38 T.C. 585">*585 The Commissioner originally determined a deficiency in petitioner's income tax for the taxable year 1956 in the amount of $ 745,302.63 on the theory that petitioner was subject to the personal holding company tax. The Commissioner withdrew this issue at the trial and, by amendment to his answer, determined a deficiency in the amount of $ 286,281.17 on the theory that petitioner was subject to the accumulated earnings tax in 1956. The correctness of the latter determination is the only issue presented. If the Court should hold for petitioner on this issue, petitioner claims an overpayment of tax in the amount of $ 73,826.91.

FINDINGS OF FACT.

The facts stipulated by the parties are incorporated herein 1962 U.S. Tax Ct. LEXIS 105">*106 by this reference.

Petitioner, a corporation organized under the laws of the State of Delaware on December 27, 1924, has its principal office in Suite 1090, DuPont Building, Wilmington, Delaware, and filed its 1956 corporate income tax return with the district director of internal revenue, Wilmington, Delaware.

During the taxable year 1956, petitioner kept its books and accounting records on a cash receipts and disbursements method of accounting, and its taxable period was the calendar year.

At the time of its organization and incorporation in 1924, Paulina duPont Dean transferred to petitioner securities, real estate, and cash having a cost basis to her of $ 962,924.19 in exchange for 10,000 shares of petitioner's no-par common stock. On May 23, 1927, J. Simpson Dean, husband of Paulina duPont Dean, transferred certain properties 38 T.C. 585">*586 to petitioner in exchange for 3,891 shares of its no-par common stock.

By reason of stock dividends the total no-par common stock issued by petitioner became 36,172 shares by December 29, 1928, of which 28,923 were owned by Paulina duPont Dean and 7,249 by J. Simpson Dean.

The Deans' sole ownership of all of petitioner's outstanding stock, totaling 36,172 shares, 1962 U.S. Tax Ct. LEXIS 105">*107 continued until December 17, 1954. On that day each transferred by gift 2,000 shares of petitioner's no-par common stock to two trusts created by them in 1937 for the benefit of their three children, with the Wilmington Trust Company named as the trustee of each trust. Thereafter, to and including December 31, 1956, petitioner's outstanding no-par common stock in the total amount of 36,172 shares was owned as follows: Paulina duPont Dean, 26,923 shares; J. Simpson Dean, 5,249 shares; trusts for the benefit of the three Dean children, 4,000 shares.

At all times here material J. Simpson Dean was president, treasurer, and a director of petitioner, and Paulina duPont Dean was vice president and a director.

During the taxable years 1934 to 1955, inclusive, petitioner was a personal holding company within the pertinent provisions of the applicable revenue acts, Internal Revenue Codes, and regulations thereunder, and petitioner filed its returns and paid its taxes as such.

Among the assets transferred by and on behalf of Paulina duPont Dean to petitioner on its organization in 1924 were 333 shares of Delaware Realty and Investment Company no-par common stock. As a result of stock splits and 1962 U.S. Tax Ct. LEXIS 105">*108 stock dividends, petitioner owned 33,300 shares of Delaware Realty and Investment Company no-par common stock as of December 31, 1956, and such stock produced dividend income to petitioner in 1956 in the total amount of $ 1,273,725. The total cost basis of such stock on petitioner's books was $ 33,333.33.

In addition to holding stock, petitioner has been engaged in operating a farm or farms since 1929. Originally these farms covered considerable lands, but during the period 1948 to 1953 petitioner sold these lands to its principal stockholder, Paulina duPont Dean, who almost immediately after acquisition resold them to the three Dean children, who thereupon leased the lands to petitioner.

Petitioner's farm operations commencing in 1929 through the taxable year 1956 resulted in losses for every year. In 1955 the gross income from farm operations was $ 21,581.25, the farm expenses were $ 115,298.68, and the net loss was $ 93,717.43. In 1956 petitioner's gross income from farm operations was $ 29,133, the farm expenses were $ 102,766.49, and the net loss amounted to $ 73,633.49.

On or about April 4, 1956, J. Simpson Dean, hereinafter for convenience sometimes referred to as Dean, was 1962 U.S. Tax Ct. LEXIS 105">*109 presented with a plan 38 T.C. 585">*587 by tax counsel to remove petitioner from its status as a personal holding company under the revenue laws. The plan contemplated the acquisition by petitioner of income from oil and gas production to the end that such gross income from oil and gas sources would exceed 20 percent of its gross income from all sources. The plan appealed to Dean, not only because of the substantial tax saving which it envisioned for petitioner, but also because it offered petitioner an opportunity to earn and retain a sufficient amount to be able to discharge its existing indebtedness (then amounting to $ 1,260,000) at the Wilmington Trust Company. Dean also considered the purchase of oil and gas properties by petitioner a form of insurance for his and his wife's estate taxes because such assets could be readily sold by petitioner and converted into cash with which the corporation could redeem all or part of their stock in the event of death.

In furtherance of the plan Lehman Brothers, an investment banking firm of New York City which was active in negotiating for the purchase, sale, and financing of oil and gas properties, was employed by petitioner to find and negotiate for the 1962 U.S. Tax Ct. LEXIS 105">*110 purchase of oil- and gas-producing properties as well as the financing of such purchases.

