26 T.C. 30">*31 The Commissioner determined deficiencies in income tax and excess profits tax as follows:

The year ended October 31, 1949, also is involved because the amount of net operating loss sustained in that year will determine the amount of net operating loss deduction allowable for the year ended October 31, 1947. The issues to be decided are: (1) Whether payments made by petitioner to its shareholders in the amounts of $ 8,988.41, $ 3,468, and $ 3,468, in the taxable years ended October 31, 1948, 1949, and 1950, respectively, were deductible by petitioner as interest payments, or whether such payments were nondeductible distributions in the nature of dividends; (2) whether petitioner's cost of subdivision lots includes the expenditures made to construct a water supply for the subdivision and the payments made to public utilities in order to induce the utilities to extend their service to the subdivision; and (3) whether the deficiencies determined for the years ended October 31, 1946, and October 31, 1947, are barred by the statute of limitations.

FINDINGS OF FACT.

The petitioner 1956 U.S. Tax Ct. LEXIS 223">*226 is a corporation organized under the laws of the State of Kentucky. Petitioner kept its books and filed its returns on an accrual method for fiscal years ended October 31. Petitioner's returns for the taxable years were filed with the collector of internal revenue for the district of Kentucky.

The petitioner's principal business is the development and sale of lots in a subdivision called The Colony, which is located outside the city limits of Lexington, Kentucky. The petitioner also owned a water supply and distribution system, and beginning in 1949, sold water to houses which were built in the subdivision.

26 T.C. 30">*32 Issue 1. Deduction of Payments to Stockholders.

The petitioner was incorporated on or about November 14, 1945. Its authorized capital stock, which was all issued, consisted of 400 shares of capital stock without par value. Its paid-in capital was $ 1,000, or $ 2.50 per share of capital stock.

On or about April 19, 1946, Hugh Meriwether, L. J. Blakely, and Charles Sturgill, as owners of all of the petitioner's stock, entered into an agreement with Dr. Halbert Leet. The agreement recited that Dr. Leet agreed to lend petitioner, on petitioner's note, the sum of $ 17,500 for 5 years 1956 U.S. Tax Ct. LEXIS 223">*227 with interest at 6 per cent, payable semiannually; that Meriwether, Blakely, and Sturgill agreed that they would convey to Dr. Leet, without further consideration, 10 per cent of petitioner's stock, that is, 40 shares; and that no dividends would be paid by petitioner without Dr. Leet's consent until the note was paid. The agreement between Dr. Leet and petitioner's shareholders provides, in part, as follows:

This memorandum of agreement between Hugh Meriwether, L. J. Blakely and Charles Sturgill, of Lexington, Ky., owners of the capital stock of the Kentucky corporation The Colony, parties of the first part, hereinafter called the "Stockholders," and Dr. Halbert Leet, of Lexington, Ky., party of the second part, hereinafter called "Dr. Leet," witnesseth that it is agreed by and between the parties hereto as follows:

Dr. Leet shall lend to the said corporation, The Colony on or before the 25th day of April, 1946, the sum of Seventeen Thousand Five Hundred Dollars ($ 17,500.00) upon the latter's negotiable promissory note in the said sum of money to be dated the day said loan is made, and to be payable on or before five years after date, with interest thereon at the rate of 6% per annum, 1956 U.S. Tax Ct. LEXIS 223">*228 payable semi-annually, from its date until its payment.

The Stockholders shall, at the same time with the making of said loan, cause the said corporation to execute and deliver said note to Dr. Leet, and will assign and transfer to Dr. Leet as his own -- without further consideration -- ten per cent (10%) of the capital stock of said corporation: and they, and their successors, if any, in the ownership of their respective shares of stock of said corporation, shall see to it that no dividend is paid by said corporation, (except with the consent of Dr. Leet or his successors in ownership of said 10% of the stock) until said note (and any similar note issued or to be issued by the corporation under similar circumstances) shall have been paid.

On April 24, 1946, Dr. Leet paid $ 17,500 to petitioner in exchange for its note, and received 40 shares of petitioner's stock from Meriwether, Blakely, and Sturgill. On the same day, L. B. Shouse also paid $ 17,500 to petitioner in exchange for its note, and received 40 shares of petitioner's stock from Meriwether, Blakely, and Sturgill. Also, on the same day, Meriwether, Blakely, and Sturgill each paid $ 7,600 to petitioner in exchange for similar 1956 U.S. Tax Ct. LEXIS 223">*229 promissory notes. The total amount received by petitioner on April 24, 1946, from the five individuals in exchange for its notes was $ 57,800. The notes issued by petitioner stated that repayment was to be made in 5 years, that is, 26 T.C. 30">*33 on April 24, 1951, and that interest was payable at the rate of 6 per cent.

Prior to the end of petitioner's first fiscal year, on October 31, 1946, petitioner also issued notes in the amount of $ 149,403 to banks. The notes held by the banks were secured by liens on petitioner's real estate.

