23 T.C. 208">*208 In these consolidated proceedings, deficiencies in income tax for the year 1948 are claimed as follows: 23 T.C. 208">*209

1954 U.S. Tax Ct. LEXIS 47">*48 The primary question raised concerns a payment of $ 19,500 by Feagans Paint Company to Frank T. Feagans. We are asked to determine whether this payment was made to purchase Frank Feagans' stock in the paint company, or in recognition of his right to share in the accumulated profits of the company, or to settle a lawsuit over control of the company. Our determination will have tax consequences for each of the three petitioners.

FINDINGS OF FACT.

Frank T. Feagans, the petitioner in Docket No. 35847, resides in Overland, Missouri. His wife, Esther, who is also a petitioner in Docket No. 35847, is deceased. They filed their joint income tax return for the taxable year 1948 with the collector of internal revenue for the first district of Missouri.

Lafayette A. Dirksmeyer, who is the petitioner in Docket No. 36074, resides in St. Louis, Missouri. He also filed his income tax return for the taxable year 1948 with the collector of internal revenue for the first district of Missouri.

Feagans Paint Company, petitioner in Docket No. 36075, is a corporation organized under the laws of Missouri, with its principal office in St. Louis, Missouri. It is engaged in the wholesale and retail paint1954 U.S. Tax Ct. LEXIS 47">*49 business. For the taxable year involved in this proceeding, it maintained its books and filed its return on the accrual basis. Its return for the taxable year involved also was filed with the collector of internal revenue for the first district of Missouri.

On May 31, 1944, Dirksmeyer purchased the Whittemore Paint Company, St. Louis, Missouri, for $ 3,020.70. The purchase included the fixtures, inventory, and goodwill.

The business acquired from Whittemore Paint Company was named the Feagans Paint Company because Dirksmeyer, who owned and operated another paint business in St. Louis under the name Dirksmeyer Hardware and Paint Company, preferred for business reasons that suppliers, competitors, and the local jobbers' association not know that he owned two paint businesses in St. Louis. It was operated as an individual proprietorship until September 7, 1944, when its successor, Feagans Paint Company, a corporation, commenced business at the same address.

Dirksmeyer was assisted in the operation of the business by Frank T. Feagans and Bernard F. Luer. Luer had been associated with 23 T.C. 208">*210 Whittemore prior to Dirksmeyer's purchase of the company and Feagans had been in the paint1954 U.S. Tax Ct. LEXIS 47">*50 business for many years as a salesman and had a considerable clientele. Although Feagans and Luer were employed by Dirksmeyer, there was an informal understanding among them that they would share in the profits if the business were successful.

The Feagans Paint Company was incorporated on August 31, 1944, under the laws of Missouri, to take over the business of the proprietorship. The corporation had authorized capital stock of 1,000 shares of $ 10 par value each. The certificate of authority to commence business was issued on September 7, 1944.

The capital paid in at the organization of Feagans Paint Company amounted to $ 10,000, and was contributed entirely by Dirksmeyer. It consisted of the Whittemore Paint Company assets which had been acquired by Dirksmeyer and additional cash and merchandise. Neither Feagans nor Luer paid in any capital or promised to pay in any capital.

The authorized capital stock of 1,000 shares of $ 10 par value in Feagans Paint Company was originally issued as follows:

1954 U.S. Tax Ct. LEXIS 47">*51 The stock certificates of Feagans Paint Company were prepared and issued by Gerald L. Seegers, an attorney. The certificates were dated September 1, 1944, but, due to a delay in getting the parties together, were not actually issued until September 12, 1944.

Stock certificates Nos. 1 and 3 were qualifying shares. Certificate No. 2 was issued showing Feagans as owner of the majority of the stock because Dirksmeyer wanted to conceal the extent of his participation from his competitors and also from his wife who was in the process of suing him for a divorce.

Feagans transferred to Dirksmeyer all rights of ownership in certificate No. 2 immediately after the issuance thereof on September 12, 1944. The certificate was endorsed as follows:

For Value Received, I hereby sell, assign and transfer unto L. A. Dirksmeyer Nine hundred ninety seven -- Shares of the Capital Stock represented by the within Certificate, and do hereby irrevocably constitute and appoint L. A. Dirksmeyer to transfer the said Stock on the books of the within named Corporation with full power of substitution in the premises.

Dated Sept. 12, 1944

In presence of

Frank T. Feagans. (Signed)

23 T.C. 208">*211 1954 U.S. Tax Ct. LEXIS 47">*52 Immediately after the endorsement, Feagans, in the presence of Seegers, delivered certificate No. 2 to Dirksmeyer, who retained the certificate in the safe at the Dirksmeyer Hardware and Paint Company, St. Louis, Missouri.

