Opinion
Docket No. 24666.
1951-04-13
ERARD A. MATTHIESSEN AND ELIZABETH C. MATTHIESSEN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Donald M. Dunn, Esq., for the petitioners. William A. Schmitt, Esq., for the respondent.
Donald M. Dunn, Esq., for the petitioners. William A. Schmitt, Esq., for the respondent.
Petitioners are husband and wife. In 1934 the husband organized a corporation and acquired 60 of the 65 shares. The paid-in capital of the corporation was $6,500. In payment for his share the husband transferred to the corporation unimproved real estate on which houses were built and sold by the corporation. Simultaneously with the formation of the corporation the husband advanced $20,000 to the corporation on its unsecured, demand, interest bearing note. During the period 1934 to 1941, in order to furnish funds for the corporation, petitioners advanced other sums to the corporation taking its unsecured demand notes. Some of the notes were interest bearing but interest was not ever fully paid. The corporation operated at a deficit in every year and was liquidated in 1941.
Held, petitioners' advances of funds to the corporation were contributions to capital, not loans, and petitioners' losses thereon were capital losses.
The respondent determined a deficiency of $34,521.83 in the petitioners' income tax liability for the year 1941.
The sole issue is whether advances made by petitioners to a corporation controlled by them were loans or investments.
FINDINGS OF FACT.
Such of the facts as were stipulated are so found, and in so far as they appear pertinent to the issues, are incorporated in the other facts below.
Petitioners Erard A. and Elizabeth C. Matthiessen are husband and wife. They filed a joint income tax return prepared on a cash basis for the taxable year 1941 with the collector of internal revenue for the second district of New York.
Erard A. Matthiessen (hereinafter referred to as ‘petitioner) is an architect. On January 11, 1934, he caused Tiffany Park, Inc., to be formed under the laws of the State of New York. Tiffany's stated purpose was to acquire, maintain, and develop real estate and to engage in a general real estate and brokerage business. Petitioner felt that in his principal business, as an architect, it would be well not to have his name connected with a venture of the nature Tiffany was to undertake other than as an office and director of the corporation.
The petitioner was elected president of Tiffany. On February 9, 1934, Tiffany resolved to purchase from petitioner for $6,000 two unimproved parcels of property in Irvington, New York. In payment for this property Tiffany issued petitioner six shares of its stock. On February 9, 1934, Tiffany's officers were authorized to execute contracts necessary to erect two buildings on the property. Tiffany's board of directors voted to accept petitioner's offer to lend Tiffany's board of directors voted to accept petitioner's offer to lend tiffany $20,000 on a demand note bearing interest at 6 per cent. Petitioner advanced to Tiffany the sum of $20,000.
Tiffany subsequently built two houses on the property acquired from petitioner. One house was sold in 1936; the other was completed and sold in 1938.
On June 16, 1936, petitioner advanced to Tiffany for its general corporate purposes the sum of $1,000 and received in exchange therefor its demand promissory note in that amount and of that date with no rate of interest specified.
On November 10, 1938, petitioner advanced to Tiffany the sum of $11,155 taking a demand note with interest at 6 per cent.
In 1931 the petitioner had purchased unimproved property in the Town of Greenburgh, Westchester County, New York, for $35,000, for the purpose of developing the property, building houses thereon and selling them. In 1936 the petitioner transferred this property to Tiffany and received therefor its promissory demand note in the amount of $35,000, which note specified no rate of interest. Nothing was ever done with this property by Tiffany. At the time of the liquidation of Tiffany on December 29, 1941 (to be referred to below), this property was transferred to the petitioner's nominee in exchange for the $35,000 note.
