W. O. Covey, Inc. v. C.I.R., 121569 FEDTAX, 4518-67

Docket Nº:4518-67.
Opinion Judge:SCOTT, Judge:
Party Name:W. O. COVEY, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Robert W. Tunnell, for the petitioner. Bert W. Hunt, for the respondent.
Case Date:December 15, 1969
Court:United States Tax Court
 
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28 T.C.M. (CCH) 1379 (1969)

T.C. Memo. 1969-273

W. O. COVEY, INC., Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 4518-67.

United States Tax Court.

December 15, 1969

Robert W. Tunnell, for the petitioner.

Bert W. Hunt, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

SCOTT, Judge:

Respondent determined deficiencies in petitioner's income taxes for the fiscal years ended March 31, 1963 and March 31, 1964, in the amounts of $1,820 and $931.36, respectively.

The issue for decision is whether petitioner is entitled to deduct as interest, payments made in 1963 and 1964 to Julia E. Covey with respect to an instrument in the form of a demand note which petitioner gave to Julia E. Covey on January 2, 1958, in exchange for 240 shares of petitioner's common stock.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

W. O. Covey, Inc. (hereinafter referred to as petitioner) is a Delaware corporation with its principal place of business at the date of the filing of the petition in this case in Seaford, Delaware.

Petitioner filed its Federal corporate income tax returns for its fiscal years ending March 31, 1963, and March 31, 1964, on an accrual method of accounting. These returns were filed with the district director of internal revenue, Wilmington, Delaware.

Petitioner was incorporated as a successor to the business of a sole proprietorship engaged in food distribution which was founded in 1923 by William O. Covey, Sr. The incorporation of the business was in 1935 shortly after the death of William O. Covey, Sr. Of petitioner's authorized 1,000 shares of no par value stock, only 720 were issued. Of the 720 issued shares, 240 were issued to Julia E. Covey, 240 to her son, William O. Covey, Jr., 220 to her daughter, Lucile C. Hitchens, and 20 to her son-in-law, Norris H. Hitchens. From 1935 until January 2, 1958, there was no change in petitioner's stockholders or the number of shares held by each. Julia E. Covey exchanged her 240 shares of stock for an instrument in the form of a demand note dated January 2, 1958. At the time of this exchange on January 2, 1958, Julia E. Covey was 76 years old.

The minutes of a meeting of petitioner's board of directors, held January 2, 1958, read as follows:

A meeting of the Board of Directors of W. O. Covey, Inc. was held in the office of the corporation in Seaford, Delaware, at 7:30 P.M. on January 2, 1958. The following directors were present:

William O. Covey, Jr.

Julia E. Covey

Norris H. Hitchens

Lucile C. Hitchens

After some discussion it was decided by the directors and agreed upon by Julia Covey that she would sell back to the corporation the 240 shares of common stock that she owns of W. O. Covey, Inc. The price agreed upon was $70,000.00 and Mrs. Covey agreed to accept a note in that amount from the Corporation. It was also agreed that approximately $3,000.00 per year would be paid on the principal of the note plus interest on the unpaid balance at 5% rate.

It was also agreed that Mrs. Covey's salary remain the same.

There being no further business, the meeting adjourned.

(Signed) Lucile C. Hitchens, Secretary

On January 2, 1958, the only directors of petitioner were those listed in the minutes as being present at the meeting of the board of directors.

Julia E. Covey's basis in her 240 shares of stock was $24,398.08 and the approximate fair market value of the stock on January 2, 1958, was $70,000.

On January 2, 1958, the officers of petitioner were:

President W. O. Covey, Jr.
Vice President Julia E. Covey
Secretary Lucile C. Hitchens
Treasurer Norris H. Hitchens

Julia E. Covey had been vice president of petitioner since July 6, 1935, and continued as vice president until August 17, 1961. She was a member of the board of directors from January 20, 1936, until August 17, 1961. From January 2, 1958, until June 1, 1961, she received a yearly salary as vice president in the amount of $2,400. Dividends were paid by petitioner as follows:

Fiscal year
ending
March 31 Amount
1951 $15,000
1952 20,000
1953 15,000
1954 15,000
1955 15,000
1956 15,000
1957 15,000
1968 18,000

No dividends were paid after the fiscal year 1957 until the fiscal year ending March 31, 1968. The instrument given by petitioner to Julia E. Covey was on a printed form which contained the provisions customary to a demand note which provides for confession of judgment. The instrument was executed as follows:

Witness our hands and seals the day and year aforesaid. WITNESS: W. O. Covey, Inc. (Seal) W. O. Covey, Jr., Pres. (Seal) Norris Hitchens, Treas. (Seal) The note contained no restriction on transferability.