Also, prior to October 31, 1946, Gilmore N. Nunn acquired 4 shares of petitioner's stock from Meriwether, Blakely, and Sturgill. On October 31, 1946, petitioner's stock and notes payable were held as follows:

The notes described above are reflected in the balance sheet attached to petitioner's 1956 U.S. Tax Ct. LEXIS 223">*230 return for the year ended October 31, 1946, as "Notes Payable-Bank Loans" in the amount of $ 149,403, and "Notes Payable-Stockholders" in the amount of $ 57,800.

None of the notes held by the stockholders has been paid by the petitioner with the exception of the note in the face amount of $ 17,500 issued to L. B. Shouse. At the time this note was paid, petitioner also purchased Shouse's 40 shares of stock at a price of $ 2.50 per share, or a total of $ 100. Sometime after the taxable years, in 1953, Sturgill and the Central Rock Company, a corporation, acquired the stock and notes of petitioner held by the remaining stockholders, namely, Meriwether, Blakely, Dr. Leet, and Nunn. Sturgill and the Central Rock Company now own, equally, all of petitioner's outstanding stock, and the notes in the face amount of $ 40,300 which remain outstanding.

In the taxable years ended October 31, 1946, and October 31, 1947, the petitioner did not pay to the holders, or accrue on its books, or claim deductions on its returns for, any amounts payable as interest on the notes held by its stockholders. In the taxable year ended October 31, 1948, the petitioner paid a total of $ 8,988.41 to the five stockholder-noteholders, 1956 U.S. Tax Ct. LEXIS 223">*231 and claimed a deduction in that amount in its return for interest paid. The total amount of $ 8,988.41 purportedly was distributed in payment of the interest due on the notes for the 3 years ended October 31, 1946, 1947, and 1948, as follows: 26 T.C. 30">*34

In each of the taxable years ended October 31, 1949, and October 31, 1950, the petitioner paid $ 3,468 to the five stockholder-noteholders, and claimed deductions in that amount in its returns for each of the years for interest paid.

The respondent disallowed the entire amount claimed 1956 U.S. Tax Ct. LEXIS 223">*232 by petitioner as interest deductions in its returns for the taxable years ended October 31, 1948, 1949, and 1950. The deficiency notice contains the following explanation for the disallowance of the interest deduction claimed in petitioner's return for the year ended October 31, 1948:

It is held that the amount of $ 8,988.41 deducted as interest in the return filed for the fiscal year ended October 31, 1948, constitutes dividends within the purview of Section 115 of the Internal Revenue Code, and is therefore not allowable as a deduction in computing net taxable income.

Similar explanations are given for the disallowance of the interest deductions claimed in the returns for the years ended October 31, 1949, and October 31, 1950.

Except for items representing the notes payable to stockholders and to banks, and reserve accounts for depreciation and for improvements, the following are the only liabilities set forth in the balance sheets attached to petitioner's returns for the years ended October 31, 1946, to October 31, 1950, inclusive:

1956 U.S. Tax Ct. LEXIS 223">*233 The $ 57,800 paid to petitioner by the five shareholders in 1946 in return for petitioner's promissory notes constituted contributions to petitioner's capital rather than bona fide loans. The payments in the fiscal years ended October 31, 1948, 1949, and 1950, to the five 26 T.C. 30">*35 stockholder-noteholders in the amounts of $ 8,988.41, $ 3,468, and $ 3,468, respectively, did not represent payments of interest.

Issue 2. Cost of Subdivision Lots to Petitioner.

Shortly after its organization, petitioner acquired a farm near Lexington, Kentucky. The farm was approximately 228 acres in size, and was acquired by petitioner for the purpose of subdivision into residential lots. The petitioner's plan of operation was to sell lots to individual buyers, rather than to construct and sell homes. The petitioner sold lots in each of the years ended October 31, 1946, 1947, and 1950.

For the purposes of reporting gain from the sale of lots, petitioner included as part of its cost or other basis in the lots a proportionate part of the estimated cost of developing the subdivision. The amount of estimated development expenses added by petitioner to its cost of the lots was $ 93,074.61, and the total basis claimed 1956 U.S. Tax Ct. LEXIS 223">*234 by petitioner in the subdivision amounted to $ 131,550. As is more fully set forth hereinafter, the respondent determined that the amount of development costs which were includible in the computation of petitioner's cost or other basis in the lots did not exceed $ 44,988.55, and that petitioner's total basis in the subdivision did not exceed $ 83,463.94. The amount of development expenses claimed by petitioner which was disallowed by respondent, $ 48,086.06, represents the following three items: The portion of the original estimated cost of development, $ 93,074.61, which petitioner had not expended as of September 30, 1950; the expenditures made by petitioner to acquire a water supply system; and the amount of payments made by petitioner to two utility companies. The amount of each of the three items is as follows:

