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https://www.courtlistener.com/api/rest/v3/opinions/4621945/	Dave Rubin and Jennie Feldman Rubin v. Commissioner.Rubin v. CommissionerDocket No. 45971.United States Tax CourtT.C. Memo 1959-223; 1959 Tax Ct. Memo LEXIS 21; 18 T.C.M. 1067; T.C.M. (RIA) 59223; 11 Oil & Gas Rep. 446; November 30, 1959Wentworth T. Durant, Esq., and Wilbur E. Swenson, C.P.A., 812 Tyler Street, Amarillo, Tex., for the petitioners. David E. Mills, Esq., for the respondent. TIETJENSMemorandum Findings of Fact and Opinion TIETJENS, Judge: This proceeding is before us pursuant to remand by the Court of Appeals for the Fifth Circuit, 252 F.2d 243. The respondent determined a deficiency in income tax of $14,660.05 for the year 1946. In our original opinion, 26 T.C. 1076">26 T.C. 1076, we resolved certain issues as to the deductions allowable for that year and the deficiency is now conceded1959 Tax Ct. Memo LEXIS 21">22 to be $14,418.51. We also decided that there was no net loss carryover from 1944 to 1946 and this is no longer disputed. The issue remaining concerns a claimed net loss carryback from 1947 which the petitioners contend is sufficient to eliminate the deficiency for 1946. Pursuant to the remand a further hearing was held and additional evidence was received. The revised findings of fact herein relate to the 1947 transactions and the computation of any applicable loss carryback to 1946. The petitioners' return for 1946 was filed with the collector of internal revenue at Dallas, Texas. Findings of Fact The petitioners, husband and wife, resided in Amarillo, Texas, and in Dallas, Texas, in 1946 and 1947. Dave Rubin was engaged in managing oil properties for a number of years. Prior to 1942 he was married to Bessie Rubin. Bessie died in 1942, intestate, leaving four adult children of a former marriage and of her marriage with Dave. Subsequently, a daughter, Marsha Saxe, died leaving three minor children and her husband as heirs. There was no probate of Bessie Rubin's estate. Dave and Bessie had possessed, in community, interests in certain oil properties herein referred to as the Barnhill1959 Tax Ct. Memo LEXIS 21">23 leases. These properties were subject to certain drilling commitments, and after 1942 Rubin attempted to meet these commitments. The surviving children of Bessie gave powers of attorney to Rubin to manage their inherited interests. Later they gave absolute conveyances to Rubin which were recorded. At the same time Rubin gave them separate reconveyances which were not placed on record until the summer of 1946. In the operation of the properties Rubin incurred indebtedness on behalf of the venture in the amount of several hundred thousands of dollars. Rubin sold an oil payment to Nubar Oil Company in an amount in excess of $200,000 to obtain other funds for operating the properties. On and prior to August 22, 1946, Rubin owned an undivided one-half interest in the Barnhill leases. Milton Rosenblume, Miriam Emmer and Mannie Jack Rubin each owned an undivided one-eighth interest. The remaining one-eighth interest was owned by William Saxe, Henry I. Saxe, Charlotte E. Saxe and Maurece T. Saxe and Rubin held a power of attorney over such interest. In August 1946 Rubin conveyed an overriding royalty in and to certain of the properties to Hugh L. Umphres and Hugh L. Umphres, Jr. The1959 Tax Ct. Memo LEXIS 21">24 First National Bank of Dallas, herein referred to as the bank, was one of Rubin's creditors. G. E. Hall and Joe Stewart were experienced oil well drillers. At the instance of the bank Hall negotiated with Rubin for an agreement whereby Hall and Stewart would drill and equip certain oil wells on the properties in which Rubin and the children of Bessie Rubin had interests. In March 1947 Rubin and Hall and Stewart entered into a letter agreement for operation of the Barnhill leases by Hall and Stewart, contemplating a subsequent formal contract. Rubin was to arrange for the transfer to him of the interests of the heirs of Bessie, and Hall and Stewart were to take up the Nubar oil payment and Rubin's indebtedness owing on March 31, 1947, amounting to $750,000 in all. One-half of the working interest was to be assigned to Hall and Stewart Drilling Company which was to operate the leases. Prior to April 1947 a friendly suit for partition was begun in the District Court of Potter County, Texas, in which the owners of interests were made parties. Rubin acquired the interests of Milton Rosenblume, Miriam Emmer and Mannie Jack Rubin subject to certain overriding royalties and for cash and1959 Tax Ct. Memo LEXIS 21">25 deferred cash considerations. The grantors retained a vendor's lien to secure the deferred cash payment. The conveyances by Mannie Jack Rubin and Miriam Emmer were dated April 1, 1947, and that by Milton Rosenblume was dated April 23, 1947. A decree was issued in the partition suit on July 29, 1947 which provided, among other things, that Hall and Stewart each owned undivided one-fourth interests in the properties and certain mineral rights, that Milton Rosenblume, Miriam Emmer, Mannie Jack Rubin, William Saxe, Henry I. Saxe, Charlotte E. Saxe and Maurece T. Saxe all were vested with certain overriding royalties and that Dave Rubin was vested with the title formerly vested in these heirs, subject to such royalty rights. Rubin thus had an undivided one-half working interest in such properties after the partition was complete. On April 5, 1947, Rubin and Hall and Stewart entered into an agreement concerning these properties, which provided, in part: "For and in consideration of the rights herein granted, and of the promises of grantees, and of the duties and obligations undertaken and assumed by the grantees, as herein set forth, the said grantor, Dave Rubin, of the County of Potter, 1959 Tax Ct. Memo LEXIS 21">26 State of Texas, has granted, sold, assigned, and conveyed, and does by these presents grant, sell, assign, and convey unto the said grantees, G. E. Hall and Joe Stewart each an equal undivided one-fourth of the following described real and personal property: "1. All personal property belonging to Dave Rubin on the lands and leases hereinafter described that has heretofore been used in connection with the management, operation, and development of said properties for producing and developing oil and gas, being the same personal property that is now in charge of the grantees under the authority of Dave Rubin. Grantees shall immediately make written inventory of such personal property, with their valuations of the respective items, and deliver the same to the grantor. "[The described property included, among other things, oil and gas leases, minerals, mineral interest and gas purchase agreements.] * "(a) As consideration for the foregoing grant, sale, assignment, and conveyance, the said G. E. Hall and Joe Stewart, grantees, agree and promise Dave Rubin, grantor, that they will refinance grantor to the amount of $750,000.00, or to the amount of his indebtedness as of April 1, 1947, whichever1959 Tax Ct. Memo LEXIS 21">27 amount is the smaller, by taking up, either directly or through Dave Rubin, such indebtedness as is owing by Dave Rubin or stands as charges or incumbrances against the property described * * * above * * * and that grantees will hold the amount of such indebtedness, after taking it up, as a charge or incumbrance against the oil and one-half of the gas to be produced from all the lands described in the aforesaid legal description paragraphs hereof, until the full amount of such indebtedness so to be taken up shall be repaid to the grantees * * * "(b) The grantees shall, as a material and primary consideration for this conveyance, grant, and assignment, drill and equip on said lands six wells for producing oil during each month hereafter, beginning immediately; provided only that material, supplies, and labor necessary for drilling and equipping six wells per month are available; if materials, supplies, and labor for drilling and equipping six wells per month are not available, the grantees shall nevertheless drill and equip at least three wells per month until one hundred wells shall have been drilled and equipped on said land on 20 acre locations to be made by them; * * * The price1959 Tax Ct. Memo LEXIS 21">28 for the drilling and equipping of each well hereunder is agreed to by $26,500.00, and grantees shall receive payment for that amount per well, out of production for drilling and equipping them as herein specified. * * "(c) It is agreed that grantor shall be entitled to manage and sell the gas produced from said lands, after it is produced, and the $2,550,000.00 consideration to be paid to grantor, as hereinafter specified and provided, shall receive credit for one-half of all proceeds of the sale of the gas until all amounts payable to grantees out of production provided for herein shall be fully paid; thereupon and thereafter said one-half of all proceeds of the sale of the gas shall be paid into the operating fund which is established herein. * * "(e) Of all the proceeds of the oil and one-half the gas produced from said lands after grantees shall have received enough to liquidate and discharge the amount expended by grantees in taking up the indebtedness of grantor, as aforesaid, and the amount of $26,500.00 per well for each well of the first fifty wells that grantees shall drill and equip hereunder, all royalties specified in the aforesaid leases shall be paid out1959 Tax Ct. Memo LEXIS 21">29 of the production from which such royalties are payable under the terms of such leases; likewise, all the overriding royalties payable by the terms of grants or reservations shall be paid. Twenty-five per cent of the proceeds of all the oil and one-half the gas not necessary to pay the foregoing items, royalties, and overriding royalties, shall constitute an operating fund, and seventy-five per cent of all the oil and one-half the gas not necessary to pay the foregoing items, royalties, and overriding royalties, shall constitute a drilling fund; but although these two funds are established, the establishing of them shall in nowise impair or militate against the right of G. E. Hall and Joe Stewart to manage both funds together * * * until full payment to G. E. Hall and Joe Stewart has been made for each of the second fifty wells that they shall drill and equip hereunder. "(f) Until grantees shall have received from the aforesaid production the amount expended by them in taking up the aforesaid indebtedness of grantor and the amount necessary to pay grantees $26,500.00 for the drilling and equipping of each of the 100 wells that they shall drill and equip hereunder, the grantees shall1959 Tax Ct. Memo LEXIS 21">30 be entitled to receive and disburse all the proceeds of the sale of the production except one-half of the proceeds of the sale of the gas, from said leases, in accordance with the terms hereof; * * "(g) After all amounts specified in paragraphs (a), (e), and (f) above have been fully liquidated and discharged, the royalties and overriding royalties shall thereafter be paid as in said paragraphs (a), (e), and (f) specified, and the costs and expenses of operating such properties; and, in the discretion of grantees, the drilling and equipping of any additional well's shall be paid out of the operating fund. Of the remaining seventy-five per cent of the proceeds of all the oil and gas, Dave Rubin shall be entitled to one-half on his own account and the grantees shall be entitled to the other one-half on their own account; and the parties shall be paid directly by the purchasers of such production, except that Dave Rubin shall also be paid directly by the purchasers of such production one-half of the one-half to which the grantees are entitled, until Dave Rubin shall have received from the proceeds of one-half of grantees' one-half the sum of two million five hundred and fifty thousand1959 Tax Ct. Memo LEXIS 21">31 dollars, less whatever amount Dave Rubin shall have already received from one-half of the proceeds of the sale of gas, this payment of $2,550,000.00 out of such production being consideration to grantor for making this grant, sale, assignment, and conveyance. * "(i) It is understood and agreed that the one-half interest herein conveyed is burdened with the obligation and duty of managing and operating such properties as an entirety, for the equal advantage of the grantor and grantees, and that grantees, or the owners of the interests of the grantees at any time, shall have the right and duty to operate and manage such leases and to pay all necessary and reasonable costs of operation, charging one-half thereof to themselves and one-half to grantor, or the owners of grantor's interest at the time such expense is incurred. Costs and expenses shall include all ad valorem taxes on the entire properties of grantor and grantees herein, but shall never include wages or salaries to the owners of the grantees' one-half interest in excess of $12,000.00 per year, unless, at the same time, the owners of the grantor's one-half interest shall be paid an equal amount at the same time that1959 Tax Ct. Memo LEXIS 21">32 such wages or salaries in excess of $12,000.00 per annum are paid to the owners of grantees' one-half interest." Pursuant to the contract of April 5, 1947, Hall and Stewart paid $750,000 to refinance the indebtedness and discharge certain claims against the property. They paid $276,441.64 to Nubar Oil Corporation, and paid $10,005 each to Mannie J. Rubin, Miriam Emmer and Milton Rosenblume as well as $10,000 to the Court for distribution in the partition suit. They paid certain obligations of Rubin's and took assignments and releases from the creditors. They also paid certain notes of Rubin's. Hall and Stewart obtained a loan from the bank in the amount of $700,000 for which they gave their note secured by a deed to a trustee covering the properties involved. In June 1947 Rubin secured a lease from certain other individuals, including J. A. Whittenburg, Jr., Roy R. Whittenburg and others, and certain executors of estates and guardians covering oil and gas lands in Hutchinson County, Texas, herein referred to as the Hedgecoke-Whittenburg lease. On August 1, 1947, Rubin conveyed to Hall and Stewart each a one-fourth interest in this lease. Hall and Stewart thereby agreed to drill1959 Tax Ct. Memo LEXIS 21">33 and equip wells required by the terms of the lease and to rework and recondition wells already on the property. This contract did not provide for any cash consideration to Rubin. The price for drilling and equipping each well was fixed at $31,000 to be paid out of production. Rubin reserved a production payment of $200,000 out of proceeds after Hall and Stewart had recouped their drilling and completion costs. Equipment on the leases as of March 1947 had an allocated cost of over $750,000 and additional equipment was added during 1947 having costs of over $280,000. In the summer of 1948 Rubin and Hall and Stewart agreed to cancel the contracts of April 5 and August 1, 1947, and settle accounts. Pursuant to this agreement Rubin assigned to Hall and Stewart all his interest in the Hedgecoke-Whittenburg lease and Hall and Stewart assigned to Rubin their interests in the Barnhill leases. In these assignments the stated consideration was the cancellation of all Rubin's obligations to Hall and Stewart and of their obligations to Rubin. The oil and gas sales and the expenses of the leases operated by Hall and Stewart under the agreements of April 5 and August 1, 1947 were as follows: 1959 Tax Ct. Memo LEXIS 21">34 Hedgecoke-BarnhillWhittenburgTotalOil and Gas Sales$155,836.89$44,219.12$200,056.01Gross Production Taxes6,609.861,861.638,471.49Operating Expense80,070.8535,812.28115,883.13General Expense16,230.528,671.0324,901.55Development Expense247,399.2078,234.46325,633.66Depreciation allowable on lease and well equipment for the new equipment on these leases during the operations in 1947 amounted to $7,486.38 on the Barnhill leases and $2,019.01 on the Hedgecoke-Whittenburg lease, a total of $9,505.39. The net loss from operations of the leases during 1947 was $284,339.21. The petitioners' adjusted net income for 1945 was $66,788.79. They had a net operating loss carryover from 1944 giving a net operating loss deduction of $52,487.91, which was applied leaving a balance of $14,300.88 to be absorbed by any 1947 loss carryback. The petitioners' net income for 1946, as determined by the respondent, was $36,513.55. The computation of such income included long-term capital gain of $18,469.22 and depletion of $34,804.20. The petitioners' return for 1947 included long-term capital gains on sale of a scale, $375.47, 1959 Tax Ct. Memo LEXIS 21">35 sale of a warehouse, $2,066.67 and sale of a royalty, $3,200. On the return deductions for depletion were claimed in the amount of $6,098.90 on a Brown-Kilgore lease and of $2,642.19 on royalties. Opinion The issue is whether the petitioners incurred a loss in 1947 sufficient as a loss carryback to eliminate the agreed deficiency for 1946. On their return for 1947, the petitioners reported $485,265.50 of the amounts paid by Hall and Stewart as representing income from cancellation of Rubin's debts in that amount in 1947 and claimed an adjusted basis of $493,474.26 on the properties transferred, resulting in a loss of $8,208.76 on that transaction. They reported other losses and claimed a loss of $109,821.89 on their return. The respondent's agent computed the correct basis in these properties as $212,744.56 and made adjustments resulting in a taxable income of $91,412.50, but no deficiency was formally determined for 1947 because of a loss carryback from 1949 which would eliminate any net taxable income in 1947. The properties here referred to as the Barnhill leases had been operated by Rubin as a managing partner of a partnership composed of Rubin and the heirs of his deceased1959 Tax Ct. Memo LEXIS 21">36 wife. This the respondent concedes. The petitioners now present a different argument. They say that the transaction with Hall and Stewart was nothing more than the sale to Hall and Stewart of the interests of Bessie Rubin's heirs. Rubin was to retain a one-half interest, the other half interest was to be transferred to Hall and Stewart who were to undertake the responsibility of development and operation of the whole property, the interests of the heirs were to be transferred free of indebtedness with retention of overriding royalties and payment of some cash. Court action to partition the property was commenced to effect transfer of the interests of the minor heirs and this was duly accomplished. The petitioners contend that the arrangement resulting was a partnership between Rubin and Hall and Stewart and the effect of the agreement of April 5 was that Hall and Stewart became Rubin's partners, in place of the heirs of Bessie Rubin. The contribution of Hall and Stewart, it is said, was their refinancing of the indebtedness of the former partnership. The contention is advanced that Rubin was previously liable for half the debts of the earlier partnership and now was liable for half1959 Tax Ct. Memo LEXIS 21">37 the debts of the successor partnership. Hence, he had no gain or loss by virtue of the transaction. Also, the petitioners contend that the income from one-half of the operation and the expenses allocable to that half should be treated as the income and expenses of Rubin and since the expenses exceeded the income realized in 1947 from operating these properties, a substantial loss was incurred by Rubin from this alone. The respondent takes the position that Rubin terminated the partnership with the heirs of his deceased wife and became the owner of the entire working interest in the Barnhill leases, that he sold a one-half interest to Hall and Stewart and received $485,265.50 as income through the cancellation of his indebtedness in that amount in 1947, resulting in a net gain for 1947, that the petitioners were not entitled to treat a share of the income in 1947 from operation of the properties as theirs nor to deduct any share of the expenses paid by Hall and Stewart under the contract of April 5, 1947, and finally, if they were entitled to operating loss deductions, such losses in 1947 were not sufficient in amount to affect the deficiency for 1946. The agreement of April 5, 1947 does1959 Tax Ct. Memo LEXIS 21">38 not purport to create a partnership between Rubin and the operators, Hall and Stewart. But this is not determinative. The respondent has interpreted an oil development arrangement under certain circumstances as in the nature of a joint venture or partnership for tax purposes. Rev. Ruling 54-84, C.B. 1954-1, 284. The agreement provided that Hall and Stewart"will refinance grantor [Rubin] to the amount of $750,000 * * * by taking up * * * such indebtedness as is owing by Dave Rubin or stands as charges or incumbrances against the property * * , and that grantees will hold the amount of such indebtedness, after taking it up, as a charge or incumbrance against the oil and one-half of the gas to be produced * ." In the course of this refinancing Hall and Stewart took assignments from the various creditors of their claims against Rubin. When the parties terminated the arrangement in 1948 they expressed their intention to cancel all Rubin's obligations to Hall and Stewart and the operators' obligations to Rubin, indicating that all parties considered Rubin indebted to Hall and Stewart. These circumstances bear out the argument of the petitioners that the debts were not cancelled1959 Tax Ct. Memo LEXIS 21">39 and that Hall and Stewart in paying the claims became substituted as creditors of Rubin. The respondent argues that the operators agreed to look only to the oil for reimbursement, that Rubin was financially unable to pay the indebtedness personally and that the operators had no intention of relying upon him for payment if the oil production should fail. These factors, even if true, do not prove a cancellation of the indebtedness. Although the agreement of April 5, 1947 did not specifically provide that Rubin be liable for the indebtedness in the absence of sufficient production, there was no provision exempting him from such liability. This is a "carried interest" situation. The operators acquired a one-half interest in the Barnhill leases by "refinancing" Rubin and undertaking to drill wells and operate them. Rubin was the "carried party" with a onehalf interest. The operators were to recover their investment out of production from Rubin's interest as well as theirs before Rubin received anything from production, except as to one-half the gas proceeds which he had reserved. After the operators recovered their investment Rubin was to receive up to $2,550,000 out of one-half of the1959 Tax Ct. Memo LEXIS 21">40 operators' share or one-half of the gas, after which the production was to be shared onehalf by Rubin and one-half by the carrying parties. In 1947 the operators did not recover their investment and in 1948 the contract was cancelled by agreement. The respondent contends that this situation is similar to Manahan Oil Co., 8 T.C. 1159">8 T.C. 1159 (1947) in which we held that proceeds of fractional interests of the carried party temporarily assigned to the operator were income to the operator rather than to the carried party. In that case the carried party had no obligation to pay expenses allocable to its interest if production was inadequate to do this. The petitioners contend that the case of J. S. Abercrombie Co., 7 T.C. 120">7 T.C. 120 (1946) affd. 162 F.2d 338 (C.A. 5, 1947), Acq. 1949-1 C.B. 1, is applicable here. In that case the assignors retained a one-sixteenth carried working interest, and the operators were to recoup one-sixteenth of their expenditures by charging them against the production from the carried interest. We held that since income is taxable to the owner of the investment which produced it the income of the carried interest1959 Tax Ct. Memo LEXIS 21">41 belonged to the carried parties, as did also the expenditures chargeable to that interest. The Court of Appeals agreed, stating that "an assignment in anticipation of such income is ineffective to avoid taxation thereof to the real owner. The economic reality of the transaction was that the assigning co-owners mortgaged their interest to their operating co-owner; and by so doing they not only reaped the benefit of development but acquired an undivided one-sixteenth interest in valuable physical equipment placed on the property by the operators. The value of the leases was in the oil and gas that could be produced from the demised premises. The assignors desired to participate in the production to the extent of onesixteenth; and arranged by contract for its exploitation, reserving to themselves a share in the net profits that was not disassociated from the retained economic interest but was derived from such interest and partook of the quality of rent." We have had occasion to consider other carried interest cases recently. In Carl A. Prater, 30 T.C. 1262">30 T.C. 1262 (1958) (on appeal, C.A. 5) the carried party was under no requirement to repay any advances of the carrying parties1959 Tax Ct. Memo LEXIS 21">42 had the production been insufficient to do this. We held that the carrying parties were taxable on the production recovered from the carried interest, since the carrying parties held the economic interest in the oil in place attributable to the carried interest. In Myrtle J. Wood, 31 T.C. 528">31 T.C. 528 (1958) (on appeal, C.A. 5) we held that the income from production allocable to the carried interest was taxable to the carried party. The carrying party there had the right to recover expenses out of oil or from sale of the fee interest of the carried party. In Estate of H. H. Weinert, 31 T.C. 918">31 T.C. 918 (1959) (on appeal, C.A. 5) the carrying party, Lehman, advanced funds under a loan agreement and was to recover such advances only from production from the carried interest which was assigned to a trustee to secure the advances. We held that the advances were in fact loans and that the income of the carried interest was taxable to the carried party notwithstanding the stipulation for recovery solely out of profits arising from the carried interest. In that case we said (page 931): "In our opinion, under the facts in this case, Lehman did not acquire the equitable interest1959 Tax Ct. Memo LEXIS 21">43 in the oil and gas in place by virtue of these advances. The funds advanced were used to meet petitioner's obligation for his pro rata share of the drilling and recycling plant costs. They were not used to pay any part of Lehman's pro rata share of these costs. Lehman did not acquire any interest in the product of these expenditures and they were not made for Lehman's direct benefit. The funds advanced were used to provide a direct economic benefit to petitioner, being used to pay his obligations under the unitization agreements. Lehman acquired nothing for these advances except the right to be repaid, first, with interest, from the proceeds of petitioner's retained interest in the leases. The equitable interest in the proceeds assigned, insofar as they were used to repay these advances and interest, remained in petitioner. He assigned these proceeds, in trust, as security for the repayment of the loans. Even though petitioner may have had no personal obligation to repay the loans, the income from the pledged property having been received and used by the trustee to repay the loans and thus release the property and future income therefrom to petitioner, the income was received for the1959 Tax Ct. Memo LEXIS 21">44 economic benefit of petitioner and was taxable to him." In Anderson v. Helvering, 310 U.S., 404 (1940), IT WAS STATED THAT INCOME FROM PRODUCTION OF OIL AND GAS IS TAXABLE TO THOSE WHO HAVE A CAPITAL INVESTMENT IN THE OIL IN PLACE. In the present case Hall and Stewart advanced loans to Rubin to pay his creditors and took assignments of their claims. Rubin owed these amounts to Hall and Stewart He transferred to them one-half the working interest in the properties and in the personal property on the premises and the grantees were enttiled to receive all proceeds of production (except for the reservation of one-half the gas) until reimbursed for the advances then or subsequently made. In effect this was a mortgage or pledge of Rubin's retained one-half interest to secure the loans and subsequent loans contemplated by the contract. Hall and Stewart did not have to depend solely on oil production. There was considerable equipment on the leases and one-half of that was transferred. Also there was a possibility that Rubin could repay from other sources. The proceeds of Rubin's interest were being applied to pay his obligations and therefore inured to his benefit. Accordingly, 1959 Tax Ct. Memo LEXIS 21">45 the income from his interest was taxable to him and the expenses allocable to that interest were his expenses. The Abercrombie, Wood, and Weinert Estate cases, supra, are applicable. This conclusion brings us to the problem of computing the income and expenses allocable to Rubin's interest in 1947. The leases included in the contract of August 1, 1947, were operated under a similar arrangement and the income and expenses of such leases should be treated similarly. The parties have presented various computations based upon their theories of the legal effect of the 1947 transactions. The petitioners' computations are erroneous in certain particulars, as, for example, including charges for wells which were not completed until 1948. The respondent's computations start with the assumption that Rubin realized income from cancellation of indebtedness, and assume that long-term gain was received from the Hall-Stewart transaction, which we have determined was not the case. When the supposed gains from these sources are eliminated, it appears that the petitioners had a loss in 1947, or at least no taxable net income, outside the Hall and Stewart transaction and the drilling operations. It1959 Tax Ct. Memo LEXIS 21">46 is not necessary to determine the exact amount of any such loss and for our purposes it is sufficient if the petitioners had no net taxable income outside of these items. In that situation, the computations of income and expenses least favorable to the petitioners show that Rubin's share of the loss from the Hall and Stewart operations of these leases was sufficient as a loss carryback to eliminate the agreed deficiency for 1946. The net loss from operations, according to the books of Hall and Stewart and shown in our findings of fact, was $284,339.21. One-half of this, allocable to Rubin, was $142,169.60. In computing the amount of the carryback this figure is to be reduced pursuant to section 122, Internal Revenue Code of 1939, 1 by adjustments for depletion of $6,098.90 claimed on the Brown-Kilgore lease, and $2,642.19 on royalties and by adjustments amounting to $5,642.14 for longterm capital gains. (The respondent computes an additional amount of long-term capital gain on the Hall-Stewart transaction, which we have found was not realized.) This reduces the loss carryback to $127,786.37. Next it is to be applied against the income for 1945 not previously absorbed by a 1944 net1959 Tax Ct. Memo LEXIS 21">47 operating loss deduction. This amounts to $14,300.88, reducing to $113,485.49 the amount carried back to 1946. The net income for 1946 according to the deficiency notice, was $36,513.55, which is subject to adjustments under section 122, of $18,469.22 for long-term capital gain and $34,804.20 for depletion. Adding the adjustments to the income gives a total of $89,786.97. Since the carryback exceeds this, it is sufficient to eliminate the deficiency for 1946. 1959 Tax Ct. Memo LEXIS 21">48 Footnotes1. SEC. 122. NET OPERATING LOSS DEDUCTION. (a) Definition of Net Operating Loss. - As used in this section, the term "net operating loss" means the excess of the deductions allowed by this chapter over the gross income, with the exceptions, additions, and limitations provided in subsection (d). (b) Amount of Carry-Back and Carry-Over. - (1) Net Operating Loss Carry-Back. - (A) Loss for Taxable Year Beginning Before 1950. - If for any taxable year beginning after December 31, 1941, and before January 1, 1950, the taxpayer has a net operating loss, such net operating loss shall be a net operating loss carry-back for each of the two preceding taxable years, except that the carry-back in the case of the first preceding taxable year shall be the excess, if any, of the amount of such net operating loss over the net income for the second preceding taxable year computed - (i) with the exceptions, additions, and limitations provided in subsection (d)(1), (2), (4), and (6), and (ii) by determining the net operating loss deduction for such second preceding taxable year without regard to such net operating loss and without regard to any reduction specified in subsection (c). * (d) Exceptions, Additions, and Limitations. - The exceptions, additions, and limitations referred to in subsections (a), (b), and (c) shall be as follows: (1) The deduction for depletion shall not exceed the amount which would be allowable if computed without reference to discovery value or to percentage depletion under section 114(b)(2), (3), or (4); * *(4) The amount deductible on account of losses from sales or exchanges of capital assets shall not exceed the amount includible on account of gains from such sales or exchanges. The deduction provided in section 23(ee) shall not be allowed.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621946/	MRS. J. C. PUGH, SR., EXECUTRIX OF THE LAST WILL AND TESTAMENT OF J. C. PUGH, SR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. EXCHANGE BANK & TRUST CO. OF SHREVEPORT, LA., ADMINISTRATOR, ESTATE OF J. C. PUGH, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. MRS. JOHN PUGH, SR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. MRS. J. C. PUGH, JR., PETITIONER, v.COMMISSION OF INTERNALO. L. PUGH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, O. L. PUGH, PETITIONER, v.COMMISSION OF INTERNAL REVENUE, RESPONDENT. MRS. O. L. PUGH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. L. G. PUGH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. MRS. L. G. PUGH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Pugh v. CommissionerDocket Nos. 17153-17158, 17173, 17174.United States Board of Tax Appeals17 B.T.A. 429; 1929 BTA LEXIS 2304; September 23, 1929, Promulgated 1929 BTA LEXIS 2304">2304 1. The fair market value of the surface rights in land owned by certain of the petitioners was reduced in 1920, due to the fact that the land became impregnated with oil and salt water from oil wells drilled thereon and was thereby rendered permanently less fitted for cultivation. Held that said shrinkage in value is not an allowable deduction from gross income. 2. The amount of sales of cotton made by certain of the petitioners in 1920, determined. 3. A written instrument executed by J. C. Pugh, Sr. and one Eastham on August 1, 1919, held to be a contract of sale which immediately vested in Eastham title to the property described therein, and Pugh was not entitled to any deduction in 1920 and 1921 for depletion of such mineral rights, although the greater part of the consideration for the sale was payable out of royalties. 4. The petitioners held to beentitled to deduct from gross income for the years 1920 and 1921, amounts as allowances for the depletion of mineral rights conveyed to them by J. C. Pugh, Sr., on July 12, 1920. Rush L. Holland, Esq., George E. Strong, Esq., and R. Colbert, C.P.A., for the petitioners. Philip A. Clark,1929 BTA LEXIS 2304">2305 Esq., and C. C. Holmes, Esq., for the respondent. MARQUETTE 17 B.T.A. 429">429 These proceedings, which were duly consolidated for hearing and decision, are for the redetermination of deficiencies in income taxes 17 B.T.A. 429">430 which the respondent has asserted for the years 1920 and 1921, as follows: 19201921J. C. Pugh, sr$42,638.62$417.35J. C. Pugh, jr655.23792.82Mrs. J. C. Pugh, sr42,638.621,523.17Mrs. J. C. Pugh, jr655.23792.82O. L. Pugh$277.04$141.80Mrs. O. L. Pugh277.04184.84L. G. Pugh366.32151.04Mrs. L. G. Pugh366.31151.04FINDINGS OF FACT. The petitioner, Mrs. J. C. Pugh, Sr., is the widow of J. C. Pugh, Sr., who died April 21, 1921, and she is also the executrix of his last will and testament. The petitioners O. L. Pugh and L. C. Pugh are children of J. C. Pugh, Sr.; Mrs. O. L. Pugh is the wife of O. L. Pugh; and Mrs. L. G. Pugh is the wife of L. G. Pugh. The petitioner, the Exchange Bank & Trust Co. of Shreveport, La., is the administrator of the estate of J. C. Pugh, Jr., son of J. C. Pugh, Sr., who died May 9, 1926. Mrs. J. C. Pugh, Jr., is the widow of J. C. Pugh, Jr. J. C. Pugh, 1929 BTA LEXIS 2304">2306 Sr., J. C. Pugh, Jr., O. L. Pugh, and L. G. Pugh, and their wives, were during the taxable years involved herein residents of Louisiana, and they reported their income on the community property basis. During the year 1920, and until April 21, 1921, J. C. Pugh, Sr., and his wife, operated a 1,380-acre cotton plantation owned by J. C. Pugh, Sr., which he had acquired prior to March 1, 1913, and which was known as the "Petrovic Plantation." This plantation had a fair market value on March 1, 1913, of $75 per acre. Between March 1, 1913, and the year 1920, improvements were added at a cost of at least $15,000. In the year 1919 oil was discovered underlying the plantation and a number of wells were brought in in the latter part of 1919 and during the year 1920, the greater part of the development occurring in 1920. The oil and salt water from the wells impregnated the ground and caused a growth of coco grass, Johnson grass and noxious weeds, which made the cultivation of cotton and other crops on the plantation unprofitable and permanently impaired the value of the plantation for agricultural purposes, and reduced the fair market value of the surface rights, as distinguished from1929 BTA LEXIS 2304">2307 the mineral rights, to the extent of $50,000 in the year 1920. In the year 1920 Johns. C. Pugh, Sr., and Mrs. Pugh sold a number of bales of cotton from their plantation for $4,320 and reported that amount in their income and profits-tax return for that year. Oil was discovered on the Petrovic Plantation in 1919 under a lease providing for the payment to J. C. Pugh, Sr., of a one-eighth 17 B.T.A. 429">431 royalty on all oil and gas taken therefrom. On August 1, 1919, J. C. Pugh, Sr., and one J. M. Eastham entered into the following written contract: STATE OF LOUISIANA, PARISH OF CADDO. Before me, the undersigned authority, personally came and appeared J. C. Pugh, husband of Carrie Gahagan, a resident of Caddo Parish, Louisiana, who declared that he has this day sold to J. M. Eastham, a resident of Caddo Parish, Louisiana, one-half (1/2) of his one-eighth (1/8) royalty on the following described property, situated in Red River Parish, Louisiana, to-wit: All of Section 12, except that part thereof situated in the Northwest quarter (NW 1/4), lying West and North of Shingle Bayou, the Northeast quarter (NE 1/4) of Section 13, and the North half (N 1/2) of the Northwest quarter (NW1929 BTA LEXIS 2304">2308 1/4) of Section 13, all in Township 12, Range 11, and all of that part of the Southwest quarter (SW 1/4) of Section 6, and all of Section 7, situated west of Cypress Bayou, and all that part of the Southwest quarter (SW 1/4) of Section 18 situated South and West of Cypress Bayou, all in Township 12, Range 10, and being all of the property owned by the said J. C. Pugh in Red River Parish, except the part acquired from C. H. Polly situated East of Cypress Bayou; the property embraced in this sale being known as the "Petrovick Plantation" and containing Thirteen Hundred (1300) acres, more or less. This sale and transfer is made for the price and sum of Two Hundred and Fifty Thousand ($250,000) Dollars; Fifty Thousand ($50,000) Dollars of which is paid in cash, and the balance of Two Hundred Thousand ($200,000) Dollars to be paid out of the one-half royalty herein conveyed to the said Eastham, the said J. C. Pugh to receive the entire royalty of one-eighth (1/8) until the said unpaid balance of Two Hundred Thousand ($200,000) Dollars has been paid out of the said one-half (1/2) belonging to the said Eastham, and thereafter the said one-half (1/2) shall be paid to the said J. M. Eastham1929 BTA LEXIS 2304">2309 or his assigns. It is further agreed and understood that the said J. M. Eastham in no way binds or obligates himself personally to pay the said balance of Two Hundred Thousand ($200,000) dollars, and if one-half (1/2) of the royalty from the said property is not sufficient to pay said sum, then the vendor in no way looks to the said J. M. Eastham personally for the payment thereof. This sale to be operative from the first day of August, 1919, and all oil in tanks now on hand shall go exclusively to the said J. C. Pugh. Thus done and passed on this the first day of August, 1919. J. C. PUGH J. M. EASTHAM Attest: W. W. FLOURNOY A. G. NUSSER JNO. D. WILKINSON, Notary Public.Endorsed: No. 3368. J. C. Pugh to J. M. Eastham. Sale of Royalty. Filed for record at 2 p.m. o'clock, August 6, 1919. Drew Davis, Dy. Clerk and Ex-officio Recorder. Recorded in Book 29, page 208 of Red River Parish Record, on this 7th day of August, 1919. 17 B.T.A. 429">432 A reasonable allowance to J. C. Pugh, Sr., and his wife for the depletion of their interest in the mineral rights in the Petrovic Plantation is $126,561.54 for 1920 and $17,331.54 for 1921. On July 12, 1920, J. 1929 BTA LEXIS 2304">2310 C. Pugh, Sr., his wife, Mrs. J. C. Pugh, Sr., and his children, J. C. Pugh, Jr., O. L. Pugh, L. G. Pugh, and Carama Pugh, executed a written instrument which is in the words and figures following, to wit: STATE OF LOUISIANAPARISH OF CADDO Before me, the undersigned authority, personally came and appeared J. C. Pugh, a resident of Caddo Parish, Louisiana, who stated and declared to me, Notary, that he has this day given, donated, transferred and delivered, and does by these presents give, grant, donate, and deliver unto his sons, J. C. Pugh, Jr., O. L. Pugh, J. C. Pugh, and to his daughter, Carama Pugh, and to his wife, Mrs. J. C. Pugh, nee Gahagan, of same residence, here present and accepting this donation, all of the following described property, situated in the Parish of Red River, said state, to wit: An undivided one-sixteenth (1/16) interest in and to all of the mineral and mineral rights in and under and appertaining to the following described property: All of Section Twelve (12), except that part of Northwest Quarter (NW 1/4) lying west and north of Shingle Bayou; Northeast quarter (NE 1/4) and North half (N 1/2) of Northwest quarter (NW 1/4), Section Thirteen (13), 1929 BTA LEXIS 2304">2311 Township Twelve (12) North, Range Eleven (11) West; all that part of the North half (N 1/2) of Section Eighteen (18) lying south and west of Cypress Bayou; also that part of the Southwest quarter (SW 1/4) of Section Six (6) lying West of Honey Bayou and that part of Section Seven (7) lying West and North of Honey Bayou, and that part of said Section Seven (7) lying North of Shingle Bayou, and that part of Section Seven (7) lying West of Cypress Bayou, all in Township 12 North, Range 10 West, Red River Parish, La. TO HAVE AND TO HOLD said described property unto said donees, their heirs and legal representatives forever. This donation is made for and in consideration of the love and affection which the donor has for the donees. It is agreed and understood that said property is donated to the said donees in equal division, and that all of said parties hereby appoint J. C. Pugh, Jr., as Trustee, to handle all of the income from said property herin donated, with full power and authority to sign all division and transfer orders, and to do all things necessary or incidental to the administration or sale of said property, including the receiving of moneys, he to have full charge1929 BTA LEXIS 2304">2312 of the management of same and of the distribution of all of the income from said property between said donees. The donees, being now present, stated and declared to me, Notary, that they hereby accept the above and foregoing donation according to the terms on which the same is made, and sign hereunto as evidence of their acceptance thereof. It is further agreed and understood that this donation is to be in force and effective of date August 1, 1920. 17 B.T.A. 429">433 IN TESTIMONY WHEREOF said parties have hereunto signed their names, in the presence of me, Notary, and the two attesting witnesses, on this the 12th day of July, A.D. 1920. J. C. PUGH CARRIE GAHAGAN PUGH L G. PUGH CARAMA PUGH J. C. PUGH, JR. O. L. PUGH WITNESSES: M. TODD HENRY E. RONDEAU. ABE GOODMAN, Notary Public in and for Caddo Parish, Louisiana.Endorsed: No. 8449. J. C. Pugh to O. L. Pugh, et als. DONATION. Filed for record at 9 a.m. o'clock, July 14, 1920. Recorded in Book 37, page 619 of Conv. record, Red River Parish, La., on this 14th day of July, 1920, Drew Davis, Clerk and Ex-officio Recorder. The amounts of allowable depletion of the mineral rights covered by1929 BTA LEXIS 2304">2313 said written instrument were $24,872.95 for 1920 and $59,202.35 for 1921. The respondent, upon audit of the returns of income filed by the above named persons for the years 1920 and 1921, determined that J. C. Pugh, Sr., and his wife were not entitled to any deduction from gross income for the year 1920 on account of the damage done to the surface rights of the Petrovic Plantation by oil, salt water, weeds, grass, etc.; that they were not entitled to any allowance in the years 1920 and 1921 for depletion of the interest in mineral rights covered by the contract of August 1, 1919, between J. C. Pugh, Sr., and J. M. Eastham, and that the donees named in the written instrument of July 12, 1920, and their respective husbands and wives, are not entitled to any deductions from their gross incomes for the years 1920 and 1921 as allowances for the depletion of the property conveyed by said instrument. The respondent also increased the income of J. C. Pugh, Sr., and Mrs. J. C. Pugh, sr., for 1920 on account of cotton sold by them in that year from $4,320 to $13,181.30. OPINION. MARQUETTE: These proceedings involve the income-tax liability for the years 1920 and 1921 of four men and1929 BTA LEXIS 2304">2314 their respective wives. Four issues are raised by the pleadings, three of which are found only in the cases of J. C. Pugh, Sr., and Mrs. J. C. Pugh. The other issue is common to all of the cases. It appears to be accepted by the parties that the incomes on which the taxes are based were community incomes and were reported on that basis. 17 B.T.A. 429">434 The first issue is whether J. C. Pugh, Sr., and his wife are entitled to any deduction from their income for 1920 on account of damage to or a loss of value in the Petrovic Plantation, which damage or loss was due to the fact that the land became impregnated with oil and salt water from oil wells drilled thereon, and covered with a growth of noxious weeds and grasses, thereby rendering it permanently less fitted for cotton and other crops, to the production of which it had theretofore been devoted. It appears to be fairly established by the evidence that the plantation, which had been acquired by J. C. Pugh, Sr., prior to March 1, 1913, had a fair market value of $105,000 on that date. It also has been established that in 1919 oil was discovered underlying the plantation and that in the latter part of 1919 and in the year 1920 oil1929 BTA LEXIS 2304">2315 wells were drilled, the larger part of the development occurring in 1920. Oil and salt water from these wells impregnated the land and caused the growth of coco grass, Johnson grass, and other noxious grasses and weeds, so that the plantation was rendered permanently less fitted for the production of cotton and other crops which had theretofore been raised thereon, and that the fair market value of the surface rights of the plantation in 1920, as distinguished from the mineral rights, was reduced by at least $50,000. We are, however, unable to find any reason or authority for allowing the deduction claimed. Granting that the usefulness of the plantation for agricultural purposes has been permanently impaired, it does not follow that a deductible loss has been sustained. There was a shrinkage in fair market value, but such shrinkage in value does not give rise to a deductible loss, any more than an increase in such value gives rise to income. Until there has been a sale or other disposition of the property is is impossible to say whether a gain or loss will be sustained. In 1929 BTA LEXIS 2304">2316 , this theory was expressed as follows: "The income tax laws do not profess to embody perfect economic theory. They ignore some things that either a theorist or a business man would take into account in determining the pecuniary condition of the taxpayer. They do not charge for appreciation of property or allow for a loss from a fall in market value unless realized in money by a sale." In our opinion Pugh and his wife sustained no deductible loss within the meaning of the Revenue Act of 1918. The evidence herein also shows to our satisfaction that J. C. Pugh, Sr., sold on his own account, in the year 1920, certain cotton for which he received $4,320. The respondent has increased the amount of such sales to $13,181.30. It appears that other cotton was in fact sold by Pugh, but that it was not for his own account but for the accommodation of other persons, and that he was not entitled to the proceeds. Mrs. Pugh testified positively that the cotton sold by J. C. 17 B.T.A. 429">435 Pugh, Sr., on his own account, brought only $4,320. On this point we sustain the petitioners. The third question is whether J. C. Pugh, Sr., was entitled1929 BTA LEXIS 2304">2317 to deduct any amount for depletion of the mineral rights covered by the written instrument executed by him and witnessed on August 1, 1919. The respondent denies that Pugh was entitled to any allowance for depletion of that interest, on the ground that he conveyed the entire interest to Eastham on August 1, 1919. The petitioners contend that Pugh and Eastham intended that the conveyance to Eastham should cover only the interest remaining after Pugh had received $200,000 in royalties and that Pugh was the owner of the mineral rights until they had been depleted to that extent. We do not agree with that contention. In the case of , the same contention was made by the petitioner relative to the effect of a written instrument which, in its essentials, is practically identical with the instrument executed by Pugh and Eastham. In holding adversely to the petitioners, we stated: The contract between the petitioners and West on one side, and Foster, Looney & Wilkinson on the other, refers to the petitioners and West as "vendors" and to Foster, Looney & Wilkinson as "vendees," which term we adopt for the purpose of this opinion. 1929 BTA LEXIS 2304">2318 It recites that in consideration of $200,000, to be paid entirely out of the oil produced on the tract of land described in the contract "the said H. C. Walker, Jr., and Elias Goldstein do sell, transfer and convey unto the aforesaid vendees the excess royalties of one twenty-fourth (1/24) of all the oil, gas and other minerals, reserved for them under the aforesaid lease * * ." Petitioners claim that we should disregard the words used in the contract and look to its substance, and that when so viewed it was not a contract of sale but that under it their rights as lessors were continued until they had received $200,000 out of the oil and that by the contract the petitioners and George West were recognized as the owners of the one-sixteenth royalty interest which was the subject of the contract. These contentions are not borne out by the recitals and the provisions of the contract. It clearly appears that the vendors and vendees were claiming under adverse titles, and that the purpose of the agreement was not to recognize the rights of each other, but to settle the controversy by a compromise of that which had theretofore been contested. The sum of $200,000 was "to be paid entirely1929 BTA LEXIS 2304">2319 out of the oil produced from the above described tract of land, either by the lessees of the said George West and their assigns, or by the lessees of the said Lillie G. Taylor, and their assigns, and accruing to the credit of the undivided one-sixteenth (1/16) interest that is vested in the said vendees by reason of the purchase above referred to by them from the said Lillie G. Taylor on the one hand, any by reason of their purchase from the said vendors under this contract on the other hand." It thus appears that the $200,000 was not payable to the petitioners and West out of their interest in the oil, but was payable out of the interest of the vendees, which they had acquired from Lillie G. Taylor, and from the petitioners and West. 17 B.T.A. 429">436 Putting aside the fact that the contract uses the words "sell, transfer and convey," and the words "vendors" and "vendees," and looking to the substance of the contract alone, the conclusion can not be escaped that the contract was a contract of sale which divested the taxpayers and West of all interest in the property therein referred to, and vested eo instanti the title thereto in the vendees for the consideration of $200,000 payable1929 BTA LEXIS 2304">2320 out of the royalties the contract for which was assigned to the vendees. Such being the case, the respondent did not err in refusing to allow the petitioner a dedution for depletion. We are of opinion that the instrument under consideration was a contract of "sale to be operative from the first day of August 1919," and that Pugh was on that day divested of the title to the property described in the instrument and that the respondent did not err in refusing to allow him deductions for depletion thereof in 1920 and 1921. The last question is whether the several petitioners are entitled to deduct from gross income in the years 1920 and 1921, any amount for the depletion of the mineral rights covered by the donation deed executed by Pugh, Sr., on July 12, 1920. The respondent denies the right of the petitioners to this deduction, on the ground that the property was held in trust, the income to be collected and distributed by a trustee, and that the deductions for depletion should be allowed only to the trust as an entity. The petitioners also proceed on the theory that the property was held in trust for them. We think, however, that the instrument of July 12, 1920, merely created1929 BTA LEXIS 2304">*2321 an agency, and that the petitioners, as the owners of the property, are entitled to allowances for depletion according to their respective interests. Reviewed by the Board. Judgment will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621948/	APPEAL OF CLARENCE C. SMITH.Smith v. CommissionerDocket No. 3767.United States Board of Tax Appeals4 B.T.A. 514; 1926 BTA LEXIS 2265; July 29, 1926, Decided 1926 BTA LEXIS 2265">2265 The fair market value of shares of stock, received by the taxpayer as compensation for personal services, determined. Thomas O. Marlar, Esq., and Harry J. Gerrity, Esq., for the petitioner. George G. Witter, Esq., for the Commissioner. MARQUETTE 4 B.T.A. 514">514 Before MARQUETTE, GREEN, and LOVE. This appeal is from the determination by the Commissioner of a deficiency for the year 1916 in the amount of $712.08, consisting of a proposed additional tax in the amount of $474.72 and a penalty in the amount of $237.36 added to the tax for failure on the part of the taxpayer to file an income-tax return for the year 1916. FINDINGS OF FACT. The taxpayer is an individual residing at Toledo, Ohio. The Toledo Steel Casting Co. is a corporation organized in the year 1904 under the laws of the State of Ohio. On July 30, 1912, the outstanding capital stock of the corporation consisted of 850 shares of preferred stock of the par value of $100 each, of which 844 shares 4 B.T.A. 514">515 were held by S. D. Carr and Curtis T. Johnson. At that time the corporation had a book deficit or impairment of capital in the amount of about $33,000, due to operating losses1926 BTA LEXIS 2265">2266 in prior years. On July 30, 1912, The Toledo Steel Casting Co. and S. D. Carr and Curtis T. Johnson entered into a contract with the taxpayer and John B. Nordholt, by which the taxpayer and Nordholt agreed to assume the management of the company for a joint compensation of $5,000 per annum, the transfer to them by Carr and Johnson of $42,000 par value of the company's stock when the net value of the company's assets should have increased by $50,000, and the issuance to them by the company of $15,000 par value additional stock, when the "stock and materials on hand, plus good and collectible credits, accounts, notes and bills receivable, shall equal the unsecured indebtedness of" the company. The contract stipulated that the net value of the company's assets at that time was $80,523.67. In November, 1916, Carr and Johnson transferred to the taxpayer and John B. Nordholt as compensation due under the contract of July 30, 1912, capital stock of The Toledo Steel Casting Co. of the par value of $42,500, which was divided between them in equal amounts. The assets and liabilities of The Toledo Steel Casting Co. on December 31, 1912, 1913, 1914, 1915 and 1916, respectively, as shown1926 BTA LEXIS 2265">2267 by its books, were as follows - 19121913191419151916Assets$233,196.68$230,234.56$239,053.00$264,969.14$304,670.32Liabilities other than capital stock181,595.73178,027.04171,498.21180,805.67182,850.72Capital stock85,000.0085,000.0085,000.0085,000.0085,000.00Surplus or deficits33,399.0532,792.4817,445.21836.3336,819.60The capital stock of The Toledo Steel Casting Co. is and has at all times been closely held. There were no sales of the stock between July 30, 1912, and the end of the year 1916, it having been held in trust during that period to guarantee performance of the stockholders' liability under the contract of July 30, 1912. A few small lots of the stock were sold during the years 1919, 1920 and 1921. The fair market or reasonable value of the capital stock of The Toledo Steel Casting Co. in November, 1916, was at least $100 per share. The taxpayer did not file an imcome-tax return for the year 1916 and a return was made for him by the Commissioner some time subsequent to the enactment of the Revenue Act of 1918. The Commissioner determined that the capital stock of The Toledo Steel1926 BTA LEXIS 2265">2268 Casting 4 B.T.A. 514">*516 Co., received by the taxpayer in the year 1916, had a value of $21,250 at the time of its receipt by the taxpayer, and he included that amount in the taxpayer's income for that year, and determined that there is a deficiency in tax for the year 1916 in the amount of $474.72, to which he added 50 per cent of the amount of the tax as a penalty for failure to file an income-tax return within the time prescribed by law. OPINION. MARQUETTE: The facts in this appeal are identical with the facts in the Appeal of John B. Nordholt, decided this day, ante, 509, and for the reasons set forth in the opinion in that appeal, the penalty involved herein should be reduced to 25 per cent of the tax. In all other respects the determination of the Commissioner is approved. Order of redetermination will be entered on 15 days' notice, under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621953/	ESTATE OF LOUIS DURANTE, DECEASED, JOHN L. DURANTE, EXECUTOR, AND ANGELA DURANTE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentEstate of Durante v. CommissionerDocket No. 2145-86.1United States Tax CourtT.C. Memo 1988-60; 1988 Tax Ct. Memo LEXIS 60; 55 T.C.M. (CCH) 123; T.C.M. (RIA) 88060; February 22, 1988. S. Mac Gutman, for the petitioners. Jody Tancer, for the respondent. SHIELDSMEMORANDUM FINDINGS OF FACT AND OPINION SHIELDS, Judge: Respondent determined deficiencies in petitioners' Federal income taxes for tax years 1981 and 1982 in the amounts of $ 35,797.00 and $ 19,101.00, 61 respectively. The issue is whether petitioners are entitled to deduct as business bad debts certain amounts paid by Louis Durante during his lifetime as the guarantor of a corporate loan. