text:
    Frederick Davis Van Sicklen, Horace Davis Van Sicklen and Wells Fargo Bank and Union Trust Co., Executors of the Last Will and Testament of Frederick W. Van Sicklen, Deceased, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 82545.
    Promulgated January 21, 1937.

      Marshall P. Madison, Esq., and Gerald S. Levin, Esq.,- for the petitioners.

      John D. Kiley, Esq., for tbe respondent.
   0TINI0N.

Smith :

This is a proceeding for the redetermination of a deficiency in estate tax in the amount of $2,995.78. The xietition alleges that the respondent made the following errors in the determination of the deficiency:

(a) In determining that the property acquired jointly by means of community earnings of Frederick W. Van Sicklen and an inheritance of Mrs. Frederick W. Van Sicklen, which appears as item 1 in Schedule D-l in the estate tax return, Form 706, filed with the Collector of Internal Be venue in San Francisco, California, on or about September 22, 1934, the Commissioner erroneously determined that said property is entirely taxable to the estate of the decedent, in the amount of $10,000.
(b) In determining the transfer under that certain agreement of April 1, 3918, between Frederick W. Van Sicklen and Union Trust Co. of San Francisco (now Wells Fargo Bank & Union Trust Co.), referred to in Schedule E of the estate tax return, Form 706, filed with the Collector of Internal Revenue in San Francisco, California, on or about September 22, 1934 (a copy of which said agreement is hereto attached and marked Exhibit “C”), the Commissioner erroneously determined that the transfer under the provisions of section 302 (c) of the Revenue Act of 1928 [1926], as amended, was made in contemplation of death and/or to take effect at or after death, and therefore the value of the trust property in the sum of $20,068.20 is taxable , as part of the gross estate.

The petitioners submitted no evidence in support of'tlieir first allegation of error and it must be deemed to have been waived. The material facts were all stipulated.

On April 1,1918, tlie decedent, as trustor, and the Union Trust Co. of San Francisco, California, as trustee, entered into a written agreement whereby the trustor transferred to the trustee $30,000 in, Libert}*- bonds and $20,000 of other bonds for the trustee to manage and control and, on the first days of January, April, July, and October of each year, to pay all the income from the corpus to the trustor’s daughter, Hilda Van Sicklen, during her life. If and when Hilda Van Sicklen should reach the age of 50, the trustee upon a written request was to pay her, in addition to the income, up to $2,500 a year out of the corpus. Upon her death the trustee was to pay the proceeds to her then living children, if any, and to the children of any deceased child, if any, by right of representation. The trust instrument, so far as material, provided as follows:

The said Trustee is to manage and control the said property and shall have power, with the consent of Hilda Van Sicklen, the daughter of the Trustor, hereinafter called the Beneficiary, and the consent of the Trustor during his life, and of H. D. Pillsbury, of San Francisco, after his death, to sell and dispose of any or all of said property as in its discretion it shall deem most beneficial, and the said Trustee shall reinvest the proceeds of the sale of any such property in first class securities as in its discretion it shall deem best, but only in such securities as shall meet with the approval of said Beneficiary and the Trustor during his life and of said H. D. Pillsbury after his death.
The said Trustee is to pay on the first days of January, April, July and October of each year, during her life, the net income from said property to said Beneficiary, and upon the request in writing of said Beneficiary, from and after the date she attains the age of fifty years, the Trustee shall pay to her each year from the trust property then in its hands, the sum requested hy her, but not exceeding in any year the sum of Twenty-five Hundred Dollars (,$2500.), said payment so made at the request of said Beneficiary to be in addition to the income paid to her during each year.
Upon the death of the said Beneficiary the trust hereby created shall at once cease and determine and all of the property hereby conveyed to the said Trustee, and the subject of this trust, shall at once go and belong in equal shares to any children of the said Beneficiary then living, should she hereafter marry and have children, and in ease any such child shall have then died leaving issue, his or her share shall at once go and belong to- such issue in equal shares by right of representation.
In the event that the said Beneficiary shall die without marrying and without leaving issue, then the trust hereby created shall at once cease and determine and all of the property hereby conveyed to the said Trustee, and the subject of this trust, shall at once go and' belong to the said Trustor, and, in the event of his death prior to such time, to the estate of said Trustor, and shall be distributed to the legatees or devisees under his will, or shall vest in his heirs at law according to the provisions of the law of succession as they now exist in the State of California.
It is expressly Agbeed, and a condition of this trust, that the said Beneficiary shall have the right by an instrument under her hand, acknowledged according to the laws of the State of California, delivered to the said Trustee, and with the consent in writing of the Trustor, or of said H. D. Pillsbury, to revoke this deed of trust, whereupon the property then in the hands of the Trustee hereunder shall at once go and belong to the said Beneficiary, free and discharged from said trust; and the said Beneficiary shall also have the right, by an instrument under her hand, similarly acknowledged and delivered, and consented to by either said Trustor or said H. D. Pillsbury, from time to time to amend this deed of trust in such manner as they shall deem proper.
In the event of the death of either said Trustor or H. D. Pillsbury, the said Beneficiary shall have the right, by an instrument in writing, delivered to the said Trustee, with the consent of the survivor, to name a successor, who shall take the place in all respects hereunder, and with like powers to consent to revocation and amendment hereof, as enjoyed by said Trustor or said H. D. Pillsbury, so deceased, and in the event of the death of both said Trustor and said IT. D. Pillsbury, or of their successors without naming a successor to act with said Beneficiary, as herein provided, then the Trustee shall have the power to name, with the consent of said Beneficiary, such successor, who shall, when named, have all the powers herein granted to said Trustor and said H. D. Pillsbury.
The Trustee shall charge for its services as Trustee hereunder the sum of Thirty and no/100 Dollars ($30.00) per year for' each year during which this agreement shall be in force, such compensation to be due and payable on the first day of October of each year.

Pursuant to the above agreement the property described therein was delivered by Frederick W. Van Sicklen, the trustor, to the Union Trust Co. of San Francisco, trustee. The trust agreement has remained in force and effect up to the present time. Hilda Van Sicklen, the life beneficiary, survived the trustor, who died on March 6, 1934, and is still living.

In the Federal estate tax return filed by the executors on behalf of the estate of Frederick W. Van Sicklen no value was included in the gross estate in respect of tire trust property described above. In bis deficiency notice herein the respondent has included the property in the gross estate at a value of $20,068.20, which was arrived at as follows:

Gross value of tlie property transferred-$72,818. 85
Less value of fund to produce $2,500 per year for life of a person 50 years of age; factor 12.47032 x $2,500=- 31,175. 80
Thic remainder is subject to the life estate of the sister [daughter), aged 50 years at date of the decedent’s death. Factor .48191 x $41,643.05=_$20,068. 20

The value of the trust property as determined by the respondent is admitted to be the correct value- provided any amount representing such value is to be included in the gross estate.

At the time the trust was created the life beneficiary, Hilda Van Sicklen, was 36 years of age, was not married, and had no issue. At the date of the decedent’s death, March 6, 1934, she was 52 years of age, not married, and without issue.

In this proceeding the resjiondent has made no contention in the deficiency notice or in his brief that the property transferred by the decedent to the trustee under the agreement of April 1, 1918, was made in contemplation of death. His entire argument is that it was made “to take effect at or after death.” In view of the fact that the transfer was made approximately 16 years prior to the date of death of the decedent, and of the further fact that the stipulation of facts and the briefs are silent upon the point, it must be deemed that the transfer was not made in contemplation of death.

The statute involved in this proceeding is section 302 (c) of the Revenue Act of 1926, as amended by section 803 of the Revenue Act of 1932, which reads in part as follows:

Sec. 302. The value of tbe gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated—
v * * * * * #
(c) To the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, in contemplation of or intended to take effect in possession or enjoyment at or after his death, including a transfer under which the transferor has retained for his life or any period not ending before his death (1) the possession or enjoyment of, or the income from the property, or (2) the right to designate the persons who shall possess or enjoy the property or the income therefrom; except in case of a bona fide sale for an adequate and full consideration in money or money’s worth. * * *

The pertinent question presented by this proceeding is, Did the possibility of a revestment of the trust property in the testator in the event that the life beneficiary predeceased the testator, without marrying and without leaving issue, make the transfer one intended to take effect in possession or enjoyment at or after death” within the meaning of section 302 (c) above quoted? We are of the opinion that this question must be answered in the negative upon the authority of Helvering v. St. Louis Union Trust Co., 296 U. S. 39. In the course of its opinion the Court stated:

* * * After tlie execution of the trust he [testator] held no right in the trust estate which in any sense was the subject of testamentary disposition. His death passed no interest to any of the beneficiaries of the trust, and enlarged none beyond what was conveyed by the indenture. His death simply put an end to what, at best, was a mere possibility of a reverter by extinguishing it; that is to say, by converting what was merely possible into an utter impossibility. This is well stated by the court below, 75 F. (2d) 416, at page 418: “ It was only in the case of the happening of certain contingencies over which he had no control that the property would revert to him. One of these contingencies was the death of his daughter prior to his death, while the trust still continued; and the second was a termination by the trustee of the trust during the lifetime of the grantor. Neither of these contingencies occurred, and there was, during the decedent’s lifetime, nothing more than a possibility that either would occur. In no proper sense was there an enlargement of the interests of the beneficiaries of the trust resulting from the death of the decedent. That event merely changed the possibility that the property would revert to him into an impossibility.”
It is not, in reason, possible to find in the circumstances anything which suggests that the death of the grantor, whenever it might happen, would effect any change, or was intended to effect any change, in the extent or quality of the estates conveyed in trust. The. only death which could have had any such effect was that of the daughter, the grantee; and that event did not taire place.