Lehman Brothers started negotiations for the purchase of working interests in some 18 gas condensate wells located in and around the Carthage and Bethany gasfields in Panola County, Texas, from groups known as the Hudson group and the F. Kirk Johnson group. However, it was realized by Dean that the receipts from this contemplated purchase would not produce sufficient gross income in 1956 to take petitioner out of the category of a personal holding company in the months remaining in 1956. To obtain such gross income for the year 1956, Dean arranged through Lehman Brothers to purchase an oil production payment from William Associates, Inc., a corporation owned by Lehman Brothers. William Associates had purchased the production payment from Midstates Oil Corporation of Tulsa, Oklahoma, on December 28, 1955, for $ 3,750,000 and had financed the purchase in its entirety by a loan from the Chase Manhattan Bank (formerly the Chase National Bank) on a note maturing December 26, 1956, at 4 1/4 percent per annum.

After applying for a ruling from the Commissioner of Internal Revenue that receipts from an 1962 U.S. Tax Ct. LEXIS 105">*111 oil production payment would not be considered personal holding company income and receiving assurances to that effect, petitioner purchased a 40-percent interest in the Midstates production payment on June 11, 1956, from William Associates for $ 990,740.93. On the same day William Associates sold a 50-percent interest in the same production payment to Renappi Corporation, in which Wilhemina duPont Ross and Donald P. Ross (sister and brother-in-law of Paulina duPont Dean) are principal stockholders, and a 10-percent interest to Naed Corporation, in which 38 T.C. 585">*588 the Deans are principal stockholders. On June 11, 1956, the total amount owing under the production payment was $ 2,476,852.33 and accrued interest.

Petitioner financed the purchase of its 40-percent interest in the oil production payment by borrowing the sum of $ 990,740.93 from the Chase Manhattan Bank on a promissory note, payable in 8 months, bearing interest at 4 1/4 percent per annum, and secured by collateral consisting of 2,000 shares of Delaware Realty and Investment Company stock which the bank valued at $ 1,200 per share for loan purposes.

At no time from acquisition to final payout did any of the gross proceeds from the 1962 U.S. Tax Ct. LEXIS 105">*112 oil production payment pass into or through the hands of petitioner. The established procedure for handling such proceeds was that Midstates Oil Corporation transferred and paid over the monthly oil production payment directly to the Chase Manhattan Bank, and the proceeds were then applied by the bank (1) to interest on the loan; (2) an amount equal to two-seventeenths of the amount applied as interest under (1) was credited to a special deposit account of petitioner at the bank; and (3) the balance was applied against unpaid principal of the note. The total deposits in petitioner's special deposit account for the oil production payment at the Chase Manhattan Bank amounted to $ 1,597.40 in 1956 and $ 39.57 in 1957. The oil production payment paid out in full in January 1957. Petitioner's loan at the Chase Manhattan Bank was paid in full on January 22, 1957, and the Delaware Realty and Investment Company stock pledged by petitioner was returned by the bank on that date.

The negotiations by Lehman Brothers in petitioner's behalf with the Hudson-Johnson groups concerning the purchase of working interests in some 18 gas condensate wells resulted in an agreement on a purchase price of 1962 U.S. Tax Ct. LEXIS 105">*113 $ 3 million for such interests. On or about August 8, 1956, petitioner purchased the working interests (as of July 1, 1956) for a consideration of $ 3 million, and the following day petitioner assigned a 10-percent undivided interest in them to Naed Corporation for $ 300,000.

Through arrangements made by Lehman Brothers, petitioner financed its 90-percent share of the working interests acquired from the Hudson-Johnson groups at a cost to it of $ 2,700,000 by borrowing the sum of $ 2,800,000 on August 8, 1956, as follows:

(a) Petitioner borrowed $ 800,000 from the Swiss Bank Corporation (New York Agency), New York, New York, on a promissory note payable in equal monthly installments of $ 22,000, at interest of 5 percent per annum. The term of the note was 6 months, provided that if not in default "said term shall be extended for not exceeding five additional successive six-month periods" unless the Swiss Bank38 T.C. 585">*589 should notify petitioner of cancellation. Petitioner had the right to prepay the note or any part thereof, provided there was also prepayment on its loans, hereinafter described, from the American Express Company, Inc., and the Cleveland Trust Company. Petitioner pledged 1,350 1962 U.S. Tax Ct. LEXIS 105">*114 shares of Delaware Realty and Investment Company stock as collateral which the Swiss Bank valued at $ 1,330 per share for purposes of the loan. As of December 31, 1956, petitioner had prepaid installments on the loan covering the months of January, February, and March, 1957, in the amount of $ 66,000. Petitioner paid off the loan in full in accordance with its terms on or about April 3, 1959.

(b) Petitioner borrowed $ 1,500,000 from the American Express Company, Inc. (New York Agency), New York, New York, on a promissory note payable in equal monthly installments of $ 42,000 at interest of 5 percent per annum. The term of the note was 6 months, with provision for five 6-month extensions and prepayment provisions similar to those contained in the Swiss Bank note. Petitioner pledged 2,500 shares of Delaware Realty and Investment Company stock as collateral which the American Express Company valued in the aggregate at $ 3 million for purposes of the loan. As of December 31, 1956, petitioner had prepaid installments on the loan covering the months of January, February, and March, 1957, in the amount of $ 126,000. Petitioner paid off the loan in full on or about April 3, 1959, in accordance 1962 U.S. Tax Ct. LEXIS 105">*115 with its terms.