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits associated therewith are incorporated herein by reference. Prior to his death in 1984, Louis Durante ("Mr. Durante") and petitioner Angela Durante were husband and wife. They filed joint income tax returns for 1981 and 1982. At the time their petition in this case was filed, Angela Durante and John L. Durante, who had qualified as Executor of the Estate of Louis Durante, resided in New York. From about 1950 until his death in 1984, Mr. Durante was involved with several partnerships and corporations in the construction industry. During the 1960s and early 1970s, he was a shareholder, officer, and employee of Durante Brothers, a corporation engaged in excavating, paving, and residential and commercial building. His responsibilities with Durante Brothers included sales and the general promotion of their construction projects. In the course of his activities with Durante Brothers, 62 he was required to execute performance bonds guaranteeing the work of the corporation and the payment of its subcontractors. In or about 1964, Mr. Durante became a shareholder, officer, and employee of Jet Asphalt Corporation ("Jet"), a manufacturer of asphalt. His responsibilities with Jet were limited to sales. He was not involved with the daily management of the company. For his services, he was paid both wages and consulting fees by Jet. After going with Jet, Mr. Durante, continued to provide services to Durante Brothers until that corporation ceased to exist in the early 1970s. The operation of the corporations were entirely separate except that on occasion Durante Brothers would purchase asphalt from Jet. After Durante Brothers' operations ceased, Mr. Durante concentrated his efforts in promoting the business and goodwill of Jet. For such services, Jet paid him wages and other compensation totaling $ 52,094.00 in 1975, $ 51,500.00 in 1976, $ 80,000.00 in 1977, $ 25,700.00 in 1978, $ 127,200.00 in 1979, $ 179,350.00 in 1981, and $ 76,011.00 in 1982. While working for Durante Brothers and Jet, Mr. Durante obtained an interest in other construction ventures. For example, 63 in the early 1960s, he was a partner in Bella Homes, which was engaged in residential construction and sales; and, in the early 1970s, he had an interest in Galante Realty Company, which constructed and managed real properties. He also participated to some extent in the businesses known as Carat Contracting Company and Salvmonte Construction Corporation. However, none of the ventures except Durante Brothers and Jet existed for an extended period, and while Mr. Durante was involved in the promotion and business affairs of the short-lived ventures, the record contains no evidence of the compensation, if any, he received for such services. In the latter part of 1974 Mr. Durante met with Murray Marcovitz, (Marcovitz) the president and owner of 50 percent of the stock in Jerder Realty Services Co. ("Jerder). The other 50 percent of the stock in Jerder was owned by Ben Restelli and his wife, June Restelli. Originally, Jerder had been organized for the purpose of purchasing for resale a development in Staten Island, New York. The development consisted of approximately 100 townhouses in various stages of construction. As president of Jerder, Murray Marcovitz had been responsible for64 coordinating the construction, promotion and sale of the townhouses. In 1974 when Mr. Durante first met with Marcovitz, the construction and sale of the 100 original townhouses had been completed. Jerder, however, was in the process of negotiating the purchase of an additional 20 townhouses that had been used as models. The models were structurally complete with the exception of water and sewer lines, electrical facilities, and paving. The total price of the 20 models as negotiated by Marcovitz was $ 600,000. At the time, however, Jerder did not have and could not obtain financing for such funds but subsequently, in June of 1975, financing for the purchase was arrange by Marcovitz with the help of Mr. Durante and the $ 600,000 was borrowed from Mortgagee Affiliates Corporation in exchange for a mortgage note in that amount executed by Marcovitz for Jerder and personally guaranteed in a separate document by Mr. Durante. The parties agree that Mortgage Affiliates Corporation would not have made the $ 600,000 loan to Jerder without the personal guarantee by Mr. Durante or a similar guarantee by some other person with an adequate financial statement. Mr. Durante executed the65 guarantee solely for the purpose of acquiring Marcovitz's 50 percent interest in Jerder. Apart from the execution of the guarantee, he contributed no money or other property for the acquisition of his interest in Jerder and the record contains no evidence that he rendered any service to Jerder except the execution of the guarantee. Prior to 1980, Jerder defaulted on the $ 600,000 mortgage note and Mr. Durante was called upon to make payment under the guarantee. In January of 1981, Mortgage Affiliates Corporation and Mr. Durante reached a settlement agreement regarding the payment of the debt. Under the settlement, Mr. Durante, as guarantor of the note, paid $ 58,000 in 1981 and $ 40,000 in 1982 to Mortgage Affiliates Corporation. Prior to 1964 Mr. Durante's primary source of income was from Durante Brothers. Thereafter and particularly during the years 1975 through 1982 his primary source of income was from wages and other compensation paid by Jet. He received no salary, wages, consulting fees or other income from Jerder. On their 1981 and 1982 tax returns Mr. and Mrs. Durante deducted the amounts paid by Mr. Durante under the guarantee agreement as business bad debts. 66 2 In his notice of deficiency respondent disallowed the business bad debt deductions and treated the payments as short term capital losses subject to the limitations of section 1211. 3OPINION In this proceeding respondent contends that Mr. Durante's debt constituted a nonbusiness bad debt under section 166(d), or alternatively, the debt constituted a capital investment. Petitioners contend that the payments made by Mr. Durante in 1981 and 1982 to discharge his guarantee of the Jerder Realty debt are fully deductible as business bad debts under section 166(a)(1). Generally, losses sustained by a guarantor on a worthless debt are deductible under section 166. Putnam v. Commissioner,352 U.S. 82">352 U.S. 82 (1956); Horne v. Commissioner,59 T.C. 319">59 T.C. 319 (1972),67 affd. 523 F.2d 1363">523 F.2d 1363 (9th Cir. 1975), cert. denied 439 U.S. 892">439 U.S. 892 (1978). When an individual guarantees a debt in the course of his trade or business any subsequent payment as a result of the guarantee is fully deductible under section 166(a)(1) as a business bad debt. However, a payment by an individual taxpayer as guarantor of a corporate debt in a transaction for profit, but not incurred in the taxpayer's trade or business, is deductible as a nonbusiness bad debt under section 166(d) which restricts nonbusiness bad debts to the treatment accorded losses on the sale of short-term capital assets under section 1211. Whipple v. Commissioner,373 U.S. 193">373 U.S. 193, 200-201 (1963). Under section 166(a)(1) the full deductibility of a bad debt turns upon the proximate connection of the debt with activities recognized as a trade or business, a concept which falls short of reaching every income or profit making activity. Whipple v. Commissioner, supra at 201; Putnam v. Commissioner, supra at 90-92. Thus, to be entitled to a business bad debt deduction under section 166(a)(1) it must be shown that the taxpayer was engaged68 in a trade or business and that the bad debt was proximately related to it. Section 1.166-5(b), Income Tax Regs; Whipple v. Commissioner, supra.In determining whether the loss of a taxpayer is proximate to his trade or business, rather than his investment interest as a shareholder, business considerations must be the dominant motive for making the loan. United States v. Generes,405 U.S. 93">405 U.S. 93, 103 (1972). The burden of proof is on petitioners to show that they are entitled to a business bad debt deduction. United States v. Clark,358 F.2d 892">358 F.2d 892, 895 (1st Cir. 1966); United States v. Byck,325 F.2d 551">325 F.2d 551 (5th Cir. 1963). Their burden includes proof of the existence of the business in which Mr. Durante was engaged and the manner in which the disputed debt was proximately related to such business. Syer v. United States,380 F.2d 1009">380 F.2d 1009, 1010 (4th Cir. 1967). In their petition, petitioners allege that Mr. Durante was engaged in the business of rendering advice on the technical and financial aspects of construction contracting. At trial, petitioners' recharacterized his business as promoting, financing69 and managing real estate and construction enterprises. As proof that Mr. Durante was in a trade or business, petitioners called as a witness Ben Castiglione who testified about his participation with Mr. Durante in a number of construction ventures. From Mr. Castiglione's testimony, we are satisfied that in 1975 through 1982 Mr. Durante was in the trade or business of rendering advice to and promoting the business interests of Jet for wages or other compensation. However, the record before us is not sufficient to support a finding that his trade or business during those years embraced the promotion of any other venture including Jerder in which he held an interest. The Code does not contain an all-embracing definition of the term "trade or business." It is clear, however, that not every income-producing activity constitutes a trade or business. Commissioner v. Groetzinger,480 U.S. , 107 S.Ct. 980, 987 (1987); Whipple v. Commissioner, supra.In Whipple v. Commissioner, supra at 202, the Supreme Court addressed what constitutes a trade or business within the meaning of section 23(k)(1) of the Internal Revenue Code70 of 1939, the predecessor to section 166. The Court stated: Devoting one's time and energies to the affairs of a corporation is not of itself, and without more, a trade or business of the person so engaged. Though such activities may produce income, profit or gain in the form of dividends or enhancement in the value of an investment, this return is distinctive to the process of investing and is generated by the successful operation of the corporation's business as distinguished from the trade or business of the taxpayer himself. When the only return is that of an investor, the taxpayer has not satisfied his burden of demonstrating that he is engaged in a trade or business and the return to the taxpayer, though substantially the product of his services, legally arises not from his own trade or business but from that of the corporation. * * * In Whipple the Court went on to stress that "absent substantial additional evidence" the promotion of a corporation for a return no different than that flowing to an investor is not a trade or business. Furthermore, to be engaged in a trade or business, as distinguished from a transaction entered into for profit, the taxpayer must71 be prepared to show not only that his primary purpose for engaging in the activity was to realize income or profit, but also to show that he was involved in the activity with continuity and regularity. See Commissioner v. Groetzinger, supra.From this record, we are able to find that the only activities conducted by Mr. Durante with any continuity and regularity were those pertaining to Jet. 4 With the exception of his execution of the guarantee 5 whatever activities, if any, he may have performed in behalf of Jerder are purely a matter of conjecture. Even if we assume that Mr. Durante performed significant promotion or other activities for Jerder, our result would remain unchanged in the absence of a basis for finding that his anticipated reward was compensation directly for his own services as distinguished from receiving an investor's return generated by the successful and profitable operation of the corporation. 72 Mr. Durante's historic participation in other construction ventures does not supply the "substantial additional evidence" needed to support a finding that with respect to Jerder he was a participant in a trade or business rather than an investor. His involvement with each venture was short-lived and sporadic. See Estate of Campbell v. Commissioner,343 F.2d 462">343 F.2d 462, 463 (2d Cir. 1965), affg. a Memorandum Opinion of this Court. Furthermore, the record contains no evidence of the nature and amount of his activity with respect to the ventures. We conclude, therefore, that Mr. Durante's guarantee of the Jerder loan was not incurred by him in the course of any trade or business but in order to acquire 50 percent of Jerder's stock as an investor. 6 See United States v. Generes,405 U.S. 93">405 U.S. 93, 99 (1972); Estate of Broadhead v. Commissioner,391 F.2d 841">391 F.2d 841, 845 (5th Cir. 1968), affg. a Memorandum Opinion of this Court. Decision will be entered for the respondent.Footnotes1. The parties have agreed to be bound by the result in this case in the separate but related case at docket No. 2146-86. ↩2. Neither tax return contains a Schedule C, Income (or Loss) from a Trade or Business. The deductions for business bad debts in 1981 and 1982 appear on the Forms 1040 on the lines ordinarily reserved for reporting "other income." ↩3. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure. ↩4. Petitioners did not contend or produce evidence to show the guarantee was incurred for the purpose of generating income or sales commissions in connection with Mr. Durante's services for Jet. See Whipple v. Commissioner,373 U.S. 193">373 U.S. 193, 201 (1963); Dorminey v. Commissioner,26 T.C. 940">26 T.C. 940↩ (1956) (losses on loans to corporation were proximately related to taxpayer's independent produce business where corporations provided a produce resource). 5. Petitioners have stipulated that he executed the guarantee in exchange for 50 percent of the stock of Jerder, which standing alone is the obvious act of an investor. ↩6. In light of this result, we do not address respondent's alternative argument. ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621954/	Stanley J. Trohimovich, Anna Mae Trohimovich, Estate of Richard A. Trohimovich, Deceased, Merita M. Trohimovich, Executrix, and Merita M. Trohimovich, Individually, Petitioners v. Commissioner of Internal Revenue, RespondentTrohimovich v. CommissionerDocket No. 7879-78United States Tax Court77 T.C. 252; 1981 U.S. Tax Ct. LEXIS 80; August 10, 1981, Filed 80 Stanley J. Trohimovich deliberately, knowingly, and intentionally refused to obey two summonses issued by this Court, one issued at the request of the Internal Revenue Service and one issued at the request of two of his copetitioners, and a direct order of this Court, to produce certain books and records necessary for the trial of this case. Held, Stanley J. Trohimovich is guilty of criminal contempt of court and it was ordered that he be imprisoned for 30 days as punishment therefor. Drennen, Judge. DRENNEN252 OPINIONAn order was entered by this Court dated July81 21, 1981, adjudging Stanley J. Trohimovich (hereinafter Stanley) to be in criminal contempt of this Court for refusing to comply with two subpoenas issued by this Court and one direct order of this Court to produce certain books and records of Grays Harbor Motors for use in the trial of this case. The order referred to the transcript of the contempt hearing held in Seattle, Wash. on July 21, 1981, for cause. This memorandum will summarize the reasons the Court reached the conclusion reflected in the contempt order (copy attached).A brief review of Stanley's actions relative to filing tax returns and his relationship with the Internal Revenue Service, the Tax Court, the United States District Court, and other Government officials during the past 10 years is important to a complete understanding of the circumstances surrounding the contempt citation.Stanley and his brother, Richard, now deceased, operated as partners a Volvo automobile business in Aberdeen, Wash., under the name Grays Harbor Motors. They and their wives, Anna Mae and Merita, respectively, filed joint income tax returns for 1971 reporting income from Grays Harbor Motors. For the years 1972 and 1973, they filed 82 income tax return forms but entered no figures for income or deductions, filling in various articles of the Constitution instead. Upon audit of the above returns, they refused to allow the revenue agents 253 access to the books and records of Grays Harbor Motors to verify or compute the income of the partnership. Consequently, the Revenue Service computed their taxable incomes by an indirect method, using whatever third-party records they could find, and issued notices of deficiencies to the Trohimoviches. They filed a petition in this Court for redetermination of those deficiencies, but when the case was called for trial, they refused to produce evidence of their taxable incomes, so on respondent's motion, the Court dismissed the case for failure to prosecute and entered decisions against them in the amount of the deficiencies determined in the notices of deficiency.Subsequently, it appears from the opinion of the United States District Court for the Western District of Washington, at Seattle, in the case of Clark v. McGovern, filed November 18, 1976, Stanley and others in a group of tax protesters (for lack of a better designation) brought numerous legal actions from83 time to time against Federal judges, U.S. attorneys, and other Government officials. In Clark v. McGovern, the court found that the pending action, against a District Court judge and the U.S. attorney, was groundless and frivolous and brought to vex, harass, and annoy Federal officials and the courts. The opinion stated that the petitioners had been put on notice that the Federal courts could not possibly grant relief or recognize defenses based on the legal theories advanced by petitioner, particularly any claim containing a necessary premise that the Internal Revenue Code is unconstitutional. Consequently, it dismissed the action and granted a permanent injunction against certain named individuals, including Stanley, enjoining them from filing any more similar suits relying on similar arguments, unless first obtaining the permission of the courts.For the years 1974 and 1975, which are involved in this proceeding, Stanley and Richard, and their respective wives, filed joint income tax forms giving no information about their taxable incomes, citing only provisions of the Constitution. When they were again denied access to any books or records, the revenue agents auditing 84 these so-called returns again computed the taxable incomes of the Trohimoviches by an indirect method similar to that used for 1971-73 and determined the deficiencies that are here in dispute. The Trohimoviches 254 filed petitions in this Court in 1978 seeking a redetermination of their tax liabilities for 1974 and 1975, and the cases of all four were consolidated and assigned docket No. 7879-78 (Richard Trohimovich died in late 1980 and his wife, Merita, as executrix of his estate, has been substituted as a petitioner). After several false starts, this case was set for trial in Seattle on December 11, 1980. When the case was called for trial, Stanley refused to comply with a subpoena issued by this Court, at respondent's request, to produce the books and records of Grays Harbor Motors. Although being advised repeatedly by the Court that the books and records were necessary and that it would be useless to proceed with the trial without them, Stanley persisted in his refusal to produce them. Thereupon, the Court dismissed his case for failure to prosecute. Since Richard had died and no representative had been appointed for his estate, the Court continued the other three 85 cases. The Court withheld the decision in Stanley's case pending the outcome of the other three cases. See memorandum sur order of Judge C. Moxley Featherston dated March 3, 1981.Merita Trohimovich, widow of Richard, was appointed executrix of Richard's estate, and the cases of the other three petitioners were set for trial in Seattle on May 11, 1981. On May 4, 1981, respondent served a Court-issued subpoena on Stanley to produce specified books and records of Grays Harbor Motors for use at the trial on May 11, 1981. Merita had also written Stanley asking him to produce the books and records. Stanley, his wife, Anna Mae, and his sister-in-law, Merita, answered the call of the case on May 11. Although he was advised that his case was not involved, Stanley orchestrated the proceedings. He refused to comply with the subpoena and Merita's request to produce the books and records. The case was set for trial on Wednesday, May 13, and Stanley was ordered by the Court to produce the books and records at that time. When Stanley refused to produce the books and records on May 13, Merita asked for time to employ an attorney to represent her and Richard's estate. The case was continued86 to Friday, May 15. Merita obtained the services of an attorney on May 13, and a subpoena was issued at her request and served on Stanley on May 14 to produce the books and records on May 15. When the case was called for trial on May 15, Merita and 255 her attorney and Anna Mae were present but Stanley was not. After a telephone call from Anna Mae, Stanley did appear in court but again refused to comply with the subpoena served by Merita. Counsel for Merita and Richard's estate moved for a continuance of the case to give him time to familiarize himself with it and determine what procedure to follow in behalf of his clients. The motion was granted.Stanley was then advised by this Court that if he did not produce the books and records he risked being cited for contempt of court and was advised of the consequences thereof. Stanley persisted in his refusal to obey the Court's orders to produce the books and records, so the Court cited him for contempt of court and set a hearing on the citation for July 21, 1981, in Seattle, and advised Stanley of his rights and the procedure that would be followed. Because of the fact that this Court does not sit continuously in Seattle and87 the Court's conclusion that Stanley would not be coerced into producing the books and records by a civil contempt citation, the Court cited Stanley for criminal contempt, and an order and notice setting the time for hearing was issued on May 21, 1981 (copy attached).At the contempt hearing on July 21, 1981, Stanley offered the testimony of three witnesses from the Aberdeen area who testified that Stanley had the reputation in his home area of being an advocate of obedience rather than disobedience of the law. They were asked no questions about the disobedience we are concerned with here. Stanley, himself, testified that he was a law-abiding citizen and had no intent to violate any law by refusing to obey the orders of this Court mentioned above because he did not believe the orders of the Court were lawful or valid.The petition in this case, while rambling and lengthy, appears to rely primarily on arguments that neither the Internal Revenue Service nor this Court has authority to determine petitioner's tax liability because the 17th Amendment to the Constitution, which changed the method of electing senators to the U.S. Congress, was improperly proposed and/or adopted, and therefore88 all laws enacted by Congress (and the Senate) subsequent to at least 1919 are invalid. This included the Internal Revenue Code and the legislation which established this Court. The petition also 256 alleged that the actions and methods used by the revenue agents and the Internal Revenue Service in determining petitioners' taxable income for 1974 and 1975 were unlawful and constituted a crime, and that a "Notice of Felony" sent by petitioners to this Court and numerous Government officials, presumably pursuant to title 18, U.S.C. sec. 4, in some way precludes any proceeding to determine their tax liability until someone prosecutes the Internal Revenue Service or agents thereof for the crimes petitioners claim they have committed, which are not specified.Throughout these proceedings, Stanley has filed numerous lengthy motions and other documents, usually at the last moment, espousing various legal theories that have occurred to him for dismissing or delaying this case. For example, he telephoned the Clerk of the Tax Court on the afternoon of Friday, July 17, 1981, to advise that he was filing a notice of appeal from one of the Court's rulings89 issued during the week of May 11 through 15, accompanied by a motion to stay the contempt proceedings. These documents were not received by the Court until after the judge had left Washington, D.C., for Seattle at 5 p.m., Monday, July 20. On Tuesday, July 21, the date of the contempt hearing, the Clerk of the Court received in Washington, D.C., five documents entitled (1) "Petitioners' motion for stay in all proceedings until Judges of this Court and the employees of the United States stop the pretext (or sham) of compliance with the laws of the United States (including the United States Constitution, Rule 201 of the Federal Rules of Evidence, and the Rules of Practice and Procedure, United States Tax Court)"; (2) "Petitioners' (and/or witness') motion to correct the corrupt and criminal application and administration of the laws of the United States by Judges Scott, Drennen, Featherston, and Tannenwald"; (3) "Petitioners' motion for information"; (4) "Petitioners' motion to discharge all proceedings for lack of subject matter jurisdiction"; and (5) "Petitioners' (Stanley J. Trohimovich) motion for stay of all oral orders at the May 11, 1981, Seattle trial session of the Court in90 the above docket number (with the exception of the oral order made with reference to the appointment of an executrix to appear for the Richard Trohimovich Estate)." All of these motions contain numerous citations of authorities, with no explanation of their relevance or application, which 257 the Court could not possibly have reviewed prior to the scheduled hearing, even if they had been received in Seattle.At the contempt hearing, Stanley argued that since this was a criminal contempt citation, the requisite intent must be proved beyond a reasonable doubt and that since the only evidence presented was from his witnesses, such intent had not been proved. The Court is not certain to just what intent Stanley refers. Contempt of Court is not a statutory crime which includes intent as a statutory element, such as first degree murder. The distinction between civil contempt and criminal contempt, as we understand it, is not so much in the manner in which the contemptous action is taken nor the intent of the contemnor, but is in the purpose which the adjudication of contempt is to accomplish. Civil contempt has a coercive purpose to compel compliance; the extent of the punishment91 is dependent upon whether the contemnor purges himself by obeying the Court's order. 1 Criminal contempt has a punitive purpose, to punish defiance of a court order, i.e, to vindicate the authority of the Court. See Norman Bridge Drug Co. v. Banner, 529 F.2d 822 (5th Cir. 1976). It is in the public interest and the orderly and expeditious administration of justice that an order of a court with jurisdiction over the subject matter and the person must be obeyed by the parties until it is reversed by proper proceedings. See Maness v. Meyers, 449">419 U.S. 449 (1975). "Even when a Court issues an order which it had not the power or authority to issue, in matters of criminal contempt the disobedient party may be held and appropriately punished. This is true if the order is later found to have been invalid, even to the extent of infringing constitutional rights." Norman Bridge Drug Co. v. Banner, supra at 827.92 There is no doubt that Stanley knowingly, intentionally, and deliberately disobeyed the orders of this Court, and that such disobedience has delayed and obstructed the orderly and proper disposition of this case. This is particularly true with respect to Merita and the Estate of Richard, who need these records to prosecute their case. The intent necessary to sustain an adjudication of criminal contempt is the intent to perform 258 or refuse to perform an act when one knows, or should reasonably be aware, that his conduct is wrongful. United States v. Seale, 461 F.2d 345">461 F.2d 345 (7th Cir. 1972). Stanley cannot deliberately disobey an order of this Court and avoid being adjudged guilty of contempt by fabricating legal theories to support a claim that the orders were not lawfully issued. He has been advised by various courts during the past 10 years, implicitly or explicitly, that his arguments were not valid and he has had reason to believe that his actions were wrongful.We will mention a few of Stanley's legal theories upon which he relies to show that this Court was without jurisdiction or authority to issue the orders to produce and upon which he93 apparently relies to argue that he had no intent to commit a crime by refusing to produce. Incidentally, when questioned by the Court with regard to his Fifth Amendment plea, the only fear of incrimination mentioned by Stanley was that he could be imprisoned as a result of the contempt proceeding. Of course, incrimination of that sort would result only from Stanley's disobedience of the Court's orders, not his obedience thereof. Practically all of his arguments not mentioned below have been decided by the courts many times. See Cupp v. Commissioner, 65 T.C. 68">65 T.C. 68 (1975); Hatfield v. Commissioner, 68 T.C. 895">68 T.C. 895 (1977).Stanley's basic argument seems to be that the 17th Amendment was not properly adopted and therefore all laws enacted by Senators elected under the amendment are invalid. The argument centers around whether article V of the Constitution requires a vote of two-thirds of all the members of both Houses of Congress to adopt a resolution proposing an amendment to the Constitution or whether a vote of two-thirds of those members present is sufficient. This was debated in the House of Representatives in connection94 with the 17th Amendment on May 13, 1912, at the conclusion of which the Speaker of the House ruled that the vote of only two-thirds of those members present was required, and he declared the resolution adopted. The Secretary of State declared in a proclamation dated May 13, 1913, that the 17th Amendment had been ratified by the legislatures of 36 of the 48 States and was, therefore, a part of the Constitution. In United States & Lyons v. Sluk, an unreported opinion ( S.D. N.Y. 1979, 44 AFTR 2d 79-6048, 79-2 USTC par. 9650), the United States District 259 Court for the Southern District of New York upheld the validity of the 17th Amendment. While we have found no higher authority ruling directly on the validity of the 17th Amendment, the Supreme Court and other courts have relied on it. See MacDougall v. Green, 335 U.S. 281">335 U.S. 281 (1948); Phillips v. Rockefeller, 435 F.2d 976 (2d Cir. 1970). While we doubt that Stanley has standing to raise this issue in this proceeding, we disagree with his theory and, in the absence of any authority supporting his view, we do not believe 95 that he sincerely thinks the 17th Amendment is null and void and that all laws passed by the U.S. Senate, by Senators elected under the amendment, are null and void. This argument is similar to Stanley's arguments in other courts that the Internal Revenue Code is unconstitutional, which was enjoined by the District Court in Clark v. McGovern, supra.This Court does not understand how Stanley could expect relief by relying on a "Notice of Felony." Title 18, U.S.C. sec. 4, which he cites as authority, simply provides that it is a felony for anyone, having knowledge of the actual commission of a felony cognizable by a court of the United States, to conceal such knowledge and not make it known to some judge or other person in civil authority under the United States. At best, the "Notice of Felony" sent by Stanley to this Court and numerous other Government officials might protect him from violating that statute but it has nothing to do with the activities of this Court in carrying out its duties under the law. The fact that Stanley claims a felony was committed by the Internal Revenue Service in the audit of his returns does not make it a felony96 cognizable by a court. 2 Furthermore, the Tax Court 260 would have no jurisdiction to do anything about such a felony if one had been committed. Here, again, the Court cannot conceive that Stanley sincerely believes that the "Notice of Felony" has or should have anything to do with the proceedings in this Court in this case. We find this argument to be groundless and frivolous.97 With respect to Stanley's argument that this proceeding should be suspended until the Court of Appeals acts on his appeal from this Court's order to produce, the notice of appeal was not filed in time to suspend the contempt hearing. Furthermore, there is a question whether the order he is attempting to appeal is a final appealable order. There is some uncertainty among the circuits on this issue (compare Ryan v. Commissioner, 517 F.2d 13 (7th Cir. 1975), with United States v. Secor, 476 F.2d 766">476 F.2d 766 (2d Cir. 1973)), but this is something the Ninth Circuit will have to decide. In any event, we do not believe anyone's rights were denied by proceeding with the contempt hearing, even if the notice of appeal from the production order was timely. If the contempt order is appealed, both orders can be considered by the Court of Appeals at the same time.At the contempt hearing, Stanley, for the first time, raised an argument that being forced to produce his books and records would somehow infringe upon his First Amendment freedom of religion to enforce the Constitution and laws of the United States. He relied upon a recent Supreme98 Court case, Thomas v. Review Board of Indiana, decided April 6, 1981, which he apparently had just come upon. That case is inapposite here. Stanley points to no link between his religious beliefs and the determination of his income tax liability under the Internal Revenue Code.Based on the history of this case, Stanley's actions with respect to his taxes over the past 10 years, and the frivolous character of his arguments in this case, we think there can be no doubt that Stanley intentionally, knowingly, and deliberately refused to obey the orders of this Court for the purpose of 261 delaying the determination of his and his family's tax liabilities, obstructing the orderly procedures of this Court, and disrupting the tax collection system of this country. He has not shown that obedience to the Court's orders would in any way deprive him of any of his constitutional rights. His exhaustive efforts to press every reason he can think of to delay this case and avoid producing the books and records of Grays Harbor Motors convince us that he is more interested in avoiding the payment of taxes than complying with the law. He has intentionally and knowingly defied the undeniable99 authority of this Court and we cannot accept his fabricated legal arguments, which have been rejected time and again, as justification for doing so. See Hatfield v. Commissioner, supra at page 899.For the above and other reasons, we have adjudged Stanley to be in criminal contempt of Court and have ordered that he be imprisoned for 30 days.UNITED STATES TAX COURTWASHINGTON, D.C. 20217Stanley J. Trohimovich, Anna Mae Trohimovich, Estate of Richard A. Trohimovich, Deceased, Merita M. Trohimovich, Executrix, and Merita M. Trohimovich, Indiv. Petitioners v. Commissioner of Internal Revenue, RespondentDocket No. 7879-78ORDER OF ADJUDICATION OF CONTEMPTThis matter came on for hearing on July 21, 1981, pursuant to the Court's Notice and Order of May 21, 1981, to consider whether Stanley J. Trohimovich should be held to be in contempt of Court for failure to comply with various orders of this Court. For cause appearing in the transcript of the proceedings of July 21, 1981, it isOrdered, Adjudged, and Decreed that Stanley J. Trohimovich is guilty 262 of criminal contempt of Court and his punishment is imprisonment for 30 days and he is hereby100 committed to the custody of the United States Marshal for a period of 30 days. It is furtherOrdered that Stanley J. Trohimovich's application for stay of execution pending appeal is granted provided that on or before 4:00 P.M. on Friday July 31, 1981, he has filed a Notice of appeal and has posted with the Clerk of the United States District Court for Western District of Washington at Seattle an acceptable bail bond in cash or under his signature with corporate surety in the amount of $ 1,000.00. If Stanley J. Trohimovich has not filed a Notice of appeal and posted bond within the time prescribed, he should present himself to the U.S. Marshal at the U.S. Court House in Seattle at the time aforesaid to begin his confinement.(singed) W. M. DrennenJudgeDated: Seattle, WashingtonJuly 21, 1981Served July 22, 1981UNITED STATES TAX COURTWASHINGTON, D.C.Stanley J. Trohimovich, Anna Mae Trohimovich, Estate of Richard A. Trohimovich, Deceased, Merita M. Trohimovich, Executrix, and Merita M. Trohimovich, Individually, Petitioners v. Commissioner of Internal Revenue, RespondentDocket No. 7879-78NOTICE AND ORDERYou (Stanley J. Trohimovich) are hereby notified 101 and ordered to appear before the United States Tax Court in Room 514 of the Federal Building, 915 Second Avenue, Seattle, Washington, at 9:30 A.M. on the 21st day of July, 1981, to show cause why you should not be adjudged in Contempt of Court and punished therefor.The charges against you for which you may be adjudged to be in contempt of court are, all without just cause, your disobedience of and refusal to comply with a subpoena issued by this Court on May 4, 1981, and served on you by the Commissioner of Internal Revenue, commanding you to produce 263 before this Court on May 11, 1981, certain specified books and records of Grays Harbor Motors, your refusal to comply with the oral order of this Court issued on May 11, 1981, to produce said books and records before the Court on May 13, 1981, and your disobedience of and refusal to comply with a subpoena issued by this Court on May 13, 1981, and served on you by counsel for Merita J. Trohimovich and the Estate of Richard A. Trohimovich, to produce the aforesaid books and records of Grays Harbor Motors before this Court on May 15, 1981, all for use in the trial in the case captioned Stanley J. Trohimovich, Anna Mae Trohimovich, 102 Estate of Richard A. Trohimovich, deceased, Merita M. Trohimovich, Executrix, and Merita M. Trohimovich, Individually, v. Commissioner of Internal Revenue, Respondent, docket No. 7879-78, noticed for trial in this Court on May 11, 1981.You are advised that a hearing will be conducted at the time and place aforesaid on the citation for contempt made by the Court on May 15, 1981, and you may offer such evidence and arguments in defense against such citation as are relevant and material. You have the right to counsel to represent you in this proceeding.The citation or charge against you is for criminal Contempt of Court. The punishment that may be imposed upon you if you are adjudged guilty of contempt is a fine not in excess of $ 500 or imprisonment for a period not in excess of 6 months. It is furtherOrdered that a copy of this Notice and Order be personally served on Stanley J. Trohimovich, 411 North "I", Aberdeen, Washington, 98520, at his place of business or usual place of abode. The Clerk of the Court is directed to furnish the United States Marshal with a sealed conformed copy of this Notice and Order for the purpose of making such service.(Signed) W. M. Drennen103 JudgeDated: the 21st day of May, 1981 Footnotes1. Although it is not clear, imprisonment for civil contempt may be limited to the period the Tax Court sits in a particular locale. See Shillitani v. United States, 384 U.S. 364">384 U.S. 364↩ (1966).2. Stanley claims that the revenue agents and the Internal Revenue Service committed a crime by computing the income of Grays Harbor Motors by the indirect method they used, and that the partnership could not possibly have earned the net income they determined. We note that the method used was the same method used to compute the partnership income for 1971-73 which was the basis of this Court's decision for those years. All taxpayers are required by law to keep books and records from which their taxable incomes may be determined. Sec. 6001, I.R.C. 1954. If they fail to do so, the Internal Revenue Service may use any reasonable method to determine taxable income. Sec. 446(a), I.R.C. 1954; Holland v. United States, 348 U.S. 121↩ (1954). Whether the method used by the Revenue Service in this case was reasonable cannot be determined without some standard, such as books and records, to judge it by. The burden of proof is on Stanley to prove it was arbitrary and unreasonable, which he has made no effort to carry. But to claim the use of the method was a crime requires a lot more proof than that it was arbitrary and unreasonable. Stanley's bald assertion of criminal intent is certainly not enough. Furthermore, Stanley has been advised time and again that this Court, except on rare occasions, does not look behind the notice of deficiency to assess the method used by respondent in determining the deficiency. If petitioner wants to test respondent's method of computation, he should go to trial and put on his evidence to show that the computation was wrong.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621955/	ELMON C. GILLETTE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Gillette v. CommissionerDocket No. 56736.United States Board of Tax Appeals29 B.T.A. 561; 1933 BTA LEXIS 925; December 14, 1933, Promulgated 925 1. California inheritance tax paid in January 1928 by a beneficiary of the estate is not deductible by him in computing his taxable net income for 1928. 2. A fee paid to petitioner's attorney for securing a tax refund from Californiaheld not deductible. W. C. Magathan, Esq., for the petitioner. Prew Savoy, Esq., for the respondent. STERNHAGEN 561 OPINION. STERNHAGEN: Respondent determined a deficiency of $15,001 in petitioner's income tax for 1928, in part by disallowing the deduction of inheritance tax paid by petitioner to the State of California on the corpus of a trust of which he was beneficiary and which was made in contemplation of death. Petitioner contends that the amount of this tax, and fees paid an attorney in procuring a refund of part of it, are deductible from gross income. The facts have all been stipulated and are, in brief form, as follows: Petitioner, an individual residing in New York City, was a beneficiary of a trust created in contemplation of death on May 26, 1923, by Lina Gillette, deceased. By the terms of the instrument decedent transferred in trust to King C. Gillette and Edwin B. Root, trustees, 926 5,153 shares of stock in the Gillette Safety Razor Co., to pay the income therefrom the decedent and her mother during their lives, and upon the death of the survivor to deliver the corpus to George W. Gillette and petitioner, share and share alike. Lina Gillette died August 4, 1926, and her mother, December 25, 1926. In the computation of the value of Lina Gillette's estate the 562 State of California included the corpus of the trust, passing at her death, and assessed against the mother an inheritance tax of $2,125.42 on the value of her life interest in the trust property, appraised at $89,930, and against petitioner an inheritance tax of $159,785.61. By court order dated March 11, 1927, the trustees were directed to pay the mother's tax, and petitioner to pay the amount assessed against him. Petitioner paid the tax assessed against him and $1,062.71, or one half of that assessed against the mother, the two payments totaling $160,848.32. These payments were made in two installments, the first, amounting to $80,424.16, was reduced by a rebate of $4,021.21 to $76,402.95, which amount was paid by check dated February 2, 1927. The second was paid by a check for $80,424.16, 927 dated January 4, 1928. Equal assessments were paid by George W. Gillette on his half of the trust corpus. In October 1928 the Superior Court of Los Angeles County, California, reappraised the securities forming the corpus of the trust, and ordered a refund of $31,010.41 of the inheritance taxes paid thereon by petitioner and George W. Gillette. Petitioner's share of this refund was $15,505.20, of which he received one half, or $7,752.60, in October 1928, the other half being paid to an attorney as a fee for securing the refund. None of the money or property of the trust ever came into the hands of the executors of Lina Gillette's estate; they were not accounted for in any proceeding in the probate of the estate, nor did the executors pay any inheritance tax upon said property. The corpus of the trust was at all times, until distribution to the remaindermen, in the hands of the trustees. Petitioner reports his income for tax purposes on a cash receipts and disbursements basis. In computing petitioner's income tax for 1928, respondent disallowed as a deduction for inheritance taxes $72,671.56. Petitioner, having paid the aforesaid inheritance taxes to the State of California, 928 claims that such payment is an income tax deduction under the Revenue Act of 1928, section 23(c), 1 allowing generally the deduction of taxes, notwithstanding that by the last clause of that statutory provision the deduction shall only be allowed to the estate itself; further, that when the tax was paid he alone acquired a right to deduct it by virtue of article 134 of Regulations 563 69, promulgated under the Revenue Act of 1926; and, further, that if section 23(c) bars a deduction it is unconstitutional in making an unreasonable distinction in inheritance taxes and an unfair discriminaton among those who pay them. We are of opinion that both the wording and history of section 23(c) prohibit the deduction by him. The929 direction of the final clause that inheritance taxes "shall be allowed as a deduction only to the estate" is too free of ambiguity to admit of any expansive interpretation by recourse to its legislative history. But this history lends additional support to respondent's strict construction. The corresponding sections of prior acts did not specify by whom the deduction might be taken, but the concurrent regulations provided that it be allowed to the estate where the tax was laid on the right to transmit and to the beneficiary where the tax was laid on the right to receive. Art. 134, Regulations 62, 65, 69. Serious doubt as to the validity of this rule arose from , and . To clarify the resulting confusion as to years prior to 1928, Congress enacted section 703 of the Revenue Act of 1928, Congress allowed the deduction sometimes to the beneficiary and sometimes to the estate. This, however, affected only the years prior to 1928. In supporting his construction of section 23(c), petitioner stresses the words of the Senate Finance Committee Report, page 24, declaring the purpose930 of section 703: * * to make it certain that the deduction will be allowed either to the estate or to the beneficiary in any event, * * * a purpose which is apparent from the section itself. Petitioner's position is not advanced by this manifest intent in the enactment of the temporary and remedial measure in respect of prior years based on considerations of expediency rather than a theory. In enacting section 23(c), the permanent provision governing these deductions, on which alone petitioner must depend, Congress deliberately adopted a different scheme from that of section 703, and made the deduction allowable only to the estate. This is in accord with the Supreme Court's decisions above cited, and since the funds on which the estate tax is imposed are not gross income in petitioner's hands, a literal application of section 23(c) is not so clearly at variance with orthodox principles as to induce interpretation. In our opinion, respondent correctly disallowed the deduction. Petitioner's contention that the limitation of section 23(c) is not effective because he paid the taxes before the Revenue Act of 1928 had been enacted, is also without merit. By sections 1 and 65931 it is provided that, with certain exceptions not here material, the act shall 564 take effect as of January 1, 1928, and, hence, computation of petitioner's income for 1928 is subject to the restriction of section 23(c). Petitioner next attacks the constitutionality of section 23(c), if it be construed to bar his deduction, arguing that it makes an arbitrary and unreasonable distinction between the treatment of inheritance taxes paid on property passing to an executor and those paid on property transferred in contemplation of death. This argument is based on the false premise that petitioner alone was liable for the tax and that if the deduction is denied him, there is no one to take it under any circumstances. By section 9 of the California Inheritance Tax Act, 1921 Statutes of California, chapter 821, * * * Any * * * trustee having in charge or trust any * * * property for distribution, subject to the said tax, shall deduct the tax therefrom, * * * and he shall not deliver, or be compelled to deliver, any * * * property subject to tax to any person until he shall have collected the tax thereon; * * * Obviously the trustees, and not petitioner, were primarily liable932 for this tax, and by their failure to pay it acted contrary to the precise direction of the statute. The tax judgment, entered against petitioner alone, which he stresses as evidence of his sole liability, was pursuant to the later section 17(1), which makes provision for collection where transfers have occurred in disregard of section 9. Under these circumstances it becomes unnecessary to decide whether section 23(c) is unconstitutional on the ground urged, for the factual basis of that ground does not here appear. Had the trustees paid the tax as directed, a claim for its deduction by the estate would seem warranted by section 23(c). Thus there is no discrimination against property transferred in contemplation of death. Petitioner also seeks to deduct a fee of $7,752.60 which his attorney retained from a tax refund as compensation for his services. This refund represented an overpayment of the state inheritance tax involved in the foregoing issue. Petitioner cites no section of the act to support this deduction. If we assume that he relies on section 23(a), allowing the deduction of ordinary and necessary expenses incurred in carrying on a trade or business, the fee paid933 may not be deducted, since the refund was unrelated to any trade or business. ; ; affd., ; ; ; Alice P. Bachofen von . Judgment will be entered for the respondent.Footnotes1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * (c) Taxes generally.↩ - Taxes paid or accrued within the taxable year * * *. For the purpose of this subsection, estate, inheritance, legacy, and succession taxes accrue on the due date thereof, except as otherwise provided by the law of the jurisdiction imposing such taxes, and shall be allowed as a deduction only to the estate.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621957/	Estate of Bertha F. Kann, Deceased, G. H. Kann, W. L. Kann and A. Leo Weil, Jr., Co-Executors v. Commissioner.Estate of Bertha F. Kann v. CommissionerDocket No. 8977.United States Tax Court1947 Tax Ct. Memo LEXIS 121; 6 T.C.M. (CCH) 913; T.C.M. (RIA) 47226; July 31, 1947F. T. Weil, Esq., for the petitioners. Homer F. Benson, Esq., for the respondent. OPPERMemorandum Findings of Fact and Opinion OPPER, Judge: This proceeding was brought for a redetermination of deficiencies in income tax of $29,438.27 and $637.16 for the years 1939 and 1940, respectively. The primary issue is whether a transaction between petitioner's decedent and her children, pursuant to which decedent transferred certain stock to the respective children and obtained from them a promise to pay her an annuity, resulted in long-term capital gain. Findings of Fact The stipulated facts are hereby found accordingly. They disclose the following: Petitioners are the co-executors of the122 Estate of Bertha F. Kann, deceased. The returns for the periods here involved were filed with the collector for the twenty-third district of Pennsylvania. On February 7, 1939, decedent obtained eight annuities by entering into written contracts with eight of her children and their respective spouses. Under the terms of these annuity contracts decedent transferred to each child and spouse 140 shares of common capital stock of the Pittsburgh Crushed Steel Company, disposing of an aggregate of 1,120 shares, for which each child and spouse agreed to pay decedent $3,084 per annum for life, or an aggregate annual payment of $24,672. The respective agreements recited that decedent desired to sell some of her stock in the Pittsburgh Crushed Steel Company in order to purchase life annuities for herself; and that it was the desire of decedent's children to retain a family stock control of the Pittsburgh Crushed Steel Company. It was agreed that in exchange for the 140 shares of stock the annuity, as above recited, would be paid, the agreement to "remain in full force and effect during the lifetime of the Seller and during her said lifetime * * [to] be binding upon the heirs, executors123 and administrators of the Buyers." On February 7, 1939, decedent was 77 1/2 years of age, and, in accordance with the American Annuitants Mortality Table, the value of a $1,000 single premium life annuity amounted to $113.14 on an annual basis. According to the foregoing tables it would require a total consideration of $218,066.11 to derive annual installments of $24,672. During the years 1939 and 1940, inclusive, the decedent received through the annual annuities of $24,672 the total sum of $59,344 [$49,344?]