Although the facts in the above case differ from those in the case at bar in that the remaindermen there were named in the trust instrument, the reasoning of the Supreme Court in that case is equally applicable in this proceeding. Just as in that case, the testator here retained no right in the trust estate, after the execution of the trust instrument, which was the subject of testamentary disposition. His death enlarged no interest of any of the beneficiaries beyond what was conveyed by the trust indenture.

To the same effect is St. Louis Union Trust Co. v. Becker (C. C. A., 8th Cir.), 76 Fed. (2d) 851; affd., Becker v. St. Louis Union Trust Co., 296 U. S. 48.

Another case in which the facts are closely analagous to those in the proceeding at bar is Nanaline H. Duke et al., Executors, 23 B. T. A. 1104. In that case two trusts had been created by the decedent, by the terms of which the income was to be paid' to Doris Duke, a daughter of decedent, for life, for the benefit of herself and any child or children and descendant or descendants of Doris Duke. Both trust instruments provided that if Doris Duke should die after the death of the trustor, leaving no child or children or descendant or descendants surviving her, the trusts should cease and determine and the trust properties should be distributed in accordance with the provisions of any will of Doris Duke, or, if she should leave no will, in accordance with the statutes of New Jersey covering the descent of real property to and among those who would have inherited the properties had the trustor died intestate and owning the same. In that case the Board said:

We see no basis for the contention of the respondent that the transfer of the property was contingent. The property was clearly transferred from the decedent, by the trust instruments. As above set out, the fact that he was trustee is of no importance. Any uncertainty or contingency as to who might eventually receive the trust corpus as the result of the named beneficiary dying or the fact that under a certain contingency the legal heirs of decedent might receive the property does not indicate that the decedent had not parted with the proi>erty and all economic benefits thereof in his lifetime. We can not overlook the plain fact that the decedent did not own the property or any economic benefits therein when he died or the fact that no economic interests or benefits therein passed at his death. The entire disposition of the property in so far as the decedent was concerned was completed during his lifetime. The death of the decedent was not the generating source of any right in any beneficiary. Nothing moved from him on his death in so far as the property here involved is concerned. It is unimportant that under certain circumstances other or different beneficiaries might eventually, pursuant to the trust instrument, receive the corpus.

The respondent contends that the facts in the above cited cases are in each instance distinguishable from those in the proceeding at bar and that the decisions are not decisive of the issues involved. He calls attention to the fact that at the date of the decedent’s death, March 6,1934, the beneficiary of the trust created April 1, 1918, was 52 years of age, that she had no children, and that she was unmarried. He then submits:

* * * the stipulated facts disclose that the beneficiary of the trust was 52 years of age at the date of the decedent’s death and was unmarried and had no children. Under these facts was title to the trust property affected by decedent’s death? Certainly it was. * * *

He further submits that “The death of the decedent passed an immediate vested interest or title in the trust property to the heirs of the decedent.”

It can not be assumed legally that a woman of the age of 52 years is incapable of having issue. Cf. United States v. Provident Trust Co., 291 U. S. 272.

Under the terms of the trust instrument the testator parted with every vestige of control over the beneficial enjoyment and possession of the trust property when he transferred the same to the trustee. The trust instrument provides:

It is expressly Agbeed, and a condition of this trust, that the said Beneficiary shall have the right by an instrument under her hand, acknowledged according to the laws of the State of California, delivered to the said Trustee, and with the consent iu writing of the Trustor, or of said H. D. Fillsbury, to revoke this deed of trust, whereupon the property then in the hands of the Trustee hereunder shall at once go and belong to the said Beneficiary, free and discharged from said trust; and the said Beneficiary shall also have the right, by an instrument under her hand, similarly acknowledged and delivered, and consented to by either said Trustor or said H. D. Pillsbury, from time to time to amend this deed of trust in such manner as they shall deem proper.

By virtue of this provision tRe beneficiary might at any time, either before or after the death of her father, with the consent of H. D. Pillsbury, or of some other person appointed in his place, take the trust property free and discharged of the trust. This power was vested in the beneficiary from the time of the execution of the trust instrument and still remains in her. In the light of this fact it can not be said, as is contended by the respondent, that “the death of the decedent passed an immediate vested interest or title in the trust property to the heirs of the decedent.”

The estate tax is imposed upon the value of the interest of the decedent which ceased by reason of death. In the proceeding at bar the decedent had no interest in the trust property which ceased by reason of his death. The action of the respondent in including in the gross estate of the decedent any amount representing the claimed value of the interest of the decedent in the trust property is reversed

Judgment will be entered imder Rule 50.


source: Caselaw Access Project

author: Smith :

license: Public Domain

text:
    Sara R. Preston, Petitioner, v. Commissioner of Internal Revenue, Respondent. John W. Preston, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 74559, 74560.
    Promulgated January 21, 1937.

      AdoVphus E. Graupner, Esq., for the petitioners.

      Ralph E. Smith, Esq., and T. G. Mooney, Esq., for the respondent.
   OPINION.

Smith :

These proceedings, consolidated for hearing, involve income tax deficiencies for 1930 as follows:

Since J anuary 8,1902, the petitioners have been husband and wife, domiciled within the State of California.

In his income tax return for 1930 John W. Preston reported that he:

* * * Collected during 1930 a/c fees for personal legal services rendered prior to closing law office [December, 1926], the following: Case — Preston v. Hermingliaus, 49,123.10' — 'Rowlands ease, 1,000 — Bullard case, 68.25 — Total, 50,191.35.

On the face of the return the above mentioned $50,191.35 was reported as “Income from Business or Profession.” The net income was returned as $31,460.35. He claimed that he was taxable upon only one-half of that amount, $18,733.18, and computed his tax liability upon the basis of that amount of net income.

Sara R. Preston in her return showed gross income of $18,733.17, one-half of the net income shown on her husband’s return, less contributions of $300, or a net income of $18,433.17, upon which the tax liability was computed.

In the determination of the deficiency the respondent added to the net income reported by Sara R. Preston $29,087.86 which the respondent contends was constructively received by John W. Preston during the year, and determined a deficiency of $3,572.10 accordingly.

In the determination of the deficiency due from John W. Preston the respondent added to the net income shown on the return $58,175.72 representing income constructively received, although one-half of this amount was added to the net income of Sara R. Preston in the determination of the deficiency against her, and also $18,733.17 reported as income by the wife, on the ground that that amount was not community income.

The returns were both made on the cash receipts and disbursements basis.

Sara R. Preston contends that the respondent erred in adding any amount to the net income reported by her on her return. John W. Preston contends that the respondent erred in adding to his net income $58,175.72 which the respondent determined was constructively received by him and also erred in adding to his income any part of the $18,733.17 reported by the wife. He also contends that minor errors were made by the respondent in the determination of the deficiency, which will be noted below.

The material facts bearing upon these cases are contained in a lengthy written stipulation of facts signed by counsel for both parties.

From January 1,1928, to December 24,1920, John W. Preston and Robert Duncan, both attorneys at law, were engaged in the practice of law in California as copartners under the firm name of Preston & Duncan. The copartnership was dissolved on or about December 24, 1926, by reason of the fact that John W. Preston had been elected an associate justice of the Supreme Court of California. Pie entered on his duties as associate justice on December 27, 1926, and held such office continuously thereafter until October 1, 1935. '

During 1924 John W. Preston and James F. Peck, attorneys, were employed by oral agreement by three individuals, hereinafter called the “Herminghaus heirs”, to represent them. On October 8, 1925, the terms of the oral agreement of employment between John W. Preston and James F. Peck were reduced to writing and signed by the parties. It was understood between all parties concerned that Robert Duncan might assist in the rendering of the legal services. There was an agreement between Preston and Duncan that Duncan was to be paid one-half of all amounts of money received by Preston from the Herminghaus heirs under the contract of employment, after deduction of expenses incurred and paid by Preston thereunder. Subsequent to the dissolution of the partnership between Preston and Duncan on or about December 24,1926, Duncan continued to render and perform services under the contract.

During November, or the early part of December, 1926, the attorneys, Preston and Peck, secured q>ayments to the Herminghaus heirs of $260,000. From this amount the Plerminghaus heirs paid to Preston and Peck the sum of $35,000 on account as follows:

December 26, 1926_$12, 000
June 25, 1927_ 8,000
July 24, 1927_ 15,000

All of said amounts were paid by checks made payable jointly to “James F. Peck and John W. Preston” and delivered to John W. Preston, who endorsed them and deposited them in his personal bank account, and divided the amounts thus received, one-half to James F. Peck and the other half in equal shares to Robert Duncan and himself.

Subsequent to July 29, 1927, and on or about November 1, 1927, the Herminghaus heirs, without consulting Preston or Peck, sold the lands which were the subject of the litigations to a subsidiary of the Southern California Edison Co. The question immediately arose as to the fees to which Preston and Peck were entitled under their contract. No settlement of such dispute being otherwise obtainable, Preston and Peck employed Theodore M. Stuart to bring suit against the Herminghaus heirs for a recovery of the fees due them under the contract. Judgment was rendered in their favor, which was affirmed by the Supreme Court of the State of California on November 1, 1930. Preston v. Herminghaus. 211 Cal. 1; 292 Pac. 953.

On December 9,1930, the Herminghaus heirs delivered to John W. Preston a check made payable jointly to John W. Preston and James F. Peck in the amount of $311,447.65 in satisfaction of the above mentioned judgment and in payment of the final legal services rendered by John W. Preston, James F. Peck, and- Robert Duncan under the terms of the contract. The judgment was rendered in the amount of $314,597.65, but from the total was deducted $3,150 which represented $2,500 theretofore paid by the Herminghaus heirs to John W. Preston and $650 interest thereon. In his income tax return for 1930 John W. Preston did not report the receipt of any part of the $2,500. John W. Preston admits, however, that the $2,500 deducted from the face of the judgment, as above indicated, constitutes taxable income to him for 1930. (He contends that if the $650 should be included in his gross income he is entitled to a deduction of a like amount representing interest paid on indebtedness.)

