52 T.C. 119">*120 Respondent determined deficiencies in the Federal income tax against petitioner as follows:

The issues remaining to be decided are (1) whether petitioner must include in gross income $ 402,524.71 ¹ received from its contract-holders in 1958; (2) whether petitioner can deduct in 1958 legal fees paid during that year in the amount of $ 17,264.75; 1969 U.S. Tax Ct. LEXIS 151">*152 (3) whether petitioner is entitled to a deduction in 1958 for payment of actuarial fees in the amount of $ 5,909.73; and (4) the amount, if any, of operating loss deduction to which petitioner is entitled for the taxable year ending November 10, 1959. Respondent has conceded his claim regarding "loading on" expenses. Petitioner has conceded an issued regarding interest expenses.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference.

Petitioner is the Cardinal Corp. It was incorporated under the laws of the Commonwealth of Kentucky on February 15, 1955. Originally, petitioner's name was Cardinal Life Insurance Co. On December 30, 1959, the name was changed to the Cardinal Corp. Petitioner's Federal income tax return and amended return for the calendar year 1958, together with the return for the taxable period January 1 through November 10, 1959, were filed with the district 1969 U.S. Tax Ct. LEXIS 151">*153 director of internal revenue for the district of Kentucky.

At the time of incorporation, Cardinal's total authorized capital stock was $ 1 million. This amount was divided as follows: 99,000 shares of common stock with $ 10 par value per share; 1,000 shares of preferred stock with $ 10 par value per share. On March 23, 1955, an amendment to petitioner's articles of incorporation was filed with the secretary of state of Kentucky. The amendment changed the authorized capital stock of Cardinal to 50,000 shares of voting preferred stock with a par value of $ 10 and 50,000 shares of nonvoting common stock with a par value of $ 10 per share.

52 T.C. 119">*121 On March 25, 1955, Cardinal was licensed as a stock dealer by the Division of Securities, Department of Banking for the Commonwealth of Kentucky. Cardinal registered with the division 20,000 shares of nonvoting common stock to be sold at $ 25 per share and 1,000 shares of voting preferred to be sold at the same price. The maximum commission in connection with the sale of each issue was set at 15 percent.

On September 2, 1955, the incorporators and original directors surrendered, and were relieved of, portions of their subscriptions for preferred stock. 1969 U.S. Tax Ct. LEXIS 151">*154 Subscriptions for the 1,000 shares of voting preferred stock were redistributed. On September 2, 1955, the board of directors also voted to issue stock options to the holders of the voting preferred stock. The optionees were entitled to purchase common stock of the petitioner for $ 25 per share at any time within 10 years. An optionee could purchase 30 shares of common stock for each share of voting preferred stock he held.

In November 1955 the commissioner of insurance for the Commonwealth of Kentucky authorized petitioner to commence the sale and issuance of insurance policies. By the end of March 1956, 20,000 shares of petitioner's authorized common stock had been sold and issued to the public at $ 25 per share.

On March 28, 1956, 29,400 of the remaining 30,000 shares of petitioner's unissued authorized common stock were made the subject of contracts. These contracts were between petitioner and the 13 individuals who held petitioner's outstanding preferred stock. Twelve of the 13 individuals were directors of petitioner. Each contract provided for the purchase of 30 shares of common stock for each share of voting preferred stock presently held. The resulting distribution was 1969 U.S. Tax Ct. LEXIS 151">*155 as follows:

52 T.C. 119">*122 Each contract contained the following material provisions: ²

Whereas,    , a stockholder of this corporation, being the owner of     shares of preferred stock; and

Whereas, it is the judgment of this Board that the interest of this corporation will be advanced by entering into the contract for the purchase from this corporation,     shares of its non-voting common capital stock at the time, or times, at the price and on the terms as hereinafter set out in this resolution; and

Whereas, this Board is empowered to enter into such an agreement and to dispose of the shares contracted by the said stockholder; and said shares are available for the purpose; and

