author: Love : Phillips,

text:
    S. Naitove & Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 8186.
    Promulgated October 7, 1927.
    Where a corporation, keeping its books on tbe accrual basis, entered into an agreement with certain employees whereby it agreed to pay each employee as contingent compensation, a percentage of the net profits for the year 1919, subject, however, to the condition that no employee should be entitled to withdraw any amount credited to him pursuant to the agreement, except upon consent of the president of the corporation, unless he should remain in the employ of the corporation for a period of five years, and to the further condition that during the period of five years the amounts credited to each employee should remain in and at the risk of the business, it may not deduct from gross income for the year 1919, the amounts credited to each employee as of December 81, 1919.

      Robert E. Ooulson, Esq., and R. Kemp Slaughter, Esq., for the petitioner.

      George G. Witter, Esq., for the respondent.
    This proceeding is for the redetermination of a deficiency in income and profits tax for the calendar year 1919 in the amount of $59,049.33. The petitioner alleges that, in determining the deficiency herein, the respondent erred in the following particulars:
    (1) In disallowing as a deduction from gross income for the calendar year 1919, the amount of $116,548.88, which amount it is alleged represented compensation of certain employees for that year p'ursuant to an agreement hereinafter set forth, but which amount was charged on the petitioner’s books as a selling expense.
    (2) In failing to compute the petitioner’s profits tax for 1919 under the provisions of section 328 of the Revenue Act of 1918, instead of upon the basis of book invested capital after the disallowance of selling expenses in the amount of $116,548.88.
    BINDINGS OF FACT.
    The petitioner is a corporation organized and existing under the laws of the State of New York, with its principal place of business at 725 Broadway, in the City of New York. Its business is that of buying and selling woolen, silk, and cotton goods.
    Samuel Naitove, petitioner’s president, was general executive in charge of the business and during the year 1919 he owned 85 per cent of the outstanding capital stock. The remaining 15 per cent of the outstanding capital stock was owned by Herbert H. Rabiner, a member of the board of directors.
    Petitioner had five employees who held important positions and who constituted the entire staff of the business for the purpose of b'uying and selling. One of these employees did all of the buying in his department, another assisted the president of the company in the buying in the department over which the president gave personal supervision, two others were efficient salesmen, and another handled all of the credit matters.
    These employees were dissatisfied with the compensation being paid to them by the petitioner and they informed the petitioner’s president that they were contemplating going into business for themselves. In order that those employees would remain with the petitioner an agreement was entered into between the petitioner and t.he employees, by which agreement they would, under certain conditions, participate in the profits of the business. This agreement was expressed in a resolution passed by the board of directors of the petitioner on February 10, 1919, as follows:
    Resolved, That additional compensation for the year 1919 be paid to the following officers and employees of the company in accordance with the practice of the company on the following basis:
    Mr. Moe Naitove, 10% of the net profits for the year 1919;
    Mr. Nat Naitove, 10% of the net profits for the year 1919;
    Mr. Jack Naitove, 10% of the net profits for the year 1919;
    Mr. Moe Turman, 5% of the net profits for the year 1919;
    Mr George Naitove 5% of the net profits for the year 1919;

      Provided, however, That any and all sums to which the above named officers and employees may become entitled under the terms of this resolution shall remain in the business at the risk of the business for a period of five years, and that prior to the expiration of such period said officers and employees shall be entitled to demand and receive payment of the sums to which they may become entitled only to the extent that drawings against such sum may be authorized by the president of the company, it being the intention of this resolution that any and all contingent compensation to which said officers and employees may become entitled under the terms of this resolution, be at the risk of the business in the sense that it shall be subject to pro rata deductions in the event that losses are incurred by the business during the period within which such sums are to remain at the risk of .the business; and provided, further, that no officer or employee shall at any time be entitled to withdraw any sums credited to him under the terms of this resolution, except as hereinabove provided, unless he shall remain in the employ of S. Naitove & Co., Inc., during the entire period during which the credits mentioned are to remain at the risk of the business, and in the event of the discharge of any such officer or employee or withdrawal during such period, all right, title or interest of such officer or employee in or to any sums credited to said officer or employee under the terms of this resolution shall revert to this corporation.
    The petitioner kept its books of account on an accrual basis of accounting and pursuant to the above-quoted resolution the following entry was made in closing the petitioner’s books as of December 31, 1919, which entry was correctly computed:
    Charge, selling and commission $116,548.44
    Credit Moe Naitove_$29,187.11
    Jack Naitove_ 29,137.11
    Nat Naitove_ 29,137.11
    George Naitove_ 14, 568.56
    Moe Turman_ 14,568.55
    additional compensation as per agreement.
    The compensation provided for in the above-quoted resolution and which was accrued on petitioner’s books, was reasonable for the services rendered by those employees in the year 1919.
    In the year 1920, a resolution, similar to that of February 10, 1919, was passed by the petitioner’s board of directors, continuing the compensation for services rendered in 1920 on the same basis as authorized for services rendered in the year 1919.
    In the year 1920, the petitioner suffered a loss of approximately $90,000 and pursuant to the terms of the above-quoted resolution there was entered on the petitioner’s books as of December 31, 1920, the following accruals:
    Charge Moe Naitove 10%-$10,441. 42
    Nat Naitove 10%_ 10, 441. 42
    Jack Naitove 10%- 10, 441. 42
    George Naitove, 5%- 5,220.71
    Moe Turman, 5%- 5,220.71
    Credit surplus account. $41,765.68

      This entry gave effect to the participation by the five employees in the petitioner’s losses for the year 1920.
    Upon audit of the petitioner’s return for the year 1919, the Commissioner disallowed as a deduction from gross income the amount of $116,548.44 accrued as additional compensation to employees for that year.
   OPINION.

Love :

The first question presented for our consideration is whether the amount of $116,548.88 accrued on the petitioner’s boohs on December 81, 1919, as additional compensation under the above-quoted resolution, constitutes an allowable deduction from gross income for the year 1919.

The petitioner urges that to deny the deduction claimed and accrued on its books at the close of the /ear 1919, would not only be a reversal of the decision of the Board in the Appeal of Block & Kohner Mercantile Co., 4 B. T. A. 673, but would be equivalent to holding that, contingencies which may arise would abrogate a closed transaction.

We are of the opinion that the facts in the instant appeal do not bring it within the purview of the Board’s decision in the Appeal of Block & Kohner Mercantile Co., supra. In that appeal the petitioner entered into an agreement with one Weinbach whereby, in consideration of the mutual covenants therein, Weinbach was to work for the petitioner on a regular monthly salary and in addition thereto he was to receive one-third of the net profits earned by the petitioner and he was also to share any of the petitioner’s losses. The contract was for three years unless terminated by consent or notice as provided therein, or by Weinbach’s death, at which time the right to share in the net profits terminated. In holding that the amount accrued to Weinbach as of December 31, 1919, constituted a liability against the petitioner in the accrued amount, subject only to be defeated by subsequent losses, the Board stated:

The petitioner is entitled to this deduction on the ground that the one-third share of its profits was at the end of the year definitely committed to Weinbach, subject only to be defeated by a subsequent net loss, over which the petitioner had no control. * * *
Weinbach had no right to have part of the profits impounded or intrusted. He merely had a cause of action in contract the damages of which would be measured by the percentage of profits. This is an accrual deduction.
It is said that the liability is not determined until the end of the contract period, which, so far as payment is concerned, is true. Weinbach could not have sued to recover. But this is too rigid a test. As a reasonably prudent person the petitioner was committed not to impair the percentage. It was only by a business loss which the petitioner would not reasonably be supposed to bring about voluntarily that the amount could be impaired, and since a subsequent loss would not he taxable the petitioner here would be in no better tax position in any event.

The Board’s decision is predicated on the fact that the liability for the one-third share of its profits to Weinbach had definitely accrued as of December 31, 1919.

Examining the agreement between the petitioner herein and the employees, as embodied in the above-quoted resolution, it will be noted that it contains a provision to the effect that the employees shall share in the losses of the business. This provision is the only one in common with the contract between Weinbach and the petitioner as set out in the Appeal of Block & Kohner Mercantile Co., supra. However, in addition to this provision, the above-quoted resolution provides that the employees are not entitled to withdraw, except as provided therein, any of the contingent compensation unless they shall remain with the petitioner for five years, and it is further-provided that in the event of the discharge or withdrawal of any employee, all right, title, and interest in any of the contingent additional compensation shall revert to the petitioner.

By reason of the language employed in the resolution and from the conditions contained therein, the petitioner incurred no liability to the employees on December 31,1919,. by accruing on its books the contingent additional compensation pursuant to the resolution. There was no absolute liability on the part of the petitioner for any part of the contingent compensation until after the expiration of five years. The accrual on December 31, 1919, was merely a memorandum entry for the purpose of ultimately determining the liability, if any. The condition in the resolution to the effect that no employee shall at any time be entitled to withdraw any sums credited to him under the terms of the resolution unless he shall remain for five years in the employee of the petitioner, is clearly a condition precedent to the accrual of any liability.

