text:
    Appeal of The Trego County Cooperative Association.
    Docket No. 2137.
    Promulgated May 10, 1927.
    Fixed dividends paid by a cooperative corporation are not deductible by the corporation.

      Robert H. Worline, Esq., and Alexander G. Johnson, G. P. A., for the petitioner.

      Briggs G. Simpich, Esq., for the Commissioner.
    This appeal is from the determination of deficiencies in income taxes of $231.57 and $5,945.97 for the fiscal , years ended June 30, 1918 and 1919, respectively. The petitioner claims deductions of so-called patronage dividends and of fixed payments on capital stock.
    FINDINGS OF FACT.
    The petitioner was incorporated under the laws of Kansas in 1914. Its principal office is at Yvhikeeney, Kans. It has elevators at Wakeeney, Collyer and Voda, and maintained general stores at Wakeeney and Voda. .
    The purposes of the corporation are set forth in its charter as follows:
    The conversion of all agricultural products, by means of mills, eleyators, warehouses or stores. Buying and selling of grain for profit. Manufacturing and marketing of dairy products, buying and selling of coal, flour, feed farm supplies, live stock and other merchandise for the shareholders and members of the F. If. & C. Union.

      The corporation was organized by farmers for the purposes of disposing of their products, creating a saving on the purchase and sale of goods, and cutting the margin of profit taken by the old companies in marketing produce. Only farmers are stockholders and members in the corporation. The organization of the corporation had the effect of raising the market price of wheat, 5 to 7 cents a bushel, in the localities where the company operated.
    The by-laws of the corporation in effect during the taxable years involved, in addition to stating the purposes of the corporation as set forth above, contain, among others, the following provisions:
    ARTICLE III.
    Seo. 1. — The office and place of business of this association shall be at Wakeeney and such other places as the directorate shall decide.
    Sec. 2. — The business shall be conducted on a ware house basis, the warehouses to be located at points most convenient to the members.
    Sec. 3. — These warehouses shall be bought, built or rented as the directors see fit.
    ARTICLE IV.
    Eligibility to membership in this Association shall consist as follows:
    Seo. 1. — Membership in good standing in the E. E. & C. Union.
    Seo. 2. — Subscription for at least one share of this Association’s capital stock.
    Sec. 3. — And in signing of the name and place of residence of the applicant to these by-laws.
    ARTICLE VII.
    After the payment of the operating expenses of this association from the remaining profits, if any, two per cent shall be kept in the treasury and carried on the books as a reserve fund for the payment of any unexpected losses, not otherwise provided for; the reserve fund may be invested or loaned to stockholders, provided a part of said fund may be used in payment of interest on eapital stock, at the discretion of the directors.
    ARTICLE VIII.
    Seo. 1. — The capital stock of this Association shall be $25,000 to be divided into 2500 shares of $10.00 each, and at least twenty per cent of the face of all shares subscribed shall be paid for in cash and in case of deferred payments such payments shall be settled for in full by note, secured by the capital stock for which said note is taken as part payment.
    Seo. 2. — All shall be negotiable and transferable at the option of the holder and on approval of directors, and all transfers must be recorded on the books of the Association.
    Sec. 3. — Certificates of stock shall be numbered and registered in the order in which they are issued, and shall be signed by the president, secretary, and the seal of the company impressed on each of the certificates.
    ARTICLE IX.
    After the reserve fund is deducted from the profits, interest at the rate of eight per cent on all eapital stock shall be paid, but no interest shall be paid on any shares of stock that are not paid up in full at the time of annual settlement, and interest shall be paid only from and after date when said shares are paid in full, all interest to become due and payable on and after the annual settlement. All profits accruing above interest and actual operating expenses shall be prorated back to each share holder in proportion to the amount of business done by saw! share holder. This article to- apply to shares bought under Article XXVI of these by-laws.
    ARTICLE XII.
    Seo. 1. — All money received on shares, contributions, or otherwise shall be paid to the treasurer unless otherwise ordered by the directors and said money shall be withdrawn only by vote of the board of directors on the written order of the president countersigned by the Secretary.
    Sec. 2. — Such funds as the Association may have, not needed for immediate use in said Association’s business or to meet accruing liabilities, shall, with the consent of the association, given at any regular meeting, be invested by the directors.
    Sec. 3. — The business of this association shall be conducted on a cash basis.
    Seo. 4. — The business agent shall keep a sales book showing a correct list of all sales, the amount and price of said sales, the name of purchaser and the kind of goods sold.
    ARTICLE xvn.
    Upon the decease of any member of the Association, the directors may repay to his legal representatives the face value of the entire stock, less arrearages, owned by said member at the time of his death, together with all accrued interest and purchase dividends, within twelve months after decease of said member.
    ARTICLE XVIII.
    Every member of this Association shall be entitled to but one vote regardless of the number of shares owned by him or her.
    ARTICLE XX.
    The Board of Directors shall appoint a manager of the business who with the consent of the directors may hire or discharge such help as he shall deem necessary but all salaries shall he approved by the hoard of directors. The manager shall have power to sign or endorse the name of this association to any draft checks necessary to the business of said association but no power to sign name of company to any accommodaton of security whatsoever.
    ARTICLE XXI.
    The business agent shall draw a salary such as the hoard of directors shall, decide.
    ARTICLE XXII.
    The business agent may he removed at any time by a majority voto of all the stock holders.
    ARTICLE XXVI.
    Any person who is unable to pay for at least one share of capital stock of this Association on the terms named in Article VIII may at the discretion of the directors purchase one share on account, said share to be held by the treasurer and issued to the purchaser when the dividends on his purchases shall amount to the face value of said share. Provided (1) That said purchaser of dependent share shall not be entitled to vote until said share is paid for in full; (2) That said dependent share shall he paid for on or before two years from date of said share, either by accrued dividends on purchases or by other means.
    The 8 per cent return to the stockholder's established by Article IX of the by-laws was fixed at that rate for the reason that it was the legal rate of interest which it would have been necessary to pay if the money had been borrowed. It was considered as an expense of the corporation.
    The capital stock of the corporation, when organized, consisted of 500 shares with a par value of $10 each. In March, 1915, the stock was increased to 1,500 shares; in September, 1915, to 3,000 shares; in January, 1917, to 7,500 shares; in December, 1919, to 12,500 shares; and in May, 1921, to 25,000 shares.
    The “F. E. and C. Union” is the Farmers Educational and Cooperative Association, made up of members of various farmers’ organizations in the United States and Canada.
    The corporation purchased produce from its members and, when facilities were available, it purchased from nonmembers. The prevailing market price for the product in the particular locality was paid both members and nonmembers. In addition to the purchase and resale of farm produce, it dealt in groceries, farm machinery, coal and general merchandise, not only with its members but with the general public.
    Nonmembers sold their produce to the corporation to secure the advantage of the increased prices paid, and because they knew it promoted a higher price in the market. The corporation dealt with the nonmembers with the hope of inducing them to become members and for the purpose of making a profit on their business.
    A complete record was kept of all purchases from and sales to members during each year.
    All the business of the corporation is conducted by a business manager who is not a member of the association. The officers of the corporation have no active part in the management of the business and they draw no salary as such, but are paid a per diem fee of $5 for each day they are in attendance at board meetings.
    During the years involved the corporation, after deducting from its gross earnings from all sources the rental, clerk hire and other expenses of operating, made the 8 per cent payment to stockholders as required by the by-laws on the basis of the amount of stock owned by each stockholder. The balance still remaining was prorated among the stockholders in proportion to the amount of business done by each during the year. No distribution was made to nonmembers.