Whereas, the stockholder devoted his time and energy to the promotion and organization of this corporation without remuneration, and that his influence emanating from his 1969 U.S. Tax Ct. LEXIS 151">*156 sphere of prominence, engendered good will to this corporation, and the execution of this Contract will inculcate the continued faith and confidnece [sic] of his following and will further serve as a notivation [sic] for the success of this corporation, and as an incentive toward the continued and successful administration of his duties in his service to the corporation, whether or not he, at any time, may hold office of become entitled to a salary or other fixed compensation;

Now, Therefore, be it

Resolved, That this agreement made and entered into this     day of    , 1956, by and between the CARDINAL LIFE INSURANCE COMPANY, a Kentucky corporation, hereinafter called the Company, and    , hereinafter called the Stockholder,

The Stockholder does hereby agree to pay $     to the Company on or before the 2nd day of September, 1965, in consideration of the Company issuing to him     shares of its $ 10.00 par non-voting common capital stock.

The Stockholder shall have a right at any time to demand the Company to issue any or all of the shares contracted for, and the Company agrees to issue to the Stockholder all or any of the shares, provided the Company shall issue only the number of shares 1969 U.S. Tax Ct. LEXIS 151">*157 represented by the payment from the Stockholder which shall be equivalent to $ 25.00 for each share issued to the Stockholder, and provided further, that the Stockholder, upon the exercise of his rights provided for in this Contract, shall present to the company, at its transfer agency in the City of LouisvilleState of Kentucky, this Contract accompanied by payment in cash.

Upon the exercise of the right the Stockholder shall be entitled to receive one or more certificates for fully paid and non-assessable common stock of the par value of $ 10.00 for the number of shares as determined by the election of the Stockholder as herein provided.

* * * *

If on or before the expiration date of this contract the Company shall offer any shares of common stock of any class for subscription by the common stockholders at a price less than this Contract price, the Stockholder, and to the extent that the rights provided for in this Contract are unexercised or unexpired, will become entitled to subscribe for purchase at the same price per share at 52 T.C. 119">*123 which such stock is offered to the holders of the common stock to the number of shares of such common stock for which he would have been entitled to subscribe 1969 U.S. Tax Ct. LEXIS 151">*158 if he had been the holder of record of the number of shares of common stock then called for by this Contract and the Stockholder shall be given the same opportunity to exercise such subscription rights as the holders of the common stock, and further, that all shares of common stock issuable upon the exercise by the Stockholder of rights provided for in this Contract shall be issued as of the date on which the Contract is presented, and his right to purchase as provided by the terms of this instrument, and payment in full of the purchase price is made to the Company, and upon the exercise of such Contract right, the Stockholder shall become entitled as of such date to all dividends, subscriptions and other rights of a holder of record of such shares of common stock.

The Company shall

(a) at all times authorize and reserve unissued a number of shares of the common stock sufficient to satisfy the rights as vested in the Stockholder to purchase stock as provided for in this Contract and keep supplied with sufficient stock certificates to provide for the exercise of such rights to purchase as provided to the Stockholder in this Contract; and

(b) not pay any dividend on its common stock unless 1969 U.S. Tax Ct. LEXIS 151">*159 such dividend is paid in cash or in common stock or in both.

In the event of death of the Stockholder, prior to the Stockholder's exercising his discretion in the payment and purchase of all the stock under the terms and conditions as provided herein, this Contract shall be binding and in full force and effect upon his heirs, executors, administrators and assigns.

All payments made under the terms of this Contract shall be payable to the chief executive officer at its principal place of business in Louisville, Kentucky.

This Contract contains all the terms and conditions between the Stockholder and the Company.

Cardinal Life Insurance Company

By    

S. H. Goebel, President

[Emphasis supplied.]

On June 7, 1956, petitioner filed an amended articles of incorporation with the secretary of state of Kentucky. Petitioner changed the number of its authorized shares of common stock from 50,000 shares with a par value of $ 10 per share to 250,000 shares with a par value of $ 2 per share.

At January 1, 1957, 1969 U.S. Tax Ct. LEXIS 151">*160 the owners of petitioner's outstanding voting preferred stock held contracts in the form above. These contracts authorized the purchase of 150 shares of petitioner's common stock for each share of preferred stock held. The term of the option was for 10 years from the date of the contract. Only one contract-holder, C. C. Bales, was not a director of Cardinal.

