
    I. UNTERBERG & CO. v. THE UNITED STATES
    [No. D-323.
    Decided November 7, 1927]
    
      On the Proofs
    
    
      Income and excess-profits taxes; debenture notes to stockholders; borrowed money; invested capital. — Where the members of a partnership, upon organizing a corporation, of which they are the sole stockholders, to take the place of it, determine upon a capitalization less than the former working capital, but retain the difference in the business and receive therefor from the new company interest-bearing debenture notes payable at a fixed date and subordinate to claims of general creditors, the fund so covered is borrowed money, and not invested capital as defined in section 207 of the revenue act of 1917.
    
      The Reporter's statement of the case;
    
      Mr. Prison Howie for the plaintiff. Messrs. Frank 3. Bright and H. Stanley Hinrichs were on the brief.
    
      Mr. Alexander H. McCormick, with whom was Mr. Assistant Attorney General Herman J. Galloway, for the defendant.
    
      The court made special findings of fact, as follows:
    I. Plaintiff, I. Unterberg & Co., Inc., is a corporation duly organized under the laws of the State of New York, with its principal place of business at 90 Franklin Street, New York City, and its business is the manufacture and sale of men’s shirts.
    II. On January 1,1910, Israel Unterberg, William Slutske (his name being later changed to William S. Slater), and Israel L. Butler entered into a partnership for the manufacture and sale of men’s shirts under the firm name of I. Unterberg & Company, with a capital of $419,843.35, contributed as follows: By Israel Unterberg $371,567.25, by William S. Slater $33,276, and by Israel L. Butler $15,000. Said agreement provides, among other things, that before the distribution of any of the profits of the partnership the individuals furnishing the capital invested therein shall receive interest at the rate of 6% per annum upon money put into the business by each of them. A copy of said agreement is attached to plaintiff’s amended petition, marked “ Exhibit B,” and made a part of this finding by reference.
    ITT. The partnership continued until the 2nd day of May, 1916, when it was dissolved and a corporation formed by the same individuals to continue, carry , on, and engage in the business of the partnership under the firm name of I. Unterberg & Co., Inc. All of the assets of the partnership were taken over and all of the debts and liabilities of the partnership weTe assumed by the corporation. During the existence of the said partnership there was no change in the personnel thereof. At the time of the dissolution of said partnership the net worth of the respective interests of said partners therein was as follows:
    Israel Unterberg_$296, 638. 35
    William S. Slater_ 96, 394. 72
    Israel L. Butler_ 43, 622. 64
    IV. The authorized capital stock of said corporation was $200,000 and was all issued to the said Unterberg, Slater, and Butler, and in addition to this amount the three stockholders left in the business the sum of $236,655.71, making a total working capital of $436,655.71. For the excess by which the contribution of the partners exceeded the capital stock, to wit, $236,655.71, the said partners received three debenture notes, each dated May 1, 1916, payable on May 1, 1919, with interest at the rate of 6% per annum.
    Y. The said partners received shares of the capital stock and debenture notes of the plaintiff corporation in exchange for their respective interests in said property conveyed to the plaintiff corporation as follows:
    Israel Unterberg, 1,450 shares of the capital stock of claimant corporation of a paT value of $145,000 and a debenture note in the sum of $151,638.35, bearing interest' at the rate of 6% per annum;
    William S. Slater, 300 shares of the authorized capital stock of the claimant corporation of the par value of $30,000 and a debenture note in the sum of $66,394.72, bearing interest at the Tate of 6% per annum;
    Israel L. Butler, 250 shares of the authorized capital stock of the claimant corporation of the par value of $25,000 and a debenture note in the sum of $18,622.64, bearing interest at the rate of 6% per annum.
    All of said debenture notes were identical except as to amounts. The said note issued to Israel Unterberg is as follows, viz:
    New Yoke, May 1st, 1916.
    