      Earnings from the different departments were carried direct to surplus, and the 8 per cent payments and pro rata distribution were charged direct to surplus.
    Tax has always been paid on the income derived from nonmember business.
   OPINION.

MoRRis:

The respondent in his answer admits that the proportion of the patronage dividends paid to stockholders during the fiscal year 1919 computed on the following basis is an allowable deduction for that year:

First compute the apparent net income of the corporation. From this amount deduct the fixed dividend paid or payable on any outstanding capital stock. The amount of such fixed dividend is the portion of net income properly attributable to the investment made in the corporation by the holders of any outstanding capital stock. The balance consists of (1) the amount available for refund to the members of the association and (2) the profits made from non-members. In the absence of evidence to the contrary it will be assumed that the dealings with members and non-members are equally profitable, and, accordingly, that the amount available for refund consists of that proportion of the apparent net profits, after deducting the fixed dividend on outstanding capital stock, which the amount of business transacted with members bears to the entire amount of business transacted. Up to the amount available for refund, thus computed, a distribution by a cooperative association to its members, upon the basis of the business transacted with them, will be deemed to be a true patronage dividend, deductible by the association in computing its taxable net income for the Federal income and profits tax purposes.

In view of that admission the only question left for our consideration is whether the 8 per cent fixed dividends on capital stock may be deducted in determining net income. In the Appeals of Sacred Heart Cooperative Mercantile Co., 2 B. T. A. 24, and Farmers Cooperative Assn., 5 B. T. A. 61, we held that such dividends are not deductible, and those decisions are controlling here.

Judgment will be entered on 15 days' notice, under Hule 50.

Lansdon not participating.


source: Caselaw Access Project

author:
KoenbR,
      Chairman:

license: Public Domain

text:
    Vaughan & Barnes, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 7311.
    Promulgated May 11, 1927.
    1. A salary was duly authorized by corporation action in 1912. The services were performed pursuant to said authorization in 1921, in which year the corporation was without funds to pay the salary. The salary was paid in 1922. The corporation accounted on the basis of cash receipts and disbursements. The salary is allowed as a deductible expense in 1922.

      2. Certain salaries of officers were authorized toy corporate resolution in 1922, as and for the year 1922 but measured by services and circumstances surrounding the payment of salaries in 1921. Such salaries allowed as deductible expenses in 1922.
    3. Salaries authorized and paid in a given year as and for salaries in a prior year are not allowable as deductible expenses in the year in which authorized and paid.
    4. Matter of what constitutes reasonableness of salaries discussed.

      'William II. White, Jr., Esq., for the petitioner.

      W. Frank Gibbs, Esq., for the respondent.
    Proceeding- for the redetermination of income and profits taxes for the fiscal year ended August BÍ, 1922. The deficiency determined by the Commissioner, and of which the petitioner was notified on July 31, 192a, is in the amount of $4,804.29.
    FINDINGS OF FACT.
    Petitioner is a Virginia corporation with its principal office in Norfolk, and is engaged in business as a “ cotton factor.” It was incorporated in 1912 and succeeded a predecessor business carried on by John N. Vaughan trading as Vaughan & Barnes. Prior to the death of Barnes in 1890 the business had been a partnership.
    During the taxable period and prior thereto, the nature of the business of the petitioner was as follows: In the spring of each year the company makes loans principally to country merchants who sell supplies to farmers in the cotton-growing districts. These loans carry the current rate of interest and are secured by collateral furnished bjr the merchant. The loan agreement obligates the merchant to ship an agreed amount of cotton to petitioner, which amount varies with the amount of the loan. In the early fall this cotton is shipped to and received by the petitioner and by it stored in warehouses in Norfolk where it is held for sale subject to the merchant’s directions. Upon receipt of instructions from the merchant, the cotton is sold by petitioner and a commission is charged therefor. The rate of commission is fixed by the Norfolk Cotton Exchange and is 1 per cent of the gross sale. When the petitioner sells the cotton, it reimburses itself for the loan made to the merchant with interest; for the charges for storage, insurance and handling of the cotton, and deducts its commission. The balance is remitted to the merchant who shipped the cotton.
    In the years 1921 and 1922 the capital stock of the petitioner was $50,000, held as follows:
    John N. Vaughan, president___ 300 shares
    L. P. Bruce, treasurer_100 shares
    B. C. Crews, secretary- 50 shares
    H. Pincus, assistant secretary_■_50 shares

      In order to carry on a business of the character and volume of the petitioner, it was necessary to borrow large sums of money. This was necessary in order that the loans above referred to might be made to the merchants. At the end of the fiscal year 1921, the petitioner owned Vaughan approximately $213,355.39. In addition, it owed banks $335,000. At the end of the fiscal year 1922 the petitioner owed Vaughan approximately $216,134.73, while its obligations to banks were very small.
    At a meeting of the directors on May 2, 1912, the following resolutions were adopted:
    Upon motion duly made, seconded, and unanimously adopted, the following salaries were fixed for the several officers of this corporation: President, $12,000; Treasurer, $1,500; Secretary, $1,200; Assistant Secretary, $900; and it was further resolved that in addition to the above named amounts, the Treasurer shall receive 15 per cent of annual profits of the business, the Secretary 10 per cent, and the Assistant Secretary 8 per cent, all to be calculated annually. Said profits, however, to be fixed and determined upon the following basis, that is to say
    1st. After the payment of taxes, license and charges due to the State, City, and Government,
    2d. After the payment of all rents.
    3d. After the payment of. all incidental expenses of the business, including all interest charges for money borrowed or otherwise. The salaries of all the above named officers, except the president, and including all salaries and compensation to clerks or other employees of the company, servants and laborers, insurance and telegraph bills, stationery bills, stamps and generally all such incidental expenses as are now necessary in the proper conduct of the business and a dividend equal to 6 per cent of the stock of the company outstanding, it being the purpose and intention of this resolution to provide for an increase in the salaries hereinbefore specified and provided to the said several officers to be paid in the proportionate amounts hereinbefore named out of the profits of the business which may remain after the deduction of the hereinbefore mentioned charges of conducting and maintaining the same.
    At the end of the fiscal year 1921 the books of the petitioner disclosed a lose for that year. During that year Bruce, Crews, and Pincus had been paid their fixed salaries of $1,500, $1,200, and $900, respectively. These three men were heads of families and the salaries so drawn were deemed insufficient for the support of their families, and accordingly, they had, with the knowledge, consent and agreement of all the stockholders and officers, drawn additional amounts in that year as follows: Bruce $1,500, Crews $1,20Q, Pipcua $1,200. These additional withdrawals were considered loans and were treated as such and carried by the petitioner in its balance sheet for the fiscal year 1921 as “ accounts receivable.” Vaughan did not receive payment in the fiscal year 1921 for his services as presi^ dent during that year.