On March 27, 1957, Cardinal and Buckley Enterprises entered into a contract. Buckley Enterprises agreed to become the exclusive agent in Kentucky for the sale of all stock made available by the officers and directors of Cardinal. Buckley Enterprises would collect the gross 52 T.C. 119">*124 remittances and retain 15 percent thereof as sales commissions. Of the remaining 85 percent, $ 5 per share was to be paid to Cardinal. The balance thereof was to be paid to the individual contract-holder who had made the stock available for sales. The $ 5 represented the price of the stock to the contract-holder.

In June 1957 each of the 14 preferred shareholders signed "authorizations" with respect to the shares referred to in their individual contracts. It was agreed that the shares sold would be allocated in proportion to the amount of contract shares 1969 U.S. Tax Ct. LEXIS 151">*161 of each contract-holder.

From June 1, 1957, through March 1958, Buckley Enterprises sold 71,001 shares of petitioner's nonvoting common stock to the public at prices ranging from $ 12 to $ 13.25 per share. The proceeds were distributed pursuant to the aforementioned contract. These 71,001 shares were sold to 660 purchasers for a total consideration of $ 891,343.25, which was distributed: $ 133,913.54 to Buckley Enterprises as commissions; $ 355,005 to petitioner; and $ 402,524.71 to owners of the preferred stock and their assignees.

During 1958 the Kentucky Department of Insurance conducted an examination of Cardinal. Such an examination was customary with all new insurance companies. During the examination C. P. Thurman (hereinafter referred to as Thurman), commissioner of insurance, became concerned about the public sale of the contract stock. Thurman believed that all sales proceeds, less commissions to Buckley Enterprises, belonged to Cardinal. He was especially concerned that the capital surplus of Cardinal might become impaired by the end of the year. The full sales proceeds would be needed as reserves to cover the insurance expected to be in force at the end of the year.

During 1969 U.S. Tax Ct. LEXIS 151">*162 the course of the investigation by the department of insurance, Cardinal filed an amended articles of incorporation on May 20, 1958. As a result of such amendment, the common stock was converted to voting stock. The 1,000 shares of $ 10 par preferred stock were converted to 5,000 shares of $ 2 par common stock. The authorized capital stock of the corporation was changed to a total of 255,000 shares of $ 2 par common stock with each share having one vote.

Thurman sought the services of an independent attorney who was not politically active. The Governor accepted Thurman's recommendation and appointed Leo T. Wolford as special counsel (hereinafter referred to only as Wolford). Wolford advised Thurman that the entire net proceeds from the sale of contract stock, and not merely the $ 5 per share paid to Cardinal, properly belonged to Cardinal. He looked to the fact that 12 of the 13 contract-holders were directors of Cardinal. Thus, the contract-holders were in the position of fiduciaries. As such, they could not profit to the detriment of the corporation. By 52 T.C. 119">*125 retaining their profit of $ 402,524.71, the contract-holders precluded Cardinal from using these funds as reserves to protect 1969 U.S. Tax Ct. LEXIS 151">*163 the policyholders. Thus, their contracts to purchase the common stock should be ignored. The contract-holders should be treated as only agents for Cardinal. The full sales proceeds, less broker's commissions, belonged to Cardinal. On November 12, 1958, Thurman advised Cardinal that pursuant to the laws of Kentucky the contract-holders must immediately pay in full for their authorized and unissued shares of nonvoting common stock.

After a series of meetings, various State officials, the contract-holders, and petitioner reached an agreement on or about December 4, 1958. The contract-holders agreed to pay into Cardinal the amount of their profits on the sale of the contract stock. Pursuant to the same agreement, purchasers acceptable to the commissioner of insurance acquired 57,383 shares of contract stock at $ 5 per share.

When Cardinal received the $ 355,005 following the sale of the 71,001 shares by Buckley Enterprises, Cardinal recorded $ 142,002 as paid-in capital and $ 213,003 as paid-in surplus. When Cardinal later received the $ 402,524.71 from the contract-holders, the full amount was credited to paid-in surplus.