Upon the receipt of the check for $311,447.65 on December 9,1930, John W. Preston endorsed on the back thereof his own name and that of James F. Peck and attempted to deposit the same to his personal account in the Crocker First National Bank of San Francisco for division between Peck and himself in the proportion of one-half to Peck, and one-half to himself for himself and Duncan, as had been theretofore done with the $35,000 hereinabove mentioned. The bank declined to accept the check for deposit or to credit the amount to the account of Preston on such endorsement and requested the personal signature of James F. Peck as endorsement on the check before it would credit the amount to the account of John W. Preston. Preston thereafter, and on the same date, caused the check to be presented to James F. Peck with the request that he endorse the same in order that it might be deposited in bank and the amount thereof divided.

When the check was presented to James F. Peck for his endorsement Peck took possession of it, endorsed his name thereon, and deposited the same in the Crocker First National Bank of San Francisco to the joint account of himself and John W. Preston under terms of deposit which would not permit the withdrawal of the funds of said joint account except on the signatures of both James F. Peck and John W. Preston.

When the check was so delivered to, endorsed by, and deposited by James F. Peck he knew that John W. Preston claimed one-half of the amount thereof. Peck claimed two-thirds of the amount of the check and also two-thirds of the amount of $3,150 credited by the Herminghaus heirs to Preston as above set forth.

After the deposit had been made Preston, on December 9, 1930, called at the office of Peck in San Francisco and demanded an equal division and distribution of the amount of the check which had been deposited. Peck refused and rejected the demand of Preston and informed Preston that he would not consent to the distribution of any amount of the deposit to Preston in excess of one-third of the amount of the check less two-thirds of the amount of $3,150 credited by the Herminghaus heirs to Preston as above set forth, or $2,100. At the same time Peck insisted on his right to receive two-thirds of the sum of $311,447.65 plus $3,150, or $209,731.76, and refused to recognize the right of Preston to receive from the deposit any amount greater than $101,715.89.

On December 11, 1930, Preston again called upon Peck at his office and again demanded the division and distribution of the amount of $311,447.65 on joint deposit as aforesaid. Peck again refused to consent to a division and distribution upon any other terms than the two-thirds basis hereinabove set forth. Thereupon Preston proposed that pending adjustments of the controversy checks be drawn upon the account to the amount of $200,000, one check to Peck in the amount of $100,000 and one in favor of Preston in the amount of $100,000. Peck assented to such proposal and thereupon a check in favor of each was drawn upon the joint account in the amount of $100,000. Preston immediately deposited the check drawn in his favor to the credit of his individual account in the Crocker First National Bank.

Approximately $2,000 in interest was credited to the joint account from the date of the deposit to March 1, 1932. In 1932 Peck was indebted to the Crocker First National Bank and by agreement between Preston and Peck $37,803.33 of the amount in the joint account was applied by the bank in satisfaction of Peck’s indebtedness. On May 11, 1934, Peck was permitted to withdraw an additional $550. On March 25, 1932, Theodore M. Stuart levied an attachment against the joint account in the amount of $73,402.26 to secure the payment of any judgment he might recover against Preston and Peck for legal services performed by him in obtaining the judgment against the Herminghaus heirs in the amount of $314,-597.65. The attachment remained in force until about January 18, 1935, on which date the amount of $55,984.83 was paid out of the joint account in full satisfaction of a final judgment with interest thereon rendered in favor of Stuart and against Preston and Peck.

On November 25,1935, John W. Preston and Adele McM. Duncan, as assignee of Robert Duncan, who died in 1929, brought an action in the Superior Court of the State of California in and for the City and County of San Francisco against James F. Peck and the Crocker First National Bank of San Francisco to determine the respective rights of the parties to the balance of the money then remaining in the bank to the credit of the joint account and also to recover from Peck the amount of $11,848.15, together with interest, which the plaintiffs in the case alleged to be due them in excess of the balance remaining in the bank account on account of the share in the deposit of $311,447.65 to which the plaintiffs claimed right. On December 2, 1935, Preston, on behalf of himself and Adele McM. Duncan, and Peck agreed to compromise the above mentioned action upon the following terms: Peck was to receive $5,478.56 of the balance of $12,498.96 then remaining in the joint bank account, and Preston was to receive $5,478.56 plus an additional amount of $1,541.93 as reimbursement for court costs and expenses previously advanced by him from his personal funds.

When John W. Preston, on December 11, 1930, received $100,000 cash from the joint account he immediately turned over to Adele McM. Duncan, assignee of Robert Duncan, the sum of $50,000. The respondent admits that this was a legal deduction from the portion of the fee received by Preston. The respondent also admits that $1,753.81 of the amount received by Preston represented a reimbursement for moneys advanced by Preston and did not constitute a receipt of taxable income. Upon the $2,500 that had been advanced by the Herminghaus heirs to John W. Preston there was a charge for interest of $650. If Preston is chargeable in 1930 upon the $2,500 plus the accrued interest thereon payable by Preston in the amount of $650, that amount is a legal deduction from Preston’s income as interest paid upon indebtedness in 1930. The essence of the respondent’s contention is that Preston is liable to income tax in 1930 on account of the Herminghaus fee as follows:

One-lialf of judgment of $314,597.05-$157, 298. 82
X.ess:
Reimbursement legal expenses-$1,753. 81
Interest on indebtedness- 650. 00
Payment to A. M. Duncan_ 50, 000. 00
. - 52,403.81
Balance. 104, 895. 01

Petitioners, on the other hand, contend that the amount taxable to both of them should be determined as follows:

Cash received December 11, 1930_$100, 000. 00
Payable to Adele McM. Duncan_ 50, 000. 00
Gross share of John W. Preston_ 50, 000. 00
Deduct for reimbursement for advanced costs and expenses- 1,753. 81
Net of check for $311,447.65 returnable by Preston- 49, 246.19
Add credit to Preston by Herminghaus heirs_ 3,150. 00
Total_ 52,390.19
Deduct amount of interest included in said credit- 650. 00
Taxable net income John W. Preston for 1930_ 51, 746.19

The petitioners also contend that the above mentioned $51,746.19 constitutes community property under the California law and that only one-half of the amount is taxable income of each spouse.

The first question for consideration is whether the petitioners are chargeable to income tax in 1930 upon an amount in excess of $51,-746.19 in respect of the Herminghaus fee. In his deficiency notice the respondent states:

* * * in order to protect the interest of the Government, pending final settlement of the dispute relative to proper division of the fee, one-half of the total has been held to have been constructively received by you during the taxable year. * * *

In his brief the respondent submits that “The receipt in 1930 by the petitioner of a check in satisfaction of a judgment for legal fees constituted receipt of income in that year by the petitioner to the extent of his interest therein.” The respondent does not, however, state what Preston’s interest in the judgment amounted to. The stipulation of facts filed in these proceedings provides:

8. During the period in which services were to be performed under the above mentioned oral and written contracts said Robert Duncan rendered services as attorney in all matters required to be performed thereunder. Such services were performed under agreement between said Duncan and said John 'W. Preston that said Duncan was to receive from and be paid by said Preston one-half of all amounts of money received by said Preston from said “Herminghaus heirs” under said contracts of employment, after deduction, of expenses incurred or paid by said Preston thereunder. Subsequent to the dissolution of the aforesaid partnership of Preston & Duncan on December 24, 1926, said Duncan continued to render and perform services required by said contract. Payments under said agreement were made to said Duncan by said Preston as hereinafter set forth.

It also appears from the stipulation of facts that:

* * * On November 25, 1935, said John W. Preston and Adele McM. Duncan, as assignee of said Robert Duncan, brought action No. 262,507 in the Superior Court of the State of California, in and for the City and County of San Francisco, against said James F. Peck and The Crocker First National Bank of San Francisco to determine the respective rights of said parties to the balance of said money then remaining in said Bank to the credit of said joint account and, also, to recover from said Peck the amount of $11,848.15, together with interest, which the plaintiffs in said action alleged to be due to them in excess of the balance remaining in said bank account or account of the share in said $811,447.65 to which said plaintiff’s claimed right. * * *

From the above, apparently Preston never had more than a one-fourth interest in the fees to be received from the Herminghaus heirs. In any event the stipulation of facts is to the effect that Preston accounted to Duncan or to Duncan’s assignee for one-half of any portion of the fees ever received by him from the Herminghaus heirs.

The petitioners herein kept their books of account and made their income tax returns upon the basis of cash receipts and disbursements. In such returns they are required to include in taxable income not only the amounts of cash income received, but also items of income in the form of property that are the equivalent of cash. In Percy K. Hexter, 8 B. T. A. 888, at page 896, we said:

When a taxpayer keeps bis accounts and renders bis returns on the basis of cash receipts and disbursements, the tax is levied only upon gains, profits and income received in money or in that which is the equivalent of money, that is, something having an exchangeable or reasonable market value.

Checks are deemed the equivalent of money and are taxable when received. Gustav W. Lembeck, 16 B. T. A. 250; Avery v. Commissioner, 292 U. S. 210.

In John A. Brander, 3 B. T. A. 231, 235, we said:

* * * When taxable income is consistently computed by a citizen on the basis of actual receipts, a method which the law expressly gives him the right to use, he is not to be defeated in his bona fide selection of this method by “construing” that to be received of which in truth he has not had the use and enjoyment. * * * [Italics supplied.]

In Eisner v. Macomber, 252 U. S. 189, the Supreme Court defined income as:

* * * not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being “derived" — that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal — that is income derived from property. Nothing else answers the description.

In Commissioner v. Darnell, Inc., 60 Fed. (2d) 82, it was held that income not actually received during the taxable year, and where right to the receipt has not been definitely fixed, is not taxable) income of the year.