(c) Petitioner borrowed $ 500,000 from the Cleveland Trust Company, Cleveland, Ohio, on a promissory note maturing August 8, 1959, and payable in equal monthly installments of $ 14,000 at interest of 5 percent per annum. The note provided that either party could terminate the note with 30 days' written notice. Petitioner pledged 850 shares of Delaware Realty and Investment Company stock as collateral. As of December 31, 1956, petitioner had prepaid installments on the loan covering the months of January, February, and March, 1957, in the amount of $ 42,000. Petitioner paid off the loan in full in accordance with its terms on or about August 8, 1959.

The difference of $ 100,000 between the $ 2,800,000 borrowed by petitioner on August 8, 1956, and the $ 2,700,000 which petitioner paid for its 90-percent share of working interests in the gas condensate wells was made available to Lehman Brothers to pay a $ 90,000 commission for negotiating the purchase and financing of the working interests. The balance of $ 10,000 was retained by petitioner.

Petitioner's aggregate monthly payments due on the notes to the Swiss Bank, the American Express Company, and the Cleveland Trust 1962 U.S. Tax Ct. LEXIS 105">*116 Company amounted to $ 78,000, commencing on September 8, 1956. Because the larger part of petitioner's income was dividend income received quarterly on March 15, June 15, September 15, and 38 T.C. 585">*590 December 15, Dean decided it would be best to tie in the note payments with the dividend receipts. By correspondence with the lenders an arrangement was worked out whereby petitioner, starting in September 1956 upon receipt of its quarterly dividends, did make prepayments to all lenders covering amounts due in October and November 1956. On December 8, 1956, by borrowing $ 60,000 from Naed Corporation, petitioner made the note payments due on that date, and on December 17, 1956, after receipt of its December 15 dividends, petitioner made prepayments for the installments due January 8, February 8, and March 8, 1957. This tie-in procedure with dividend receipts continued until all of the notes were discharged. Dean considered the procedure economical as well as convenient, since an interest saving was effected by the immediate use of petitioner's dividend income which otherwise would have remained in petitioner's bank account drawing no interest.

The working interests in the gas condensate wells 1962 U.S. Tax Ct. LEXIS 105">*117 which petitioner acquired on August 8, 1956, were operated as follows: The gas condensate produced from the wells was processed by the Carthage Processing Company, Carthage, Texas, a company unrelated to petitioner. As payment for such processing, Carthage had the right to retain certain fixed percentages of the processed products in accordance with existing contracts which predated August 8, 1956. Hudson Gas and Oil Company of Shreveport, Louisiana, which had managed the wells prior to petitioner's purchase of working interests, acted as petitioner's agent in managing operations of the wells from August 8, 1956, until February 1958, in accordance with an agency agreement under which Hudson received a management fee of $ 1,500 per month. Petitioner opened a bank account at the First National Bank, Shreveport, Louisiana, in which it made deposits to meet the expenses incurred by Hudson in the operation of the wells. Hudson had authority as petitioner's agent to draw upon such account and did draw upon it to pay operating expenses, including royalties. At the end of each month Hudson sent petitioner a statement accounting for such expenditures.

The purchasers of the products which 1962 U.S. Tax Ct. LEXIS 105">*118 Carthage processed from the gas taken from petitioner's wells paid the purchase price to Hudson during the period of the agency agreement. Hudson then paid petitioner and others holding working interests in the gas condensate wells their proportionate share of the net proceeds realized from the operation of the wells. During the taxable year 1956, petitioner received gross income from Hudson in the total amount of $ 114,898.58.

When petitioner purchased its working interest in the wells in August of 1956, there were then three individuals in Shreveport, Louisiana, who had been conducting the operation of oil and gas properties owned by the Dean children. Shortly after the purchase, Dean 38 T.C. 585">*591 traveled to Shreveport to contact the Hudson people and work out plans to take over operations from Hudson as expeditiously as possible. As a result the three employees of the Dean family began immediately to work in petitioner's behalf with the Hudson organization to learn the management and operation of petitioner's newly acquired working interests. While Hudson continued to manage the wells as petitioner's agent, petitioner's Shreveport "staff" was increased by the employment of an engineer, 1962 U.S. Tax Ct. LEXIS 105">*119 additional clerical help, and fieldmen in a gradual takeover of operations, with most of the work being done by petitioner prior to the termination of Hudson's services in February 1958. Thereafter, petitioner's staff managed petitioner's interests as well as the other working interests in 11 of the 18 wells involved, and a concern by the name of Carter-Jones operated the remaining wells. Dean anticipated that petitioner's increased staff in Shreveport would manage and operate its purchased working interests as well as any possible future oil and gas acquisitions of petitioner. This staff as of the date of trial had been expanded to a total of 18 full-time employees of petitioner, of which 7 work in the office and 11 in the field.