A condition precedent is defined in Corpus Juris, vol. 13, p. 564, as follows :

Conditions Precedent.- — -A condition precedent in the law of contracts either may be a condition which must he performed before the agreement of the parties shall become a binding contract, or it may be a condition which must be fulfilled before the duty to perform an existing contract arises, and in this ease may consist in performance of his promise by one of the parties or the happening of some other stipulated contingency. The question of whether stipulations in a contract constitute conditions precedent is one of construction dependent on the intent of the parties to be gathered from the words they have employed and, in case of ambiguity, after resort to the other permissable aids to interpretation. * * *

Looking again to the above-quoted resolution, we note that the additional compensation which the petitioner seeks to deduct was termed “contingent compensation.” Upon what was it contingent? The answer is obvious. Each of the employees named in the resolution must remain in the employ of the petitioner for five years. But, any one or all of them might be discharged, or might resign or might die within the period of five years. In such case, liability on the part of the petitioner did not and would not accrue. The resolution expressed a contract in form but it was not to become operative as a contract until the happening of the contingency.

In further support of its contention that it is entitled to the deduction of $116,548.88 from gross income for the year 1919, on account of the additional compensation accrued on its books as of December 31,1919, the petitioner cites the case of American National Co. v. United States, 274 U. S. 99; 6 Am. Fed. Tax Rep. 6747; 47 S. Ct. 520, and urges that the decision therein concludes the issue in this appeal. We are of the opinion, however, that the cases are distinguishable.

In the case cited by the petitioner, the Supreme Court stated the facts to be as follows:

The findings of fact show that the Company, an Oklahoma corporation, had been engaged since 1908 in the business of making loans secured by mortgages upon real estate, which it negotiated and sold to investors. Under its usual course of business the borrower, upon the making of a loan, executed to the order of the Company his note for the amount loaned, due in five years, with interest at 5 per cent, per annum, payable semiannually; with the privilege of paying $100 or any multiple thereof on the principal, on or after two years, at the maturity of any interest payment. At the same time the borrower executed to the Company another note due in two years, without interest, for 10 per cent, of the total amount of the loan, as the Company’s commission or compensation for making and negotiating the loan. From these commission notes the Company derived its income.
At first the Company negotiated and sold the loan notes to investors entirely through brokers or agents, to whom it paid fees or commissions. But from and after 1916 it sold many of these notes direct to investors; and being thus relieved from payment of these fees or commissions, and as an inducement to investors to purchase from it direct, agreed to pay them bonuses upon the notes as added consideration for the purchases; this being evidenced by a contract, styled a Guarantee, which the Company gave the investor, agreeing to pay him during the life of the loan, according to the terms of the note, 1 per cent, per annum of its amount, in addition to the 5 per cent, per annum that the borrower was to pay.
The Company consistently kept its books of account from year to year on an “ accrual basis.” Under the practice followed from the inception of its bonus method of doing business, whenever a loan note was sold it charged on its books, as an expense incurred in the sale, the aggregate amount of the payments called for in the bonus contract, computed at 1 per cent, per annum to the maturity of the note, and credited the investor on its books with a like amount, in a subsidiary bills payable ledger. The total amount of this liability on the bonus contracts was carried on its general ledger under a control account called the Guarantee Fund Account.
In the year 1917, in accordance with this practice, the Company accrued and set up on its books as a liability and charged to expense, the aggregate amount of the payments called for in the bonus contracts given investors during that year. And it made its tax return for that year upon the basis upon which the accounts were kept, claiming as an expense the aggregate amount of these bonus contracts, as set up on its books. And as admitted in argument, although not shown specifically by the findings of fact, it also entered on its books and returned as income received during the year, the aggregate amount of the commission notes given by borrowers when it made the loans.
Furthermore, under the Company’s practice, if any loan note was paid by the borrower before maturity, the difference between the amount of the bonus contract credited to the investor’s account and the payments that had been made on the contract, was credited back to Profit and Loss, and treated as income of the Company for the year in which the note was paid.
The Commissioner of Internal Revenue disallowed the claim of the Company for the deduction of the total amount of the bonus contracts issued in 1917, and allowed the deduction only to the extent of the installments called for by such contracts which matured in 1917, and in accordance with this ruling made the additional assessment which is here involved.

In holding that the company was entitled to the deduction of the aggregate amount of the bonus contracts issued in 1917, the Supreme Court, in part, stated:

So, in the present case, we think that the amount of the bonus contracts was “ an expense incurred and properly attributable ” to the Company’s process of earning income during the year 1917. These contracts were not analogous to obligations to pay interest on money borrowed, but were expenses incurred in selling the loan notes in as real a sense as if under its original system of doing business the Company had paid these amounts to brokers as fees for selling the loans or given them notes for such fees. The Company’s net income for the year could not have been rightly determined without deducting from the gross income represented by the commission notes, the obligations which it incurred under the bonus contracts, and would not have been accurately shown by keeping its books or making its return on the basis of actual receipts and disbursements. The method which it adopted clearly reflected the true income. And, just as the aggregate amount of the commission note was properly included in its gross income for the year — although not due and payable until the expiration of two years — so, under the doctrine of the Anderson Case, the total amount of the bonus contracts was deductible as an expense incurred within the year, although it did not “ accrue ” in that year in the sense of becoming then due and payable.

It becomes apparent, therefore, from an examination of the above statement, that the Supreme Court considered the liability on account of the bonus contracts to have become fixed in 1917. To be sure, liability for further payment on account of a bonus note might be defeated by the payment of the loan note at the expiration of two years as provided in that note. But in all events, at the time of giving the bonus notes in 1917, there was a fixed and definite liability on the part of the company, subject to defeasance only by the subsequent action of the borrower.

In the instant appeal, as above stated, we are of the opinion that on December 31, 1919, there was no fixed liability on the part of the petitioner to pay any amount on account of the contingent additional compensation. The liability, if any, on the part of the petitioner depended entirely upon the happening of a specified contingency, namely, that each employee must remain in the employ of the petitioner for five years. We think that during the five years provided in the resolution of February 10, 1919, there was an inchoate or potential liability on the part of the petitioner, which at the expiration of that period became a fixed and definite liabilty for the payment of some amount of money to those employees named in the resolution who have been during the entire period in the petitioner’s employ, provided, of course, that during the same period petitioner’s business had been profitable.

We, therefore, approve the action of the respondent in disallowing the deduction of $116,948.88 from gross income for the year 1919 on account of additional compensation accrued on petitioner’s books as of December 31,1919.

The petitioner alleges that the respondent erred in failing to compute its profits tax for 1919 under the provisions of section 328 of the Bevenue Act of 1918. It has not, however, presented any evidence showing abnormality of income or invested capital or that any other conditions prescribed in section 327 existed. The action of the respondent in regard^thereto is approved. Appeal of Edward Rose Co., 2 B. T. A. 341.

Reviewed by the Board.

Judgment will he entered for the respondent.

SteRNíiageN, MillikeN, VaN Foss AN, and Murdock dissent.

Phillips,

dissenting: I am of the opinion that the deduction claimed is allowable under the decisions of the Supreme Court in United States v. Anderson, 269 U. S. 422, and American National Co. v. United States, 274 U. S. 99; 6 Am. Fed. Tax Rep. 6747; 47 S. Ct. 520. I am further impelled to this conclusion by my opinion that if the amount claimed (which is admittedly an ordinary and necessary expense of the business and deductible in some year as such) is ever to be allowed, it must be as an expense of conducting the business for the year in question.

It seems that at the end of tbe year the employees had done everything required of them to earn the compensation in question. Subject to certain contingencies under which these employees might lose the right to demand payment, the petitioner was obligated to the employees for the amount in question. The contingencies affected the payment, not the accrual of the liability; as to payment,.these contingencies may be conditions precedent, but in my opinion the liability accrued in the taxable year subject only to certain conditions subsequent under which it might be wiped out.

I appreciate that difficulties are involved in the acceptance of this view in determining the course to be followed in computing income for subsequent years should this liability be canceled in such subsequent years by losses of the business or termination of the employment. The agreement of the employees that this compensation should be subject to diminution by subsequent losses may properly be treated as a sharing of such losses of the petitioner by the employees, and to the extent that such losses are borne by the employees, the petitioner is compensated and to that extent does not sustain the full loss of such subsequent year.