Julia E. Covey from the time the note was issued in 1958 until her death in February 1967, made no demand upon petitioner to pay any part of the principal of the note and received no such payment. Petitioner each year paid $3,500 to Julia E. Covey which it denominated as interest at the rate of 5 percent per annum on the $70,000 note. Norris H. Hitchens was executor of the estate of Julia E. Covey. No demand was made upon petitioner to pay any part of the principal of the $70,000 during the settling of the estate and no such payment was made. Julia E. Covey in her will left the residue of her estate which included the instrument in question to her granddaughter, Julia L. Hitchens, who has made no demands on petitioner to pay any part of the $70,000 principal. Julia L. Hitchens is the daughter of Norris H. Hitchens. On January 28, 1968, a new instrument was issued to Julia L. Hitchens. This instrument was also in the form of a demand note, given under seal, bearing 5 percent interest per annum, and providing for confession of judgment. There was no restriction on transferability of the new instrument. In September 1968, petitioner made a payment of $5,000 as its first payment on the principal of $70,000 to show ‘ good faith.’ There was a closely knit relationship between the members of the Covey family. At the time of the transaction concerning the exchange of stock by Julia E. Covey for the instrument dated January 2, 1958, and during the yearn which followed, there was never any dissension between Julia E. Covey and her children nor between her and her son-in-law, Norris H. Hitchens. W. O. Covey, Jr., died on July 9, 1963. Lucile C. Hitchens died prior to December 1966. Norris H. Hitchens has a life estate and Julia L. Hitchens has a remainder interest in the 220 shares held by Lucile C. Hitchens prior to her death. On August 17, 1967, Julia L. Hitchens was elected as a director of petitioner and has continued from that time to serve as a member of the board. She was elected secretary of petitioner on October 25, 1966, and has continued to serve in that capacity. The following tables show the balance sheets and profit and loss statements of petitioner for the years 1959 through 1968:

Balance Sheet, 1959-1963
1959 1960 1961 1962 1963
__ __ __ __ __
Assets
__--
Current assets
Cash $ 26,190 $ 20,076 $ 52,451 $ 18,240 $ 46,519
Accounts receivable 81,112 79,561 113,656 117,678 126,159
Inventory 141,510 160,578 197,358 164,539 235,094
Investments (at cost) 10,650 10,650 10,650 10,650 10,650
U.S. Government bonds 49,000 49,000 49,000 49,000 49,000
Cash surrender value of
life insurance 8,475 9,738 10,736 11,745 12,774
Advance on commissions -0- -0- -0- -0- -0-
____ ____ ____ ____ ____
Total current assets $316,937 $329,603 $433,851 $371,852 $480,196
Fixed assets
Land 1,500 1,500 1,500 1,500 1,500
Bldg, fixtures and equip. 7,811 6,685 6,380 5,036 3,815
____ ____ ____ ____ ____
Total fixed assets 9,311 8,185 7,880 6,536 5,315
____ ____ ____ ____ ____
Total assets $326,248 $337,788 $441,731 $378,388 $485,511
Liabilities
______
Current liabilities
Accounts payable 63,935 60,474 141,826 $ 49,768 $116,944
Payroll taxes 2,810 4,018 3,934 3,692 4,356
Notes payable-bank 3,000 9,000 4,000 -0- -0-
Accrued commissions
and salaries 6,198 23,063 33,740 33,692 41,848
Profit sharing trust 16,944 13,832 13,497 19,745 20,294
Federal income tax 7,000 4,601 4,444 6,055 8,071
Loans payable-officers
and others 20,015 5,352 15,212 30,128 40,092
____ ____ ____ ____ ____
Total current liabilities $119,902 $120,340 $216,653 $143,080 $231,605
Long-term liabilities
Notes payable
Redemption of stock 70,000 70,000 70,000 70,000 70,000
Officers -0- -0- -0- -0- -0-
Employees' profit sharing -0- -0- -0- -0- -0-
____ ____ ____ ____ ____
Total long-term liabilities 70,000 70,000 70,000 70,000 70,000
____ ____ ____ ____ ____
Total liabilities 189,902 190,340 286,653 213,080 301,605
Shareholders' Equity
__________
Capital assigned to common
stock--1,000 authorized,
no par value--720 outstanding,
240 treasury stock 73,179 73,179 73,179 73,179 73,179
Retained earnings 133,167 144,269 151,899 162,129 180,727
____ ____ ____ ____ ____
Total 206,346 217,448 225,078 235,308 253,906
Less treasury stock 70,000 70,000 70,000 70,000 70,000
____ ____ ____ ____ ____
...

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