Before petitioner purchased working interests in the 18 gas condensate wells on August 8, 1956, Lehman Brothers had a survey prepared of such interests by Ralph E. Davis, a petroleum and natural gas consultant. Davis submitted his report to Lehman Brothers under date of June 28, 1956. In it he estimated that the 18 wells would continue to produce gross income through the year 1967 and that the total net income (before income tax depletion and depreciation) 1962 U.S. Tax Ct. LEXIS 105">*120 from the working interests for the period July 1, 1956 through 1967, would amount to $ 5,932,710. On the basis of the Davis survey, Dean was of the view in 1956 that the working interests acquired from the Hudson-Johnson groups would alone produce sufficient gross income to keep petitioner out of a personal holding company classification for a period of 5 years thereafter.

Early in 1958 an engineer employed by petitioner reported to Dean that the 18 gas condensate wells were producing considerably less than the Davis survey had estimated. Dean went back to Lehman Brothers with this information, and as a result Lehman Brothers asked Davis to review his original estimates and make a new survey. Davis prepared a new report, submitted under date of July 28, 1958, in which he lowered his original estimate of expected net income from the wells by 24.45 percent, from $ 5,932,710 to $ 4,481,815.

When Dean introduced oil and gas operations into petitioner's corporate activities in 1956, he considered the possibility of having petitioner acquire other gas and oil interests in the future. However, no specific plans were formulated along these lines, nor was anything 38 T.C. 585">*592 relating to such possible 1962 U.S. Tax Ct. LEXIS 105">*121 future acquisitions recorded in a formal corporate resolution in 1956.

In the years following 1956, petitioner acquired other producing oil and gas properties as more particularly set forth in the paragraphs that immediately follow. It acquired no such additional properties until 1959.

The balance sheets of petitioner reflect the capitalized book cost of its oil and gas properties and equipment as of the end of each of the years 1956 through 1961, as follows:

During the period 1957 to 1960, inclusive, petitioner's cash expenditures in its oil and gas operations for intangible drilling costs and for other purposes which were not capitalized were as follows:

On or about March 1, 1959, Montchanin Corporation, a Delaware corporation wholly owned by the Dean children, was merged into petitioner. As a result of this 1962 U.S. Tax Ct. LEXIS 105">*122 merger, petitioner acquired leases and oil and gas production interests which had cost Montchanin Corporation $ 338,129.85 in exchange for which the Dean children acquired 4,464 shares of petitioner's no-par common stock.

On or about April 6, 1959, petitioner purchased working interests in certain oil-producing properties in Kentucky for $ 830,662.28. Petitioner financed this purchase by borrowing $ 1 million from the Chase Manhattan Bank of New York, New York, on a collateral note pledging 3,000 shares of Delaware Realty and Investment Company stock.

On or about September 1, 1959, petitioner purchased working interests in certain Oklahoma oil-producing properties for $ 178,973.16. Petitioner financed this purchase by borrowing $ 100,000 from the Wilmington Trust Company on a demand note.

On or about October 27, 1960, petitioner purchased working interests in certain oil-producing properties in Texas for $ 693,902.35. Petitioner financed this purchase by borrowing $ 692,000 from the First National Bank, Shreveport, Louisiana, and used the working interests purchased as collateral for the loan.

38 T.C. 585">*593 On or about November 28, 1961, petitioner purchased working interests in certain oil-producing 1962 U.S. Tax Ct. LEXIS 105">*123 properties in Texas for $ 160,000. It was not necessary for petitioner to borrow funds for the purchase of this property.

Petitioner's gross receipts for the years 1956 to 1960, inclusive, from its oil and gas properties (including the receipts in 1956 and 1957 from the Midstates oil production payment) were as follows:

Prior to 1956 (while petitioner was a personal holding company under the applicable revenue laws), petitioner's dividend policy was correlated with the income tax rate of petitioner's principal stockholders, J. Simpson Dean and Paulina duPont Dean. The Deans caused petitioner to declare only sufficient dividends in each year as would produce the smallest overall tax payment for them and for petitioner. Under the statute as a personal holding company petitioner's tax ceiling was set at 85 percent. Since each year the Deans had income from sources other than petitioner which fluctuated in amount, they had petitioner declare a balancing dividend with the result that their own top bracket would not exceed 85 percent. Thus, dividends declared by petitioner fluctuated from year to year according 1962 U.S. Tax Ct. LEXIS 105">*124 to the outside income of the Deans. An exception to this policy occurred in 1954 when the Deans made a gift of 4,000 shares of petitioner's stock to two trusts created by them in 1937 for the benefit of their three children. To put the trusts in cash the Deans caused petitioner to pay a larger dividend in 1954 and thereby brought their individual tax rate up to 89 percent. Part of the dividend went to the trusts and because the trusts were in a lower tax bracket they retained sufficient funds to pay certain insurance premiums, thereby sparing the Deans the need of giving cash to the trusts and paying gift taxes on such cash transfers.

In 1956, when the Deans no longer considered petitioner a personal holding company, petitioner's dividend policy changed. At first Dean was of the opinion that petitioner should declare no dividend in 1956. However, it was ultimately decided that petitioner declare and pay a dividend of $ 2 per share or a total of $ 72,344 on its 36,172 outstanding shares for the year 1956.

