Before BIGGS, Chief Judge, and MCLAUGHLIN and GANEY, Circuit Judges.
The question posed on this petition for review is whether advances by petitioner to Park Lane Furniture Mfg., Inc., (a corporation in which petitioner was a 50% stockholder) from October of 1953 through December of 1954 were loans or capital contributions. The Tax Court*fn1 found that the advances were contributions to capital, and sustained the Commissioner of Internal Revenue's determination of income tax deficiency, based on his disallowance of petitioner's claim in its income tax return that $100,079.75 of the advances was a bad-debt deduction in its fiscal year ending June 30, 1955, under § 166(a)(1) of the Internal Revenue Code of 1954, 26 U.S.C.A. § 166(a)(1).*fn2
The petitioner, Diamond Brothers Company, is a corporation organized under the laws of New Jersey, with its principla place of business in Reading, Pennsylvania. During the fiscal year ending June 30, 1955, its principal place of business was in Trenton, New Jersey, and its income tax return for that fiscal year was filed with the district director of internal revenue, Camden, New Jersey. The petitioner's business is the manufacture and sale of upholstered living-room furniture. Sol Diamond, a director and vice president of petitioner, owned one-third of its stock.
A rather detailed recital of the factual background is here requisite for the proper disposition of the problem posed.
Park Lane Furniture Mfg., Inc., was a California corporation with plants in Santa Monica and Gardena of that State.*fn3 Sigmund Berkowitz owned 125 shares or one-half of the issued and outstanding common stock of Park Lane; Harry and Stanley Strasberg, together, owned the other half. Sigmund was chairman of the board of the corporation; the Strasbergs were directors.During the fiscal year ending June 30, 1952, Park Lane had a deficit of $30,071.12 and needed working capital. Sigmund wanted to obtain additional capital for the corporation, but was unable to do so. His credit rating was not high at the time and Park Lane's credit had been extended to almost the limit and it could not obtain a bank loan without the guarantee of the Strasbergs. The latter, who were already guarantors for the repayment of a Park Lane bank loan as well as being contingently liable on certain of its accounts payable by reason of written guarantees or oral assurances, were apparently unwilling to personally guarantee any more borrowing by Aprk Lane or Sigmund.
At a furniture convention held sometime before August 3, 1953, Sigmund approached Sol Diamond and told him that he (Sigmund) and his associates had agreed to separate. He asked Sol if, in return for a half interest in Park Lane, petitioner would be willing to expand its business to the west coast and assist in increasing the business of Park Lane by using its facilities as an outlet for its products. He told Sol that Park Lane needed working capital and asked him if petitioner had a banking connection. Sol was interested and went to a bank in Camden, New Jersey, and worked out an agreement whereby the bank would lend money to Park Lane. Some of the conditions were that petitioner would "stand in back" of Park Lane, that Park Lane's accounts receivable would be given as security and that Park Lane's books be kept in Trenton for inspection and audit by the bank. Petitioner consented to this agreement and the bank made loans to Park Lane.
On or about July 27, 1953, Quaker Pile Fabric Corp. obtained a judgment against Park Lane for $9,716.27 with interest at 7% plus costs. Prior to the entry of the judgment, Quaker Pile Fabric Corp. caused a writ of attachment to issue against the assets of Park Lane. In order to have the attachment released, Park Lane obtained a bond for which it deposited $2,500, and Harry Strasberg deposited with the bonding company a certificate of indebtedness in the sum of $10,000.
In California, on August 13, 1953, the petitioner joined in a written agreement with Sigmund, his wife, Norma, and the Strasbergs and Park Lane, whereby Sigmund obtained the remaining half interest in Park Lane from the Strasbergs in return for his wife's interest in Imperial Mills, Inc. The Strasbergs were to resign as officers and directors of Park Lane, while Sigmund and his wife were to give up their positions as officers and directors of Imperial Mills. Park Lane was to deliver two promissory notes to Harry Strasberg, one in the amount of $5,000, payable after sixty days, the other in the amount of $9,500, payable after thirty days; to pay him $193.05 representing accrued interest on the certificate of indebtedness in return for the certificate; and to pay the balance of costs, not exceeding $500, in Quaker Pile's suit against it. The Strasbergs also agreed to release Park Lane of any other claims which they might have against it.