The effect upon income of a discharge or withdrawal of the employees within five years is not so clear. Whether income would be realized from an act by which the amount theretofore earned by the employee was to “ revert to this corporation ” (to use the words of the resolution) is not before us. It appears, however, that in American National Co.v. United States, supra, the court allowed a deduction for the full amount contracted to be paid over a period of years, although it appeared that such amount might be reduced prior to the date of payment. In that case the taxpayer had treated the amount of his reduced liability as income in the year of such reduction. While the court does not comment on this situation, it does state that the method which was adopted clearly reflected the true income, thereby implying that a change in the liability must, by reason of the method of accounting followed by the taxpayer, be accounted for as income.

In the case before us it will scarcely be contended that the financial condition of the petitioner could have been reflected without showing the liability to its employees and in my opinion its true net income for the year could not be computed without allowing the deduction claimed. For these reasons I dissent from the conclusion reached.

MoRRis concurs in the dissenting opinion.


source: Caselaw Access Project

author: Littleton :

license: Public Domain

text:
    Amigo Coal Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 11684.
    Promulgated October 7, 1927.
    1. A reserve of $5,000 entered upon the petitioner’s books in the year 1920 represents the amount which it believed would be necessary for it to expend in the subsequent year for the removal of rock and slate from the roof of its mine to permit of continued coal-mining operations. The work of removing the rock and slate was performed in the year 1921 and the cost of such work amounted to $5,926.67. Held, that the cost of this work was not incurred in the year 1920 and the reserve was not a proper deduction from gross income in that year.
    2. The evidence in this proceeding shows that the petitioner determined a debt of $44,443.40 to have been wholly worthless in December, 1920. It charged off within the year 1920 $15,608.52 thereof. Held, the Commissioner erred in refusing to allow the petitioner to deduct the amount charged off.

      E. J. Goodrich, Esq., for the petitioner.

      Maxwell E. McDowell, Esq., for the respondent.
    The Commissioner determined a deficiency of $3,818.98 for the calendar year 1920. The deficiency notice shows no deficiencies for the calendar years 1921 to 1923, inclusive. Prior to the determination of the Commissioner of the deficiency for 1920, petitioner filed a claim for the abatement of a portion of a tax originally assessed by reason of which it claims the tax in controversy in this proceeding is $13,302.78'.
    The errors urged at the hearing are that the Commissioner erred (1) in disallowing as a deduction for 1920 a reserve in the amount of $5,000 entered upon the petitioner’s books in that year for the removal of rock from its coal mine, which amount it is claimed would have been expended in the year 1920 but for the delay in obtaining repair parts for automatic drills which made it necessary to do this work in the year 1921, and (2) in failing to allow a deduction of $15,608.52 representing that portion of a debt for $44,443.40 determined to have been worthless and charged off within the taxable year 1920.
    FINDINGS OF FACT.
    Petitioner is a West Virginia corporation engaged in mining and selling coal with principal office at Amigo, Raleigh County, of that State.
    The mine operated by petitioner is a very low seam of coal ranging from 26 to 40 inches in thickness. It is necessary in the operation of this mine for the petitioner, as the extraction of coal progresses, to remove by the process of blasting, a considerable portion of sandstone and slate roof of tbe mine to permit the erection of trolley-wires and the operation of mine cars. Entries into the mine for the extraction of coal can not be advanced very far without the removal ' of the rock roof of the mine entry so as to permit of advancement of transportation facilities. Throughout the year 1920 petitioner had an arrangement with its miners whereby it paid them $5 a yard for the removal of a sufficient thickness of the sandstone and slate roof of the mine to permit of the proper operation of the mine. For the purpose of blasting this rock roof an automatic drill was used. The use of hand drills for this purpose was impracticable for the reason that the drilling had to be done overhead and because of the hardness of the stone. In or about December, 1920, the automatic drill became broken and the petitioner was unable, after repeated efforts during the remainder of that year, to obtain a new drill or proper repair parts for the drill which had been in use. Petitioner carried on its mining operations during the remainder of December, 1920, as best it could without any further removal of the rock and on December 31, 1920, there were 1,185% yards of mine entry from which it would be necessary to remove the roof before it would be practicable to continue successful mining operations. At December 31, 1920, petitioner estimated the number of yards of stone roof whiqh would have to be removed at a cost of $5 a yard and entered upon its books a reserve of $5,000 for this work. The repair parts for the automatic drill were finally secured and early in 1921 the 1,185% yards of rock roof were removed at an actual cost of $5,926.67. Petitioner claims this amount is a deduction from gross income for the year 1920 upon the ground that the cost of this work, which it knew it would have to do before successful mining operations could be continued, was an accrued expense in the year 1920. The Commissioner refused to allow the deduction of this reserve upon the ground that the setting up of reserves of this character is not permitted by the Revenue Act of 1918 and that the cost of removing the stone was neither paid nor incurred within the taxable year 1920.
    Some time in July, 1920, when the demand for coal was great and coal was selling at high prices, petitioner entered into a contract with the Interstate Coal & Dock Co., hereinafter referred to as the Interstate Company, a corporation engaged in the sale of coal with principal office at Green Bay, Wis., whereby the Interstate Company agreed to purchase petitioner’s entire output of coal. The Interstate Company also had branch offices or representatives in New York, N. Y., Chicago, Ill., in Richmond and Norfolk, Va., Beckley, W. Va., and at other coal-shipping points. This company was engaged exclusively as a coal-selling organization and had no assets other than coal contracts, and operated on a very small margin of cash. In the contract with petitioner the Interstate Company agreed to purchase petitioner’s entire output at $4.50 a ton. This contract also provided that in the event petitioner was compelled to increase the wages of its employees engaged in mining coal that the purchase price per ton to the Interstate Company would be increased accordingly. The Interstate Company had many contracts with many coal-operating companies. It had contracts to purchase the output of practically all of the coal mining companies in the West Virginia field. In these contracts the Interstate Company agreed to make payment for coal shipped in the latter part of the month following the month in which shipment was made. Petitioner made shipments of coal to and received payments from the Interstate Company during the year 1920 as follows:

    This left a balance due petitioner by the Interstate Company of $44,443.40.
    In September or October, 1920, a slump in the coal market occurred and the price of coal declined materially. The Interstate Company therefore found itself with numerous contracts wherein it had agreed to purchase coal at high prices and with a large supply of coal on hand for which there was very little demand. It had difficulty in selling coal and that which it could sell was in most instances sold at prices considerably below the price at which it was com- ' pelled under its contracts to pay the operator. The Interstate Company relied upon payments to it for coal sold with which to pay for coal purchased and at no time had a very large amount of ready cash on hand with which to meet its bills. In the latter part of September or in October, 1920, the Interstate Company finding itself unable to meet its bills gave trade acceptances and subsequently made part payments thereon. Early in December, 1920, the Interstate Company was hopelessly insolvent, its trade acceptances were protested and it was unable, after December 15, 1920, to make payments on coal which had theretofore been shipped to it. More than $339,000 of trade acceptances held by operators in the West Virginia field alone were protested for nonpayment early in December, 1920. In the latter part of November, and throughout the month of December, 1920, petitioner made every effort to collect on its accounts but could get no remittances. It wrote letters and sent telegrams to the principal office of the petitioner and to its New York office but could get no reply. Petitioner’s secretary and manager who was in charge of its operations and financial affairs did everything he could without personally going to Green Bay, Wis., to collect the amount due petitioner from the Interstate Company. He knew that the sudden drop in coal prices and the lack of demand for coal had caused the Interstate Company to become financially involved and that this was the reason for his company not receiving payments in full for coal which had been shipped to the Interstate Company. He made several trips from Amigo to Beckley, W. Va., in an effort to confer with the representative of the Interstate Company in that territory with the view of seeing if anything could be done to have the Interstate Company make payment of its past due accounts. He was never able to see the Interstate Company’s representative. None of the coal operators in the West Virginia field were able to collect anything on their accounts. About the middle of December, 1920, petitioner determined that the Interstate Company was hopelessly insolvent, could not pay anything upon its large outstanding indebtedness, and that the debt of $44,443.40 due it by the Interstate Company was worthless and a total loss. Before charging the amount off on the books of account, however, petitioner’s secretary and manager, being uninformed as to income-tax matters and being desirous of strictly complying with the law and Department regulations, sought information from those whom he believed knew something about the matter of charging off worthless debts insofar as such action related to income-tax matters. He consulted certain individuals who had previously been connected with the handling of some tax questions, explained the circumstances to them, told them that the debt of the Interstate Company of $44,443.40 was worthless and an absolute loss to his company, and asked if, under these circumstances, the total debt might under the income-tax statutes and regulations be legally charged off as worthless without subjecting the company to a penalty. Petitioner’s officer was advised by those with whom he consulted that their understanding of the matter of charging off worthless debts from an income-tax standpoint was that before a debt could legally be charged off the debtor must have gone through bankruptcy and that every possible means to collect on the account must first have been exhausted. After being thus informed petitioner, although desirous of charging the debt off in full, concluded that the best it could do and stay within the regulations of the Treasury Department was to charge to profit and loss the amount of $15,608.52, which represented the profit at which the company had sold the coal, and carry the remainder of the account, amounting to $28,834.88, into the inventory as a part of the cost of goods sold. This effect of the treatment of the debt by the petitioner upon its books is explained by its principal officer that his “ job was to dig that coal out of the hillside and get what I could for it. I could not understand the law on that [charging off of the debt] * * *. I asked everybody I could find, and some of them said ‘ well, you can take off your profit, as a net loss, or you can take your inventory at your cost of production, inventory your coal at cost of production or market value,’ and I decided to do that, and I came to the conclusion that if we put in the inventory the cost which was above the market, and then take no credit to profit, that that at least would be subject to a fair interpretation that I was not trying to make a fraudulent return. Now, that is where I got that $15,608.52. The average cost of production that we could turn that in and charge the rest of it off.”
    Shortly after December 31, 1920, before the books were closed for that year the petitioner charged $15,608.52 of the $44,443.40 off as worthless. The Commissioner refused to allow any deduction on account of the debt of the Interstate Company. Petitioner employed the accrual method of accounting. The affairs of the Interstate Company were wound up by a court in bankruptcy some time in 1921. Petitioner filed its claim for $44,443.40 in the bankruptcy proceeding and the trustee in bankruptcy reduced the same in the amount of $9,543.34 on the ground that the contract price of coal with the Interstate Company was $4.50 a ton and declined to permit the petitioner to add 50 cents a ton under the contract on account of increase in the wages of miners prior to the shipment of the coal in question. Nothing was ever paid to the petitioner on account of the debt of the Interstate Company.
   OPINION.