In Commissioner v. Cleveland Trinidad Paving Co., 62 Fed. (2d) 85, the court stated:

In Commissioner v. R. J. Darnell, Inc., 60 F. (2d) 82, 84, we reviewed practically all of tlie autliorities now cited to us and came to the conclusion that as to both income and permissible deductions “it is the fixation of the rights of the parties that is controlling.” In Lucas v. American Code Co., 280 U. S. 445, 449, 50 S. Ct. 202, 203, 74 L. Ed. 538, the Supreme Court expressed the same thought in saying: “Generally speaking the income tax law is concerned only with realized losses, as with realized gains.” And in Burnet v. Logan, 283 U. S. 404, 413, 51 S. Ct. 550, 563. 75 L. Ed. 1143, it is said: “Conversely, a promise to pay indeterminate sums of money is not necessarily taxable income.” In MacLaughlin v. Alliance Ins. Co., 286 U. S. 244, 249, 52 S. Ct. 638, 539, 76 L. Ed. 1083, it is said that “realization of the gain is the event which calls into operation the taxing act.” Again, in North American Oil Consolidated v. Burnet, 286 U. S. 417, 423, 52 S. Ct. 613, 615, 76 L. Ed. 1197, it is held that the taxpayer “was not required in 1916 [the year in which profits were earned and paid to a receiver] to report as income an amount which it might never receive.” * * *

In Stoner v. Commissioner, 79 Fed. (2d) 75, it was held that a stockholder’s share of an amount deposited, out of proceeds of the sale of corporate stock by a stockholder who acted on behalf of all the stockholders, as an indemnity fund to insure buyer of the fulfillment of the seller’s obligations, was not taxable income of the year so deposited, since such stockholder had only qualified possession and control of the whole fund, and was not entitled to his share until the terms of the contract were fulfilled. Certiorari denied, 296 U. S. 650.

The respondent, in support of his contention that Preston is taxable upon the amount of his interest in the fund deposited to the joint account of Preston and Peck, relies upon many decisions of the Board and the courts. We have carefully considered these cases, but find that they are not strictly in point. Thus in James M. Butler, 19 B. T. A. 718, the facts were that a taxpayer received a check in 1925 from the' executor of an estate for legal services on behalf of the estate. The executor informed him that certain matters of the estate had not been settled and that the petitioner might have to pay back a part of the check given for $15,000. Butler therefore held such check unendorsed until January 1926, at which time he was informed by the executor that there -was no possibility that any part of the amount paid him would have to be repaid. The check was cashed in 1926. We held that Butler wras liable to income tax in 1925 upon the check received. To the same effect is Board v. Commissioner, 51 Fed. (2d) 73. In Hans Pederson, 14 B. T. A. 1089, the facts were that a taxpayer entered into a contract for construction of certain ships. An initial payment was made under the contract in 1918, amounting to $209,420.30. Subsequently, the taxpayer was denied permission by the United States Shipping Board to construct the ships contracted for. The contract was canceled and suit was brought to recover from Hans Pederson the amount which had been paid to him. The litigation was terminated in 1921, at which time it was determined that the taxpayer was entitled to retain $96,630.50. In our opinion we said:

* * * Looking to what actually occurred, we find that petitioner was in possession and claiming the ownership of this sum long prior to the taxable year 1921, and that the final judgment confirmed his right thereto. Under these circumstances we are compelled to hold that respondent erred in including this income in petitioner’s gross income for the year 1921. * * *

In the last named case, and in numerous others cited by the respondent, the Board has held that where a taxpayer actually received money or property under a claim of right the taxpayer is liable to income tax upon the amounts received even though at a later date a portions of the money had to be refunded. Those cases are, however, distinguishable from the one at bar. The facts in this case are clear that Preston did not have the use and enjoyment in 1930 of any portion of the check received and made payable to Preston and Peck except to the amount of $100,000. Preston tried to get, in 1930, the joint payee to make a division of the check. The joint payee refused. Of the check deposited to the joint account the money that was not actually distributed to Preston in 1930 was beyond the control and enjoyment of Preston to just as great an extent as though the Herminghaus heirs had not paid it in 1930. The realized gain to Preston in 1930 was no amount in excess of that upon which he admits he is taxable, namely, $51,746.19.

In support of his position that Preston is taxable upon a greater amount the respondent cites North American Oil Consolidated v. Burnet, 286 U. S. 417. We are of the opinion, however, that that opinion supports Preston’s contentions and not those of the respondent. In the course of its opinion the Court stated:

* * * If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.

If Preston had received any part of the check made payable to himself and Peck “without restriction as to its disposition” he would undoubtedly be taxable upon such amount in the year 1930. But the evidence abundantly shows that all that he could receive out of the payment made by the Herminghaus heirs for his separate use and enjoyment in 1930 was the amount which he admits he received, namely, $51,746.19.

The respondent contends that if Preston is not taxable upon a greater amount such a result:

* * * would place within the hands of the taxpayer the power to select the year in which income subject to dispute shall be taxable to him. Instead of agreeing with Peck to receive $100,000 each in 1930 from the proceeds of the check, the petitioner could have agreed to receive any lesser sum, and by determining from time to time with Peck the amount to be distributed to each could select not only the year in which the income is to be taxed to him but also the amount. Such a result does violence to the position consistently adhered to that it is not open to taxpayers to postpone the incidence of taxation. Heinz v. Commissioner, (C. C. A. 5th, 1934) 70 F. (2d) 461; Newman v. Commissioner (C. C. A. 10th, 1930 ) 41 F. (2d) 743. * * *

The facts in the instant proceedings do not show an attempt on the part of either Preston or Peck to postpone the incidence of taxation.- The case before us must be decided upon realities and not 'upon hypotheses. Preston is taxable in 1930 only upon the amount of income received to his “separate use.” Eisner v. Macomber, supra. He did not in 1930 receive to his separate use an amount in excess of $51,746.19, the amount upon which he admits he is taxable.

Preston makes the further contention that the receipt of the $51,746.19 in 1930 was the receipt of community income and that only one-half of that amount constitutes taxable income to him.

The judgment recovered by Preston and Peck for legal fees in connection with the Herminghaus litigation was recovered under a contingent fee contract entered into October 8, 1925, between the Herminghaus heirs and Preston and Peck. The services rendered by petitioner Preston under that contract were all performed prior to December 27, 1926, when he qualified and entered upon his office as an associate justice of the Supreme Court of the State of California. Only community property acquired after July 29, 1927, the effective date of section 161 (a) .of the Civil Code of California, is taxable one-half to the husband and one-half to the wife. Preston contends, however, that the fees were earned as a result of the judgment entered by the Supreme Court of California on November 1, 1930, that such judgment represented damages for breach of contract by the Herming-haus heirs, and that Preston’s interest in the fees received constituted community property under the laws of California. Such is not, however, the case. See Preston v. Herminghaus, supra. The judgment was for fees due under the contract, plus interest.

The Board has consistently held that the test of when property is acquired for (the purpose of determining whether or not it is community or separate property is not the time of the vesting of the property in the husband or receipt of the income therefrom, but the time of the inception of the rights whereby income is earned. See John M. King, 26 B. T. A. 1158; affd., 69 Fed. (2d) 639; Helen N. Winchester, Administratrix, 27 B. T. A. 798; Gouverneur Morris, 81 B. T. A. 178; Albert J. Houston, 81 B. T. A. 188. The controlling principle is that as between husband and wife:

* * * when a right, legal or equitable, is acquired whether before or during marriage, all things of value into which the initial right develops by the performance of conditions, the running of time or the like, or into which it is converted by an assignment, or, if the initial right rests in obligation, all that which is obtained through the performance, discharge, satisfaction, enforcement or assignment of the obligation, are deemed in law to have been acquired as of the date of the acquisition of the initial right, and take the character, as separate or common, of that right. [Community Property — McKay, §517.]

Preston performed services for which he received a part of the Herminghaus fee prior to July 29, 1927, the effective date of section 161 (a) of the Civil Code of California. He performed no services under the contract after that date. Since Preston would have been taxable upon the fees if they had been received prior to the effective date, he is likewise taxable upon those received after that date; for the amendment to the Civil Code did not serve to change separate property into community property.

We are therefore of the opinion that John W. Preston is liable to income tax in 1930 upon the entire amount of $51,746.19 collected by him in 1930, and that Sara B. Preston is not liable to income tax in respect of any portion of that amount.

Reviewed by the Board.

Judgment will be entered u/nder Rule 50.

Murdock and Mellott dissent.


author: Ttson:

text:
    Alexandria Gravel Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 73687.
    Promulgated January 21, 1937.

      Ed. J. de Verges, Esq., and Sol Weil, O. P. A., for the petitioner.

      E. A. Tonjes, Esq., for the respondent.
   OPINION.

Ttson:

This proceeding involves income tax deficiencies in the $643.51 and $791.37 for fiscal years' ended May 31, 1931 and 1932, respectively, asserted by respondent upon his determination that petitioner is not entitled to deductions of $5,362.71 and $6,216.56 for those years, respectively, claimed by petitioner as commissions paid on sales of sand and gravel. Petitioner assigns error in such determination.

Petitioner is a Louisiana corporation and was engaged in the production and sale of sand and gravel during the years here in controversy.