Elizabeth C. Matthiessen, since 1930, had been the owner of certain improved real property, approximately 11 acres, in Irvington, New York, assessed by the Town of Greenburgh for 1940 and five previous years at $123,550. This property had been rented for a number of years. On August 12, 1940, Elizabeth C. Matthiessen contracted to exchange the property for two apartment houses in Mount Vernon, New York, at an agreed price of $60,000 over and above existing mortgages thereon totaling approximately $180,000. The consideration to be paid by Elizabeth C. Matthiessen was the transfer of the Irvington property valued at $45,000 and $15,000 in cash. On August 29, 1940, Tiffany's board of directors resolved to buy Elizabeth C. Matthiessen's interest in the exchange contract in payment for which Tiffany agreed to give its demand promissory note for $39,000 with interest at 5 per cent and 60 shares of Tiffany's $100 par value stock. Elizabeth C. Matthiessen assigned her interest in the exchange contract to Tiffany and received Tiffany's promissory note for $39,000 with interest at 5 per cent and 60 shares of its stock. Tiffany also gave petitioner its promissory note payable on demand in the amount of $16,871.98 with interest at the rate of 5 per cent. This note to petitioner was to cover the sum of $15,000 in cash advanced by him in order to consummate the exchange contract and the additional sum of $1,871.98 representing tax adjustment, insurance and title acquisition costs. Elizabeth C. Matthiessen took no part in the negotiation involving the exchange contract and merely signed the necessary papers. She believed that the result of this transaction would be to give her equal position with her husband in Tiffany.
On September 12, 1940, petitioner advanced for Tiffany the sum of $906.84 in payment for the legal services of attorneys who acted for Tiffany in the closing of the exchange contract referred to above. A note in this amount with interest at 5 per cent was issued to the petitioner.
On January 30, 1941, petitioner advanced $3,500 on behalf of Tiffany in payment of taxes on the apartment house owned by Tiffany in Mount Vernon, New York. Petitioner received Tiffany's note in the amount of $3,500 dated January 30,1941, and payable on demand with interest at 5 per cent.
On May 14, 1941, petitioner paid on Tiffany's behalf the sum of $1,050 to the rental agents for the Mount Vernon property, and on that date took Tiffany's note in the amount of $1,050 payable on demand with interest at 5 per cent.
On July 28, 1941, petitioner advanced on Tiffany's behalf $3,500 for the payment of taxes due on the Mount Vernon property and received in exchange therefor Tiffany's demand note for that amount bearing interest at 5 per cent.
On December 23, 1941, Tiffany sold the Mount Vernon property for $7,000 in cash subject to the mortgages thereon.
Tiffany's 1934 Federal income tax return had written on its face ‘No income at all.‘ Its 1935 return showed gross receipts of $15,000, cost of operations at $22,176.55, and a deficit of $7,409.66. Deductions were taken in a total of $233.11 consisting of payment for taxes, legal fees, blueprints, and sundries. Cash at the end of 1935 was shown to be $12,374.76, and work in process $3,017.51.
Tiffany's 1936 return showed an operating loss of $3,020.96 and a payment of interest in the amount of $2,924.17 on notes payable to petitioner.
At the beginning of 1937, Tiffany had cash on hand of $15.17, at the end of that year, $341.60; ‘construction in process‘ at the beginning of the year was $15,893.09 and at the end, $19.828.94. There was a year-end deficit of $12,778.50.
Tiffany's 1938 return showed a net loss of $8,306. Its 1939 return is blank, showing no gross income and no deductions. Tiffany's return for 1940 showed income only from rents in the amount of $11,865.77. Deductions exceeded gross income resulting in a net loss of $1,433.15. Deductions included an interest payment of $2,070.43.
There was never any security given by Tiffany to petitioners for the advances made by them to that corporation. Tiffany never received advances from anyone other than petitioners and it gave no promissory notes other than those to petitioners.
Dissolution of Tiffany was authorized at a meeting of its directors and stockholders on December 29, 1941, and its dissolution duly followed. Pursuant to a plan of liquidation the stockholders surrendered their shares of stock in the corporation for cancellation and redemption. The cash in bank of $5,479.66 was distributed 50.15 per cent to petitioner and 49.85 per cent to his wife, Elizabeth C., Matthiessen. The promissory notes of Tiffany outstanding at that time were of the principal amount of $76,8983.82. The distributions of cash in bank were accomplished on December 29, 1941.
The notice of deficiency contains the following explanation of adjustments:
(a) and (b) It is held that the following advances made by you to Tiffany Park, Inc. represent additional investments in the capital stock of that corporation.
(1) Advances by Erard A. Matthiessen in the amount of $37,983.82
It is further held that upon complete liquidation of the above corporation in 1941 you sustained a loss of $35,235.78 on your investment, the deductibility of which is limited by the provisions of section 117(b) of the Internal Revenue Code since the capital stock of that corporation constituted a capital asset as defined in section 117(a) of the Code and said stock was held by you for more than 24 months. Accordingly, the long-term capital loss deduction of $4,675.24 claimed on your return has been increased by $17,617.89 (50% of $35,235.78) and the bad debt deduction claimed in the amount of $35,235.78 has been disallowed.