Littleton :

No portion of the work representing a claim of expenditure of $5,926.67 was performed in the year 1920. At the end of the year 1920 the petitioner had incurred no liability to any one in respect of the amount which might be necessary to remove the roof of the mine. Petitioner claims that the expenditure of this amount was “ incurred ” in the year 1920 because it knew at the close of 1920 that in order to proceed with its mining operations in the year 1921 it would be necessary for it to pay this amount, but knowledge of a taxpayer that some expenditure, even though determinable in amount, will have to be paid or incurred in the following year for certain work necessary, if its operations are continued, is not sufficient to justify a deduction of such amount in the taxable year in which it is neither paid nor liability therefor incurred. In these circumstances we are of the opinion that the reserve was not a proper deduction from gross income. William J. Ostheimer, 1 B. T. A. 18; Consolidated Asphalt Co., 1 B. T. A. 79; Uvalde Co., 1 B. T. A. 932; Morrison-Ricker Manufacturing Co., 2 B. T. A. 1008; H. V. Greene Co., 5 B. T. A. 442; Hirst & Begley Linseed Co., 4 B. T. A. 1160.

The Board is of the opinion that the Commissioner was in error in declining to allow the xietitioner a deduction of any amount in the year 1920 on account of the debt of the Interstate Coal & Dock Co. The debt was wholly worthless and was so determined within the taxable year, and $15,608.52 was charged off in the return. In the petition only $15,608.52 is claimed as a deduction. The amount claimed, to wit, $15,608.52, was a xu’oxier deduction from the gross income for 1920. Mason Machine Works Co., 3 B. T. A. 745, and Higginbotham-Bailey-Logan Co., 8 B. T. A. 566.

The petitioner claims that because the trustee in bankrux>tcy reduced its claim of $44,443.40 by the amount of $9,543.34, representing the amount of 50 cents a ton added to the price mentioned in the contract on account of an increase in the miners’ wages occurring prior to shipment of the coal in question, its income from sales should be correspondingly reduced, but the evidence is not sufficient to warrant us in holding that this should be done. The evidence submitted by the petitioner is to the effect that the contract with the Interstate Company specifically provided that the Interstate Company would pay $4.50 a ton for the coal and that this price should be increased by whatever amount should be necessary to take care of any increase which the petitioner might be compelled to make in the wages of its miners.

Reviewed by the Board.

Judgment will he entered on 15 days’ notice, under Rule 50.


author: Murdock.: Love, Phillips :

text:
    Robert W. Bingham, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 8823.
    Promulgated October 8, 1927.
    The petitioner regularly reported his income on the basis of cash received and disbursed. Various companies of which ho was an ordinary stockholder declared dividends payable either on December 30 or 31, 1922, and mailed dividend checks to him on those days. He was unable to receive these checks in the ordinary and usual course of business until 1923 and was not required by the provisions of section 201(e) of the Revenue Act of 1921 to report the amount of the dividends as part of his income for the calendar year 1922.

      Jolm D. Watkins, Esq., for the petitioner.

      Joseph K. Moyer, Esq., for the respondent.

      This is a proceeding for the redetermination of a deficiency in income taxes for the year 1922 in the amount of $8,988.53. The Commissioner included certain dividends in the petitioner’s gross income for the year 1922. The petitioner claims that this was an error in that he reported his income on the basis of cash receipts and disbursements and did not receive the dividends until 1923. Most of the facts were stipulated.
    FINDINGS OF FACT.
    The petitioner is an individual who has an office and a residence in Louisville, Ky.
    During the years 1920, 1921, 1922, and 1923 he kept a set of books showing his cash receipts and disbursements over the calendar year periods, and made returns of income for the same years upon the cash receipts and disbursements basis. This method of accounting and rendering returns was used consistently by him and was accepted by the Commissioner, and the petitioner’s tax liability for these years was determined in accordance therewith.
    On January 2, 1923, the petitioner received from companies of which he was a stockholder dividend checks for the aggregate amount of $62,524.01. These checks were drawn on December 30 and 31, 1922, in payment of dividends declared during 1922 and payable on or about December 31, 1922, and were mailed from the offices of the companies on December 30 and 31, 1922, but were not received by the petitioner during the calendar year 1922.
    The receipt of the dividends is shown on the petitioner’s books as follows:

    • The petitioner reported these dividends in his return of income for the calendar year 1923, and paid the tax thereon. The respondent has held that the dividends were part of the petitioner’s income for the calendar year 1922, and determined the tax accordingly.
    The petitioner was not an officer or director of, and did not have a majority or controlling interest in any of the companies which paid these dividends. He did n<A have a running or open account with any of them and did not owe any debts to any of the companies, but his relation with each of the companies was that of an ordinary minority stockholder.
   OPINION.

Murdock.:

The question involved in this appeal is whether the petitioner, making his return on the cash receipts and disbursements basis, should report in 1923, as taxable income for that year, the sum of $62,524.01, representing dividend checks mailed to him in December, 1922, and payable in 1922, but not physically received by him until 1923.

The petitioner contends that the amount in question is income for 1923, since that is the year in which he received it, and since he kept his books on the cash receipts and disbursements basis.

The respondent has taken the position that the amount in controversy should have been reported as income for 1922, because of section 201(e) of the Revenue Act of 1921, which reads as follows:

Sec. 201. (e) For the purposes of this Act, a taxable distribution made by a corporation to its shareholders or members shall be included in the gross income of the distributees as of the date when the cash or other property is unquali-fiedly made subject to their demands.

The respondent contends that as to this petitioner the dividends were unqualifiedly made subject to his demands not later than the dates when they were payable.

The Ways and Means Committee’s Report, No. 350, 67th Congress, 1st Session, at page 9 refers to this subsection as follows:

It further clarifies a minor obscurity in the present law by providing that a distribution made by a corporation to its shareholders shall be included in the gross income of the latter as of the date when the cash or other property is unqualifiedly made subject to their demands.

The Finance Committee of the Senate in its report, No. 275, 67th Congress, at page 10, stated in regard to this subsection—

Minor obscurities in the present law have been clarified by stating conclusively certain provisions which heretofore have been stated in presumptions. It is further provided that a taxable distribution shall be included in the gross income of the distributees as of the date when the cash or other property is unqualifiedly made subject to their demands, which is in accord with the decisions of the Courts and is well established in departmental practice.

The Commissioner’s Regulations 45 related to the Revenue Act of 1918 and contains article 54, entitled “ Examples of constructive receipt,” which reads in part as follows:-

Where interest coupons have matured, but have not been cashed, such interest payment, though not collected when due and payable, is nevertheless available to the» taxpayer and should therefore be included in his-gross income for the year during which the coupons matured. * * * Dividends on corporate stock are subject to tax when set apart for the stockholder, although not yet collected by him. See section 201 of the statute and articles 1641-1549. * * *

Article 1541 referred to is entitled “Dividends” and purports to be a definition. It reads in part as follows:

The mere declaration of a dividend is not a distribution. Dividends are income and are taxed at the rates for the year in which paid, regardless of when the earnings or profits out of which they were paid were accumulated.