At some time in 1930 J. Hugo Lore, an attorney and, during the taxable years, a Louisiana State senator, requested employment as petitioner’s sales representative on a commission basis. J. G. Raxs-clale, petitioner’s president, had been acquainted with Lore for several years and he knew at the time that Dore was “friendly with the administration”, had “good personal contacts”, and wras “a good mixer.” By oral agreement, Raxsdale employed Dore as petitioner’s sales representative on the customary basis of a flat 10 percent commission on gross sales of sand and gravel made by him, such commission to become due and payable upon petitioner’s receipt of payment for the sand and gravel delivered on Dore’s orders. Dore was so employed during the two years here in controversy. Once a week he called at the offices of the Louisiana State Plighway Commission at Baton Rouge, was very active in procuring orders from that commission for sand and gravel from petitioner, and, if payments due therefor to petitioner were slow, he would visit the state auditor’s office and ask, as a special favor, that payments in warrants be made promptly. The Louisiana State Highway Commission called for competitive bids on a monthly basis on sand and gravel to be used for maintenance of roads, and also for bids on sand and gravel to be used on particular projects, and petitioner submitted its bids through Dore, who could not change or vary the price fixed by the home office without special authority to do so. The contracts were awarded “to a great extent” to the lowest bidder. It was under these bids that the sales to the Louisiana State Highway Commission involved herein were made.

Approximately three or four months after petitioner employed Dore as sales representative it also employed O. H. Nugent as a sales representative on the customary flat 10 percent commission on sales made by him. Subsequently, Dore and Nugent formed a firm, by that name, which also represented petitioner in making sales of sand and gravel on the same customary flat 10 percent commission basis, and the sales made by said firm to the Louisiana State Highway Commission involved herein were made through the same means and methods as above set out with regard to sales made to that Commission by Dore individually. Petitioner’s president, Raxsdale, had known Nugent for several years prior to 1930. Nugent was a sawyer by trade, but the lumber company which had employed him had closed down due to the depression.

Dore and Nugent, each individually, and the firm of Dore & Nu-gent, were petitioner’s only salesmen who sold sand and gravel to the Louisiana State Highway Commission during the two years here in question, although during that period petitioner had other salesmen in its employ, who were paid either the customary 10 percent commission or a salary plus expenses. Dore and Nugent, in their individual capacities, and Dore & Nugent, as a firm, also made sales of sand and gravel on behalf of petitioner to certain contractors, but the amounts thereof are not shown.

During the years in question the petitioner made the following payments as commissions on sales of sand and gravel made on its behalf by the designated persons:

The above payments were made partly in cash and partly, in warrants issued by the Louisiana State Highway Commission. The warrants were received by petitioner at par in payment of obligations due it from the highway commission and from contractors, and were used by petitioner at par in making such payments.

In its income tax returns for the years in question petitioner reported all of its gross sales and claimed as deductions the payments above set out and here in controversy as ordinary and necessary expenses of doing business. Respondent disallowed the claimed deductions for both years, based upon his determination that such amounts paid as commissions on sales of sand and gravel to various contractors in connection with contracts from the Louisiana State Highway Commission did not constitute ordinary and necessary expenses of doing business.

Upon this record it is evident, and we so conclude, that the agreement under which State Senator Dore was employed as petitioner’s sales representative and was paid a large portion of the above mentioned commissions on sales made by him in his individual capacity to the Louisiana State Highway Commission and also the agreement under which the firm of Dore & Nugent, of which Dore was a member, was likewise employed and likewise received a large portion of its commissions from sales made by it to the highway commission, were entered into for the purpose of utilizing, in the making of such sales, the personal influence Dore had by reason of his personal contacts and his being “friendly” with the state administration. Was such agreement between petitioner and State Senator Dore void and unenforceable as contrary to public policy, as urged by respondent?

In the recent case of Easton Tractor & Equipment Co., 35 B. T. A. 189, we considered the question of the validity of an agreement made with an agent for the purpose of enlisting the exercise of the personal influence of the agent in the procurement of contracts from a governmental department and found that the overwhelming weight of authority holds such an agreement to be void as against public policy.

In this proceeding the facts further disclose that Dore was a member of the Louisiana State Legislature during the two years in controversy, and as such he was an officer of the State of Louisiana. (See 22 R. C. L. 395, par. 31: also 46 C. J. 924, par. 3, and the authorities there cited.) Of the cases cited in the above mentioned decision of this Board, that of Oscanyan v. Arms Co., 103 U. S. 261, wherein it was said that the turpitude of such an agreement becomes more glaring when the agent employed is also an officer of the government from which the contract is procured, is particularly applicable here. Also, cf. Crocker v. United States, 240 U. S. 74.

In accordance with the principles established in the cited authorities, we conclude that the commissions paid during the two years in question to Dore in his individual capacity and to the firm of Dore & Nugent on sales made to the Louisiana State Highway Commission were paid under agreements which, in so far as these sales were concerned, were void and unenforceable as against public policy and did not constitute ordinary and necessary business expenses within the meaning of section 23 (a) of the Revenue Acts of 1928 and 1932. Easton Tractor & Equipment Co., supra.

With regard to the deduction of commissions on the sales made to contractors, as distinguished from those made to the Louisiana State Highway Commission, the testimony shows that petitioner kept books containing a record of all these transactions and it was therefore within petitioner’s power to have shown the amounts of commissions paid to Dore, individually, and to the firm of Dore & Nugent, for the sales made by them to the contractors. Had this been done the deduction of such commissions would be allowed, but it was not done, nor were the amounts of such commissions otherwise shown. It follows that there is a failure of proof as to both what amounts of commissions were paid to Dore in his individual capacity and to Dore & Nugent, as a firm, on sales made by each respectively to the contractors, and we consequently affirm the respondent’s disallowance of the entire amount of the commissions paid to Dore, individually, and to the firm of Dore & Nugent, during both of the years in controversy.

As to the employment of Nugent in his individual capacity, the record merely discloses that he was employed by petitioner in both of the years in question as its sales representative and that he, individually, was paid commissions on sales made by him under such employment both to the Louisiana State Highway Commission and to certain contractors. In our opinion petitioner has overcome the prima facie correctness of the respondent’s determination as to such commissions and we, therefore, conclude that the commissions paid to Nugent, individually, in the amounts of $924.80 and $2,293.27, in the fiscal years ended May 31, 1931, and 1932, respectively, constituted legitimate expenses incurred as compensation for services rendered and as such are deductible as ordinary and necessary business expenses.

Reviewed by the Board.

Decision will be entered under Rule 50.

Smith, MoeRis, and Arundell dissent.


author: Steenhagen:

text:
    Marshall C. Allaben and Florence C. Allaben, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 79866.
    Promulgated January 21, 1937.

      Ralph E. Brush, Esq., and James G. Hannon, Esq., for the petitioners.

      Byron M. Goon, Esq., and Allen T. Aikin, Esq., for the respondent.
   OPINION.

Steenhagen:

The petitioners, on their joint return, treated $20,000 of the $40,000 received from the state as “consequential damages” to the remaining portion of the tract, and omitted it from the sale price. This treatment they attempted to support by testimony of the highway engineer who had approved the purchase, that he had computed the $40,000 by adding together his estimate of the value as $5,500 an acre, or $22,830.50, and “consequential damage” of $17,169.50, and by the testimony of petitioner that he regarded the price as comprising compensation for damage. But this was not the way the transaction was negotiated nor the way it was accounted for in the state’s purchase voucher, which simply shows the whole amount as a lump sum purchase price for the parcel containing 4.151 acres. The transaction was a simple purchase by the state for $40,000, and it is unimportant what method or factors either party to it used in arriving at the amount at which the transaction would be finally closed. Had the property been condemned or had the state bought it for $20,000 and settled with petitioner upon $20,000 as compensation for damage to the remaining land, there would have been a different case. See George A. Spencer, 33 B. T. A. 936; Christian Ganahl Co., 34 B. T. A. 126 (on review, C. C. A., 9th Cir.). But a lump sum purchase price is not to be rationalized after the event as a combination of factors which might properly have been separately stated in the contract if the parties had seen fit to do so, Baltimore & Ohio Railroad Co. v. Commissioner, 78 Fed. (2d) 460; 29 B. T. A. 368, 372; McDonald v. Commissioner, 76 Fed. (2d) 513; New York, Chicago & St. Louis Railroad Co. v. Helvering, 71 Fed. (2d) 956; 26 B. T. A. 1229, 1289, 1290; Henrietta Mills, Inc. v. Commissioner, 52 Fed. (2d) 931, 933; Daniel Bros. Co. v. Commissioner, 28 Fed. (2d) 761. Cf. Nelson-Wiggin Piano Co. v. Commissioner, 84 Fed. (2d) 47. The entire $40,000 was properly treated by the Commissioner as sale price.

Judgment will be entered for the respondent.


author: HaRRON:

text:
    Long Island Drug Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 75225, 79616.
    Promulgated January 21, 1937.

      Morris Rosenstrauoh, O. P. A., for the petitioner.

      G. W. Brooks, Esq., for the respondent.
   OPINION.

HaRRON:

Issue 1. — The petitioner contends that the total salaries paid to the four officers were reasonable and deductible as ordinary and necessary expenses. The respondent contends that only the fixed annual salaries are deductible and that the contingent compensation was not payment for services rendered, but represents a distribution of profits and is not ordinary and necessary expense within the meaning of the applicable provisions of the statutes.

To determine whether salaries or other compensation are reasonable so as to be deductible from gross income as a business expense requires that the petitioner prove that the total amount claimed is reasonable payment for services rendered. The fact that the directors or stockholders have approved the entire amount claimed or that an agreement to pay these amounts is set forth in a contract or in the bylaws of the petitioner does not make the amounts paid ordinary and necessary expenses of business under the income tax laws. See Samuel Heath Co. v. United States, 2 Fed. Supp. 637; L. Schepp Co., 25 B. T. A. 419.

Section 23 (a) of the Revenue Acts of 1928 and 1932 includes in deductible business expense “a reasonable allowance for salaries or other compensation for personal services actually rendered.” A business concern may make payment for services in diverse ways — by a fixed annual salary; by a flat salary plus commissions; by a salary plus a bonus; by a salary plus a share in net earnings. Compensation paid by'any of these methods is a deductible expense if reasonable and for services rendered. It is a corollary of this rule that when net earnings are paid to employees as compensation it must be shown that the amount paid out of net earnings is directly related to services performed so as to be earned.