Petitioner claimed a deduction on its 1958 return for legal 1969 U.S. Tax Ct. LEXIS 151">*164 fees paid to the law firm of Gambrell, Harlan, Russell, Moye & Richardson (now Gambrell, Harlan, Russell & Moye), of Atlanta, Ga., in the amount of $ 17,264.75. This amount was accrued on petitioner's books as an expense during the year 1958. Petitioner paid the $ 17,264.75 in 1958 when said firm submitted its bill to Cardinal. Gambrell advised Cardinal in connection with: (1) Services which were being performed by Foundation Life Insurance Service Co.; (2) Federal and State investigations; (3) possible merger with another insurance company; and (4) various other corporate matters. Petitioner accrued the fee of $ 17,264.75 as an expense during the year 1958 and paid the fee in 1958.

In 1958 the Kentucky commissioner of banking engaged the firm of J. Huell Briscoe & Associates to conduct an examination relating to the registration and sale of petitioner's stock. The firm submitted to the banking department a statement dated November 1, 1958. The total fee for examination of petitioner was $ 5,909.73. The department forwarded the statement to petitioner for payment. Petitioner paid the full amount with a check dated November 20, 1958.

Petitioner did not report the $ 402,524.71 1969 U.S. Tax Ct. LEXIS 151">*165 received from the contract-holders as gross income on its Federal income tax return for calendar year 1958. Petitioner deducted $ 17,264.75 as legal fees and $ 5,909.73 as actuarial fees on that same return. Respondent has disallowed these deductions and included the $ 402,524.71 in petitioner's gross income for 52 T.C. 119">*126 1958. Respondent has further disallowed an operating loss deduction in the amount of $ 443,914.88 for the taxable year ended November 10, 1959. The disallowance was based upon adjustments to petitioner's gross income for calendar year 1958.

OPINION

The first issue to be considered is whether petitioner must include in gross income for 1958 the $ 402,524.71 received from preferred shareholders and their assignees.

Section 1032 of the Internal Revenue Code of 1954 provides that no gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation. Section 1032 had no counterpart under the 1939 Code. Congress enacted section 10321969 U.S. Tax Ct. LEXIS 151">*166 to remove uncertainties regarding the taxation of dispositions by a corporation of its own stock. H. Rept. No. 1337, to accompany H.R. 8300 (Pub. L. 591), 83d Cong., 2d Sess., p. 268 (1954).

The key words of section 1032 so far as this case is concerned are "in exchange for stock * * * of such corporation." If the contract-holders owned the 71,001 shares of common stock at the time of its public distribution by Buckley Enterprises, then Cardinal did not receive the $ 402,524.17 directly in payment for the issuance of the 71,001 shares of common stock. Conversely, if the contract-holders did not validly own the 71,001 shares of common stock at the time of its public distribution by Buckley Enterprises, then Cardinal did receive the $ 402,524.17 directly in payment for the issuance of the 71,001 shares of common stock.

On or about December 4, 1958, the contract-holders agreed to pay Cardinal the amount of their profits on the sale of the contract stock. They acted pursuant to the opinions of Wolford and Thurman, who had concluded that the common shares were sold for and on behalf of petitioner. The entire sales proceeds, less broker's commissions to Buckley Enterprises, belonged to petitioner. 1969 U.S. Tax Ct. LEXIS 151">*167 Relying on the advice of Wolford, Thurman advanced two theories in support of his opinion. ^{31969 U.S. Tax Ct. LEXIS 151">*168} One 52 T.C. 119">*127 theory was that the common shares represented authorized but unissued stock. Under sections 304.123 and 304.132 of the Kentucky Revised Statutes an insurance company could not have authorized an unissued stock. ⁴ The second theory looked to the fact that 12 of the 13 contract-holders were directors of Cardinal. Thus, the contract-holders were in the position of fiduciaries. As such, they could not profit to the detriment of the corporation. By retaining their profit of $ 402,524.71, the contract-holders precluded Cardinal from using these funds as reserves to protect the policyholders. Accordingly, their contracts to purchase the common stock should be ignored. The contract-holders should be treated as only agents for Cardinal. The full sales proceeds, less broker's commissions, belonged to Cardinal.