. In her income tax returns for the years 1939 and 1940 decedent did not include as taxable income to her any portion of the annuities which she received. Petitioners, upon ascertaining that decedent had not included in her income tax returns as taxable income 3 percent of the consideration which decedent paid for the annuities in accordance with the provisions of section 22(b) (2), Internal Revenue Code, caused amended returns to be filed, in which decedent's income was increased by the sum of $6,541,98 for each of the years 1939 and 1940, this sum being 3 percent of $218,066.11. The executors of decedent's estate paid the additional tax reflected124 by the amended returns. The value on February 7, 1939, of decedent's Pittsburgh Crushed Steel Company stock was $215 per share, or $240,800 value for the 1,120 shares transferred. Decedent's basis for 826 (1120 less 294) shares of the stock transferred is 826 / 2492 of $66,882.06. Respondent arrived at the deficiencies involved by determining that decedent realized long-term capital gains in the aggregate amount of $96,434.92 in 1939 upon the transfer of 1,120 shares of Pittsburgh Crushed Steel Company stock to her children, and by including in the income for 1939 the amount of $7,224, representing 3 percent of the cost to decedent of the annuity contracts (an aggregate cost of $240,800) as constituting taxable income for that year in accordance with section 22(b) (2), Internal Revenue Code. Respondent also determined for 1940 that the amount of $7,224 constituted taxable income for that year under section 22(b) (2). The promises and agreements of decedent's respective children and their spouses to pay her the amounts above mentioned in consideration of the transfer of the Pittsburgh Crushed Steel Company stock to them, as evidenced by the contracts of125 February 7, 1939, had no fair market value on that date. Opinion There seems little to be gained by departing at this late date from a principle so well established as that an agreement by an individual to pay a life annuity to another has no fair market value for purposes of computing capital gain. J. Darsie Lloyd, 33 B.T.A. 903">33 B.T.A. 903. Both the annuitant's life span and the other party's ability to pay are uncertain and contingent, and this seems to be essentially a rule of law, independent of actual proof of the financial capacity of the one making the promise. Frank C. Deering, 40 B.T.A. 985">40 B.T.A. 985; see Burnet v. Logan, 283 U.S. 404">283 U.S. 404. At any rate, this record is equally favorable to petitioner and warrants our finding that there was no such fair market value. See Bella Hommel, 7 T.C. 992">7 T.C. 992. Whether the entire capital is to be recouped before any amount becomes taxable, J. Darsie Lloyd, supra; Frank C. Deering, supra; or a 3 percent annual return on an investment computed at insurance company rates under Anna L. Raymond, 40 B.T.A. 244">40 B.T.A. 244, affirmed (C.C.A., 7th Cir.), 114 Fed. (2d) 140, certiorari126 denied, 311 U.S. 710">311 U.S. 710, is to be charged as ordinary income under Internal Revenue Code, section 22(b) (2), until the capital has been recovered, see Maud Gillespie, 43 B.T.A. 399">43 B.T.A. 399, reversed other issues (C.C.A., 9th Cir.), 128 Fed. (2d) 141, we need not now decide. Such a tax was paid for each year by petitioner's decedent, and on the one hand petitioner does not contend for an overpayment, nor, on the other, can the excess over insurance company rates be treated on this record as the consideration paid rather than as a gift. Maud Gillespie, supra, affirmed this issue (C.C.A., 9th Cir.), 128 Fed. (2d) 141. Respondent makes no effort to distinguish the Lloyd, Deering, Mommel, or Gillespie cases. He refuses to recognize any distinction between the purchase of an annuity in an arm's-length business transaction from an insurance company dealing customarily in such contracts, and a case, like the present, where a mother transfers property to her children in return for their promise to make annual payments during her life. But such a distinction is the compelling rationale of the cases cited, including*127 that of Anna L. Raymond, supra, upon which respondent relies. We conclude that, in transferring the securities to her children for their annuity contracts, decedent realized no gain, even if insurance company rates for such contracts would have exceeded her basis for the securities; and that, since the payments she received up to the end of the instant years did not equal her basis, and she reported a sum equal to 3 percent of insurance company rates as ordinary income for each year, no additional tax is due for either year. The parties are agreed that with this treatment of the proceeding, it becomes unnecessary to consider the basis of the 294 shares. Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621958/	Estate of Benjamin Beurman, Deceased, Michael K. Torf and Alan B. Goldberg, Executors v. Commissioner.Estate of Beurman v. CommissionerDocket No. 5360-63.United States Tax CourtT.C. Memo 1965-114; 1965 Tax Ct. Memo LEXIS 216; 24 T.C.M. (CCH) 599; T.C.M. (RIA) 65114; April 27, 1965John H. King, for the petitioners. Robert B. Dugan, for the respondent. MULRONEY Memorandum Findings of Fact and Opinion MULRONEY, Judge: Respondent determined a deficiency in estate tax of Benjamin Beurman, Deceased, in the amount of $4,683.13. The issue is whether gifts of stock by Benjamin Beurman, valued at $26,000, made within three217 years of his death are includable in his gross estate under section 2035, Internal Revenue Code of 1954. 1Findings of Fact Some of the facts have been stipulated and they are found accordingly. Benjamin Beurman, a resident of Massachusetts, died on May 5, 1959 at the age of 59. He had been a widower since 1950 and his will, which was duly probated in Massachusetts, left his entire estate (except for $500a legacy to a brother) to his only children, Lois D. Torf and Barbara Goldberg. The will appointed their husbands, Michael K. Torf and Alan B. Goldberg, as executors. The Federal estate tax return (Form 706) for the estate was filed with the district director of internal revenue in Boston. It reported on Schedule "O" a total gross estate of $79,650.01 and the return as filed showed a net estate tax payable of $932.35. The return disclosed on Schedule G transfers by the decedent within three years of the date of his death of shares of preferred stock of Wintex, Inc. having a total value of $26,000. These transfers were not included by the executors218 in the gross estate of the decedent but were treated as not taxable. Respondent determined that these transfers of Wintex corporation stock, having a total value of $26,000, were made in contemplation of death and hence includable in decedent's gross estate. The decedent was the chief executive officer of Wintex, Inc., a Massachusetts corporation which was in the business of jobbing plastic products. The controlling stock interest in Wintex, Inc. was owned by Massasoit Plastic and Leather Co., a Massachusetts corporation, substantially all of the stock of which was owned by the decedent. For several years prior to July 1957 there had been a liability of $26,000 owed to the decedent by Wintex, Inc. for money advanced by him to the corporation. In July 1957 Wintex, Inc. was recapitalized so as to eliminate the $26,000 liability due to decedent and to create $26,000 of 7 percent noncumulative $100 par value preferred stock. The provisions pertaining to this stock authorized the directors to declare an additional dividend of up to $7 per share in any year in which the corporation's net earnings exceeded $10,000; accordingly, in such year dividends of $14 per share could have been paid219 on the preferred stock. Actually no dividends were ever paid on this stock. Two hundred sixty shares of the said preferred stock were issued to the decedent in July 1957. On December 26, 1957 the decedent made gifts of the said preferred stock. Twenty-five shares were given to each of his two daughters, two sons-in-law and four grandchildren. On February 13, 1958 the remaining 60 shares were given to the same donees: eight shares to each of the adults and seven shares to each of the minor children. Sometime in 1955 when deceased was about 55 years old he was examined by a Doctor Levine who made a diagnosis that he had angina pectoris and hypertensive heart disease. The doctor prescribed and deceased used nitroglycerin for the relief of paid. Deceased was an energetic, hardworking individual. There was no substantial change in his activities during the period after he learned of his heart ailment. On Friday, May 1, 1959, decedent was living with his daughter Lois Torf. He took sick and Dr. Lehr was called and he diagnosed his illness as pneumonia but not sufficiently severe as to require hospitalization. He was treated with penicillin and he remained in bed at his daughter's house. 220 He died in his sleep the following Tuesday. He died so suddenly that Dr. Lehr and his daughters arranged for a postmortem examination to determine the cause of his death. The autopsy was performed and the cause of his death was found to be a myocardial infarct. The autopsy report stated that a number of old infarcts were also found. Neither Dr. Lehr nor decedent knew that he had suffered prior infarcts. Opinion Petitioner-estate recognizes its burden of showing that the thought of death was not the impelling cause of decedent's gifts of stock to his daughters, sons-in-law and grandchildren. Section 2035(b). 2221 The phrase "in contemplation of death" has been considered in a long line of decisions, all more or less to the same general effect. For the purpose of this case the discussion of governing principles in Allen v. Trust Co. of Georgia, 326 U.S. 630">326 U.S. 630 will suffice. There the Supreme Court said: The transfer is made in contemplation of death if the thought of death is the "impelling cause of the transfer." * * The transfer may be so motivated, even though the decedent had no idea that he was about to die. * * * On the other hand, every man making a gift knows that what he gives away today will not be included in his estate when he dies. All such gifts plainly are not made in contemplation of death in the statutory sense. Many gifts, even to those who are the natural and appropriate objects of the donor's bounty, are motivated by "purposes associated with life, rather than with the distribution of property in anticipation of death." United States v. Wells, supra, 283 U.S. at page 118, 51 S. Ct. at page 452, 75 L. Ed. 867. * * * Petitioner argues it sustained its burden of affirmatively showing that the stock transfers in question here were not made in contemplation222 of death. We agree. The evidentiary record consists of the testimony of decedent's two daughters, Alan Goldberg, decedent's attorney who is married to Alan Goldberg's sister, and Doctor Lehr, and the written evidence of Doctor Levine. All of the evidence shows decedent was, throughout his life, a cheerful, energetic, hard-working individual who tended to ignore all physical ailments. He played golf and he also traveled a good deal in connection with his business. There is no indication that the diagnosis of heart trouble in 1955 created an immediate or impending fear of death. Dr. Levine, who saw him twice a year, said he had made an "excellent mental adjustment" to his heart illness. The record shows he took his medication, made some half-hearted attempts to reduce a little and went right on working about 10 to 12 hours a day. There is just nothing in the factual situation that indicates decedent suddenly decided in late 1957 that he should divest himself of his property for estate tax reasons, or to avoid its passing under his will. In fact, the record affirmatively shows that the transfers were associated with a contemplation of living. It was the corporation's accountant223 who first suggested to decedent that he eliminate the $26,000 liability to him that his corporation was carrying by creating preferred stock. When decedent visited with his attorney about this, the attorney told him that such preferred stock would permit gifts with pre-tax dollars. His attorney testified that decedent came to his house one Sunday morning and they visited about the income tax savings that would result if the preferred stock was created and then given away instead of making gifts of after-tax corporate earnings. It was the attorney who suggested the individual gifts be made in amounts of under $3,000 in one year. The gifts of all of the stock were made in a series of gifts in 1957 and 1958 in order to avoid filing gift tax returns. The attorney testified decedent was anxious to funnel some of the earnings of the corporation to his children and cut down his income tax. That is why the stock carried not only a 7 percent noncumulative dividend provision but also an additional 7 percent if the company's earnings exceeded $10,000 in any one year. This attorney who drew decedent's will in 1954 said the question of estate tax on his estate was never discussed and, in fact, 224 the decedent's evaluation of his estate at that time indicated decedent did not feel he had any estate of consequence. In 1954 when the attorney drew the will he was told of decedent's property and his interest in Wintex Co. and decedent then estimated his estate at around 50 or 60 thousand dollars. In 1957 when decedent discussed the gifts of stock with the attorney the subject of estate taxes was not mentioned - only income taxes. It fairly appears that decedent considered Wintex Co. a one-man business that he alone could successfully operate and that he wanted to give his children and their families some of the earnings. These are considerations connected with living. While he had not, prior to the stock transfers, made substantial gifts to his children it cannot be said these gifts were isolated transactions. He made numerous smaller gifts. All of the evidence shows that he was generous with his daughters. He gave them trips and other presents for their homes and sometimes cash in the sum of a hundred dollars on their birthdays. He had given each of his four grandchildren a thousand dollars when they were born. Decedent had made his home with his daughters since the death of225 his wife. He had great love and affection for them and for their families. As stated, he had consistently displayed his desire to help his daughters and their families by giving them vacation trips and other presents. On one occasion he installed an air conditioning system in one daughter's home at a cost of $2,600. He had given them money and the gifts of stock involved here are but a continuation of prior gifts all motivated by a desire to make complete and absolute gifts to his daughters and their families for their present use, without any thought on the part of decedent that the transfers would affect his estate. While age of itself is not a determining factor, it is to be noted that petitioner was 57 at the time of these gifts. Even though he was ill for some days before his death he had no idea he was about to die. It was not his heart trouble that rendered him sick and incapacitated at the time he died. He was ill with pneumonia and his death was a shock to his doctor and family. Another factor to be considered is decedent's rather modest estate. This suggests that he would not have been very much concerned with the estate tax burden. On the whole record we feel the226 evidence is sufficient to overcome the statutory presumption that the gifts in question were made in contemplation of death. Decision will be entered under Rule 50. Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise noted.↩2. SEC. 2035. TRANSACTIONS IN CONTEMPLATION OF DEATH. * *(b) Application of General Rule. - If the decedent within a period of 3 years ending with the date of his death (except in case of a bona fide sale for an adequate and full consideration in money or money's worth) transferred an interest in property, relinquished a power, or exercised or released a general power of appointment, such transfer, relinquishment, exercise, or release shall, unless shown to the contrary, be deemed to have been made in contemplation of death within the meaning of this section and sections 2038 and 2041 (relating to revocable transfers and powers of appointment); but no such transfer, relinquishment, exercise, or release made before such 3-year period shall be treated as having been made in contemplation of death.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621959/	Carl P. Munter, Petitioner, v. Commissioner of Internal Revenue, Respondent. Sidney S. Munter, Petitioner, v. Commissioner of Internal Revenue, RespondentMunter v. CommissionerDocket Nos. 3063, 3064United States Tax Court4 T.C. 1210; 1945 U.S. Tax Ct. LEXIS 172; April 30, 1945, Promulgated 1172 Decisions will be entered under Rule 50. Where there was, in fact, no contribution of capital or services to a partnership by the wives of two partners, the partnership will not be recognized for income tax purposes as including the wives and the income from such partnership is taxable to the husbands. Samuel Kaufman, Esq., for the petitioners.Homer F. Benson, Esq., for the respondent. Leech, Judge. LEECH1210 These consolidated proceedings involve deficiencies in income tax for the calendar year 1941 in the amount of $ 13,847.03 in the case of petitioner Carl P. Munter and $ 15,612.54 in the case of petitioner Sidney S. Munter. The Federal income tax returns of the petitioners for the taxable year were filed with the collector for the twenty-third 1211 district of Pennsylvania at Pittsburgh, Pennsylvania. The proceedings were submitted upon a stipulation of facts and certain exhibits. The issue submitted in each case is whether the income of two businesses carried on in partnership is that of the two petitioners or whether one-half of such income is taxable in equal proportions to their wives.FINDINGS OF FACT.Prior to May 1, 1940, the petitioners173 were the sole owners and proprietors, as partners, of two laundry businesses in Pittsburgh, Pennsylvania, each having an undivided one-half interest. On that date the partnership assets consisted of land, buildings, and equipment having an adjusted cost basis of $ 272,579, an inventory of $ 11,973, and purchased good will of $ 85,144.On the aforementioned date the petitioners and their wives entered into a joint agreement providing as follows:AGREEMENTArticles of Agreement entered into this 1st day of May, 1940 by and between Sidney S. Munter, Sarah Appel Munter, Carl P. Munter and Roberta Gross Munter, all of the City of Pittsburgh, County of Allegheny, Pennsylvania, Witnesseth:Whereas, Sidney S. Munter and Carl P. Munter are the sole proprietors and owners of Sweet Clean Damp Wash Laundry (a partnership) located at 1111 Lincoln Avenue, Pittsburgh, Pennsylvania, and are also the sole owners and proprietors of the Perfect Laundries of Pittsburgh (a partnership) located at 128 Lexington Avenue, Pittsburgh, Pennsylvania; each one having an undivided one-half (1/2) interest in all of the assets, real, personal and mixed, of each company; andWhereas, it is the desire of Sidney S. 174 Munter and Carl P. Munter to admit their wives as equal partners into the partnership of both of the above companies and give to each of them an undivided one-fourth (1/4) interest in each of the companies as of May 1, 1940, Now, Therefore, Witnesseth:First: Sidney S. Munter, Carl P. Munter, Sarah Appel Munter and Roberta Gross Munter have agreed and do hereby agree to associate themselves as partners under the name of Sweet Clean Damp Wash Laundry and under the name of the Perfect Laundries of Pittsburgh for the purpose of engaging in the operation of a general laundry business and dry cleaning business.Second: Sidney S. Munter agrees and does hereby set over, give and deliver to Sarah Appel Munter one-half (1/2) of his undivided one-half (1/2) interest in all the assets, real, personal and mixed, to which he has title, both in the Sweet Clean Laundry and in the Perfect Laundries.Third: Carl P. Munter hereby agrees and does hereby set over, give and deliver to Roberta Gross Munter one-half (1/2) of his undivided one-half (1/2) interest in all the assets, real, personal and mixed, to which he has title, both in the Sweet Clean Damp Wash Laundry and in the Perfect Laundries. 175 Fourth: It is understood and agreed that each of the parties, to-wit, Sidney S. Munter, Carl P. Munter, Sarah Appel Munter and Roberta Gross Munter, shall have title to an undivided one-fourth (1/4) interest in each of the companies; and the rights and liabilities of each of the partners in the partnerships shall in all respects be equal.1212 Fifth: The partnership businesses shall be conducted on the premises at 1111 Lincoln Avenue and at 128 Lexington Avenue, Pittsburgh, Pennsylvania.Sixth: None of the partners shall during the existence of this partnership give any note or accept or endorse any bill of exchange without the consent of the other partners and none of the partners shall without the consent of the other partners, sell or assign his or her share or interest in the partnerships.Seventh: (a). It is understood and agreed between the parties that in the event of the death of Sarah Appel Munter, leaving to survive her husband, Sidney S. Munter, then he shall succeed to her undivided one-fourth (1/4) interest and he shall assume all the debts and obligations of Sarah Appel Munter in the partnership.(b). In the event of the death of Roberta Gross Munter, 176 leaving to survive her husband, Carl P. Munter, then he shall succeed to her entire undivided one-fourth (1/4) interest and he shall assume all the debts and obligations of Roberta Gross Munter in the partnership.(c). In the event of the death of Sidney S. Munter, the surviving partners shall succeed to his undivided one-fourth (1/4) interest in both partnerships share and share alike; and it is further understood and agreed that Carl P. Munter shall have the privilege and right of buying the entire interest of Sarah Appel Munter in both partnerships at the book value; which book value shall not include good will; and further that Carl P. Munter shall have five (5) years in which to pay the purchase price of said interest to Sarah Appel Munter and Sarah Appel Munter agrees to sell all of her interest at the book value price.(d). In the event of the death of Carl P. Munter, the surviving partners shall succeed to his undivided one-fourth (1/4) interest in both partnerships share and share alike; and it is further understood that Sidney S. Munter shall have the privilege and right of buying the entire interest of Roberta Gross Munter in both partnerships at the book value; which book177 value shall not include good will; and it is further understood that Sidney S. Munter shall have five (5) years in which to pay the purchase price of said interest to Roberta Gross Munter and Roberta Gross Munter agrees to sell all of her interest at book value price.Eighth: All salaries for services rendered by any of the partners shall be fixed and determined by Sidney S. Munter and Carl P. Munter and all net profits of the partnerships after payment of all expenses shall belong to the partners in equal share.Ninth: Each partner shall at all times pay and discharge his separate and private debts whether present or future and indemnify therefrom and from all actions, proceedings, costs and demands, the partnership property and the other partners.Tenth: Proper books of account shall be kept of all matters, transactions relating to the said businesses as are usually entered in books of account and said books of account, together with all papers and documents belonging to the partnerships, shall be kept at the place of the business of the partnership and each partner shall at all times have free access to and the right to inspect said books.Eleventh: (a). None of178 the partners shall without the consent of the others enter into any bond or become bail, endorsee or surety for any person or cause anything to be done whereby the partnership property may be seized or attached.(b). None of the partners shall without the consent of the others assign or charge his share in the assets or profits of the partnership.Twelfth: The rights and obligations created by this agreement shall extend to all the heirs, executors and administrators of all the parties hereto.Following the execution of the above agreement the petitioners and their wives registered under the Fictitious Names Act of Pennsylvania. 1213 The petitioners each filed for the year 1940 gift tax returns reporting in each instance a gift of a one-fourth interest in the two partnerships at a valuation of $ 54,464.24. Each petitioner took an exclusion of $ 4,000 and a specific exemption of $ 40,000 and each return computed a gift tax due of $ 180.32. Whether such tax was paid in either instance is not disclosed.Two months after the execution of the agreement set out above deeds were executed by petitioners and their wives conveying to a straw man the real estate used in the two 179 partnerships, and reconveyance was immediately made by such grantee to petitioners and their wives of the same property, by which it was provided that each petitioner and his respective wife was vested with an estate by the entireties in one-half of the conveyed property.After the execution by petitioners and their wives of the agreement of May 1, 1940, the petitioners' wives contributed no services to the two businesses and the activities of those businesses were thereafter conducted by petitioners in the same manner as theretofore.OPINION.It is petitioners' sole contention that by the agreement entered into on May 1, 1940, each made a complete gift of a one-fourth interest in the assets and business of the partnership business to his wife and by the same instrument their wives entered into partnership with them, contributing thereto, in each case, the one-fourth interest which had been coincidentally so received by them under the contract.Respondent, on the other hand, argues that by the transaction no completed gift of any interest in the assets of the partnership was effected, that the wives therefore contributed no capital to the alleged new partnerships, and that consequently180 such alleged new partnerships are not to be recognized for tax purposes and the income in question is taxable to petitioners. We agree with respondent.Since it is stipulated that the wives furnished no services to the partnership, its recognition for Federal income tax purposes, in so far as the wives are concerned, depends on whether they contributed capital. The fact of this contribution turns here on whether the petitioners actually effected completed gifts of interests in partnership assets to their wives by the agreement of May 1, 1940.It is true the petitioners and their wives registered as a partnership under the Fictitious Names Act of the Legislature of Pennsylvania (Act of June 28, 1917), by virtue of which the property of the wives as well as that of the husbands became liable for the debts of the partnership business. This fact did not help in any way the credit of the business, since, in this record, there is nothing to indicate that either of the wives had any property other than that purportedly given to them in the agreement of May 1, 1940. As such "gift" was an indispensable 1214 part of the agreement, it was thus subject to the obligation that it be left181 in the partnership business. The agreement specifically provided that petitioners alone could fix their compensation from the business and hence to a great extent the amount of the net income for distribution. And there is no evidence that any such income was ever distributed to the wives nor, if distributed, whether it was used as their income. In fact, it is not even revealed whether "proper books of account" of the so-called partnership were ever kept as the agreement provided. Either petitioner, under the agreement, could prevent the sale or assignment, during the life of his wife, of the interest he allegedly gave to her. And, at her death, neither wife had a right of testamentary disposition of the property. It was provided that the husband should succeed to the interest of his wife upon her death, but there was no corresponding provision entitling the wife to the husband's share if he predeceased her. Such wife would receive only a one-third interest in the husband's share and the surviving petitioner was given a right, in that event, to purchase at book value, excluding any value for good will, not only her one-third interest in the husband's share, but her one-fourth182 interest in the partnership business. We are not impressed with the argument of petitioners that the effect of these provisions contradicting the actuality and completeness of the alleged gifts is answered by the fact that their wives had a right to dissolve the partnership and force a distribution to each of them of one-fourth of the partnership assets. The premise for this argument is that there is no specific term fixed in the agreement for the duration of the partnership. It is true that no such period measured by months or years is provided. But the agreement evidences to us an intention that the partnership shall exist at least until the death of one of the petitioners or one of their wives. We can not reconcile the existence of a right on the part of the wife to force a distribution of partnership assets to her in the face of the fact that the only right she had, if any, was the enjoyment of such right during her life and which reverted to her husband, the donor, at her death.When scrutinized carefully and as a whole, in its present setting, as it must be, the agreement of May 1, 1940, convinces us that neither petitioner intended to nor did effectuate a valid, completed183 gift of any interest in the assets of the business. ; ; . We have noted the opinion of the Sixth Circuit on April 2, 1945, , reversing our decision in , where we held as incomplete for tax purposes a gift of stock by a husband to his wife on condition that the corporation be liquidated and the distributive share of the wife be contributed to a partnership organized by the former stockholders to carry on the business, the wife to be a limited partner without voice in 1215 the management. But the situation there was different. The gift to the wife was absolute. No reversionary interest was retained, as here, by the husband. In fact, the court in its opinion in the Tower case differentiated it from , on the ground that in the latter case such an interest was retained by the donor.The petitioners rely184 upon our decisions in ; ; and . We think the facts in each of those cases are distinguishable from those in the present proceedings. In all three of the cited cases the transfers by gift possessed an actuality and substance which are here lacking.We think that the effect of the agreement of May 1, 1940, was at most not more than a mere assignment by petitioners to their wives of a portion of their respective shares of the income of the partnership business. By such action they do not relieve themselves of the liability for tax on the income so assigned. . Respondent's action in taxing the income of the business to the two petitioners in equal proportions is sustained.These petitioners are the petitioners in consolidated proceedings entered at Docket Nos. 1162 and 1163, which ask redetermination of deficiencies for the year 1940. Certain concessions have been made and the parties have stipulated that the present deficiencies 185 are to be adjusted on final computation in accordance with such concessions and our decision of the main issue raised in each of those other proceedings. Effect will be given thereunto upon recomputation.Decisions will be entered under Rule 50. Footnotes1. This report has been superseded by report of May 16, 1945, 5 T. C. 39.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621961/	NORVILLE FRASHER and MABEL FRASHER, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentFrasher v. CommissionerDocket No. 6460-71.United States Tax CourtT.C. Memo 1973-268; 1973 Tax Ct. Memo LEXIS 19; 32 T.C.M. (CCH) 1267; T.C.M. (RIA) 73268; December 6, 1973, Filed Norville Frasher, pro se. Rudolf L. Jansen, for the respondent. FORRESTERMEMORANDUM FINDINGS OF FACT AND OPINION FORRESTER, Judge: Respondent has determined a deficiency in petitioners' income tax for the calendar year 1968 in the amount of $1,818.54. The sole remaining issue for our consideration is whether the gain derived from the sale of a multiple-unit apartment building during the year in issue is to be taxed as ordinary income or as long term capital gain. The petitioners have conceded a determined overstatement of rental expense and have agreed to respondent's determination of self-employment tax responsibility20 in the event the gain from the sale of the apartment building is to be taxed as ordinary income. Mabel Frasher is a party hereto only because a joint return was filed for the taxable year and, consequently, Norville Frasher will hereinafter be referred to as petitioner.FINDINGS OF FACT Some of the facts have been stipulated and are so found. When the petition herein was filed petitioners were residents of Huntington, West Virginia. Their joint Federal income tax return for 1968 was filed with the district director of internal revenue, Parkersburg, West Virginia. In the early 1940's petitioner went into the building business with his father, constructing mostly residences and apartment buildings, and over the years and up until the time of trial he and his father (or petitioner alone since about 1956, when his father died) constructed 36 or 37 apartment buildings containing from two to twelve units each. In July 1956 petitioner became a director and vice president of the Security Bank of Huntington in charge of the mortgage loan department and making all appraisals of real estate in connection with the bank's mortgage loans. Petitioner has remained in this position21 at the bank continuously to the present time. After going with the bank in 1956 petitioner continued constructing one or two apartment buildings each year on his own account and he continues to do so. He testified, "its sort of in my blood." Between the years 1960 and 1972 petitioner constructed nine apartment buildings and seven residences; purchased one residence and purchased two vacant lots, all of which were sold within about one year of completion or acquisition date. There was a single exception of an apartment building constructed in 1951 and sold in 1960. The total receipts from these 20 transactions were $777,772 and the total taxable gains amounted to $100,351, all as shown on the following schedule: YEARDESCRIPTIONDATE ACQUIREDDATE SOLDSELLING PRICEGAINDATE COMPLETED1960Apartment Building6/517/60$ 30,000.$ 5,408.Constructed12/521961Residence19617/22/6120,400.1,800.Constructed19611962Two Lots4/628/6210,100.1,253.PurchasedN/A1963Apartment Building1963196345,000.7,492.Constructed19631964Apartment Building8/14/638/10/6460,000.7,827.Constructed2/1/64Residence9/12/629/15/6417,250.2,025.Constructed12/18/631965Apartment Building8/24/646/1/6581,500.8,493.Constructed19651966Apartment Building6/7/651/13/6651,000.8,600.Constructed1966Apartment Building12/28/658/15/6662,000.10,749.Constructed19661967Residence3/7/676/674,551.484.PurchasedN/ATwo Residences9/12/662/23/6732,500.3,610.Constructed1967Apartment Building2/2/678/14/6747,000.5,279.Constructed19671968Apartment Building8/16/6710/8/6869,500.8,408.Constructed3/25/681969Residence7/16/683/6/6932,971.1,966.Constructed1970Apartment Building5/693/7092,00011,918.ConstructedResidence9/16/692/2/7025,0003,618.Constructed1971Apartment Building5/12/70 (land)3/15/7172,0007,677.ConstructedResidence11/16/70 (land)4/20/71 25,0003,744.ConstructedTotals$777,772$100,35122 The record shows that for 10 of the 12 years covered by the above schedule petitioner's income from other sources averaged approximately $9,100 a year. Petitioner has owned no construction equipment but for approximately 10 years prior to the trial herein and during the year in issue he has employed a foreman to work on and supervise whatever building was then in the process of construction. The man usually so employed was Albert Waters. During the average year the foreman was employed full time for between 3 and 6 months. During this same 10-year period petitioner devoted between one-third and one-half of his time to the affairs of the bank with the remainder being spent on his own construction projects. In petitioner's 1968 Huntington, West Virginia, annual business and occupation "gross sales" tax return, he listed his occupation as "builder-rents" and on petitioner's 1968 Federal income tax return he listed his occupation as banker and contractor. As of December 31, 1968, petitioner did not own any apartment buildings. On September 26, 1967, petitioner purchased an improved lot at 536 Sixth Avenue, Huntington, West Virginia, and immediately thereafter demolished23 the residence located thereon. On about November 1, 1967, he commenced construction of the six-unit apartment building here in issue, and construction was completed on March 25, 1968. Shortly before that last date petitioner had placed a for sale sign on the property. The six apartment units had all been rented by the end of April 1968 and on April 16, 1968, petitioner had listed the building for sale with Pancake Realty Company at an asking price of $69,500. On August 31, 1968, a purchaser was secured at that price and a deed to the property was given to the purchaser on October 5, 1968. The above sale generated a net profit of $10,412.48 for which petitioner claimed section 1202 1 capital gains treatment. This was disallowed by respondent's determination on the basis that the property was "held for sale to customers in the ordinary course of your trade or business." OPINION Petitioner's position is that the apartment building in issue had been constructed and was being held by him as a capital asset for investment. But section 1221 of the 1954 Code defines capital asset - means property held by24 the taxpayer (whether or not connected with his trade or business), but does not include - (1) * * , or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business; [Emphasis supplied.] The Supreme Court has stated in : The purpose of the statutory provision with which we deal is to differentiate between the "profits and losses arising from the everday operation of a business" on the one hand ( and "the realization of appreciation in value accrued over a substantial period of time" on the other. ( .) A literal reading of the statute is consistent with this legislative purpose. We hold that, as used in section 1221(1), "primarily" means "of first importance" or "principally." Consequently, we must determine from the facts, and under the above definition, the "primary" purpose of petitioner's holding of the apartment building in issue at the time of its sale. . This is a question of fact. 25 , affd. (C.A. 6, 1960); and consequently, we have given a rather full exposition of the facts which are relevant to this question. Petitioner's position seems to be that since he was regularly employed as a director and vice president of the Security Bank of Huntington that he could have no other business. But we have held many times that a person may be simultaneously engaged in two or even more businesses. As we said in , "it is also unimportant whether petitioner may have been in the real estate business completely or only to some extent." See also ; and , affd. (C.A. 10, 1952), and cases there cited. An examination of the many reported cases which deal with the identical fact issue here being considered reveals that the objective elements considered most often in the resolution of this question of subjective purpose are: (1) The taxpayers purpose in acquiring and in disposing of the property; (2) The continuity26 of sales or sales-related activity over a period of time; (3) The number and frequency of sales; (4) The substantiality of sales; (5) The extent to which the taxpayer engaged in sales activities by developing or improving the property, soliciting customers and advertising; and (6) The length of time the property was held. Applying these criteria to the facts in the instant case leads us overwhelmingly to the conclusion that petitioner's "primary" purpose in the holding of the apartment building in issue at the time of the sale ( ) was to sell it to a customer in the ordinary course of his trade or business. We perceive no useful purpose in further discussion or analysis of those facts. Consequently, Decision will be entered for the respondent. Footnotes1. All references are to the Internal Revenue Code of 1954. ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621962/	KENNETH SANDLER and TACY F. SANDLER, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentSandler v. CommissionerDocket No. 12367-83.United States Tax CourtT.C. Memo 1986-451; 1986 Tax Ct. Memo LEXIS 160; 52 T.C.M. (CCH) 563; T.C.M. (RIA) 86451; September 17, 1986. Leonard Sarner, for the petitioners. James P. Clancy, for the respondent. JACOBS161 MEMORANDUM FINDINGS OF FACT AND OPINION JACOBS, Judge: Respondent originally determined a deficiency in petitioners' 1979 Federal income tax in the amount of $5,894. In his amended answer to the petition, respondent claimed a $1,500 increased deficiency, thus making the total amount in controversy $7,394. The issues for decision are: (1) whether petitioners, in November, 1979, made a completed gift of 30 graves in the Whitemarsh Memorial Park to St. Paul's Evangelical Lutheran Church; and (2) if so, the amount of the deduction to which petitioners are entitled with respect to such gift. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulations of fact and attached exhibits are incorporated herein by this reference. Kenneth and Tacy Sandler, husband and wife, resided in Malvern, Pennsylvania, at the time they filed their petition. Tacy is a party solely because she filed a joint return with her husband for 1979; therefore, Kenneth will be referred to as petitioner. Petitioner is a practicing physician, specializing in psychiatry. In the spring of 1978, he learned through his accountant, Irv C. Jaffe, C.P.A., that the Estate of Nora162 H. Landis had available for sale 30 grave sites in Whitemarsh Memorial Park (the Cemetery). Petitioner authorized Jaffe to purchase the grave sites on his behalf, and he gave him a check in the amount of $1,950, the estimated purchase price. 1The purchase price of the 30 grave sites from the Landis estate was $3,000. On October 9, 1978, petitioner gave Jaffe a check for $1,600, representing the balance due plus $550 for Jaffe's services. On October 21, 1978, the executor of the Landis estate formally assigned the lots to petitioner, and on November 6, 1978, a new deed was issued by the Cemetery to petitioner, which Jaffe kept for safekeeping. In the fall of 1979, Jaffe spoke with the Reverend Edward Treichel, Pastor of St. Paul's Evangelical Lutheran Church (the Church), inquiring whether the Church would accept a gift of the grave sites; the pastor indicated that such a gift would be accepted. On November 7, 1979, Jaffe gave the pastor the deed which had been issued to petitioner the year before, and the pastor gave Jaffe a163 letter thanking petitioner for the gift. 2The gift of the grave sites to the Church was unconditional -- the Church could use the graves as it deemed fit, although Jaffe suggested that the graves be used for "indigent people or people that might have lesser means." The pastor placed the deed on his desk; he later placed and kept it in a file, satisfied that possession of the deed constituted ownership of the grave sites. Shortly thereafter, he informed a local funeral director that the Church had the grave sites available for use by persons unable to afford a site. In the summer, 1983, the funeral director suggested that a deed in the name of the Church be obtained from the Cemetery. The pastor followed this suggestion, and he obtained cards of transfer, which petitioner signed on September 3, 1983. A deed was issued by the Cemetery to the Church on February 16, 1984. Neither petitioner nor Jaffe told the pastor to delay obtaining this deed; the delay in perfecting record title was due solely to the pastor's inadvertence. In 1980, petitioner purchased, again at Jaffe's164 suggestion, an additional 30 grave sites in Whitemarsh Memorial Park for $5,000. In 1981, Jaffe donated these grave sites, on petitioner's behalf to another church. All deeds issued by the Cemetery provided: "No transfer, conveyance or assignment of any interest or rights acquired by Grantee shall be valid without the written consent of Grantor [Whitemarsh Memorial Park Cemetaries Company] and being thereafter recorded on its books." In his 1979 return, petitioner claimed a charitable contribution deduction of $15,000 attributable to the 30 grave sites donated to the Church.In his notice of deficiency, respondent disallowed $12,000 of the claimed $15,000 deduction. Subsequently, in his amended answer, respondent disallowed the entire $15,000 deduction, contending that no completed gift occurred in 1979. Alternatively, respondent contends that had petitioner sold the grave sites (rather than donate them to the Church), any gain realized from such theoretical sale would have been taxed as ordinary income (rather than capital gain); thus, pursuant to section 170(e) 3, the amount of the charitable contribution deduction allowable to petitioner with respect to the donation of165 the grave sites is limited to his cost basis. ULTIMATE FINDINGS OF FACT (1) Petitioner made a completed gift of 30 grave sites to the Church on November 7, 1979. (2) The fair market value of the donated 30 grave sites on November 7, 1979 was $4,000. (3) The grave sites were capital assets in petitioner's hands. OPINION Section 170(a) allows as a deduction a contribution or gift to any entity described in section 170(c) 4, payment of which is made within the taxable year. Section 1.170A-1(c)(1), Income Tax Regs., provides that if property other than money is contributed to charity, the amount of the contribution is the fair market value of the property at the time of contribution, reduced as provided by section 170(e)(1). Section 1.170A-1(c)(2), Income Tax Regs., defines fair market value as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. 166 " See United States v. Cartwright,411 U.S. 546">411 U.S. 546 (1973). Respondent's primary argument is that petitioner did not make a completed charitable gift of the grave sites to the Church in 1979. 5 We disagree. Section 1.170A-1(b), Income Tax Regs., provides that a contribution is ordinarily made at the time delivery is effected. In general, with respect to the contribution of a check to charity, delivery occurs when the check is mailed or delivered to the charity, not when the check clears the bank; with respect to the contribution of stock to charity, the gift is completed on the date of delivery to the donee or on the date of mailing, not on the date the stock is transferred on the books of the corporation. Here, both petitioner and the Church believed that the gift of the 30 grave sites occurred on November 9, 1979 and that as of that date, the Church unconditionally owned the grave sites. The issuance of a deed167 to the Church was, under the instant circumstances, a formality; the delay in obtaining the deed was due solely to the pastor's inadvertence. Petitioner knew nothing of the delay, believing that everything necessary to cause the Church to own the grave sites had occurred. The subsequent issuance of a deed to the Church ratified and confirmed the earlier act of the parties. In our opinion, the provision in the deed restricting transfer of the lots without the consent of the Cemetery was for the sole protection of, and enforceable only by, the Cemetery; it did not vitiate that which already had occurred, i.e., the gift of the grave sites from petitioner to the Church in 1979. For tax purpose, a charitable contribution is synonymous with a gift. DeJong v. Commissioner,36 T.C. 896">36 T.C. 896, 899 (1961), affd. 309 F.2d 373">309 F.2d 373 (9th Cir. 1962). Under Pennsylvania law, in order to establish a valid inter vivos gift, there must be (1) an intent to make an immediate gift, and (2) an actual or constructive delivery to the donee, as well as divestiture by the donor of dominion and control of the property. Actual delivery is necessary in order to avoid possible adverse168 effects on third parties as well as to protect the donor from fraud. Where the donor admits the making of a gift and where no third party is involved, actual delivery is not required. See Hengst v. Hengst,491 Pa. 120">491 Pa. 120, 420 A.2d 370">420 A.2d 370 (1980). Here, petitioner admits the making of a gift which involved no third party. We therefore hold that petitioner is entitled to a charitable contribution deduction in 1979 for the donation of the 30 grave sites to the Church. We must now determine the amount of the deduction. In determining the amount of the charitable contribution deduction to which petitioner is entitled, we must first determine whether petitioner would have realized ordinary income had he sold the grave sites at a price in excess of his cost. Section 170(e)(1)(A) provides that the amount of any allowable charitable contribution shall be reduced by the amount of gain which would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value. Section 1.170A-4(b)(1), Income Tax Regs., provides that "ordinary income property" includes property held by the donor primarily for sale to customers in the ordinary169 course of his trade or business. Respondent's argument is premised on the fact that petitioner contributed 30 cemetery lots in each of 1977, 1979 and 1981. Therefore, argues respondent, petitioner's activities were substantially equivalent to those of a dealer; hence, gain from a theoretical sale of the grave sites would have resulted in the recognition of ordinary income by petitioner. We do not agree. In our opinion, the limitation of section 170(e)(1)(A) does not apply absent a finding that petitioner actually engaged in the trade or business of selling grave sites. Petitioner is a practicing physician and has never sold grave sites. He is not transformed into a dealer merely by virtue of his donations. See Anselmo v. Commissioner,80 T.C. 872">80 T.C. 872 (1983), affd. 757 F.2d 1208">757 F.2d 1208 (11th Cir. 1985). Petitioner is therefore entitled to a charitable contribution deduction equal to the fair market value of the 30 grave sites on November 9, 1979. In determining the fair market value of the grave sites, we must examine the market in which they are ordinarily sold to the ultimate consumer. Lio v. Commissioner,85 T.C. 56">85 T.C. 56 (1985); Skripak v. Commissioner,84 T.C. 285">84 T.C. 285, 322 (1985);170 Anselmo v. Commissioner,supra;Goldman v. Commissioner,388 F.2d 476">388 F.2d 476 (6th Cir. 1967), affg. 46 T.C. 136">46 T.C. 136 (1966). In Lio, we said, "the sale to the ultimate consumer is any sale to those persons who do not hold the item for subsequent resale * * * and the most appropriate market for valuation purposes is the most active marketplace for the particular item involved." Lio v. Commissioner,85 T.C. at 70. Petitioner argues that the grave sites should be valued on the basis of what would have been paid for them had they been purchased directly from the Cemetery. We disagree. The purchase of grave sites from the Cemetery is the primary market; the purchase of grave sites from others is the secondary market. The price of a grave site in the primary market is substantially more than that in the secondary market, as evidenced by the facts in this case. Petitioner paid $3,000 for 30 grave sites in Whitemarsh Memorial Park in 1978 and $5,000 for 30 similar grave sites in 1981. These purchases were made on the secondary market; had the same 30 grave sites been purchased, on an individual basis, directly from the Cemetery,171 the aggregate price paid for the sites would have been in excess of $15,000. A variety of factors enter into the purchase price of cemetery lots in the primary market. In general, the Cemetery will charge whatever the market will bear. The Cemetery does not sell grave sites in bulk. Also, we are mindful that there are a number of transactions in the Philadelphia area involving bulk purchases of cemetery lots which are subsequently donated to a charitable organization. 6 We do not believe petitioner obtained the 30 grave sites for a bargain price when he purchased them from the estate in 1978, as he suggests. The executor undoubtedly was obligated to sell the lots at the highest price available. In our opinion, the most active marketplace for a theoretical sale of the donated grave sites would be the secondary market. Lio v. Commissioner,supra. Thus, the sites should be valued as if they had been sold in that market. After carefully considering the record as a whole, we conclude that the fair market value of the 30 grave sites at the time of contribution by petitioner in November, 172 1979 was $4,000. Accordingly, petitioner is entitled to a $4,000 charitable contribution deduction in 1979 with respect to his donation. To reflect the foregoing, Decision will be entered under Rule 155.Footnotes1. Jaffe had, in 1977, arranged for petitioner to donate grave sites which gave rise to a charitable contribution deduction not here in issue.↩2. Neither petitioner nor his wife are members of the Church, nor has either ever visited the Church.↩3. All statutory references are to the Internal Revenue Code of 1954, as amended and in effect in 1979. All Rule references are to the Tax Court Rules of Practice and Procedure.↩4. Respondent concedes that the Church qualifies as an entity described in section 170(c).↩5. Since this position was first raised in respondent's amended answer, respondent bears the burden of proof with respect to this issue. Rule 142(a).↩6. See Broad v. Commissioner,T.C. Memo. 1986-340↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621963/	Middle Atlantic Distributors, Inc., Petitioner v. Commissioner of Internal Revenue, RespondentMiddle Atlantic Distributors, Inc. v. CommissionerDocket No. 1982-78United States Tax Court72 T.C. 1136; 1979 U.S. Tax Ct. LEXIS 55; September 20, 1979, Filed 55 Decision will be entered for the petitioner. Petitioner was a wine and liquor importer. At various times between 1957 and 1962, it released liquors from its bonded warehouse to an official of the Turkish Embassy. Subsequently, it was discovered that the documents under which this official withdrew the liquors were fraudulent. Criminal charges were filed against petitioner but were dismissed on motion of the United States. A civil suit against petitioner under 19 U.S.C. sec. 1592 was also filed, but was settled prior to trial under an agreement by which petitioner paid the United States $ 100,000 as liquidated damages, and the United States dismissed the civil suit. Held, 19 U.S.C. sec. 1592, as it stood prior to amendment in 1978, had both penal and remedial aspects. Held, further, the payments in this case were compensatory in nature and were not in respect of a "fine or similar penalty" within the meaning of sec. 162(f), I.R.C. 1954. Michael F. Curtin and David Barmak, for the petitioner.Dale C. Allen, for the respondent. Sterrett, Judge. STERRETT1136 In a timely mailed notice of deficiency dated November 30, 1977, respondent determined deficiencies in petitioner's income taxes due for the following years and in the following amounts:FYE Jan. 31 --Claimed deficiency1970$ 17,984.04197416,716.38197517,128.661137 After concessions, the only issue for our decision is whether certain installment payments made by petitioner during its taxable years ended January 31, 1970, 1974, and 1975, pursuant to a stipulation of compromise which settled a civil suit against petitioner by the United States, are nondeductible by virtue of section 162(f), I.R.C. 1954. The parties have agreed that our resolution of this issue will automatically resolve (1) the amount of petitioner's net operating loss carryback deduction to its taxable year ended January 31, 1970, from its 197258 and 1973 taxable years, and (2) the amounts of petitioner's maximum allowable contribution deductions for its taxable years ended January 31, 1974 and 1975. If we should hold that the payments in issue are not deductible as expenses, then we must also decide whether the installment payments made during petitioner's taxable years ended January 31, 1974 and 1975, should be considered undistributed personal holding company income subject to the tax imposed by section 541.FINDINGS OF FACTThe facts herein were fully stipulated. Said facts, together with the exhibits attached thereto, are incorporated herein by this reference.Petitioner Middle Atlantic Distributors, Inc., is a Delaware corporation, the principal office of which was in West Palm Beach, Fla., at the time it filed its petition herein. Timely Federal corporate income tax returns for petitioner's taxable years ended January 31, 1970, 1974, and 1975 were filed with the Internal Revenue Service at Jacksonville, Fla.From April 1942 through February 16, 1972, petitioner was in the business of distributing wines and liquors. At all times relevant hereto, petitioner had both an importer's basic liquor permit and a wholesaler's59 basic liquor permit, each of which had been issued by the Alcohol and Tobacco Tax Division pursuant to the Federal Alcohol Administration Act. Beginning in at least May 1954, petitioner operated a United States Customs bonded warehouse, under the supervision of United States Customs officials, in which imported liquors were held prior to distribution.During the period from approximately August 1, 1957, through approximately May 10, 1962, an official of the Embassy of Turkey withdrew from petitioner's bonded warehouse large 1138 quantities of imported liquor. Under 19 U.S.C. section 196(a)(1930), 1 imported liquor could be acquired for the use of foreign military personnel on duty in the United States free of United States import duties and United States alcohol taxes upon the presentation of withdrawal permits (U.S. Customs Form 7505) reviewed and approved by United States Customs officials. It was later ascertained that the withdrawal permits submitted by this Turkish official were forged. Further, it was later discovered that, instead of distributing the liquor withdrawn from petitioner's warehouse to members of the armed forces of60 Turkey as required by section 196(a) and as stated in the withdrawal permits, this Turkish official had diverted the liquor to unauthorized persons for sale within the commerce of the United States.61 As a result of this unlawful diversion of imported liquor, criminal charges were filed against petitioner and its office manager by the United States. The United States later moved to dismiss its case against petitioner, which motion was granted. The District Court later directed a verdict of not guilty in the action against petitioner's employee. Neither petitioner nor any of its officers or employees were ever convicted or otherwise shown to have had any knowledge of, or complicity in, the Turkish official's plot.On June 1, 1965, the U.S. Customs Service 2 issued to petitioner, the office manager, and the Turkish official, a "Notice of Penalty or Liquidated Damages Incurred and Demand for Payment." This demand was made pursuant to the provisions of 19 U.S.C. section 15923 and sought recovery of $ 502,109.17, the 1139 full value of the liquor fraudulently withdrawn by the Turkish official from petitioner's warehouse and injected into United States commerce. Petitioner objected to the payment sought by this notice of demand. In due course, the United States filed a civil action against petitioner, pursuant to section 1592, seeking62 the same $ 502,109.17, plus costs and interest. The United States v. Middle Atlantic Distributors, Inc., civil action No. 676-67 (D.D.C., March 21, 1967), hereinafter U.S. v. Middle Atlantic.63 In "Count I" of its complaint against petitioner in U.S. v. Middle Atlantic, the Government alleged that petitioner had:entered and introduced into the commerce of the United States of America, or aided in entering and introducing into the commerce of the United States of America, * * imported whiskey by means of false, forged, and fraudulent Customs Forms 7505 * * * [and that petitioner] * * * knew or should have known, or in the alternative, was negligent in failing to discover that the aforesaid Customs Forms were false, fraudulent and forged.In "Count II" of its complaint, the Government alleged that petitioner "aided or procured the making of false statements in Customs Forms 7505 * * * [and that petitioner] knew or should have known that said Forms contained false statements and * * * [petitioner] did not have reasonable cause to believe that said statements were true." Petitioner denied these allegations and all the operative allegations of the complaint.Subsequent to March 21, 1967, the parties entered into settlement negotiations. These negotiations culminated in a 1140 letter dated April 28, 1969, to the United States in which petitioner made an offer to64 settle the Government's claim for $ 100,000 stating:Accordingly, * * * I hereby increase to $ 100,000 our offer to settle the claim asserted by the Government, as liquidated damages, in order to reimburse the Government for all or a portion of the taxes to which it asserts a claim.This offer is conditioned upon the Government's dismissal of the captioned action, with prejudice, upon the receipt of defendant's payment.The United States accepted petitioner's offer "as set forth in * * * [petitioner's] letter of April 28, 1969" by letter to petitioner dated September 16, 1969.On October 14, 1969, the parties in U.S. v. Middle Atlantic executed a document entitled "Stipulation of Compromise" in which the parties settled, without trial, the Government's civil action against petitioner in U.S. v. Middle Atlantic. This paper read in relevant part: "Accordingly, the parties hereto have agreed to settle the asserted claim of liquidated damages made by the plaintiff, for the sum of One Hundred Thousand Dollars ($ 100,000.00)." Under the terms of this Stipulation of Compromise, the $ 100,000 settlement amount was to be paid in 6 annual installments. These installments were actually65 made in the following amounts and on the following dates:Petitioner'sAmountDate of paymentFYE Jan. 31 --$ 20,000Oct. 30, 1969197016,000Nov. 9, 1970197116,000Nov. 22, 1971197216,000Sept. 7, 1972197316,000Oct. 22, 1973197416,000Jan. 10, 19751975By 1974, petitioner had discontinued the active conduct of its wine and liquor business. Petitioner filed its 1974 and 1975 corporate income tax returns as a personal holding company.OPINIONThe first issue with which we must deal is the deductibility to petitioner of its payments to the United States under the Stipulation of Compromise. On June 1, 1965, the Customs Service issued a "Notice of Penalty or Liquidated Damages Incurred and Demand for Payment" to petitioner and others for 1141 the payment of $ 502,109.17 as a "penalty against goods" pursuant to 19 U.S.C. section 1592 (1930). 