38 T.C. 585">*594 Petitioner's dividend income and its cash dividend distributions for the years 1924 to 1956, inclusive, were as follows:

1962 U.S. Tax Ct. LEXIS 105">*125 As of December 31, 1956, the Deans were indebted to petitioner in the total amount of $ 2,563,098.07 on non-interest-bearing demand notes. Since 1929 they had been borrowing from petitioner from time to time on such notes and, in addition thereto, since 1938 they had been borrowing from petitioner on open account. On December 31, 1952, the advances to the Deans on open account were transferred to non-interest-bearing demand notes in the amounts of their open account balances. Advances were made in 1953 to Paulina duPont Dean only, which after repayments showed a net amount owing by her on December 31, 1953, of $ 42,275 for which she gave a non-interest-bearing demand note. Further advances and repayments on open account were made during the year 1954 to both of the Deans, with full repayment of the net amounts then owing by December 31, 1954. During the year 1955 additional advances and repayments were made to the Deans, the principal advances being $ 250,000 to each on March 15, 1955, with which to pay gift taxes on the gifts of petitioner's stock made by them in 1954 to trusts for the benefit of their children. On December 31, 1955, Dean gave a non-interest-bearing demand note 1962 U.S. Tax Ct. LEXIS 105">*126 to petitioner in the amount of $ 133,431.85 covering the balance owed by him on open account, and his wife gave a similar note in the amount of $ 373,039.95 covering her balance. During 1956 advances were made to Paulina duPont Dean only in the total amount of $ 462,137.24. 38 T.C. 585">*595 Partial repayment was made from time to time throughout the year, and on December 31, 1956, the outstanding balance in the amount of $ 399,403.01 was fully repaid. The Deans did not borrow additional funds from petitioner on non-interest-bearing demand notes during 1956.

From 1929 to 1956, inclusive, the yearend balances due to petitioner from J. Simpson Dean and Paulina duPont Dean on their note obligations, on open account, and the total borrowings on both notes and open account were as follows:

At times (while petitioner was a personal holding company) when the Deans wanted to borrow funds from petitioner and petitioner lacked the necessary cash, Dean caused petitioner to borrow money at prevailing interest rates from the Wilmington Trust Company (in which he was a director), with the prearranged purpose of then borrowing the same funds from petitioner on non-interest-bearing notes. Thus, for example, on March 15, 1955, petitioner borrowed $ 500,000 from the bank at an interest rate of 3 percent per annum and on the same day advanced such funds to the Deans on open account so that the Deans had cash with which to pay gift taxes owed by them. The Deans did not pay interest to petitioner on their borrowings from petitioner when the corporation was a personal holding company because in their view such interest payments would have involved only cross balancing tax deductions for them and additional income for 38 T.C. 585">*596 petitioner, as well as potentially increased taxable dividends from petitioner to them.

On December 31, 1955, petitioner was indebted to the Wilmington Trust Company on demand notes signed between November 1962 U.S. Tax Ct. LEXIS 105">*128 of 1947 and March of 1955 in an aggregate amount of $ 1,260,000. By letter dated October 3, 1956, the bank wrote to Dean indicating that in view of the "change in the money market," the bank wanted payments on petitioner's outstanding indebtedness "with no specific amounts mentioned or times mentioned, but frankly as large and as rapidly as possible." On December 21, 1956, petitioner made a payment of $ 400,000 to the bank, leaving a balance owing as of December 31, 1956, of $ 860,000. The bank held 10,000 shares of Delaware Realty and Investment Company stock in 1956 as security for petitioner's indebtedness. In the regular course of making periodic appraisals of all collateral held by the loan department, the bank determined that the asset value per share of such Delaware Realty and Investment Company no-par common stock on December 29, 1955, was $ 1,367.77 and that 75 percent of the asset value per share was $ 1,025.83. On December 28, 1956, the bank determined that the asset value per share of such stock was $ 1,179.74 and that 75 percent of the asset value per share was $ 884.81.

The $ 990,740.93 indebtedness which petitioner incurred on June 11, 1956, in connection with the 1962 U.S. Tax Ct. LEXIS 105">*129 purchase of an oil production payment had been reduced to $ 111,105.62 as of December 31, 1956.

The $ 2,800,000 indebtedness which petitioner incurred on August 8, 1956, in connection with the purchase of working interests in 18 gas condensate wells had been reduced to $ 2,254,000 as of December 31, 1956.

Petitioner's comparative balance sheets as of December 31, 1955 and 1956, as shown on its Federal income tax returns for such years, were as follows:

38 T.C. 585">*597 A stipulated schedule containing a comparative analysis of petitioner's assets (excluding reserves) based on cost for the years 1940 to 1956, inclusive, is incorporated herein by this reference.

Condensed profit and loss statements of petitioner for the years 1950 to 1956, inclusive, were as follows.

38 T.C. 585">*598 Petitioner's accumulated earnings and profits as of December 31, 1955 and 1956, as adjusted by stipulation of the parties, were $ 1,088,950.15 and $ 1,626,868.87, respectively. If petitioner's increase of accumulated earnings and profits during the taxable year 1956 had been distributed as dividends, there would have resulted a substantial increase in the Federal income taxes due and payable by J. Simpson Dean and Paulina duPont Dean.