There is no question here regarding the reasonableness and de-ductibility of the fixed annual salaries. The question is narrowed to whether payment of 12% percent of net earnings to each of four executive officers, a total of 50 percent of net earnings, was also treasonable compensation for services rendered, and the burden of proof is on the petitioner to show that it was. A review of the evidence fails to show that the services of each officer were worth 12% percent of net earnings, or more or less. Excepting that all four devoted all of their time to petitioner’s business, there is no evidence to show that they separately performed such services as to have earned the share in net earnings allocated, even though each of the officers had distinct duties and some were in charge of distinct divisions of the business. A comparison of the facts in this proceeding with those in the case of Gray & Co. v. United States, 35 Fed. (2d) 968, is not favorable to petitioner’s contention, although petitioner relies largely on the decision therein. There the officers received shares in net profits ranging from 60 percent to 5 percent after a dividend of 7 percent per annum was paid to all stockholders, which indicates that the shares in net earnings bore some relation to the value of services rendered by each officer. There also the fund of “net earnings” available for additional compensation to officers did not exist until a return on outstanding stock had been paid, which is not the case in the instant proceedings. The petitioner agreed to pay its officers 50 percent of net earnings each year without giving consideration to the effect of this on the ability of the corporation to pay earnings on capital invested in the business. Petitioner has never paid a cash dividend. In the taxable years in question net earnings left after paying salaries would have enabled payment on capital invested in the business of 9 percent in 1931 but less than 3 percent in both 1932 and 1933. While the relation of compensation to net income is not the only test of reasonableness, it is important where a corporation has failed to pay dividends and appears to fail to consider the effect of paying fixed percentages of net income to its officers who are stockholders upon its ability to make a return on investment.

The determination of whether compensation paid is a reasonable and ordinary business expense for purposes of computing net income under the income tax laws is dependent upon the facts in each proceeding. Out of many determinations of such issues tests emerge which may be applied, yet their application to given sets of facts is difficult. Petitioner has stressed the argument that high percentages of net income have been allowed as reasonable compensation as a part of the ordinary and reasonable expenses of operating corporations. The relation of compensation to net income is only one of the tests of reasonableness. Many other factors are determinative of reasonableness and each case is dependent upon its particular set of facts. There are cases where salaries, or other compensation, which have been held reasonable have represented a high percentage of net earnings, but all of the facts supporting reasonableness must be considered and such results as petitioner refers to have been, rather, the fortuitous results of all factors involved. “The question of reasonableness of salaries must be determined with reference to volume of business, the profits made, the character of the services for which compensation was paid, and all other pertinent facts shown.” New York Talking Machine Co., 13 B. T. A. 154, 161.

Looking at the total compensation paid each officer, comprising both salary and a fixed percentage of net earnings, we fail to find satisfactory proof that the amounts paid were reasonable and not more than reasonable. Opinions of witnesses as to the reasonableness of amounts paid by petitioner were not supported by facts showing what other concerns in the same business with corresponding gross income pay for services similar to those rendered by petitioner’s executive officers. Petitioner having failed to sustain the burden of proof to show that respondent’s determination was erroneous with respect to reasonable compensation, it is held that the amounts paid out of net earnings are not deductible as ordinary and necessary business expense.

It is not necessary to determine that the amounts paid out of net earnings were a distribution to the three stockholders in the nature of dividends, but it is pointed out that whether such distributions are in proportion to stockholdings is not necessarily determinative of such result. “By unanimous agreement among the stockholders of a corporation, the profits may be divided and distributed other than rata-bly according to stockholdings”, see Joseph Goodnow & Co., 5 B. T. A. 1154, 1158, and 6 Fletcher on Corporations, 6114, sec. 3674.

Issue 2. — With respect to the question whether respondent erred in partially disallowing the total amounts claimed by petitioner for depreciation of various types of property — a building, a sprinkler system, and various kinds of automobiles — the issues arise out of the fact that petitioner and respondent used different bases and different rates of depreciation. The burden of proof was on the petitioner to show that the bases and rates used by respondent were wrong. Articles 204, 205, and 591 of Regulations 77 make it clear that in general the cost of the property is the basis, and the useful life of the property must be estimated to provide the rate of depreciation. And yet petitioner did not introduce evidence other than the opinion of an officer of the corporation to provide the elements for affirmatively showing what the bases and rates should be, or that the bases and rates used by respondent were wrong. In the absence of necessary proof to the contrary the bases and rates used by respondent are presumed to be correct, and his determination is sustained. Uncasville Manufacturing Co., 19 B. T. A. 920; affirmed in Uncasville Manufacturing Co. v. Commissioner, 55 Fed. (2d) 893; Elmore Milling Co., 27 B. T. A. 84; affirmed in Elmore Milling Co. v. Commissioner, 70 Fed. (2d) 736.

Decision will be entered for the respondent.


author: Arnold:

text:
    Derby Realty Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No 81213.
    Promulgated January 27, 1937.

      O. W. SwecJcer, Esq., for the respondent.
   OPINION.

Arnold:

This case involves a deficiency of $846.07 in petitioner’s income tax for the year 1932, which arises in part on respondent’s disallowance of $19,804.84 ás a net loss in that year carried forward from 1931 and resulting from the sale, in foreclosure of a mortgage, of certain land in 1930. The issue raised on a reserve for future improvements which was disallowed by respondent has apparently been abandoned by the petitioner, leaving as the sole issue the year in which the loss on the foreclosure sale was sustained. Respondent contends that it was the year of the sale, 1930; petitioner, the year when its right of redemption expired, 1931.

The facts, which, were stipulated, are as follows:

The petitioner, Derby Realty Corporation, is a Michigan corporation.

The business of the petitioner is that of a subdividor of and dealer in real estate.

The petitioner in March of 1926 purchased farm property in Michigan at a cost of $50,570iij>, paying part of the purchase price in cash and securing the balance to the vendor by the execution of mortgages. Petitioner later defaulted in its payments on the mortgages. At that time the principal of the mortgages had been reduced to $22,140. The property was advertised for sale and sold in foreclosure of the mortgages on October 11, 1930. The period during which the petitioner could redeem the property under Michigan law expired on October 11,1931.

Petitioner reported on its income tax return for the year 1931 a loss resulting from the foreclosure in the amount of $28,430.25.

As a result of the foreclosure loss, the petitioner’s income tax return for the year 1931 showed a net loss of $19,804.84, which was carried forward to its 1932 return as a deduction.

The property above referred to was purchased in 1926 and was never redeemed by the petitioner.

Petitioner here contends that under Michigan law the mortgagor retains legal title to mortgaged property after foreclosure sale and until the expiration of his right to redeem; and that the purchaser on foreclosure sale therefore acquires no interest in the realty, but only a right to be vested with legal title when the deed executed at the time of the foreclosure sale shall become finally effective at the end of the redemption period. Furthermore, it is urged that the mortgagor has a right of possession after foreclosure sale and until the end of the redemption period.

The relevant provisions of the statutory law of Michigan on foreclosure of mortgages and extinction of the right of redemption after foreclosure are as follows (Comp. Laws of Michigan, 1929, vol. 3) :

§ 14433 Deed of sale; endorsement, deposit with register, recording; entry upon redemption. Sec. 9. The officer or person making the sale shall forthwith execute, acknowledge, and deliver, to each purchaser a deed of the premises bid off by him; * * * And he shall endorse upon each deed the time when the same will become operative in case the premises are not redeemed according to law. * * * In case such premises shall be redeemed, the register of deeds shall, at the time of destroying such deed, as provided in section twelve [12] of this chapter, write on the face of such record the word “Redeemed,” stating at what date such entry is made, and signing such entry with his official signature.
§ 14434 Same; effect upon failure to redeem premises. Sec. 10. Unless the premises described in such deed shall be redeemed within the time limited for such redemption as hereinafter provided, such deed shall thereupon become operative, and shall vest in the grantee therein named, his heirs or assigns, all the. right, title, and interest which the mortgagor had at the time of the execution of the mortgage, or at any time thereafter, * * * and the record thereof shall thereafter, for all purposes be deemed a valid record of said deed without being re-recorded, * * *
§ 14435 Redemption; payment of sum bid and expenses, effect. Sec. 11. If the mortgagor, his heirs, executors, administrators, or any person lawfully claiming from, or under him or them, shall, within one [1] year from the time of such sale, redeem the entire premises sold, by paying to the purchaser, his executors, administrators or assigns, or to the register of deeds in whose office such deed is deposited for the benefit of such purchaser, the sum which was bid therefor, with interest from the time of the sale at the rate per cent, borne by the mortgage, not exceeding ten [10] per cent, per annum, and in case such payment is made to the register of deeds, the sum of one [1] dollar as a fee for the care and custody of such redemption money, then such deed shall be void and of no effect; * * *
§ 14436 Same; destruction of deed; record. Sec. 12. Upon the payment of the entire sum bid at such sale, and interest thereon, and the fee of one [l'J dollar mentioned in the preceding section, as aforesaid, to the register in whose office the deed therefore shall have been deposited, or upon delivering to such register a certificate, signed and acknowledged by the person entitled to receive the same, and certified by some officer authorized to take the acknowledgement of deeds, setting forth that such sum, with interest, has been paid to such person, and upon paying to such register a fee of twenty-five [25] cents, such register shall thereupon destroy such deed, and shall enter in the margin of the record of such mortgage a memorandum that such mortgage is satisfied; * * *
§ 14656 Equity of redemption; liability to sale on execution; redemption. Sec. 121. All rights of redeeming mortgaged real estate and real estate sold on execution, may be sold on execution in the manner herein prescribed for the sale of other real estate on execution, excepting in the case hereinafter specified ; and such equity of redemption may be redeemed, and the rights of any purchaser may be acquired, in the same manner, and upon the same terms and conditions as other real estate sold on execution.
§ 14659 Equity of redemption not to be sold under execution on certain judgment. Sec. 124. When a judgment shall be recovered for a debt secured by mortgage of real estate, or for any part of such debt, it shall not be lawful for the sheriff or other officer to sell the equity of redemption of the mortgagor, his heirs or assigns in such estate, by virtue of any execution upon such judgment.