Feagans served as president of Feagans Paint Company from the date of its organization until his resignation effective July 10, 1948. Dirksmeyer was vice president from the date of incorporation until he succeeded Feagans as president. Bernard F. Luer served as secretary and treasurer from September 1, 1944, until he was succeeded in 1946 by Hilda Jo Hight.

The day-to-day operations of the company were supervised by Feagans who consulted frequently with Dirksmeyer on matters of policy. Feagans and Dirksmeyer each had full authority to commit the company and authority to sign checks on its bank account.

Dirksmeyer had a discussion with Luer and Feagans on or about the date of the purchase of the business from Whittemore in May 1944 concerning their participation in the profits of the business when it was successful. They had a general understanding that Luer and Feagans were to share in the profits but there was no agreement on the specific percentage of profits1954 U.S. Tax Ct. LEXIS 47">*53 each would receive nor was the understanding ever reduced to writing.

Feagans was employed by Dirksmeyer at a beginning salary of $ 200 per month, a salary substantially less than he had been earning before associating with Dirksmeyer. Luer also received $ 200 per month salary. However, Feagans, who handled outside sales, received an additional allowance of $ 100 per month to cover traveling expenses. Feagans and Luer continued at the same pay scale after the business was incorporated. Their compensation, however, was increased after the business improved and the earnings permitted such raises.

Feagans' salary was raised on July 2, 1945, to $ 275 per month and his expense allowance increased to $ 150 per month. In addition, Luer was granted an expense allowance. Beginning February 10, 1947, the corporation provided Feagans with an automobile and, instead of a fixed expense allowance, paid all of his traveling expenses. Feagans' salary was raised to $ 500 monthly beginning February 9, 1948. All adjustments in salary and expense were voted by the board of directors.

About four or five months after the incorporation of Feagans Paint Company, Dirksmeyer became fearful that his1954 U.S. Tax Ct. LEXIS 47">*54 wife, who was demanding alimony from him under a suit for divorce instituted on May 18, 1944, would discover he was the assignee of certificate No. 2 for 997 shares and, therefore, the undisclosed owner of the business. In order to prevent the wife's discovery of the assignment, Dirksmeyer, with the assistance and understanding of Feagans, then caused a duplicate 23 T.C. 208">*212 certificate No. 2 for 997 shares to be prepared. The duplicate certificate, however, was not endorsed by Feagans and the stock record book contained no filled-in stub for it. No documentary stamps were attached to the duplicate certificate, and it did not represent ownership. The sole purpose of the duplicate certificate was to put Feagans in a position, if confronted by a subpoena duces tecum, to display the duplicate certificate and represent to Dirksmeyer's estranged wife that he, and not Dirksmeyer, was the owner of the business.

The duplicate certificate, after being prepared in accordance with the plan of concealment, was placed in the corporation safe on the premises. Subsequently, Dirksmeyer effected a reconciliation with his wife, and on June 25, 1945, the divorce suit was dismissed. Dirksmeyer, 1954 U.S. Tax Ct. LEXIS 47">*55 however, permitted the spurious certificate to remain in the safe because he anticipated that further demands for alimony and domestic disorder might arise.

Personal relations between Feagans and Dirksmeyer became very strained during the fall of 1947. At the outset of the difficulties, Feagans made no specific demands on Dirksmeyer but informed him that "he [Feagans] would do as he pleased" in operating the business. Subsequently, Feagans asserted that he, and not Dirksmeyer, controlled the business entirely because he had in his possession one of the two stock certificates (No. 2) which had been prepared in connection with the divorce suit.

Sometime in the fall of 1947, Dirksmeyer requested Feagans to deliver to him the duplicate, unendorsed certificate which Feagans had removed from the corporate safe. In April 1948, Dirksmeyer, through his attorney, Gerald L. Seegers, formally demanded that Feagans deliver the duplicate, unendorsed certificate to him. Feagans, however, refused to comply and demanded instead that he be given 75 per cent of the accumulated surplus and profits.

On April 23, 1948, Dirksmeyer, through his attorney, Gerald L. Seegers, instituted an equity suit in1954 U.S. Tax Ct. LEXIS 47">*56 the Circuit Court of the City of St. Louis against Frank T. Feagans, president, Hilda Jo Hight, who replaced Luer as secretary of the corporation, and Feagans Paint Company. In the suit, Dirksmeyer sought to compel Feagans to surrender to him the duplicate, unendorsed certificate No. 2, issued in connection with the divorce suit, and to correct the corporate records so as to reflect accurately the fact that Dirksmeyer was the actual owner of the business.