The first part of petitioner's real estate to be subdivided was The Colony, which comprised about 65 lots covering approximately 60 acres. When subdivision of The Colony began, there was no available source of water. 1956 U.S. Tax Ct. LEXIS 223">*235 Without water, the lots would not have been salable. The petitioner was advised that it would cost between $ 40,000 to $ 60,000, and perhaps more, to connect The Colony with the facilities of the Lexington Water Company, which were approximately 1 1/2 miles away. The petitioner's stockholders decided that petitioner would construct a water system to provide water to lot purchasers instead of entering into any arrangement with the Lexington 26 T.C. 30">*36 Water Company. Prior to 1949, the petitioner completed a water supply and distribution system for The Colony. The chief source of water for the system is a well capable of producing 576,000 gallons of water each 24 hours. Water from the well is pumped automatically by turbine pump through a chlorination tank to a 55,000-gallon capacity concrete pool, and then, by highlift pumps, into a 3,000-gallon capacity steel pneumatic tank. For convenience, the portion of the water system described above is referred to as the pumping system. From the pneumatic tank, the water passes into the "distribution system," which consists of 6,500 feet of 4- and 6-inch pipe, about 2,500 feet of 2-inch pipe, and meters to the various houses.

In a brochure put out 1956 U.S. Tax Ct. LEXIS 223">*236 by petitioner, the water system is described as follows:

In order to provide fire protection and to supply home owners in The Colony, with pure, soft water, The Colony will have its own private water works. The chief source is a well which is now producing 576,000 gallons of pure water each twenty-four hours, sufficient for the normal use of 14,000 people. Water will be supplied to home owners from a 55,000-gallon concrete reservoir. The water supply will at all times be under the supervision of the State and County Boards of Health.

The water system constructed by the petitioner was intended to supply 20 houses to be located near The Colony, as well as the houses located in The Colony subdivision. Also, during the taxable year ended October 31, 1948, the petitioner sold an additional 40 acres of land from the original farm tract. The 40 acres were sold at public auction, and in order to induce purchasers to pay a higher price, the petitioner agreed to provide water for the land.

The total cost incurred by petitioner in constructing the water supply system was $ 33,781.70, as follows:

1956 U.S. Tax Ct. LEXIS 223">*237 The petitioner retained easements over lots which it sold in The Colony. These easements reserved to petitioner the right to maintain its water distribution system on the lots, but did not obligate petitioner to do so.

The water supply system began operation sometime during the taxable year ended October 31, 1949. Water meters installed by petitioner measured the water supplied to the houses served by the water distribution system, and petitioner was paid by the consumers for the water it provided. In the taxable years ended October 31, 1949, to 26 T.C. 30">*37 October 31, 1954, inclusive, petitioner realized, from the operation of its water supply system, the following amounts of gross receipts and profit or loss, the profit or loss being computed without deductions for electricity expense or depreciation:

The largest item of expense incurred by the petitioner in the operation of the water system was for wages. L. J. Blakely, who lived near the pump site, was paid $ 300 per year to "look 1956 U.S. Tax Ct. LEXIS 223">*238 after" the water system in the years ending October 31, 1949, 1950, and 1951; $ 440 in the year ended October 31, 1952; $ 480 in the year ended October 31, 1953; and $ 400 in the year ended October 31, 1954.

The number of houses to which petitioner supplied water in each of the years set forth above is not shown in the record before us.

Throughout the taxable years and thereafter, the petitioner retained full ownership and control of the assets comprising the water supply system.

In 1948 and 1949, petitioner made payments to the Kentucky Utilities Company (hereinafter called Utilities Company) and the Central Kentucky Natural Gas Company (hereinafter called Gas Company), pursuant to agreements between petitioner and the companies relating to the extension of gas and electricity service to The Colony. Petitioner's contract with the Gas Company was dated October 16, 1946. Petitioner entered into two contracts with the Utilities Company, one dated December 17, 1947, and the other dated December 1, 1949. The total payments made by petitioner to the two companies under the contracts amounted to $ 8,713.54, as follows:

The 1956 U.S. Tax Ct. LEXIS 223">*239 payments made by petitioner were required by the companies before the latter would extend their services to The Colony. The contracts between petitioner and the companies provided that all or a part of the payments might be refunded to petitioner. For example, 26 T.C. 30">*38 the contract with the Gas Company provided that the latter would refund to petitioner a total of $ 75 for each new customer connected to the company's gas mains, but that no refund would be made after 10 years from date of the contract, that is, after October 16, 1956. Each of the contracts with the Utilities Company provided for the refund of approximately $ 160 to petitioner for each new customer connected to the company's electric line, but that no refund would be made after 5 years from the time of completion of the service extensions provided for in the contracts. Exhibits 16 and 17 are incorporated by this reference. Up to the date of the hearing of this proceeding, the petitioner had received refunds of $ 1,407.41 from the Utilities Company and $ 750 from the Gas Company, or a total of $ 2,157.41, as follows:

An 1956 U.S. Tax Ct. LEXIS 223">*240 account titled "Reserve for Improvements" was set up on petitioner's books and credited on September 30, 1946, in the amount of $ 93,074.61. This amount represented petitioner's estimate of the costs which would be incurred in the development of The Colony, and petitioner added a pro rata portion of this amount to its cost of each of the lots which it sold in the taxable years ended October 31, 1946, 1947, and 1950.

