioner accrued by the company, the amounts paid, and the amounts accrued but unpaid are as follows:
+-------------------------------------------------------------+ ¦Years¦Amounts accrued¦Amounts paid¦Amounts accrued but unpaid¦ +-----+---------------+------------+--------------------------¦ ¦1943 ¦$7,500 ¦$5,775.00 ¦$1,725.00 ¦ +-----+---------------+------------+--------------------------¦ ¦1944 ¦7,500 ¦3,580.00 ¦3,920.00 ¦ +-----+---------------+------------+--------------------------¦ ¦1945 ¦7,500 ¦3,580.00 ¦3,920.00 ¦ +-----+---------------+------------+--------------------------¦ ¦1946 ¦7,500 ¦3,473.60 ¦4,026.40 ¦ +-----+---------------+------------+--------------------------¦ ¦1947 ¦7,500 ¦3,477.60 ¦4,022.40 ¦ +-----+---------------+------------+--------------------------¦ ¦ ¦$37,500 ¦$19,886.20 ¦$17,613.80 ¦ +-------------------------------------------------------------+
The company deducted the entire $7,500 salary on its income tax returns for each of the years, and, although petitioner was on the cash basis, he reported the full amount of such compensation on his returns.
During the years 1948-1950, the ratio of premiums written to the total capital and surplus of the company was as follows:
+--------------+ ¦1948¦4.6 to 1 ¦ +----+---------¦ ¦1949¦5.3 to 1 ¦ +----+---------¦ ¦1950¦5.9 to 1 ¦ +--------------+
The practice in the health and accident insurance business, which was also a requirement of the New York Department of Insurance, was that the ratio of premiums written to total capital and surplus should not exceed 2 to 1, or at most 3 to 1. Representatives of the New York Department of Insurance had brought to the attention of the company the fact that its premiums written exceeded permissible limits, and the board of directors was concerned about the matter.
The amounts of petitioner's accrued but unpaid compensation were not reported in the annual statements which the company filed with the New York Department of insurance, but the facts were known to the State examiners. In 1950 the chief examiner raised the question of petitioner's unpaid salary and requested that it be ‘disposed of’ either by payment or by being written off the books. Petitioner took the matter up with the board of directors, and it was recognized that payment resulting in reduction of surplus would jeopardize the financial structure of the company. In view of the excessively high ratio of premiums written to total capital and surplus, there was the danger that the State authorities might order the company to stop writing any new business. Such an order would have crippled the company as it would have resulted in forcing the company to close up established agencies. In the circumstances petitioner reluctantly agreed to cancel the indebtedness. At the same time Backer also agreed to cancel similar indebtedness for unpaid compensation. Such cancellations occurred at some undisclosed time in 1950.
The reason that petitioner canceled the indebtedness was to improve the financial condition of the company and thereby protect his investment as stockholder as well as his future salary from the company. The 1950 return filed by petitioner and his wife discloses salary paid by another employer in the amount of $92,099.89. Petitioner's salary from the company on the date of the hearing, in 1956, was $24,000 per annum.
In the years following 1950 the company raised additional capital by the sale of stock.
The company included the amount of the canceled indebtedness in its 1950 income for Federal income tax purposes.
OPINION.
RAUM, Judge:
Petitioners argue that they are entitled to the deduction as an expense under section 23(a) or as a loss under section 23(e) of the Internal Revenue Code of 1939. However, we conclude on all the evidence that the release constituted a contribution to capital and, therefore, is not deductible in 1950 under any section of the Code.
The company's financial condition was acute. Its capital and surplus account was for too low in relation to the amount of premiums written, and there was danger that the State insurance authorities might take action that would cripple the company. It was in such circumstances that the chief examiner of the State department of insurance told petitioner that the matter of the unpaid compensation must be ‘disposed of.’ No practical alternative was open to petitioner. His purpose in canceling the indebtedness, although virtually forced upon him, was to strengthen the company's capital structure. To be sure, that purpose in turn had behind it petitioner's motive to protect his own investment in the company as well as his future salary, but the basic fact remains that he, a substantial stockholder and one of the principal officers, canceled the indebtedness in order to improve the financial condition of the company. We hold that such action constitutes a contribution to capital. It is settled that a contribution to capital need not be proportionate to the stockholdings of the contributor. Harry Sackstein, 14 T.C. 566, 569; Dezso Goldner, 27 T.C. 455.
Petitioner is not aided by the fact that what he contributed was his claim to unpaid compensation which he had reported as ordinary income in earlier years. Petitioner was on the cash basis of accounting and it is far from clear why he had reported as income amounts which he never received. But whatever the explanation for petitioner's actions in the earlier years,
he in fact chose to contribute his claim to unpaid compensation to the company and thereby strengthen its financial position. That, we hold, was a contribution to capital (cf. Lidgerwood Manufacturing Co. v. Commissioner, 229 F.2d 241 (C.A. 2), certiorari denied 351 U.S. 951; Bratton v. Commissioner, 217 F.2d 486 (C.A. 6)); it increased the basis of petitioner's stock, and he will obtain tax benefit therefrom when he subsequently sells or otherwise disposes of his stock in a taxable transaction.
There is some suggestion in the record that he reported the unpaid salary on the theory of constructive receipt. However, the dubious financial condition of the company and the attitude of the directors against payment make doubtful whether the doctrine of constructive receipt would apply here. Perhaps the full salary was reported in order to support the company's claim to deduction therefor on its returns. Cf. sec. 24(c), I.R.C. 1939.
Decision will be entered for the respondent.