    On May 1st, 1919, I. Unterberg & Co., Inc., for value received, promises to pay to Israel Unterberg or order one hundred and fifty-one thousand six hundred and thirty-eight 35/100 ($151,638.35) dollars, at No. 90 Franklin Street, in the city of New York, with interest thereon from February 1,1916, at the rate of six per cent (6%) per annum, payable semiannually on the 1st days of May and November; with the privilege to said company to pay the principal at any time after May 1st, 1917, on giving thirty days’ notice by mail to the holder hereof.
    This note is one of three similar notes, bearing like date, amounting in the aggregate to the sum of two hundred and thirty-^ix thousand six hundred and fifty-five 71/100 ($236,655.71) dollars, which have been issued by said company and are to stand on an equal basis as obligations without preference or priority of one over another.. All of said notes are issued on condition that they shall be subordinate to the claims of the general business creditors of ,said company, and upon the liquidation or dissolution of said company, or upon the final distribution of its assets, such general business creditors shall be entitled to priority of payment in full over said note^.
    $151,638.55.
    I. Unterberg & Co., Inc.,
    By Henrt C. Taylor, President.
    
    YI. Interest on said debenture notes was paid regularly by the corporation on the 1st day of May and November of each year.
    VII. On the 17th day of April, 1916, an agreement was entered into between Israel Unterberg, William S. Slater, and Israel L. Butler, being all of the stockholders of the plaintiff corporation, which provided, among other, things, for certain options to purchase the stock of any of the stockholders retiring from the business, and further provided that if said options were exercised the purchaser should also purchase the debenture note of the corporation held by said stockholder. A copy of said agreement is attached to plaintiff’s amended petition and marked “ Exhibit D,” and made a part of this finding by reference.
    VIII. The authorized capital of said plaintiff corporation was fixed at the sum of $200,000 on May 1, 1916, remained the same until January 8, 1919, when upon proper authority it wa,s increased to $600,000, and thereafter, on or about January 27, 1919, the stockholders of said corporation surrendered to it the debenture notes aforesaid held by them and received in exchange therefor 2,366 shares of the capital stock of the plaintiff corporation, which said shares were distributed among said three stockholders in exact proportion to the amounts due them, respectively, on,account of principal and interest due upon said debenture note,?, and upon the delivery of said stock as aforesaid each of said debenture notes were endorsed across the face thereof as follows: “ January 27, 1919. Stock issued in payment of these notes. David W. Unterberg, secretary.”
    IX. For the year 1917 the said corporation reported net profits in the (sum of $127,316.96 for the purpose of corporation income and excess-profits taxes and thereafter paid the tax due thereon in the sum of $28,679.42, said tax being determined and based upon an invested capital of $436,-655.71, which included the amount of $236,655.71 for which said debenture notes had been issued. Thereafter the Commissioner of Internal Revenue assessed an additional tax amounting to $15,812.04, based upon an invested capital of $200,000.00, being the said sum of $436,655.71 less the said sum of $236,655.71, which was represented by said debenture notes, basing his decision on the ground that this amount represented borrowed money and was a liability and could not be included in invested capital under section 207 of the revenue act of 1917.
    X. Thereafter, and on the 14th day of November, 1922, the said additional tax and interest aggregating in all the sum of $19,685.98 was paid under protest by said corporation to the collector of internal revenue, second district of New York. Thereafter, and on the 29th day of June, 1923, said corporation filed with the collector of internal revenue, second district of New York, a claim for refund of the said additional tax paid as aforesaid in the sum of $19,685.98, which claim was denied on or about February 7, 1924.
    The court decided that plaintiff was not entitled to recover.
   Moss, Judge,

delivered the opinion of the court:

On January 1, 1910, Israel Unterberg, William Slutske, and Israel L. Butler formed a partnership under the firm name of I. Unterberg & Co., with a capital of $419,843.35, contributed in varying proportions by the three members thereof. It was agreed between the partners that before the distribution of any profits ,the individuals contributing capital thereto should receive interest at the rate of 6 per cent per annum on the amount that each had contributed to the business.

On May 2, 1916, the partnership was dissolved and a corporation composed of the same individuals was formed under the corporate name, I. Unterberg & Co., Inc., to continue the business of .the partnership.