The reserve account was debited in the amount of each expenditure which petitioner considered an expense of development for the subdivision. As of September 30, 1950, the total amount debited to the reserve account was $ 87,483.79, and on that date there remained, from the original credit entry of $ 93,074.61, a credit balance of $ 5,590.82. The total amount debited to the reserve account, $ 87,483.79, consisted of the following entries: $ 33,781.70, the cost of the water supply system; $ 8,713.54, the total of the payments made to the utility companies; and $ 44,988.55 for other expenditures which are not in issue.

For the purpose of computing gain from the sale of the lots which were sold in 1946, 1947, and 1950, the petitioner added a proportionate part of $ 93,074.61, 1956 U.S. Tax Ct. LEXIS 223">*241 the amount originally credited to the reserve account for improvements to its cost of the lots sold. In its returns for the years ending October 31, 1946, 1947, and 1950, petitioner reported gain from the sale of lots and gross income, as follows: 26 T.C. 30">*39

The respondent determined that the development costs which might be added to petitioner's cost of the lots did not exceed $ 44,988.55. Accordingly, the respondent determined that petitioner had overstated its cost of the lots in the total amount of $ 48,086.06, which is the difference between the estimated development costs claimed by petitioner, $ 93,074.61, and $ 44,988.55, the amount determined by respondent. The respondent also determined that petitioner overstated the costs of lots sold and understated the profit from lot sales in the years ended October 31, 1946, 1947, and 1950, in the amounts of $ 20,972.54, $ 6,789.80, and $ 2,741.51, respectively. The 1956 U.S. Tax Ct. LEXIS 223">*242 amount of the adjustment in each of these years is the portion of the total overstatement of cost determined by respondent, $ 48,086.06, which is allocable to the lots sold in each year. The method used by respondent to redetermine petitioner's cost of the lots sold in each year is as follows: The petitioner claimed a basis of $ 131,550 in the entire subdivision, after adding in the amount of $ 93,074.61 for the estimated cost of improvements. The respondent determined that petitioner overstated its basis in the amount of $ 48,086.06, and that the petitioner's basis did not exceed $ 83,463.94. The basis determined by respondent, $ 83,463.94, amounted to 63.44655 per cent of the basis reported by petitioner. Accordingly, respondent allowed petitioner, as the cost of the lots it sold each year, an amount equal to 63.44655 per cent of the cost claimed by petitioner in its returns.

The deficiency notice contains the following explanation for respondent's determination that petitioner realized additional income in the amount of $ 20,972.54 from the sale of lots in the year ended October 31, 1946:

It is held that the cost of lots sold in the fiscal year ended October 31, 1946, reported 1956 U.S. Tax Ct. LEXIS 223">*243 in the return filed for that year as amounting to $ 57,375.00, is not in excess of the amount of $ 36,402.46, the reduction representing the allocable portion of the following items incorrectly included in the computation of the total cost of the lots in the subdivision (Sections 24 (a) (2) and 43 of the Internal Revenue Code):

26 T.C. 30">*40 Similar explanations appear for the adjustments determined by respondent for the years ended October 31, 1947, and October 31, 1950.

The total amount of development costs includible in petitioner's basis in the subdivision lots is $ 53,702.09. This amount is the total of the development expenses incurred by petitioner which are not in issue, $ 44,988.55, and the total of the payments made by petitioner to the utility companies, $ 8,713.54. The estimated development costs claimed by petitioner, $ 93,074.61, were overstated in the total amount of $ 39,372.52. The basis in the subdivision lots claimed by petitioner, $ 131,550, also was overstated in the total amount of $ 39,372.52. Petitioner's basis in the subdivision 1956 U.S. Tax Ct. LEXIS 223">*244 lots did not exceed $ 92,177.48, or 70.07 per cent of the basis it claimed.

Petitioner's basis for gain in the lots it sold in the years ended October 31, 1946, 1947, and 1950, did not exceed 70.07 per cent of the basis claimed in its returns for each of these years. Petitioner's basis in the lots sold in these 3 years was $ 40,202.66, $ 13,015.50, and $ 5,255.25, respectively, computed as follows:

Issue 3. Statute of Limitations.

In the taxable years ended October 31, 1946, and October 31, 1947, petitioner's gross income amounted to $ 39,422.37 and $ 23,654.91, respectively, computed as follows:

In each of the years ended October 31, 1946, and October 31, 1947, petitioner omitted from gross income an amount properly includible therein which was in excess of 25 per cent of the amount of gross income stated in its returns. The 1956 U.S. Tax Ct. LEXIS 223">*245 following schedule sets forth, for the years ended October 31, 1946, and October 31, 1947, the amount of petitioner's gross income; the amount of gross income reported by petitioner; the amount of gross income omitted from petitioner's returns; and the percentage which the gross income omitted bears to the gross income reported: 26 T.C. 30">*41

Petitioner's income and declared value excess-profits tax return for the taxable year ended October 31, 1946, was filed on January 15, 1947. More than 3 years and less than 5 years later, on October 17, 1951, petitioner executed an agreement under the provisions of section 276 (b) of the 1939 Code extending the period of limitations for the assessment and collection of deficiencies for the year ended October 31, 1946, to June 30, 1952. On May 14, 1952, petitioner executed a second agreement extending the period to June 30, 1953; and on April 25, 1953, petitioner executed a third agreement extending the period to June 30, 1954.