We have examined Kentucky law and have concluded that the second theory is correct. It is the law of Kentucky that directors and dominant or controlling shareholders, or groups of stockholders, 1969 U.S. Tax Ct. LEXIS 151">*169 are fiduciaries, Zahn v. Transamerica Corporation, 162 F.2d 36">162 F.2d 36 (C.A. 3, 1947); Pepper v. Litton, 308 U.S. 295">308 U.S. 295 (1939), and that such fiduciaries have an inherent obligation not to use their position to advance their own interest. 162 F.2d 36">Zahn v. Transamerica Corporation, supra;Central West Casualty Co. v. Stewart, 248 Ky. 137">248 Ky. 137, 58 S.W.2d 366 (1933); Graham v. Tom Moore Distillery Co., 42 F. Supp. 853 (W.D. Ky. 1941).

The law in Kentucky in this regard is very well stated by the Court in the Zahn case as follows:

The law of Kentucky also demonstrates the fact that those in charge of a corporation stand in a fiduciary relation to its minority stockholders. In Graham v. Tom Moore Distillery Co., D.C. W.D. Ky., 42 F. Supp. 853, 855, 856, the District Court issued an injunction against the carrying out of a contract peculiarly advantageous to a majority holder of the corporation's stock but not to the corporation. Judge Miller, quoting from Venus Oil Corporation v. Gardner, n8 244 Ky. 176">244 Ky. 176, 50 S.W.2d 537, 538, went on to state "that it is * * * well settled by many Kentucky decisions that a person occupying a fiduciary or confidential relationship can not lawfully acquire any private interest of 1969 U.S. Tax Ct. LEXIS 151">*170 his own in opposition to his position of trust, and that transactions between fiduciaries and cestuis que trust are constructively fraudulent." Citing Hoge v. Kentucky River Coal Corp., 216 Ky. 51">216 Ky. 51, 287 S.W. 226">287 S.W. 226; Walker v. Carter, 208 Ky. 197">208 Ky. 197, 270 S.W. 770">270 S.W. 770; Clay v. Thomas, 191 Ky. 685">191 Ky. 685, 231 S.W. 512">231 S.W. 512; Louisville Point Lumber Co. v. Thompson, 202 Ky. 263">202 Ky. 263, 259 S.W. 345">259 S.W. 345. He also said, 42 F.Supp., at page 856, that a contract entered into by such parties as were there involved, viz., between the corporation itself and the majority stockholder, is "either constructively fraudulent or absolutely void regardless of whether or not actual fraud can be spelled out of the express provisions of the contract." Judge Miller is a judge of long experience 52 T.C. 119">*128 in the interpretation of Kentucky law. See Huddleston v. Dwyer, 322 U.S. 232">322 U.S. 232, 322 U.S. 232">237, 64 S. Ct. 1015">64 S. Ct. 1015, 88 L. Ed. 1246">88 L. Ed. 1246.

Other Kentucky decisions hold that public policy forbids an agent to act for his principal in a matter involving the agent's private interest and that such a contract is void as between principal and agent. See Central West Casualty Co. v. Stewart, 248 Ky. 137">248 Ky. 137, 58 S.W.2d 366; Weatherholt v. National Liberty Ins. Co., 204 Ky. 824">204 Ky. 824, 265 S.W. 311">265 S.W. 311; 1969 U.S. Tax Ct. LEXIS 151">*171 King Const. Co. v. Mary Helen Coal Corporation, 194 Ky. 435">194 Ky. 435, 239 S.W. 799">239 S.W. 799, and F.T. Gunther Grocery Co. v. Hazel, supra. In the Weatherholt case, 204 Ky. 824">204 Ky. at page 826, 265 S.W. 311">265 S.W. at page 312, the Court of Appeals of Kentucky quoted, "'The law has too much regard for the infirmity of human nature to allow a person to be subjected to the temptation of acting as an agent in a matter in which he has an interest adverse to his principal. The law, dealing with the average integrity and disinterestedness, wisely assumes that no man can faithfully serve two masters whose interests are in conflict.'" [Footnote omitted. 162 F.2d 36">162 F.2d at 43.]