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May 27, 1952

MARCELLE, Commissioner of Internal Revenue, et al.

The opinion of the court was delivered by: RAYFIEL

This is an action under Title 28 U.S.C. §§ 1331, 1340 and 1346, for the recovery of internal revenue taxes wrongfully, erroneously and illegally assessed and collected. The facts, which were stipulated, are as follows:

On November 12, 1929, the plaintiff, a New York corporation leased from Raystarr Holding Corporation, also a New York corporation, hereinafter referred to as Raystarr, the warehouse premises known as No. 49 Junius Street, Brooklyn, New York, for a term ending April 30, 1950, at a rental of $ 53,000 per annum in addition to real estate taxes with the plaintiff assumed and agreed to pay. By agreements dated March 1, 1933, and May 12, 1933, the terms of the said lease were modified by reducing the rent therein reserved to $ 33,000 per annum for the period between March 1, 1933, and February 28, 1935, and the real estate taxes were to be paid by Raystarr. When said modification agreements were executed the president of the plaintiff was also the president of Raystarr and the three directors who comprised plaintiff's board of directors were three of the five members who constituted Raystarr's board of directors, and the said three individuals cast their votes authorizing and confirming the aforementioned modification agreements.

 On August 20, 1936, a further modification agreement was entered into which confirmed an oral agreement extending the date of the aforementioned modification until September 1, 1936, and which further reduced the rent to $ 25,000 per annum for the period commencing September 1, 1936, and ending March 1, 1939, and also provided that Raystarr was to continue to pay the real estate taxes. At the time of the said modification agreement plaintiff's board of directors consisted of two individuals, both of whom had been members of its board when the modification agreements first hereinabove mentioned were entered into, and Raystarr's board of directors consisted of the same five individuals who on that occasion had been members of its board, and the same three directors cast their votes authorizing and modification.

 On May 7, 1937, the lease was further modified by providing that the period for the reduced annual rental of $ 25,000 be extended to April 30, 1950, the date of the termination of the lease. At the time of this modification the directors of both corporations were the same as those who served in that capacity at the time of the modification effected on August 20, 1936.

 At the time of the execution of the original lease on November 12, 1929, there had been issued and were then outstanding 3990 shares of the common stock of Raystarr, for which it had received $ 10 per share, and coupon bonds in the total face amount of $ 165,000, maturing on September 15, 1942, bearing interest at 7% per annum, payable semi-annually on the 15th day of March and September, which said principal amount had been reduced by 1942 to $ 129,600. Raystarr defaulted in payment of interest on the said bonds which was due on March 15, 1933, and made no interest payments thereafter. Likewise, it had defaulted in the payment of the principal due September 15, 1942. No dividends have ever been paid to Raystarr's stockholders.

 Raystarr's stockholders and bondholders learned of the modification agreements for the first time at their meeting held on or about December 3, 1940, at which time a protective committee of Raystarr bondholders was appointed. It consisted of three individuals, none of whom was a stockholder, officer or director of the plaintiff. This committee asserted the following claims against the plaintiff:-

 (1) That at the time of the execution of the several modification agreements all the directors of Raystarr who approved the same were directors of the plaintiff and completely dominated by it.

 (2) That the modification agreements could not have been adopted by Raystarr without the concurrence of the said directors, all of which was improper, illegal and not in the interest of Raystarr, but rather for the benefit of the plaintiff.

 (3) That the plaintiff induced such wrongful action and that by reason thereof Raystarr's security holders had been injured and the plaintiff was liable to Raystarr's security holders for the damages resulting therefrom.

 Thereafter negotiations were held between the plaintiff and the bondholders committee of Raystarr and in December, 1942, an agreement was entered into between the plaintiff and the bondholders committee of Raystarr under the terms of which the plaintiff agreed to pay to the said bondholders the sum of $ 132,960 in full accord and satisfaction of their claims, payable $ 120,000 in 24 equal quarter-annual installments of $ 5,000 each, all said sums to be paid ratably according to the holdings of the bondholders, who, in consideration of such payments, agreed to release the plaintiff from any and all liability arising from the alleged wrongful acts. The agreement provided further that upon the payment by the plaintiff of the said sum of $ 132,960 it would have the option to purchase the bonds and the Raystarr stock owned by the bondholders for the sum of $ 75,000, like wise payable ratably in quarter-annual installments of $ 5,000 each. The terms of this settlement were embodied in a letter, dated December 31, 1942, to Raystarr's bondholders, and were accepted.

 The plaintiff maintains its books on an accrual basis and for the calendar year 1942 it listed as accrued its obligation to pay $ 132,960 to the Raystarr bondholders. The plaintiff in its income tax return for the year 1942, filed on March 15, 1943, deducted from its gross income the obligation to the Raystarr bondholders. Due to an error $ 129,600 was deducted instead of $ 132,960. The Commissioner of Internal Revenue assessed a deficiency in the sum of $ 53,967.19 with interest, holding that it was not an allowable deduction under section 23 of the Internal Revenue Code, 26 U.S.C. § 23. The plaintiff paid the assessment and on April 1, 1946, filed a claim for the refund of the said sum and, more than six months having elapsed since the filing thereof, instituted this action.

 The plaintiff contends that the deduction of $ 132,960 paid to Raystarr's bondholders was an ordinary and necessary expense in the operation of its business and as such is deductible under Section 23(a) (1) of the Internal Revenue Code, 26 U.S.C. 23. The government disputes plaintiff's right to such deduction.

 Concededly the plaintiff's three directors constituted a majority and controlled the operations of Raystarr's board of directors when the latter entered into the aforementioned ...

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