Petitioner was not a mere holding or investment company as of December 31, 1956.

The reasonable needs of petitioner's business (including the reasonably anticipated needs of such business) did not require the accumulation of any of the corporation's earnings and profits for the taxable year 1956.

OPINION.

The nature of the controversy herein has undergone a complete change since the Commissioner initially sent a deficiency notice to petitioner. The major portion of the $ 745,302.63 deficiency originally determined by the Commissioner was based on the factual determination that petitioner, which filed its returns and paid its taxes as a personal holding company under the applicable revenue laws each year from 1962 U.S. Tax Ct. LEXIS 105">*134 1934 through 1955, remained a personal holding company during the taxable year 1956 and was subject to the personal holding company tax. In its petition filed with this Court, petitioner alleged that the Commissioner erred in this determination. Shortly before the trial of this case the Commissioner amended his answer to the petition to allege for the first time that, in the alternative, if petitioner was not a personal holding company in 1956, then it was subject to the accumulated earnings tax for such year, and an alternative, reduced deficiency in the amount of $ 286,281.17 was claimed. The Commissioner's new theory was necessarily stated as an alternative contention because section 532(b)(1) of the 1954 Code ¹ (as did predecessor revenue acts throughout the time petitioner was a personal holding company) provides that the accumulated earnings tax is not applicable to a personal holding company. Hence, it had to be assumed (contrary to the deficiency notice) for purposes of the accumulated earnings tax allegation that petitioner no longer remained a personal holding company in 1956. At the trial the Commissioner entirely abandoned the personal holding company issue, leaving 1962 U.S. Tax Ct. LEXIS 105">*135 the applicability of the accumulated earnings tax to petitioner in 1956 the only question for decision.

As an accumulated earnings tax dispute, this case has several unusual features. First of all because this issue was raised by the 38 T.C. 585">*599 Commissioner for the first time in an amended answer to the petition, under the rules of practice of this Court it is the Commissioner and not the petitioner who has the burden of proof regarding the applicability of this special tax, that is, whether petitioner in 1956 was "availed of for the purpose of avoiding the income tax with respect to its shareholders * * * by permitting earnings and profits to accumulate instead of being divided or distributed." Sec. 532(a), I.R.C. 1954. In particular, the Commissioner has the burden in respect of the question whether petitioner permitted earnings and profits to accumulate in 1956 beyond the reasonable needs of its business, a matter upon which he presumably would have the burden in these circumstances in any event since he had not sent the notification provided for in section 534. But it must be noted 1962 U.S. Tax Ct. LEXIS 105">*136 from the outset that section 533² permits the Commissioner (even in the unusual circumstances of this case) to shift the burden of proof to petitioner on the ultimate question of the purpose of the accumulation by proving that the earnings and profits of petitioner were in fact permitted to accumulate beyond the reasonable needs of the business in 1956 or that petitioner was in fact a mere holding or investment company during the taxable year.

Aside from burden-of-proof responsibilities, there is a second unusual factor which sets this case 1962 U.S. Tax Ct. LEXIS 105">*137 apart from prior cases considered by this Court involving the accumulated earnings tax. This factor is the continuous history of the petitioner as a personal holding company under the revenue laws for over 20 years immediately preceding the taxable year in issue. During this period petitioner was subject to the added personal holding company tax but as already noted was not also subject to the accumulated earnings tax. Thus, the petitioner's business history during the years prior to the taxable year in controversy, a matter generally of considerable importance in an accumulated earnings tax case, is of limited relevance in the instant case. As a personal holding company from 1934 through 1955, for example, petitioner's dividend policy of gearing its distributions to the tax bracket of its shareholders and its loan policy of advancing in excess of $ 2,500,000 to its principal shareholders on personal loans without interest cannot be viewed in the same light for purposes of decision of the present issue as if petitioner had been other than a personal holding company during this period and had experienced a 38 T.C. 585">*600 similar history. While at the Commissioner's request we have made extended 1962 U.S. Tax Ct. LEXIS 105">*138 findings of fact concerning the petitioner's business and financial history while it remained a personal holding company, we think such findings are of limited usefulness except as a general background to petitioner's changed status during the taxable year in issue.

We do not mean to imply that petitioner's former status as a personal holding company in any sense exempts petitioner from the application of the accumulated earnings tax after it no longer comes within the statutory definition of a personal holding company. On the contrary, in the framework of the 1954 Code both the accumulated earnings and personal holding company taxes are contained within subchapter G which is entitled "Corporations Used to Avoid Income Tax on Shareholders," and thus petitioner's extended history as a personal holding company, if anything, makes it suspect in terms of other means, such as accumulating surplus, for avoiding shareholder taxes. We do think, however, in fairness to petitioner that while the corporation was paying its taxes as a personal holding company, petitioner and especially petitioner's principal shareholders, the Deans, had the right to treat and use the corporation as a personal 1962 U.S. Tax Ct. LEXIS 105">*139 holding company for all purposes and that petitioner's conduct during this period (when the accumulated earnings tax did not apply) should not necessarily prejudice its position once it becomes an ordinary operating corporation under the revenue laws.