      The business proved more profitable in the fiscal-year 1922, and on August 31, 1922, the following resolution was adopted by the directors:
    It was ordered that the following named employees be paid the following respective amounts, as provided by previous resolutions May 2, 1912:

      L. ÍP. Bruce, treasurer- 8, 376. 93 15 per cent
    B. O. Crews, secretary- 5, 584. 62 10 per cent
    H. Pincus, assistant secretary- 4, 407. 69 8 per cent
    J. G-. Lindsay___’- X, 116. 92 2 per cent
    The treasurer was requested to set aside the amount of $300.01 as reserve for any further taxes which would be due as a result of the years’ operations.
    On motion duly made, seconded and unanimously carried, the salary of John N. Vaughan, President, in the amount of $12,000 for the previous year 1921 was ordered paid out of the remaining balance, and in addition thereto the following were voted extra compensation to make up for lack of same in 1921:
    L. F. Bruce_:_ 4, 800
    B. C. Crews_ 2, 400
    J. N. Vaughan_ 2, 400
    H. Pincus_ 2, 400
    12, 000
    The obligations to the petitioner of Bruce, Crews, and Pincus arising out of their additional withdrawals in the fiscal year 1921, above referred to, were liquidated and canceled and the difference between those amounts and the amounts voted to be paid to them in the last quoted resolution, was paid to them in cash. In addition thereto, the additional payments authorized in the last quoted resolution were duly made.
    The petitioner in filing its return of taxable income for fiscal year 1922, claimed deduction on account of salaries in the amount of $58,329.24, as follows:
    J. N. Vaughan, president, salary for 1921--$12, 000*
    J. N. Vaughan, “ “ “ 1922_12,000
    J. N. Vaughan, “ bonus “ 1922- 2,400*
    L. F. Bruce, treasurer, salary “ 1922- 1,500
    L. F. Bruce, “ bonus “ 1922_ 4,800*
    L. F. Bruce, “ 15 per cent of profits_ 8, 376. 93
    B. O. Crews, secretary, salary for 1922- 1, 200
    B. C. Crews, “ bonus “ 1922- 2,400*
    B. C. Crews, “ 10 per cent of profits--- 5, 584. 62
    H. Pincus, assistant sec. salary for 1922- 1, 200
    H. Pincus, “ “ bonus “ 1922- 2,400*
    H. Pincus, “ “ 8 per cent profits- 4,467. 69
    Total_ 58, 329. 24
    All of the foregoing items were allowed as deductions by the Commissioner with the exception of those items indicated by asterisks, which were disallowed by the Commissioner and restored to income. The items disallowed are tabulated as follows:
    J. N. Vaughan_$12, OOO salary for 1921 ordered paid in 1922 by resolution of Aug. 31, 1922.
    J. N. Vaugban_ 2, 400 bonus paid in 1922 by resolution of Aug. 31, 1922.
    L. F. Bruce_ 4, 800
    B. C. Crews_ 2,400
    H. Pincus_ 2,400 “ “ “ “
    24,000
    In addition to the deductions for salaries set out above, the respondent allowed a deduction of $1,116.92 paid in fiscal year 1922 to J. G. Lindsay, an employee, who was not a stockholder of the petitioner. The allowed amount of $1,116.92 represented 2 per cent of the profits of the year.
    The petitioner accounted and made return of its income on the basis of cash receipts and disbursements.
    During the fiscal year 1921 the business of the petitioner was light and as a result the labors of its officers were light. But during the fiscal year 1922, the business of the petitioner was abnormally heavy and the labors of its officers were correspondingly heavy. The officers were required by circumstances to work long hours during the day, as well as at nights and on Sundays. The volume of business transacted by the petitioner in 1922, measured by the sales of bales of cotton, was about twice that transacted in 1921. Vaughan, the president, had general authority and direction of the affairs of the company; Bruce, the treasurer, arranged the financing of the company with the banks, passed on credits and made arrangements with customers, and was in charge of sales; Crews, the secretary, kept the books of the petitioner, attended to arrangements respecting storage, insurance and warehousing, invoiced the sales and prepared statements and the like; Pincus, the assistant secretary, graded and valued the cotton and assisted largely in the selling, to a large extent attended to sales on his own responsibility, and assisted generally in the office ivork.
    The gross income reported by petitioner for fiscal year 1922 was $118,190.81, while its net income after deducting salaries in the amount of $58,329.24, was $3,294.43. Of this last amount, the petitioner, on August 31, 1922, distributed $3,000 as dividends to its stockholders.

       This decision was prepared during Mr. Korner’s term of office.

   OPINION.

KoenbR, Chairman:

The issue here involves the deductibility, as salaries and compensation for personal services, of $24,000 paid in 1922 under the circumstances set out in the findings. Of this amount Vaughan, the president, received $12,000 in payment of salary for 1921 which had theretofore been authorized but which, due to lack of funds in 1921, had not been paid to him. The remaining $12,000 represents additional compensation to the officers authorized by resolution of August 31, 1922 — the last day of the fiscal year. The issue naturally divides itself into two elements, the first concerning the $12,000 paid to Vaughan as salary for 1921, and the second concerning the additional amounts paid as set out above.

The first of these items is clearly allowable. A salary of $12,000 to the president had been voted and authorized by the resolution of May 2, 1912 — ten years before the taxable year in question here. The president, Vaughan, had performed his duties as president in the year 1921, but the financial condition of the company did not permit the payment of his salary in the year in which the services were performed. The next year the money was available and the salary was paid. The petitioner accounted on the basis of cash receipts and disbursements. The resolution of August 31, 1922, in so far as it authorized the payment of Vaughan’s salary for 1921, was surplusage. He was entitled to it anyway. The petitioner owed him that salary because it had not paid it to him the year before. The respondent is in error. The salary being paid in 1922 should be allowed as a deduction in that year.

The second group of items, amounting to $12,000, presents a more difficult question. It is necessary, first, to determine what these items represent. Was this “extra compensation” voted for and paid in the year 1922 while measured by services performed in the year 1921, or was it voted and paid in 1922 as and for salaries in 1921? The language of the resolution of August 31, 1922, is ambiguous and might be susceptible to either interpretation. The resolution says:

On motion (Inly made, seconded and unanimously carried * * * the following were voted extra compensation to make up for lack of same in 1921 * * ».

If the interpretation be that contained in the second query above, then we are of opinion that the deduction should not be allowed. That is to say, if the compensation voted and paid in 1922 was the payment of additional salaries as and for a prior year, without previous authorization therefor, it would not properly be allowable in 1922. The reason is obvious. To hold otherwise would permit a corporation with a large surplus in 1922 to effectually dispose of that surplus by voting salaries over a long series of prior years. No simpler method of evading taxes could be thought of J. E. Duval Printing Co., 1 B. T. A. 1205; H. T. Cushman Mfg. Co., 2 B. T. A. 39; Matchless Metal Polish Co., 2 B. T. A. 79; Melrose Granite Co., 2 B. T. A. 113; Columbia Textile Co., 2 B. T. A. 472; W. W. Harrison Co., 4 B. T. A. 174; W. K. Henderson Iron Works & Supply Co., 6 B. T. A. 92.

But the authorization and payment of salaries in a given year as and for salaries in that year, where the amount thereof is in part measured by services performed in a prior year and in the light of circumstances surrounding the payment of salaries already paid in those years, presents a different situation. This is subject to the modification that the salaries paid in the given year come within the statutory definition of “a reasonable allowance for salaries or other compensation for personal services actually rendered.” We should be very cautious in substituting our judgment as to the reasonableness of salaries for that of the corporation itself.