The corporation's bank account was frozen after the suit by Dirksmeyer was filed. However, the business continued and some of the accounts were paid in cash or by endorsement of checks received by the corporation.

In negotiations subsequent to the filing of the suit, Feagans at first demanded $ 27,500 before he would agree to surrender to Dirksmeyer 23 T.C. 208">*213 the duplicate, unendorsed certificate. The amount was one-half of an estimated net worth of $ 55,000 based on an audit prepared for Feagans. Dirksmeyer, through his counsel, offered $ 10,000. Subsequently, Feagans consented to surrender the duplicate certificate for $ 19,500.

The accumulated surplus of the corporation on May 31, 1948, as reflected by a financial statement1954 U.S. Tax Ct. LEXIS 47">*57 prepared by Claude C. Ellis, C. P. A., at Feagans' request, amounted to $ 41,173.04. Dirksmeyer refused to concede that Feagans was entitled to any profits or that the accumulated surplus amounted to $ 41,173.04 but, upon advice of counsel, agreed for the purposes of settlement to have Feagans Paint Company pay Feagans $ 19,500.

On July 10, 1948, a stipulation for compromise and settlement of the litigation and controversy was signed. The stipulation provided, in part, as follows:

Whereas, there is a genuine dispute between the parties, particularly between L. A. Dirksmeyer and Frank T. Feagans regarding the ownership of the certificate of stock mentioned in said suit [by Dirksmeyer to recover possession of the duplicate certificate and to correct the corporate records] and, whereas, Frank T. Feagans is in possession of a duplicate of the certificate of stock mentioned in the petition in said suit, and

Whereas, Frank T. Feagans is claiming a share in the accumulated profits and surplus of the Feagans Paint Company, a corporation, and there is a genuine dispute between L. A. Dirksmeyer and Frank T. Feagans and the Feagans Paint Company, a corporation, regarding such claim by Frank1954 U.S. Tax Ct. LEXIS 47">*58 T. Feagans, * * *

Therefore, be it agreed:

That in consideration of the sum of Nineteen Thousand five hundred Dollars ($ 19,500.00) paid by L. A. Dirksmeyer and the Feagans Paint Company, a corporation, to Frank T. Feagans, * * * the said Frank T. Feagans forever releases L. A. Dirksmeyer and the Feagans Paint Company, a corporation, from any and all claims and liabilities of whatsoever kind or nature that the said Frank T. Feagans may have had or does now have, or may have in the future, arising from and out of the formation of the corporation, the conduct of same, the law suit * * * or any agreement, verbal, written, or implied for the sharing of profits, assets, stock, or otherwise.

* * * *

The said Frank T. Feagans delivers herewith, * * * any and all stock certificates that he may hold or have in his possession or under his control, and in particular certificate No. Two dated September 1, 1944 for 997 of the common capital stock of the Feagans Paint Company, a corporation, issued in the name of Frank T. Feagans and relinquishes to L. A. Dirksmeyer any claim of whatsoever kind or nature to possession, ownership or rights connected with said certificate.

* * * *

The said Frank 1954 U.S. Tax Ct. LEXIS 47">*59 T. Feagans relinquishes herewith to L. A. Dirksmeyer any right, claim, or interest in and to the cash, evidences of indebtedness, and accounts, now situated on the premises of the Feagans Paint Company, a corporation, * * *

23 T.C. 208">*214 Frank T. Feagans relinquishes forever to L. A. Dirksmeyer all his right, title and interest in and to Government bonds now held in the safe of the Feagans Paint Company and issued to Frank T. Feagans and L. A. Dirksmeyer jointly and severally, such bonds being listed on the books of the corporation as assets of the corporation.

Pursuant to the stipulation, Feagans Paint Company on July 9, 1948, paid $ 19,500 to Frank T. Feagans. On the same date, Feagans endorsed the duplicate stock certificate and surrendered custody thereof to Dirksmeyer. Feagans then resigned as director and president of the corporation.

The minutes of the special meeting of the board of directors of Feagans Paint Company, held on July 10, 1948, recite, inter alia, that:

L. A. Dirksmeyer, acting as chairman, called the meeting to order and announced the purpose of the meeting was a discussion of the litigation between the company and Frank Feagans, former president and manager, 1954 U.S. Tax Ct. LEXIS 47">*60 and the ratification of a settlement proposition to dispose of all controversies between the company and Feagans.