We turn then to the issue of the applicability of the accumulated earnings tax to petitioner in 1956. After carefully studying all of the evidence of record and the arguments of counsel, we have concluded that petitioner in 1956 was availed of for the purpose of avoiding the income tax with respect to its shareholders by permitting its earnings and profits to accumulate instead of being distributed and that, therefore, it is subject to the accumulated earnings tax imposed by section 531.

Although the question is not free from doubt, we have made a finding that petitioner was not a "mere holding or investment company" (as the phrase is used in section 533(b), supra) as of December 31, 1956. We think that petitioner's purchase of working interests in 18 gas condensate wells in 1956 constitutes sufficient nonholding or noninvestment company activity to take petitioner out of the "mere holding or investment company" category as used in the 1962 U.S. Tax Ct. LEXIS 105">*140 statute and the applicable regulations. Sec. 1.533-1(c), Income Tax Regs. In this regard, we reject the Commissioner's argument on brief that petitioner's purchase of oil and gas interests in 1956, because "for the admitted specific purpose of removing petitioner from a personal holding company classification, is incompatible with business status and is legally inadequate to remove petitioner from a holding and 38 T.C. 585">*601 investment company status." By conceding that petitioner was no longer a personal holding company in 1956, the Commissioner has recognized the validity of the oil and gas interest purchases. We therefore find it difficult to follow the Commissioner's reasoning that such investments (for whatever purpose) were something less than they purported to be. To be sure, petitioner's working interests in gas condensate wells in 1956 were managed and operated by its agent, Hudson Gas and Oil Company. However, we think this agency arrangement and the gradual takeover of operations by petitioner were consistent with prudent business practice and in no way detract from petitioner's actual entry into the gas condensate business in the taxable year. We think that the scope of this business 1962 U.S. Tax Ct. LEXIS 105">*141 ³ was of such magnitude that petitioner cannot properly be described as a mere holding or investment company as of the close of the taxable year. ⁴

As noted above in our discussion of the burden of proof, section 533(a) provides that the fact that the 1962 U.S. Tax Ct. LEXIS 105">*142 earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be considered determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary. We think on the record before us that the Commissioner has successfully proved that petitioner's earnings and profits were permitted to accumulate beyond the reasonable needs of the business (including the reasonably anticipated needs of the business as provided in section 537) and that the petitioner has failed to offer a preponderance of evidence to show that such accumulation was not for the interdicted purpose of avoiding shareholder taxes.

As of the start of the taxable year 1956, the parties have stipulated that petitioner's adjusted accumulated earnings and profits amounted to $ 1,088,950.15. The Commissioner has argued that no further accumulations were necessary for petitioner's business needs in 1956. The petitioner has tried to show that such needs justified the retention of the additional $ 537,918.72 earnings and profits which it is agreed were accumulated during the taxable 1962 U.S. Tax Ct. LEXIS 105">*143 year. We think that the Commissioner has proved his case.

38 T.C. 585">*602 In 1956 petitioner's chief income-producing asset continued to be its 33,300 shares of Delaware Realty and Investment Company stock. ^{51962 U.S. Tax Ct. LEXIS 105">*144 1962 U.S. Tax Ct. LEXIS 105">*145} While its dividend income from such stock in 1956 was slightly less than it had been in 1955, still such income alone, amounting to $ 1,273,725, was nearly sufficient to pay all of petitioner's operating expenses during the taxable year. ⁶ In addition, petitioner received over $ 1 million in gross income from the oil and gas interests it acquired in 1956. By removing itself from the personal holding company classification, petitioner eliminated a Federal income tax expense of in excess of $ 800,000 in 1956. Thus, although petitioner's net income before taxes in 1956 was almost $ 150,000 under what it had been in 1955, its net income after taxes was $ 1,021,492.36 in 1956 as compared to $ 761,405.70 in 1955. As a result, petitioner's earnings per share after taxes increased from $ 21.04 in 1955 to $ 28.24 in 1956.

From these facts it is difficult to understand why, when petitioner was able to pay a dividend of $ 19.35 per share in 1955, it paid only $ 2 per share with increased net earnings in 1956. The answer of petitioner's president, J. Simpson Dean, in testimony at the trial was that petitioner's indebtedness incurred in connection with the purchase of its working interests in gas wells, together with its indebtedness on demand notes to the Wilmington Trust Company, was of such magnitude in relation to its cash position at the end of 1956 that a $ 2 dividend was determined to be all that was "reasonably safe" in the circumstances. If petitioner in fact had no choice but to pay any dividend declared in 1956 in cash, such reasoning might perhaps ⁷ be persuasive. However, this was not the case. Petitioner held non-interest-bearing notes in the total amount of $ 2,563,098.07 from its principal stockholders, the Deans, and in these 1962 U.S. Tax Ct. LEXIS 105">*146 circumstances a sizable 38 T.C. 585">*603 dividend might have been declared by discharging a substantial portion of these notes without reducing the corporation's cash or general quick assets position.

At the trial when petitioner's counsel asked J. Simpson Dean whether such a method of paying a noncash dividend had been considered in 1956, his answer was as follows:

You could not give much consideration to that because if Mrs. Dean and I had gotten let's say a dividend not in cash from Nemours, we could not get the money to pay the tax on what we got. So it, it could be thought of, but not actually considered. It was not practical or feasible.