We conclude, therefore, that under the conditions just outlined, where a salary is authorized and paid in a given year as and for salary in that year, although one of the impelling influences in determining the amount to be paid was the services and circumstances surrounding the prior year, and when such payments for the year in which paid are reasonable in amount, the deduction therefor is properly allowable. The Board has so held in C. H. Simonds Co., 1 B. T. A. 105, 107, wherein we said:

The fact that the measure of the additional compensation was the amount of the reduction in salaries suffered during the period above mentioned is not proof that the additional amounts paid for 1918 were not in reality additional compensation for services performed by the officers during the year 1918.

Again, in Lihue Plantation Co., Ltd., 2 B. T. A. 740, 742, the Board said:

So long as additional compensation paid within a year does not exceed a reasonable amount it may be deductible even though it is measured by services rendered and compensation received in prior years.

To the same effect: Flint River Brick Co., 2 B. T. A. 31; H. T. Cushman Mfg. Co., 2 B. T. A. 39; Van De Kamps Holland Dutch Bakers, 2 B. T. A. 1247.

A case well nigh on all fours with the instant case is that of Union Dry Goods Co., 1 B. T. A. 833. There a resolution was passed in 1918 reciting that “ the back salary should be credited for the years ending July 31, 1915, 1916, 1917, and 1918.” By the evidence it was shown that by the resolution it was meant to pay additional salaries for the taxable year in question, 1918. The Board said:

We conclude from the evidence that the additional salaries paid to taxpayer’s officers, pursuant to the action of the advisory board, taken on July 12, 1918, were, and were intended to be, additional compensation for personal services actually rendered by them in the fiscal year ended July 31, 1918.

As we have said above, the language of the resolution in tbe instant case, of August 31, 1922, is ambiguous and gives rise to a reasonable doubt as to its meaning. However, in view of our interpretation of a similar given state of facts, we conclude that the resolution of August 31, 1922, was intended to authorize additional compensation for the fiscal year 1922, measured by the services of the recipients of the compensation in a prior year.

The respondent contends that the sum of the two items of $12,000, which is here in controversy, shows a distribution of profits in the ratio of stockholdings but in the guise of salaries. He calls attention to the fact that Vaughan held 60 per cent of the stock, Bruce 20 per cent, Crews 10 per cent, and Pincus 10 per cent; that adding the salary of Vaughan for 1921 to the additional compensation paid, the following is obtained:

Vaughan:
1921 salary-$12, 000
1922 bonus_ 2, 400
- $14,400=60 per cent of $24, 000
Bruce, 1922 bonus_ 4, 800 4, 800=20 per cent of 24, 000
Orews, 1922 bonus_ 2,400 2, 400=10 per cent of 24,000
Pincus, 1922 bonus_ 2, 400 2,400=10 per cent of 24, OCX)

The predicate of respondent’s position is (1) that the liability of the petitioner to pay Vaughan his salary for 1921 did not exist until after there had been sufficient profits to pay the other officers their salaries and percentages of the profits computed after other expenses had been met, and (2) that since there was a deficit in 1921, there was no liability to pay Vaughan any salary for that year.

If the foregoing predicate were founded in fact, there might be strong reasons for sustaining his contention. But we can not find that such is the case. All hinges on the resolution of May 2, 1912. We are unable to find in that resolution that the salaries and percentages of net profits payable to Bruce, Crews, and Pincus were to be computed before ascertaining whether or not Vaughan was to receive any salary. The resolution provides first for definite and fixed salaries for the officers, including Vaughan. The resolution then continues — “ and it was further resolved that, in addition to the above named amounts [specific annual salaries], the Treasurer shall receive 15% of the annual profits of the business, the Secretary 10% and the Assistant 8%, all to be calculated annually. Said profits, however, to be fixed and determined upon the following basis * * Then follows the method of computing the profits which were to be divided. No provision is made that the designated salary of the president shall depend on the amount of the profits. On the contrary, it would appear that the profits were to be computed without reference to the president’s salary. It seems to have been the intent to deduct all salaries of - officers, except the president’s, from gross profits to ascertain net profits as the basis for the payment of the percentages to the treasurer, secretary, and assistant secretary.

If, as we haye held, the salary of $12,000 for 1921 was due and payable to Vaughan under the former authorization of May 2, 1912, the remaining $12,000 was not distributed in its entirety to the stockholders in-proportion to their stockholdings. That failing, the conclusion of the respondent is unsupported in fact.

A further contention of the respondent is that in any eyent the salaries and compensation paid were unreasonable. In the light of what we have said above, in this opinion, we conclude that the salaries paid for services in 1922 were reasonable. It should be noted, that in spite of the salaries and compensation paid and after the deduction of all other allowable expenses, the petitioner, declared and paid 6 per cent on its stock to its stockholders.

Accordingly, we find that the disallowance of the items aggregating $12,000 paid to Bruce, Crews, Pincus, and Vaughan was in error. They should be allowed as claimed by the petitioner.

Judgment will he entered for the petitioner.


author: LittletoN:

text:
    Henry L. Berg and Rose Berg, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 7029.
    Promulgated May 11, 1927.
    Certain instruments lierein construed and held to he oil and gas leases and not sales of capital assets within the meaning of section 206 of the Revenue Act of 1921.