4 The basis for this demand was that petitioner and others had been determined to be jointly and severally liable for the forfeiture value ($ 502,109.17) of certain alcoholic beverages which had been entered into petitioner's warehouse under appropriate66 bonds, and later irregularly withdrawn, duty and tax free, on withdrawal permits which were based on false and/or fraudulent documents.Petitioner objected to the payment sought by the Customs Service, and subsequently, the United States filed a civil action against petitioner, pursuant to 19 U.S.C. section 1592, seeking recovery of $ 502,109.17 as a "penalty against goods." This civil action was settled after lengthy negotiations by the execution of a Stipulation of Compromise dated October 14, 1969. In that Stipulation of Compromise, petitioner agreed to settle the asserted claim of the United States by payment of $ 100,000.The $ 100,000 was paid in 6 installments. Petitioner deducted these installment payments on its Federal income tax returns, during each of the taxable years that such payments were made, as ordinary and necessary business67 expenses under section 162. Respondent disallowed these deductions under section 162(f), alleging that they had been paid in settlement of an actual or potential liability for a fine or penalty.Respondent does not argue that the payments at issue are not "ordinary and necessary" within the meaning of section 162, but argues simply that they are nondeductible because, although described in section 162(a), they are also described in section 162(f). 5 Petitioner, on the other hand, argues that the payments in issue are deductible "since they represent liquidated damages expressly agreed to by the Government in the Stipulation of Compromise entered by the parties." Thus the question we face on this first issue is a narrow one: are the payments in issue, although admittedly ordinary and necessary business expenses, 1142 nondeductible as "fines or similar penalties" within the meaning of section 162(f)?68 The statute itself does not define the phrase "fine or similar penalty." The regulations thereunder, however, provide in relevant part as follows:Sec. 1.162-21 Fines and penalties.(a) In general. No deduction shall be allowed under section 162(a) for any fine or similar penalty paid to --(1) The Government of the United States * * ;(2) The government of a foreign country; or(3) A political subdivision of, or corporation or other entity serving as an agency or instrumentality of, any of the above.(b) Definition. (1) For purposes of this section a fine or similar penalty includes an amount --(i) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding;(ii) Paid as a civil penalty imposed by Federal * * law * * ;(iii) Paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal); or(iv) Forfeited as collateral posted in connection with a proceeding which could result in imposition of such a fine or penalty.(2) * * Compensatory damages * * * paid to a government do not constitute a fine or penalty.As neither petitioner nor any of its69 employees were ever convicted of any crime, and as no other plea of guilty or nolo contendere by either petitioner or any of its employees was ever made, section 1.162-21(b)(1)(i), Income Tax Regs., is inapplicable. Similarly, neither the definition contained in section 1.162-21(b)(1)(ii), Income Tax Regs., nor that given in section 1.162-21(b)(1)(iv), Income Tax Regs., applies to the facts before us. No civil judgment and concomitant penalty was ever actually entered against or imposed upon petitioner. Finally, there is no indication in the record that any amount was claimed as forfeiture of collateral -- as, for example, forfeiture of petitioner's warehouse bond. Thus, the question before us resolves itself into the determination of whether the payments in issue, which were made in settlement of the taxpayer's potential liability under 19 U.S.C. section 1592, were paid in respect of a "potential liability for a [civil] fine or penalty" within the meaning of section 1.162-21(b)(1)(iii), Income Tax Regs. -- or were paid, rather, as "compensatory damages" to the United States.The legislative history of section 162 has been called ambiguous. 70 Uhlenbrock v. Commissioner, 67 T.C. 818">67 T.C. 818, 824 n. 7 (1977); 1143 Tucker v. Commissioner, 69 T.C. 675">69 T.C. 675, 678 n. 4 (1978). Certainly, however, by 1972 it was clear that section 162(f) was intended to include civil penalties "which in general terms serve the same purpose as a fine exacted under a criminal statute." S. Rept. 92-437 (1971), 1 C.B. 559">1972-1 C.B. 559, 599-600. A criminal "fine or similar penalty" is one imposed to punish and/or deter. See Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30">356 U.S. 30, 35-36 (1958) (describing the application of the "public policy" doctrine to the deductibility of fines and penalties. S. Rept. 91-552, supra, 1969-3 C.B. at 597). See also Tucker v. Commissioner, supra at 680; McGraw-Edison Co. v. United States, 156 Ct. Cl. 590">156 Ct. Cl. 590, 300 F.2d 453">300 F.2d 453, 455 (1962); Helvering v. Superior Wines & Liquors, 134 F.2d 373">134 F.2d 373, 376 (8th Cir. 1943). Thus, it is clear that, if the deduction of a civil fine (or similar penalty) 71 is to fall within the proscription of section 162(f), the fine must be one which punishes and/or deters.We believe it quite clear that section 1592 is essentially remedial in nature and does not require the imposition of a quasi-criminal fine. In fact, the U.S. Government, itself, in another context in another court, argued to that effect. Thus, it was said in United States v. Alcatex, Inc., 328 F. Supp. 129">328 F. Supp. 129, 132 (S.D. N.Y. 1971), that "At the same time, the Government is on firm ground when it characterizes the statute here in question as being broadly 'remedial'." There, the Government was seeking forfeiture of some imported silk by reason of the filing of a false declaration statement. The defendant's motion for summary judgment, alleging double jeopardy, was denied. In so concluding, the Court further noted that:It seems clear, in short, that forfeiture of the illegally imported property "or the value thereof" is a reasonable and fair form of liquidated damages. * * * The amount of recovery is not so excessive as to defeat Congress's clear intent that sec. 1592 be viewed as creating a civil action for present purposes. [United States v. Alcatex, Inc., supra at 133.]72 Our view of the nature of section 1592 is supported by reference to 19 U.S.C. 16156 which provides that the burden of proof is on the defendant once the Government has shown that there is probable cause to institute the suit. The defendant's burden is to carry the day "by a fair preponderance of the 1144 evidence" ( United States v. One 1937 Hudson T. Coupe, Etc., 21 F. Supp. 600">21 F. Supp. 600, 603 (W.D. Ky. 1937)), i.e., the type of burden present in an ordinary civil lawsuit.Clearly, section 1592 is designed to protect the security of the commerce of the United States: as noted, violation of a customs law may result in forfeiture of the goods involved, or their value, pursuant to section 1592. No doubt section 1592 may sometimes be used for purposes of punishment or deterrence, but other times it is used for remedial73 purposes. This is the way in which the Customs Service has perforce used section 1592. See W. Dickey, "Survival From More Primitive Times: Customs Forfeitures in the Modern Commercial Setting Under Sections 592 and 618 of the Tariff Act of 1930," 7 Law & Policy Int'l Bus. 691 (1975).The remedial, as well as punitive, use of section 1592 is confirmed by the wording of the section 1592 "mitigation" provision, section 1618. Tariff Act of 1930, ch. 497, tit. IV, sec. 618, 46 Stat. 757, 19 U.S.C. sec. 1618. That section provides in relevant part that:Sec. 1618. Remission or mitigation of penaltiesWhenever any person interested in any * * merchandise, * * * seized under the provisions of this Act or who has incurred, or is alleged to have incurred, any fine or penalty thereunder, files with the Secretary of the Treasury * * * for the remission or mitigation of such fine, penalty, or forfeiture, the Secretary of the Treasury, [or the Secretary of Commerce,] if he finds that such fine, penalty, or forfeiture was incurred without wilful negligence or without any intention on the part of the petitioner to defraud the revenue or to violate the74 law, * * may remit or mitigate the same upon such terms and conditions as he deems reasonable and just * * * [Emphasis added.]It is obvious from this language that a section 1592 claim can be made in respect of both punitive and remedial purposes. 7 That the Customs Service itself has recognized the section 1592 remedial aspects is indicated by its policy of reducing the section 1592 "penalty" claim, which is perforce originally for the goods or their full value, to an amount equal to 1 times the revenue loss, i.e., the amount of actual damages incurred by the United States in lost revenue where there is no culpable intent. See, e.g., 19 C.F.R. sec. 171.1(a)(1)(iv)(1975).Turning again to section 162(f), the character of the payment 1145 involved depends on the origin of the liability giving rise to it. Uhlenbrock v. Commissioner, supra at 823; United States v. Gilmore, 372 U.S. 39">372 U.S. 39, 48-49 (1963).75 Our decision, then, must be based upon an inquiry into the question of whether, in this case, the section 1592 claim was made in respect of section 1592 compensatory purposes or was made, on the other hand, for the purpose of punishing culpable behavior. We do not believe that the settlement in this case had the effect of the imposition of a "penalty" by the Government.It is clear throughout the settlement negotiations between petitioner and the United States, as well as in the settlement document itself, that petitioner was offering to make only a settlement payment representing liquidated damages. It is equally clear that, when the United States accepted petitioner's offer in settlement, it accepted the settlement as "liquidated damages." We conclude, therefore, that at all relevant times during the settlement negotiations, the United States was attempting to recover, and subsequently recovered, only reimbursement for lost revenue and other damages. Obviously, such an intent by the Government does not also comport with an intent to punish or deter. We conclude that the amounts at issue herein were not paid as a "fine or similar penalty."The pre-1969 case of Grossman & Sons, Inc. v. Commissioner, 48 T.C. 15">48 T.C. 15 (1967),76 reviewed by the Court, is in many respects similar to the one now before us. That case involved certain payments made by the taxpayer in settlement of a suit brought against it by the United States under the False Claims Act. 31 U.S.C. secs. 231 through 233 (1976). Certain of the taxpayer's officers and stockholders had been convicted of criminally conspiring to supply inferior goods to the United States under a contract the taxpayer had with the Navy Department. A civil action was later filed against petitioner claiming both compensatory and punitive damages. This action was settled and the payment in settlement deducted. In that case we were, therefore, confronted with a situation like the one before us, involving attempted deduction of amounts paid in settlement of a claim made under a statute having both penal and compensatory aspects. Grossman & Sons, Inc. v. Commissioner, supra at 31. From all the evidence, we concluded that the settlement was made in respect of the Government's compensatory claim and allowed the deduction:1146 But while the Government chose to proceed under the False Claims Act, 77 this does not necessarily mean that the amount petitioners agree to pay, although resulting in a dismissal of this suit with prejudice, was payment of a penalty or forfeiture. * * Petitioners claim that the amount they agreed to pay represented only the damages suffered by the Government and did not include any forfeitures or double damages. This finds support * * * in the settlement offer submitted by petitioners and accepted by the Government * * ** * * Had the United States intended that the payment be penal in nature it could have insisted on so indicating in the settlement agreement. Instead, a duly authorized representative of the Government wrote to counsel for petitioners stating that "the Attorney General has accepted the offer in settlement you have proposed on behalf of your clients, as contained in your letters of July 1, 1958 and July 2, 1958, modified by your letter of December 2, 1958." On the record before us we must conclude that the characterization of the payment as damages for breach of contract contained in petitioner's settlement offer, which was accepted by the Attorney General, must be given effect. [Grossman & Sons, Inc. v. Commissioner, supra at 28-29.]78 Once again, we conclude that the characterization of the payment as damages by the parties must be given effect.In conclusion, the parties have called our attention to the recently decided case of Adolf Meller Co. v. United States, 220 Ct. Cl. , 600 F.2d 1360">600 F.2d 1360 (1979). That case also involved the deductibility under section 162 of a section 1592 penalty against goods. Meller had imported synthetic gemstones in such a way as to bypass normal customs procedures. The District Director of Customs sent Meller a Notice of Penalty under section 1592 demanding payment of $ 533,370.12. In addition to the forfeiture amount, the Customs Service demanded $ 55,560.34 in lost customs duties on the allegedly mislabeled gems. After negotiations, Meller agreed to pay the demanded duties, "plus an additional sum of $ 43,000 in compromise of the original assessed penalty of $ 533,370.12." Adolf Meller Co. v. United States, supra at 1361.Before the Court of Claims, Meller "conceded that the $ 43,000 payment at issue here falls squarely within subsection (1)(b)(iii) [sic] [sec. 1.162-21(b)(1)(iii)] * * and that the deduction is therefore barred if the regulation79 is valid." Clearly Meller had conceded the very point at issue in the case before us. On the other hand, our petitioner has not challenged the validity of the regulation under section 1.162-21, Income Tax Regs. We do not disagree with the decision.1147 As we hold for petitioner on this first issue, we need not reach respondent's personal holding company claim.Decision will be entered for the petitioner. Footnotes1. Act of August 27, 1949, ch. 517, sec. 1, 63 Stat. 666, repealed Act of May 24, 1962, Pub. L. 87-456, tit. III, sec. 303(c), 76 Stat. 78, effective with respect to articles entered, or withdrawn from warehouses for consumption, on or after Aug. 31, 1963. As originally enacted, sec. 196(a) read as follows:"Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, That (a) articles entered, or withdrawn from warehouse, for consumption in the United States, its Territories, or possessions for the official use of persons who are on duty in the United States, its Territories, or possessions as members of the armed forces of any foreign country, or for the personal use of any such person or of any member of his immediate family, shall be admitted free of all duties and internal revenue taxes imposed upon or by reason of importation (including taxes imposed by sections 3350 and 3360 of the Internal Revenue Code↩) and of all customs charges and exactions * * "2. Prior to Aug. 1, 1973, the U.S. Customs Service was known as the Bureau of Customs. See Treasury Dept. Order 165-23 of Apr. 4, 1973, 38 Fed. Reg. 13037↩.3. Sec. 1592. Penalty against goodsIf any * * importer * * * or other person or persons enters or introduces, or attempts to enter or introduce, into the commerce of the United States any imported merchandise by means of any fraudulent or false * * * statement, written or verbal, or by means of any false or fraudulent practice or appliance whatsoever, or makes any false statement in any declaration under the provisions of section 485 of this Act * * * without reasonable cause to believe the truth of such statement, or aids or procures the making of any such false statement as to any matter material thereto without reasonable cause to believe the truth of such statement, whether or not the United States shall or may be deprived of the lawful duties, or any portion thereof, accruing upon the merchandise, or any portion thereof, embraced or referred to in such * * * statement; or is guilty of any willful act or omission by means whereof the United States is or may be deprived of the lawful duties or any portion thereof accruing upon the merchandise or any portion thereof, embraced or referred to in such * * * statement, or affected by such act or omission, such merchandise, or the value thereof, to be recovered from such person or persons, shall be subject to forfeiture, which forfeiture shall only apply to the whole of the merchandise or the value thereof in the case or package containing the particular article or articles of merchandise to which such fraud or false paper or statement relates. The arrival within the territorial limits of the United States of any merchandise consigned for sale and remaining the property of the shipper or consignor, and the acceptance of a false or fraudulent invoice thereof by the consignee or the agent of the consignor, or the existence of any other facts constituting an attempted fraud, shall be deemed, for the purposes of this section, to be an attempt to enter such merchandise notwithstanding no actual entry has been made or offered.↩4. 19 U.S.C. sec. 1592↩ was amended Oct. 3, 1978, Pub. L. 95-410, tit. I, sec. 110(a), 92 Stat. 893.5. SEC. 162. TRADE OR BUSINESS EXPENSES.(a) In General. -- There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, * * ** * * *(f) Fines and Penalties. -- No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.↩6. 19 U.S.C. sec. 1615↩ was amended Oct. 3, 1978, Pub. L. 95-410, tit. I, sec. 110(d), 92 Stat. 896.7. We note here again that neither petitioner nor its employee was convicted of any criminal acts.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621964/	ED W. AND CHARLOTTE B. BUFORD, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentBuford v. CommissionerDocket No. 26100-92United States Tax CourtT.C. Memo 1994-171; 1994 Tax Ct. Memo LEXIS 175; 67 T.C.M. (CCH) 2710; April 19, 1994, Filed 175 Ed W. Buford, pro se. For respondent: Linda J. Ozkan. POWELLPOWELLMEMORANDUM OPINION POWELL, Special Trial Judge: This case was heard pursuant to the provisions of section 7443A(b)(3) and Rules 180, 181, and 182. 1By notice of deficiency issued September 29, 1992, respondent determined a deficiency in petitioners' 1988 Federal income taxes in the amount of $ 2,855.72. Petitioners filed a timely petition and an amended petition in this Court. Petitioners resided in Baton Rouge, Louisiana, when they filed their petitions. Following concessions, 2 the issue is whether petitioners are entitled to a bad debt deduction for funds that they allegedly advanced to Dixieland Helicopters, Inc. (Dixieland), and which were used to pay their son's educational expenses. 176 The facts may be summarized as follows. During all times relevant to this case, petitioner Ed W. Buford (Ed Sr.) was employed by the State of Louisiana as an engineer, and petitioner Charlotte B. Buford, a registered nurse, was employed by a hospital in Baton Rouge to direct in-service education. The genesis of petitioner' association with Dixieland was in their desire to help their son, Ed W. Buford, Jr. (Ed Jr.), "become a commercial helicopter pilot, own his own company, and earn a livelihood." To that end, petitioners and Ed Jr. (the Bufords) formed Dixieland; Ed Jr. received 50 percent of the stock, and petitioners each received 25 percent. Ed Jr. was president of Dixieland, and Ed Sr. was its vice president, secretary, and treasurer. Ed Jr. was commercially qualified as a fixed-wing and helicopter pilot. The Bufords did not contribute any capital or assets to Dixieland. Petitioners, however, extended Dixieland a $ 15,000 line of credit, evidenced by a series of unsecured promissory notes due January 1, 1988. Each of the notes included the provision that failure to pay this indebtedness at its maturity shall, at the option of the holder of this note, * * * become177 at once due and exigible. * * In the event of failure to pay this note at maturity, and of the same being placed in the hands of an attorney at law for collection, the maker, endorser, agree to pay, in addition to principal and interest, as attorney's fees two (2) per cent additional on principal and interest. 3Dixieland applied for a Small Business Administration (SBA) loan in the amount of $ 48,000. The Bufords planned that, if the loan were approved, Dixieland would purchase a helicopter with the proceeds. However, the SBA twice rejected the loan application. 4178 While waiting for the SBA loan, the Bufords decided to "enhance ourselves further to make the corporation a more valuable asset" by having Ed. Jr. get training in aircraft repair. On June 1, 1987, Dixieland drew approximately $ 10,000 5 from the line of credit to pay Ed Jr.'s tuition at Colorado Aero Tec. While he was in school, Ed Jr. worked at part-time jobs, and following his graduation in September 1988 he began working in Alabama as a helicopter pilot. Petitioners realized toward the end of 1987 that they were not going to be repaid. Ed Sr. explained the default on the notes stating that since he [Ed Jr.] had not graduated from school and our expected source of repayment had not materialized like we had anticipated it being at the time the notes were called upon to be due * 179 there was no way that the corporation could pay them on demand and there was no basis at that point for asking for an extension and/or modification of payments so that it could be prorated over a longer period of time. That is why at the [December 16, 1987] board meeting * * * we asked that the loan be defaulted.Petitioners did not institute collection proceedings against Dixieland. Ed Sr. indicated that he did not expect that Ed Jr. could repay the money: "He [Ed Jr.] was driving my car. He was using my telephone credit card and my gas card. He had nothing to attach." On their 1988 Federal income tax return, petitioners claimed a $ 10,000 loss stemming from the transfer. 6 Respondent disallowed the loss. In general, section 166(a) allows a deduction for any debt which becomes worthless within the taxable180 year. 7 Only a bona fide debt, arising from a "debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money" qualifies for a section 166 deduction. Sec. 1.166-1(c), Income Tax Regs. A note does not in and of itself determine the existence of a bona fide debt. Wolff v. Commissioner, 26 B.T.A. 622">26 B.T.A. 622, 625 (1932). The basic question is whether the purported lender had a "reasonable expectation of repayment regardless of the success of the business or whether his advances were put at the risk of the corporate venture." Stark v. Commissioner, T.C. Memo. 1982-639. In this regard, we note that Dixieland181 could not get outside financing, that Dixieland had no capital or assets, that there was no security for the so-called loan, and that no collection activity, though anticipated by the promissory notes, was instituted. These factors indicate that petitioners could not have reasonably expected repayment. See Charles W. Williams Contracting Co. v. Commissioner, T.C. Memo 1966-93">T.C. Memo. 1966-93. Furthermore, we may disregard the form of a transaction that has no economic significance and look at the substance of the arrangement. Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935); see also Horn v. Commissioner, T.C. Memo 1982-741">T.C. Memo. 1982-741. Although cast in the form of a loan to Dixieland, the realities of the arrangement indicate that the transfer was made by petitioners to Ed Jr., with Dixieland serving as a "convenient conduit" to generate perceived tax benefits. See Elbert v. Commissioner, 45 B.T.A. 685">45 B.T.A. 685, 690 (1941). When examined with detached scrutiny, the credit line here did not spring from a business purpose but rather from "commendable parental interest". Rothbard v. Commissioner, T.C. Memo. 1957-155;*182 see also Nova v. Commissioner, T.C. Memo 1993-563">T.C. Memo. 1993-563. Accordingly, we uphold respondent's disallowance of the deduction. To reflect the concessions by the parties, Footnotes1. Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩2. Petitioners agree that they are not entitled to deductions for certain expenses they had claimed on Schedule C, and respondent allowed an additional $ 611 as a Schedule A deduction.↩3. Ed Sr. indicated that the collection provision was included for the benefit of the Internal Revenue Service rather than for purposes of collecting the debt.↩4. The first application, filed with the Louisiana area SBA, was turned down because another helicopter business in the Baton Rouge area had defaulted on a sizable loan, and the SBA was "very reluctant to do anything that said helicopter." The second application was submitted to the Florida regional SBA office, proposing to set up operations near Panama City. It was rejected without explanation.↩5. Apparently, $ 10,235 was drawn from the credit line, but petitioners claimed a loss of only $ 10,000. The record does not reveal the manner of the disbursement, but Ed Sr., as treasurer, had authority over corporate funds.↩6. On their return, petitioners characterized the loss as resulting from the worthlessness of stock in a small business corporation, pursuant to sec. 1244. They subsequently abandoned this argument.↩7. Sec. 166 distinguishes between business and nonbusiness debts. Even if there were bona fide debts here, the debts would not have been a business debt, as they were not dominantly motivated by petitioners' trade or business. See United States v. Generes, 405 U.S. 93↩ (1972).	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621967/	UNIFORM PRINTING & SUPPLY CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Uniform Printing & Supply Co. v. CommissionerDocket No. 60909.United States Board of Tax Appeals33 B.T.A. 1073; 1936 BTA LEXIS 789; February 11, 1936, Promulgated 789 1. BUSINESS LEAGUE. - A corporation engaging in a regular business of a kind ordinarily carried on for profit is held not a "business league" within the purview of section 103 of the Revenue Act of 1928, and its earnings and profits are not exempt from taxation. 2. DIVIDENDS. - Distributions of earnings and profits accumulated subsequent to February 28, 1913, are dividends and, under the evidence in this case, are not exempt from taxation as "rebates" or "refunds" to customers. Walter H. Eckert, Esq., and Tom Leeming, Esq., for the petitioner. J. E. Marshall, Esq., for the respondent. MELLOTT1074 Petitioner seeks a redetermination of a deficiency in income tax for the year 1930, determined by the respondent in the amount of $16,319.42. The issues raised by the pleadings are: (1) Whether petitioner is exempt from taxation under the provisions of section 103(7) of the Revenue Act of 1928; (2) in the alternative, whether certain distributions made by it are rebates or refunds, and not dividends, and should be excluded from its taxable income; (3) whether respondent erred in adding to petitioner's taxable income an item of interest790 in the amount of $6,601.70; and (4) whether respondent erred in disallowing a deduction for attorney's fees paid in the amount of $450. Issues (3) and (4) were abandoned by the petitioner. FINDINGS OF FACT. The petitioner was incorporated under the laws of the State of Illinois, November 16, 1915, with a capital stock of $35,000, consisting of 350 shares of $100 each. The object for which it was formed, set out in the "statement" filed with the proper authorities of the state, was "printing, publishing, engraving, lithographing, and the manufacture, purchase, and sale of books, stationery, office supplies, equipment and merchandise, and to act for others as agent in the sale and distribution of similar lines, and to do such other things as may be necessary for the proper conduct of such business not in conflict with the laws of this State." The original shares of stock were distributed among 12 individuals in blocks of from 10 to 500 shares each. Its capital stock was subsequently increased to 5,000 shares of the par value of $100 and, on September 22, 1930, was changed to 250 shares of no par value. Thereafter, the following resolution of the stockholders was adopted: 791 That the stock certificate shall provide that all of the surplus earnings not in the opinion of the Board of Directors required in the conduct and/or expansion of the business of the corporation, shall each year be returned to the customers of the corporation in the proportion that the gross amount of business furnished by any customer, bears to the gross amount of business done by the company, and the decision of the Board of Directors as to the percentage and/or amount to be returned to each customer shall be conclusive. New certificates of stock were issued containing the language specified in the resolution. The stockholders of the petitioner were its sole and only customers. Prior to the formation of petitioner the various fire insurance companies had their own blank forms printed and distributed to their 1075 agents. In many instances the form differed. The various agents, although representing numerous companies, were expected to keep, and commonly did keep, on hand a more or less complete supply of forms furnished by each company. The disadvantages of such an arrangement were obvious and in order to overcome them, the representatives of two associations792 in the middle western portion of the United States, known respectively as the "Union" and the "Insurance Bureau" devised the plan of having all the member companies of the two associations use the same forms. The petitioner corporation was organized to handle the printing and distribution of such forms "functioning as a supply department of a number of companies." In addition, it, through its representatives, consulted with the state insurance departments and disseminated to the various companies information and rulings of especial interest to them. The business was begun in a small way simply with the printing of uniform forms but it was soon ascertained that the cost of those forms would be very much increased unless general work could be secured to keep the plant busy during the time when the uniform forms were not being printed. The member companies were therefore permitted to have their other printing work done there and the plant was extended from time to time to meet the necessities of the growing business. The petitioner, during the taxable year, occupied a five-story building located at 341-351 West Chicago Avenue, approximately one hundred feet square with a total793 of approximately fifty or sixty thousand square feet of floor space devoted to its business. It had printing presses on three floors of the building, the other floors being used for storage and other purposes incident to the business, and it employed approximately one hundred and fifty employees. The blank forms printed by petitioner were supplied direct to the agents upon requisition from a member company. The bill or statement for the forms so distributed was rendered monthly to the Uniform Forms Committee, the membership of which was composed of representatives of the two associations "Union" and "Insurance Bureau." Requisitions were based upon the experience of the previous period, the actual cost was determined, 10 percent thereof was added, and the bill was submitted upon that basis with the understanding that such amount was the maximum to be paid. The bills were paid by the associations out of funds raised by assessments against the member companies based upon the business transacted, that is, upon the premiums written by each. In some instances the petitioner printed insurance policies for the companies and a charge for such service was made and paid directly without794 the 1076 intervention of the associations. It was the policy of the company to print and distribute forms and policies at a price which would be sufficient, and only sufficient, to pay the expenses of operating and maintaining the plant and organization. During the year 1918 petitioner did a gross business of approximately a quarter of a million dollars. This progressively increased during subsequent years to approximately a million dollars in 1921, 1922, 1923, and 1924, a million and a quarter dollars in 1928, and more than a million and a half dollars in 1929 and 1930. No distribution of profits or of capital was made prior to 1930. Its balance sheet at the end of the taxable year 1930, was of follows: ASSETSCash$229,770.51Accounts Receivable141,301.66Inventories211,839.53Deferred Charges1,167.09Capital Assets$802,700.80Less Reserve for Depreciation442,794.55359,906.25Cash - Equipment Fund23,804.37967,789.41LIABILITIESAccounts Payable$2,584.61Accrued Expenses3,822.94Other Liabilities1,635.00Capital Stock (common)250,000.00Uniform Forms Committee - Trustees709,746.86967,789.41795 The petitioner's method of doing business was not changed in 1930, but after the change in its corporate structure on September 22, 1930, from 5,000 shares of the par value of $100 per share to 250 shares of no par value, there was distributed in December of 1930, $128,943.46, the entry upon the books reading as follows: Uniform Forms Committee Trustee: Net amount in excess of costs, subject to refund to customers for year ending Dec. 31, 1930. To segregate and transfer from the former acct. the results of operations for the year ending Dec. 31, 1930, representing the net amount in excess of costs for that period which are subject to refund to customers, and which were credited to the former a/c during 1930 upon the closing of the books as follows: June 30, 1930$81,612.19Dec. 31, 193047,331.27128,943.461077 The amount was determined by the "Accounting Department finding out the excess over actual cost for the year." In other words, it was based upon "the proportion of the individual purchases, of the companies' individual purchases, in relation to the gross sales for the year, to all." The distribution was not made upon the basis of stock796 ownership. A sheet attached to petitioner's 1930 return contains the following statement: "This corporation is a business league not organized for profit and all net earnings are turned over to the Uniform Forms Committee for distribution to its stockholders." In schedule L of its income tax return for the year 1930, under the heading "Reconciliation of net income and analysis of changes in surplus" petitioner listed as "Net Profit for year, as shown by books, before any adjustments are made therein," the same amount as shown in the preceding finding, i.e., $128,943.46. This amount was included in its gross income and deducted as "non-taxable income" in computing its net income. The deficiency herein results from respondent's adding this amount, together with an item of interest - $6,601.70 and attorney's fees - $450, to the taxable net income reported by petitioner. OPINION. MELLOTT: Petitioner contends that it is exempt from taxation under the provisions of section 103(7) of the Revenue Act of 1928, 1 shown in the margin. It contends that it is a "business league" not organized for profit and that no part of its net earnings inured to the benefit of any private stockholder797 or individual. In the alternative, it contends that the sum of $128,943.46 distributed by it to its customers, all of whom were stockholders, represented "rebates" or "refunds" which should be excluded from its taxable income. We shall discuss these contentions in the order of their statement, but before doing so shall dispose of respondent's plea in bar, presented upon brief, in which he avers that a previous decision of this Board is res adjudicata of the issues raised herein, citing in that connection Tait v. Western Maryland Railway Co.,289 U.S. 620">289 U.S. 620. The previous decision relied upon is Uniform Printing & Supply Co.,9 B.T.A. 251">9 B.T.A. 251; affd., 798 33 Fed.(2d) 445; certiorari denied, 280 U.S. 591">280 U.S. 591. 1078 In that case it was held that this petitioner was not a business league and its claim for exemption was denied. In affirming the decision of the Board, the court, after adverting to the fact that the profits or net income of the petitioner was included in the value of the property owned by it, which, upon dissolution, might be divided among the stockholders, said: It necessarily follows therefore that the petitioner was organized for profit, and that the profits or net income of petitioner company for the year 1918 did inure to the benefit of the stockholders, thereby removing it from that class of taxpayer which is exempt under section 231(7) of the Revenue Act of 1918 [which section is identical with setion 103(7) of the 1928 Act in all particulars here important]. In Tait v. Western Maryland Railway Co., supra, the Supreme Court decided that parties are "concluded in a suit for one year's tax as to the right or question adjudicated by a former judgment respecting the tax of an earlier year," and that both the Government and the taxpayer should be relieve "from redundant799 litigation of the identical question of the statute's application to the taxpayer's status." The petitioner argues that the evidence presented in the former proceeding differs from that in the instant case and lays emphasis upon the change made in its corporate structure as reflected in our findings, namely, the change which occurred on September 22, 1930. It also stresses the fact that the new stock certificates provided that the surplus earnings not required in the conduct and expansion of the corporation's business should be returned to its customers. Respondent's contention has substantial merit, and it may be that the previous decision of this Board, affirmed by the courts, is res adjudicata. We prefer, however, to resolve the doubt in favor of petitioner and to determine whether or not, under the facts and the evidence before us, it is entitled to exemption. Do our findings show that petitioner is exempt from taxation as a business league within the purview of section 103(7), supra?Article 528 of Treasury Regulations 74 reads as follows: Art. 528. Business leagues, chambers of commerce, real estate boards, and boards of trade. - A business league is an800 association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit. It is an organization of the same general class as a chamber of commerce or board of trade. Thus its activities should be directed to the improvement of business conditions or to the promotion of the general objects of one or more lines of business as distinguished from the performance of particular services for individual persons. An organization whose purpose is to engage in a regular business of a kind ordinarily carried on for profit, even though the business is conducted on a cooperative basis or produces only sufficient income to be self-sustaining, is not a business league. An association engaged in furnishing information to prospective investors, to enable them to 1079 make sound investments, is not a business league, since its activities do not further any common business interest, even though all of its income is devoted to the purpose stated. A stock exchange is not a business league, a chamber of commerce, or a board of trade within the meaning of the law and801 is not exempt from tax. This administrative interpretation of the term "business league" has continued over a period of several years. By clear implication it has been ratified by Congress in the reenactment of the provision here under consideration without substantial change. It is, therefore, entitled to great weight and should not be disturbed. United States v. Hermanos y Compania,209 U.S. 337">209 U.S. 337, 339; United States v. Falk,204 U.S. 143">204 U.S. 143, 152; United States v. Safety Car Heating & Lighting Co.,297 U.S. 88">297 U.S. 88. The courts and this Board have frequently held that to be exempt from income tax the petitioner must show three facts - (1) that it is a business league, chamber of commerce, real estate board, or board of trade; (2) that it is not organized for profit; and (3) that no part of its net earnings inures to the benefit of any private stockholder. Clearly no other interpretation of section 103(7) can be mdae. Cf. Northwestern Jobbers Credit Bureau,14 B.T.A. 362">14 B.T.A. 362; affd., 802 37 Fed.(2d) 880; Produce Exchange Stock Clearing Association, Inc.,27 B.T.A. 1214">27 B.T.A. 1214; affd., 71 Fed.(2d) 142; Fort Worth Grain & Cotton Exchange,27 B.T.A. 983">27 B.T.A. 983; Adjustment Bureau of St. Louis Association of Credit Men,21 B.T.A. 232">21 B.T.A. 232; Louisville Credit Men's Adjustment Bureau v. United States,6 Fed.Supp. 196. In its brief petitioner states that the decision of the Board in its earlier case (Uniform Printing & Supply Co., supra,) indicates that the possibility of dividends, or the possibility of an accumulation of income, was the reason why it was denied the exemption therein claimed, and that it has now rendered such possibilities impossible by amendment to its charter and by-laws. It apparently overlloks, however, the following language in the decision, which, notwithstanding the amendments relied upon, is still applicable: "This taxpayer does, in part at least, 'engage in a regular business of a kind ordinarily carried on for profit' and therefore unless the regulation is wrong it must be enforced and the exemption denied." Petitioner has made no change in the nature803 of its activities. It still operates a large printing establishment from which it derives its earnings and is clearly engaged in a regular business of a kind ordinarily carried on for profit. While the above holding is sufficient to warrant the denial of the claimed exemption, it should be noted in passing that petitioner's surplus earnings will, very definitely, inure to the benefit of its stockholders. The resolution specifically provides that "all of the surplus earnings not in the opinion of the Board of Directors required 1080 in the conduct and/or expansion of the business of the corporation, shall each year be returned to the customers of the corporation in the proportion that the gross amount of business furnished by any customer, bears to the gross amount of business done by the company * * ." The stockholders of the petitioner are its sole and only customers. Any distribution of earnings must, therefore, and does, inure to the benefit of its stockholders. The fact that some of the stockholders may not receive distributive shares in any particular year because they have furnished no business to petitioner is immaterial. All of the stockholders will eventually804 receive some benefit from the earnings which have been used for the expansion of the business of the corporation. That a large proportion of its profits has been devoted to this purpose is apparent from the fact that although it started with an initial investment of $35,000, it now has total assets of nearly $1,000,000. Notwithstanding the change in petitioner's charter and bylaws, therefore, we are satisfied that its profits do inure to the benefit of its stockholders. It is not a "business league" within the purview of section 103(7) of the Revenue Act of 1928. The remaining question is whether the distribution made by the petitioner was, as contended by it, a "rebate" or "refund", or a "dividend" within the meaning of the word as used in the revenue act. The statute (sec. 115, Act of 1928) says that a dividend "means any distribution made by a corporation to its shareholders, whether in money or in other property, out of its earnings or profits accumulated after February 28, 1913." Clearly, the distribution made by petitioner was a part of its earnings or profits accumulated after February 28, 1913. It was made to its shareholders in money, and falls squarely within the805 statutory definition of a dividend. The citation of additional authorities is supererogatory. Reference to a recent decision by the Circuit Court of Appeals for the Second Circuit, however, may be helpful. In Produce Exchange Stock Clearing Association, Inc. v. Helvering, supra, substantially the same contention was made as is here being made by petitioner. The court, holding that the statute was never intended to grant an exemption from tax to an association "which merely serves each member as a convenience or economy in his business", said: The statute could never have contemplated that by creating a subsidiary corporation to furnish such facilities, even though they were intended to be performed at cost, it could obtain tax exemption for its creature. We must, and do, hold that petitioner is not entitled to exemption from taxation, and that the respondent committee no error in determining the above deficiency. Judgment will be entered for the respondent.Footnotes1. SEC. 103. EXEMPTION FROM TAX ON CORPORATIONS. The following organizations shall be exempt from taxation under this title - * * (7) Business leagues, chambers of commerce, real estate boards, or boards of trade, not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual; * * * ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621968/	JOHN B. SIMONS AND DELLA D. SIMONS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentSimons v. CommissionerDocket No. 12098-82.United States Tax CourtT.C. Memo 1987-270; 1987 Tax Ct. Memo LEXIS 270; 53 T.C.M. (CCH) 959; T.C.M. (RIA) 87270; June 2, 1987. George R. Kucera, for the petitioners. Alan S. Beinhorn, for the respondent. CLAPPMEMORANDUM FINDINGS OF FACT AND OPINION CLAPP, Judge: Respondent determined a $79,425.00 deficiency in petitioners' 1978 Federal income tax. After concessions, the issue for decision is the amount of petitioners' distributive share of partnership income taxable to them. FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. The stipulation of facts and the exhibits attached thereto are incorporated by this reference. Rancho Los Charcos Development Company (Rancho), a limited partnership, was formed on June 28, 1974. It issued 360 investment units valued at $1,000 each273 in exchange for property and services as follows: Number ofPartners'PartnerUnits IssuedContributionLowell Simons &200 $200,000Simons IndustriesLowell & Marilyn Simons60servicesStonegate Company53landSimons Industries40servicesLowell Simons7servicesThereafter to November 19, 1976, there were various sales of partnership units as fully set forth in the stipulation of facts. Rancho issued an additional 100 partnership units for $100,000 ($1,000 per unit) on November 20, 1976. It offered the units to its partners on a pro rata basis. Some partners did not acquire their pro rata additional units, which were then offered to and purchased by those partners who did acquire their additional pro rata shares. During the period November 20, 1976 to July 24, 1977, Lowell and Marilyn Simons sold 128 partnership units to petitioners. In 1978, Rancho had $815,170.00 of ordinary income. Petitioners' distributive share was $226,617.00. Petitioners did not include their distributive share in their taxable income on their 1978 Federal income tax return. Rancho filed partnership returns in each of the years 1974 through274 1978. It did not elect on these returns to adjust the basis of partnership property pursuant to section 754. 1 On April 15, 1982, Rancho filed an amended 1978 partnership return on which it elected to adjust the basis of partnership property pursuant to section 754. Respondent determined a $79,425.00 deficiency in petitioners' 1978 Federal income tax because petitioners did not report their distributive share of partnership income from Rancho. Petitioners filed a petition which contested the deficiency, and a trial was held. At trial, the parties informed the Court that the issues for decision were: 1) whether 50 percent or more of the partnership capital and profits in Rancho was sold or exchanged within a 12-month period; and 2) whether Rancho's section 754 election was timely. The parties filed a stipulation of facts with exhibits attached thereto. Said exhibits reflect, inter alia, that Rancho had $815,170.00 of ordinary income in 1978 and that petitioners' distributive share was $226,617.00. After trial, each of the parties filed a brief and reply brief. 275 On November 21, 1986, we ordered petitioners to file a supplemental brief to explain fully how a section 708(b) termination or section 754 election affects petitioners' distributive share of Rancho's ordinary income. We further ordered that "all the facts necessary to said explanation should be accompanied by an affidavit, signed and sworn under the penalties of perjury by the affiant." Petitioners filed a supplemental brief on March 10, 1987 and respondent filed a supplemental brief on April 16, 1987. OPINION Petitioners contend that Rancho terminated pursuant to section 708(b)(1)(B). Petitioners also contend that Rancho timely elected to adjust the basis of partnership property pursuant to section 754. Respondent denies both contentions. Section 708 provides: (a) General Rule. -- For purposes of this subchapter, an existing partnership shall be considered as continuing if it is not terminated. (b) Termination. -- (1) General Rule. -- For purposes of subsection (a), a partnership shall be considered as terminated only if -- * * (B) within a 12-month period there is a276 sale or exchange of 50 percent or more of the total interest in partnership capital and profits. * * When a partnership terminates by a sale or exchange of an interest, the partnership constructively distributes its property to the partners and the partners immediately thereafter contribute the property to a new partnership. Sec. 1.708-1(b)(1)(iv), Income Tax Regs. A partner's basis in the distributed property is his basis in his partnership interest reduced by any money distributed. Section 732(b). When the partner contributes the property to the new partnership, the partnership's basis in the property is the partner's adjusted basis in the property at the time of the contribution. Section 743(a) provides: (a) General Rule. -- The basis of partnership property shall not be adjusted as the result of a transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 754 (relating to optional adjustment277 to basis of partnership property) is in effect with respect to such partnership. Section 754 provides: If a partnership files an election, in accordance with regulations prescribed by the Secretary, the basis of partnership property shall be adjusted, in the case of a distribution of property, in the manner provided in section 734 and, in the case of a transfer of a partnership interest, in the manner provided in section 743. * * Section 743(b) provides: (b) Adjustment to basis of partnership property. -- In the case of a transfer of an interest in a partnership by sale or exchange or upon the death of a partner, a partnership with respect to which the election provided in section 754 is in effect shall -- (1) increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property, or (2) decrease the adjusted basis of the partnership property278 by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership. Under regulations prescribed by the Secretary, such increase or decrease shall constitute an adjustment to the basis of partnership property with respect to the transferee partner only. * * The burden of proof with respect to both the section 708(b) termination and the section 754 election is on petitioners. Rule 142(a), Tax Court Rules of Practice and Procedure.Petitioners contend that a section 708(b) termination or a section 754 election would increase the bases in various assets. Assuming arguendo that a section 708(b) termination was effected or a timely 754 election was filed, the record does not indicate which assets' bases would be adjusted, how much they would be adjusted, or how such an adjustment would affect the deficiency in question. Thus, regardless of whether Rancho terminated pursuant to section 708(b) or filed a timely 754 election, the record would not support a finding for petitioner. Our order dated279 November 21, 1986, specifically requested petitioners to "explain fully how a section 708(b) termination or section 754 election affects petitioners' distributive share of Rancho's ordinary income and to submit all facts necessary to said explanation." Petitioners failed to submit any evidence which would establish the relevance of their arguments, at trial or pursuant to our order. Since there is no basis in the record to support the relevance of the section 708(b) and section 754 arguments, we decline to decide those "issues." The parties stipulated that in 1978 Rancho had $815,170.00 of ordinary income. They further stipulated that petitioners' distributive share of said income was $226,617.00. Said distributive share is includible in their taxable income. Section 702(a). 2280 Decision will be entered for the respondent.Footnotes1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended.↩2. Section 702(a) provided: (a) General Rule. -- In determining his income tax, each partner shall take into account separately his distributive share of the partnership's -- (1) gains and losses from sales or exchanges of capital assets held for not more than 6 months, (2) gains and losses from sales or exchanges of capital assets held for more than 6 months, (3) gains and losses from sales or exchanges of property described in section 1231 (relating to certain property used in a trade or business and involuntary conversions), (4) charitable contributions (as defined in section 170(c)), (5) dividends or interest with respect to which there is an exclusion under section 116 or 128, or a deduction under part VIII of subchapter B, (6) taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States, (7) other items of income, gain, loss deduction, or credit, to the extent provided by regulations prescribed by the Secretary, and (8) taxable income or loss, exclusive of items requiring separate computation under other paragraphs of this subsection.