Such an answer, obviously given in complete candor, furnishes no basis to the corporation for retaining earnings. The inconvenience of a noncash dividend to shareholders, while admittedly a matter of practical concern to the shareholders, 1962 U.S. Tax Ct. LEXIS 105">*147 can hardly justify a corporation which has more than sufficient accumulated earnings and profits but relatively little cash (in relation to its business needs) from declaring an appropriate dividend in terms of its current earnings. Certainly the cash requirements of the shareholders do not constitute a "business need" of the corporation insofar as the retention of earnings under the statute is concerned. Dean's answer to petitioner's counsel's question can only be viewed as a frank admission that no corporate business reason existed for not paying a dividend in 1956 in the notes of the principal shareholders and that the true reason for not following such a course was to avoid the resulting tax on the shareholders.

In Whitney Chain & Mfg. Co., 3 T.C. 1109">3 T.C. 1109, affirmed per curiam 149 F.2d 936 (C.A. 2), a similar situation existed. In that case, a major portion of the corporation's assets was tied up in corporate stock for which there was no ready market and in the form of non-interest-bearing loans to shareholders. ^{81962 U.S. Tax Ct. LEXIS 105">*150} The corporation in that case was considering expanding, and it argued that its lack of quick assets fully justified the accumulations involved. This Court's answer to 1962 U.S. Tax Ct. LEXIS 105">*148 such argument is particularly relevant here (3 T.C. 1109">3 T.C. 1119):

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 38 T.C. 585">*604 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 would 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, in Whitney Chain, this Court concluded that a predominantly independent board of directors could not have been ignorant of the ready means available by which a dividend might have 1962 U.S. Tax Ct. LEXIS 105">*149 been paid and that the board's failure to follow such a course was indicative of a purpose to reduce the surtax burden of the shareholders. In the present case, where petitioner's board of directors was made up of and controlled by the very shareholders (the Deans) who received the tax benefits of a minimum dividend, the same conclusion follows with even greater force. Cf. Kerr-Cochran, Inc. v. Commissioner, 253 F.2d 121, 128 (C.A. 8), affirming a Memorandum Opinion of this Court.

Apart from petitioner's cash position at the end of 1956, the only other reason suggested for petitioner's failure to distribute its current earnings was that petitioner intended to expand its oil and gas activities and in fact did expand such interests in subsequent years and that such expansion plans constituted a reasonable need of the business in 1956 (or, at least, a reasonably anticipated need of the business in such year) for which an accumulation of earnings was required. While there is some indication in the record that Dean, as petitioner's president, did consider the possibility of causing petitioner to acquire other oil and gas properties subsequent to 1956, it appears that no plans were made along such lines during the taxable year. The testimony that we heard showed that petitioner's officers in 1956 were concerned mainly with obtaining sufficient gross income from oil and gas sources to remove petitioner from the personal holding company classification in that year and in subsequent years, and that expansion beyond this goal -- while it may possibly have been in Dean's mind -- was vague and indefinite. Such nebulous expansion "plans" do not justify the retention 1962 U.S. Tax Ct. LEXIS 105">*151 of earnings by petitioner over and above the earnings already accumulated prior to the taxable year. Cf. Barrow Manufacturing Company v. Commissioner, 294 F.2d 79, 80-81 (C.A. 5), affirming a Memorandum Opinion of this Court, certiorari denied 369 U.S. 817">369 U.S. 817; American Metal Products Corporation v. Commissioner, 287 F.2d 860, 864-865 (C.A. 8), affirming 34 T.C. 89">34 T.C. 89; Dixie, Inc. v. Commissioner, 277 F.2d 526 (C.A. 2), affirming 31 T.C. 415">31 T.C. 415, certiorari denied 364 U.S. 827">364 U.S. 827; I. A. Dress Co. v. Commissioner, 273 F.2d 543 (C.A. 2), affirming 32 T.C. 93">32 T.C. 93, certiorari denied 362 U.S. 976">362 U.S. 976; Smoot Sand & Gravel Corp. v. Commissioner, 241 F.2d 197, 202 (C.A. 4), reversing on other grounds a Memorandum Opinion of this Court, certiorari denied 354 U.S. 922">354 U.S. 922. Moreover, it must be recalled that the oil and gas interests acquired in 1956 were obtained with borrowed funds 38 T.C. 585">*605 rather than out of petitioner's own assets, and it seems plain that any possible future acquisitions could similarly be financed by borrowing. Indeed, the record affirmatively shows that such future purchases were in fact made primarily with borrowed funds. In our judgment, the explanation that petitioner's earnings were retained 1962 U.S. Tax Ct. LEXIS 105">*152 for this purpose is spurious.

We conclude, on the record as a whole, that the Commissioner has proved that the earnings and profits of petitioner in 1956 were allowed to accumulate beyond the reasonable needs of the business. Under the statute the accumulated earnings tax is thereby applicable, the petitioner having failed to prove by a preponderance of the evidence that the earnings and profits in fact accumulated in 1956 were not for the purpose of avoiding the income tax with respect to its shareholders.

Decision will be entered under Rule 50.