3 T.C. 1109">*1109 This proceeding is to test the correctness of respondent's determination of a deficiency in income tax for the year 1939 in the amount of $ 17,611.81. The sole issue is whether the petitioner was availed of during the year 1939 for the purpose of preventing the imposition of surtax upon its shareholders through the medium of permitting earnings or profits to accumulate instead of 1944 U.S. Tax Ct. LEXIS 84">*85 being divided or distributed. Some of the facts have been stipulated by the parties and others are covered by testimony of witnesses and by the introduction of exhibits.

FINDINGS OF FACT.

The petitioner is a corporation of the State of Connecticut, having its principal place of business in Hartford. Its income and excess profits tax return for the year 1939 was filed with the collector of internal revenue for the district of Connecticut.

The petitioner is an operating company engaged in the manufacture and sale of chains and sprockets used in the transmission of power, and keys and cutters used in metal-working operations. In addition, the petitioner since 1940 has been engaged in the manufacture of various component articles of materials of war, and it is now wholly engaged in war work.

During the year 1939 the petitioner had outstanding capital stock of 15,000 shares, par value $ 100 per share. Of this amount, 3,693 shares were held as treasury stock, having been purchased in 1936 from an erstwhile stockholder in settlement of a dispute over policy. The remaining shares, with the exception of directors' qualifying shares, were held by 5 persons, the wife and children of C. E. 1944 U.S. Tax Ct. LEXIS 84">*86 Whitney, who had been, prior to his death in 1933, president of the corporation and owner of approximately 75 percent of its stock.

3 T.C. 1109">*1110 For the calendar year 1939 the petitioner had section 102 net income in the amount of $ 138,289.23, and paid dividends of $ 67,842.00. These dividends were at the rate of $ 6 per share. The sum of $ 70,447.23 was retained as undistributed net income.

The petitioner's board of directors was composed of Robert Stevens, chairman, who was president of the J. P. Stevens Co., textile brokers of New York, a director of the Federal Reserve Bank of New York and of the American Telephone & Telegraph Co., and a trustee of the Metropolitan Life Insurance Co.; William J. Gallon, who was vice president and general manager of J. P. Stevens Co., and a director and overseer of the operations of 27 operating mills; Thomas Hewes, a lawyer; Leon B. Reed, a vice president of petitioner; Einar A. Hanson, a vice president of petitioner; W. H. Whitney, president of petitioner; and Park C. Boyd, secretary-treasurer of petitioner. ¹

1944 U.S. Tax Ct. LEXIS 84">*87 Only one of the directors, W. H. Whitney, was a stockholder of petitioner at the time it was decided to retain a part of the year's earnings. He owned approximately 3 percent of petitioner's stock, and devoted his full time to the affairs of petitioner and the Hanson-Whitney Machine Co.

In 1939 the directors were of the opinion that the United States would become involved in the war in which a large part of Europe was already engaged. They anticipated an acceleration of their business in consequence of war work, and planned an expansion and renovation of the plant and equipment. The equipment had not been kept in a proper state of repair, and much of it had become antiquated and would have to be replaced to put the petitioner in a competitive position. A considerable sum of money would be necessary to finance the expansion and renovation. The directors also felt that it would be necessary to expand a certain plant owned by the petitioner and leased to the Hanson-Whitney Machine Co., in which company the petitioner owned a 75 percent stock interest.

The following are the balance sheets of the petitioner for the years 1938 and 1939.

1944 U.S. Tax Ct. LEXIS 84">*89 3 T.C. 1109">*1113 The entry designated "marketable securities" denotes the market value of certain stocks and bonds maintained as an investment portfolio. In December of 1938 this portfolio consisted of securities having a value of $ 348,175. At that time a considerable portion of these stocks was sold, with a cash realization of approximately $ 326,000. Of that sum, $ 78,000 was immediately reinvested, and at the close of the year the portfolio amounted to $ 156,450. The balance of approximately $ 248,000 from the amount realized upon the transaction was held uninvested at the close of the year. During the year 3 T.C. 1109">*1114 1939 securities were bought and sold, and at the close of the year the market value of the portfolio was $ 196,934. The difference between this figure and the value as of the beginning of the year represents reinvestment of a part of the proceeds of the sale of securities in December 1938.