(2) Advances by Elizabeth C. Matthiessen in the amount of $39,000.00
It is further held that upon complete liquidation of the above corporation in 1941 you sustained a short-term capital loss of $36,268.38 on your investment, since the capital stock of that corporation constituted a capital asset as defined in section 117(a) of the Internal Revenue Code and said stock was held by you for less than 18 months. Accordingly, the bad debt deduction of $36,268.38 claimed on your return has been disallowed and the short-term capital loss recognized cannot be availed of as a deduction in 1941 due to the limitation provisions of section 117(d) of the Internal Revenue Code.
OPINION.
VAN FOSSAN, Judge:
Petitioners contend that the sums they advanced to Tiffany Park, Inc., represent loans and the loss upon liquidation of the corporation is a bad debt loss. Respondent determined that petitioners' losses were capital losses subject to the provisions of section 117 of the Internal Revenue Code.
Tiffany Park, Inc., was formed by petitioner Erard A. Matthiessen in order that he could keep separate his professional activities as an architect and the venture Tiffany was to undertake. Petitioner transferred unimproved real estate to the corporation in exchange for 60 shares of its $100 par value capital stock. Petitioner simultaneously advanced $20,000 to Tiffany, taking its unsecured promissory note, and with this money Tiffany proceeded with the erection of two buildings on the property. We have set out in our Findings of Fact, in detail, the list of subsequent advances made by petitioner's to Tiffany, the use to which those advances were put and the ultimate dissolution of the corporation in 1941. There is no need to comment at length on the disproportionate relationship between Tiffany's capital structure and the total of money advanced to the corporation by petitioners. It is obvious that the corporation was inadequately capitalized that a comparison of the capital structure with the amount of advances is alone sufficient to support the conclusion that the money advanced by petitioners was at all times put at the risk of the business as capital. It is apparent from the nature of the operations to be conducted by Tiffany that it was never intended to stand on its own feet financially and operate without petitioners' continuing supply of funds.
Aside from the relationship of Tiffany's capital to the amount of advances, the lack of any adequate security for the advances negatives completely petitioners' insistence that they were bona fide loans and not capital contributions. The possibility is remote indeed that a disinterested lender of money would have made the initial unsecured loan of $20,000 to Tiffany in order to provide that corporation with the working capital necessary to embark on a speculative building project. It would be even more improbably that such a lender would continue to advance funds for a venture such as Tiffany which was showing an increasing deficit in every year. The petitioners' self-serving statements that the advances were intended to be loans bear little weight in the face of the other facts of record. Petitioners' references to the interest paid on the notes does no more than point out that interest payments were made in only two years and that other interest accrued from time to time was never paid.
There is nothing novel in the situation presented here. We have recently considered in the following cases the subject of inadequate capitalization, holding that under the facts advances were capital contributions and not loans: Edward G. Janeway, 2 T.C. 197, affd., 147 F.2d 602; Sam Schnitzer, 13 T.C. 43, affd., 183 F2d 70; Isidor Dobkin, 15 T.C. 31, on appeal, C.A. 2; Hilbert L. Bair, 16 T.C. 90. See, also, Harry Sackstein, 14 T.C. 556, holding that a taxpayer's payments of a share of the losses of a corporation created to furnish a source for otherwise unattainable merchandise, were capital contributions and not taxpayer's ordinary and necessary business expenses.
In Isidor Dobkin, supra, we said:
When the organizers of a new enterprise arbitrarily designate as loans the major portion of the funds they lay out in order to get the business established and under way, a strong inference arises that the entire amount paid in is a contribution to the corporation's capital and is placed at risk in the business. Cohen v. Commissioner, 148 Fed.(2d) 336; Joseph B. Thomas, 2 T.C. 193. The formal characterization as loans on the part of the controlling stockholders may be a relevant factor but it should not be permitted to obscure the true substance of the transaction. Sam Schnitzer, 13 T.C. 43, 60.
The record made in this case falls far short of providing a valid distinction such as to merit our holding for petitioners on this issue. Respondent, therefore, did not err in his determination that petitioners' advances to Tiffany Park, Inc., were contributions to the capital of that corporation and not loans.
Decision will be entered for the respondent.