      P. J. O’Connor, Esg., for the petitioners.

      J. E. Marshall, Esq., for the respondent.
    This proceeding involves the determination of a deficiency in income tax for the year 1922, in the amount of $10,655.82. The only point at issue is whether the consideration received by Henry L. Berg for leasing certain oil and gas rights in certain lands falls within the classification of gain from the sale of capital assets as provided by section 206 of the Revenue Act of 1921. The facts are found as stipulated.
    FINDINGS OF FACT.
    Petitioners are husband and wife and are residents of Camden, Ark.
    Plenry L. Berg and his brother, Leo Berg, for nearly forty years prior to 1922, were in the mercantile business together at Camden. Throughout such period they acquired the fee simple title to approximately 40,000 acres of land in Calhoun and Ouchita Counties, Arkansas. By deed dated May 16, 1922, and duly executed by Henry L. Berg and his brother, Leo Berg they conveyed to Bose Berg, wife of Henry L. Berg, a fee simple title to fractional interests in the said 40,000 acres of land. At sundry times in the year 1922 on or before November 18, 1922, Henry L. Berg and Bose Berg, his wife, together with Leo Berg and his wife and children, executed certain oil and gas leases to divers parties. All of the leases were in all respects similar and so far as is material here provided:
    Tliat the said lessor for and in consideration of-Dollars cash in hand paid, the receipt of which is hereby acknowledged, and of the covenants and agreements hereinafter contained on the part of the lessee to be paid, kept and performed, have granted, conveyed, demised, leased and let, and by these presents do grant, convey, demise, lease and let unto said lessee, for the sole and only purpose of mining and operating for oil and gas, and laying of pipe lines, and of building tanks, towers, stations and structures thereon to produce, save and take care of said products, and all that certain tract of land situated in the County of- State of-.
    It is agreed that this lease shall remain in force for a term of-from this date, and as long thereafter as oil or gas, or either of them is produced from said land by the lessee.
    In consideration of the premises the said lessee covenants and agrees: 1st. To deliver to the credit of the lessor, free of costs in tanks or pipe line to which it may connect its wells, the equal one-eighth part of all oil produced and saved from the lease premises.
    2nd. To pay the lessor-Dollars each year in advance, for the gas from each well where gas only is found, while the same is being used off the premises, and lessor to have gas free of cost from any such well for all stoves and all inside lights in the principal dwelling houses on said land during the same time by making his own connection with the well at his own risk and expense.
    3rd. To pay lessor for gas produced from any oil well used off the premises at the rate of - Dollars per year, for the time during which such gas shall be used, such payments to be made each three months in advance.
    If no well be commenced on said land on or before the- day of-, 19 — , this lease shall terminate as to both parties, unless the lessee, on or before that date, shall pay or tender to the lessor, or to the lessor’s credit in the --■ — ■ Bank of -, Arkansas, or its successors, which shall continue as the depository regardless of changes in the ownership of said land, the sum of - which shall operate as a rental and cover the privileges of deferring the commencement of a well for-from said date. In like manner and upon like payments or tenders the commencement of a well may be further deferred for like periods in the same number of months successively. And it is understood and agreed that the consideration first recited herein, the down payment, covers not only the privileges granted to the date when said first rental is payable as aforesaid, but also the lessee’s option of extending that period as aforesaid, and any and all other rights conferred.
    Should the first well drilled on the above described land be a dry hole, then, in that event, if a second well is not commenced on said land within twelve months from the expiration of the last rental period from which rental has been paid, this lease shall terminate as to both parties, unless the lessee on or before the expiration of said twelve months shall resume the payment of rentals in the same amount and in the same manner as hereinafter provided. And it is agreed that upon the resumption of the payment of rentals, as above provided, that the last preceding paragraph hereof governing the payment of rentals and the effect thereof, shall continue in force just as though there had been no interruption in the rental payments. * * *
    For the calendar year 1922, the petitioners filed a joint return on March 14, 1923, showing the income of the wife separate and apart from the income of the husband. The only income reported for the wife represented profits of $35,134.14 from the leasing of the oil and gas rights in the land mentioned and described on the return as “capital net gain.” The return also included like profits of $40,230.37 of the husband, described likewise on the return as “capital net gain;” and for the purpose of arriving at the tax liability of both individuals jointly, the income of the wife was added to the husband’s income, making an aggregate reported joint net income of $78,458.83 — on which amount a tax of $9,807.35 was computed by petitioners at 12% per cent, on the theory that such computation was authorized by section 206 of the Revenue Act of 1921.
    Upon an audit of the return, the Commissioner found the aggregate joint net income of petitioner's to be $81,941.57, which net income is admitted by petitioners to be correct. The Commissioner in computing the tax did not consider the profits arising out of the leasing of the oil and gas*rights aforesaid as falling within the provisions of section 206 of the Revenue Act of 1921, but computed the tax under sections 210 and 211 of that Act; and he arrived at a deficiency in tax of $10,655.82 due by Henry L. Berg and Rose Berg. Of the admitted net income of $81,941.57, there was received by the petitioners from the leasing of the oil and gas rights on the property mentioned the sum of $78,844.24, divided between them as follows:
    Henry L. Berg-$42, 872.12
    Hose Berg- 35,972.12
    The income of $42,872.12 of Henry L. Berg arose out of the leasing of the aforementioned oil and gas rights on land in which he owned an undivided fee simple interest for more than two years prior to the execution of the said leases. The income of $35,972.12 of Rose Berg arose out of the leasing of the said oil and gas rights on land in which she owned an undivided fee simple interest for less than two years prior to the execution of the said leases.
   OPINION.

LittletoN:

The tax in controversy is for the year 1922 and if the consideration received by the petitioners for leasing the said oil and gas rights falls within the classification of gain from the sale of capital assets as provided by section 206 of the Bevenue Act of 1921, the Commissioner’s determination is erroneous, but if section 206 does not apply to the income received by petitioners from the oil and gas leases involved herein, the Commissioner’s determination is correct.

The pertinent parts of section 206 of the Bevenue Act of 1921, which petitioners insist apply and the Commissioner contends are not applicable to this case, are as follows:

Sec. 206. (a) That for the purpose of this title:
(1) The term “ capital gain ” means taxable gain from the sale or exchange of capital assets consummated after December SI, 1921;
* # sj: * * # *
(6) The term “capital assets” as used in this,section means property acquired and held by the taxpayer for profit or investment for more than two years (whether or not connected with his trade or business), but does not include property held for the personal use or consumption of the taxpayer or his family, or stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year.
(b) In the case of any taxpayer (other than a corporation) who for any taxable year derives a capital net gain, there shall (at the election of the taxpayer) be levied, collected and paid, in lieu of the taxes imposed by sections 210 and 211 of this title, a tax determined as follows:
A partial tax shall first be computed upon the basis of the ordinary net income at the rates and in the manner provided- in sections 210 .and 211, and the total tax shall be this amount plus 12% per centum of the capital net gain ; but if the taxpayer elects to be taxed under this section the total tax shall in no such case be less than 12% per centum of the total net income. The total tax thus determined shall be computed, collected and paid in the same manner, at the same time and subject to the same provisions of law, including penalties, as other taxes under this title.

The Committee on Ways and Means said at-page 10 of its report:

The sale of farms, mineral properties, and other capital assets is now seriously retarded by the fact that gains and profits earned over a series of years are under the present law taxed as a lump sum (and the amount of surtax greatly enhanced thereby) in the year in which the profit is realized. Many such sales, with their possible profit taking and consequent increase of the tax revenue, have been blocked by this feature of the present law. In order to permit such transactions to go forward without fear of a prohibitive tax, the proposed bill, in, section 206, adds a new section (207) to the income tax, providing that where the net gain derived from the sale or other disposition of capital assets would, under the ordinary procedure, be subjected to an income tax in excess of 15 per cent, the tax upon capital net gain shall be limited to that rate. It is believed that the passage of this provision would materially increase the revenue, not only because it would stimulate profit-taking transactions hut because the limitation of 15 per cent is also applied to capital losses. Under present conditions there are likely to be more losses than gains.

The question, therefore, is whether the execution of such oil and gas leases as the one herein is a “ sale ” or “ exchange ” of a capital asset, as defined by the section quoted.

Whether or not such leases constitute a sale of the oil and gas in place has been variously held by different courts, there being much conflict of authority, though, in our opinion, the greater weight of authority is to the effect that such oil and gas leases are not outright sales of oil and gas in place, but merely grants to such lessees of the right or privilege to go upon the land, drill for oil and gas and remove it when found.

In Appeal of Nelson Land & Oil Co., 3 B. T. A. 315, the Board held that certain instruments, somewhat similar to the leases now under consideration, were oil and gas leases and not conveyances of oil and gas in place and that amounts paid to the grantor of oil and gas leases as a bonus constituted additional royalties and not a return of capital.

In Rich v. Doneghey, 71 Okla. 204; 177 Pac. 86, referring to oil and gas leases, the court said:

The right so granted or reserved, and held separate and apart from the possession of the land itself, is an incorporeal hereditament; or more specifically, as designated in the ancient French, a profit d prendre, analogous to a profit to hunt and fish on the land of another.