At the close of 1940 the market value of the portfolio was $ 174,269.25. By December 31, 1941, all of the securities had been disposed of, except United States savings bonds totaling $ 15,600. On December 31, 1942, the portfolio consisted of savings bonds in the amount of $ 16,000.

1944 U.S. Tax Ct. LEXIS 84">*90 In 1939 the stockholders were indebted to the corporation in the amount of $ 347,768.54. This amount originated for the most part in loans to the late C. E. Whitney and to his estate. At the time of his death in 1933, C. E. Whitney was indebted to the corporation in the amount of $ 143,050, which, with interest in the amount of $ 28,846.14, amounted to $ 171,869.14 at the close of 1938. From 1933 to 1938, inclusive, loans totaling approximately $ 160,000 had been made to the estate of Whitney to enable it to pay certain claims and taxes without resorting to the sale of petitioner's stock on the open market. Repayments in the amount of $ 55,000 had been made by the estate, so that at the close of 1938 the total indebtedness of the estate, including interest, was $ 282,920.87. No loans to the estate were made after 1938.

The balance of the total stockholders' indebtedness originated in loans to three stockholders in the total amount of $ 54,947.67. This amount had been loaned to these stockholders in years prior to 1939 for personal reasons. No loans to stockholders were made in 1939, with one exception. On January 9, 1939, a loan in the amount of $ 11,000 was made to W. H. 1944 U.S. Tax Ct. LEXIS 84">*91 Whitney, secured by his stock and bearing interest at 3 percent. Monthly repayments of $ 100, plus interest, have been made regularly by him on this loan. The interest and collateral provisions were incorporated in compliance with a Connecticut statute regulating loans to directors of corporations. The only loan made subsequent to 1939 was an interest-bearing loan of $ 3,200 in 1941 to W. H. Whitney, which was repaid within the year in accordance with its terms.

In 1939 a novation was effected among the corporation, the estate, and the heirs, whereby the stock held by the estate was distributed to the heirs in consideration of their assumption of the debt owed the corporation by the estate. This new debt was evidenced by demand notes bearing no interest except as to the amount assumed by W. H. Whitney, which was to bear interest at a rate not exceeding 4 percent, to be determined by agreement upon payment of the principal amount. It was provided that reasonable collateral could be requested, limited, however, to shares of stock of the petitioner.

3 T.C. 1109">*1115 At all times during 1939 and since that time, the stockholder-debtors were solvent. Of the stockholders, Laura Whitney Hawkinson's1944 U.S. Tax Ct. LEXIS 84">*92 assets consisted only of her home, her stock in the petitioner, and a small investment in an insurance company paying $ 100 in annual dividends. Mrs. C. E. Whitney's assets consisted only of her home and a lot, her stock in the petitioner, and other stocks worth between $ 10,000 and $ 12,000. Winthrop H. Whitney's assets consisted only of his home, with a mortgage on it, and his stock in the petitioner. Lawrence A. Whitney's assets consisted solely of his stock in the petitioner.

As of December 31, 1939, the above described debts of the stockholders to the petitioner stood as follows:

All of said debts incurred in 1939 were incurred as the result of the assumption of the debts of the estate of C. E. Whitney, except that the debts shown above as incurred in 1939 by 1944 U.S. Tax Ct. LEXIS 84">*93 Winthrop H. Whitney include the loan made to him by petitioner on January 9, 1939, of $ 11,000.

The Hanson-Whitney Machine Co. was organized in 1923 by B. M. W. Hanson and C. E. Whitney, and thereafter it engaged in the manufacture of machine tools and related products. At the time of organization Hanson contributed for his corporate interest various patents covering certain of his own inventions, and Whitney contributed the money needed as operating capital. As additional capital was required over the course of years, Whitney induced the petitioner to make loans to the Hanson-Whitney Co. and during the same period Hanson made loans to that company. Upon the death of Whitney in 1933, the assets of Hanson-Whitney were insufficient to pay its debts to petitioner and the estate of Hanson. A settlement was finally reached by all parties in interest, the effect of which was to cancel the Hanson-Whitney indebtedness to petitioner and to give to petitioner a 75 percent stock interest in that company. The Hanson estate was given a 25 percent stock interest in settlment of the debts due it. The Whitney estate lost all its stock and other interest in the Hanson-Whitney Co. as a result 1944 U.S. Tax Ct. LEXIS 84">*94 of the settlement. The Hanson-Whitney stock was carried on the books of the petitioner at a figure of $ 381,867.51, but was worth more than this. In 1939 there was no ready market for this stock.