Section 213 of the Revenue Act of 1921 defines gross income and contains the following sentence:

The amount of all such items (except as provided in subdivision (e) of section 201) shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under subdivision (b) of section 212, any such amounts are to be properly accounted for as of a different period; * * *

Section 212(b) of the 1921 Act provides:

The net income shall be computed upon the basis of the taxpayer’s annual accounting period * * * in accordance with the method of accounting regularly employed in keeping the books of such taxpayer * * *.

Even in the light of the above reports, of the portions of the regulations quoted, and of the decisions of the courts which have come to our attention, several different meanings can be deduced from a consideration of the pertinent provisions of the entire Act.

Up to the time of the passage of this Act it had been generally recognized that the cash receipts and disbursements method of reporting income was a proper method under the revenue acts. Any other method of accounting regularly employed by a taxpayer which clearly reflected the income of the taxpayer was also recognized as a proper one for the purpose of the income-tax return. The revenue acts, the decisions of the courts, and thtf decisions of this Board have consistently required that the method of reporting income should clearly reflect income for the period reported.

If Congress intended to provide by the passage of section 201(e) that dividends should be reported only in the year when payable, as contended by the respondent, it would in effect have abolished the requirement that income of the period should be clearly reflected in the method of reporting it. This is true because the section is general in its application and if “ unqualifiedly subject to their demands ” means payable, it requires one on the cash receipts and disbursements basis to report his income from dividends when they are payable but not received, and just as surely requires one using a form of the so-called accrual method to refrain from accruing his income from dividends until the year in which they are payable.. In each case there would be a distortion of income if judged by the previously well-recognized principles of correctly reporting income. See Dodge & Bloomer v. United States (Court of Claims, decided April 4, 1927).

In this connection see also the case of Archer Maynard Campbell v. Commissioner, 6 B. T. A. 60. The question involved was whether a dividend declared by a corporation in December, 1922, payable January 1, 1923, was income to the petitioner, a stockholder, for the calendar year 1922 or 1923. The Board held that the dividend was income for the year 1922 and said:

Petitioner consistently kept bis books and rendered bis returns upon tbe accrual basis. Wlien tbe directors of tbe Glamorgan Pipe & Foundry Co., of wbieb be was chairman, by appropriate resolution in December, 1922, declared tbe cash dividend, petitioner accrued bis proportion thereof upon bis books as income and reported the same in bis income-tax return for tbe year 1922. It is not claimed by tbe Commissioner and there is nothing to indicate that tbe method of accounting employed by petitioner in keeping bis books of account, in accordance with which bis return was filed, did not clearly reflect bis income. We therefore approve tbe petitioner’s treatment of tbe dividend as income in 1922.

If Congress intended “ unqualifiedly subject to their demands ” to be synonymous with “ payable ” and that section 201 (e) should apply to all dividends no matter by what method the distributee regularly reported his income, then the above decision is wrong.

In the case of Archer L. Kent v. Commissioner, 6 B. T. A. 614, the Board held that the petitioner should report as income for 1923, dividends declared and payable in 1923, .but not received by him until 1924. In that case, however, the parties expressly stipulated that “ of the total dividends declared, the amount of $7,464.79 was payable on December 31, 1928, and was unqualifiedly subject to the taxpayer's demand on that date.” Because of this stipulation this latter case has no effect on the ruling in the earlier Campbell case.

Neither the two regulations of the Commissioner, nor the Act itself mentions the word “ payable ” and we do not believe that Congress intended any such dogmatic, narrow construction as this to be placed upon these words. The two regulations of the Commissioner are worded differently. One says dividends “ are subject to tax when set apa/rt for the stockholder, although not yet collected by him.” The other says “ dividends are income and are taxed at the rates for the year in which paid.” A dividend is not paid when the check for it is placed in the mail unless the distributee has authorized such method of payment, Thairlwall v. Great Northern Railway Co., 2 K. B. 509 (1910), and yet the money may have been set apart for the stockholder. If Congress intended to clear up this minor obscurity by enacting section 201(e) as a definition of constructive receipt of dividends we .can readily understand the reference to this section in section 213. It should then be applied generally wherever receipt is material in reporting income from dividends. One reporting on the cash receipts basis who had in his hand a coupon due in December, is required by regulations to report the money to be received from it as income of that year even though he does not cash it until the following year. Similarly, one who can receive his dividends in December, should not be allowed to turn his back on them until the following year.

Let us examine section 201(e) with this possible intent in mind. “ Unqualifiedly ” means absolutely and completely, without any qualification and not restricted by any reservation. When the day for payment arrives the dividend is subject to the demand of the stockholder (see Cook on Corporations, 8th Ed., vol. II, §§ 541 et seq. and cases there cited), but is it unqualifiedly so ?

After a dividend has been declared the directors of a corporation have the power to fix the place, manner, and means of payment with only such limitations as reason and good faith with the stockholders may require. Richter & Co. v. Light, 97 Conn. 364; 116 Atl. 600; Hyams v. Old Dominion Copper Mining & Smelting Co., 82 N. J. Eq. 507; 89 Atl. 37 (aff'd. 83 N. J. Eq. 705; 92 Atl. 588); Thairlwall v. Great Northern Railway Co., supra.

In the Thairlwall case, which has been cited with approval by courts in this country, the question was whether the mailing of a dividend check constituted payment of the dividend. Lord Coleridge, J., in his opinion wrote:

The next point is whether the posting of the warrant to the registered address was payment. To establish this it is necessary to prove either a request to pay by such means or an agreement that payment shall be thus made. Where there has been such a request payment is made by proof of posting although the cheque never is received, being stolen in transit: (Norman v. Ricketts, sup.) * * * Whether it was within their [directors’] power to declare the mode of payment seems to me a question which can only be answered in the affirmative.

If they decide to mail every stockholder a check on the day the dividend is payable, as is done by most corporations, is this unreasonable ? The petitioner in this case was a stockholder in many widely separated corporations. What could he do to prevent each of them from sending him a check instead of paying him the cash on the 30th or 31st of December? If he could not have gotten all of his cash on that day how can we say that it was unqualifiedly subject to his demand ? It may be that if he had gone to any one of these corporations on December 31st and had demanded his dividend, he could have gotten it. But it is just as probable and reasonable to believe that the corporation would have told him that checks were being mailed and no exceptions would be made. Would not his demand have been subject to this reasonable restriction? And in any event he could not have been in nine widely separated places on the same day.

In the present case we have an individual taxpayer who consistently reported and computed his income on the cash receipts and disbursements basis, which was the method of accounting regularly employed in keeping his books, who was an ordinary stockholder in widely separated corporations, and who made no effort to report his income in any other than the regular and reasonable way. In his system of reporting income the date of receipt was material and we think that the words of section 201(e) mean that he must report these dividends in the 3?ear 1923, when for the first time he could have gotten his money if he had wanted it, or, in other words, as of the day when in the ordinary and regular course of business he should have received the dividends. He did exactly as the Act required.

Reviewed by the Board.

Judgment will be entered in accordance with the foregoing opinion after notice of W days, under Rule 50.

Marquette, MorRts, Arundell, Van Fossan, and Sieekin dissent.

Love,

dissenting: I can not agree with the opinion or decision in the foregoing proceeding. I feel myself bound by the explicit terms and conditions of the statute. The statute lays down an unambiguous mandate and a judicial tribunal is transcending its prerogative to construe it into the discard.

In the instant proceeding the respective corporations in which petitioner owned stock declared dividends in 1922 and checks were issued by these corporations and mailed to the petitioner in 1922, and these checks were payable in 1922 Avithout any restrictions or limitations. That being true, it seems to me that only one interpretation can be givun to the plain English of the statute, to wit, that the amount of the dividend was unqualifiedly made subject to the demand of the petitioner at the instant the dividend was declared.

Section 201(e) of the Revenue Act of 1921 prescribed:

For the purposes of this Act, a taxable distribution made by a corporation to its shareholders or members shall be included in the gross income of the distributees as of the date when the cash or other property is unqualifiedly made subject to their demands.

The 1921 Revenue Act is the only income-tax act that contains that or any similar provision. At the time of the enactment of that statute, the accounting system of constructive receipt, as well as the system of cash receipts and disbursements, was well known and recognized.

Article 54 of the Commissioner’s Regulations 45 was in force at the date of the enactment of the Revenue Act of 1921, and that article reads in part as follows:

Dividends on corporate stock are subject to tax when set apart for the stockholder, although not yet collected by him.

The Finance Committee of the Senate in its report No. 275, 67th Congress, at page 10, in discussing section 201 (e) states:

Minor obscurities in the present law have been clarified by stating conclusively certain provisions which heretofore have been stated in presumptions. It is further provided that a taxable distribution shall be included in the gross income of the distributees as of the date when the cash or other property is unqualifiedly made subject to their demands, which is in accord with the decisions of the courts and is well established in departmental practice.