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621969/	MILTON W. HOROWITZ, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentHorowitz v. CommissionerDocket No. 18332-93United States Tax CourtT.C. Memo 1995-201; 1995 Tax Ct. Memo LEXIS 202; 69 T.C.M. (CCH) 2558; May 8, 1995, Filed 202 Decision will be entered under Rule 155. Milton W. Horowitz, pro se. For respondent: Miriam A. Howe. CHIECHICHIECHIMEMORANDUM FINDINGS OF FACT AND OPINION CHIECHI, Judqe: Respondent determined the following deficiencies in, and additions to, petitioner's Federal income tax: Additions to TaxYearDeficiencySection 6651(a)(1) 1Section 6654(a)1988$ 5,465$ 1,366$ 349198917,6164,4041,190199066,95816,7404,411199138,0119,1042,083The issues remaining for decision are: (1) Did petitioner have unreported pension, dividend, and interest income for each of the years 1988, 1989, 1990, and 1991 in the amounts determined by respondent? We hold that he did. (2) Did petitioner have unreported capital gains and losses for each of the years 1989, 1990, and 1991? We hold that he did. (3) Is petitioner203 entitled to itemized deductions for any of the years at issue in amounts greater than those stipulated by the parties? We hold that he is not. (4) Is petitioner liable for each of the years at issue for the addition to tax for failure to file a return under section 6651(a)(1)? We hold that he is. (5) Is petitioner liable for each of the years at issue for the addition to tax for failure to pay estimated tax under section 6654(a)? We hold that he is. FINDINGS OF FACT Some of the facts have been stipulated and are so found. 2204 Petitioner resided in Reston, Virginia, at the time the petition was filed. Petitioner, who had been an electronics engineer, did not file a Federal income tax return for any of the years 1988, 1989, 1990, or 1991. Petitioner made no estimated tax payments and had no withholding for 1988, 1989, and 1990. Petitioner made no estimated tax payments for 1991, but he had a prepayment credit of $ 1,595 for that year. Petitioner received the following amounts of pension, dividend, and interest payments during each of the years at issue: YearPensionDividendInterest1988$ 27,830$ 1,237$ 1,799198928,89810,7823,093199030,16022,9554,195199131,7329,6547,893During 1989, petitioner received total payments of $ 27,575 from the sale of various securities and mutual funds that resulted in a total capital gain of $ 1,773 for that year. During 1990, petitioner received total payments of $ 169,666 from the sale of various securities and mutual funds. Of those total payments, petitioner received (1) $ 12,275 from the sale of shares of ASA in which he had a basis of $ 10,824 and (2) $ 144,334 from the sale of shares of Fidelity High Income Fund in205 which he had a basis of $ 161,989. 3During 1991, petitioner received total payments of $ 87,941 from the sale of various securities and mutual funds. Of those total payments, petitioner received (1) $ 59,042 from the sale of shares of Financial Bond Shares -- High Yield Bond Portfolio in which he had a basis of $ 59,832 and (2) $ 7,102 from the sale of shares of Select American Gold Fund in which he had a basis of $ 6,867. 4During 1990 and 1991, petitioner206 paid the following amounts of mortgage interest and real property tax relating to his personal residence: YearMortgage InterestReal Property Tax1990$ 9,082.10$ 2,023.461991$ 14,166.96$ 2,076.28OPINION Petitioner bears the burden of proving that respondent's determinations in the notice of deficiency (notice) are erroneous. Rule 142(a); . Petitioner was the only witness at trial. His testimony was self-serving, general, vague, and, in virtually every instance, uncorroborated by documentary evidence. We find much of his testimony to be unhelpful and/or questionable. Under the circumstances, we are not required to, and we generally do not, rely on petitioner's testimony to support his positions in this case. See , affg. per curiam ; , affg. ; .207 Unreported Pension, Dividend, and Interest IncomeRespondent determined that petitioner received the following amounts of pension, dividend, and interest income for each of the years at issue: YearPension IncomeDividend IncomeInterest Income1988$ 27,830$ 1,237$ 1,799198928,89810,7823,093199030,16022,9554,195199131,7329,6547,893Petitioner testified that he received pension, dividend, and interest payments during each year at issue, but he could not remember the amounts of those payments. On the instant record, we find that petitioner failed to prove that respondent's determinations in the notice relating to his pension, dividend, and interest income for each year at issue are erroneous. We therefore sustain those determinations. Capital Gains and LossesRespondent determined that petitioner received payments of $ 27,575 from the sale of various securities and mutual funds during 1989. Respondent further determined that since petitioner failed to establish a basis or holding period in the various securities and mutual funds he sold, the total amount of such payments is includible in petitioner's gross income for 1989208 as ordinary income. Through concessions and stipulations, the parties agree that the payments petitioner received during 1989 from the sale of various securities and mutual funds resulted in a total capital gain of $ 1,773 for that year.Respondent determined that petitioner received payments of $ 175,616 from the sale of various securities and mutual funds during 1990. Respondent further determined that since petitioner failed to establish a basis or holding period in the various securities and mutual funds he sold, the total amount of such payments is includible in petitioner's gross income for 1990 as ordinary income. 5 The parties stipulated that $ 5,950 of the total payments of $ 175,616 that respondent determined petitioner received from the sale of securities and mutual funds during 1990 was from the sale of Select Money Market Portfolio that should not have been included as a securities transaction for that year. Of the remaining $ 169,666 in sales proceeds, the record establishes petitioner's bases and the proceeds he received for only two sales and does not show the bases or proceeds he received for the remaining sales. On the instant record, we find that for 1990 petitioner209 had a total capital gain of $ 14,508 and a total capital loss of $ 17,655. Respondent determined that petitioner received payments of $ 87,941 from the sale of various securities and mutual funds during 1991. Respondent further determined that since petitioner failed to establish a basis or holding period in the various securities and mutual funds he sold, the total amount of such payments is includible in petitioner's gross income for 1991 as ordinary income. 6 Of the $ 87,941 in sales proceeds that respondent determined petitioner received during 1991, the record establishes petitioner's bases and the proceeds he received for only two sales and does not show the bases or proceeds he received for the remaining sales. On the instant record, we find that for 1991 petitioner had a total capital gain of $ 22,032 and a total capital loss210 of $ 790. DeductionsDuring 1990 and 1991, petitioner paid the following amounts of mortgage interest and real property tax relating to his personal residence: YearMortgage InterestReal Property Tax1990$ 9,082.10$ 2,023.461991$ 14,166.96$ 2,076.28Petitioner claims that he paid additional amounts of (1) mortgage interest for 1988, 1989, and part of 1990 and (2) real property tax for 1988 and 1989. Petitioner's testimony was vague and inconclusive as to the additional amounts of mortgage interest and real property tax he claims to have paid during those years. He failed to present any other evidence to support his claim. On the instant record, we find that petitioner failed to prove that during the years at issue he paid mortgage interest or real property tax in amounts greater than those stipulated by the parties. Petitioner also contends that he is entitled to deductions for expenses he paid during the years at issue relating to certain rental real estate211 he claims he owned, including expenses for traveling to meetings with realtors and tenants, for maintenance and repair of the rental properties, and for advertising those properties for rent. Petitioner did not testify as to the amount of those expenses. Nor did he offer any other evidence to support his claim. We also note that petitioner did not report any income from rental real estate for any of the years at issue and that respondent did not include any amount attributable to rental real estate in petitioner's income for any of those years. On the instant record, we find that petitioner failed to prove that he paid expenses attributable to rental real estate for which he is entitled to a deduction for any of the years at issue. Petitioner further claims that he paid medical expenses during the years at issue for which he is entitled to deductions. Section 213(a) allows a deduction for medical expenses paid during the year, and not reimbursed by insurance, to the extent such expenses exceed 7.5 percent of adjusted gross income. Apparently, petitioner suffers from diabetes and underwent several operations during the years at issue on his eyes and spent time in the hospital212 because of a problem with his legs related to his diabetic condition. Petitioner did not testify as to the amounts of medical expenses he claims to have paid during the years at issue. Nor did he present any other evidence to support his claim. We also note that petitioner admitted that he was covered by medical insurance during the years at issue that reimbursed him for a "very large part" of his medical expenses. On the instant record, we find that petitioner failed to prove that he paid medical expenses for which he is entitled to a deduction for any of the years at issue. Based on our review of the entire record in this case, we find that petitioner is not entitled to any itemized deductions for any of the years at issue in excess of the amounts of mortgage interest and real property tax for 1990 and 1991 to which the parties stipulated. Addition to Tax -- Failure to FileRespondent determined that petitioner is liable for each year at issue for an addition to tax under section 6651(a)(1) in the amount of 25 percent of the amount required to be shown in the return. The parties stipulated that petitioner did not file an income tax return for any of the years at issue. 213 In the case of failure to file an income tax return on the date prescribed for filing, section 6651(a)(1) provides for an addition to tax equal to five percent of the amount required to be shown in the return, with an additional five percent to be added for each month or partial month thereof during which such failure continues, not to exceed 25 percent in the aggregate. The addition to tax under section 6651(a)(1) does not apply if it is shown that the failure to file was due to reasonable cause, and not due to willful neglect. Although it is not altogether clear, petitioner appears to argue that his failure to file returns for any of the years at issue was due to reasonable cause, and not willful neglect, because he was suffering from diabetes and related side effects that prevented him from completing his income tax returns for those years. It appears that petitioner has difficulty reading and completing forms due to bad eyesight caused by diabetes and suffers great discomfort if he sits at a table or desk for extended periods due to diabetes-related problems in his legs and feet.On the present record, we find that petitioner failed to prove that during the years at issue 214 his physical impairment incapacitated him in a manner that prevented him from filing his returns for those years. See . Although petitioner testified generally about his diabetes-related problems, he failed to testify specifically as to the periods during which he was suffering from such problems. It is also significant that during the years at issue petitioner was able to manage a significant portfolio of investments despite his apparent medical condition and seems to have managed several rental properties. 7 Although both of those tasks were evidently accomplished with some professional assistance, petitioner offered no explanation as to why he did not seek the assistance of a professional to prepare and file, as required by law, his returns for the years at issue. 215 Based on our review of the entire record in this case, we find that petitioner failed to prove that he had reasonable cause for his failure to file income tax returns for the years at issue. 8 We therefore sustain respondent's determination that petitioner is liable for each of those years for the addition to tax under section 6651(a)(1) in the amount of 25 percent of the tax required to be shown in the return. Addition to Tax -- Failure to Pay Estimated TaxRespondent determined that petitioner is liable for each year at issue for the addition to tax under section 6654(a) for failure to pay estimated tax. 216 Respondent further determined, and the parties stipulated, that although petitioner did not pay estimated income tax for any year at issue and had no withholding for 1988, 1989, and 1990, he did have a prepayment credit of $ 1,595 for 1991. 9The addition to tax under section 6654(a) is mandatory unless petitioner qualifies under one of the exceptions in section 6654(e). . Petitioner does not argue, and did not prove, that he qualifies under any of the exceptions listed in that section. On the instant record, we find that petitioner failed to prove that respondent's determination that petitioner is liable for each year at issue for the addition to tax under section 6654(a) is erroneous. We217 therefore sustain that determination. To reflect the foregoing and the concessions of the parties, Decision will be entered under Rule 155. Footnotes1. All section references are to the Internal Revenue Code in effect for the years at issue. All Rule references are to the Tax Court Rules of Practice and Procedure.↩2. On Apr. 7, 1994, respondent filed a request for admissions with the Court. On Apr. 4, 1994, respondent served petitioner by mail with a copy of that request. Petitioner did not file any response to respondent's request for admissions. During the course of the trial herein, the parties entered into stipulations, inter alia, with respect to two matters that were raised in that request. Specifically, the parties stipulated (1) that $ 5,950 of the $ 175,616 included in respondent's request for admissions as payments petitioner received during 1990 from the sale of securities was a payment from the sale of Select Money Market Portfolio that should not have been included as a securities transaction for that year and (2) that petitioner had a prepayment credit of $ 1,595 for 1991. We shall follow the parties' stipulations as to those two matters. Except for those two matters, each matter set forth in respondent's request for admissions is deemed admitted pursuant to Rule 90(c). ↩3. The record does not disclose petitioner's bases in the other securities he sold during 1990 (i.e., Select Precious Metal, Stotler & Co., and Vision Ltd. Partnership).↩4. The record does not disclose petitioner's bases in the other securities he sold during 1991 (i.e., Fidelity Select Technology Portfolio, Fidelity Select Air Transportation, Fidelity Short-Term Bank, and Fidelity Select Auto).↩5. On brief, respondent acknowledges that the payments petitioner received during the years at issue from the sale of securities and mutual funds resulted in capital gains or losses.↩6. See supra↩ note 5.7. We also note that petitioner was able to sit through the course of the trial herein, which involved two separate hour-long sessions, without expressing any discomfort or need to request a recess for medical reasons.↩8. Petitioner argues that respondent's counsel testified during the course of the trial about the extent of petitioner's ability to perform certain tasks, including filing a tax return. Respondent's counsel did not testify during the trial, and, even if she had attempted to do so, the Court would have ignored any such statements of respondent's counsel as not constituting part of the record in this case.↩9. In her explanation of the addition to tax under sec. 6654(a) in the notice, respondent reduced the amount of the underpayment of estimated tax for 1991 by the amount of the prepayment credit for that year in accordance with sec. 6654(g).↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621970/	MaBelle Houghton Plumb Trust u/w of Charles F. Houghton, Deceased, City Bank Farmers Trust Company, Trustee, Petitioner, v. Commissioner of Internal Revenue, RespondentPlumb Trust v. CommissionerDocket No. 8860United States Tax Court8 T.C. 300; 1947 U.S. Tax Ct. LEXIS 286; February 13, 1947, Promulgated 286 Decision of no deficiency will be entered. During the period of a lease ended December 31, 1941, the taxpayer's lessees erected a building on the property. The taxpayer recovered possession immediately after expiration of the lease. The value of the building, held, not includible in the taxpayer's income for 1941, as recovery of possession fell in 1942. Carter T. Louthan, Esq., for the petitioner.Sheldon B. Ekman, Esq., for the respondent. Johnson, Judge. JOHNSON300 The Commissioner determined a deficiency of $ 1,199 in petitioner's income tax for 1941 by adding to income reported the value of a building erected on leased premises by the lessees. Petitioner assails the determination, contending that, since the lease covered a period ended December 31, 1941, it did not recover possession and hence realized no income in 1941 because of the building's erection.FINDINGS OF FACT.This case was presented on a stipulation of facts and exhibits, which are hereby adopted by reference as our findings. From this evidence it appears that petitioner, a New York trust company, with principal office in New York City, is trustee of a trust created by the will of Charles287 F. Houghton for the benefit of MaBelle Houghton Plumb, and it filed an income tax return on the cash basis for 1941 with the collector of internal revenue for the second district of New York. Among assets of the trust was real estate known as 305-7 West Superior Street, Duluth, Minnesota, which petitioner, as trustee, leased by contract dated January 29, 1921, to Albert H. Polinsky and E. R. Ribenack "for a term of twenty-one years, to commence on the first day of January, 1921, and to end on the 31st day of December, 1941, unless sooner terminated." As a covenant of the lease, the lessees agreed to erect on the premises a two-story building adapted to general business use. They did so. By other sections of the contract the parties further agreed that:Twelfth. -- On the last day of the said term, or other sooner termination of the said estate hereby granted, * * the lessees shall and will peaceably and quietly leave, surrender and yield up unto the said lessor, all and singular the said demised premises, together with any and all improvements * * . * * Fifteenth. -- * * Any and all new buildings and improvements erected upon the demised premises shall immediately be288 and become the property of the lessor * .301 * * * Twenty-fifth. -- * * Upon the expiration or earlier termination of the term * * , hereby granted, all buildings and improvements upon the demised property shall be the absolute property of the lessor * .In 1928 Ribenack assigned his interest in the lease to Dorothy N. Ribenack, and by agreement of the parties the stipulated rent was reduced in 1932. Otherwise the contract remained in full force and effect until the end of the original term thereof on December 31, 1941, but in 1935 the trust terminated as to one-half of the property held by the trustee, and the trust has since owned only an undivided one-half interest.By letters dated December 17 and 19, 1941, Polinsky notified petitioner's renting agent and the agent notified petitioner that Polinsky "would surrender the premises on December 31st." On December 31, 1941, the premises were vacant in part and were occupied in part by subtenants of the lessees. The lessees did not surrender the premises by any overt act in 1941, and no such act was required by the lease contract, but they "remained in possession of said premises under said lease for the full original289 term specified in said indenture," and the lease "came to an end upon the expiration of the original term specified therein." The lessees had paid premiums on policies of insurance covering the properties for terms extending beyond the term of the lease, and petitioner reimbursed them for one-half of the premiums applicable to the period after the lease's expiration.In the trust's income tax return for 1941 petitioner reported no income because of possession of the building. In an attached note it was stated:On December 31, 1941, the lease expired and the building passed to the owners of the land. * * ** * * Since the building passed to the owners of the land not as a result of forfeiture but solely by the terms of the lease, and since the value of the land and building together at the termination of the lease is materially less than the value of the land alone at the time of the inception of the lease, the taxpayer believes and states that no taxable income resulted from the termination of the lease and none is being reported.The Commissioner added to the trust's income for 1941 $ 8,000 representing one-half of the value of the building, "possession of which one-half was acquired290 December 31, 1941, by you on termination of a lease."OPINION.The trust involved herein owned a half interest in real estate on which a tenant erected a building during the period of lease. The lease expired on December 31, 1941, and petitioner recovered possession. The parties are in agreement that the erection of 302 the building increased the value of petitioner's interest in the property by $ 8,000, and that under the doctrine of , the $ 8,000 is taxable as income of the petitioner for 1941 if realized in that year. The issue for decision is thus the year of realization, and that is fixed by the date on which petitioner recovered possession. It is stipulated that the lessees remained in possession for the full term specified in the lease that no "overt act" accompanied the delivery of possession, since a part of the premises was occupied by subtenants who remained and a part was vacant. The question posed must, therefore, be settled by a theoretical determination of when petitioner's right took effect.Respondent invokes nice logic for the proposition that the expiration of the lease and reversion of291 possession to petitioner were simultaneous, and if the lease expired at midnight on December 31, 1941, then petitioner acquired possession at the same moment, and this moment fell in December 31, 1941, not in January 1, 1942. If we were disposed to apply for tax purposes the logistic refinements of the mediaeval schoolmen, we should weigh against this reasoning the equally cogent argument that the lessees were entitled to the premises through the last moment of 1941 and any possession by petitioner in that year would be contrary to the terms of the lease. Whether the atom of time marking midnight can be split, however, we shall not decide, being of the opinion that the construction of contracts and the incidents of business transactions are not to be interpreted by philosophical refinements, but rather by the practical understanding of terms according to business usage.By this test we think it plain that the lessees' tenancy ended in 1941 and petitioner's possession began in 1942. This view is well supported by a decision of the Supreme Court of the State of Minnesota, wherein the premises are located. In ;292 , the plaintiff lessor was required by law to give his tenant a month's notice to vacate leased premises. On April 30, 1936, the plaintiff served the notice, adding: "so that we may have possession of said premises on and after May 31, 1936." The defendant tenants contended "that since the notice asks possession and contains the word 'on' referring to May 31, it does not constitute a sufficient month's notice." In holding that it did, the court said: * * it was proper to ask for vacancy on May 31, and for possession after May 31. It is not unreasonable to suppose that this is what was intended by plaintiff, and there is nothing to indicate that defendants were misled into believing anything else by this notice. * * While it is true that a notice to quit is statutory and technical, , the construction of any given one must be reasonable, and there is no justification for the splitting of legal hairs because of the fact of technicality. Sound reason and common sense must govern the construction of even a technical document.303 The court's293 remarks are singularly applicable to the facts of the case at bar. As held in the cited decision, a day under Minnesota law ends at midnight, and, while respondent attempts to impute to petitioner and the lessees an intention to terminate before midnight on the ground that delivery of possession on December 31 is mentioned in a tax declaration and in correspondence between petitioner's agent, the petitioner, and the lessees, we are not persuaded of any intended change in the lease's terms by reason of expressions in documents which do not expressly purport to change those terms. Indeed, consideration of any intention of the parties to make a change seems precluded by the stipulation that the lease "came to an end upon expiration of the original term specified therein." Nor do we think, as respondent argues, that the effect of the Minnesota holding can be limited because "on and after" created ambiguity or because the tenancy there involved was from month to month.It seems clear and unambiguous that by petitioner's lease contract the lessees were entitled to possession until the end of the year 1941 and that petitioner became entitled to possession immediately after the end of 1941, 294 which point of time is the beginning of 1942. A business man would so understand, and we so understand. Petitioner, therefore, did not recover possession of the property in 1941, and the Commissioner erred in including in 1941 income any amount representing the value of the building on the leased premises.Decision of no deficiency will be entered.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621971/	FELLIPO DICENSO, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Dicenso v. CommissionerDocket No. 13526.United States Board of Tax Appeals11 B.T.A. 620; 1928 BTA LEXIS 3768; April 16, 1928, Promulgated 3768 A. Morris Williams, Esq., for the petitioner. T. M. Mather, Esq., for the respondent. SIEFKIN620 SIEFKIN: This is a proceeding for the redetermination of deficiencies in income taxes and penalties as follows: YearDeficiencyPenalty1921$109.68$27.421922102.1425.54192390.30192485.3521.34The deficiencies and penalties result from returns prepared and filed on behalf of the petitioner by a collector of internal revenue and result in a large part from the computation of tax upon the so-called percentage method. The petitioner can not read or write, and was assisted in a grocery business in Springfield, Ill., by his wife, Teresa Di Censo, who had a meagre acquaintance with the English language. The evidence of the wife was taken by deposition and is extremely confusing and unsatisfactory in showing what the income of the business was. Apparently the respondent's representative had before him some sort of an account book kept by the wife and showing the receipts and disbursements, but that book was lost at the time the deposition was taken and the only other books used in making the respondent's computation, 3769 the check book and bank book, were not introduced in evidence. The petitioner did introduce, however, a number of canceled checks which the wife testified she cashed as an accommodation to friends and salesmen, later depositing the cash in the bank. If we could be satisfied that this was the case, and that the amounts so deposited were treated as income by the agent of the Government, we might reduce the amount of gross income to that extent, but we are not advised of either fact. There is, however, definite evidence showing erroneous action by the respondent in including in the income for each of the years 1920 and 1921 the sum 621 of $2,878.87 on account of net rentals on a two-story building, a flat building and a dwelling house. The testimony and a deed offered in evidence show that the store building was not acquired by the petitioner until January, 1923. To the extent that rentals from that building were included the respondent was in error. The respondent also included in income for each of the years in question the sum of $1,800 on account of groceries used for home consumption. The evidence, however, is definite that not more than $1,000 a year should be so*3770 included. In all other respects the respondent's action is approved. See , and cases there cited. Judgment will be entered upon 15 days' notice, under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621972/	Solitron Devices, Inc., Petitioner v. Commissioner of Internal Revenue, RespondentSolitron Devices, Inc. v. CommissionerDocket No. 8313-78United States Tax Court80 T.C. 1; 1983 U.S. Tax Ct. LEXIS 129; 80 T.C. No. 1; January 10, 1983, Filed 129 Decision will be entered for the respondent. Petitioner was engaged in the business of designing, manufacturing, and marketing electronic components. In 1968, it decided to enter the microwave industry. After several unsuccessful attempts to acquire large microwave manufacturing companies, petitioner began to acquire a number of smaller companies which collectively could offer the broad product mix of the larger competitors. Pursuant to this strategy, petitioner purchased GRFF, a manufacturer primarily engaged in the custom connector business. After abbreviated negotiations, petitioner purchased all of the stock of GRFF on Aug. 29, 1968, for $ 3.9 million cash, of which $ 600,000 was attributable to realty and $ 958,551 to tangible assets.On Jan. 13, 1969, GRFF was liquidated and its assets transferred to a wholly owned subsidiary of petitioner. After the purchase of GRFF, petitioner began to alter the operations of that corporation. Accordingly, New GRFF, the wholly owned subsidiary into which GRFF's assets were transferred, began to undergo a change in product mix and a restructuring of product line, thereby transforming its products from specialty products to a standard130 line of products. This transformation took 1 1/2 to 2 years. Sometime in early 1971, New GRFF was liquidated by petitioner.On its tax return for the year ended Feb. 28, 1971, petitioner claimed an abandonment loss deduction of $ 2,341,449 on the ground that it abandoned an intangible asset derived from GRFF's reputable image as a custom connector manufacturer. Held: GRFF possessed goodwill and going-concern value equal to the amount paid by petitioner to purchase that corporation in excess of the value attributable to GRFF's realty and tangible assets. Petitioner did not spontaneously create goodwill by such acquisition. Held, further, such intangible assets were transferred into petitioner's wholly owned subsidiary along with the underlying tangible assets of GRFF. Held, further: Petitioner has not proven that the assets of New GRFF were distributed to it in liquidation at any time prior to the end of its taxable year ended Feb. 28, 1971. Accordingly, petitioner is not entitled to the abandonment loss deduction for such year and we need not decide whether such abandonment actually took place during that period. John Y. Taggart and M. Jack Duksin, for the petitioner.David M. Kirsch, for the respondent. Sterrett, Judge. STERRETT2 By notice of deficiency dated April 20, 1978, respondent determined a deficiency in petitioner's Federal income tax for132 the taxable year ended February 28, 1970, in the amount of $ 981,762. The issues for decision are (1) whether petitioner purchased certain intangible assets previously held by General RF Fittings, Inc. (hereinafter GRFF), upon its acquisition of the stock of GRFF or whether petitioner created such intangible assets in itself by such acquisition; (2) whether, upon liquidation of GRFF, petitioner received such intangible assets to which it must allocate the attributable portion of its basis in the GRFF stock; (3) whether petitioner transferred all assets received upon the liquidation of GRFF, including the intangible assets, to a preexisting subsidiary, Integronics, Inc. (hereinafter New GRFF); (4) assuming that the intangible assets are found to have belonged to New GRFF, whether the assets of New GRFF were transferred to petitioner at any time prior to March 1, 1971; and (5) if it is found that petitioner owned the intangible assets during the fiscal year ended February 28, 1971, whether petitioner abandoned such assets during the fiscal year ended February 28, 1971.FINDINGS OF FACTSome of the facts have been stipulated and are so found. The stipulation of facts and attached exhibits133 are incorporated herein by this reference.3 Petitioner Solitron Devices, Inc., was at all times material herein a New York corporation having its principal place of business in Tappan, N.Y. Petitioner's principal place of business at the time of filing the petition herein was Riviera Beach, Fla. The returns for the taxable years ended February 28, 1970, and February 28, 1971, were filed timely with the Internal Revenue Service Center, Andover, Mass. Petitioner did not file consolidated income tax returns with its subsidiaries at any time prior to its taxable year beginning March 1, 1970. Petitioner filed a consolidated income tax return for its taxable year ended February 28, 1971.At all times material herein, petitioner was engaged in the business of designing, manufacturing, and marketing electronic components, including semiconductor devices. Petitioner was very successful in this business, having experienced a growth of sales from $ 8.5 million in 1966 to more than $ 18 million in 1968. It had the image of an innovative and dynamic electronics company in the forefront of the development and marketing of semiconductors.Early in 1968, petitioner decided to enter the134 microwave field, an area in which it previously had not been engaged, and to attempt to gain an immediate reputation as a microwave company. This decision was kindled by petitioner's perception that there would be significant growth in the microwave communications business in the ensuing years. 1135 Petitioner believed that there would be rapid movement by other companies into the microwave field. Thus, it appeared necessary for it to gain an immediate presence or reputation as a microwave component manufacturing company in order 4 to compete successfully. Petitioner understood that it would be unable to gain an immediate reputation or presence if it relied solely upon internal growth, for it would take anywhere from 18 months to 2 years to produce and market a newly conceived microwave connector 2 and from 3 to 5 years to establish a reputation in the industry as a reliable source for the product. Therefore, it chose to enter the microwave business through the purchase of companies already engaged in that business.Petitioner first made an unsuccessful stock tender offer for 136 Ampherol Corp., a major electronics company which was a significant microwave component manufacturer. Petitioner realized an unexpected profit of more than $ 29 million as a result of this unsuccessful offer. Thus, petitioner had adequate funds to engage in a cash acquisition program. Petitioner also sought unsuccessfully to acquire Microwave Associates, one of the largest independent microwave companies, and a company with a record of $ 20 million in sales.Petitioner then began to eye a number of smaller companies with the objective of entering the microwave industry by acquiring companies that collectively could offer a broad product line. This would allow petitioner to compete with such companies as Microwave Associates, a company which at that time offered the type of product mix that petitioner sought. Petitioner would have attempted to purchase any company in the microwave field that provided a product that fit within the spectrum that petitioner coveted. Conversely, petitioner would not have attempted to purchase two companies that made the identical product; the acquisition of only one would have satisfied petitioner's needs.After deciding to acquire a number of smaller137 microwave companies, petitioner became interested in General RF Fittings, Inc., a company that manufactured microwave connectors. 3 GRFF's business consisted of the manufacture of electronic 5 connectors in limited quantities for microwave applications in missiles, satellites, avionics, and undersea use, where size, weight, and premium operating performance were required. It was considered a high-quality, job-order specialty house.138 GRFF was highly regarded in the connector industry, having had substantial before-tax profits generated from sales exceeding $ 1 million for the previous 5 years. It had a good reputation with its customers and was known for producing quality products. It was known as a dependable supplier that delivered on time, and, because it was a pioneer in the development of the product it manufactured, occupied a somewhat unique position in the industry. Its image as a reputable microwave connector company made it attractive to petitioner.GRFF was engaged primarily in the custom connector business. The type of connector in which it specialized represented a very small fraction of the connector market. GRFF developed its connector business in the TNC and stainless steel areas. A TNC connector is not a specific type of connector, but encompasses a broad range of types and sizes. It is a threaded, medium-sized, medium-power connector with only a limited market. GRFF had continued as a manufacturer of custom connectors and, in this respect, had deviated from the trend of the industry as a whole, which was to concentrate on the miniature and subminiature types of connectors and on the types139 of standardized connectors that would be covered by military specification. 4140 6 GRFF was a high-grade machine shop. It had no secret formulas or patented drawings of value. The equipment in GRFF's plant was ordinary machinery for working metal and plating, with little specialized equipment. GRFF filled specific customer orders in small quantities with connectors made to order. It did not produce connectors in volume or by using mass production techniques. GRFF did not sell in large quantities. It did not maintain a distributor network, but sold only through its own four sales representatives.GRFF was attractive to petitioner because its acquisition would provide an addition to the broad line of products that petitioner was attempting to assemble and would provide an immediate competitive advantage in that area. The fact that GRFF's product was somewhat outmoded did not detract from its desirability.Petitioner commenced negotiations for the acquisition of GRFF in July of 1968 with the shareholders of that corporation. These shareholders were members of the Potsdam family. William Kearns, then executive vice president of petitioner, contacted Jay Potsdam, who was president of GRFF, and informed him of petitioner's interest in acquiring GRFF. 141 Mr. Potsdam told Mr. Kearns that his family was not interested in selling the company. Subsequently, Jay and Harold A. Potsdam met with Mr. Kearns, who was again told that GRFF was not for sale. Mr. Kearns continued to press the matter until he finally was given a figure of $ 3 million, all payable in cash, and not subject to negotiation.On July 23, 1968, there was a meeting between the two Potsdams and various representatives of petitioner. After a brief discussion, petitioner offered $ 3.5 million for GRFF, to be paid in 3 years. The Potsdams declined to accept less than $ 3.9 million, all cash. This amount was readily agreed to by petitioner. The purchase price was to consist of $ 3.3 million for the stock of GRFF and $ 600,000 for the real property on which the plant was located.The acquisition of the stock and real property of GRFF 7 closed on August 29, 1968, pursuant to letter agreements and a memorandum of sale between the parties. Solitron did not seek or obtain an appraisal of GRFF before it purchased the company.At approximately the same time petitioner purchased GRFF, it made a number of additional acquisitions in the microwave field. The other companies142 purchased were Filmohm Corp., ESCA (Electronic Standard Corp. of America), Microwave Chemical Laboratories, Plaxial, and Royal Microwave. The GRFF plant at Port Salerno, Fla., was expanded in size by 30 percent (10,000 square feet) as a result of these acquisitions. Petitioner also attempted other acquisitions, among them Microlab/FXR.On August 28, 1968, petitioner's board of directors directed that GRFF should be liquidated and its liabilities discharged as soon as possible. Accordingly, GRFF was liquidated on January 13, 1969, and its assets and liabilities were then transferred to petitioner. 5143 On January 13, 1969, petitioner transferred the assets received from GRFF to Integronics, Inc. (hereinafter Integronics), a wholly owned subsidiary of petitioner. On February 18, 1969, Integronics changed its name to General RF Fittings, Inc. (hereinafter New GRFF). Upon transfer to Integronics, 8 petitioner did not retain any of the assets received from GRFF upon the liquidation of that company. 6144 Upon liquidation of GRFF into petitioner, petitioner allocated $ 958,551 of the $ 3.3 million stock purchase price to the tangible assets received. In making this allocation, GRFF's machinery was written up to its original cost to reflect the value of such assets. Petitioner allocated the balance of the purchase price, $ 2,341,449, to an intangible asset that it described on its general ledger and general journal for its fiscal year ended February 28, 1969, as "Goodwill re: General RF Fittings" and in its annual reports as "Excess of Purchase Price over Book Value of Assets Acquired."The assets that had been received by petitioner upon liquidation of GRFF, and subsequently were transferred to Integronics, carried over their basis from petitioner to Integronics. However, the $ 2,341,449 attributable to the intangible asset was not recorded on New GRFF's books, but was retained on petitioner's books when the assets received by petitioner from GRFF were transferred to Integronics. The latter was renamed New GRFF shortly thereafter.No effort was made by petitioner to secure the services of the personnel of GRFF by long-term contracts, or otherwise. From the outset, petitioner planned145 to operate GRFF using petitioner's key employees from its nearby Riviera Beach9 plant. GRFF's president, sales manager, chief engineer, and production manager left GRFF shortly after the acquisition of GRFF by petitioner.After purchasing GRFF, petitioner began to change the operations of that corporation. It was concluded by the sales and marketing arm of petitioner that the optimal means of enhancing its image in the microwave industry would be by implementing a "divisional" approach, rather than by maintaining a disconnected series of small companies. Thus, petitioner began to create a divisional image by developing its own logo and by phasing out the product identification that came from the individual companies acquired. However, the GRFF name was retained for corporate identification purposes. After some time, though, it was phased out and New GRFF's products were marketed under petitioner's name using the terminology "Solitron/Microwave."In accordance with this plan, the ESCA corporation was moved into the GRFF building, as eventually was the Microwave Semiconductor Division. An extension also was added to the building to house the Plaxial operation.Petitioner146 had little interest in the number and quality of GRFF's customers. The number of users of microwave companies was limited, and petitioner could readily have identified them. In the electronics industry, new contracts are based upon price, quality, and in some cases, uniqueness of product. At its acquisition, GRFF was a leader in the manufacture of a unique product, that is, TNC connectors. Nevertheless, petitioner began to direct its efforts toward a market entirely different from that in which GRFF had been engaged.Some 3 to 5 months after the acquisition of GRFF, petitioner began the restructuring of GRFF's product line. From its sales staff, petitioner ascertained that the specialty products manufactured by GRFF would not generate the desired level of business, that the future was in the military specification types of microwave connectors. Accordingly, New GRFF began to undergo a change in product mix and a restructuring of product line, thereby transforming its products from specialty products to a standard line of products. It added new product lines and changed the design of existing product lines. GRFF designs were discarded or updated to meet new design criteria. 147 New GRFF turned to the filling of large orders rather than 10 special ones, and it terminated the old GRFF sales representatives and began using distributors to market its products. This transformation took a substantial period of time, at least 1 1/2 to 2 years. By February 28, 1971, the new designs were in wide use. 7Sometime in early 1971, New GRFF was liquidated by petitioner. The minute book of New GRFF contains a document entitled "Minutes of Action of the Shareholders of General RF Fittings, Inc. Taken as of March 1, 1971," providing as follows:Whereas, Solitron Devices, Inc. owns all of148 the issued and outstanding voting stock of this Corporation; andWhereas, Solitron Devices, Inc., as the sole shareholder, has determined it would be desirable to discontinue the operation of the Corporation and to dissolve the Corporation and transfer its assets to Solitron Devices, Inc; andWhereas, it is necessary for this Corporation to hold an annual meeting of shareholders and to elect directors to govern the Corporation until it has been dissolved; andWhereas, Solitron Devices, Inc. desires to waive notice of said meeting and to hold said meeting by written consent:Now, Therefore, Be ItResolved, that Solitron Devices, Inc. the sole voting shareholder of the Corporation, hereby waives notice of the annual meeting of shareholders of the Corporation; and be it furtherResolved, that the officers or directors of the Corporation are hereby authorized to take whatever steps are necessary to dissolve the Corporation and to transfer its assets to Solitron Devices, Inc., and to execute any documents necessary to achieve such purpose, and any steps heretofore taken with regard thereto are hereby ratified; and be it furtherResolved, that the following named persons be and they are149 hereby elected directors of the Corporation to serve until their successors are elected and qualified:Charles WhorlJoseph FriedmanRichard Trivison(S) Benjamin FriedmanBenjamin Friedman, PresidentSolitron Devices, Inc.11 Also contained therein is a document entitled "Minute of Action of the Shareholders of General RF Fittings, Inc. taken as of June 8, 1971," which states:Whereas, Solitron Devices, Inc. owns all of the issued and outstanding voting stock of this Corporation; andWhereas, it is necessary for this Corporation to hold an annual meeting of shareholders and to elect directors to govern the corporation for the ensuing year;Whereas, Solitron Devices, Inc. desires to waive notice of said meeting and to hold said meeting by written consent;Now, Therefore, Be ItResolved, that Solitron Devices, Inc., the sole voting shareholder of the corporation, hereby waives notice of the annual meeting of shareholders of the Corporation; and, be it furtherResolved, that the following named persons be and they are hereby elected directors of the Corporation to serve until their successors are elected and qualified.Charles WhorlJoseph FriedmanRichard Trivison(S)150 Benjamin FriedmanBenjamin Friedman, PresidentSolitron Devices, Inc.Another document entitled "Minute of Action of the Shareholders of General RF Fittings, Inc. taken as of June 8, 1971" provides:Whereas, Solitron Devices, Inc. owns all of the issued and outstanding voting stock of this Corporation; andWhereas, Solitron Devices, Inc., as the sole shareholder, has determined it would be desirable to discontinue the operation of the Corporation and to dissolve the Corporation and transfer its assets to Solitron Devices, Inc.; andWhereas, it is necessary for this Corporation to hold an annual meeting of shareholders and to elect directors to govern the Corporation until it has been dissolved; and12 Whereas, Solitron Devices, Inc. desires to waive notice of said meeting and to hold said meeting by written consent;Now, Therefore, Be ItResolved, that Solitron Devices, Inc., the sole voting shareholder of the Corporation, hereby waives notice of the annual meeting of shareholders of the Corporation; and be it furtherResolved, that the officers or directors of the Corporation are hereby authorized to take whatever steps are necessary to dissolve the Corporation and to151 transfer its assets to Solitron Devices, Inc., and to execute any documents necessary to achieve such purpose, and any steps heretofore taken with regard thereto are hereby ratified; and be it furtherResolved, that the following named persons be and they are hereby elected directors of the Corporation to serve until their successors are elected and qualified.Charles WhorlJoseph FriedmanRichard TrivisonBenjamin Friedman, PresidentSolitron Devices, Inc.Also submitted into evidence was a document entitled "Assignment of Assets From General RF Fittings, Inc. To Solitron Devices, Inc.," which provided as follows:Whereas, Solitron Devices, Inc. owns all the issued and outstanding voting stock of this Corporation, andWhereas, Solitron Devices, Inc. in February 1971 elected to liquidate this Corporation and discontinue its operations as General RF Fittings, Inc.Whereas, in 1971 all the assets of General RF Fittings, Inc. were physically transferred to Solitron Devices, Inc., but no formal documentation of that transfer was made except on the books of the corporations,Now Therefore, to evidence the foregoing prior transfers this Corporation hereby transfers all its 152 rights, title and interest in all its assets to Solitron Devices, Inc.In Witness Whereof, the parties hereto, acting through their individually authorized officers have caused this assignment to be executed as of this 1st day of March 1971.Attest:(S) Joseph FriedmanGeneral RF Fittings, Inc.By: (S) R. J. TrivisonPresidentAttest:(S) James S. TragerSolitron Devices, Inc.By: (S) Benjamin Friedman13 This was the only executed document transferring title of New GRFF's assets to petitioner. Petitioner failed to produce its books of account for its fiscal year that began March 1, 1971.During the 1971 fiscal year, an ultrasonic screw machine was transferred from petitioner to New GRFF. This is recorded on petitioner's General Ledger and on New GRFF's "Intercompany Account." No transfer of assets from New GRFF to petitioner was recorded on petitioner's books for its fiscal year ended February 28, 1971. As of February 28, 1971, New GRFF had a debit balance in its "Intercompany Account," indicating the presence of assets in that account. 8153 According to the Official Records of Martin County, Fla., the real property belonging to New GRFF was not transferred to petitioner until October 23, 1973.Petitioner claimed an abandonment loss for the intangible asset in the amount of $ 2,341,449 on its tax return for the fiscal year ended February 28, 1971. This was reflected in petitioner's books of account. Petitioner reported a net operating loss on its tax return for its fiscal year ended February 28, 1971, resulting from the $ 2,341,449 deduction. This was carried back and used to offset income in that amount for petitioner's fiscal year ended February 28, 1970, a year during which it had not filed a consolidated return. Petitioner then applied for, and received, a refund of tax for the carryback year. The refund was paid in due course to petitioner. Petitioner's returns for its fiscal years ended February 28, 1971, and February 28, 1970, subsequently were audited. 9154 Respondent asserts that the claimed abandonment loss must be denied petitioner because the intangible asset upon which the loss deduction was based did not belong to petitioner, or, 14 alternatively, that such asset was not, in fact, abandoned during petitioner's fiscal year ended February 28, 1971.OPINIONThe first issue we must decide is whether petitioner purchased $ 2,341,449 in intangible assets along with its acquisition of GRFF's tangible assets or whether such assets were created by petitioner's purchase of that company. If the latter is true, then there is no question but that such assets were petitioner's to abandon during the year in issue.A brief review of the essential facts should be helpful. In early 1968, petitioner made a decision to enter the microwave industry. In order to establish an immediate presence in this industry, it chose to gain entry by means of acquisition rather than by internal growth. Having been thwarted in its attempts at takeover of two large microwave companies, petitioner began to acquire a number of smaller companies which it hoped collectively would offer the broad product mix that petitioner desired. As part of this strategy, 155 petitioner purchased GRFF, a reputable company which specialized in the manufacture of custom connectors. After a brief period of negotiation, petitioner agreed to pay the $ 3.9 million asking price of the GRFF shareholders. Of this amount, $ 3.3 million was paid for the stock of GRFF and $ 600,000 was paid for the underlying real property. The stated value of GRFF's tangible 15 assets was $ 958,551. It is the treatment of the stock consideration in excess of this stated amount that is in issue.Petitioner contends that as a result of its haste to enter the burgeoning microwave industry, it paid a premium for GRFF's stock that far exceeded the fair market value of that stock. By acquiring GRFF, petitioner asserts, it augmented its product mix, thereby creating a previously nonexistent intangible asset with a basis of $ 2,341,449. This intangible asset was alleged to be petitioner's new image as a producer of high-performance microwave connectors custom-manufactured in limited quantities for sophisticated microwave circuits. It is argued that this asset never belonged to GRFF since it was created solely by the synergistic fit of that company into the larger unity brought156 together through petitioner's efforts. In reaching this conclusion, petitioner posits that GRFF possessed no goodwill or going-concern value at the time of its purchase.Respondent counters by arguing that GRFF possessed intangible assets in the nature of goodwill and going-concern value at the date of acquisition and that the amount paid by petitioner for GRFF's stock in excess of the amount attributable to GRFF's tangible assets is allocable to such intangible assets. Accordingly, when GRFF was liquidated and its assets dropped into a newly created subsidiary, petitioner transferred ownership of the intangible assets previously held by GRFF to that subsidiary.As is evident, the underlying dispute centers on whether petitioner or New GRFF owned the intangible asset(s) at the time of the purported abandonment. If petitioner is correct in its assertion that it created an intangible asset in its own hands with its purchase of GRFF, then it follows that petitioner retained the asset upon liquidation and reincorporation of the GRFF enterprise. If respondent is correct that the intangible assets followed the tangible assets of GRFF into the newly formed corporate entity, we must still157 decide whether that entity, New GRFF, was liquidated during petitioner's taxable year ended February 28, 1971, and then whether the intangible assets were abandoned by petitioner during that year.We begin with the axiom that petitioner bears the burden of 16 proof. Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933); Rule 142(a), Tax Court Rules of Practice and Procedure. Ordinarily, upon the purchase of the stock of one corporation by another, the acquiring corporation assumes a cost basis in the purchased stock. Sec. 1012, I.R.C. 1954. The cost is the amount paid for the property received. Sec. 1.1012-1(a), Income Tax Regs. Section 334(b)(2) provides that if a subsidiary is purchased by the parent corporation and liquidated shortly thereafter, the parent's basis in the property distributed to it is equal to the adjusted basis of the stock of the subsidiary with respect to which the distribution was made. Thus, in the case of a purchase of all the stock of a subsidiary followed by a liquidation of that subsidiary, the parent would take an aggregate basis in the distributed property equal to its cost basis in the stock. This basis must be allocated158 to the individual assets, both tangible and intangible, received from the liquidated subsidiary in proportion to their respective fair market values. Sec. 1.334-1(c)(4)(viii), Income Tax Regs. Application of these rules is mandatory, not elective. Broadview Lumber Co. v. United States, 561 F.2d 698">561 F.2d 698, 711 (7th Cir. 1977). To complete the analysis, if the parent corporation then drops all of the recently distributed assets into a newly formed subsidiary, its basis in the stock of the subsidiary will be equal to its aggregate basis in those assets (which in turn was equal to its cost basis in the first subsidiary's stock). Sec. 358(a).Applying these rules to the instant case, respondent asserts that petitioner's basis in the stock of GRFF was, pursuant to section 1012, the amount paid for that stock, that is, $ 3.3 million. Upon the subsequent liquidation of GRFF, petitioner's basis in the assets was to be determined by allocating the $ 3.3 million in proportion to the relative fair market values of the assets. The parties apparently are in agreement that the fair market value, and consequently the allocable basis, of the tangible assets acquired upon159 GRFF's liquidation was $ 958,551. Respondent departs from petitioner's portrayal by insisting that the remainder of the purchase price, $ 2,341,449, is allocable to the intangible assets of GRFF purchased by petitioner. All assets received by petitioner from GRFF then were transferred by the general assignment of assets to the newly formed subsidiary, New GRFF.Petitioner describes a different version. It maintains that 17 GRFF's fair market value was equal to the fair market value of its tangible assets, and that the excess purchase price constituted a "premium" paid by petitioner to secure an immediate image as a reputable manufacturer of custom-made connectors. This image, petitioner alleges, was an intangible asset created by petitioner upon its purchase of GRFF and held continuously by petitioner until its eventual abandonment.Petitioner proposes a somewhat unique exception to section 1012. According to its spontaneous-creation theory, the normal cost basis rule that property obtained from the seller receives a basis equal to the consideration given by the buyer (sec. 1.1012-(a), Income Tax Regs.) is suspended, or at least extended into a new realm. Here, according160 to petitioner, the stock acquired from GRFF takes as a basis only a fraction of the amount paid for it, with the remainder of the purchase price forming the cost basis of petitioner's spontaneously created intangible asset.In order for us to uphold petitioner's position in its entirety, we would be required to find that GRFF had no goodwill and no going-concern value at the time it was purchased. We would then have to find that, once title to the stock passed, an intangible asset was born, an immaculate conception of sorts, in the hands of the purchaser. Thus, we would have to accept the unusual concept that cost basis can be allocated to property other than the property purchased. This we refuse to do, although we compliment the attorneys for petitioner on their creative reasoning.We first address the issue of whether GRFF possessed any goodwill at the time of its purchase. If so, petitioner acquired such goodwill with the purchase of GRFF's stock. Winn-Dixie Montgomery, Inc. v. United States, 444 F.2d 677">444 F.2d 677, 681 (5th Cir. 1971); Webster Investors, Inc. v. Commissioner, 291 F.2d 192">291 F.2d 192, 195 (2d Cir. 1961), affg. a Memorandum161 Opinion of this Court; 10Peerless Investment Co. v. Commissioner, 58 T.C. 892">58 T.C. 892, 895 (1972). 11 The question of whether goodwill exists is to be 18 resolved based upon the particular facts and circumstances. Staab v. Commissioner, 20 T.C. 834">20 T.C. 834, 840 (1953).Goodwill is an amorphous concept which consists of "the sum total of those imponderable qualities which attract the custom of a business." Grace Bros., Inc. v. Commissioner, 173 F.2d 170">173 F.2d 170, 175-176 (9th Cir. 1949). Goodwill has been defined as --the advantage or benefit, which is acquired by an establishment beyond the mere value of the capital, stock, funds, or property employed therein, in consequence of the 162 general public patronage and encouragement which it receives from constant or habitual customers, on account of its local position, or common celebrity, or reputation for skill, or affluence, or punctuality, or from other accidental circumstances or necessity, or even from ancient partialities or prejudices. [Metropolitan Bank v. St. Louis Dispatch Co., 149 U.S. 436">149 U.S. 436, 446 (1893).] 12Goodwill exists where there is an "expectancy of both continuing excess earning capacity and also of competitive advantage or continued patronage." Wilmot Fleming Engineering Co. v. Commissioner, 65 T.C. 847">65 T.C. 847, 861 (1976). More succinctly, it has been described as the probability that "old customers will resort to the old place." Metallics Recycling Co. v. Commissioner, 79 T.C. 730">79 T.C. 730 (1982); Brooks v. Commissioner, 36 T.C. 1128">36 T.C. 1128, 1133 (1961); see also Miller v. Commissioner, 56 T.C. 636">56 T.C. 636, 649 (1971). The indicia of goodwill are numerous and include practically every imaginable trait that has a positive bearing on earnings.163 After an exhaustive review of the case law and a thorough examination of the record, we are of the opinion that GRFF possessed substantial goodwill at the time it was purchased by petitioner. GRFF was a successful company which had a reputation within the industry and among its customers for manufacturing unique, high-quality products. It was known for dependability and timely delivery. Petitioner asserts that the intangible it created by acquiring GRFF was the image of a reputable manufacturer of custom-made connectors, an image that gave it an immediate competitive boost it could not otherwise have obtained. Petitioner contends that it created 19 this image. We believe that the "image" that petitioner alleges it created was precisely the same image owned by GRFF prior to its sale.A history of high earnings, reliability, a reputation for quality, and the competitive edge resulting from these traits and from the uniqueness of the product sold all are indicative of goodwill. See Buddy Schoellkopf Products, Inc. v. Commissioner, 65 T.C. 640">65 T.C. 640, 647 (1975); Miller v. Commissioner, supra at 649; Schulz v. Commissioner, 34 T.C. 235">34 T.C. 235, 248 (1960),164 affd. 294 F.2d 52">294 F.2d 52 (9th Cir. 1961); Friedlaender v. Commissioner, 26 T.C. 1005">26 T.C. 1005, 1017 (1956); LeVine v. Commissioner, 24 T.C. 147">24 T.C. 147, 156 (1955); Staab v. Commissioner, supra at 840; Estate of Trammell v. Commissioner, 18 T.C. 662">18 T.C. 662, 668 (1952); Clarence Whitman & Sons, Inc. v. Commissioner, 10 T.C. 264">10 T.C. 264, 272 (1948). 13 The GRFF name carried with it an "aura" of quality and reliability. Petitioner exploited the characteristics associated with the GRFF name by continuing the company under that name for a period of time subsequent to its purchase of the company. This suggests that petitioner was aware of and attempted to benefit from the goodwill of GRFF. See Winn-Dixie Montgomery, Inc. v. United States, supra at 681; Miller v. United States, 181 Ct. Cl. 331">181 Ct. Cl. 331, 347 (1967); Cohen v. Kelm, 119 F. Supp. 376">119 F. Supp. 376, 379 (D. Minn. 1953).165 It is undisputed that GRFF had an excellent reputation for the manufacture of a quality product. It also had an impressive earnings history over the 5 years prior to its acquisition. We find that GRFF possessed substantial goodwill at the time of its purchase, and that the existence of this intangible asset was reflected in the consideration paid by petitioner for its stock.We next turn to the question of whether GRFF had any going-concern value at the time petitioner acquired it. Going-concern value has been defined as "the additional element of value which attaches to property by reason of its existence as an integral part of a going concern." VGS Corp. v. Commissioner, 68 T.C. 563">68 T.C. 563, 591 (1977); Conestoga Transportation Co. v. Commissioner, 17 T.C. 506">17 T.C. 506, 514 (1951). It is 20 manifested by the ability of the acquired business to continue generating sales without interruption during and after acquisition. Concord Control, Inc. v. Commissioner, 78 T.C. 742">78 T.C. 742, 746 (1982); Computing & Software, Inc. v. Commissioner, 64 T.C. 223">64 T.C. 223, 234 (1975). A number of cases166 have not distinguished between goodwill and going-concern value. See, for example, Computing & Software, Inc. v. Commissioner, supra at 234-235; Winn-Dixie Montgomery, Inc. v. United States, 444 F.2d 677">444 F.2d 677, 685 (5th Cir. 1971). Others have. See, for example, VGS Corp. v. Commissioner, supra at 591.We believe that GRFF possessed going-concern value at the time of its acquisition. We have found as a fact that, if petitioner had relied upon internal growth to develop a business identical to that of GRFF, it would have taken 18 months to 2 years to produce and market its product and from 3 to 5 years to establish the reputation enjoyed by GRFF. GRFF had before-tax profits generated from sales exceeding $ 1 million for the 5 years prior to its acquisition and had a good reputation with its customers. Certainly, GRFF possessed that "additional element of value that attaches to property because of its existence as part of an ongoing business." Concord Control, Inc. v. Commissioner, supra at 746. This value was not diminished by the change of ownership; there was167 no interruption of sales inflicted upon GRFF as a result of its acquisition. The fact that petitioner eventually shifted GRFF's business away from the production of custom connectors does not have the effect of reducing the value of GRFF's ongoing business at the time of purchase.We recognize that there frequently is an overlap between the goodwill and going-concern value of a business. See Winn-Dixie Montgomery, Inc. v. United States, supra at 685, and cases cited therein. However, we need not establish a strict boundary between the two concepts since it is not necessary in this instance to allocate values to each of the intangible assets that have been found to have existed during the purchase of GRFF.The sale of GRFF was a sale between unrelated parties at arm's length. In such circumstances, the sales price is the best evidence of fair market value. Florida Publishing Co. v. Commissioner, 64 T.C. 269">64 T.C. 269, 280 (1975), affd. by unpublished order (5th Cir., Apr. 25, 1977). Fair market value is the price at 21 which property would change hands between a willing buyer and a willing seller, neither being under any168 compulsion to buy or sell, and both reasonably informed as to all relevant facts. See VGS Corp. v. Commissioner, supra at 588-589. Petitioner in essence contends that it was under a "compulsion" to purchase GRFF in order to carry out its objective of establishing a broad product mix that could successfully compete with the larger microwave companies. Consequently, petitioner asserts, it was compelled to pay a premium above and beyond the fair market value of GRFF in order to pry ownership away from the somewhat stubborn sellers.It is true that the sellers of GRFF took a firm stance in the abbreviated negotiations between the parties, demanding an up-front cash payment of $ 3.9 million. Petitioner offered little resistance, appearing quite willing to meet this price. We believe that the resulting price reflected the substantial goodwill and going-concern value that was transferred to petitioner along with GRFF's tangible assets. We do not accept the proposition that GRFF's prior owners were unwilling sellers. On the contrary, they were quite ready to sell the company at the right price, and petitioner was quite willing to pay this price. Petitioner's169 lofty aspirations with respect to GRFF did not give rise to a "compulsion" to purchase that company, they simply produced the usual motivations prompting a willing buyer. As we stated in Florida Publishing Co. v. Commissioner, supra at 280, "Different purchasers see different benefits in making acquisitions and such benefits do not necessarily give rise to calling a portion of the acquisition cost a 'premium.'" Here, we conclude that the price paid by petitioner is the best evidence of fair market value and that such price constituted the fair market value of GRFF at the time of acquisition. The so-called "premium" alleged to have been paid by petitioner was paid for the substantial goodwill and going-concern value of GRFF. See Winn-Dixie Montgomery, Inc. v. United States, supra at 686. The "image" enjoyed by petitioner immediately after the acquisition of GRFF was not created by that acquisition, but was purchased along with the tangible assets of GRFF from the owners of that company.In the case of a business possessing goodwill and going-concern value, where the fair market value of the business as a whole and the170 fair market value of the tangible assets of the 22 business have both been established, the "residual" or "gap" method of valuation is a proper method for determining the value of the intangible assets owned by the business. Under such method, the value of the intangible assets equals the difference between the total purchase price and the value of the tangible assets. See R. M. Smith, Inc. v. Commissioner, 69 T.C. 317">69 T.C. 317, 320 (1977), affd. 591 F.2d 248">591 F.2d 248 (3d Cir. 1979); Florida Publishing Co. v. Commissioner, supra at 281; Massey-Ferguson, Inc. v. Commissioner, 59 T.C. 220">59 T.C. 220, 231 (1972); McKinney Manufacturing Co. v. Commissioner, 10 T.C. 135">10 T.C. 135, 140 (1948); Jack Daniel Distillery v. United States, 180 Ct. Cl. 308">180 Ct. Cl. 308, 379 F.2d 569">379 F.2d 569, 579 (1967). 14 Here, because the parties have stipulated to the value of the tangible assets of GRFF and because we have determined the value of the company as a whole, we hold that the residual method is the appropriate method of establishing the value of the intangible171 assets of GRFF.172 Due to the vigor with which petitioner propounds its spontaneously created basis theory, we deem it appropriate to examine this contention in greater detail. In general terms, petitioner's theory stands for the proposition that an amount paid for property in excess of that property's fair market value constitutes a premium which is not attributable to the cost basis of the property. Rather, this premium gives birth to a quantity of free-floating basis which attaches to an alleged intangible asset which is none other than the incarnation of the expected surplus benefit that motivated the purchaser to pay the surplus price. 15173 This proposition runs counter to the principle that a buyer's cost basis in stock includes the entire consideration paid for the stock despite the fact that he got the worst of the bargain by paying an amount in excess of fair 23 market value. See Commissioner v. Matheson, 82 F.2d 380">82 F.2d 380, 381 (5th Cir. 1936), affg. 31 B.T.A. 493">31 B.T.A. 493 (1934). 16More importantly, if we were to accept petitioner's theory, we would be guilty of engendering an administrative nightmare. One of the verities of tax law is that the cost basis of property is equal to the amount of cash paid for such property. Petitioner's proposition would demolish this faithful truism, opening the door to a vast new arena of controversy. We refuse to open this door.The fallacy underlying petitioner's position stems from its confusion in distinguishing between value and basis. We would agree that an art collector's purchase of the 10th and final painting in a series would have a positive effect upon the value of the related property. However, the increment in value does not produce a corresponding increment in the basis of the affected property. The premium paid to acquire the last painting is part of the cost basis of that final purchase. This result is mandated under section174 1012 and section 1.1012-1(a), Income Tax Regs. To hold otherwise would create a chaotic situation permitting the manipulation of basis according to the whims and fancies of each individual taxpayer. If such a proposition were carried to its logical extreme, any indirect benefit derived by a purchaser as a result of the acquisition of property would require some sort of basis allocation. We would prefer to stick with the proper rule: the cost basis of property is the amount of cash paid for that property. 17Sec. 1012; sec. 1.1012-1(a), Income Tax Regs. Thus, even if petitioner were 24 correct in its assertion that it paid a premium for the GRFF stock, such premium would still be allocable to petitioner's cost basis in the GRFF stock rather than to the enhanced value of petitioner's own corporate entity indirectly resulting from the acquisition.175 Having found that GRFF owned intangible assets with a value determined by application of the residual method of valuation, it follows that the totality of such assets was transferred to New GRFF by the general assignment of assets. Such assignment transferred all assets received by petitioner from GRFF; therefore, any contention that GRFF's goodwill and going-concern value were retained by petitioner upon formation of New GRFF is inconsistent with the plain language of the assignment. Furthermore, such retention would have been virtually impossible, since, as a general rule, such intangibles are inseparable from the underlying assets. See Webster Investors, Inc. v. Commissioner, 291 F.2d 192">291 F.2d 192, 195 (2d Cir. 1961), affg. a Memorandum Opinion of this Court; Peerless Investment Co. v. Commissioner, 58 T.C. 892">58 T.C. 892, 895 (1972); Gumpel v. Commissioner, 2 B.T.A. 1127">2 B.T.A. 1127, 1129 (1925); Cohen v. Kelm, 119 F. Supp. 376">119 F. Supp. 376, 378 (D. Minn. 1953). 18 We hold that the intangibles previously belonging to GRFF were transferred to New GRFF along with the underlying tangible assets.176 Petitioner argues in the alternative that even if we find that New GRFF owned the intangible asset(s) in question, it is still entitled to an abandonment loss deduction for such assets for its taxable year ended February 28, 1971, on the ground that New GRFF was liquidated in February of 1971, prior to the end of petitioner's taxable year. Respondent maintains that New GRFF was not liquidated until the succeeding taxable year, and therefore, petitioner did not come into possession of any intangible property held by New GRFF until that time.Both parties are guilty of erroneous reasoning. We are not concerned with the precise time of liquidation. Liquidation generally is a process that can extend over a period of months or even years. See McDaniel v. Commissioner, 25 T.C. 276">25 T.C. 276, 280-281 (1955); Estate of Fearon v. Commissioner, 16 T.C. 385">16 T.C. 385, 394-395 (1951); R. D. Merrill Co. v. Commissioner, 4 T.C. 955">4 T.C. 955, 96925 (1945). In fact, we can assume for argument's sake that some liquidation activities commenced prior to March 1, 1971, and that such activities continued well into petitioner's 177 following taxable year. This does not resolve the issue.The critical question is one of ownership, or, more specifically, whether New GRFF distributed its assets, including its intangible assets, to petitioner prior to March 1, 1971. In order for petitioner to be entitled to a loss deduction on account of its abandonment of certain assets, it is an obvious prerequisite that petitioner be the owner of such assets. It matters not that New GRFF began its liquidation in February of 1971 if its distribution of assets took place on or after March 1, 1971, the first day of petitioner's new taxable year.The timing of the distribution of assets is a question of fact, upon which petitioner bears the burden of proof. Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933); Rule 142(a), Tax Court Rules of Practice and Procedure.The liquidation of New GRFF did not require or give rise to a physical transfer of assets. Since petitioner was the sole shareholder of New GRFF stock, and since the New GRFF facilities continued to operate in conjunction with the unified Solitron complex, the liquidation was essentially a documentary one. The transfer of assets therefore must178 be, and can only be, established by means of the records and documents of the related corporations. We find that petitioner has failed to establish that the New GRFF tangible assets, and accordingly its intangible assets, were distributed from New GRFF at any time prior to March 1, 1971.The only documentation of the transfer of New GRFF's assets to petitioner introduced into evidence was the Assignment of Assets from General RF Fittings, Inc., to Solitron Devices, Inc., dated "as of this 1st day of March 1971." Of course, an assignment as of March 1, 1971, is too late to help petitioner. The assignment states that New GRFF's assets were "physically transferred" to petitioner at some prior date, but "that no formal documentation of that transfer was made except on the books of the corporation." As we said before, no physical transfer of the assets was undertaken and since no formal documentation was made, petitioner's only hope could be that the books of the corporations establish a transfer prior to March 1, 1971. With respect to the assignment, one 26 additional comment is instructive. The document purports to transfer all of New GRFF's "rights, titles and interest in 179 its assets to" petitioner as of March 1, 1971. Thus, even if the transfers were recorded on the books of the two corporations sometime in February, it appears that ownership did not change hands until the date recited in the assignment. 19Petitioner asserts that its accountants were instructed to place New GRFF's assets on petitioner's books as of the beginning of the new fiscal year, that is, as of March 1, 1971. Petitioner's books of account indicate that New GRFF still held its assets as of February 28, 1971. Petitioner asserts that the appropriate bookkeeping entries establishing the transfer were made on the books of petitioner as of March 1, 1971. However, petitioner was not able to introduce such books into evidence since they had been lost during the intervening years. We repeat that a transfer of assets to petitioner on March 1, 1971, is too late to permit petitioner to take an abandonment loss deduction180 for those assets during its taxable year ended February 28, 1971.Assuming, arguendo, that we had found that petitioner did in fact become the owner of New GRFF's assets at some time during mid- or late February of 1971, and assuming that we had found that the intangible assets in question were abandoned, petitioner would still have an extremely difficult time proving its entitlement to the abandonment loss deduction. Petitioner argues that the abandonment of the intangible assets resulted from its transformation of the business of GRFF from that of the custom connector business into the military specification connector business. This transformation allegedly took almost 2 years to complete. Yet, in order for petitioner to be entitled to the claimed abandonment loss deduction for its taxable year ended February 28, 1971, we would have to find that such abandonment was effectuated after petitioner came into possession of the intangible assets but before the close of the taxable year. Thus, assuming the transfer of assets was made on February 14, 1971, a date that is wholly unsupported by the facts, we would have to find that abandonment occurred at some time within the 181 next 2 weeks. 27 At most, there is minimal, though insufficient, support for the assertion that the assets were transferred on February 28. This means that petitioner would be entitled to the claimed deduction only if abandonment occurred after such transfer but before March 1, a highly unlikely proposition.No matter. We find that the assets were not transferred prior to March 1, 1971, and, therefore, that petitioner is not entitled to the abandonment loss deduction claimed on its income tax return for the year ended February 28, 1971. 20To reflect the foregoing,Decision will be entered for the respondent. Footnotes1. Microwave technology first was developed during World War II in response to military needs. Vast sums were expended on microwave research after the war to accommodate increasingly complex military systems. In the 1950s, as the microwave art developed, new by-products began to find their way into nonmilitary applications such as radar, and, particularly, telecommunications. The concept of microwave telecommunications inspired very large investment in this new industry. However, because the U.S. Government insisted on emphasizing the military role in research and development expenditures and because of problems in using telephone lines for communication, civilian applications of microwave technology were slow to develop. Prior to the late 1960s, common carrier telephone companies primarily were interested in microwave. During the late 1960s, favorable administrative and judicial decisions appeared to permit private microwave communication companies to have access to telephone lines without special interconnection devices, which access the telephone companies had been resisting vehemently. Large growth in the microwave communications business was foreseen.↩2. Between the time of inception to the time of marketing, a product design would have to be developed, plant and machinery would have to be acquired, parts would have to be ordered, and a labor force would have to be recruited.↩3. A connector is a device which is used to fasten two or more electronic components together. In August 1968, there were three categories of microwave connectors: (1) The ordinary commercial shield connectors, that is, inexpensive connectors used in portable radios, television, and other unsophisticated applications; (2) a series of connectors that had been developed and used in radar and transmitter systems during World War II and thereafter formalized (some of these connectors were manufactured in compliance with military specifications); and (3) the class I, high-performance connectors custom manufactured in limited quantities for very sophisticated microwave circuits. The standard type of connectors, and those covered by military specifications, were used throughout the microwave industry and were manufactured in large volume. The custom connectors normally were manufactured in small volume, sometimes in as few as 5 or 10 pieces.↩4. In the middle 1960s, MIL-C-39012, a military specification standard, was formulated to standardize the design rules of the RF connector industry by establishing uniform specification and performance parameters so that customers could be assured of a certain measure of performance. MIL-C-39012 covers the bulk of the connectors used for medium-performance microwave applications for radar and communications applications. Although the specification came into being around 1965, the individual specification sheets did not appear until 1966 through 1968, after which time they came into general use.By contrast, the custom connector area in which GRFF operated had a more demanding set of criteria than the MIL-C-39012 specification area. For the most part, GRFF chose not to pursue the mass-production market, but elected to stay in the custom market. However, to a limited degree, GRFF had started to engage in the MIL-C-39012 segment of the microwave business prior to its acquisition by petitioner, but soon decided not to compete in this area. GRFF never really had an opportunity to qualify or modify its product in accordance with specification sheets because of its acquisition by petitioner.↩5. The general assignment of assets from GRFF to petitioner provided as follows:Know All Men By These Presents:That General RF Fittings, Inc. a Florida corporation by Jack N. Popper, its president, its duly authorized agent, in consideration of all its outstanding capital stock the receipt of which is hereby acknowledged, hereby assigns and transfers to Solitron Devices, Inc. all of the assets of the corporation, including, but not limiting, all real and personal property, both tangible and intangible, all claims, whether matured or unmatured, all choses in actions, and all assets of every kind and nature.In Witness Whereof, said corporation has caused these presents to be signed in its name, by its President, and sealed with its corporate seal, attested by its Secretary.Dated this 13th day of January, 1969.General RF Fittings, Inc.By: (S) Jack N. PopperJack N. PopperATTEST: (S) George ReilandGeorge Reiland, Secretary↩6. The general assignment of GRFF assets by petitioner to Integronics, Inc., provided as follows:Know All Men By These Presents:That Solitron Devices, Inc., a New York Corporation, by Benjamin Friedman, its president, its duly authorized agent, hereby assigns and transfers to Integronics, Inc. all of the assets of General RF Fittings, Inc. which it has received in liquidation of said corporation, including, but not limiting, all real and personal property, both tangible and intangible, all claims, whether matured or unmatured, all choses in actions, and all assets of every kind and nature.In Witness Whereof, said corporation has caused these presents to be signed in its name by its President, and sealed with its corporate seal, attested by its Secretary.Dated this 13th day of January, 1969.SOLITRON DEVICES, INC.By: (S) Benjamin FriedmanBenjamin Friedman, PresidentATTEST: (S) Paul Windels, Jr.Paul Windels, Jr., Secretary↩7. New GRFF did not entirely terminate its production of custom-made connectors, because it felt bound to continue to supply such long-time customers of GRFF as NASA and RCA. Because of the unique nature of GRFF's specialty product, these customers would have experienced difficulties in obtaining another source for their needs. Petitioner felt honorbound to fulfill these carryover contractual responsibilities.↩8. Another subsidiary, Soledei Italia, also had a debit balance in its "Intercompany Account" as of Feb. 28, 1971.↩9. On its Federal income tax return for the taxable year ended Jan. 31, 1967, Integronics reported no income and no deductions. It was a dormant corporation that year. On its Federal income tax return for the period ended Jan. 31, 1968, Integronics reported no income, and deductions of $ 238,427.53 for research and development expenses resulting in a loss in that amount. On its final return for the period July 1, 1968, through Aug. 31, 1968, a period of 2 months, GRFF reported gross income of $ 53,124. In its tax return for the fiscal year ended June 30, 1968, GRFF reported gross income of $ 1,253,166. In its tax return for the period ended June 30, 1967, GRFF reported gross income of $ 667,876.On its Federal income tax return for the period ended Feb. 28, 1969, New GRFF reported total income of $ 820,794; total deductions of $ 457,127; taxable income before a net operating loss deduction of $ 363,665; net operating loss deduction of $ 554,860 (carried over from Integronics); and no taxable income and no tax.On its tax return for the year ended Feb. 28, 1970, New GRFF reported total income of $ 1,178,436; total deductions of $ 718,791; taxable income before net operating loss of $ 459,645; net operating loss deduction of $ 209,665 (carried over from Integronics); taxable income of $ 249,980; and total tax of $ 125,560. Prior to the transfer of GRFF to New GRFF (formerly Integronics) the latter was an inactive corporate shell that nevertheless possessed substantial net operating loss carryovers. Petitioner sought to, and in fact did, offset earnings of the business acquired from GRFF against these net operating loss carryovers in the total amount of $ 573,330.↩10. T.C. Memo. 1960-74↩.11. See also Fox & Hounds, Inc. v. Commissioner, T.C. Memo. 1962-229; Yellow Cab & Baggage Co. v. Commissioner↩, a Memorandum Opinion of this Court dated Sept. 15, 1950.12. See Pfleghar Hardware Specialty Co. v. Commissioner, 11 B.T.A. 361">11 B.T.A. 361, 363-364 (1928); Seaboard Finance Co. v. Commissioner, T.C. Memo. 1964-253, affd. 367 F.2d 646">367 F.2d 646↩ (9th Cir. 1966).13. See also Proctor v. Commissioner, T.C. Memo. 1981-436; Fedders Corp. v. Commissioner, T.C. Memo 1979-350">T.C. Memo. 1979-350, affd. by unpublished order (3d Cir., May 8, 1981); H & R Distributing Co. v. Commissioner, T.C. Memo 1972-203">T.C. Memo. 1972-203; Broyles v. Commissioner, T.C. Memo. 1962-215↩.14. See also Proctor v. Commissioner, T.C. Memo 1981-436">T.C. Memo. 1981-436; Black Industries, Inc. v. Commissioner, T.C. Memo 1979-61">T.C. Memo. 1979-61; R. M. Smith, Inc. v. Commissioner, T.C. Memo. 1977-23, affd. 591 F.2d 248">591 F.2d 248 (3d Cir. 1979); Pensacola Greyhound Racing, Inc. v. Commissioner, T.C. Memo. 1973-225, affd. by unpublished order (5th Cir., Sept. 3, 1974); H & R Distributing Co. v. Commissioner, T.C. Memo. 1972-203; Plantation Patterns, Inc. v. Commissioner, T.C. Memo 1970-182">T.C. Memo. 1970-182, affd. 462 F.2d 712">462 F.2d 712 (5th Cir. 1972); Philadelphia Steel & Iron Corp. v. Commissioner, T.C. Memo. 1964-93, affd. 344 F.2d 964">344 F.2d 964 (3d Cir. 1965); Charlotte Corp. v. Commissioner, T.C. Memo. 1960-97, affd. sub nom. Meister v. Commissioner, 302 F.2d 54">302 F.2d 54↩ (2d Cir. 1962).15. Again, we have found as a fact that no such premium was paid in this case.↩16. See also Spitcaufsky v. Commissioner, a Memorandum Opinion of this Court dated Jan. 20, 1954. Compare P & R Investors, Inc. v. Commissioner, T.C. Memo. 1963-284↩.17. We are not unmindful of a number of cases wherein the purchaser of property for more than fair market value has been denied that portion of basis attributable to the excess purchase price. However, in these atypical cases, the parties were not adverse and did not deal at arm's length. Accordingly, where the parties are related, and a payment in excess of fair market value is a disguised dividend, gift, contribution to capital, or the like, the cost basis of property might not be equal to the value received by the seller. See Majestic Securities Corp. v. Commissioner, 120 F.2d 12">120 F.2d 12 (8th Cir. 1941), affg. 42 B.T.A. 698">42 B.T.A. 698 (1940); Mountain Wholesale Co. v. Commissioner, 17 T.C. 870">17 T.C. 870, 875 (1951); New Hampshire Fire Insurance Co. v. Commissioner, 2 T.C. 708">2 T.C. 708, 724 (1943), affd. 146 F.2d 697">146 F.2d 697 (1st Cir. 1945); Estate of Monroe v. Commissioner, 45 B.T.A. 1061">45 B.T.A. 1061, 1072 (1941); McDonald v. Commissioner, 28 B.T.A. 64">28 B.T.A. 64, 66 (1933); Memphis Transit Co. v. United States, 155 Ct. Cl. 797">155 Ct. Cl. 797 (1961), 297 F.2d 542">297 F.2d 542, 545 (1962); Broadwell Construction Co. v. United States, an unreported case ( E.D. N.C. 1977, 40 AFTR 2d 77↩-6072, 77-2 USTC par. 9725). This is not the situation in the instant case.18. See also Fox & Hounds, Inc. v. Commissioner, T.C. Memo. 1962-229↩.19. We note that ownership of the realty possessed by New GRFF was not transferred until Oct. 23, 1973.↩20. Because of this finding, we need not reach the issue of whether the intangible assets in question were, in fact, abandoned during the year in question.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621973/	Sarah Campbell Blaffer v. Commissioner. Estate of R. L. Blaffer, Deceased, Sarah Campbell Blaffer, John Hepburn Blaffer, Jane Blaffer Owen and Cecil Amelia Blaffer, Executors v. Commissioner.Blaffer v. CommissionerDocket Nos. 110835, 110836.United States Tax Court1943 Tax Ct. Memo LEXIS 28; 2 T.C.M. (CCH) 1117; T.C.M. (RIA) 43513; December 15, 194328 Walter E. Barton, Esq., Investment Bldg., Washington, D.C., for the petitioners. Samuel G. Winstead, Esq., for the respondent. LEECH Memorandum Opinion LEECH, Judge: These consolidated proceedings involve gift tax deficiencies for the year 1938 as follows: Sarah Campbell Blaffer$8,615.51Estate of R. L. Blaffer8,615.51The only contested issue is whether respondent erroneously computed net prior gifts in determining the gift tax liability of each of the petitioners on gifts made in 1938, under the Revenue Act of 1932, sections 502, 504 and 505, as amended. The cases were submitted on stipulated facts which we adopt as our findings of fact. We repeat here only so much as is necessary to our decision of the issues. [The Facts] Prior to and during the period involved, the petitioner, Sarah Campbell Blaffer, and R. L. Blaffer were husband and wife residing in Houston, Texas. Each filed separate gift tax returns for the year 1938 with the collector of internal revenue for the first district of Texas. R. L. Blaffer died on October 22, 1942, and his estate was duly substituted as petitioner herein. In the years 1933 to 1938, both inclusive, petitioner, Sarah Campbell29 Blaffer, and decedent each made gifts in trust for the benefit of one or more of their children. In 1933, each made such gifts in a gross value of $14,500 from which each claimed one exclusion of $5,000 and a specific exemption deduction in the amount of $9,500. No gift tax was paid for that year, and no deficiency was determined against either donor. In 1934, petitioner, Sarah Campbell Blaffer, and decedent each made similar gifts of much larger amounts. The former, in her return, claimed five exclusions and the latter six exclusions of $5,000 each. The additional exclusion by decedent was based upon the fact that he had made one more such gift to a trust other than those to whom both had given. Each also deducted a specific exemption of $40,500. Respondent determined deficiencies against each but did not disallow any of the five exclusions claimed for 1934 by petitioner, Sarah Campbell Blaffer, nor five of the six exclusions claimed for decedent. He did so by, inter alia, (1) disallowing the additional exclusion claimed by decedent, on the ground that it was a gift to the beneficiary of a trust who was also the beneficiary of one of the trusts through which one of his other30 gifts had been made and which based one of his other exclusions, and (2) disallowing the exclusion each had taken for 1933, charging the amount of such exclusion against the specific exemption of each and thus reducing the amount of the remaining specific exemption available to each donor for 1934 to the sum of $35,500. Each donor contested these deficiencies before the United States Board of Tax Appeals, Sarah Campbell Blaffer in a proceeding docketed at number 90945, and decedent, at Docket number 89317. At the hearing, in which these cases were consolidated, a stipulation was filed covering the respective assignments of error which, inter alia, contains the following pertinent paragraphs: * * * II. During December, 1934, each of the petitioners made gifts as follows: ToValue of Gift(a) R. L. Blaffer & Company, asTrustee, for the use and benefitof Joyce Campbell Blaffer, un-der a trust instrument datedDecember 28, 1934$55,046.91(b) R. L. Blaffer & Company, asTrustee, for the use and benefitof John Hepburn Blaffer, undera trust instrument dated Decem-ber 28, 193455,121.22(c) R. L. Blaffer & Company, asTrustee, for the use and benefitof Sarah Jane Blaffer, under atrust instrument dated Decem-ber 28, 193454,826.22(d) R. L. Blaffer & Company, asTrustee, for the use and benefitof Cecil Amelia Blaffer, under atrust instrument dated Decem-ber 28, 193455,053.03The total value of gifts madeby each petitioner was$220,047.3831 * * * * IV. In addition to the foregoing gifts, the petitioners, each made a gift in 1934 of the value of $14,812.50 to the Guardian Trust Company of Houston, Texas, as Trustee, for the use and benefit of Joyce Campbell Blaffer under a trust instrument dated December 27, 1933, * . V. The petitioners, each claimed an exclusion in his or her gift tax return for 1934 of $5,000.00 for each of said gifts, which are referred to in II and IV supra, or total exclusions of $25,000.00 each on account of said gifts. The respondent allowed petitioner R. L. Blaffer total exclusions of $20,000.00, and petitioner Sarah Campbell Blaffer total exclusions of $25,000.00 on account of said gifts. VI. During 1933, each of the petitioners made a gift of the value of $14,500.00 to the Guardian Trust Company of Houston, Texas, as Trustee, for the use and benefit of Joyce Campbell Blaffer, under a trust instrument dated December 27, 1933, * . Each of the petitioners claimed an exclusion of $5,000.00 and a specific exemption of $9,500.00 in his or her gift tax return for 1933. VII. In his or her gift tax return for 1934, each of the petitioners claimed a specific exemption of $40,500.00, 32 representing the unused portion of $50,000.00 specific exemption allowed by Section 505 (a) (1) of the Revenue Act of 1932. In the case of each petitioner for 1934, the respondent disallowed $5,000.00 of said specific exemption of $40,500.00 which each petitioner claimed; and respondent allowed a specific exemption to each of the petitioners of $35,500.00 for 1934. It is agreed that if each of the petitioners was entitled to an exclusion of $5,000.00 in 1933 on account of the gifts made by him or her during said year, which is referred to in VI supra, each petitioner is entitled to a specific exemption of $40,500.00 for the year 1934. If the respondent correctly disallowed said exclusion of $5,000.00 in the case of each petitioner for 1933, it is agreed that each of the petitioners is entitled to a specific exemption of $35,500.00 for the year 1934. VIII. On December 29, 1934, the petitioner, R. L. Blaffer, made an irrevocable assignment of all of his right, title and interest in and to certain life insurance policies on his own life to a life insurance trust dated December 29, 1934, * * . The petitioners were married on April 22, 1909, and subsequent to said date, the premiums33 on said policies were paid from the community property of the petitioners. The petitioner, R. L. Blaffer, reported one-half of the values of said policies in his gift tax return for 1934. * * * * XI. In his gift tax return for 1934, the petitioner, R. L. Blaffer, claimed an exclusion of $5,000.00 on account of gift made by him to said life insurance trust, which is referred to in VIII supra, the respondent allowed the said exclusion of $5,000.00. * * * The opinion of the then United States Board of Tax Appeals in those proceedings, promulgated September 28, 1938 and reported in , 1 contains the following: In his brief the respondent states the questions presented as follows: Did the Commissioner properly determine that the petitioner, R. L. Blaffer, residing in Texas, should properly include in his taxable gifts the full value of certain insurance policies, rather than only one-half thereof as contended by petitioner? The first three issues of the petitions in both proceedings raised questions of value. There matters have been disposed of by the stipulations of the parties. Both petitions also raise the question of the extent34 of the exemption to which the petitioners are entitled for the year 1934. The respondent concedes the correctness of the petitioners' contentions in this respect. The respondent also concedes the correctness of the contention of R. L. Blaffer as to the exclusions to which he is entitled for the year 1934. The stipulation and the concessions leave only the question presented above. In the recomputations under the order, effect was given to the respondent's concessions. In the year 1935 the petitioner, Sarah Campbell Blaffer, and the decedent each made similar and additional gifts in trust. Included therein were several gifts, the value of each of which did not exceed $5,000, and were therefore not reported. The total value of these latter gifts, 20-year gold debenture bonds of the Standard Oil Company of New Jersey, owned in community by petitioner, Sarah Campbell Blaffer, and decedent, was $12,000. Each donor took four exclusions of $5,000 each from the gifts reported, which respondent allowed. He determined deficiencies, however, against each donor. In so doing, he35 did not include the unreported gifts. The deficiency against decedent rested wholly upon a reduction in the aggregate amount of net gifts for prior years from the amounts used by decedent in his return for 1934, and involved in his deficiency litigated in , supra, then undecided on appeal, to the amount of those gifts used in recomputing his deficiency under the Board's opinion in the cited case. This reduction consisted of one-half the value of an insurance policy transferred by decedent to an insurance trust. The petitioner, Sarah Campbell Blaffer, accepted the respondent's determination but the decedent filed a petition at Docket number 98054 with the United States Board of Tax Appeal for a redetermination. At the hearing thereon the only issue was the propriety of the mentioned reduction in the amount of that donor's net gifts for prior years. Upon affirmance of , supra, by the , in accordance with a concession of decedent, decision was entered for the respondent. During the years 1936 and 1937 the petitioner, Sarah36 Campbell Blaffer, and the decedent each made similar and additional gifts to trusts for the benefit of certain of their children. In reporting those gifts for gift tax purposes the donors each took an exclusion for each gift to each trust for each of the two years. Respondent determined deficiencies against each for each of those years. In so doing he reduced the respective net gifts for prior years, as claimed by each donor and as used in computing the 1935 deficiencies, by amount of $10,000 on the ground that the specific exemption of $10,000 as provided by section 505 (a)(1) of the Revenue Act of 1932 had been reduced to $40,000 by the Revenue Act of 1935, section 301 (b), and made retroactively effective in section 301 (c). Respondent also disallowed all but two exclusions to each petitioner for each year. Each donor filed petitions for redetermination with the United States Board of Tax Appeals. The proceeding by Sarah Campbell Blaffer was docketed at number 101033 and that in the case of the decedent, at number 101032. At the consolidated hearing thereof the only issue submitted, and which was raised by the petitions and answers, was the propriety of the above-mentioned actions37 of the respondent. The United States Board of Tax Appeals determined those issues and directed that decisions be entered under Rule 50, in a Memorandum Opinion entered December 9, 1941. Recomputations were filed and judgments entered in accordance therewith. Only decedent appealed and the judgment of the Board was affirmed in . During the calendar year 1938, the petitioner, Sarah Campbell Blaffer, and the decedent each made net gifts of the value of $59,945.50 from community property. In computing the contested gift tax deficiencies for that year, the respondent determined the net gifts for preceding calendar years in the following amounts: R. L. Blaffer$474,878.34Sarah Campbell Blaffer438,392.63In Docket No. 110836, respondent in his deficiency notice explains the adjustments in determining net prior gifts as follows: The increase in net gifts for preceding years from $403,758.34, as disclosed in Bureau letter of October 4, 1939, to $474,878.34 is due to various adjustments in your gift tax returns filed for the calendar years 1933 to 1937, inclusive. One exclusion of $5,000.00 previously38 allowed with respect to the transfer in trust under the trust agreement of December 27, 1933, for the benefit of Joyce Campbell Blaffer is now disallowed. Three exclusions of $5,000.00 each previously allowed with respect to the transfers in trust under the trust agreements of December 28, 1934, for the benefit of Joyce C., Sarah J. and Cecil A. Blaffer are disallowed, and one exclusion of $5,000.00 previously allowed with respect to the addition made on May 29, 1934, to the trust created December 27, 1933, for the benefit of Joyce C. Blaffer is also disallowed. [The exclusion of $5,000.00 allowed with respect to the transfer in trust under the insurance trust agreement of December 29, 1934, is also disallowed, in view of the fact that the gift under said trust agreement constituted a gift of future interest.] Since the transfers in trust, during the calendar year 1935, for the benefit of Sarah J., Cecil A. and Joyce C. Blaffer constituted gifts of future interests three exclusions of $5,000.00 each, previously allowed, are now disallowed, and in view of the fact that the beneficiaries of a trust are the donees for gift tax purposes three $1,000.00 and one $9,000.00 par 20 year Gold39 Debenture Bonds of Standard Oil Company of New Jersey dated December 15, 1926, which were not included for gift tax purposes for the reason that they did not constitute a gift in excess of $5,000.00 to any one trust, are now included for gift tax purposes, and in view of the fact that you had only a one-half community property interest in said bonds this adjustment results in a further increase for the calendar year 1935 to $6,120.00. With respect to your gift tax returns filed for the calendar years 1936 and 1937 two exclusions of $5,000.00 each, for the benefit of Cecil A. and Joyce C. Blaffer, as disclosed in Bureau letter of October 4, 1939, are disallowed, in view of the fact that the gifts to said beneficiaries in each calendar year constituted gifts of future interests. You will note that the above adjustments for the calendar years 1933 to 1937, inclusive, result in a total increase of $71,120.00, or total net gifts for preceding years of $474,878.34 as determined above. The adjustments for said calendar years for the purpose of arriving at the correct net gifts for preceding years are in accordance with the provisions of Section 513 (g) of the Revenue Act of 1932, as amended, 40 and Article 5 of Regulations 79 relating to gift tax. In Docket No. 110835, the respondent states: The increase in net gifts for preceding years from $372,272.63, as disclosed in Bureau letter of October 4, 1939, to $438,392.63 is due to adjustments in your gift tax returns filed for the calendar years 1933 to 1937, inclusive. Then follow the identical figures and explanations, except as to the matter bracketed, in the above explanation in Docket No. 110836. After completing the explanation of adjustments it states: You will note that the above adjustments for the calendar years 1933 to 1937, inclusive, result in a total increase of $66,120.00, or total net gifts for preceding years of $438,392.63, as determined above. [Opinion] The petitioners, in Docket No. 110836, contend that the respondent is estopped (1) by our former judgment in proceedings docketed to No. 89317 from increasing net gifts by $5,000 in 1933 and $25,000 in 1934; (2) by our former judgment in proceedings docketed to No. 98054 from increasing net gifts in 1935 by the amount of $21,120 and (3) by our former judgment, docketed to No. 101032, from increasing net gifts by $51,120, or in any amount. Petitioners41 further contend that the respondent is precluded by the statute of limitations from increasing prior net gifts by disallowing the exclusions previously allowed in 1933, 1934 and 1935 in the respective amounts of $5,000, $25,000 and $21,120. The petitioner, in Docket No. 110835, contends that the respondent is estopped (1) by our former judgment in a proceeding docketed to No. 90945 from increasing net gifts by $5,000 in 1933 and $20,000 in 1934; and (2) by the former judgment docketed to No. 101033, from increasing prior net gifts by the sum of $46,120, or in any amount. Petitioner further contends that the respondent is precluded by the statute of limitations from increasing prior net gifts for the year 1935 by the sum of $21,120. The contention of the petitioners that the respondent is precluded by the limitations prescribed in sections 513 (a) and 518 of the Revenue Act of 1932 from increasing net prior gifts is without merit. The only gift taxes involved in the instant proceedings are those for the year 1938. The respondent is not attempting to collect additional taxes for the prior years. The limitation provisions are not applicable to the gift tax liability for the year 1938. 42 ; . The extent, if any, to which the doctrine of res judicata or estoppel by judgment now precludes the respondent from increasing the net prior gifts in fixing the gift tax liabilities of the respective taxpayers for the year 1938, presents solely a question of law. This court, in the recent case of , reviewed the history of the gift tax provisions of the pertinent Revenue Acts and the application of the doctrine of res judicata and estoppel by judgment. We do not deem it necessary to repeat what was there said. Under the principles there announced, we conclude that none of the prior judgments to which reference is hereinabove made estop the respondent from increasing the aggregate net prior gifts of either petitioner as he did in determining the contested deficiencies for 1938, except (1) the judgment entered to Docket No. 89317 does estop respondent from increasing the net prior gifts of the decedent by $5,000 for the year 1933 and by $5,000 for the year 1934, *43 and (2) the judgment entered to Docket No. 90945 estops him from increasing the aggregate of net prior gifts of petitioner, Sarah Campbell Blaffer, by the sum of $5,000 for the year 1933. We therefore hold that, except for those three adjudicated items, respondent's contested action was correct. Decisions will be entered under Rule 50. Footnotes1. Affirmed on appeal () which did not include the present issue.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621974/	PATRICK A. COCKEY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentCockey v. CommissionerDocket Nos. 25336-82, 25337-82.United States Tax CourtT.C. Memo 1985-336; 1985 Tax Ct. Memo LEXIS 295; 50 T.C.M. (CCH) 372; T.C.M. (RIA) 85336; July 10, 1985. 295 Held, petitioner is liable for deficiencies in personal income tax for the years 1973, 1974, and 1975 as determined by respondent. Held further, petitioner is also liable for the addition to tax under sec. 6653(b), I.R.C. 1954, for each of those years. Held further, petitioner, as transferee, is liable for deficiencies in corporate income tax of Champs Outboard Sales and Service, Inc. (Champs), as determined by respondent. Held further, petitioner, as transferee of Champs, is not liable for the addition to tax under sec. 6653(b) for the year 1974. Held further, petitioner, as transferee of Champs, is liable for the addition to tax under sec. 6651(a) for the year 1975. Patrick A. Cockey, pro se. Elizabeth S. Henn, for the respondent. STERRETTMEMORANDUM FINDINGS OF FACT AND OPINION STERRETT, Chief Judge: By notice of deficiency dated July 20, 1982 in docket No. 25337-82, respondent determined that petitioner was liable for deficiencies in personal income tax and additions to tax under section 6653(b), I.R.C. 1954, for the years 1973, 1974, and 1975 in the following amounts: Addition to taxYearDeficiencyunder sec. 6653(b)1973$15,301.95$7,650.9819748,600.634,300.3219759,045.004,522.50By 296 separate notice of deficiency dated July 20, 1982 in docket No. 25336-82, respondent determined that petitioner, as transferee of the assets of Champs Outboard Sales and Service, Inc. (hereinafter referred to as Champs), was liable for deficiencies in corporate income tax and additions to tax under sections 6651(a) and 6653(b) for the years 1974 and 1975 in the following amounts: Addition to tax underYearDeficiencysec. 6651(a)sec. 6653(b)1974$2,004.76$1,002.401975182.21$45.55These cases were subsequently consolidated for purposes of trial, briefing, and opinion. Petitioner has stipulated to be bound by this Court's decision in Cockey v. Commissioner,T.C. Memo. 1983-609, that he is liable as a transferee for any resulting income tax deficiencies and additions to tax of the transferor corporation, Champs. The issues for decision are: (1) whether, and if so to what extent, petitioner is liable for deficiencies in personal income tax for the years 1973, 1974, and 1975; (2) whether petitioner is liable for the addition to tax under section 6653(b) for the years 1973, 1974, and 1975; (3) whether, and if so to what extent, there are deficiencies in the corporate income tax of Champs for 297 the years 1975 and 1975; (4) whether petitioner, as transferee, is liable for an addition to tax under section 6653(b) for the year 1974; and (5) whether petitioner, as transferee, is liable for an addition to tax under section 6651(a) for the year 1975. FINDINGS OF FACT With the exception of the above-referenced stipulation, none of the facts have been stipulated. At the time he filed his petitions herein, petitioner resided in Stevensville, Maryland. Petitioner did not file personal income tax returns for the years 1973, 1974, and 1975. Champs did not file corporate income tax returns for the years 1974 and 1975. During the years 1973 through 1975, petitioner was a 50-percent stockholder in Champs. His now former spouse, Gladys Cockey, owned the remaining 50-percent of the corporation's stock. Champs was in the business of selling and repairing boats. Petitioner also was a 100-percent stockholder in Lykeki Inc. (hereinafter Lykeki), whose primary business was the wholesale distribution of boats to dealers. Petitioner was married to Gladys Cockey during all of the years in issue. The couple was separated in September 1974. Gladys Cockey sued petitioner for a divorce in the 298 Circuit Court for Anne Arundel County. In January 1975 the state court enjoined petitioner from spending any monies or disposing of any property of Champs of Lykeki other than that which was absolutely essential for the operation of the businesses. In May 1975 petitioner left the country and sailed to the Caribbean on a Hatteras yacht. Prior to that time, petitioner was the person primarily responsible for the operation and management of both Champs and Lykeki. After petitioner left the country in May 1975, the state court appointed Gladys Cockey receiver for Champs and Lykeki. In early 1976 the assets of Champs were sold, and the net proceeds from the sale, after the payment of debts, totaled $38,205.01. By order dated May 26, 1976, the state court permitted Gladys Cockey to withdraw $19,102.51 from the corporation, representing her one-half of the net sales proceeds. Petitioner returned to the country in April 1976. On October 4, 1976 petitioner and Gladys Cockey entered into a property settlement agreement pursuant to the divorce action. This agreement stated that petitioner owed various amounts of money to Gladys Cockey as a result of his failure to pay child support from 299 April 1, 1975 to the date of the agreement. It also acknowledged therein that certain corporate assets had been reduced to the possession and control of petitioner without the permission of Gladys Cockey. In recognition of these and other obligations, petitioner agreed to assign to Gladys Cockey any right, title, and interest he might have to the remaining proceeds from the sale of Champs' assets. Petitioner's Personal LiabilityPetitioner filed income tax returns for the taxable years 1969 through 1972. Petitioner's personal tax returns normally were prepared by an accountant, Leon S. Braunstein. Petitioner delivered his income tax information to Mr. Braunstein, who then prepared petitioner's returns. After the returns were prepared, petitioner signed them and mailed them to the IRS. In 1974 Mr. Braunstein called petitioner several times to secure the information needed to prepare petitioner's 1973 return. However, petitioner did not file a personal income tax return for that year; nor did he file returns for 1974 or 1975. Petitioner knew that he had sufficient income to require the filing of returns for 1973, 1974, and 1975. Petitioner received taxable wages from Champs in 300 1973, 1974, and 1975 in the respective amounts of $30,200, $18,200, and $7,000. Petitioner knew that he had such income and received statements of his wages from Champs for those taxable years. 