At the time of the dissolution of the partnership the net value of the respective interests of said partners therein was as follows: Israel Unterberg, $296,638.35; William Slutske (whose name was later changed to William S. Slater) $96,-394.72; and Israel L. Butler, $43,622.64. The authorized capital stock of the corporation was $200,000, which was distributed to the three members of the corporation in amounts equal to their respective contributions as stated above. The difference between the amount of the stock so distributed and the total sum of the working capital, said difference amounting to $236,655.71, was allowed by the partners to' remain in the company, for which the company executed and delivered to each of the partners its note. These notes were identical in terms except as to name and amount. They were payable on a fixed date and bore interest from date at the rate of 6 per cent per annum payable semiannually, with the privilege to said company of paying the principal at any time after May 1, 1917, on giving thirty days’ notice to the holder. Said notes contained ¡the following provision:

“ This note is one of three similar notes, bearing like date, amounting in the aggregate to the sum of two hundred and thirty-six thousand six hundred and fifty-five 71/100 ($236,655.71) dollars, which have been issued by said company, and are to stand on an equal basis as obligations, without preference or priority of one over another. All of said notes are issued on condition that they shall be subordinate to the claims of the general business creditors of said company, and upon the liquidation or dissolution of said company, or upon the final distribution of its assets, such general business creditors shall be entitled to priority of payment in full over said notes.”

An agreement was entered into between the three stockholders on April 17,1917, which provided for certain options to purchase the stock of the stockholders retiring from the business and it further provided that if said options were exercised said notes should also be purchased.

On January 8, 1919, the authorized capital of plaintiff company was increased to $600,000, and on January 17, 1919, the stockholders surrendered to plaintiff said notes, and received in exchange therefor certain shares of the capital stock of plaintiff company.

In its tax return for the taxable year 1917 plaintiff based its tax upon an invested capital of $436,655.71, which included the total amount of said notes. The Commissioner of Internal Revenue assessed an additional tax of $15,812.04, on the ground that said notes represented borrowed money, and that the fund for which they were executed could not properly be included in invested capital. This action is' for the recovery of said additional tax.

Section 207 of the revenue act of 1917 (40 Stat. 306) defines invested capital in the following language:

“ That as used in this title, the term ‘ invested capital ’ for any year means the average invested capital for the year) as defined and limited in this title, averaged monthly.
“As used in this title ‘ invested capital ’ does not include stocks, bonds (other than obligations of the United States) , or other assets, the income from which is not subject to the tax imposed by this title nor money or other property borrowed, and means subject to the above limitations:
“(a) In the case of a corporation or partnership: (1) Actual cash paid in, (2) the actual cash value of tangible property paid in other than cash, for stock or shares in such corporation or partnership, at the time of such payment (but in case such tangible property was paid in prior to January first, nineteen hundred and fourteen, the actual cash value of such property as of January first, nineteen hundred and fourteen, but in no case to exceed the par Avalué of the original stock or shares specifically issued therefor), and (3) paid in or earned surplus and undivided profits used or employed in the business, exclusive of undivided profits earned during the taxable year. * * * ”

It is plaintiff’s contention that the notes under consideration represented a species of preferred stock, and that the fund left with the company in exchange therefor should properly be included in its invested capital. We are unable to agree with plaintiff’s theory on that point. The money left with the company belonged to the individuals. The notes provided for its repayment at a fixed time, with interest from date, payable semiannually. The provision that the three notes were to stand on an equal basis, and that they should be subordinate to any claim of general creditors, does not in anywise affect the legal status of the transaction. It is nothing more nor less than a declaration of the legal requirements under the particular circumstances involved therein. Preferred stock entitles the holder to an interest in the assets of the corporation, with a voice in its management, and to the right to share in its surplus profits. The holder of these notes, as such, acquired no such rights or privileges. They were merely entitled to the payment of the notes in accordance with the terms thereof; and each of them was so paid, and endorsed across the face of the note “ January 27, 1919. Stock issued in payment of these notes. David W. Unterberg, secretary.”

The court holds that the fund for which the notes involved herein were executed was borrowed money, which is expressly excluded from consideration as invested capital.

It follows that the petition should be dismissed. And it is so ordered.

Geaham:, Judge; Booth, Judge; and Campbell, Chief Justice, concur.

Hat, Judge, absent.  