Petitioner's 1956 U.S. Tax Ct. LEXIS 223">*246 return for the taxable year ended October 31, 1947, was filed on December 22, 1947. More than 3 years and less than 5 years later, on May 14, 1952, petitioner executed an agreement under the provisions of section 276 (b) of the Code extending the period of limitation to June 30, 1953. On April 25, 1953, petitioner executed a second agreement extending the period to June 30, 1954.

The respondent's statutory notice of deficiency for the years ended October 31, 1946, and October 31, 1947, was mailed on March 29, 1954.

OPINION.

Issue 1.

The first question to be decided is whether the payments made by petitioner to five of its stockholders in the amounts of $ 8,988.41, $ 3,468, and $ 3,468, in the taxable years ended October 31, 1948, 1949, and 1950, respectively, were payments of interest on indebtedness, which are deductible under section 23 (b) of the 1939 Code, or whether the payments constituted nondeductible distributions in the nature of dividends. The determination of this issue depends on whether the $ 57,800 paid by the shareholders to petitioner in return for petitioner's notes constituted, in substance, a loan giving rise to a creditor-debtor relationship, or a contribution to 1956 U.S. Tax Ct. LEXIS 223">*247 capital, which gave the stockholders an additional proprietary interest.

The petitioner concedes that it is a "thin corporation." It argues, however, that the notes must be recognized as a valid indebtedness because the petitioner's capitalization reflected the business judgment of unrelated persons who dealt with each other at arm's length; because 26 T.C. 30">*42 the notes were issued to the stockholders in face amounts which were disproportionate to their stockholdings; and because the transaction was carried out in the form proper to create an indebtedness, rather than a contribution to capital. The respondent takes the position that the $ 57,800 paid in by the shareholders must be considered as a contribution on their part to petitioner's capital, in view of the capital structure of the petitioner, the circumstances under which the notes were issued, and the lack of evidence indicating that the transaction was intended to create a debtor-creditor relationship.

The question to be decided is one of fact. Sam Schnitzer, 13 T.C. 43, 60, affd. 183 F.2d 70, certiorari denied 340 U.S. 911">340 U.S. 911. The issue is whether there was an intention to create a debtor-creditor relationship, on the one hand, or a 1956 U.S. Tax Ct. LEXIS 223">*248 capital contribution, on the other hand, "and such intention is a fact to be gleaned from the entire record." Estate of Herbert B. Miller, 24 T.C. 923. It is true, in this case, that the notes received by the five shareholders upon their payment of $ 57,800 to petitioner satisfy the formal requirements for a corporate indebtedness. However, our inquiry is not limited to the formalities, however meticulously observed, in which the parties cast their transaction. R. M. Gunn, 25 T.C. 424; Estate of Herbert B. Miller, supra;Gooding Amusement Co., 23 T.C. 408, 418; Proctor Shop, Inc., 30 B. T. A. 721, affd. 82 F.2d 792. There are other factors present which establish that the $ 57,800 was paid over to petitioner by the stockholders to be placed immediately at the risk of petitioner's business as a capital contribution rather than as a true loan.

In the first place, the petitioner's formal capital, $ 1,000 was patently inadequate to carry on the business for which it was formed. The petitioner was organized to purchase, subdivide, and sell a substantial tract of land. For this purpose, petitioner's formal capital of $ 1,000 was wholly insignificant. To finance the project, the additional 1956 U.S. Tax Ct. LEXIS 223">*249 amount of $ 57,800 was turned over to petitioner by the stockholders, and in addition the petitioner obtained loans of at least $ 149,403 from banks. The bank loans were secured by liens on petitioner's real estate. The notes received by the stockholders were not secured. If petitioner's characterization of the transaction is accepted, it is apparent that petitioner's business was placed in operation with loans in the amount of $ 207,203, and formal capital in the amount of $ 1,000. This alleged arrangement, which amounts to an indebtedness to capital ratio of greater than 207 to 1, clearly establishes that petitioner was undercapitalized and strongly suggests that the shareholders recognized that the $ 57,800 would be risked in petitioner's business as a capital contribution to the same extent as the formal capital of $ 1,000. See Hilbert L. Bair, 16 T.C. 90, affd. 199 F.2d 589. In these circumstances, we think our language in Isidor Dobkin, 15 T.C. 31, 33, affd. 192 F.2d 392, is particularly appropriate:

26 T.C. 30">*43 When the organizers of a new enterprise arbitrarily designate as loans the major portion of the funds they lay out in order to get the business established and under way, 1956 U.S. Tax Ct. LEXIS 223">*250 a strong inference arises that the entire amount paid in is a contribution to the corporation's capital and is placed at risk in the business. Cohen v. Commissioner, 148 F.2d 336; Joseph B. Thomas, 2 T.C. 193. The formal characterization as loans on the part of the controlling stockholders may be a relevant factor but it should not be permitted to obscure the true substance of the transaction. Sam Schnitzer, 13 T.C. 43, 60.