1In August or September 1975 Special Agent Donald Temple commenced a criminal investigation of petitioner. He attempted to contact petitioner but learned that petitioner was out of the country. The Criminal Investigation Division requested the assistance of Revenue Agent Raymond Hull from the Examination Division. After petitioner returned to the country, Temple and Hull conducted three interviews with him, the first one occurring in September 1976. In June 1980 petitioner was convicted of one count of willful failure to file an income tax return for the taxable year 1973, in violation of section 7203, and was sentenced to 30 days' imprisonment and 2 years' probation, 301 with the condition that petitioner perform 200 hours of community service. In the course of their investigations, the agents determined that petitioner had diverted a rather substantial amount of corporate assets of Champs and Lykeki to his own personal use. In 1973 petitioner deposited a $5,500 check into his personal savings account. The check represented payment received on the sale of a boat called "Old Leaky," which the agents determined had been carried in Lykeki's inventory. In addition, Lykeki sold another boat in 1973, receiving a Ford LTD in payment therefor. The automobile was used by petitioner's daughter. However, it was registered with the Maryland Department of Transportation in petitioner's name. The registration form showed a purchase price of $1,100. On its 1973 corporate income tax return, Champs claimed a travel expense deduction of $1,062.75. Said deduction was disallowed for lack of substantiation in Cockey v. Commissioner,T.C. Memo 1983-609">T.C. Memo. 1983-609. Since the agents could not determine what this particular item was attributable to, but did determine that petitioner received this item, they considered it a dividend to him from Champs. In 1974 petitioner bought 302 a motorcycle for his son, using a check in the amount of $740.40 drawn on the account of Lykeki to pay for the purchase. Petitioner wrote "sub-contract freight" at the bottom of the check. In December 1974 petitioner purchased a Hatteras yacht for his personal use with funds drawn on the bank account of Lykeki. The agents determined that petitioner had used Lykeki's bank account to pay for numerous personal expenses. They determined that he had received $11,797.32 from Lykeki in 1974, which amount represented the excess of all monies withdrawn from Lykeki's account for petitioner's personal use over the amounts of money that petitioner had put into the business of Lykeki from his personal accounts. The agents' determination of the amounts of money that petitioner had put into Lykeki's business was based on statements made by petitioner during the interviews and a subsequent verification of those statements from an examination of bank records. Lykeki paid various personal expenses of petitioner in 1975, as well. For example, the corporation paid approximately $565 to Engines Unlimited for work done on petitioner's personal yacht. In addition, Lykeki paid approximately $437 to Edgewater 303 Yacht Club for docking petitioner's yacht. The agents determined that petitioner had received $1,417.99 from Lykeki in 1975, which amount represented the excess of all monies withdrawn from Lykeki's account for petitioner's personal use over the amounts of money that petitioner had put into the business of Lykeki from his personal accounts. Between January and May 1975, petitioner diverted approximately $19,055 from Champs. The money was diverted by selling various assets of Champs and converting the cash proceeds to petitioner's own benefit. For example, prior to leaving the Caribbean, petitioner instructed someone to sell a Cadillac owned by Champs. The Cadillac was sold for approximately $5,000, and the proceeds were then sent to petitioner in the Caribbean. In addition, Champs sold a boat to a Mr. Jenkins for $7,155. According to petitioner, he kept this amount for his personal use. Based on an examination of Champs' bank account, the agents determined that petitioner actually retained only $6,055 of the $7,155 purchase price and deposited the remainder of the purchase price into Champs' bank account. Petitioner also received a $1,000 cash payment from a Mr. Ott for the repair 304 of a boat by Champs in May 1975. Just before he left the country, petitioner sold a 19-foot Drummond boat owned by Champs to a Mr. Plews for $6,200. Petitioner took the cash received from Mr. Ott and Mr. Plews with him when he left the country. In his notice of deficiency respondent determined that petitioner had received wages, dividend income from either Lykeki or Champs or both, and miscellaneous items of income, primarily interest, for each of the years in issue. Respondent also determined that all or a part of the underpayments of tax was due to fraud and accordingly asserted the addition to tax under section 6653(b) for each of those years. Transferee LiabilityChamps filed corporate income tax returns for the years 1972 and 1973. Both returns were signed by petitioner. Petitioner had a 1974 corporate return prepared for Champs in January 1975 by an organization called Pro-Tax. The return was prepared from information provided by petitioner and showed a taxable loss of $40,412. However, this return was never filed but, instead, was turned over to the state court before which Gladys Cockey's divorce action was pending. Because the books and records of Champs were not 305 sufficient to determine income, Revenue Agent Hull used a modified bank deposits method to reconstruct Champs' income for 1974 and 1975. An analysis of Champs' bank account revealed to him that there were total deposits of $374,256.04 in 1974, of which $23,713.01 represented nontaxable deposits, 2306 leaving a balance of 350,543.03. Champs' used the accrual method of accounting in keeping its books and records. Based on an analysis of Champs' books and records, Hull determined that there was an accounts receivable balance at the end of 1973 in the amount of $2,908.36 and an accounts receivable balance at the end of 1974 in the amount of $1,422.27. To adjust for income that might have been received in 1974 (and therefore calculated in the total deposits), but accrued in 1973, Hull subtracted the accounts receivable balance at the close of 1973 from the gross receipts. To adjust for income that was accrued in 1974, but not yet received, Hull added the accounts receivable balance at the end of 1974 to the gross receipts. He determined that Champs had total gross receipts of $349,056.94 for 1974 after adjustments for nontaxable deposits and accounts receivable. With respect to the year 1975, Hull determined, based on an analysis of Champs' bank acounts, that there were gross deposits of $37,205.26, of which $13,278.85 represented nontaxable deposits. 3307 Hull then subtracted the accounts receivable balance at the close of 1974 of $1,422.27 from the gross receipts, because he had included such amount in Champs' taxable income for 1974. In addition to the bank deposits, Hull determined that Champs had various other items of income that had never been deposited into Champs' bank accounts. The transactions giving rise to this additional income included the following: (1) the sale of a boat to a Mr. Bernard for $3,195, (2) $1,000 of repair work done for Mr. Ott, (3) the sale of a boat to Mr. Jenkins for $6,055, 4 (4) the sale of a boat to Mr. Plews for $6,200, and (5) $1,107.92 of gain on the sale of a Cadillac. Hull determined that Champs' gross receipts for 1975, after adjustments for nontaxable deposits, the 1974 year-end accounts receivable, and the additional income not deposited, amounted to $40,062.06. In his notice of deficiency sent to petitioner as transferee of Champs, respondent determined that Champs had gross receipts of $349,056.94 and $40,062.06 in 1974 and 1975, respectively. 5 He further determined that Champs had a cost of goods sold of $257,526.95 and $24,321.72 and other business deductions of $81,421.11 and $24,530.78 in 1974 and 1975, respectively. With respect to Champs' 1974 taxable year, respondent determined a deficiency of $2,004.79 and an addition to tax for fraud of $1,002.40 under section 6653(b). With respect to Champs' 1975 taxable year, respondent determined that Champs had an overall loss of $8,790.44; however, 308 he determined a deficiency of $182.21, resulting from the recomputation of a prior year's investment credit and also determined an addition to tax for failure to timely file a return of $45.55 under section 6651(a). OPINION Personal LiabilityDeficienciesa. 1973Respondent determined that during his 1973 taxable year, petitioner received $30,200 of wages from Champs, $1,062.75 of dividends from Champs, $6,600 of dividends from Lykeki, and other income in the amount of $7,137.41, made up of interest income and an unexplained deposit. Petitioner agrees that he received taxable wages of at least $30,200 from Champs for the year 1973. In addition, judging from his silence on the matter, petitioner apparently does not dispute that he received "other income" in the amount of $7,137.41. Respondent's determination of dividend income from Champs is based 309 on his disallowance of a travel expense deduction claimed by Champs in 1973, which disallowance was upheld by this Court in Cockey v. Commissioner,T.C. Memo 1983-609">T.C. Memo. 1983-609. Respondent's determination of dividend income from Lykeki is based on his determination that petitioner diverted $6,600 from that corporation in 1973. The $6,600 figure is comprised of a $5,500 payment received directly by petitioner from the sale of a boat, "Old Leaky," carried in Lykeki's inventory and of an asserted $1,100 fair market value of a Ford LTD received by petitioner in 1973 as payment on the sale of a boat owned by Lykeki. Under sections 301(a) and (c)(1) and 316, a distribution of rpoperty made by a corporation to a shareholder generally is includable in the shareholder's gross income as a dividend to the extent of the corporation's earnings and profits. It is well settled that payments by a corporation for the personal benefit of a shareholder may result in the receipt by the shareholder of a constructive dividend. Challenge Manufacturing Co. v. Commissioner,37 T.C. 650">37 T.C. 650, 663 (1962). Moreover, where a controlling shareholder diverts corporate income to himself, it is proper to regard such diverted 310 funds as constructive dividends for tax purposes. Dawkins v. Commissioner,238 F.2d 174">238 F.2d 174, 178 (8th Cir. 1956); Currier v. United States,166 F.2d 346">166 F.2d 346, 348 (1st Cir. 1948); Chesbro v. Commissioner,21 T.C. 123">21 T.C. 123, 129 (1953), affd. 225 F.2d 674">225 F.2d 674 (2d Cir. 1955), cert. denied 350 U.S. 995">350 U.S. 995 (1956). The burden of proving that the corporation did not have earnings and profits sufficient to support diidend treatment lies with petitioner. DiZenzo v. Commissioner,348 F.2d 122">348 F.2d 122, 126-127 (2d Cir. 1965). With respect to respondent's determination that the disallowed travel expense deduction constitutes a constructive dividend to petitioner, we think it important to note that our prior decision upholding respondent's disallowance of the deduction was based on a failure to substantiate the deduction as required by section 274(d). Cockey v. Commissioner,T.C. Memo. 1983-609. The disallowance to a corporation of a claimed travel expense deduction for failure to substantiate the expense under section 274(d) does not necessarily mean that such expense will be treated as a constructive dividend. Palo Alto Town & Country Village, Inc. v. Commissioner,565 F.2d 1388">565 F.2d 1388, 1391 (9th Cir. 1977). The test for constructive 311 dividends in such circumstances is twofold; not only must the expenses be nondeductible to the corporation, but they must also represent some economic gain or benefit to the shareholder. Palo Alto Town & Country Village, Inc. v. Commissioner,supra at 1391; see also United States v. Gotcher,401 F.2d 118">401 F.2d 118, 121-124 (5th Cir. 1968). Petitioner herein has the burden of proving erroneous respondent's determination that the disallowed deduction claimed by Champs constitutes a constructive dividend to petitioner. Rule 142(a), Tax Court Rules of Practice and Procedure.6 Petitioner presented absolutely no evidence to refute the asserted dividend or to establish that Champs did not have sufficient earnings and profits available for a dividend. Accordingly, under the circumstances we have no choice but to hold that petitioner has failed to carry his burden of proof on this matter. With respect to the $5,500 constructive dividend determined by respondent in connection with the sale of "Old Leaky," petitioner admits that he deposited the $5,500 of sales proceeds into his personal account, but maintains that the boat 312 was a personal boat owned by petitioner himself and that respondent failed to give him credit for his cost basis. However, aside from his self-serving and somewhat unclear testimony, petitioner failed to produce any evidence to rebut respondent's determination that "Old Leaky" was carried in Lykeki's inventory. Moreover, petitioner's self-serving statements with respect to the cost of building "Old Leaky" were inconsistent. During one of his interviews with Hull and Temple, petitioner stated that he purchased the materials to build the hull of the boat at a cost of approximately $100 and that he paid nothing for labor. He further stated that the pump that was put into the boat was taken out of another boat and had a wholesale cost of $500; that the engine in the boat was a Chevrolet race engine received on a trade for a boat owned by Lykeki; and that the seat in "Old Leaky" was a racing seat taken out of a boat that Lykeki had purchased. However, petitioner testified that "[i]t probably cost in excess of $7,000 to build the boat," and, on brief, he asserted that the cost of materials alone exceeded $7,000. Petitioner produced no evidence whatsoever to support his various assertions 313 relating to the cost of "Old Leaky." At any rate, to the extent that the $5,500 proceeds from the sale of that boat constituted a constructive dividend to petitioner, as asserted by respondent, the cost of "Old Leaky" is irrelevant. The amount of any distribution to a noncorporate shareholder, for purposes of section 301, is the amount of money received by the shareholder, plus the fair market value of any other property received by the shareholder. Section 301(b)(1)(A). Thus, Lykeki's basis in "Old Leaky," whatever that may be, cannot be offset against the amount of any constructive dividend properly chargeable to petitioner. With respect to the $1,100 constructive dividend asserted by respondent in connection with petitioner's receipt of a Ford LTD as payment on the sale of a boat owned by Lykeki, petitioner admitted at trial that the automobile was used by his daughter for personal purposes. The registration documents filed by petitioner with the Maryland Department of Transportation indicated that the purchase price of the automobile was $1,100. Petitioner testified that he reimbursed the company approximately $300 or $400, which according to petitioner was the "real value" 314 of the car. Aside from this self-serving testimony, petitioner offered no evidence to establish that he in fact reimbursed Lykeki for the Ford LTD or to establish that the automobile's fair market value was less than $1,100. Petitioner adduced no evidence to establish that Lykeki did not have sufficient earnings and profits available to support dividend treatment in 1973. Accordingly, we sustain respondent's determination that petitioner received a constructive diidend totaling $6,600 from Lykeki in 1973. b. 1974Respondent determined that, during his 1974 taxable year, petitioner received $18,200 of wages from Champs, $11,797.32 of dividends from Lykeki, and $1,078.29 of interest income. Petitioner agrees that he received taxable wages of $18,200 and apparently does not dispute that he received interest income as determined by respondent. Petitioner used the bank account of Lykeki to pay for various personal expenses during 1974. Respondent determined that petitioner received constructive dividends from Lykeki in the amount of $11,797.32 in 1974. According to respondent, he arrived at his figure by adding together all monies that were taken out of Lykeki for petitioner's personal 315 benefit and subtracting therefrom all monies that petitioner put into the business of Lykeki from his personal accounts. 7Petitioner admitted that he used funds of Lykeki to purchase items for his personal benefit, but he has attempted to dispute respondent's determination that said use of Lykeki's funds gave rise to constructive dividends. Petitioner's attempts in this respect are wholly unpersuasive. Petitioner freely admitted that he purchased a motorcycle for his son, using a check in the amount of $740.40 drawn on the account of Lykeki. At trial petitioner claimed that, a few days after the motorcycle was purchased, he took out a bank loan in the amount of the purchase price and redeposited the proceeds of that loan into the account of Lykeki. However, Hull testified that he examined the records of Lykeki and was unable to discover any such deposit into the account of Lykeki. In the interest 316 of giving petitioner every opportunity of presenting his case, this Court held the record open for a 2-week period following trial to allow petitioner to introduce documentary evidence of the alleged bank loan and redeposit into Lykeki's account. Petitioner thereafter introduced into evidence a document purporting to evidence the loan. Having examined the document introduced by petitioner, we fail to see how it can be of any assistance to him. The document submitted by petitioner does not so much as identify petitioner as having any connection with it. It in no way shows that a loan was taken out by petitioner and certainly does not serve as evidence of any deposit being made into Lykeki's account. In his letter transmitting the document, petitioner stated that he made monthly payments of $62.19 on the alleged loan for a period of 12 months, for a total payment of $746.28. As respondent points out, if such were the case, the bank loan bore interest at the very attractive and unbelievable rate of less than 1 percent. In short, petitioner has offered no credible evidence to establish that he repaid Lykeki the amount of the funds used to purchase the motorcycle. Petitioner's attempts, 317 in general, to dispute receipt of constructive dividends from Lykeki in 1974 raise a considerable question with respect to his credibility. In explaining why the amounts withdrawn from Lykeki should not be treated as constructive dividends to him, petitioner has offered at least three contradictory theories. In one of his interviews with Hull and Temple, petitioner stated that he was entitled to use funds of Lykeki to purchase the Hatteras Yacht in 1974 because he had never drawn a salary from Lykeki. At trial petitioner changed his story and maintained that he was entitled to use Lykeki's funds because the corporation owed him a great deal of money for travel expenses for which he had not received reimbursement or, alternatively, that the monies withdrawn from Lykeki in 1974 represented monies that petitioner had loaned or otherwise contributed to the corporation to get it started. While perhaps any one of petitioner's explanations for the 1974 withdrawals from Lykeki may have been logical standing on its own, the fact that he has managed to formulate three inconsistent explanations casts doubt on the truthfulness of any of them. Petitioner offered no evidence with respect to 318 the earnings and profits of Lykeki. Under the circumstances, we conclude that petitioner received a constructive dividend of $11,797.32 from Lykeki in 1974. c. 1975Respondent determined that, during his 1975 taxable year, petitioner received $7,000 of wages from Champs, $1,417.99 of dividends from Lykeki, $19,055 of dividends from Champs, and $850 of interest income. Petitioner agrees that he received wages of at least $7,000 and evidently does not dispute that he received interest income as determined by respondent. During 1975 petitioner again used the bank account of Lykeki to pay for various personal expenses. For example, Lykeki paid $565 to Engines Unlimited for work done on petitioner's Hatteras yacht and $437 to Edgewater Yacht Club for docking the yacht. Respondent determined that petitioner received constructive dividends from Lykeki in the amount of $1,417.99 in 1975 by adding together all monies taken out of the corporation for petitioner's personal benefit and subtracting therefrom all monies that petitioner put into the business of the corporation from his personal accounts. Petitioner apparently does not dispute respondent's determination that $1,417.99 was withdrawn 319 from Lykeki in 1975 for petitioner's personal benefit, but merely disputes that he is taxable on the withdrawals. Although it is unclear from the record, petitioner presumably takes the position that he is not taxable on such withdrawals under one of the various theories discussed above in connection with the 1974 constructive dividend from Lykeki.For the reasons set forth above, we reject petitioner's attempt to dispute taxability of the withdrawals. Again, petitioner offered no evidence with respect to Lykeki's earnings and profits. Accordingly, we sustain respondent's determination that petitioner received constructive dividends from Lykeki in the amount of $1,417.77 in 1975. With respect to the determined $19,055 of dividends from Champs, petitioner admits that he withdrew approximately that amount from Champs by selling various assets of the corporation and converting the proceeds to his own personal use. Petitioner argues, however, that the diverted sums did not constitute dividends because he simply was divesting himself of his stock in the corporation. Apparently petitioner is contending that the sums withdrawn from Lykeki represented a return of capital. Petitioner's 320 return of capital argument will not withstand scrutiny. In the first place, when pressed by respondent, petitioner admitted that he had never discussed his alleged plan of divestiture with Gladys Cockey, the other 50-percent owner of Champs. More importantly, it is clear under the facts, that petitioner did not divest himself of his stock ownership in Champs during 1975 but rather assigned all of his interest in the corporation to Gladys Cockey during the following year. After petitioner left the country in May 1975, Gladys Cockey was appointed the receiver for Champs. In early 1976 the assets of Champs were sold, and the net proceeds realized therefrom totaled $38,205.01. By order of the state court before which her divorce action was pending, Gladys Cockey was permitted to withdraw $19,102.51, which represented her one-half interest in the net sales proceeds. In October 1976 petitioner and Gladys Cockey entered into a property settlement agreement pursuant to the divorce action. The agreement acknowledged that petitioner had failed to pay child support and had reduced corporate assets to his possession and control without the permission of Gladys Cockey. Accordingly, in satisfaction 321 of these and other obligations, petitioner agreed to assign the remaining proceeds from the sale of Champs' assets to Gladys Cockey. In contending that the money diverted from Champs in 1975 was actually a payment for his stock interest in the corporation, petitioner is asking us to ignore the terms of the subsequently executed property settlement agreement, whereby petitioner purported to assign his interest in the proceeds derived from the sale of the corporation's assets. This we decline to do. Petitioner presented no evidence whatsoever that would justify a holding that the sums diverted from Champs in 1975 merely represented a return of capital. Likewise, he presented no evidence to establish that Champs did not have earnings and profits sufficient to support a dividend. Under the circumstances, we hold that petitioner has failed to carry his burden of proving erroneous respondent's determination that he received constructive dividends of $19,055 from Champs in 1975. Addition to tax for fraudRespondent determined that all or a part of the underpayments of tax by petitioner for 1973, 1974, and 1975 was due to fraud, and hence seeks to impose an addition to tax for fraud under 322 section 6653(b) for each of those years. Fraud, for purposes of the section 6653(b) addition to tax, has been defined as an intentional wrongdoing with the specific intent to evade a tax believed to be due and owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Stoltzfus v. United States,398 F.2d 1002">398 F.2d 1002, 1004 (3d Cir. 1968); Powell v. Granquist,252 F.2d 56">252 F.2d 56, 60 (9th Cir. 1958). The addition to tax for fraud is a civil sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer's fraud. Helvering v. Mitchell,303 U.S. 391">303 U.S. 391, 401 (1938); Rowlee v. Commissioner,80 T.C. 1111">80 T.C. 1111, 1123 (1983). Respondent has the burden of proving, by clear and convincing evidence, that some part of an underpayment for each year was due to fraud. Section 7454(a); Rule 142(b). The existence of fraud is a question of fact to be resolved upon consideration of the entire record. Gajewski v. Commissioner,67 T.C. 181">67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d 1383">578 F.2d 1383 (8th Cir. 1978). Fraud is never presumed; rather, it must be established 323 by affirmative evidence. Beaver v. Commissioner,55 T.C. 85">55 T.C. 85, 92 (1970). Fraud may, however, be proved by circumstantial evidence. Spies v. United States,317 U.S. 492">317 U.S. 492 (1943). The taxpayer's entire course of conduct may establish the requisite fraudulent intent. Stone v. Commissioner,56 T.C. 213">56 T.C. 213, 223-224 (1971); Otsuki v. Commissioner,53 T.C. 96">53 T.C. 96, 105-106 (1969). Having considered all of the evidence before us, we conclude that respondent has established, by clear and convincing evidence, that there was an underpayment in each of the years in issue and that at least some part of the underpayment for each of those years was due to fraud. The evidence reveals that petitioner was aware of the responsibility of filing proper income tax returns and in fact filed returns for a number of years immediately preceding the years in issue. However, although petitioner knew that he had sufficient income to require the filing of a return for his 1973 taxable year and was contacted on numerous occasions by his accountant with respect to the preparation of such a return, petitioner nevertheless failed to file for that year. Likewise, petitioner failed to file returns for the succeeding 2 years. 324 A pattern of nonfiling, when coupled with affirmative evidence of intent to defraud, warrants imposition of the addition to tax for fraud. Stoltzfus v. United States,supra at 1004-1005; Grosshandler v. Commissioner,75 T.C. 1">75 T.C. 1, 19 (1980). Petitioner offered no tenable explanation for his failure to file individual income tax returns for the years in issue. At one point in the trial, petitioner indicated that he could not file accurate returns because he was unable to obtain financial information such as bills from his ex-wife. Petitioner's explanation in this respect is patently weak. Petitioner and his wife did not separate until September 1974, several months after the due date for the 1973 return. With respect to 1975, petitioner and his wife lived apart for the entire year, and petitioner offered no reason why he would not have had access to all information regarding his income for that year and the expenses that he himself incurred during that year. With respect to 1974, petitioner knew that he had income and certainly could have filed a return reporting his income, even assuming he was in doubt with respect to his expenses for the year. At another point in the trial petitioner 325 claimed that he did not file personal income tax returns because he was afraid of filing incorrect returns and afraid of being found guilty of fraud. Petitioner stated, "I have been unable to file because if I can be sent to jail for 30 days for being late then I'm sure not going to file a fraudulent return." Petitioner's statement was evidently made in reference to his conviction in June 1980 of willful failure to file an income tax return pursuant to section 7203. Thus, petitioner's testimony related to his state of mind after he had been sent to jail in 1980, several years after the due dates of the returns in issue. As such, his testimony has no relevance to the issue of petitioner's intent at the time the returns in issue were required to be filed. In short, petitioner's explanations for his failure to file personal income tax returns are so weak that they are perhaps more damaging than would have been the case had he offered no explanation at all. Petitioner also made numerous inconsistent statements both at trial and during his interviews with Special Agent Temple and Revenue Agent Hull regarding the constructive dividend issue. Such inconsistencies raise a serious question 326 with respect to his credibility and forthrightness, in general, and may be considered as evidence of continuing attempts to conceal his true tax liability for the years in issue. Petitioner testified that he, on his own initiative and prior to learning of the criminal investigation, contacted the Internal Revenue Service when he returned from the Caribbean in April 1976 to request assistance in filing his returns but that he was given no assistance. Petitioner also testified that he contacted Special Agent Temple in April 1976 about getting his "taxes straight. " Petitioner's testimony in this respect did not impress us as credible. Temple, on the other hand, credibly testified that he had no recollection of petitioner contacting him in April 1976 and that he first met with petitioner at the interview he set up in September 1976. Temple testified that he had no memorandum of any contact with petitioner in April 1976 and that in all likelihood he would not have recommended prosecution if petitioner had contacted him voluntarily prior to learning of the criminal investigation. Moreover, he testified that, had petitioner contacted him in April, he would not have delayed setting up 327 an interview until September. In addition, petitioner's actions in diverting rather substantial amounts of money from Champs and Lykeki, and his actions in having Lykeki pay various of his personal expenses, may also be considered as badges of fraudulent intent. 8In light of the foregoing, we conclude that respondent has carried his burden of proving that at least some part of the underpayment of tax by petitioner for each of the years in issue was due to fraud and accordingly hold that petitioner is liable for the section 6653(b) addition to tax for each of those years. Transferee LiabilitySection 6902(a) provides that the burden of proof shall be on respondent to show that a petitioner is liable as a transferee of property of a taxpayer, but not to show that the taxpayer was liable for the tax. In the instant case, petitioner has agreed to be bound by this Court's decision in Cockey v. Commissioner,T.C. Memo. 1983-609, holding him liable as transferee of the assets of Champs. Under section 6902(a) petitioner bears the burden 328 of proving that respondent's determination with respect to the tax liability of Champs for 1974 and 1975 is erroneous. Petitioner contends that Champs filed a corporate income tax return for 1974 showing a loss of approximately $40,000. We have rejected said contention and have found as a fact that, although petitioner had a return prepared for Champs' 1974 taxable year, such return was not filed but merely was turned over to the state court before which Gladys Cockey's divorce action was pending. Similarly, as far as we have been able to determine from the record, Champs did not file a corporate income tax return for its 1975 taxable year. Because the books and records of Champs were not adequate to determine the corporation's income for 1974 and 1975, respondent utilized a modified bank deposits method to determine Champs' income for those years. It is well established that, in the absence of adequate books and records, respondent may determine a taxpayer's income by a bank deposits analysis. Goe v. Commissioner,198 F.2d 851">198 F.2d 851, 852 (3d Cir. 1952); Nicholas v. Commissioner,70 T.C. 1057">70 T.C. 1057, 1064 (1978); Estate of Mason v. Commissioner,64 T.C. 651">64 T.C. 651, 656 (1975), affd. by order 566 F.2d 2">566 F.2d 2 (6th Cir. 1977). 329 Where a taxpayer has filed to maintain adequate records as to the amount and source of income, and respondent has determined that the deposits are income, petitioner has the burden of showing that the determination is incorrect. Rule 142(a); Estate of Mason v. Commissioner,64 T.C. at 657. Deficienciesa. 1974Respondent determined that deposits to Champs' bank accounts for 1974 totaled $374,256.04. He then gave the corporation credit for nontaxable deposits totaling $23,713.01. Since Champs used the accrual method of accounting in keeping its books and records, respondent found it necessary to make certain adjustments to the bank deposits method of computing Champs' income. Specifically, he subtracted from the deposits the accounts receivable balance at the end of 1973 in an attempt to prevent a double inclusion in the corporation's income. He added to the deposits the accounts receivable balance at the end of 1974 to reflect income accrued but not yet received. Respondent also determined that Champs had a cost of goods sold of $257,526.95 and other business deductions of $81,421.11 in 1974. These determinations resulted in an asserted deficiency of $2,004.79. Petitioner vigorously 330 objects to the foregoing method of reconstructing Champs' income. However, his precise contentions are unclear. At one point in the trial petitioner maintained that Champs was a cash basis taxpayer. At another point, petitioner stated that the accrual method "is the only way to bookkeep merchandise in the boat business" and that respondent's calculations placed Champs on the cash basis method of accounting, resulting in inevitable overlaps. While we recognize that reconstructions comparable to the one used by respondent herein are rarely, if ever, exact, they are not required to be. It is enough that the reconstruction be reasonable in light of all the attendant facts and circumstances. The dilemma in which petitioner finds himself, having kept inadequate records of his controlled corporation, is of his own making. Petitioner has failed to offer any credible evidence in rebuttal of the accuracy of respondent's computations. In the absence of any such evidence, and although we are troubled by respondent's failure to introduce sufficient documentary evidence to verify the accuracy of his determinations, we must conclude that petitioner has failed to carry his burden of proving 331 that respondent's determination of Champs' tax liability for 1974 is erroneous, and we accordingly, sustain that determination. b. 1975Respondent determined that deposits to Champs' bank accounts for 1975 totaled $37,205.26. He then gave the corporation credit for nontaxable deposits totaling $13,278.85. To prevent a double inclusion in the corporation's income, respondent subtracted out the accounts receivable balance at the end of 1974, the amount of which had already been included in his 1974 calculations. Respondent also determined that various items of income that were not deposited into Champs' accounts were properly chargeable as income to the corporation. The transactions giving rise to these items of income represent essentially the same transactions, with certain modifications, by which petitioner diverted approximately $19,000 from Champs in 1975. Petitioner does not dispute that the proceeds from these sales were not deposited into Champs' bank account. Respondent determined that total gross receipts for Champs in 1975, after taking all adjustments into account, amounted to $40,062.06 and further determined that Champs had a cost of goods sold of $24,321.72 and 332 other business expenses of $24,530.78 for 1975. These determinations by respondent resulted in a loss to Champs of $8,790.44, which loss was carried back to Champs' 1972 taxable year. According to respondent, the determined $182.21 deficiency for 1975 resulted from a recomputation of a prior year's investment credit. Again, petitioner proffered no evidence whatsoever to disprove respondent's determined deficiency, which is presumptively correct. In the absence of any such evidence, we sustain respondent's determination. Addition to tax for fraudRespondent determined that at least some part of the underpayment of tax required to be shown on Champs' 1974 return was due to fraud and, hence asserts that petitioner, as transferee of the corporation, is liable for the addition to tax for fraud under section 6653(b) with respect to Champs' 1974 taxable year. Section 7454(a) places the burden of proving fraud on respondent, and it must be proven by clear and convincing evidence. Carter v. Campbell,264 F.2d 930">264 F.2d 930, 936 (5th Cir. 1959); Green v. Commissioner,66 T.C. 538">66 T.C. 538, 549 (1976). Respondent must establish both (1) that there was an underpayment and (2) that at least part of the underpayment 333 was due to fraud. Plunkett v. Commissioner,465 F.2d 299">465 F.2d 299, 303 (7th Cir. 1972); Hebrank v. Commissioner,81 T.C. 640">81 T.C. 640, 642 (1983). Without an underpayment of tax there is nothing to which the 50-percent addition to tax for fraud can attach. Thus, affirmative proof of an underpayment is a necessary part of respondent's burden. To prove an underpayment, respondent is not required to establish the precise amount of the deficiency determined by him. However, he cannot discharge his burden by simply relying on the taxpayer's failure to prove error in his determination of the deficiency. Otsuki v. Commissioner,53 T.C. 96">53 T.C. 96, 106 (1969); Pigman v. Commissioner,31 T.C. 356">31 T.C. 356, 370 (1958). Respondent attempted to establish an underpayment in Champs' 1974 tax liability through a modified bank deposits analysis. He was required to do this by clear and convincing evidence. In our opinion he failed to do so. Respondent's proof consisted of little more than having the revenue agent testify, in a more or less conclusory fashion, with respect to the analysis he performed. Respondent submitted into evidence little in the way of underlying documentary support for or verification of his determination. 334 In addition, we recognize that a reconstruction of income such as was used in the instant case is inherently fraught with inaccuracies. We conclude under the circumstances that respondent falls short of satisfying the requisite burden of proof. The conclusion that respondent has failed to establish an underpayment by clear and convincing evidence obviates the necessity of inquiring into the issue of fraudulent intent. In light of the foregoing, we hold that petitioner, as transferee, is not liable for the section 6653(b) addition to tax for 1974. Addition to tax under section 6651(a)Respondent determined that petitioner, as transferee of Champs, was liable for the addition to tax for failure to timely file a return under section 6651(a) with respect to Champs' 1975 taxable year. Under section 6651(a), respondent may add to the tax due upon a return an amount not exceeding 25 percent if the return is filed late, unless the taxpayer shows that such failure is due to reasonable cause and not due to willful neglect. Although the record is not entirely, clear, we have found as a fact that Champs filed no corporate income tax return for its 1975 taxble year. Petitioner bears the burden *335 of proving that Champs' failure to timely file a 1975 return was "due to reasonable cause and not due to willful neglect." Rule 142(a). However, he adduced no evidence whatsoever on this point. Accordingly, we sustain respondent's determination that petitioner, as transferee, is liable for the addition to tax for delinquent filing under section 6651(a) for the taxable year 1975. Decisions will be entered under Rule 155.Footnotes1. Petitioner's Forms W-2 for 1973 and 1975 actually reveal that petitioner received wages of $32,212.50 and $7,350, respectively. Respondent's analysis of Champs' payroll checks led him to conclude that the figure on the 1973 Form W-2 was overstated by $2,012.50 and that the figure on the 1975 Form W-2 was overstated by $350.↩2. The nontaxable items included Maryland sales tax collected, customer refunds, returned checks, and customer taxes collected for the DMV and CBA.3. The nontaxable items included Maryland sales tax collected, customer refunds, returned checks, customer taxes collected for the MDV and CBA, transfers from one Champs' account to another, and a loan from Cladys Cockey. 4. Mr. Jenkins actually purchased the boat for $7,155. Respondent determined that petitioner retained $6,055 of the sales proceeds and deposited $1,100 of the proceeds into Champs' bank account. Since Hull had already taken $1,100 of the proceeds into account as deposits, he increased Champs' gross receipts by only $6,055 of the total purchase price.↩5. The notice of deficiency actually states in one place that Champs had gross receipts of $349,056.96 in 1974, and in another place the notice of deficiency states that Champs had gross receipts of $349,256.96 in 1974. It is clear from the evidence and respondent's position on brief that the numbers in the notice of deficiency are erroneous.↩6. All Rule references herein are to the Tax Court Rules of Practice and Procedure.↩7. Respondent notes on brief that he has inadvertently given petitioner a benefit in computing the dividend income from Lykeki in the above-described manner, since there is no basis in the statute for reducing the amount of dividend income by a shareholder's contributions to a corporation.↩8. Cf. Gualtieri v. Commissioner,T.C. Memo. 1981-104; Smith v. Commissioner,T.C. Memo. 1980-410; A.A. Aaron, Inc. v. Commissioner,T.C. Memo. 1978-28↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621975/	Estate of Raymond Parks Wheeler, Evelyn King Wheeler, Executrix, Petitioner, v. Commissioner of Internal Revenue, RespondentWheeler v. CommissionerDocket No. 54749United States Tax Court26 T.C. 466; 1956 U.S. Tax Ct. LEXIS 170; June 7, 1956, Filed 170 Decision will be entered under Rule 50. 1. Decedent Raymond Parks Wheeler created an inter vivos trust in 1940 to which he transferred certain securities and made the Hartford-Connecticut Trust Company of Hartford, Connecticut, trustee. He was made the income beneficiary for life and at his death his wife, Evelyn King Wheeler, and his children were to receive certain benefits under the terms of the trust. The trust was revocable and upon the death of the settlor in 1951, the value of the trust assets was included in decedent's gross estate. In the estate tax return a marital deduction of $ 200,462.83 was claimed. This deduction was disallowed on the ground that the assets of the trust did not pass to the surviving spouse within the meaning of section 812 (e) (1) (F), Internal Revenue Code of 1939. Held, that so much of the marital deduction claimed by the estate as is based upon the net value of the trust assets at the date of decedent's death is disallowed because the rights and benefits granted Evelyn under the terms of the trust do not meet the conditions imposed by section 812 (e) (1) (F) and Treasury regulations relating thereto.2. Decedent, in his last will and171 testament, devised and bequeathed to his wife, Evelyn King Wheeler, all property of whatsoever kind, real, personal, or mixed, in which he had any interest at the time of his death. The Commissioner in his determination of the deficiency held that after the payment of administration expenses, debts of the decedent, and estate taxes, there remained no assets in the possession of the executrix of the estate for distribution to the surviving spouse under the terms of decedent's last will and testament and consequently no marital deduction could be allowed on the devise and bequest of the residuary estate to the surviving spouse. Held, the Commissioner is sustained in his determination on the facts in the record with respect to the bequest of the residuary estate to the surviving spouse. Estate of Herman Hohensee, Sr., 25 T. C. 1258, followed on this issue. Percy E. Godbold, Jr., C. P. A., for the petitioner.Homer F. Benson, Esq., for the respondent. Black, Judge. BLACK 466 The Commissioner has determined a deficiency in estate tax of the Estate of Raymond Parks Wheeler of $ 66,714.60. The deficiency is due to adjustments to net estate described in the deficiency notice as follows:Net estate for basic tax as disclosed by return$ 100,462.83Additions to value of net estate and decreases in deductions:Real estate$ 12,500.00Stocks and bonds1,800.00Other miscellaneous property606.37Bequests, etc., to surviving spouse -- maritaldeduction200,462.83215,369.20Total$ 315,832.03467 None of the adjustments described above are contested except that one where the claimed marital deduction of $ 200,462.83 is disallowed. In explaining his disallowance of the claimed marital deduction the Commissioner states in his deficiency notice as follows:It is held that the trust assets included in the gross estate at a determined value of $ 324,822.80 did not pass173 to the surviving spouse within the meaning of Section 812 (e) (F) [sic] of the Internal Revenue Code, and Section 81.47 (a) of Regulations 105, and consequently no part of the assets of the trust may be considered deductible as a marital deduction. It is also determined that the assets passing from the estate to the executrix were subject to the payments of administrative expenses, debts of the decedent, and estate taxes payable to the State of Alabama and the Federal Government. It is held also that after the payment of the administration expenses, debts of the decedent, and estate taxes, there remained no assets in the possession of the executrix of the estate for distribution to the surviving spouse under the terms of decedent's last will and testament, and consequently the claim to a marital deduction is determined to be disallowed in full.To the action of the Commissioner in disallowing any marital deduction, the petitioner assigns error. These assignments of error will more fully appear in our Opinion.FINDINGS OF FACT.A stipulation of facts with exhibits attached thereto has been filed and is made a part hereof by reference.The petitioner is the Estate of Raymond 174 Parks Wheeler. Evelyn King Wheeler is executrix of the estate and she resides in Anniston, Alabama. She will sometimes hereinafter be referred to as Evelyn. The estate tax return was filed with the director of internal revenue for the district of Alabama, Birmingham, Alabama.Raymond Parks Wheeler, a resident of Anniston, Alabama, sometimes hereinafter referred to as decedent, died testate on January 10, 1951.On August 27, 1940, decedent executed a revocable trust in which he named the Hartford-Connecticut Trust Company of Hartford, Connecticut, trustee with power to manage the trust estate as set forth in the trust instrument. The settlor, in accordance with the provision of the trust, transferred certain stocks and bonds to the trust. These stocks and bonds had a value at the time of decedent's death of $ 324,822.80, as the Commissioner has determined in his deficiency notice. The trust instrument contained, among other things, the following provisions:5. After the death of the Donor net income shall be paid to Evelyn K. Wheeler, wife of the Donor, at least quarterly, throughout her life for her maintenance, support, and comfort, and the maintenance, support, comfort and 175 education of their children in accordance with her judgment. * * There may also be paid to or for the benefit of the Donor's said wife or used for the benefit of said children 468 such portion or portions, if any, of the principal as the Trustee in its absolute discretion may deem necessary or proper for the maintenance, comfort and support of the Donor's said wife and of said children and their issue. In case the Trustee deems such expenditures of principal desirable there shall be no obligation upon the Trustee to require as a prerequisite the exhausting of the personal funds of the Donor's said wife. In addition the Donor's wife shall have the privilege of requisitioning payments from the principal of the trust, but in no case shall the total amount of withdrawals of principal exceed one-half of the value of the trust at the time requisition is made. The Trustee's judgment with reference to proportion of principal and the value thereof which has been used shall be final.6. After the death of the Donor's said wife the trust shall continue for the benefit of the Donor's said children and their issue and shall terminate as hereinafter set forth. During such continuance176 of the trust income shall be used by the Trustee at its discretion for the benefit of children of the Donor who have not yet attained the age of twenty-one years. After the attainment of such age children of the Donor shall receive from the Trustee the income of their respective shares to be paid to them direct, except as expended by the Trustee for their benefit. * * ** * * 13. The Donor shall have the right to revoke this instrument at any time by a writing signed by him and delivered to the Trustee and upon such revocation the Trustee shall transfer, assign and deliver to the Donor all property in the trust, both income and principal, after paying all expenses and charges of the trust to such date.On December 18, 1940, Raymond Parks Wheeler executed an amendment to the foregoing trust which contained, among other provisions, the following:FIRST: In case of the death of the Donor the Trustee shall be authorized according to its discretion and to the extend [sic] that may in its judgment be advisable to pay out of the principal of the trust any or all funeral expenses of the Donor and expenses of settlement of his estate including just debts of the Donor and inheritance177 or succession taxes together with all ordinary administration expenses, whether levied on account of or in connection with this trust, or other assets of the Donor.The last will and testament of decedent was executed January 5, 1939, and contains the following provisions:FIRST: I direct that all my just debts and expenses of last illness be paid by my executrix hereinafter named, as soon after my death as practicable.SECOND: I will, devise and bequeath to my beloved wife, Evelyn King Wheeler, all property of whatsoever kind, real, personal or mixed, which I own or in which I have any interest at the time of my death.THIRD: I nominate and appoint Evelyn King Wheeler as executrix of this will and relieve her of giving bond. I vest in her full power to alienate, encumber and otherwise dispose of any assets of the estate, including particularly the power to transfer, or cause to be transferred, corporate stocks upon corporate records. I hereby vest in her all powers of management and control of my said estate which the law authorizes me to vest.The estate tax return which was filed contains the following recapitulation: 469 Gross estateReal estate$ 11,000.00Stocks and bonds56,550.00Mortgages, notes, and cash7,747.51Insurance3,500.00Other miscellaneous property329,725.01Total gross estate$ 408,522.52178 The item "Other miscellaneous property" contained in the statement of gross estate as given above included an item designated as "Assets in Trust of Raymond P. Wheeler for Raymond P. Wheeler, et al, Hartford, Connecticut Trust Company, Trustee per separate list attached. $ 324,216.43."This recapitulation in the estate tax return also contains the following with reference to deductions:DeductionsFuneral and administration expenses$ 3,004.58Debts of decedent4,592.28Allowable amount of above deductions$ 7,596.86Bequests, etc., to surviving spouse$ 408,522.52Adjusted gross estate400,925.66Net amount deductible for bequests, etc., tosurviving spouse [Marital deduction claimed]200,462.83Total allowable deductions, except specific exemption and propertypreviously taxed$ 208,059.69The net estate tax payable shown on the return was $ 31,627.75.At the time of his death decedent had two policies of insurance on his life in the respective amounts of $ 1,000 and $ 2,500, payable to his wife as beneficiary. It is stipulated that the $ 3,500 insurance proceeds paid Evelyn King Wheeler under these two policies qualify for the marital deduction. 179 OPINION.The Commissioner in his determination of the deficiency disallowed all of the marital deduction claimed on the estate tax return. However, he now concedes that petitioner is entitled to a marital deduction of $ 3,500 on account of the proceeds of the insurance policies paid to Evelyn on the death of the decedent. Effect will be given to this concession in a computation under Rule 50.Issue (a).The first issue which we have to decide is stated by petitioner in assignment of error (a), as follows:(a) The Commissioner erroneously determined that the trust assets included in the gross estate at a determined value of $ 324,822.80 did not pass to the 470 surviving spouse within the meaning of Section 812 (e) (F) of the Internal Revenue Code, and section 81.47 (a) of Regulations 105, and consequently no part of the assets of the trust may be considered deductible as a marital deduction.The applicable provisions of the 1939 Code are printed in the margin. 1180 Section 81.47a (c) of Regulations 105 reads, in part, as follows:Sec. 81.47a. Bequests, Etc., to Surviving Spouse. --(c) Trust with power of appointment in surviving spouse. -- In the case of property interests which passed from the decedent to a trust, the terms of which satisfy the five conditions stated in this paragraph, the expression "passed from the decedent to his surviving spouse" embraces not only the beneficial interest therein of such spouse but also the interest therein subject to her power to appoint. (As to the treatment of trusts not meeting such conditions, see paragraph (b) (2) of this section.) The five conditions which must be satisfied by the terms of the trust are as follows: (1) The surviving spouse must be entitled for life to all the income from the corpus of the trust.(2) Such income must be payable annually or at more frequent intervals.(3) The surviving spouse must have the power, exercisable in favor of herself or of her estate, to appoint the entire corpus free of the trust.471 (4) Such power in the surviving spouse must be exercisable by such spouse alone and (whether exercisable by will or during life) must be exercisable181 in all events.