The reference by that Committee to “ departmental practice ” unquestionably referred to article 54, of Regulations 45, quoted above.

It is a matter of common knowledge that in 1921, Congress, as well as the public in general, realized that rates of taxation would decrease with each successive act of Congress, and by the Act of that year surtaxes for the year 1922 were made less than for the year 1921. One does not have to draw heavily upon his imagination to perceive a plausible reason prompting Congress to incorporate subsection (e) of section 201 into the Act of 1921.

To construe section 201 (e) as it is construed in the prevailing opinion in the instant proceeding is to construe it completely into the discard. Under that construction it is absolutely superfluous in the statute, serving no purpose whatever. Without it, a taxpayer recipient of corporate dividends would report such income exactly as he is now authorized to report it by that decision and exactly as he reports all other income. I can not bring myself to believe that Congress put that subsection in the law void of a purpose and void of a meaning.

As a further indication that Congress had a purpose in view ,• and as an indication that corporate dividends should be reported with restrictions not applicable to other classes of income, section 213 (a) of the Revenue Act of 1921 (same Act) provides, after defining gross income, as follows:

* * * The amount of all such items (.except as provided in subdivision (e) of section 201) shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under subdivision (b) of section 212, any such amounts are to be properly accounted for as of a different period * * * (Italics ours.)

The above-quoted section of the statute is a clean, clearcut declaration on the part of Congress that it did not intend that corporate dividend income should be absolutely controlled, in reporting same, by the taxpayer’s accounting method. All other income may be so reported, but dividends are expressly excepted from such control.

All other income was permitted to be returned in accordance with the taxpayer’s method of accounting, but corporate dividend income was singled out, and restrictions prescribed relative thereto. That Congress had the right to so treat such income is not questioned; that it should be treated differently from other classes of income I believe is demanded as plainly as English language can express the mandate. I do not feel myself authorized to agree to a construction of that statute which completely nullifiies it and renders it absolutely meaningless and superfluous.

Whether or not the stockholder happens to be situated so he may immediately demand the dividend is not involved in the provisions of the statute. The dividend is made subject to his demand whether he makes the demand or not.

Phillips :

I concur in the dissenting opinion prepared by Mr. Love. I believe it is proper to observe further that the provisions of the Act do not make dividends taxable when declared but only when “ cash or other property is unqualifiedly made subject to their [stockholders’] demands.” The language is not equivalent to a declaration that dividends are taxable when declared or even when payable unless, in the latter case, the money or other property to be distributed is available. It would seem that the purpose of the regulation referred to in the Finance Committee report was to require that dividends should be reported in the year in which they became payable, if payment was available. Whether or not this was a proper interpretation of the Revenue Act of 1918, Congress appears to have intended to incorporate it into the 1921 Act, and to have done so in words which are not subject to the interpretation placed upon them in the prevailing opinion.


author: Phillips:

text:
    Charles H. Van Etten, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 8793.
    Promulgated October 8, 1927.
    The business of the petitioner was to secure and finance contracts with cities for garbage disposal. Such contracts were assigned to and financed through corporations. As an incident to his business petitioner was required to help finance such corporations with his personal funds. Held, that losses were sustained in petitioner’s business which may be included in computing a net loss under section 204 of the Revenue Act of 1921.

      Allan G. Muddmum, G. P. A., for the petitioner.

      L. L. Might, Esq., for the respondent.

      The petitioner appealed from the determination by the Commissioner of deficiencies in income tax for the ta-xable years 1920 and 1922 of $32.40 and $1,056.68, respectively. Petitioner alleged no errors with respect to the determination of the deficiency for 1920. He alleges that he sustained a net loss in the operation of his business for 1921 which is allowable as a deduction in 1922.
    FINDINGS OP PACT.
    Petitioner is a resident of New York State, with an office at No. 60 Wall Street, New York City. His business is engineering, promoting, designing, building and operating refuse disposal plants. He first began to deal with the matter of the disposal of garbage in 1902. Since 1907 he has been engaged solely in the business of planning, engineering, operating and financially promoting refuse disposal plants.
    In 1907 and 1908 he studied the methods, design and construction of a plant for disposal of the refuse of the Borough of Brooklyn, N. Y., and became interested in the financing of a plant therefor, which venture took the form of a corporation called the Brooklyn Development Co.
    In 1912, he developed the Boston Development & Sanitary Co. and successfully operated it for 10 years.
    In 1914 he developed the New York Disposal Co., which organization handled ashes, rubbish, street sweepings and garbage from Brooklyn and garbage from the Boroughs of Manhattan and Bronx. The company was financially successful but its activities were eventually abated as a nuisance.
    Shortly after this last-mentioned company ceased to do business, petitioner assembled plans and designs for the construction of a plant to dispose of the garbage of greater New York, to take the place of the New York Disposal Co. He associated with him one Gaffney, who had been engaged with him in the Boston plant, and one Gahagan, a contracting engineer. Gahagan had had ño prior experience in refuse-disposal work. These three men formed a partnership and made a bid to the city for a contract. At this time there was no agreement as to the proportions of the interests of the partners in the partnership. The bid was awarded to the partnership. In order to secure the contract after the bid was awarded to them, the partnership deposited $50,000, being the cash deposit required, and deposited $200,000 in lieu of a surety bond. Petitioner put in $25,000. The balance of the $250,000 was put in by his two partners and a fourth man. A bond of a surety company for $200,000 was later substituted for the cash deposit of $200,000. One hundred thousand dollars of selected securities were deposited with the surety company and the surety company took the partners’ personal guarantee for the other $100,000. A' corporation was organized, called the Metropolitan By-Products Co., to which company the contract with the city was assigned. One million dollars was borrowed by the corporation and secured by first mortgage bonds, upon an agreement that approximately $800,000 would be raised by the petitioner and his associates. This amount was obtained by petitioner and his associates from their own funds and subscriptions of their friends. Petitioner put in $25,000 in order to evidence his good faith and to encourage his friends to contribute. The subscribers to this fund of approximately $800,000 were secured by a second mortgage. The $25,000 which petitioner originally put into the project was returned to petitioner in the form of second mortgage bonds. Participating certificates were issued by the company to indemnify petitioner and his associates for their contributions to the securities which were deposited with the surety company. Capital stock of no par value was issued and distributed. Forty per cent went to the underwriters of the million dollar first mortgage bond issue, 10 per cent went to petitioner as a bonus for promotion, and 50 per cent of the stock was distributed among the holders of the second mortgage bonds. The Metropolitan By-Products Co., shortly after its organization, failed to make profits. It went into the hands of a receiver and in 1921 the plant was sold at a receiver’s sale. The sale did not bring a price sufficient to reimburse the first mortgage bond holders and the second mortgage bonds and participating certificates, including those held by petitioner, became worthless.
    The petitioner received no compensation from the city for his services, any profit being dependent upon the successful financing and operation of the contract with the city.
    On January 1, 1921, petitioner continued to own certain of said securities of the Metropolitan By-Products Co. which had cost him $21,018.66 as follows:
    Second mortgage bonds_$13, 770. 00
    Participating certificates- 7,224. 66
    Deposit charge incurred in connection with the above— 24.00
    21,018.66
    Such securities became worthless in 1921.
    For 1921 the petitioner received a total gross income of $11,961.72, computed as follows:
    Gross income from trade or business_$10, 840. 00
    Interest received on note of Brooklyn Ash Removal Co._ 281. 72 Interest received on bonds of Boston Development and
    Sanitary Oo- 840.00
    Total_ 11,961.72

      The petitioner’s business expenses for 1921 were as follows:
    Salaries and wages_$1,230.80
    Office rent_ 650.00
    Brooklyn office expense- 212.84
    Moving Brooklyn office_ 12.00
    Meadville, Pa., investigation_ 250. 00
    Meadville, Pa., traveling expense- 100. 00
    London, England, office expense- 56.16
    Living expense while in London, England, on business_ 1,404. 00
    Steamship iare, England to New York City- 193. 05
    Total_ 4, 008.85
    During 1921 petitioner sold a Liberty bond for $904 which had been acquired by him in 1918 at a cost of $1,000.
   OPINION.

Phillips:

Petitioner claims that in 1921 he sustained a net loss from the operation of a trade or business regularly carried on by him, within the meaning of section 204 of the Revenue Act of 1921, which he is entitled to deduct. There is no question that the loss was sustained. The single question involved is whether the losses sustained by reason of the worthlessness of an investment in the corporation result “ from the operation of any trade or business regularly carried on by the taxpayer.”