In Walla Walla Oil, Gas & Pipe Line Co. v. Vallentine, 103 Wash. 359; 174 Pac. 980, the court states:

The contract amounts only to a license entitling the licensee to search and, dig for oil and gas according to the terms of the grant, and appropriate the produce to his own use on payment of the royalty or proportion without acquiring any property in the minerals until they are severed from the land. They create only an incorporeal hereditament — a right issuing out of or concerning land. [Italics ours.]

Numerous authorities might be cited showing that leases similar to those involved in this proceeding are not sales of the oil and gas in place or in the land but are merely grants to the lessees of the right to go upon the land, drill for oil, and remove it when found. A few authorities only are here cited. Brown v. Spilman, 155 U. S. 665; Osborn v. Arkansas Territorial Oil & Gas Co., 103 Ark. 175; 146 S. W. 122; Kolachny v. Galbreath, 26 Okla. 772; 110 Pac. 902; Kelly v. Keys, 213 Pa. 295; 62 Atl. 911; Watford Oil & Gas Co. v. Shipman, 233 Ill. 9; 84 N. E. 53; Florence Oil & Refining Co. v. Orman, 19 Colo. App. 79; 73 Pac. 628; Pittsburgh & West Virginia Gas Co. v. Ankrom, 83 W. Va. 81; 97 S. E. 593; Richlands Oil Co. v. Morriss, 108 Va. 288; 61 S. E. 762.

Under decisions of the Supreme Court of Texas, Stephens County v. Mid-Kansas Oil & Gas Co., 113 Tex. 160; 254 S. W. 290, and a few other States such leases are held to be sales of the ore or oil in place.

We think it unnecessary in order to dispose of the issue here presented to decide whether there is ownership of oil and gas in place. By the instrument in question the petitioner “ leased and let unto the lessee, for the sole and only purpose of mining and operating for oil and gas * * * and to deliver to the credit of the lessor, free of costs, * * * the equal of one-eighth of all oil produced and saved from the leased premises ” and to pay the lessor certain sums where only gas is found. This language does not comport with the term “ sale ” as that term appears to have been used in section 206. The proceeds of minerals, and by minerals we include oil and gas, obtained from mining operations constitute gross income to the owner of the leased premises, and this is true where the minerals are leased. The result of an ordinary mining lease, such as we have here, is merely to transfer the cost of operations from the owner to the lessee. The operation remains the same and the proceeds of the operation are divided between the lessee and lessor, the portion of the minerals and amounts paid to the lessor pursuant to the lease usually being termed “ royalty.” Gross proceeds extracted in the usual course of mining operations have long been considered gross income. Stratton’s Independence v. Howbert, 231 U. S. 399; Stanton v. Baltic Mining Co., 240 U. S. 103; Von Baumbach v. Sargent Land Co., 242 U. S. 503; United States v. Biwabik Mining Co., 247 U. S. 116.

In Von Baumbach v. Sargent Land Co., supra, the court said:

The nature of these mining leases has been the subject of some difference of opinion in the courts. The Circuit Court of Appeals in this case took the view announced in some of the earlier cases, notably in Pennsylvania, that the leases were such in name only, and were in fact conveyances of the ore in place as part of the realty, and that the so-called royalties merely represented payments for so much of the land and wore in no just sense income, but mere conversions of the capital.

The court then referred to certain decisions of the Supreme Court of Minnesota to the effect that mine leases were in fact leases and the compensations paid thereunder were rent. The court continued:

Those conclusions of the Supreme Court of Minnesota are not only made concerning contracts in that State, such as are here involved, but are supported by many authorities. Ordinarily, and as between private parties, there is no question of the duty of the federal court to follow these decisions of the Minnesota Supreme Court, as a rule of real property long established by state decisions. Kuhn v. Fairmont Coal Company, 215 U. S. 349, 360. Whether in considering this Federal statute we should be constrained to follow the established law of the State, as is contended by the Government, we do not need to determine. The decisive question in this case is whether the payments made as so-called royalties amount to income so as to bring such payments within the scope of the Corporation Tax Act of 1909. The prior decisions of this court in Stratton’s Independence v. Howbert, 231 U. S. 399, and Stanton v. Baltic Mining Company, 210 U. S. 103, in which the Stratton Case was followed and approved, are decisive of this question.

The court further said:

We think that the payments made by the lessees to the corporations now before the court were not in substance the proceeds of an outright sale of a mining property, but, in view of the terms of these instruments, were in fact rents or royalties to be paid upon entering into the premises and discovering, developing and removing the mineral resources thereof, and as such must be held now as then, to come fairly within the term income as intended to be reached and taxed under the terms of the Corporation Tax Act.

In United States v. Biwabik Mining Co., supra, the court said:

The lessee takes from the property the ore mined, paying for the privilege so much per ton for each ton removed. He has this right or privilege under the form of lease here involved so long as he sees fit to hold the same without exercising the privilege of cancellation therein contained. He is, as we held in the Sargent Land Company Case, in no legal sense a purchaser of the ore in place.

Section 206 of the Revenue Act of 1921 provides for a method of taxing the “ gain from the sale or exchange of capital assets.” This provision of itself, and especially when taken in connection with the Report of the Ways and Means Committee, shows that the tax therein proposed is a tax upon gains from a sale, the basis of which gain is the difference between the cost or March 1, 1913, value and the selling price. See United States v. Flannery, 268 U. S. 98. Upon the other hand, the gross proceeds of minerals extracted in mining operations have been considered gross income without reference to cost since 1913 and all of the Revenue Acts passed since that time and the decisions of the courts have been upon this basis. It thus appears that this theory is one embodied in the Revenue Acts and exists irrespective of what the laws of various States may be relative to mining. This case presents a question similar to that presented, in the Burk-Waggoner Oil Association v. Hopkins, 269 U. S. 110, wherein it was said:

Tbe claim that tbe Act, if so construed, violates tbe Constitution is also unsound. It is true that Congress cannot make a thing, income wbicb is not so in fact. But tbe thing to wbicb tbe tax was here applied is confessedly income earned in the name of the Association. It is true that Congress cannot convert into a corporation an organization which by tbe law of its State is deemed to be a partnership. But nothing in the Constitution precludes Congress from taxing as a corporation an association which, although unincorporated, transacts its business as if it were incorporated. The power of Congress so to tax associations is not affected by the fact that, under the law of a particular State, the association cannot hold title to property, or that its shareholders are individually liable for the association’s debts, or that it is not recognized as a legal entity. Neither the conception of unincorporated associations prevailing under the local law, nor the relation under that law of the association to its shareholders, nor their relation to each other and to outsiders, is of legal significance as bearing upon the power of Congress to determine how and at what rate the income of the joint enterprise shall be taxed.

In Lynch v. Alworth-Stephens Co., 267 U. S. 364, the court, after referring to Von Baumbach v. Sargent Land Co. and United States v. Biwabik Mining Co., said:

It was held in both cases, as we hold here, that the leases under consideration did not convey title to the ore in place.

In the Revenue Act of 1921 we find in section 214 (a) (10) referring solely to mines, oil and gas wells, the word “ leases.” This word must mean leases as construed by the courts and as taxed under previous acts. It must include all mining leases which resemble the ordinary form of mining lease, and all such leases are to be given effect for taxing purposes as theretofore construed by the courts.