The conclusion that the parties did not regard the payment of the $ 57,800 to petitioner as a loan is also supported by their conduct subsequent to the issuance of the notes in April 1946. For example, the notes were not paid on the due date, namely, 5 years after issue, i. e., in April 1951. In fact, the evidence indicates that only one of the notes, that issued to L. B. Shouse, has been retired, and that the other notes were still outstanding at the time of the hearing of this proceeding. The stockholders other than Shouse held their notes as late as 1953, 2 years after the due date, and the evidence does not indicate that any attempt to enforce payment was ever made at any time after the due date. The parties treated their shares of stock and the notes 1956 U.S. Tax Ct. LEXIS 223">*251 as part of a single package whenever a transfer was made. For example, when petitioner acquired Shouse's note, it also acquired his stock. Similarly, in the transaction in 1953, in which Sturgill and Central Rock Company acquired, in equal shares, the outstanding stock of petitioner held by Meriwether, Blakely, Leet, and Nunn, the notes held by the latter four persons also were acquired.

On the basis of the foregoing, it is concluded that the petitioner has failed to establish that the notes issued to its shareholders in the face amount of $ 57,800 represented a valid indebtedness. It is held that the respondent properly disallowed the deductions claimed by petitioner for interest on indebtedness for the years ended October 31, 1948, 1949, and 1950, in the respective amounts of $ 8,988.41, $ 3,468, and $ 3,468.

In reaching our conclusion we have considered petitioner's contentions concerning the disproportionate holdings among the shareholders of stock and notes. Under the circumstances of this case, we attribute to this no greater weight than if petitioner had issued disproportionate amounts of common and preferred stock. Similarly, we consider of little weight petitioner's argument 1956 U.S. Tax Ct. LEXIS 223">*252 that the obligations represented by the notes were not subordinated to claims of other creditors. It is true that the notes, on their face, were not subordinate obligations. Under the facts of this case, however, little significance can be attached to this factor. For one thing, there was a lien on petitioner's principal asset, its real estate, in favor of the banks. This lien secured loans made by the banks to petitioner in the original amount of at least $ 149,403. In the second place, it appears that petitioner's liabilities 26 T.C. 30">*73 in each of the taxable years were in negligible amounts, compared to the $ 57,800 in question. For example, petitioner's liabilities at the end of the taxable years October 31, 1946, to October 31, 1950, ranged from a low of $ 986.04 on October 31, 1949, to a high of $ 5,325.74 on October 31, 1946, and averaged $ 2,470.29. On the entire record, it is concluded that the respondent must be sustained on this issue.

Issue 2.

The narrow question to be decided under this issue is the proper amount which petitioner may add to its cost of Colony lots for the cost of development work in The Colony subdivision. It is well established that where subdivision lots 1956 U.S. Tax Ct. LEXIS 223">*253 are sold before development work is completed, the seller may include in his cost of the lots an allocation of his estimated future expenditures for improvements to the subdivision. Country Club Estates, Inc., 22 T.C. 1283, 1293-1294; Cambria Development Co., 34 B. T. A. 1155.

The petitioner included in its cost of Colony subdivision lots a total of $ 93,074.12 for development expenses, and added a pro rata portion of this total to its cost of The Colony lots which it sold in the taxable years ended October 31, 1946, 1947, and 1950. The respondent determined that the development expenses claimed by petitioner were excessive, and that the proper amount to be added to petitioner's cost of the lots did not exceed $ 44,988.55. The respondent accordingly reduced the cost or other basis which the petitioner claimed in the lots which were sold, and increased the profit reported by petitioner from the sale of these lots. The amount by which the respondent reduced the petitioner's cost or other basis in the lots in each of the years ended October 31, 1946, 1947, and 1950, equalled a pro rata part of $ 48,086.06, the total amount by which the respondent reduced the development costs claimed 1956 U.S. Tax Ct. LEXIS 223">*254 by petitioner. The petitioner does not contest the percentage method used by respondent to redetermine the cost of the lots, in the event it is determined that petitioner overstated its development costs. The petitioner does claim, however, that its development costs were not overstated in the amount determined by the respondent.

The amount of estimated development costs disallowed by respondent, $ 48,086.06, is the total of three items, namely, an expenditure of $ 33,781.70 to construct a water supply system; payments to utility companies in the amount of $ 8,713.54; and the sum of $ 5,590.82, which is the excess of the petitioner's estimated development costs of $ 93,074.61 over the total amount it claimed to have expended for development purposes as of September 30, 1950, namely, $ 87,483.79. The respondent, in effect, allowed as development costs the total amount petitioner claimed to have expended as of September 30, 1950, 26 T.C. 30">*45 other than the cost of the water supply system and the amounts paid to utility companies.