Section 14631 permits the redemption within one year of the sale of any land sold on execution of judgment on payment of the bid price and interest.

Little is needed by way of judicial gloss upon these provisions. It seems clear that under section 14956 the mortgagor is entitled to possession of the mortgaged property until the foreclosure sale, Nusbaum v. Shapero, 249 Mich. 252; 228 N. W. 785; and even until foreclosure has been perfected by expiration of the period of redemption, Lourie & Robinson Lumber Co. v. Rubin, 245 Mich. 224; 222 N. W. 169; Janower v. Sibley Lumber Co., 222 N. W. (Mich.) 736. In the Lowrie case it was said, at page 170:

* * * The rights of plaintiff [which took title as a lienor for materials furnished] are no greater than those of a mortgagee, and, upon foreclosure, the court may not, pending sale and the statutory period of redemption, dispossess a mortgagor and place the mortgagee in full possession.

As to the nature of the interest which the mortgagor holds after the foreclosure sale and before the period of redemption has passed, the Michigan courts have held that it is a right of redemption which takes the place of his former equity of redemption held before the foreclosure sale. The court said in Roff v. Miller (sometimes cited as McCreery v. Roff), 189 Mich. 558; 155 N. W. 517, pp. 518, 519:

* * * It is now settled that the purchaser, at a foreclosure by advertisement, ordinarily acquires an equitable interest in the land which he may, during the period given for redemption, transfer in full to another. And that his assignee, if there is no redemption, will take the legal title when it matures exactly as the original bidder himself would have taken it. Gage v. Sanborn, 106 Mich. 269, 64 N. W. 32.
# * Sjt * * * *
* * * Such legal title does not vest at once upon the auction sale on statutory foreclosure (Jones on Mortgages, § 1884), but only at the expiration of the period allowed for redemption. Until the end of that period the foreclosure proceedings may be abandoned, if the parties choose to do so (Dodge v. Brewer, 31 Mich. 227), or a subsequent mortgagee may still demand an assignment of the mortgage.

In the Cage case, cited in the above quotation, it was said:

A purchaser of land at a sale on mortgage foreclosure acquires an equitable interest in the premises, which he may convey by quitclaim deed prior to the expiration of the redemption period, and which, when so conveyed, will ripen into a legal title in his grantee, if the land is not redeemed.

And in the recent case of Gerasimos v. Continental Bank, 237 Mich. 513; 212 N. W. 71, the Supreme Court of Michigan said (p. 73) :

,5* * * After foreclosure was had and the property deeded by the sheriff to the highest bidder, plaintiffs’ equity of redemption was lost, and only a right of redemption during the statutory period remained.
# :J; Hs * # sfc *
* * * and the equitable title so acquired [by the purchaser at the foreclosure sale] ripened to a legal title in defendant at expiration of redemption period provided by law.

We do not think it necessary to decide whether under local law legal title remains in the mortgagor until the expiration of the redemption period as petitioner contends, or passes on the foreclosure sale to the purchaser, leaving a mere equitable right in the mortgagor. In any event the purchaser’s legal title during such period would be at best inchoate, and what the courts have termed the mortgagor’s “right of redemption” carries with it substantial rights, possessory and otherwise. In Federal tax cases we are not concerned with the niceties of legal title, Tyler v. United States, 281 U. S. 497; or bound by the appellations applied to rights under local law, Burk-Waggoner Oil Association v. Hopkins, 269 U. S. 110. We are concerned only with the substance of the rights themselves. And we must determine here whether petitioner lost all substantial property or rights in the land when it was sold under the mortgage or only, as petitioner claims, when the right to redeem the land by payment of the mortgage with costs and interest expired.

It seems obvious to us that petitioner was not divested of material rights until the year 1931, when its right of redemption expired. The deed acquired by the purchaser at the foreclosure sale did not become operative until the end of the redemption period, §§ 14433, 14434; and if the redemption money had been paid by the mortgagor the deed would, thereupon, have become void, § 14435; and, under § 14436, would have been destroyed. The equity of redemption might be sold, § 14656; and presumably the right of redemption after foreclosure sale also, since anyone lawfully claiming under the mortgagor was given the power to redeem under § 14435. As important for our purposes as the fact that the legal title transferred to the purchaser at the foreclosure sale was defeasible on the redemption payment being made, is the fact that throughout the redemption period the mortgagor was entitled to the possession and usufruct of the land. Lowrie & Robinson Lumber Co. v. Rubin, supra. Whatever the measure of the mortgagor’s loss as fixed by the foreclosure sale, therefore, it might be mitigated in the succeeding year by the mortgagor’s sale of the right to redeem, sale of the right of possession for a year, or by the rents and profits which might accrue from such possession. With such substantial rights retained. by the mortgagor after the foreclosure sale, we think that event completely undeterminative of the loss.

Respondent falls back upon the contention that the foreclosure sale is an “identifiable event”, cf. United States v. White Dental Mfg. Co., 274 U. S. 398; which signalized sustainment of the loss, and that, applying a “practical test” in the instant case, the foreclosure sale rather than the expiration of the right of redemption must mark petitioner’s loss, for, since petitioner did not redeem the land, it must be presumed never to have intended to. We may not presume such a lack of intention, and, while there are circumstances in which an identifiable event which falls short of ultimately determining the loss will still be taken to fix it for tax purposes, the foreclosure sale here is not such a one. It only set in motion that which would result in a determination of the loss at the end of the redemption period. That event did not, as did the sequestration of the White Dental Co.’s property by the German Government in time of war, create a situation with an unforeseeable end, but merely made the loss finally determinable at a fixed time, one year thereafter. It did not require an “incorrigible optimist”, as was predicated of the White Dental Co. situation, to hope that redemption might be made in that time.

The question here presented is not new. In Frederick Krauss, 30 B. T. A. 62, we held that the sale of land in Florida for taxes did not result in a loss to its owner so long as the right of redemption existed. With this conclusion that a taw sale does not determine a loss if there is a period of redemption thereafter, respondent apparently agrees. See I. T. 2711, C. B. XII-2, p. 51; G. C. M. 15669, C. B. XIV-2, p. 154. But respondent has followed a contrary rule on mortgage foreclosures arising under state statutes somewhat similar to the Michigan statute here, and upon these rulings he now relies. See G. C. M. 12737, C. B. XII-1, p. 120 (Calif.); G. C. M. 12860, C. B. XIII-1, p. 123 (Ill.); and G. C. M. 13360, C. B. XIII-2, p. 194 (Kans.). In J. C. Hawkins, 34 B. T. A. 918, we held that under California law the mortgagor’s loss was sustained when the period of redemption expired and not when the foreclosure sale was made.

The difference in the rule followed by the Commissioner in his rulings on sales under foreclosure and on sales for taxes, where a period of redemption is alike allowed, is not fully brought out in respondent’s brief, but would appear to rest upon a supposed principle of probability of redemption; for it is argued in the Commissioner’s memoranda, supra, that a foreclosed mortgagor seldom in fact redeems, whereas the owner of land sold for taxes generally does. It is also pointed out in the same memoranda, by way of explanation, that the amount necessary to be paid by the taxpayer-debtor is generally small in proportion to the land’s value where it is owed for taxes, but often proportionately large when it is a debt secured by mortgage. This contention is apparently what is referred to by respondent in his brief as a “practical test.”

The principle laid down by the Supreme Court in Lucas v. American Code Co., 280 U. S. 445, and relied on by respondent, that “the general requirement that losses be deducted in the year in which they are sustained calls for a practical, not a legal, test”, must be read in its context and with the facts of that case fully in view, for the Court’s immediately preceding sentence i-eads: “As respects losses occasioned by the taxpayer’s breach of contract, no definite legal test is provided by the statute for the determination of the year in which the loss is to be deducted.” There the taxpayer, using the accrual method, after its breach of a contract of employment, upon which suit -was brought, sought to deduct the expected damages in the year of the breach, although the damages were at that time unpredictable and the taxpayer was then denying and contesting its liability in the courts. In the instant case, on the other hand, we have two events, the foreclosure sale and the expiration of the redemption period. The first is but a preliminary step in taking the mortgagor-taxpayer’s property in satisfaction of a debt and may result in a loss; the second is final and absolute in cutting off the mortgagor’s rights in such property and establishes the loss beyond question. The Commissioner has adopted one rule for tax sales and another for foreclosure sales, basing the distinction so made on a so-called practical test of probability of redemption. Where the legal test of the termination of petitioner’s rights is so clear as it is here, and where the practical test of benefits is also so obvious, we think that the application of either test must reach the same result. But the rule suggested by the respondent would lead us into endless speculation on petitioner’s financial situation and financial hopes before we could choose which of the two events, foreclosure sale or expiration of the right of redemption and loss of possession, would be the “identifiable event” upon which loss and deduction must hinge.

We think that clearly in such circumstances the last event is the proper test of when the loss was sustained. Cf. J. C. Hawkins, supra. That event here took place in 1931 and we think the loss was then suffered and should be treated as deductible in that year.

As petitioner put in no evidence upon the question whether respondent erred in disallowing an estimated reserve for future improvements in the amount of $10,149.98, we must assume that this claim has been waived.

Judgment will be entered under Rule 50.


author: Disney : Leech,

text:
    Edwards Drilling Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 75931.
    Promulgated January 27, 1937.

      Walter E. Barton, Esq., and J. L. Block, O. P. A., for the petitioner.