It appears from the testimony that the petitioner was paid nothing by the city for his services and advice with respect to garbage disposal. Any gain was dependent upon securing a contract for its disposal and the financing of the project, compensation being received by way of a bonus or participating interest in the corporation which was organized to take over the contract. Any profit was, therefore, dependent on the successful financing and operation of the garbage-disposal contract. To accomplish this, petitioner was dependent upon funds which might be secured from investors and usually found it necessary to invest some of his own funds as an evidence of his faith in the undertaking. The financing of these contracts constituted an integral part of the operation of the business of the petitioner. The losses claimed were sustained in the operation of that business and, therefore, are an exception to the general principle that losses from investments in corporations may not be allowed in computing a net loss sustained by an individual.

Reviewed by the Board.

Decision will be entered on 15 days' notice, v/nder Bule 50.


author: Littleton: Phillips,

text:
    Appeal of Owensboro Conserve Co.
    Docket No. 3462.
    Promulgated October 8, 1927.
    1. The evidence in this proceeding is insufficient to enable the Board to determine what amount, it any, constitutes a reasonable deduction tor amortization.
    2. A net loss in 1919 of the petitioner corporation, which was affiliated with another corporation for a part of 1919, may not in the circumstances disclosed by the evidence be used to reduce petitioner’s income for 1918 under the provisions of section 204 when it is not shown whether the consolidated group suffered a net loss or whether the petitioner suffered a loss for that part of 1919 when it was required to file a separate return, even though no portion of the net loss of petitioner sustained during the calendar year 1919 was not applied against the taxable income of the affiliated group for that portion of the year 1919 during which affiliation existed.

      G. J. McGuire, Esq., and W. 0. Magathan, Esq., for the petitioner.

      John D. Foley, Esq., for the Commissioner.
    The Commissioner determined a deficiency of $43,660.34 in income and profits tax for 1918. Petitioner claims that the Commissioner erred in refusing to allow any deduction for amortization of its facilities, and in refusing to apply against its 1918 income a net loss suffered in 1919.
    FINDINGS OF FACT.
    The petitioner is a Kentucky corporation with principal office at Owensboro. It was organized and incorporated in January, 1918, by P. J. Eitter Co., a corporation.
    At that time the Eitter Company had its headquarters and a plant at Philadelphia and other plants at Bristol, Pa., Newark, Del., and Bridgeton, N. J. It was engaged in the manufacture of tomato catsup and the canning of pork and beans.
    In 1911 one Strickler had a lease upon and option to purchase the assets of the Old Blue Grass Canning Co., of Owensboro, Ky., which, was in bankruptcy. In that year the Eitter Company purchased a quantity of tomato pulp from Strickler, which was shipped from Owensboro for use in the business of the Eitter Company at Philadelphia.
    In 1918 the petitioner was incorporated and purchased the assets of the Old Blue Grass Canning Co. It issued in payment therefor its notes for $40,000 and capital stock to Strickler of the par value of $30,000. The notes were subsequently paid. The balance of its stock, $70,000 common and $100,000 preferred, was issued to the Eitter Company for $170,000 cash. The assets acquired upon such purchase were entered on the books as follows:
    Land_$7,600
    Buildings_ 57,600
    Power plant- — - 2,000
    Machinery_ 2,000
    Crates- 1, 000
    The buildings purchased were frame structures without heating facilities and could be used only during warm weather. The only machinery in the plant was that used for packing tomato pulp.
    At the time the petitioner corporation was organized the Hitter Company had Government contracts for catsup and pork and beans. It was anticipated that they would have orders to pack large amounts which could not be taken care of in their existing plants. Catsup production at the Newark plant was discontinued and the plant devoted entirely to the canning of pork and beans. Machinery was ordered for catsup production in the petitioner’s plant and five lines were received and installed prior to August, 1918, when production began. In that year three of the five lines were used continuously during warm weather and the two additional lines were used when necessary to handle the deliveries of fresh tomatoes. After 1918 only two lines were ever used.
    In June or July, 1918, petitioner ordered machinery for the manufacture of pork and beans. This was installed late in the fall and was not operated until February or March, 1919, when it was tested. It was used to some extent in 1924 and has not been used since that year.
    The petitioner took no deduction for amortization as such in the return filed for the year 1918, but on or about June 30, 1922, it filed a claim for an amortization deduction from its 1918 income in the amount of $37,882.85. Claim for refund was filed on or about July 10, 1923. The property on which such amortization was claimed, together with its cost, was as follows:

    This property includes all catsup machinery with the exception of two lines used subsequent to 1918. The pork-and-bean machinery cost $1,909.19.
    Since 1917 petitioner has sold certain of its machinery and equipment on which amortization in 1918 is claimed. The following is a complete list of the assets sold; the actual sales prices and the dates (by months and years) in which the sales were consummated:

    The petitioner has the remainder of these assets. Some of them have been dismantled.
    The production of catsup, stated in cases of 24 eight-ounce packages each, was as follows:

    The quantity of tomato pulp on hand at the close of each year, stated in units of 5-gallon cans, was as follows:

    The stock of catsup on hand at the close of each year, stated in cases of 24 eight-ounce bottles each, was as follows:

    The pulp production, stated in units of 5-gallon cans, was as followrs:

    Tomatoes must be handled very promptly after receipt and reduced to pulp. The pulp can be carried over from one year to another but not for more than one year. Contracts were made by the petitioner to purchase tomatoes from certain amount of acreage from year to year, depending upon the anticipated demand. Such contracts are made in February and March and sometimes in April.

      In 1918 a greater production was contemplated than took place. There had been shipped to the petitioner certain supplies such as bottles, sugar, and other ingredients. The cold weather came on and the plant was not heated for winter, making production impossible. These goods were held over and tomato pulp was stored until 1919 and put into catsup in that year. In 1918 the entire production took place during the tomato season, August, September, and a part of October. In 1919, due to a supply of pulp on hand from the previous year, the packing of catsup started before the tomato season opened. In 1919 there had been a general failure of the tomato crop in th& East, but not in Kentucky. The plant of the petitioner was operated during all of the warm weather in that year. Late in the fall of that year the Ritter Company, which took the entire output of the petitioner, was able to make only partial deliveries on some of its orders.
    The plant of the petitioner was operated as a branch of the Ritter Company. That company furnished all the capital, purchased all the goods produced, and dictated the production policy. After 1919 the eastern plants of the Ritter Company were able to take care of most of its business. That company sold its Newark and Philadelphia plants and at the time of the hearing was operating only the plant at Bridgeton, N. J. The Owensboro plant was not being operated. Most of the business of the Ritter Company is in and about Philadelphia.
    After the entry of the United States into the World War in 1917, the United States Food Administration issued rules and regulations governing the manufacturers engaged in the manufacture of tomato soup, tomato catsup and other tomato products, other than canned tomatoes, limiting their production and sale except sales to the United States. Manufacturers of tomato soup, tomato catsup, and other tomato products were licensed by the Government. The petitioner received such a license.
    The petitioner was affiliated with the Ritter Company from May 22, 1919, to December 81, 1919, and in subsequent years. They were not affiliated at any time prior to May 22, 1919. During the calendar year 1919, the petitioner sustained a net loss of $15,816.19. It is not known in what part of the year this loss actually occurred, i. e., whether before or after the date of affiliation between the petitioner and the Ritter Company. No part of the $15,816.19 has been taken as a deduction in computing the net taxable income of the affiliated companies.
   OPINION.

Littleton:

It is contended by the petitioner that it acquired, after April 6, 1917, buildings and machinery for the production of articles contributing to the prosecution of the war and is entitled to a reasonable allowance for tbe amortization of their cost. The Commissioner denies that petitioner produced such articles or has established any basis for the computation of a deduction. We have set out in the findings all the facts established by the record. These are obviously insufficient upon which to determine what, if any, amount could be allowed as a reasonable deduction for amortization, even if, as petitioner contends, the production of tomato catsup was the production of an article contributing to the prosecution of the war.

The claim for amortization filed with the Commissioner covered only the catsup machinery. The petitioner claimed that of the five linos of machinery installed three were no longer used after 1918. It established the cost of the machinery which went to make up these three lines and the selling price of some of such machinery. The description of the property sold is so different, however, from the description of the machinery purchased, that it is impossible intelligently to compare cost and selling price on the record before us. The petitioner still has the machinery that was not sold. There is no showing of its postwar sales value or that any efforts were made to sell it. This does not constitute a sufficient record on which to determine the issue presented. At the hearing the petitioner also claimed that it was entitled to deduct amortization on its pork-and-bean machinery. The only proof with reference to such machinery was its cost. It also claimed the right to a deduction of amortization for the building which it purchased. The only proof with respect to the building is that it was purchased with other assets for $40,000 in notes and $30,000 of capital stock and was entered upon the books as having cost $51,500.