3 T.C. 1109">*1116 Hanson-Whitney operated in a plant leased from the petitioner. From 1931 to 1940, inclusive, the annual rental paid the petitioner was $ 17,280. In 1939 it was apparent that Hanson-Whitney would be forced to expand to meet the acceleration of its business due to war contracts. In October of that year the petitioner undertook to expand the plant to meet the needs of its tenant, and additions constructed during the next two years cost the petitioner $ 247,849.15. Since 1939 rents and dividends have been paid to the petitioner by Hanson-Whitney as follows:

Since the outbreak of war in Europe in September 1939, petitioner has converted part of its manufacturing facilities and has acquired additional facilities for production of products not theretofore produced by it, as well as of an additional volume of its regular line.

On August 23, 1940, and on December1944 U.S. Tax Ct. LEXIS 84">*95 6, 1940, respectively, petitioner entered into contracts for the production by it of machinery parts and munitions, products not theretofore produced by it; and in November 1942, petitioner began negotiations for the production of a large quantity of airplane engine starters, which are likewise a product not theretofore produced by petitioner and are now being produced by it.

The amounts expended by the petitioner for additional facilities and the conversion of its war plant were as follows:

Except for ordinary repairs and replacements no similar outlays were made by the petitioner prior to 1939.

During these four years 1939-1942, inclusive, the expenditures for petitioner's own expansion and for the additions to the plant leased to Hanson-Whitney totaled $ 831,142.66.

The net profit and dividend records of the petitioner during the years 1939 to 1942, inclusive, were as follows:

3 T.C. 1109">*1117 At the end of 1939 petitioner owed nothing to banks. In 1941 $ 250,000 was borrowed from banks, which amount the petitioner still owes.

Petitioner's net sales and inventories for the years 1938 to 1942, were as follows:

Petitioner's net profits and losses from all sources as disclosed by its books for each year from 1931 through 1942, and also the dividend record for that period, are as follows:

The petitioner's net operating profits and losses for the same period, as disclosed by its books, are set1944 U.S. Tax Ct. LEXIS 84">*97 forth in the following table:

The accumulation of the amount of $ 70,447.23 in earnings and profits resulted in surtax savings to the shareholders in the total amount of $ 12,042.28, as follows:

3 T.C. 1109">*1118 The earnings and profits of the corporation were permitted to accumulate beyond the reasonable needs of the business in 1939. The petitioner was availed of in 1939 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting the earnings or profits to accumulate instead of being divided or distributed.

OPINION.

The Commissioner has determined that the earnings or profits of 1944 U.S. Tax Ct. LEXIS 84">*98 the petitioner were permitted to accumulate beyond the reasonable needs of the business in 1939. By virtue of section 102 (c), the accumulation of earnings or profits beyond reasonable needs is determinative of a purpose to prevent the imposition of the surtax upon the shareholders, unless the corporation, by a clear preponderance of evidence, proves to the contrary. The petitioner contends that the accumulated earnings were not unreasonable in view of the conditions faced by it in 1939, and it further contends that there was no purpose to prevent the imposition of the surtax upon its shareholders through the medium of permitting earnings or profits to accumulate instead of being divided or distributed.

Several circumstances tend to confirm the correctness of the Commissioner's determination. The surplus as of December 31, 1939, was $ 1,668,000. Of this amount $ 381,800 was invested in the stock of Hanson-Whitney Co., a corporation not related to the petitioner and forming no part of petitioner's business; $ 347,800 was left idle in the form of noninterest-bearing loans to stockholders, made for reasons purely personal to the stockholders and contributing nothing to the business1944 U.S. Tax Ct. LEXIS 84">*99 activities of the petitioner. Almost one-half of the petitioner's surplus was thus deflected from its normal business purposes. While it is true that these diversions originated in past years, and for the most part while the corporation was under the control of its late president, C. E. Whitney, it is equally true that the funds continued to constitute part of the petitioner's accumulated earnings or profits, against the unreasonableness of which the statutory presumption is directed. We are of the opinion that, to the extent the assets served no useful purpose as far as petitioner's own business is concerned, the accumulated earnings must be held to have been beyond the reasonable needs of the business in 1939.