In the same agreement, petitioner agreed inter alia, as follows: To obtain, along with Sigmund, the release within six days of the Strasbergs as guarantors on the balance of a Park Lane bank loan (then approximately $67,094.56), for which some of Park Lane's accounts receivable had been assigned to the bank as security;*fn4 to guarantee the payment within ten days of certain accounts payable by Park Lane in the approximate amount of $20,000 for which the Strasbergs were contingently liable; to guarantee the payment, along with Sigmund, of Park Lane's promissory note of $9,500, payable to Harry Strasberg; to guarantee the payment of Park Lane's promissory note of $5,000 payable to Harry Strasberg; to guarantee Sigmund's promise to indemnify Imperial Mills from half of any losses (not to exceed $5,000) which might be incurred in the collection of approximately $20,000 worth of its accounts receivable; and to lend Sigmund $2,500.
Concurrently with the above agreement, petitioner, Sigmund and Park Lane also entered into a written agreement which recites that as consideration for petitioner's entering into the other or main agreement, Sigmund "sells, assigns, and conveys and transfers" 50% of the shares of stock in Park Lane to it without any further consideration from petitioner to Sigmund.The agreement also set forth the following conditions: As long as petitioner and Sigmund held the stock in Park Lane, they were to elect Sigmund as president and a director, and Sol Diamond, or some other person designated by petitioner, as vice president and a director of Park Lane. Sigmund was to act as general manager of Park Lane and receive a salary of $150 a week plus expenses; and he was not to engage in another business similar to or competitive with that of Park Lane or invest in any business that would require his personal attention.Except for the payment of wages and expenditures from petty cash accounts, no withdrawals from Park Lane's banking accounts were to be made without the signature of either Sol Diamond, as vice president of Park Lane, or of another person designated by petitioner. Horever, all purchase invoices were to be approved by Sigmund before they were paid. Payroll and petty cash records, copies of which were to be sent petitioner at its office, were to be kept at the business office of Park Lane in California; all other books and records of Park Lane were to be kept at petitioner's office in Trenton, New Jersey. Sidney Gushen was to act as a director and secretary-treasurer of Park Lane with the right of either petitioner or Sigmund to request his resignation. Neither petitioner nor Sigmund were to sell any of their shares of stock without first making a written offer to the other of the shares to be sold. If obtainable, Sigmund was to apply for a life insurance policy not to exceed $50,000, Park Lane was to be irrevocably named as beneficiary and the latter was to pay the premiums.*fn5
As a guide to the parties to the agreement concerning the financial condition of Park Lane as of June 30, 1953, a "pro forma" balance sheet was prepared, based on an audit of its books and records. The sheet reflected the following figures: A net profit of $32,099.36 for the fiscal year; current assets of $13,486.92; current liabilities of $241,133.90 and capital of $64,925.97. The latter amount consisted of the total of $25,000.00, the fixed value of the issued and outstanding stock held by petitioner and Sigmund, $37,936.49, the amount of notes payable to the officers and stockholders of Park Lane prior to June 30, 1953, and $1,989.48, the difference between $32,099.36, the net profit for the fiscal year, and $30,109.88, the deficit for the previous period. The sheet also showed that approximately half of its accounts receivable were assigned as security for loans; that among its current liabilities there was a bank overdraft of $4,272.85, accounts payable amounting to $113,166.06, and a bank loan of $67,094.56.
A comparison of the "pro-forma" balance sheet with that of Park Lane's shows that some items in the former were chv ged so as to reflect a more favorable picture of Park Lane's financial position as to current assets and capital. Two items, $37,936.49, representing notes payable to stockholders, and $82,150.00, the book value of a building and land owned by Park Lane, had been subtracted from current liabilities of $361,220.39, in order to arrive at the figure of $241,133.90 for current liabilities on the "pro-forma" sheet. The $82,150.00 was not listed under fixed assets so as not to reflect a change in the net worth of Park Lane. Since the building and land had not been sold, current liabilities should have been increased by $82,150.00 for a total of $323,283.90, which exceeded current assets by $39,878.40. Moreover, if the $25,000.00 representing the fixed value of the stock and $37,936.49, representing the notes, are disregarded, Park Lane had capital of only $1,989.48 to work with. Petitioner was given copies of the "proforma" balance sheet as well as Park Lane's sheet.
The provisions of the agreement were carried out with respect to records and accounts of Park Lane and the head of petitioner's accounting department kept ...