During the calendar year 1919 a net loss of $15,816.19 was sustained by the petitioner. From May 22, 1919, to December 31, 1919, the petitioner was affiliated with the P. J. Bitter Co. It was stipulated between the parties that it is unknown whether the loss occurred prior or subsequent to May 22, 1919, but that the loss was not used to reduce the taxable income of the affiliated group for the period from May 22, 1919, to December 31, 1919. The tax liability of the affiliated group for 1919 is not before the Board. The petitioner was not affiliated with any other corporation during 1918 when it had taxable income which it now seeks to have reduced to the extent of the aforementioned net loss in 1919 under the provisions of section 204 (b), Bevenue Act of 1918, which reads in part as follows:

If for any taxable year beginning after October 31, 1918, and ending prior to January 1, 1920, it appears upon tbe production of evidence satisfactory to tbe Commissioner that any taxpayer has sustained a net loss, the amount of such net loss shall under regulations prescribed by the Commissioner with the approval of the Secretary he deducted from the net income of the taxpayer for the preceding taxable year; * * *

The petitioner contends in effect that where one corporation in an affiliated group sustains a net loss in 1919 and this loss is not for any reason used to reduce the taxable income of the group, this net loss should be used to reduce the net income in 1918 of the corporation suffering the loss in 1919. This contention is advanced without any showing as to the ultimate status of the affiliated group for the period May 22, 1919, to December 31, 1919, i. e., whether a loss or gain was realized on the combined operations of the two companies outside of the net loss in question. We find ourselves unable to concur in this contention of the taxpayer. Whether the affiliated group claimed the benefit of the net loss of the petitioner during the period of affiliation in 1919 we think is immaterial to a decision of the claim herein presented. The Revenue Act of 1918 made specific provision for the determination of the taxable income of affiliated corporations on a consolidated basis. In Farmers Deposit National Bank, 5 B. T. A. 520, the Board said:

The effect of the consolidation of two or more companies is to weld them together for the purpose of computing the tax, as though they existed, in fact, as a single business enterprise. Their separate and distinct identities are merged in the interest of their community, just as effectively, so far as concerns the determination of the income and profits taxes, as though they existed under a single charter.

Also in the same opinion “ consolidated net income ” was defined as follows:

“ Consolidated net income ” means the gross income of the affiliated group, as defined in section 233, less the deductions allowed to the affiliated group by section 234.

And further in this opinion this statement appears:

And where, in other sections of the statute, Congress speaks of corporations as individual taxpayers, it means as to the sections dealing with consolidated units to treat the consolidated unit as a single corporation.

Therefore, in the determination of the consolidated net income, losses of members of the affiliated group allowable under section 234 should be offset against income of other members of the group in the same manner that losses on one branch of a single corporation’s business may be offset against income from another branch or transaction. Whatever portion of the net loss of the Owensboro Conserve Co. was applicable to the period May 22, 1919, to December 31, 1919, during which that company was affiliated with the P. J. Ritter Co., operated under the statute to reduce the net income of the affiliated group and to that extent this petitioner is not entitled to carry that portion of its net loss so applied back to 1918 and apply it against its net income for that year, for it is not the purpose of the statute to permit a double deduction. See United States v. Ludey, 274 U. S. 295. We have heretofore treated an affiliated group of corporations as one taxpayer for the purpose of determining the net income and invested capital under the statute. In American La Dentelle, Inc., 1 B. T. A. 575, the Board said:

* * * Until the conditions underlying the application of the special provisions of this section [240, Revenue Act of 1918] exist, the section can not be operative. The two corporations must maintain their separate incidents, therefore, at least until July 1, 1919, filing separate returns with separate computations of income and profits, for this period. * * *
From July 1, 1919, however, Congress has said that the generally recognized principle of corporate identity was to be overridden for the purpose of the income and profits tax and that a consolidated return should be filed “if substantially all the stock of two or more corporations is owned or controlled by the same interests,” which is the situation here. From July 1, in other words, the separate existences ceased for tax purposes just as effectually as if under a State statute the corporations had been consolidated for all corporate purposes. A new tax status was created. * * *

See Gould Coupler Co., 5 B. T. A. 499; Farmers Deposit National Bank, 5 B. T. A. 520; G. M. Standifer Construction Corporation, 4 B. T. A. 525.

The affiliated group is one taxpayer for the purpose of determining the net income, losses, deductions and invested capital. The allocation of the tax due upon the consolidated net income to the several members of the group relates to the matter of payment of the tax by the several units of the taxpayer group or to collection of the tax by the Government from the group in proportion to the consolidated net income properly assessable to each, but the members of the consolidated group are free to agree among themselves as to who shall pay the tax. To that extent it may be said that a member of an affiliated group under section 240 of the Revenue Act of 1918 is a “ taxpayer,” but in construing the provisions of section 204 of the Revenue Act of 1918 that “if * * * it appears * * * that any taxpayer has sustained a net loss, the amount of such net loss shall * * * be deducted from the net income of the taxpayer for the preceding year ” we must look to the entire Act and apply the provisions of this section consistently with other provisions of the statute. It is not to be supposed that Congress intended that a different rule should be applied under section 204 in the case of the net loss of a member of an affiliated group than should be applied in the case of consolidated corporations under the provisions of section 240. During the period of affiliation petitioner was a branch of a single business unit and the consolidated group, if any member of it had a net income, obtained the benefit of the net loss of the petitioner in the payment of the tax for that period, and the consolidated group would also benefit through the saving of taxes by the application of the net loss of a member of the affiliated group in the reduction of the net income of such member for the preceding year when affiliation did not exist. This would seem to be contrary to the underlying purpose of the consolidated return section to prevent corporations from escaping the payment of a tax which would otherwise be due.

The Board is of the opinion therefore that before any net loss of a member of the affiliated group occurring in 1919 may be used to reduce the income, either of the group or the separate corporation in 1918, the ultimate effect of the loss on the consolidated group during the period of affiliation in 1919 when the loss occurred, must first be determined. Since it is not shown whether there was a net loss, either of the petitioner for the period January 1, 1919, to May 21, 1919, inclusive, when it was required to file a separate return, or of the affiliated group from May 22, 1919, to December 31, 1919, when a consolidated return was required, the Board is unable to determine what net loss, if any, should be used to reduce the net income of the petitioner for the calendar year 1918.

Reviewed by the Board.

Judgment will be entered for the Commissioner.

Phillips,

dissenting: Because I believe that the petitioner falls squarely within the words of the statute permitting the deduction of the net loss claimed, I find myself unable to agree with that portion of the prevailing opinion which disallows such net loss as a deduction.

It is stipulated that for 1919 the petitioner sustained a net loss of $15,816.19. Section 204 of. the Revenue Act of 1918 provides, so far as material:

If for any taxable year beginning after October 31, 1918, and ending prior to January 1, 1920, it appears upon the production of evidence satisfactory to the Commissioner that mvy taxpayer has sustained a net loss, the amount of such net loss shall under regulations prescribed by the Commissioner with the approval of the Secretary be deducted from the net income of the taxpayer for the preceding taxable year; * * *. (Italics ours.)

The term taxpayer is defined in section 1 of the statute as including “any person, trust or estate subject to a tax imposed by this Act.” By a further definition the term “person” includes corporations. This petitioner appears to meet the definition of a “ taxpayer ” and to fall squarely within the provisions of section 204 unless there is some other section which excludes it. The Commissioner contends that because during a part of 1919 this petitioner was affiliated with the Ritter Company and filed a consolidated return for a part of the year, a new taxpayer was created of the affiliated group, that so much of the net loss as occurred during the period of affiliation can not be claimed by this petitioner, and since there is nothing from which we may determine when the loss was sustained, it may not be allowed. The pertinent provisions of the statute with reference to affiliated groups are:

Sec. 210. (a) That corporations which are affiliated within the meaning of this section shall, under regulations to be prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income and invested capital for the purposes of this title and Title III, and the taxes thereunder shall be computed and determined upon the basis of such return: Provided,, * * *
In any case in which a tax is assessed upon the basis of a consolidated return, the total tax shall be computed in the first instance as a unit and shall then be assessed upon the respective affiliated corporations in such proportions as may be agreed upon among them, or, in the absence of such agreement, then on the basis of the net income properly assignable to each. * * *

While the statute provides for a consolidated return of the income of two or more taxpayers and creates a new group for the purposes of computing the income, it still leaves the tax liability with the separate corporations forming the group. Although for a part of 1919, petitioner was a part of such an affiliated group, it was still “ a person subject to a tax imposed by this Act ” and as such is entitled to the deduction which is given in express terms to all taxpayers.

I appreciate that there may result a deduction of the same loss by the petitioner in 1918 and by the affiliated group in 1919 and that such a result should only be reached if expressly authorized by the statute. In this case it appears that the terms of the statute are clear, that this taxpayer falls squarely within them, and that the deduction of the net loss suffered by it in 1919 should be allowed in 1918. It may well be that Congress did not have this situation in mind and would have provided otherwise had the matter been expressly called to its attention. It is not our province, however, to deny by statutory construction a deduction given to a taxpayer by the express terms of the taxing statute.