G. L. Seegers, who was representing Mr. Dirksmeyer and the company in the litigation, reported that, upon the filing of the suit to compel Feagans to transfer Dirksmeyer stock on the books of the corporation, Feagans had secured counsel and was making a claim for a share of the profits of the business since its inception, and that they were threatening to sue the corporation on an alleged oral agreement between Dirksmeyer and Feagans whereby Feagans was to receive, in addition to his salary and expense account, a share of the profits of the company. He was also basing his claim on the fact he had managed the company, and that, during his management, it had accumulated over $ 40,000.00 in surplus.

He had begun by demanding 75% of the accumulated surplus, but after continued negotiation, he had agreed to accept either 50% of the surplus or $ 19,500.00 whichever amount was less. Seegers reported that after a thorough audit of the books and records, it was his opinion that the $ 19,500.00 offer should be accepted, and he pointed out that if a lawsuit were filed and Feagans1954 U.S. Tax Ct. LEXIS 47">*61 produced, in addition to his own testimony, any evidence that would convince a jury he should be entitled to share in the profits, a jury might do anything, and that it was to the best interest of the company to settle with Feagans so that business could be resumed on a normal and progressive basis.

Therefore, on appropriate motion, it was voted that:

the $ 19,500.00 payment be made to Feagans * * * and that the auditor be instructed to enter this expenditure as the settlement of litigation based upon a claim to a share of profits, and that he refigure the company's profits over the past four years by amortizing this payment in order to make a request for a refund of taxes based upon this reduction of profits and surplus.

Of the $ 19,500 payment to Feagans, $ 3,120 was deducted by Feagans Paint Company on its corporation income tax return for 1948 as "salary" paid to Frank T. Feagans. No deduction, however, was claimed in the return for the balance of the payment.

The payment by Feagans Paint Company to Feagans served to reduce the corporation's accumulated surplus and profits. Feagans Paint Company had made no distribution of surplus prior to the payment 23 T.C. 208">*215 to Feagans1954 U.S. Tax Ct. LEXIS 47">*62 on July 9, 1948. It had an earned surplus as of December 31, 1947, of $ 33,296.20, and $ 21,524.56 as of December 31, 1948. Among the assets listed on the return were "Savings Bonds" in the amount of $ 300. The company reported a net income of $ 6,445.09 for the taxable year 1948.

The net worth of Feagans Paint Company increased during the time Frank T. Feagans served as president from $ 10,000 to $ 51,173.04.

Feagans Paint Company paid Gerald L. Seegers, an attorney, legal fees of $ 1,073.20 during 1948. The entire sum was deducted on the corporation's income tax return for 1948 as legal fees.

Feagans listed the $ 19,500 payment on his 1948 income tax return as received for stock in Feagans Paint Company, and after deducting $ 1,700 in legal fees incurred in the settlement negotiations, he treated the balance as a long-term capital gain.

Feagans owned none of the stock of Feagans Paint Company and had no proprietary interest in the company, and the amount paid to Feagans by the corporation was in reality in settlement of his claims for additional compensation and to relieve the corporation of the embarrassment incident to the controversy.

OPINION.

We think a better understanding1954 U.S. Tax Ct. LEXIS 47">*63 of this case can be had if a brief resume of the facts is stated. Dirksmeyer was engaged in the hardware and paint business. He found another paint business that could be purchased and he needed someone to run the new business for him. He found just the right man in Feagans and offered him the opportunity to undertake the management of the newly acquired business. Feagans gave up more lucrative employment to accept the position and at the outset was to receive and did receive a small salary of $ 2,400 a year, plus an allowance for traveling, etc. Within a short time, the business was incorporated under the name of the Feagans Paint Company and Dirksmeyer paid into the newly organized company $ 10,000 which was the entire paid-in capital of the company.

The difficulty that ensued might not have arisen in just the manner it did if the newly issued shares had been issued to Dirksmeyer in his own name in payment for the capital contributed. Because Dirksmeyer did not want his competitors to know that he was conducting another paint business and, more important, by reason of the fact that Dirksmeyer was having marital difficulties, he had the 997 shares (all of the shares except 1954 U.S. Tax Ct. LEXIS 47">*64 qualifying ones) issued in the name of Feagans and then had the certificate for those shares endorsed over to him. This certificate was given to Dirksmeyer and was placed in the latter's safe. Some time later a second certificate was issued to Feagans for 23 T.C. 208">*216 997 shares, which certificate was not endorsed over to Dirksmeyer. This was done to have a certificate to show counsel for his wife who had commenced divorce proceedings and thus give the impression that Feagans and not Dirksmeyer owned the shares of stock.