The respondent's position under this issue is that the expenditures incurred to acquire the water supply system and to make payments to the utility companies are not 1956 U.S. Tax Ct. LEXIS 223">*255 properly chargeable to development costs which can be added to the cost of the subdivision lots. In the case of the portion of the estimated costs which petitioner had not expended as of September 30, 1950, or $ 5,590.82, the respondent contends that no part of the $ 5,590.82 will be required for future improvements, and that petitioner's original estimate of $ 93,074.61 for future developments was excessive in the amount of $ 5,590.82. The three adjustments will be discussed separately.

Petitioner introduced no evidence at the hearing of this proceeding to establish that further development work was required at The Colony after September 30, 1950, or that any expenditures were in fact made after that date for purposes of development or improvement. We accordingly sustain respondent's determination that the petitioner's estimate for future development costs, $ 93,074.61, was excessive in the amount of $ 5,590.82, which is the portion of petitioner's estimate which had not been expended as of September 30, 1950. Butler-Fornari Realty Corporation, 37 B. T. A. 933.

The next item under this issue relates to the water supply system. The petitioner has abandoned its original contention 1956 U.S. Tax Ct. LEXIS 223">*256 that the entire cost of the water supply system is a development expense which can be allocated to its cost of the subdivision lots. It concedes now that the "distribution system" or piping which carried the water from the "pumping system" to the houses, is not a development expense. It now claims that only the cost of the pumping station or pumping system is a development cost which should be added to its cost of the lots. The petitioner contends that the lots were unsalable without a water supply system, and that it was required to construct such a system because the cost of connecting the subdivision with the facilities of the Lexington Water Company was prohibitive. The petitioner contends further that when the facilities of the Lexington Water Company eventually extend to the subdivision, the pumping station will be of no further use and will have no value other than for salvage. The petitioner contends that under these facts, the cost of the pumping system must be added to its cost of the lots. The petitioner relies on Country Club Estates, Inc., supra.In that case, the taxpayer was in the business of selling subdivision lots. In order to induce people to purchase lots, 1956 U.S. Tax Ct. LEXIS 223">*257 the taxpayer conveyed a portion of its tract to a nonprofit organization for the purpose of having a country club constructed. It was held that the cost of the property transferred by the taxpayer should be regarded as part of its basis in the subdivision lots which it sold.

26 T.C. 30">*46 The difficulty with petitioner's contention is that, unlike the taxpayer in Country Club Estates, Inc., supra, the petitioner has not given up any property in order to sell its lots. For the funds it expended, the petitioner acquired a water supply system which it owned and operated during the taxable years and thereafter. It is true that the system has not been operated at a profit, due, perhaps, to the small number of houses which have been constructed at The Colony. And it also may be true, as petitioner contends, that the pumping station may be abandoned at some time in the future, when the facilities of the Lexington Water Company reach the subdivision. These circumstances, however, do not alter the fact that the petitioner retained full ownership and control of the water supply system during the taxable years, and that it did not part with the property for the benefit of the subdivision lots. Because 1956 U.S. Tax Ct. LEXIS 223">*258 of this retention of ownership, Country Club Estates, Inc., supra, is distinguishable. The retention of ownership also distinguishes this proceeding from cases in which the subdivider is permitted to add to his cost of lots the cost of land which has been dedicated or donated for use as streets. See, Commissioner v. Laguna Land & Water Co., 118 F.2d 112, modifying, on other grounds, a Memorandum Opinion of the Board of Tax Appeals. We think the facts in this proceeding more closely resemble Biscayne Bay Islands Co., 23 B. T. A. 731. In the latter case, the taxpayer subdivided for sale the waterfront portion of its property. The interior portion of its property was set aside, for a term of years only, and not irrevocably, for use as a public park. It was held that the taxpayer's cost of the waterfront lots did not include the cost of the interior park property because the taxpayer had not irrevocably parted with the interior property. We said (p. 735):

This area was not permanently and irrevocably dedicated to the public, but may later be sold by petitioner. The possibility of gain has only been postponed. It is unlike the area used for public streets, which is permanently beyond 1956 U.S. Tax Ct. LEXIS 223">*259 the possibility of sale and gain, the cost of which must be absorbed in the salable lots. See Oak Woods Cemetery Association, 6 B. T. A. 1003.

It is held that the cost of the water supply system may not be added to the cost of The Colony subdivision lots for the purposes of computing petitioner's gain on the sale of such lots.

There is an additional dispute between the parties which relates to the cost of the water supply system. The respondent determined that the total cost of the system which the petitioner had added to its cost of the lots was $ 33,781.70. The petitioner claims that the cost of the system was $ 33,277.61, or $ 504.09 less than the amount determined by respondent. The question is one of fact and the petitioner has the burden of proving the respondent's determination erroneous. The cost of the water supply system was not separately stated in the books of account maintained by petitioner. Petitioner relies, in support of 26 T.C. 30">*47 its contention, on an analysis of invoices made by the engineer who supervised the construction of the water supply system. However, the evidence indicates that the engineer did not have available all the invoices relating to the construction 1956 U.S. Tax Ct. LEXIS 223">*260 of the system. At one point the engineer testified that "practically all" the bills for materials and services came into his hands; elsewhere, he stated that the bills of which he had knowledge accounted for about 80 per cent of the cost of the project. In either event, the petitioner has not established that the engineer upon whose testimony it relies had knowledge of the total cost of the system. It is concluded that the petitioner has failed to establish that the cost of the water supply system was less than the amount determined by the respondent. It is held that the cost of the water supply system was $ 33,781.70, and that this amount is not includible in the cost of The Colony lots sold by petitioner.