The decision of the Board in the Appeal of Anna Taylor, 3 B. T. A. 1201, is relied on by petitioner in support of his contention that amounts received under the lease here involved were gains from the sale of capital assets. That case involved the outright sale of a lease and has no application to the question here involved.

For the reasons hereinbefore given, the Board is of the opinion that amounts received under the terms of the lease here involved were not a “ gain from the sale or exchange of capital assets ” within the meaning of section 206 of the Revenue Act of 1921, and the determination of the Commissioner is accordingly affirmed.

Judgment will be entered for the respondent.


author: Muedock :

text:
    J. B. Carr Biscuit Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 8988.
    Promulgated May 11, 1927.

      John S. Lloyd, O. P. A., for the petitioner.

      J. E. Marshall, Esq., for the respondent.
   Muedock :

The Commissioner has asserted a deficiency of $1,595.30 for the calendar year 1919. The petitioner contends that the entire deficiency was erroneously determined in that the amount of additional Federal income taxes for 1917, assessed in May and paid in August, 1919, and the amount of additional income tax for 1918, assessed in 1920 and 1924 and paid in 1920 and 1924, were eliminated from invested capital in accordance with the provisions of article 845 of Regulations 45, and in that good will in the amount of $25,000 has been eliminated from invested capital, and premiums paid on insurance were eliminated from invested capital.

FINDINGS OF FACT.

The petitioner is a Pennsylvania corporation with its principal offices at Wilkes-Barre, Pa.

One thousand six hundred and thirty-eight dollars- and sixty-five cents, the amount of additional income and profits taxes for 1917, was excluded from the petitioner’s invested capital for the taxable year as of January 1, 1919.

In October, 1920, an additional assessment of income taxes for 1918, amounting to $7,598.51, was made and was paid in October, 1920. Another assessment for 1918, amounting to $2,132.40, was made in February, 1924. The Commissioner added these additional assessments to the original amount of tax due as shown upon the return, which made a total of $47,166.55 and which he excluded from the petitioner’s invested capital for 1919 in accordance with article 845 of Regulations 45.

The deficiency for 1919 is $1,695.30. Judgment will be entered for the respondent.


author: GReen :

text:
    A. D. Morton, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 3559.
    Promulgated May 11, 1927.
    The cost of 46,033 shares of stock determined.

      Charles H. Garnett, Esq., L. A. Rowland, Esq., and E. R. Willson, C. P. A., for the petitioner.

      John D. Foley, Esq., and B. PL. Saunders, Esq., for the respondent.
    In this proceeding the petitioner seeks a redetermination of his liability for income taxes for the year 1919, for which the Commissioner has determined a deficiency in the sum of $15,476.35. The sole issue is as to the basis to be used in the computation of gain or loss resulting from the sale of certain shares of stock.
    FINDINGS OF FACT.
    The petitioner, for some time prior to June, 1914, had been negotiating with Baruch Brothers of New York City with reference to the organization of a corporation to take over certain oil and gas leases owned by him. One of the conditions, so far as the petitioner was concerned, was the payment to him of a substantial amount of money. After having the properties investigated and valued, Baruch Brothers agreed to organize a corporation to be known as the New York-Oklahoma Oil Co., and in exchange for the leases and equipment, to issue to the petitioner 600,000 shares of common stock of the par value of one dollar per share and to pay him $100,000. Of this stock he was to deliver to Baruch Brothers 300,000 shares and to one Surles 40,000 shares, thus leaving in his hands 260,000 shares. Preferred stock of the par value of $150,000 was sold at par and a part of the money thus received was used to pay to the petitioner the $100,000 which he was to receive in cash.
    As a part of the same arrangement the various stockholders entered into an agreement whereby each deposited in escrow all of his .stock of the company to be held for a period of five years, and pursuant to this agreement the petitioner so deposited all of his stock.
    Thereafter, and in the year 1919, all of the parties being desirous of procuring the release of the stock held in escrow, the petitioner entered into an agreement by the terms of which he agreed to pay Baruch Brothers 80,000 shares of the stock for the release from the escrow of the remaining 180,000 shares of his stock. Having thus obtained possession of his stock, the petitioner in 1919, sold 46,033 shares of the stock for $130,243.92, which was the equivalent of $2.8294 per share.
    The properties transferred to the corporation were in the main proven oil and gas properties. The full production had not been obtained and would not be obtained until additional wells were drilled. The minimum future production could be predicted with considerable certainty. The leases and personal property at the time conveyed had an actual cash value of $600,000.
    The Commissioner calculated the profit from this transaction as follows:
    Value of petitioner’s property transferred to the corporation-$360, 000. 00 '
    Less cash received by petitioner to cancel indeblness against the property- 100, 000. 00
    Final cost to petitioner of 180,000 shares (260,000 shares less 80,000 shares)_ 260,000.00
    Cost of one share, $1.444 Selling price of 46,033 shares_ 130,243.92
    Cost of 46,033 shares_ 66,490. 07
    Taxable profit- 63, 753. 85.
   OPINION.

GReen :

Two witnesses testified as to the value of the properties at the time they were acquired by the corporation. One was the engineer who investigated the properties for Baruch Brothers. In his opinion the properties were worth from $550,000 to $750,000. The petitioner testified that they were worth $700,000 subject to an indebtedness of $100,000. Cross examination developed no weakness in the opinion of values thus expressed.

The starting point for the computation of gain resulting from the sale is the cost of the stock received by the petitioner in exchange for properties. The cost of this stock to the petitioner is the value of the properties exchanged therefor, having due regard for the $100,000 cash paid. This sum may be treated either as reducing the value of the assets to get their net value, i. e., $500,000, or as cash received so that the assets of the value of $500,000 were exchanged for stock. Either treatment gives the same result. The petitioner parted with assets having a net value of $500,000 and came into possession of 260,000 shares of stock. The cost per share was $1,923.

The petitioner transferred 80,000 shares of the stock to Baruch Brothers in consideration of the release of his stock from the escrow agreement. The value of this consideration is susceptible of measurement in dollars. The transaction in itself gave rise to no income. The 80,000 shares of stock cost the petitioner $1,923 per share. This cost should be added to the cost of the remaining shares to find the total cost of the 180,000 shares. This total cost was $500,000, or a total cost per share of $2,778.

The Commissioner, in his computation of gain, used as the sale price the sum of $130,243.92. There is no evidence to indicate that this was not the true sales price. This gives a sale price of $2.8294 per share. The gain per share is ascertained by subtracting from this amount the total cost per share ($2,778). The gain per share multiplied by the number of shares sold gives the gain on the shares so sold.

Judgment will be entered after 15 days' notice, under Bule 50.


author: Teussell :

text:
    Joseph J. Haupt, Petitioner, v. Commissioner of Internal Revenue, Respondent. Oscar Burgi, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 5781, 5782.
    Promulgated May 11, 1927.
    Bad Debts. — A certain partnership account claimed as a bad debt allowed.

      Clarence L. Johnson, C. P. A., for the petitioners.

      L. L. Eight, Esq., for the respondent.
   Teussell :

These proceedings have been brought for the redetermi-nation of deficiencies in income taxes for the calendar year 1920 in the amount of $3,022.70 in the case of Joseph J. Haupt, and $2,882.50 in the case of Oscar Burgi, and were tried together.

