Appeal from the District Court of the United States for the Southern District of Indiana, Indianapolis Division; Robert C. Baltzell, Judge.
Before EVANS and MAJOR, Circuit Judges and LINDLEY, District Judge.
This is an appeal from a judgment of the District Court in an action to recover income taxes in the amount of $10,681.44, with interest thereon, alleged to have been overpaid by appellee for the calendar year 1929; a claim for refund having been disallowed by the commissioner of Internal Revenue. The applicable statute and regulation is section 23(a) of the Revenue Act of 1928, 45 Stat. 799, 26 U.S.C.A. § 23 and note, and Article 128 of Regulations 74:
"in computing net income there shall be allowed as deductions:
"(a) Expenses. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered."
Article 128: "Bonuses to employees. - Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered. It is immaterial whether such bonuses are paid in cash or in kind or partly in cash and partly in kind. Donations made to employees and others, which do not have in them the element of compensation or are in excess of reasonable compensation for services, are not deductible from gross income."
The facts were largely stipulated and are substantially as follows: Appellee is and was an Indiana corporation engaged in the business of manufacturing and selling golves and similar products. In June, 1925, at a special meeting of stockholders, it was authorized to offer 850 shares of its common stock, having a total par value of $85,000, to 15 designated employees at par, and to accept therefor their respective noninterest-bearing demand notes aggregating $85,000; the said shares of stock to be held as collateral security for the payment of the notes. Stock dividends were to be applied upon the payment of the notes and it was agreed that the notes should be canceled and surrendered to the makers when the stock dividends equaled the face value of such notes. The stock was issued in the names of the employees as authorized, and the latter delivered to appellee their demand promissory notes in respective amounts exactly equal to the par value of the shares issued to each. The notes so received were carried on appellee's books of accounts in the notes receivable account as an asset, and the shares of stock issued as aforesaid were entered and carried in appellee's books of account in the capital stock account. The certificates representing the 850 shares of stock so issued were retained by appellee as collateral security for the payment of said notes. The market value of the stock when issued was $159.50 per share.
During the years 1925 to 1929, inclusive, appellee earned $108.48 net for each share of its common stock outstanding during those years, after the payment of dividends on its preferred stock. During this period, cash dividends amounting to $37 per share were paid by appellee on its outstanding stock, including that issued in the names of the employees referred to, and this amounted to $31,450 paid to such employees. None of these cash dividends were applied on the said promissory notes; in fact, no payment whatever was made upon such notes by the makers thereof.
On August 22, 1929, the common stock of appellee had a book value of approximately $200 per share, and on that date, appellee, by appropriate action, changed the character of its common stock from $100 par value shares to no par value shares and authorized the issuance of 4 shares of the latter for each share of the former. Thus, the 850 shares of par value stock issued to the 15 individual employees were converted into 3,400 shares of no par value stock; the latter having a market value of $57.12.
By action of appellee's board of directors, August 24, 1929, new notes of the employees were substituted, aggregating $85,000, which were interest bearing, and the cash, as well as stock dividends, were to be applied on the payment of such notes. The old notes were returned to the makers and at the same time half of the 3,400 shares of common stock was delivered to such employees, and the stock thus delivered affords the basis for the present controversy.
The remaining one-half of said stock, or 1,700 shares, was retained and continued to be held as collateral for the substituted notes. The certificates delivered to the employees in August, 1929, were not reported as additional compensation to those individuals in the income tax return filed by appellee for that year, nor were they entered upon appellee's books or records as compensation paid or owing to said employees.
On March 8, 1932, appellee, by appropriate action, relieved the makers of the substituted notes of all liability to the company, ordered the notes surrendered, and repurchased ...