      L. W. Creason, Esq., and R. B. Gannon, Esq., for the respondent.
   OPINION.

Disney :

Involved in the issue raised by the petitioner is the question of whether petitioner’s tax liability should be determined on the cash or accrual basis of accounting. The petitioner claims it regularly employed the cash basis of accounting, not the accrual method, as determined by the respondent.

As part of its system of accounting, the petitioner maintained accounts designated notes receivable, accounts receivable, and others generally found in books kept according to the accrual method. It consistently entered expense items in its books as they were incurred, and all of such charges, except the one for Federal income tax, a nondeductible business expense, were taken into account in the computation of net taxable income. The fact that petitioner’s books as of the close of 1931 did not reflect more receivables and payables was, as the evidence shows, due to prompt payment of liabilities and the nature of petitioner’s business, rather than its adopted method of accounting. The evidence on the point sustains, rather than overcomes, the respondent’s finding that the petitioner regularly emT ployed the accrual basis of accounting. Accordingly, the petitioner’s net income will be determined by that accounting method. See Aluminum, Castings Co. v. Routzahn, 282 U. S. 92; Nibley-Minnaugh Lumber Co., 32 B. T. A. 791; Louis Kamper, 14 B. T. A. 767; Coatesville Boiler Works, 9 B. T. A. 1242.

The respondent argues that, the wells having been completed in 1931 pursuant to the contracts, in that year the petitioner definitely established its right to payments out of oil and realized taxable income to the extent of the cash received, plus the fair market value of the contract right to future payments, against which it may apply “as its basis for determining its gain from said transactions in 1931, the cost of drilling the wells.” The contention of the petitioner is that the drilling costs are deductible as ordinary and necessary business expenses and that, because of the indefinite and contingent character of the right to future payments out of oil, only the cash actually received is taxable as income.

Under the accrual method of accounting employed by the petitioner, items must be accrued as income when the events occur to fix the amount due and determine liability to pay. United States v. Anderson, 269 U. S. 422. The rule does not, however, extend to transactions in which the right is subject to contingencies which may never happen. “Generally speaking, the income-tax law is concerned only with realized losses, as with realized gains” (Lucas v. American Code Co., 280 U. S. 445), and a taxpayer is under no obligation to pay a tax on income he might never receive. North American Oil Consolidated v. Burnet, 286 U. S. 417.

This exception to the general rule has been recognized in numerous cases. In Commissioner v. Cleveland Trinidad Paving Co., 62 Fed. (2d) 85, affirming 20 B. T. A. 772, certain cities retained a percentage of the contract price for street paving to guarantee maintenance of the pavements for an .agreed period. In holding that the amounts withheld by the cities were not taxable as income earned during the year in which the contracts were completed, the court remarked that “Until the expiration of the period of guaranty the obligations of the sevéral municipalities remained only a contingent promise to pay.” .

Commissions on renewal premiums paid under policies of insurance written prior to March 1, 1913, do not constitute taxable income until received because of the contingent character of the right. Woods v. Lewellyn, 252 Fed. 106; Workman v. Commissioner, 41 Fed. (2d) 139, affirming 14 B. T. A. 1414.

In McPherson v. Helvering, 67 Fed. (2d) 749, affirming 22 B. T. A. 196, the partnership of which McPherson was a member performed services prior to March 1, 1913, in connection with the purchase and protection of timber lands for which it was to receive a percentage of the net profits “if, when, and as fast as” the lands were sold. The petitioner contended that the amounts received by the partnership for services rendered were not taxable until it had recovered the fair market value on March 1, 1913, of the right to future income. The Board and the court were unable to agree with this idea and taxed the amounts received under the contract during the taxable years without any deduction for the alleged March 1, 1913, value of the contingent right to income.

In E. F. Simms, 28 B. T. A. 988, rights under oil leases were sold for cash and notes, together with a right to 400,000 barrels of oil produced from the property, if the land produced such an amount, and an overriding royalty on all oil produced. We concluded that the rights reserved to future payments in oil and money were contingent in character and, following the principle of Burnet v. Logan, 283 U. S. 404, did not represent property received or amounts accruable for the purpose of determining gain realized from the sale.

Here the petitioner’s rights to receive the consideration for drilling the wells were contingent upon the happening of events which could not be foretold during the taxable period with any fair degree of certainty because of the nature of the mineral from the sale of which the money was to be paid. As we said in E. F. Simms, supra, “A ‘gusher’ of today may be a mere ‘pumper’ or even a dry hole tomorrow.” In addition to this usual uncertainty that an oil well will continue to be a producer, the petitioner’s rights to payment were subject to the possibility that the Railroad Commission of Texas would decrease the daily production of the wells. The owners of the wells were not at any time in 1931 under a definite obligation to pay, since no liability was to come into existence until oil produced and saved had been marketed. The promise of the owners of the wells to pay for t\ie drilling thereof was, therefore, contingent. Throughout the taxable period it was doubtful whether the petitioner would ever receive its consideration. The risk was always present.

The fact that the rights had a fair market value does not of itself require that the amount thereof be accrued as taxable income. Bedell v. Commissioner, 30 Fed. (2d) 622; Commissioner v. Darnell, Inc., 60 Fed. (2d) 82; Teck Hobbs, 26 B. T. A. 241; Woods v. Lewellyn, supra; Workman v. Commissioner, supra. See E. F. Simms, supra.

Under the facts in this case, we are of the opinion, and so hold, that only the cash actually received by the petitioner in 1931 for drilling the wells constitutes taxable income. Accordingly, it was error for the respondent to increase gross income by an amount for the contingent rights to future payments under the drilling contracts.

Under the alternative issue the respondent argues that the drilling costs “were capital in their nature”, and under the provisions of section 24 (a) (2) of the applicable statute and rulings of the courts and tibe Board are not deductible as ordinary and necessary business expenses.

The completion of producing wells results in the acquisition by the lessees of capital assets, the cost of which is recoverable through depletion deductions. United States v. Dakota-Montana Oil Co., 288 U. S. 459. But it does not necessarily follow that the expense incurred by the petitioner in drilling the wells resulted in the acquisition by it of a like asset. The petitioner undertook to drill the wells not for itself, but for the lessees; hence upon their completion it had nothing as the result of its- expense other than a claim for the contract price, payable out of the proceeds of oil and gas marketed from the wells. The petitioner so construed the contracts. It did not capitalize its outlay or enter the consideration for drilling the wells on its books as an account receivable; A contingent right to future income is not a capital asset. Workman v. Commissioner, supra, and McPherson v. Commissioner, supra. The petitioner was engaged extensively in a regular business, drilling oil or gas wells, and, considering the extent of its business and the fact that its books were kept on a consistent basis, we think that petitioner’s income was reflected by its returns as nearly as possible under the circumstances.

If the expenses were capital expenditures, as respondent argues, then that which the petitioner received was capital. But in Gilbert v. Commissioner, 56 Fed. (2d) 361, the Circuit Court of Appeals for the First Circuit held that stock received by a contracting firm as pay for constructing a building was income and not a capital asset. The court took that view in spite of the fact that the stock was held for more than two years, adhering to the idea that it was property held by the taxpayer primarily for sale in the course of his trade or business. In the body of the opinion the court observed:

It is not uncommon ior engineering or contracting firms to take tlieir pay in stock, as the petitioners did in these cases. This stock was income when received; it remained income for two years; and thereafter it continued to be “property held by the taxpayer primarily for sale in the course of his trade or business.”

The cases relied upon by the respondent to support his contention are clearly distinguishable from the instant case.

In State Consolidated Oil Co. v. Commissioner, 66 Fed. (2d) 648, certiorari denied, 290 U. S. 704, the taxpayer, as consideration for drilling a well, first recovered his cost of drilling and equipping the well and $1,400 out of sales of oil- and gas, and thereafter, subject to no contingency, received an undivided one-half interest in the lots owned by the persons for whom the well was drilled, including the well and its equipment, and one-half of the proceeds derived from the sale of oil and gas produced by the well.

In Consolidated Mutual Oil Co., 2 B. T. A. 1067, the expense involved the redrilling and deepening of an oil well by the owner thereof for his own account to put it on a productive basis. The cost was held to be a capital expenditure, recoverable through depreciation or depletion.

The case of Old Farmers Oil Co., 12 B. T. A. 203, involved the drilling of a well for the taxpayer and we held that the transaction resulted in the acquisition by taxpayer of a capital asset.

In Blockton Cahaba Coal Co. v. United States, 24 Fed. (2d) 180, the expenditure was made by the taxpayer to increase the depth of a coal mine and it was held that the cost should be included in invested capital.

The case of Nunn-Stubblefield Oil Co., 31 B. T. A. 180, is like State Consolidated Oil Co. v. Commissioner, supra, except that as consideration for its drilling operations the taxpayer acquired an interest in an oil and gas lease, dependent upon no contingency.

The petitioner properly deducted the cost of drilling the wells as an ordinary and necessary business expense.

Reviewed by the Board.

Decision will he entered under Bule 50.

Leech,

dissenting: In my opinion, the petitioner in this case occupies a position no different from that of any other purchaser of oil payment contracts. Certainly, it would not be held that a bank purchasing contracts of this character for cash, as is often done, has expended that money as an ordinary and necessary business expense and not as the cost of a capital asset. The use of labor and material, instead of money, in the acquisition of these oil payment contracts, in my iudgment, does not iustify any different conclusion. Burnet v. Logan, 283 U. S. 404.

Any other treatment results in a clear distortion of income,’ as repugnant to the controlling law as it is to common sense.

       SEC. 24. ITEMS NOT DEDÜCTIBLE.
      (a) General rule. — In computing net income no deduction shall in any case be allowed in respect o£ —
      * * * * * * * ,
      (2) Any amount paid out for new buildings or for permanent improvements or better-ments made to increase the value of any property or estate.