The petitioners allege that the Commissioner erred in adding to the taxable income of both petitioners for the year 1920 an amount based on the disallowance of a deduction of $30,061.02, claimed as a bad debt in the iiartnership return of Haupt & Burgi for the year 1920.

FINDINGS OF FACT.

In 1903, Joseph J. -Haupt and Oscar Burgi formed a partnership known as Haupt & Burgi, and engaged in the business of wholesale dealers in cheese.

The partnership built up a clientele of jobbers and retailers, among which was the W. H. Schwettman Co. since its incorporation in 1906. The partnership’s dealings with the Schwettman Company were the same as its dealings with other customers — it never loaned money, but it did sell merchandise on regular credit terms.

The partnership of Haupt & Burgi held 52 per cent of the outstanding capital stock of $10,000 of the Schwettman Company. Neither partner had any other interest in the corporation. Haupt and Burgi never exercised any of the rights of stockholders nor attended any stockholders’ meetings. Neither Joseph-Haupt nor Oscar Burgi was officer or director, nor at any time up to 1920 managed the affairs of the Schwettman Company. W. H. Schwettman, who held 47 per cent of the stock, was president, and Albert Weltert, who held one share, was secretary, and Schwettman and Weltert were the managers and directors of the company. The Schwettman Company became Haupt & Burgi’s largest distributors and prior to 1920 about 15 per cent of Haupt & Burgi’s entire business ivas done with the Schwett-man Company, which had always settled its obligations promptly.

On December 10, 1920, the Schwettman Company owed Haupt & Burgi, $34,069.31 for merchandise sold. That was a normal amount due to the large volume of business transacted between that -company and the partnership.

On December 10, 1920, W. H. Schwettman called the office of Haupt & Burgi by telephone and advised Haupt that the company was being sued by Reynolds & Irwin, a creditor, but that he (Schwettman) did not know why. Haupt immediately called Reynolds & Irwin and guaranteed payment of the account if Reynolds & Irwin would suspend their suit, which was done. That was done because at that time Haupt & Burgi had no concern regarding the financial affairs or condition of the Schwettman Company. For many years prior to 1920 the Schwettman Company had been in a sound financial condition, had carried reasonable cash balances and an inventory ranging from thirty to fifty thousand dollars. Later, on the same day, W. H. Schwettman came to the office of Haupt & Burgi and announced his resignation as president of the Schwettman Company and gave Haupt & Burgi his 47 per cent of the stock, but failed to give his reasons or any information. Within the next few days W. H. Schwettman was killed in an accident.

On December 11, 1920, Haupt & Burgi started an investigation of the Schwettman Company’s accounts and at that time Weltert, the secretary and bookkeeper of the said company,' disappeared and has not been heard from since. The investigation disclosed the following :

This situation presented to Haupt & Burgi two alternatives — (1) that of receivership for the Schwettman Company, which procedure would not have enabled Haupt & Burgi to recover the amount owing to them, or (2) to refinance the corporation and thus save that outlet for Haupt & Burgi’s merchandise. The latter course was adopted. Haupt & Burgi paid some $8,000 to Reynolds & Irwin, guaranteed the payment of accounts of the other creditors, canceled the outstanding stock, 99 per cent of which Haupt & Burgi held, issued new stock for which $10,000 in cash was paid in full, and elected new officers.

During December, 1920, the Schwettman Company’s debt of $34,-069.31 was ascertained to be worthless and on December 31, 1920, the said debt in the amount of $30,061.02 was charged off the partnership books. Hone of the said amount has ever been recovered. For the years 1921 to 1925, inclusive, the Schwettman Company operated at a net deficit of $2,082.35.

The said debt of $30,061.02 was a total loss in December, 1920, and having been charged off the books was a lawful deduction from the gross income of the partnership.

The deficiencies will be redetermined upon 15 days’ notice, under Rule 50, in accordance with the foregoing findings of fact, and judgment will be entered for the petitioner.


author: GREen:

text:
    Appeal of H. M. Waite Hardware Co.
    Docket No. 5298.
    Promulgated May 11, 1927.
    1. Additional deduction disallowed for want of proof.
    2. Imposition of penalty by Commissioner for failure to file a return approved. '

      Bartholomew J. Murphy, G. P. A., for the petitioner.

      Harold Allen, Esq., for the Commissioner.
    In this proceeding the petitioner seeks a redetermination of its income and profits taxes for the fiscal year ending January 31, 1920, for which year the Commissioner determined a deficiency of $9,700.34. Of this amount, only $2,780.07 is in controversy.
    The errors alleged are “ The failure on the part of the Commissioner to include $2,000 among our expenses,” and “ The addition of a penalty to the amount of the tax stated by the Commissioner to be due namely 25% of $7,8^037 or $1,960,073

    With reference to the first allegation of error, the petitioner further alleges:
    The Commissioner understated our purchases for the period by $2,000 calling this $2,000 an “Adjustment by Corporation of an unexplained difference on books.”
    This amount was charged to Surplus in the fiscal year ending January 31, 1921, as it was incurred in the fiscal year ending January 31, 1920 and not entered until it was discovered by the auditor for the taxpayer in 1921.
    Apparently the petitioner’s contention is that its borrowings from banks were $2,000 in excess of the amount shown on its books and that this amount should be added to the cost of goods purchased during the year.
    FINDINGS OF FACT.
    The petitioner is a Massachusetts corporation with its principal office at Worcester. Substantially all of its stock was, during the year in question, owned by Fred A. Chamberlain, of Orlando, Fla., who was president of the corporation during the fiscal year here under consideration.
    The petitioner did not file a return for the fiscal year ending January 31, 1920.
    Some time subsequent to the time for filing returns for such fiscal year, the petitioner employed a firm of public accountants to examine its records and prepare an “ amended return.” The evidence does not disclose that the so-called “ amended return ” for the fiscal year in question was ever filed.
    The petitioner’s books were kept on the single-entry basis. Prior to February of 1920 no record was kept of notes payable. When this account was opened there was set up therein an amount which represented the amount theretofore claimed by the petitioner upon certain of its income and profits-tax returns, at least one of which was not filed.
   OPINION.

GREen:

It is alleged that in the return (which we have found was not filed) the petitioner set up as accounts payable the amount of $7,200 and that this amount was understated by the amount of $2,000. It is further contended that this amount should be added to expense or cost of goods purchased. The record contains no evidence as to when this amount was borrowed, the purpose for which it was borrowed, the use to which it was put, or whether it has been paid. In fact we would not be justified in finding from the record that this or any other amount had been borrowed. Chamberlain, sole witness for the petitioner, stated that the amount of $7,200 was only an estimate of the indebtedness.

Chamberlain at one time during the course of his testimony swore positively that a return had been filed for the fiscal year ending January 31, 1920. This statement by him was subsequently qualified to such an extent that it is entitled to no weight. There is in the office of the collector of internal revenue for that district no record of the filing of a return by the petitioner for the fiscal year here involved. We perceive no reason for setting aside the penalty imposed for failure to file the return, and the Commissioner’s action in so doing is approved.

It was conceded at the hearing that there was a mathematical error in the computation of the deficiency and that it should be increased by the amount of $100.

Jxulgmenb will Toe entered for the Commissioner.