The petitioner contends, on the authority of United Block Co. v. Helvering, 123 Fed. (2d) 704; certiorari denied, 315 U.S. 812">315 U.S. 812, that the problem is necessarily a question of how much quick assets were on hand for use in the business in the year in question. A considerable part of petitioner's surplus was represented by assets not susceptible 3 T.C. 1109">*1119 of ready liquidation. The stock of Hanson-Whitney, though1944 U.S. Tax Ct. LEXIS 84">*100 valuable, was not marketable in 1939, and petitioner urges that it should be eliminated from surplus in considering the present question. The petitioner also argues that the amount of the loans to stockholders, totaling $ 347,800 in 1939, should not be considered in determining the reasonableness of the accumulated earnings, upon the premise that such loans were not collectible in that year. We think these contentions would acquire force if, in fact, there was no way to liquidate the assets. However, there is a ready answer to both of these propositions, which might be expected to have occurred to a directorate of the caliber of petitioner's. If the $ 70,000 retained by the petitioner was, in fact, needed in the business, a complete distribution could have been made on the condition that the stockholders apply the amount of the distribution to the reduction of their indebtedness; or a dividend in kind, payable by the cancellation of the debts of the stockholders to the extent of the $ 70,000 retained; or a dividend payable in the stock of Hanson-Whitney might have been made, to the extent of the earnings retained. Had any one of these courses been pursued, the petitioner would1944 U.S. Tax Ct. LEXIS 84">*101 have been in no worse position, as regards the financing of the proposed expansion, and yet would have avoided any further accumulation of earnings.

Moreover, it might be pointed out that the record affords no very definite indication of what the reasonable needs of the business were in 1939, as distinguished from what they proved to be in subsequent years. Certainly, the surplus was far beyond anything needed to carry on the normal business of the petitioner. As to the proposed expansion, the evidence is limited to the mere statement that an expansion was planned, with no suggestion of the anticipated cost or extent. It is true that in 1939 additions to the plant leased to the Hanson-Whitney Co. were in the course of construction, which additions were to cost $ 116,743, but there is no evidence of any definite undertakings so far as petitioner's own plant is concerned. Putting ourselves back in 1939, with such evidence as we have as of that time, it is difficult to say that the Commissioner's determination was wrong.

Although the existence of an accumulation beyond the reasonable business needs gives rise to a strong presumption in favor of the respondent, the taxpayer may overcome1944 U.S. Tax Ct. LEXIS 84">*102 the presumption by proving to the contrary by a clear preponderance of the evidence. The evidence relied upon by the petitioner consists of testimony of one of petitioner's directors to the effect that there was no purpose to save the shareholders from surtax, and that the sole purpose was to finance the expansion. There is no doubt that was one of the purposes of the retention of earnings in 1939, but such a purpose is not inconsistent with another purpose to reduce the surtax burden of the shareholders. 3 T.C. 1109">*1120 Nipoch Corporation, 36 B. T. A. 662. It is to a complete lack of the proscribed purpose that the evidence must be directed. R. L. Blaffer & Co., 37 B. T. A. 851; affd., 103 Fed. (2d) 487; certiorari denied, 308 U.S. 576">308 U.S. 576. In determining purpose, the testimony of interested witnesses, while not to be ignored, may be less persuasive than the surrounding facts and circumstances. In our opinion the purpose stated by the witness is not sufficient to explain the failure to distribute earnings, since the earnings could have been distributed, in the manner above1944 U.S. Tax Ct. LEXIS 84">*103 indicated, and the same purpose effectuated. The existence of such obvious alternatives for achieving the same end, of which the directors could not have been ignorant, contradicts the statement that the sole reason for the failure to distribute was to finance the expansion. Therefore, we think the evidence falls short of that clear preponderance required by the statute to overcome the presumption flowing from the fact of an unreasonable accumulation of earnings or profits, and the Commissioner must be sustained.

Decision will be entered under Rule 50.