The final question relating to the petitioner's cost of The Colony lots concerns the payments made by petitioner to the Gas Company and to the Utilities Company. The petitioner made payments to the companies in the total amount of $ 8,713.54, and included this amount in the cost of its Colony lots. The respondent takes the position that the petitioner is not entitled to add any part of the payments to the cost of the lots it sold during the taxable years, because there existed 1956 U.S. Tax Ct. LEXIS 223">*261 a possibility that all or a part of the payments might be refunded to petitioner at some time after the taxable years.

The evidence establishes that the companies required the payments to be made before they would extend their services to Colony. The payments were made to the companies in accordance with written agreements, the pertinent provisions of which are stated in the findings. Pursuant to the contract with the Gas Company, the petitioner paid $ 6,535 to the Gas Company in January 1948. The contract provided that the petitioner would receive a refund of $ 75 for each new customer connected to the company's gas mains, but that no refund would be made after 10 years from the date of the contract, i. e., after October 16, 1956. In the case of the second company, the Utilities Company, the petitioner made payments in the total amount of $ 2,178.54 in 1948 and 1949. The contracts with the Utilities Company provided that a refund of approximately $ 160 would be paid to petitioner for each new customer connected to the company's electric line, but that no refund would be made after 5 years from the time of completion of the service extensions provided in the contract. The period 1956 U.S. Tax Ct. LEXIS 223">*262 during which petitioner was entitled to receive refunds from the Utilities Company did not expire during the taxable years.

It is true, therefore, as respondent contends, that there was no way to ascertain, during the taxable years, the total amount of refunds which petitioner might receive under its contracts with the two companies. We do not think, however, that this circumstance militates 26 T.C. 30">*48 against the petitioner. The determinative factor is that the petitioner made unconditional payments to the two companies in order to obtain utility service for The Colony, and thereby to attract customers for The Colony lots. The payments were thus closely related to the sale of the lots, and petitioner's income from the sale of lots will be more clearly reflected if a pro rata portion of the payments in question are included in its basis for gain or loss in each lot which was sold. On the other hand, the receipt of refund payments from the utility companies is less closely related to the improvement of the lots for sale. The payment of a refund would be made only if a new customer was connected to the utility companies' service extensions, rather than at the time a lot was sold. Thus, if 1956 U.S. Tax Ct. LEXIS 223">*263 lots were sold to purchasers who, for some reason, did not proceed to construct residences, the petitioner would not receive refunds; or, if a purchaser acquired two or more lots, on which only one residence was constructed, the petitioner would receive only one refund, rather than a number of refund payments equal to the number of lots sold to the purchaser. Under these circumstances, it is concluded that the payments to the utility companies were directly related to the improvement of The Colony lots for sale, and that the petitioner correctly included these payments in computing its basis for gain or loss in the lots which it sold. The question of the taxability of the refunds which petitioner may receive from the utility companies is not before us. It is noted, however, that the petitioner concedes, on brief, that such refunds would, if made, constitute taxable income. See Chevy Chase Land Co., 34 B. T. A. 150.

Issue 3.

The final question to be decided is whether the deficiencies determined for the taxable years ending October 31, 1946, and October 31, 1947, are barred by the statute of limitations. The deficiency notices for these 2 years were mailed within the extended period 1956 U.S. Tax Ct. LEXIS 223">*264 provided in waivers which the petitioner originally executed more than 3 years and less than 5 years after the returns were filed. The question is whether the 5-year statute of limitations contained in section 275 (c) of the 1939 Code ¹ is applicable in this proceeding. The petitioner omitted from gross income in each year an amount properly includible therein which was in excess of 25 per cent of the gross income reported. The petitioner contends, however, that section 275 (c) is inapplicable 26 T.C. 30">*49 because the omission resulted from an overstatement of cost of goods sold, rather than from an omission of gross receipts. The petitioner relies on Uptegrove Lumber Co. v. Commissioner, 204 F.2d 570, reversing a Memorandum Opinion of this Court, and on Deakman-Wells Co. v. Commissioner, 213 F.2d 894, reversing 20 T.C. 610. Our holding in Estate of J. W. Gibbs, Sr., 21 T.C. 443, however, requires that this issue be decided in favor of the respondent. We have recently reviewed the decision in the Gibbs case in the light of the decisions in the Uptegrove Lumber Co. and Deakman-Wells Co. cases, and have decided to adhere to the rule in the Gibbs case. John E. Goodenow, 25 T.C. 1. On the 1956 U.S. Tax Ct. LEXIS 223">*265 basis of the Gibbs and Goodenow cases, it is held that the 5-year statute of limitations in section 275 (c) is applicable, and that the deficiencies determined for the years ending October 31, 1946, and October 31, 1947, are not barred by the statute of limitations.

Decision will be entered under Rule 50.