There is no doubt that Dirksmeyer and Feagans had an understanding that the latter was to share in the profits if the business prospered, but this understanding had not been reduced to writing and it is doubtful if even the exact terms had been orally agreed to. Dirksmeyer denies there was any such agreement with Feagans. The time came when relations became strained between Dirksmeyer and Feagans and it was then that Feagans claimed ownership of the business by reason of having possession of the duplicate certificate of stock or, in any event, claimed a proprietary interest in the corporation.

A suit was instituted by Dirksmeyer, in which Feagans, the corporation, 1954 U.S. Tax Ct. LEXIS 47">*65 and its secretary were named as defendants, to compel the surrender of the duplicate certificate of stock and the entry on the records of the corporation of Dirksmeyer's ownership of the 997 shares. The corporation's bank account was tied up so neither Dirksmeyer nor Feagans could draw on it. At this stage of the controversy and before the suit was brought to trial, counsel for the respective parties set about to negotiate a settlement. We have set forth in our Findings of Fact the important terms of the agreement of settlement which was drawn by counsel for the corporation and Dirksmeyer. Under the terms of the agreement, Feagans was to receive $ 19,500 in consideration of his surrender and assignment of the duplicate certificate of stock, and his release of the corporation and Dirksmeyer of all claims against either, including any claim to ownership in the property or any further claim to an interest in the profits. The agreement also contained all the other provisions that are usually found in a comprehensive release under the circumstances here present.

We have found as a fact, and it is clear to us from the entire record, that Feagans never did in fact own any shares of 1954 U.S. Tax Ct. LEXIS 47">*66 stock in the corporation; had no proprietary interest in the business; and that in reality his claims were for additional compensation. It is equally clear to us that there was an understanding, however informal, that Feagans was to receive a share in the profits if the business proved a success, which it did. There was maneuvering by both parties and the settlement took into consideration the various claims made, whether or not there was any merit in some of them. The figure of $ 19,500 was reached as a result of dickering between counsel, although the amount paid was very close to one-half of the accumulated earnings and surplus of the company during the period the corporation was operated by Feagans. That the corporation was induced to pay so high a price we think was due not only to a recognition that there was validity to 23 T.C. 208">*217 Feagans' claim for a share of the profits, but also because it was feared that the goodwill of the business and its continued successful operation might be seriously impaired if the bickering between Feagans and Dirksmeyer was continued much longer.

What, then, are the tax consequences of the settlement? Clearly the money received by Feagans was1954 U.S. Tax Ct. LEXIS 47">*67 not for the sale of a capital asset and the gain is not a capital gain but ordinary income. The money paid by the corporation was to compensate Feagans for his management of the corporation and to give him additional compensation by way of a share in the profits, which was indicated by an informal agreement between Feagans and Dirksmeyer, and also in some small part to protect its goodwill and business and permit it to resume operations in a normal way. ; ; cf. also . We think that the sum so paid constitutes an ordinary and necessary expense of the corporation, deductible in the year in which the settlement was reached, and in this case the year in which the money was paid. , .

The legal expenses and attorney's fees paid by the corporation to effect the settlement and for his services incident thereto are clearly1954 U.S. Tax Ct. LEXIS 47">*68 deductible in the full amount paid of $ 1,073.20.

We think the $ 1,700 paid by Feagans for attorney's fee in connection with the settlement constitutes an expense incurred in the collection of income. Feagans, having treated the transaction on his returns as in the nature of a sale of capital assets, deducted the attorney's fee from the amount received before computing his profits. The respondent would deny the deduction on the ground that it was not proven in the testimony that this sum was paid, but we think that the payment of this item was never in issue and there is no merit in respondent's argument in this particular.

There remains the treatment of respondent's contention that the money paid by the corporation to Feagans should be regarded as a dividend or distribution to Dirksmeyer. We think there is no merit in this contention. The stock of the corporation we have found at all times belonged to Dirksmeyer and at no time to Feagans, whose real claim was for additional compensation rather than a claim to ownership of stock. At the conclusion of the settlement, Dirksmeyer continued to own all the shares, but the net worth of the corporation was now $ 19,500 less than it 1954 U.S. Tax Ct. LEXIS 47">*69 was before the settlement. Certainly in these circumstances there was no profit or income accruing to Dirksmeyer. Nor is there any merit in respondent's argument that the money which was paid by the corporation was in part for Feagans' release of some Government bonds that were carried in the names of both Feagans and 23 T.C. 208">*218 Dirksmeyer. It appears that the amount of these bonds was only $ 300; that the bonds belonged to the corporation and not to the individuals who merely held them in trust; and that they continued to appear on the balance sheet of the corporation as its property.

Decisions will be entered under Rule 50.