(5) The corpus of the trust must not be subject to a power in any other person to appoint any part thereof to any person other than the surviving spouse.The foregoing regulations were considered and approved by us in Estate of Louis B. Hoffenberg, 22 T. C. 1185, affirmed per curiam (C. A. 2) 223 F. 2d 470. In that case we held that no part of the transfer in trust there involved qualified for the marital deduction under section 812 (e) (1) (F) of the 1939 Code.Our inquiry in deciding petitioner's assignment of error (a) is whether the terms of the trust satisfy all of the five conditions named in the Treasury regulations just quoted above and which we said in Estate of Louis B. Hoffenberg, supra, correctly interpreted the law relating to the marital deduction. If any one of these conditions is not satisfied then the claimed marital deduction must fail.We shall not undertake to discuss all the five conditions named in the regulations as they relate to the facts connected with the Raymond P. Wheeler trust which we have here to consider. It is obvious that the terms of the trust182 do not satisfy at least some of the five conditions enumerated in the regulations. For example, it seems clear to us that condition (5) in the regulations is not met by the terms of the trust. That condition reads:(5) The corpus of the trust must not be subject to a power in any other person to appoint any part thereof to any person other than the surviving spouse.A reading of paragraph 5 of the trust instrument given in our Findings of Fact will show the following language:There may also be paid to or for the benefit of the Donor's said wife or used for the benefit of said children such portion or portions, if any, of the principal as the Trustee in its absolute discretion may deem necessary or proper for the maintenance, comfort and support of the Donor's said wife and of said children and their issue. * * It seems certain from the foregoing language that the trustee, which is the Hartford-Connecticut Trust Company, has large powers to invade the principal of the trust, not only for the benefit of Evelyn but for the benefit of the children as well. In fact it seems clear that the trust was created for the benefit of the children as well as for Evelyn. Therefore, under183 the terms of the trust the conditions enumerated in (5) of the regulations are not met.But even if we are wrong in our holding that the conditions prescribed in (5) of the regulations are not met, nevertheless Evelyn's interest in the trust corpus would still be a terminable one. Paragraph 6 of the trust instrument reads:6. After the death of the Donor's said wife the trust shall continue for the benefit of the Donor's said children and their issue and shall terminate as hereinafter set forth. * * *472 The foregoing language in the trust instrument would prevent the estate from being entitled to the marital deduction based on the trust corpus. See Estate of Edward F. Pipe, 23 T.C. 99">23 T. C. 99. In that case we stated the issue to be decided, as follows:The question presented involves the construction of section 812 (e) of the estate tax law as enacted in 1948: Does property bequeathed to a surviving wife for life, with unlimited powers of invasion or disposition during her lifetime, but with remainders over as to any residue left at her death, qualify for the marital deduction or does the wife acquire merely a "terminable interest" included in the184 exception provided in subsection (e) (1) (B) of the same section.Our holding in that case was to the effect that decedent's bequest of a legal life estate to his spouse, coupled with unlimited lifetime power of invasion but with remainder over to the decedent's children, did not qualify for the marital deduction from gross estate permitted by section 812 (e) of the 1939 Code. In that case, in holding against the contentions of the taxpayer estate, we said:Generally speaking, the "terminable interest" concept was devised for the purpose of assuring that if the property bequeathed to the spouse was to be excluded from gross estate with respect to the decedent, it would be adequately integrated in the spouse's estate so that on her death it would not escape the death tax a second time. As petitioner expresses it, "The basic principle * * * is that the spouse first to die shall be permitted to pass on to the surviving spouse free of estate tax up to one-half of his or her estate, provided only that the terms of the transfer are such that this property will be taxable in the estate of the surviving spouse."The issue raised by petitioner's assignment of error (a) is decided against185 petitioner.Issue (b).Petitioner raises issue (b) in the alternative. It is stated in the assignment of error as follows:(b) The Commissioner erroneously determined that after the payment of the administration expenses, debts of the decedent, and estate taxes, there remained no assets in the possession of the executrix of the estate for distribution to the surviving spouse under the terms of decedent's last will and testament, and consequently the marital deduction was disallowed in full.We think petitioner's alternative issue (b) cannot be sustained.As we have already stated, the facts in the instant case have all been stipulated. Petitioner, in its reply brief, states "The trust has paid the estate tax levied to date and will pay any additional estate tax that is levied." But no facts have been stipulated which would enable us to make a fiinding that the trust has paid the estate tax levied to date and will pay any additional estate tax that is levied under our decision in this proceeding. It is clear that the estate tax liability of the estate of decedent constitutes much the largest of its liabilities. The net estate tax payable shown on the return was $ 31,627.75, 186 and it 473 is plain that as a result of our decision on issue (a) there will be a considerable deficiency in estate tax due. It is also plain that the estate tax liability, added to the other liabilities of the estate, confirm the correctness of what the Commissioner says in his deficiency notice:It is held also that after the payment of the administration expenses, debts of the decedent, and estate taxes, there remained no assets in the possession of the executrix of the estate for distribution to the surviving spouse under the terms of decedent's last will and testament, and consequently the claim to a marital deduction is determined to be disallowed in full.But even if the stipulated facts showed that the trustee of the trust has paid the estate tax which was shown on the return and will pay whatever deficiency in estate tax results from this proceeding, it would not aid petitioner. See Estate of Herman Hohensee, Sr., 25 T. C. 1258. We had an issue before us in that case similar to the one which petitioner raises in its assignment of error (b). In deciding against the taxpayer on that issue, we said:Nor was there any residuary estate187 left out of which the widow could secure any bequest "from the decedent" and hence enable the estate to claim the marital deduction as to this portion. The facts show that expenses and taxes more than consume the entire value of the estate actually left at death. True, certain sums were distributed to the widow but these are shown to have been made possible only by contributions on the part of the trust, or of decedent's "heirs-at-law," presumably the children who were also trustees and remaindermen under the trust. The widow did not receive these sums from the decedent and if debts, expenses and taxes reduce the residuary legacy to nothing, the legatee is not considered to have received anything from the estate. Rogan v. Taylor, (C. A. 9) 136 F.2d 598">136 F. 2d 598. * * Cf. Thompson v. Wiseman, (C. A. 10) 233 F.2d 734">233 F. 2d 734.We hold against petitioner on issue (b).Issue (c).This issue was raised by an amendment to the petition. The amendment contains, among other things, language as follows:The petitioner hereby prays the court for permission to submit proof of payment of any and all attorney and accountant fees188 before final computation is made of the estate tax under rule 50.Petitioner's brief with respect to this assignment of error states in part:At the time of filing this brief the only attorney fees or accountants fees paid or anticipated and not claimed on the estate tax return is a payment to Mr. J. J. Scarborough, Jr., Attorney at law, Birmingham, Alabama for $ 300.00. Unless there should be further litigation beyond the Tax Court there will be no further fees. * * There seems to be no disagreement between the parties as to this issue. The additional deduction will be treated as provided by Rule 474 51, "Estate Tax Deduction Developing After Trial," Rules of Practice Before the Tax Court of the United States.Decision will be entered under Rule 50. Footnotes1. SEC. 812. NET ESTATE.For the purpose of the tax the value of the net estate shall be determined, in the case of a citizen or resident of the United States by deducting from the value of the gross estate --* * * (e) Bequests, Etc., to Surviving Spouse. -- (1) Allowance of marital deduction. -- (A) In General. -- An amount equal to the value of any interest in property which passes or has passed from the decedent to his surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate.(B) Life Estate or Other Terminable Interest. -- Where, upon the lapse of time, upon the occurrence of an event or contingency, or upon the failure of an event or contingency to occur, such interest passing to the surviving spouse will terminate or fail, no deduction shall be allowed with respect to such interest --(i) if an interest in such property passes or has passed (for less than an adequate and full consideration in money or money's worth) from the decedent to any person other than such surviving spouse (or the estate of such spouse); and(ii) if by reason of such passing such person (or his heirs or assigns) may possess or enjoy any part of such property after such termination or failure of the interest so passing to the surviving spouse; * * *(F) Trust with Power of Appointment in Surviving Spouse. -- In the case of an interest in property passing from the decedent in trust, if under the terms of the trust the surviving spouse is entitled for life to all the income from the corpus of the trust, payable annually or at more frequent intervals, with power in the surviving spouse to appoint the entire corpus free of the trust (exercisable in favor of such surviving spouse, or of the estate of such surviving spouse, or in favor of either, whether or not in each case the power is exercisable in favor of others), and with no power in any other person to appoint any part of the corpus to any person other than the surviving spouse --(i) the interest so passing shall, for the purposes of subparagraph (A), be considered as passing to the surviving spouse, and(ii) no part of the interest so passing shall, for the purposes of subparagraph (B) (i), be considered as passing to any person other than the surviving spouse.This subparagraph shall be applicable only if, under the terms of the trust, such power in the surviving spouse to appoint the corpus, whether exercisable by will or during life, is exercisable by such spouse alone and in all events.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621976/	Manahan Oil Company, Petitioner, v. Commissioner of Internal Revenue, Respondent. G. A. Manahan, Petitioner, v. Commissioner of Internal Revenue, Respondent. R. D. Creighton, Petitioner, v. Commissioner of Internal Revenue, Respondent. Pearl V. Manahan, Petitioner, v. Commissioner of Internal Revenue, RespondentManahan Oil Co. v. CommissionerDocket Nos. 9669, 9664, 9666, 9668United States Tax Court8 T.C. 1159; 1947 U.S. Tax Ct. LEXIS 191; May 29, 1947, Promulgated 191 Decisions will be entered for the respondent. 1. Deductions from Income -- Intangible Drilling and Development Costs. -- Petitioner acquired an interest in leases by drilling and developing and was not entitled to deduct those costs as expenses. F. H. E. Oil Co., 3 T.C. 13">3 T. C. 13; affd., 147 Fed. (2d) 1002, followed.2. Income. -- Amounts received from production from fractional interests in leases temporarily assigned to the petitioner until from those interests and others the petitioner received the equivalent of the development costs, were income to the petitioner. C. H. Rosenstein, Esq., for the petitioners.Frank B. Schlosser, Esq., and L. R. Van Burgh, Esq., for the respondent. Murdock, Judge. MURDOCK 1159 OPINION.The Commissioner determined deficiencies of $ 6,316.80 and $ 1,459.21 in the income tax of the Manahan Oil Co. for the fiscal years ended June 30, 1940 and 1941. He also determined liabilities against the other three petitioners as transferees. The three individual petitioners concede that they are liable as transferees for any amounts due from the corporation. The latter will be referred192 to hereinafter as the petitioner.The issues for decision are whether the Commissioner erred, first, in disallowing deductions taken by the petitioner for intangible drilling and development costs of oil wells and, second, in adding to the income of the petitioner amounts received for oil from fractional interests in leases assigned to the petitioner only until it was reimbursed for its drilling and development costs. The facts have been stipulated and the stipulation is adopted as the findings of fact.The petitioner filed returns for the periods here involved with the collector of internal revenue for the district of Oklahoma.The Shasta Oil Co. owned a seven-eighths working interest in an oil and gas lease, called the Carlock lease, covering about 120 acres of land in Texas. The petitioner acquired an interest in the Carlock lease under a written contract with Shasta dated April 21, 1939. Shasta was described in the agreement as the vendor and the petitioner as the 1160 vendee. The agreement recited that the vendor desired to have the property developed for oil and gas and the vendee was in a position and desired to develop the property. The vendor conveyed to the vendee193 an undivided one-half of its seven-eighths interest in the leases and the vendee paid the vendor $ 37,639.25. The vendee agreed to commence the drilling of a well within 30 days and to complete the drilling of the well to a sufficient depth to test the present producing horizon. The agreement contained the following provision:Time is of the essence of this agreement, and failure of Vendee for any reason to spud in said well as and within the time above provided shall entitle vendor at its option to terminate this contract forthwith and absolutely.The vendee, after completion of the first well, was to drill such additional wells as might be required to develop and protect the property. The vendor agreed to assign to the vendee portions (hereinafter for convenience referred to as one-fourth of seven-eighths) of the vendor's retained interest in the leases until the vendee should receive, from the proceeds of that one-fourth plus the proceeds of the vendee's one-half of the seven-eighths interest, an amount equivalent to the total expended by the vendee in the development of the property, plus the $ 37,639.25 paid to the vendor. Thereafter, the vendee's interests in the one-fourth194 of seven-eighths should terminate and the full one-half of seven-eighths should remain the sole property of the vendor, so that the vendor and vendee would each own one-half of the seven-eighths interest and each should henceforth bear its one-half of the operating expenses in the jointly owned property. The vendee was to have exclusive control and sole management of the development and operation of the property. The agreement was carried out.The petitioner received $ 16,815.16 during the fiscal year ended June 30, 1940, and $ 13,919.62 in the fiscal year ended June 30, 1941, from the one-fourth of seven-eighths temporarily assigned to it by Shasta. It credited those amounts to the larger development costs previously incurred. The petitioner did not report the two amounts above mentioned in income, but the respondent included them in income in determining the deficiencies.The petitioner acquired some interests in other oil leases, under contracts requiring it to drill wells, similar to the agreement already described, except for the absence of a cash payment, and it received payments which were treated similarly. The only distinction made by either party between these agreements195 and the Carlock agreement is one made by the petitioner in which it points to the payment of cash in the Carlock agreement as giving the petitioner a basis for its alternative argument on the first issue.The petitioner's first contention is that it is entitled to deduct the intangible drilling and development costs on all of the leases as 1161 expenses. The Commissioner has held that it may not deduct those expenditures as expenses, but must capitalize them because the petitioner acquired its interest in the leases for the consideration that it develop, equip, and operate the leases, and those expenditures represent the petitioner's capital investment in the property. He relies upon F. H. E. Oil Co., 3 T. C. 13; affd., 147 Fed. (2d) 1002; rehearing denied, 149 Fed. (2d) 238; second motion for rehearing denied, 150 Fed. (2d) 857; King Oil Co. v. Commissioner, 153 Fed. (2d) 690; and Alex McCutchin, 4 T. C. 1242, 1254. The petitioner concedes that those decisions are contrary to its contention, but asks196 this Court to reconsider the question. The Court will not reconsider the question at this time, but holds on this point for the respondent upon authority of the cases just cited.The petitioner contends, in the alternative, that it is entitled to deduct one-half of the intangible drilling and development costs, at least in the case of the Carlock lease, because it purchased a one-half interest in that lease for cash and by its obligations to develop the property it only obtained the other conditional interests. The terms of the lease do not bear out this contention. The agreement was not divisible. The petitioner did not acquire its interest by the payment of cash alone, but by paying cash and agreeing to drill and develop the property. The entire intangible drilling and development costs were a part of the consideration which the petitioner paid for the interest which it acquired in that lease, and the cases above cited control. Section 29.23 (m)-16 of Regulations 111, to which the petitioner refers, but which by its terms does not apply to the facts or the years here in question, does not aid the petitioner.The petitioner's contention on the second issue is that the income197 from oil produced from the fractional interests in the leases assigned to the petitioner only until it was reimbursed from those interests and from its own separate interests for certain outlays, was the income of the assignors and not its income. Its theory is that it received the proceeds from those temporarily assigned fractional interests, not as income to it, but rather as a reimbursement from the assignors for their shares of the intangible drilling and operating costs. The Court is unable to agree with this contention of the petitioner. The somewhat complicated terms of the agreements to which the petitioner refers merely express the agreement of the parties as to how they desire the income from the oil and gas to be shared between them. Cf. Hiram T. Horton, 7 T. C. 957. The other party to each agreement contributed an interest in an oil and gas lease. The petitioner agreed to use its own funds and facilities to drill and develop the properties under the leases. Its reward was to come only from oil which might be produced from certain interests in the leases. 1162 The contracts specified just how much of the oil the petitioner was198 to have. It was to have all of the oil from certain fractional interests, while from others it was to have all of the oil only until the income therefrom equaled certain ascertainable amounts. Some of the leases involved in Hugh Hodges Drilling Co., 43 B. T. A. 1045, contained similar provisions. One of the questions involved in that case was whether income from oil produced from fractional interests temporarily assigned to the petitioner was income to it. It was held that the amounts received constituted gross income to the petitioner. Likewise, all that the present petitioner received from the production of oil under these agreements was its income, to do with as it saw fit. The mere fact that the amount to be received from some of the fractional interests was to be measured by a part of the expenditures theretofore made by the petitioner, does not prevent that income from being taxable to the petitioner. The assignors did not receive it either actually or constructively. It did not represent their income which they permitted to be diverted in the acquisition by them of a capital asset. They acquired an interest in the intangibles as the hole199 was drilled, not from later production. The contract also provided that when it had been performed to a certain stage they were to have an interest in the tangibles. But the amounts here in question were in no case quid pro quo in the acquisition by the assignors of a capital asset.The agreement in regard to the Carlock lease is different in one respect from the others. The petitioner paid Shasta $ 37,639.25 in 1939 when the agreement was entered into. Shasta temporarily assigned to the petitioner a one-fourth of seven-eighths interest (one-half of Shasta's retained share) until from that one-fourth and from the petitioner's one-half the petitioner should receive the equivalent not only of the development costs, but also of the $ 37,639.25. The petitioner's argument described above as applied to this situation would be that Shasta was repaying from its share of production one-third of the development costs and one-third of the $ 37,639.25. That argument, in so far as it applies to the development costs, has been discussed above. A further weakness in that argument appears when its application to the $ 37,639.25 is considered. The petitioner has not suggested any reason200 why the income which it received from the one-fourth of seven-eighths interest measured by one-third of $ 37,639.25, would represent income to Shasta or would not represent income to the petitioner. That part of the income from production in no way benefited Shasta. Obviously, the terms of the agreement were merely a means adopted by the parties for measuring the part of the income from production to be retained by the petitioner. The Commissioner did not err in taxing all of the income here in question to the petitioner.Decisions will be entered for the respondent.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621977/	FRANK R. AND GINA BODOR, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentBodor v. CommissionerDocket No. 14339-91United States Tax CourtT.C. Memo 1993-456; 1993 Tax Ct. Memo LEXIS 466; 66 T.C.M. (CCH) 928; September 29, 1993, Filed 466 Decision will be entered under Rule 155. For petitioners: Edward G. Ptaszek. For respondent: J. Scott Broome. COUVILLIONCOUVILLIONMEMORANDUM OPINION COUVILLION, Special Trial Judge: This case was heard pursuant to section 7443A(b)(3) 1 and Rules 180, 181, and 182. Respondent determined a deficiency in petitioners' 1987 Federal income tax in the amount of $ 1,170.74 and additions to tax under section 6653(b)(1)(A) of $ 878.06 and section 6653(b)(1)(B) of 50 percent of the interest payable that portion of the underpayment attributable to fraud. The issues for decision are: (1) Whether petitioners are entitled to deduct as rental expense under section 162(a)(3) $ 10,000 paid pursuant to a transfer-leaseback of real estate, and (2) whether petitioners are liable for the additions to tax for fraud. Some of the facts were stipulated and are found 467 accordingly. The stipulation and attached exhibits are incorporated herein by reference. Petitioners, husband and wife, resided in Warren, Ohio, at the time they filed their petition. Frank R. Bodor (petitioner) is an attorney and was engaged in the general practice of law during 1987. He had practiced law for 28 years. Petitioner did not hold himself out as a tax lawyer but had, on occasion, represented clients before the Internal Revenue Service (IRS) and had prepared some income tax returns. Petitioner Gina Bodor (Mrs. Bodor) had a college degree with a foreign language major. At various times throughout 1987, Mrs. Bodor worked at petitioner's law office. At the beginning of 1985, petitioners owned the following parcels of real property: (1) 157 Porter Street, N.E., Warren, Ohio (two-story building with petitioner's law office on the first floor and two rental apartments on the second floor); (2) 165-167 Porter Street, N.E., Warren, Ohio (apartment building); (3) 156 Scott Street, Warren, Ohio (apartment building); (4) 177 Porter Street, N.E., Warren, Ohio (residential rental house); (5) 4950 Gulf Boulevard, St. Petersburg Beach, Florida (the Florida condominium); (6) 609468 Melwood Drive, Warren, Ohio (petitioners' residence); (7) vacant lot on Porter Street, Warren, Ohio; and (8) 130 South Center Street, Newton Falls, Ohio. By written instruments dated April 30, 1985, all of petitioners' interests in the eight properties were deeded by quitclaim to various foreign entities as follows: Parcel 1 to Etruscan Lease Company, Nassau Life Insurance Company, Ltd., Trustee (Etruscan-Nassau). Parcels 2, 3, 4, 5, 7, and 8 to Nile Management Company, Nassau Life Insurance Company, Ltd., Trustee (Nile-Nassau). Parcel 6 to Attila Company, Nassau Life Insurance Company, Ltd., Trustee (Attila-Nassau). In addition to their real estate, petitioners also transferred title to several motor vehicles to one or more of these entities. The quitclaim deeds were signed by petitioners as grantors. In addition, there was a "Condominium Resale Approval" executed on May 6, 1985, for Parcel 5, in which the purchaser was listed as "Nile Co., Nassau Life Insurance Co., Ltd., Trustee, Frank R. Bodor, Pres.", and the document was signed for Nile-Nassau only by Frank Bodor, Agent". The address recited for the entity was 157 Porter Street, petitioner's law office. The documents469 effecting the transfers and the supporting board minutes relating to Etruscan-Nassau, Nile-Nassau, and Attila-Nassau appear to be preprinted forms and were virtually identical. Each was dated February 28, 1985, and the entities were each referred to as a "Business Trust Organization" contractually created "under the laws of the Turks and Caicos Islands, British West Indies". In consideration for the transfer of their real and personal properties, petitioners received 99 of 100 "Unit Capital Certificates" in each entity. In 1985, other than petitioners' signatures, the only pertinent signature on the foreign entity documents was that of Robert Chappell as president of Nassau Life Insurance Company, Ltd., Trustee (Nassau Life). For each of the three foreign entities named above, there were board minutes which appointed petitioner as "President (Agent)" and Mrs. Bodor as "Secretary (Agent)". The documents provided that petitioners were to act only as authorized by Nassau Life. In connection with petitioners' transfers of their properties, two lease agreements were entered into between Nile-Nassau and Etruscan-Nassau, as lessors, and petitioners, as lessees. In the first lease, 470 petitioners leased Parcels 1 through 5 for the period from March 1, 1985, to December 31, 1985, for a rental of $ 33,500 to be paid by petitioners by the end of 1985. The second lease also involved Parcels 1 through 5 for the year 1986 and provided for a rental of $ 20,000 for that year. Although the lease for 1985 covered the period from March 1, 1985 to December 31, 1985, the quitclaim deeds by which the properties were transferred to the foreign entities are dated 2 months later, April 30, 1985. The second lease agreement was executed only by Nile-Nassau as lessor, although the record indicates that Parcel 1 had been transferred to Etruscan-Nassau. Etruscan-Nassau was not a party to the 1986 lease agreement. Throughout 1985 and 1986, as well as the year at issue, 1987, petitioners remained in possession of their properties in the same fashion as they had prior to the transfers to the foreign entities. Due to illegal activities, in late 1986 or early 1987, Nassau Life Insurance Company ceased operations. Petitioners knew that the problems of Nassau Life stemmed from illegal activities and a "tax situation". Since Nassau Life ceased operations, other arrangements had to be471 made for petitioners' property. By the end of 1987, legal title to all parcels of property which had been held by Nassau Life as Trustee, with the exception of Parcel 5, was transferred to R.E. Services, Inc., as "Land Trustee" pursuant to a "Title Holding Trust Agreement". 2 In this agreement, R.E. Services, Inc., held legal title for the benefit of an entity known as Compass Group, Oxford Charter Corporation, Trustee (Compass-Oxford). In June 1987, Parcel 5 was deeded directly by Etruscan-Nassau to Compass-Oxford. The Compass-Oxford entity, therefore, held beneficial title to seven parcels of petitioners' property and legal title to one parcel. The warranty deeds and the holding agreement were all prepared by petitioner. According to documents dated March 1987, Compass Group was created as a Delaware common-law contractual company472 with Oxford Charter Corporation, a Delaware corporation, serving as trustee. The only mailing address given for Compass-Oxford on these documents was 157 Porter Street, N.E., Warren, Ohio 44483, petitioner's law office. In addition, petitioner was agent/general manager and Mrs. Bodor was secretary for Compass-Oxford. Petitioners opened Compass-Oxford's only bank account in a local bank, and they were the only individuals who had signatory authority on this account. There were 100 Compass-Oxford ownership units authorized, and these units were held by Lido Company, Jefferson Trust Company, Ltd., Trustee (Lido-Jefferson). Both Lido and Jefferson were foreign entities organized under the laws of the Turks and Caicos Islands, British West Indies. Robert Temple, an associate of petitioner, had signatory authority on the Lido-Jefferson bank account in Warren, Ohio. The address for Lido-Jefferson for its bank account was 157 Porter Street, petitioner's law office. There were 100 Lido-Jefferson ownership units authorized, and these units were held entirely by Concord Company, Eton Trust Company, Ltd, Trustee (Concord-Eton). Both Concord and Eton were foreign entities organized under473 the laws of the Turks and Caicos Islands, British West Indies. Petitioners had signatory authority on the Concord-Eton bank account, and the bank's mailing address for this account was 157 Porter Street, petitioner's law office. In 1987, petitioners surrendered the "Unit Capital Certificates" they had received in 1985, when they quitclaimed their properties to the foreign trusts, and in exchange for their Unit Capital Certificates received 100 ownership units of Concord-Eton, with 50 units in the name of each petitioner. Petitioners later transferred these ownership units to their two minor children with petitioners as custodians. In summary, therefore, by the end of 1987, all of petitioners' real and personal properties were titled in Compass-Oxford, as beneficial or legal owner. Compass-Oxford was owned by Lido-Jefferson. Lido-Jefferson was owned by Concord-Eton, and Concord-Eton was owned by petitioners as custodians for their two children. For the year 1987, petitioners entered into a lease with Compass-Oxford, as lessor, for Parcels 1 through 5. For the five properties, petitioners agreed to pay a rental of $ 10,000 on or before December 31, 1987. As noted earlier, Parcels474 1 through 5 included petitioner's law office, the rental properties in the vicinity of the law office, and the Florida condominium. The record is silent as to the reasons for the disparities in the rents petitioners agreed to pay for these properties for 1987 compared to the $ 20,000 they agreed to pay for 1986 and the $ 33,500 they agreed to pay for 10 months of 1985. The lease was to continue indefinitely "until terminated by either party". As part of the lease, petitioners were to pay all taxes, assessments, licenses, and inspection fees on the leased properties and were responsible for all inside and outside repairs or maintenance. In a second lease, petitioners leased their personal residence from Compass-Oxford for $ 1,500 per year. All of the bank accounts for the relevant entities were opened on December 29, 1987. Pursuant to the 1987 lease of Parcels 1 through 5, as discussed previously, on December 30, 1987, petitioner issued two checks out of his personal law practice account, totaling $ 10,000, to Compass-Oxford. Both checks were deposited into the Compass-Oxford account on December 30, 1987, and were honored. This money was distributed to Lido-Jefferson by two475 $ 5,000 checks, dated December 29 and December 30, 1987, drawn on the Compass-Oxford account and signed by petitioner. These checks were then deposited into the Lido-Jefferson account on December 30, 1987. There were no other deposits to or distributions from the Compass-Oxford account from December 29, 1987, to November 30, 1988. On December 30, 1987, two checks of $ 3,500 and $ 6,500 were drawn on the Lido-Jefferson account, signed by Robert Temple. However, except for the signature of Mr. Temple, both checks appear to have been prepared by petitioner. These checks, totaling $ 10,000, were deposited into the Concord-Eton account on December 30, 1987. The only other activity in the Lido-Jefferson account was a deposit on December 30, 1988, from an unknown source, and on the same day a check was made payable to Concord-Eton for approximately the same amount. From December 1987 through September 1989, there were deposits to the Concord-Eton account which totaled $ 33,717.84. Of that amount, $ 10,000 can be traced from petitioners. The source of the balance is unknown. Petitioners directly received $ 19,600 of those funds through four checks made out to Frank Bodor or Gina476 Bodor in 1988 and 1989. In addition, an account in the name of Adena Enterprises, Oxford Charter Corporation, Trustee (Adena-Oxford), received $ 13,697 of the Concord-Eton funds in 1988 and 1989. Petitioners also opened the Adena-Oxford account and had sole signatory authority on that account. All of the ownership units of Adena-Oxford were held by Lido-Jefferson, and the ownership units of Lido-Jefferson were held by Concord-Eton, the latter of which, as noted above, was owned by petitioners as custodians for their two children. Petitioners explained the transfers from the Concord-Eton account as loans made to petitioner and Adena-Oxford. On their 1987 Federal income tax return, petitioners reported the income and expenses relating to Parcels 1 through 5, which they leased from Compass-Oxford. The income and expenses from these properties were reported on Schedule E of petitioners' return as income and expenses from rental activities. The five properties were separately identified on Schedule E by street number. The income consisted of rents petitioners received from subleases of the apartments and offices and the Florida condominium. Included in the expenses was the $ 10,000477 petitioners paid Compass-Oxford for rent pursuant to the lease of the five properties. The properties listed on Schedule E did not include petitioners' residence, nor did petitioners claim as a deduction the $ 1,500 for rental of their residence. The Schedule E properties, however, did include the Florida condominium (Parcel 5), from which petitioners reported $ 3,600 rental income and, as to which, a portion of the $ 10,000 rental expense was claimed as a deduction. In the notice of deficiency, respondent made only one adjustment to petitioners' 1987 return. That adjustment was the disallowance of the $ 10,000 rental expense claimed for the five properties. Respondent's position is that petitioners were the owners of these properties, and that the transfers or quitclaim deeds wherein petitioners transferred their properties to the foreign entities were shams and, therefore, were without economic effect. In lieu of a rental expense deduction, respondent allowed a depreciation deduction on three of the properties, totaling $ 1,927.96. At trial, the parties stipulated that, in the event the Court sustained respondent on this issue, petitioners were entitled to depreciation deductions478 on four of the properties, totaling $ 2,815.97. Respondent did not stipulate to a depreciation deduction for the Florida condominium; however, the parties agreed to the depreciable basis and the depreciable rate in the event the Court finds petitioners are otherwise entitled to a depreciation deduction for this property. Respondent made no adjustments to any of the other income and expense items reported on Schedule E or any other items on petitioners' 1987 return, except for a computational adjustment of petitioners' Schedule A medical expenses. In the stipulation, the parties agreed that, for 1987, the aggregate fair market rental value of Parcels 1 through 5 was not less than $ 10,000, and "the rental value of those properties is not in dispute". On June 1, 1990, petitioner was contacted by Carl Gentile, an IRS agent who was to audit petitioners' 1987 income tax return. At that time, a meeting was scheduled for August 8, 1990. On June 4, 1990, Agent Gentile mailed to petitioners a standard form information document request (IDR) which requested various documents, including copies of petitioners' bank statements, canceled checks, and deposit slips as to all bank accounts "which479 you maintained * * * or over which you had signature authority." On August 8, 1990, petitioner met with Agent Gentile as scheduled. Petitioner brought with him copies of the two canceled checks to Compass-Oxford totaling $ 10,000, which represented the real estate rental expense deduction claimed on Schedule E of petitioners' 1987 return. Petitioner did not present a copy of the lease; however, at the request of the agent, petitioner agreed to submit a copy of the lease. In addition, petitioner did not mention or bring any documents regarding the various accounts over which petitioners had signature authority. From the questions asked by Mr. Gentile, it was obvious that the focus of his audit would be on petitioners' involvement with the foreign trusts. On August 8, 1990, Agent Gentile prepared and gave petitioner another handwritten IDR requesting information related to petitioners' involvement with Nassau Life and the Compass-Oxford lease. This request was much more specific than the standard form IDR sent on June 4, 1990. The information requested was to be returned by August 17, 1990. Agent Gentile did not receive any further information prior to August 22, 1990, when480 he telephoned petitioner with additional questions. In response to those questions, petitioner stated that Compass-Group owned the properties which he and his wife leased and which they subleased to other tenants. Petitioner admitted he had signature authority over the Compass-Oxford bank account, which he could exercise only with the trustee's permission. When asked how he would get permission from the trustee, petitioner answered he did not know. Mrs. Bodor, as the designated secretary of Compass-Oxford, Adena-Oxford, and Concord-Eton, received and reconciled the bank statements of these entities; however, petitioners never provided Agent Gentile with copies of the lease involving the five properties, bank statements, canceled checks, or deposit slips for the accounts of Compass-Oxford, Adena-Oxford, Lido-Jefferson, or Concord-Eton. Subsequently, in September 1990, Agent Gentile summonsed and received the bank records of Compass-Oxford and discovered that distributions were made to Lido-Jefferson by checks signed by petitioner. Thereafter, in order to trace the funds from Lido-Jefferson, Agent Gentile issued a summons to the bank where the Lido-Jefferson account was located. 481 Pursuant to a petition to quash the summons, filed in the names of Lido-Jefferson and petitioners, a hearing was held in the United States District Court for the Northern District of Ohio in Akron, Ohio, on July 8, 1991. The challenge to the summons was unsuccessful. Petitioners provided no further documentation to the IRS agent. On December 10, 1990, Mr. Gentile called petitioner and advised him that the $ 10,000 rental expense claimed on Schedule E of their 1987 return would be disallowed, and that respondent would assert the additions to tax for fraud under section 6653(b). The first issue is whether petitioners are entitled to a deduction of $ 10,000 claimed as real estate rental expense on Schedule E of their 1987 income tax return for the five properties which petitioners transferred to the foreign trusts. Respondent determined that the $ 10,000 was not allowable as a deduction for the reason that the transfers by petitioners to the "trusts" were sham transactions and had no economic substance. Petitioners contend the transfers were valid and should be recognized for tax purposes. They assert that their purpose in transferring their properties was to shield them from482 liability to third parties, which they feared could arise out of petitioner's law practice. Thus, petitioners contend their lease of these properties should be recognized, and the rental payments should be held to be deductible. As noted earlier, respondent agrees that, in lieu of a rental deduction, petitioners are entitled to a depreciation deduction on four of the five properties involved. With respect to the deficiency in tax, the determinations by respondent in a notice of deficiency are presumed correct, and the burden of proof is on the taxpayer to prove that the determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). A fundamental principle of income tax law is that economic substance prevails over form. Gregory v. Helvering, 293 U.S. 465 (1935). In order to support a deduction, the requisite "payment" must be one in substance, not merely in form, and must be made to an entity with economic substance which is recognized for Federal tax purposes. Professional Services v. Commissioner, 79 T.C. 888">79 T.C. 888 (1982). "When the form of the transaction has not in483 fact altered any cognizable economic relationships, we will look through that form and apply the tax law according to the substance of the transaction." Zmuda v. Commissioner, 79 T.C. 714">79 T.C. 714, 720 (1982), affd. 731 F.2d 1417">731 F.2d 1417 (9th Cir. 1984). This rule applies regardless of whether the entity has a separate existence recognized under State law and whether, in form, it is a trust, a common-law business trust, or some other form of jural entity. Id.; Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742 (1970), affd. 445 F.2d 985">445 F.2d 985 (10th Cir. 1971). As stated in Lazarus v. Commissioner, 58 T.C. 854">58 T.C. 854, 864 (1972), affd. 513 F.2d 824">513 F.2d 824 (9th Cir. 1975), "Technical considerations, niceties of the law of trusts or conveyances, or the legal paraphernalia which inventive genius may construct" must not frustrate an examination of the facts in light of the economic realities. Helvering v. Clifford, 309 U.S. 331">309 U.S. 331, 344 (1940). Moreover, "sham transactions" having no economic effect cannot be recognized for tax purposes. 484 Sandvall v. Commissioner, 898 F.2d 455">898 F.2d 455, 458 (5th Cir. 1990) (quoting Thompson v. Commissioner, 631 F.2d 642">631 F.2d 642, 646 (9th Cir. 1980), affg. T.C. Memo. 1989-56 and T.C. Memo 1989-189">T.C. Memo. 1989-189. The Court finds the transactions between petitioners and the entities described above are without economic substance. It is clear that there were no independent trustees functioning in a fiduciary role with regard to Compass-Oxford, Lido-Jefferson, Concord-Eton, or Adena-Oxford. In actuality, petitioners directed the creation and operation of the entities which, on paper, held title to the properties at issue. Neither petitioners' self-serving testimony nor the preprinted forms and certificates presented to the Court change this conclusion. Petitioners were the only individuals who acted for the entities with the exception of Robert Temple. The Court finds that the checks were signed by Robert Temple for Lido-Jefferson only as a formality pursuant to petitioners' overall plan. On all bank accounts, petitioners' law office was listed as the entities' address, and Mrs. Bodor reconciled485 all of the bank statements. Petitioners always remained in possession of the properties and controlled the properties as they had done before the transfers. Once the Court looks through the layers of paper creating the tier structure of the domestic and foreign trust shell entities through which the funds were channeled, no economic relationships were altered, and petitioners or their minor children remained the owners of the properties involved. Payments to "economic nullities" are not contemplated by section 162. Markosian v. Commissioner, 73 T.C. 1235">73 T.C. 1235, 1245-1246 (1980). Furthermore, as the true owners of the equity in the properties, petitioners could not "lease" the properties from themselves. See sec. 162(a)(3). The Court agrees with respondent's determination that the transfers by petitioners were shams and had no economic effect. Thus, petitioners are not entitled to claim $ 10,000 as a real estate rental expense deduction on their 1987 income tax return. Respondent, therefore, is sustained on this determination. Nevertheless, as owners of property held for rental, and for that portion of the property used by petitioner as his law office, 486 petitioners are entitled to deductions for the related depreciation of the properties. It was stipulated, and the Court agrees, that, since "petitioners are deemed to be owners of" Parcels 1, 2, 3, and 4, petitioners are entitled to depreciation deductions of $ 1,091.49, $ 410.36, $ 426.12, and $ 888, respectively, for 1987. As to Parcel 5, the condominium located at 4950 Gulf Boulevard, St. Petersburg Beach, Florida, the stipulation set forth the cost basis of the property, the date it was acquired, and the straight-line depreciation rate of the property. Respondent did not stipulate that petitioners would be entitled to a depreciation deduction for this property for 1987. Respondent's position is that petitioners are not entitled to a depreciation deduction because the requirements for deductibility under sections 167 and 280A have not been satisfied. The notice of deficiency did not disallow other expenses claimed by petitioners with respect to this property except for the claimed rental expense. Petitioners reported $ 3,600 rental income from this property for 1987 and claimed expenses of $ 6,858.07, exclusive of the rental expense. On this record, the Court finds that 487 petitioners satisfied the requirements of sections 167 and 280A, and, accordingly, petitioners are entitled to a depreciation deduction for 1987 with respect to their Florida condominium. 3The other issue is whether petitioners are liable for additions to tax for fraud under section 6653(b)(1)(A) and (B) for 1987. Respondent bears the burden of proving fraud488 by clear and convincing evidence. Rule 142(b); sec. 7454(a). Respondent's position is that petitioners fraudulently made false or misleading statements, attempted to conceal their assets through their involvement with the tiered foreign-based trust structure, back-dated documents, and failed to cooperate with taxing authorities. Petitioners' position is that the primary motive in transferring their properties into trusts was to protect their assets from potential tort and legal malpractice claims; that no actions were taken to conceal or misrepresent information to the IRS; that all relevant information was presented on their 1987 income tax return, including reported rental income; and that the transfer and leaseback transactions were entered into without any consideration for the tax effect.Fraud exists only when (1) there is an underpayment of taxes, and (2) the taxpayer knowingly underpaid the taxes with the specific intent to evade a part of the taxes underpaid. Wright v. Commissioner, 84 T.C. 636">84 T.C. 636, 639-643 (1985). Thus, in order to prove that an underpayment is due to fraud, respondent must show that the taxpayer intended to evade a tax known489 to be due by conduct designed to conceal, mislead, or otherwise prevent the collection of such tax by respondent. Patten v. Commissioner, 799 F.2d 166">799 F.2d 166, 171 (5th Cir. 1986), affg. T.C. Memo. 1985-148; Recklitis v. Commissioner, 91 T.C. 874">91 T.C. 874, 909 (1988). The existence of fraudulent intent is a factual question to be decided on the basis of an examination of the entire record. Recklitis v. Commissioner, supra at 909; Grosshandler v. Commissioner, 75 T.C. 1">75 T.C. 1, 19 (1980). It may never be presumed but must be established by affirmative evidence. Beaver v. Commissioner, 55 T.C. 85">55 T.C. 85, 92 (1970). Because direct proof of a taxpayer's intent is rarely available, however, fraud may be established by circumstantial evidence. Grosshandler v. Commissioner, supra at 19; Gajewski v. Commissioner, 67 T.C. 181">67 T.C. 181, 200 (1976), affd. without published opinion 578 F.2d 1383">578 F.2d 1383 (8th Cir. 1978). However, a finding of fraud cannot be based upon490 circumstantial evidence which creates merely a suspicion of fraud. Carter v. Campbell, 264 F.2d 930">264 F.2d 930, 935 (5th Cir. 1959); Beaver v. Commissioner, supra.In considering the existence of fraud, the courts have identified certain so-called badges of fraud which are indicative of culpable behavior. These badges include: (1) An understatement of income; (2) maintaining inadequate records; (3) failure to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealment of assets; (6) failure to cooperate with tax authorities, Bradford v. Commissioner, 796 F.2d 303">796 F.2d 303, 307-308 (9th Cir. 1986), affg. T.C. Memo. 1984-601; (7) making false or inconsistent statements to revenue personnel, Grosshandler v. Commissioner, supra at 20; and (8) filing of false documents, Stephenson v. Commissioner, 79 T.C. 995">79 T.C. 995, 1007 (1982), affd. 748 F.2d 331">748 F.2d 331 (6th Cir. 1984). Also among the factors which may be considered are the taxpayer's intelligence, education, training, and experience. 491 See Plunkett v. Commissioner, 465 F.2d 299">465 F.2d 299, 303 (7th Cir. 1972), affg. T.C. Memo. 1970-274; Drobny v. Commissioner, 86 T.C. 1326">86 T.C. 1326, 1349 (1986). An understatement of income may be established by an overstatement of deductions. Professional Services v. Commissioner, 79 T.C. at 930. As noted above, respondent made only one adjustment to petitioners' 1987 return. That adjustment was the disallowance of the $ 10,000 rental expense claimed by petitioners as a deduction. The Court has sustained respondent on this issue for the reason that petitioners' property transfers were shams and had no economic effect. This alone, however, does not establish fraud. Respondent agreed, in the stipulation, that the $ 10,000 claimed as a rental expense for the subject properties represented the fair rental value of the properties had the properties been leased in an arm's-length relationship between a lessor and a lessee. To the extent petitioners understated their income by virtue of the claimed rental expense, which exceeded their allowable depreciation, the Court does not consider492 the underpayment of taxes resulting therefrom as being fraudulent. Petitioners did not conceal their assets. The five properties in question were all identified by street number on Schedule E of petitioners' return. The Court is not convinced that, in the conferences between petitioner and the IRS agent, any information was concealed or that the agent was misled. Petitioner was not as forthcoming as he could have been in presenting documentary evidence or in explaining the property transfers; however, he provided sufficient information by which the agent proceeded through other sources to make his determinations. The Court does not consider as significant that petitioner failed, at his first meeting with the agent, to disclose that he had signatory authority on the Compass-Oxford bank account. The IDR which had been served on petitioner was in general terms, and, prior to the first conference, petitioner was not advised that the focus of the audit would be on the foreign trust transactions. At the conference and thereafter, although in piecemeal fashion, the agent obtained enough information from petitioner from which the agent concluded that the transactions were of no economic493 effect, and that the additions to tax for fraud would be determined. On the whole, the Court's perception of respondent's position is that there was a suspicion of fraud; however, suspicion alone will not sustain a finding of fraud. Carter v. Commissioner, supra. The Court envisions respondent's position on a parallel with respondent's position in Pauli v. Commissioner, T.C. Memo 1989-481">T.C. Memo. 1989-481, where this Court noted: Our reading of this record causes us to conclude that respondent's principal argument is that participation in the ALA/Dahlstrom plan to avoid taxes through the use of domestic and foreign trust organizations was, per se, evidence of fraud. We disagree. See Melvin L. Cochran, D.D.S. Inc. v. Commissioner, T.C. Memo 1989-102">T.C. Memo. 1989-102.On this record, the Court concludes that respondent has not established by clear and convincing evidence that petitioners are liable for the additions to tax for fraud under section 6653(b)(1)(A) and (B) for 1987. Petitioners, therefore, are sustained on this issue. Decision will be entered under*494 Rule 155.Footnotes1. All section references are to the Internal Revenue Code in effect for the year at issue. All Rule references are to the Tax Court Rules of Practice and Procedure.↩2. There were documents in which Nassau Life resigned as trustee of the foreign entities which held petitioners' property and appointed Oxford Charter Corporation as successor trustee.↩3. Sec. 167(a) provides generally that there shall be allowed as a depreciation deduction a reasonable allowance for depreciation "(2) of property held for the production of income." Sec. 280A(a) generally disallows a deduction, with certain exceptions, attributable to the use of a dwelling unit which is used by the taxpayer during the taxable year as a "residence". Under sec. 280A(d)↩, the term "use as residence" is defined generally as the use of a dwelling by a taxpayer for personal purposes for a number of days in any year which exceeds the greater of 14 days or 10 percent of the number of days during the year for which the unit was rented at a fair rental.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621979/	ALBERT AND VIVIAN CHEESMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentCheesman v. CommissionerDocket No. 17334-88United States Tax CourtT.C. Memo 1990-350; 1990 Tax Ct. Memo LEXIS 362; 60 T.C.M. (CCH) 96; T.C.M. (RIA) 90350; July 11, 1990, Filed 362 Decision will be entered for the respondent. Albert Cheesman, pro se. Randall B. Pooler, for the respondent. PARR, Judge. PARRMEMORANDUM FINDINGS OF FACT AND OPINION Respondent determined deficiencies in and additions to petitioners' Federal income tax as follows: Additions to tax, sections 1YearDeficiency6653(b)(1)6653(b)(2)66611984$ 7,441$ 3,992 $ 1,86019859,4864,673 2,372363 After concessions by petitioners regarding Schedule C deductions, the issues for decision are: 1) Whether petitioners had unreported income in the amounts of $ 28,543 and $ 28,492 for the years 1984 and 1985, respectively; and 2) whether petitioners are liable for additions to tax under sections 6653(b)(1), 6653(b)(2), and 6661 for each of the years in issue. Additions to tax for fraud, under section 6653(b), apply solely to petitioner Albert Cheesman. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits are incorporated herein by this reference. Petitioners, who are married, filed joint Federal income tax returns for 1984 and 1985. When they filed their petition, petitioners364 resided in Bradenton, Florida. In 1984 and 1985, petitioners resided in Arcadia, Florida, along with their two sons, who were approximately 17 to 20 years old. Petitioner Albert Cheesman (Mr. Cheesman) operated a videotape rental business and a pizza restaurant in Arcadia, Florida. In 1985, petitioner Vivian Cheesman (Mrs. Cheesman) opened a video rental business in Bradenton, Florida. Petitioners maintained a cash register in each of the businesses, but did not keep the cash register tape of their daily receipts. No bank accounts were kept for any of the businesses. The only records of the income each business earned was a sheet of paper with daily totals noted. Most of the sales were cash sales, and any checks received by a business were deposited in petitioners' personal checking account. Petitioners did not accept charge cards as payment. For the years in question, petitioners reported income (loss) from the businesses as follows: 19841985Schedule C - Pizza restaurant$ 5,447$ (1,218)Schedule C - Video Arcadia1,33210,718 Schedule C - Video Bradenton- 0 -4,907 $ 6,779$ 14,407 The only other source of funds received365 by petitioners was $ 2,122 in loan proceeds during 1984. No nontaxable or excludable income, gifts, inheritances, or legacies were received during the tax years in question. The parties stipulate that petitioners made the following applications of funds: 19841985Bank Accounts:First State Bank (increase)$ 328$ 264 Florida Federal (increase)- 0 -1,318 Inventory:Pizza restaurant505(1,066)Video - Arcadia11,9463,928 Video - Bradenton- 0 -16,959 Personal Living Expenses:Housing - Insurance172180 - Electric1,2561,273 Food - Groceries2,3402,600 Transportation - Insurance564564 - Licenses10768 Ordinary - Clothing178158 - Grooming3030 - Other151103 Payments - AVCO1,392- 0 - - GMAC2,100175 - Finance America1,1403,286 - Finance America1,854- 0 - - Mutual10,89210,569 $ 34,955$ 40,409 366 Petitioners owned their home in Arcadia, Florida, and five cars. The home, more than 50 years old, was described by Mr. Cheesman as a "dump." All the cars were at least 10 years old. Petitioners also owned four pieces of real estate in Indiana. Three of the properties were residential and one commercial. Petitioners did not rent or lease any of the properties in Indiana. Starting in 1987, Revenue Agent Sutherland examined petitioners' income tax returns for 1984 and 1985. Agent Sutherland met with Mr. Cheesman on four separate occasions. To document income, petitioners supplied Agent Sutherland with a sheet of paper listing their purported receipts each day. To document expenses, petitioners gave Agent Sutherland a stack of incomplete invoices. Agent Sutherland determined that petitioners had unreported income in the amount of $ 28,543 in 1984 and $ 28,492 in 1985, by means of an indirect method of proof -- the source and application of funds method. OPINION The first issue for our consideration is whether petitioners understated their taxable income in the amounts determined by respondent during 1984 and 1985. Using the source and application of funds method of367 reconstructing income, respondent determined that petitioners understated their taxable income for 1984 and 1985. In the absence of adequate books and records it is well established that the Commissioner has the authority to compute the income of a taxpayer by whatever method, in the opinion of the Commissioner, clearly reflects income. Section 446(b); Holland v. United States, 348 U.S. 121">348 U.S. 121 (1954). The source and application of funds method is clearly an acceptable method. Taglianetti v. United States, 398 F.2d 558">398 F.2d 558, 562 (1st Cir. 1968), affd. per curiam on another issue 394 U.S. 316">394 U.S. 316 (1969); Llorente v. Commissioner, 74 T.C. 260">74 T.C. 260, 267 (1980), affd. in part and revd. in part 649 F.2d 152">649 F.2d 152 (2d Cir. 1981); Skirpan v. Commissioner, T.C. Memo 1983-439">T.C. Memo. 1983-439. The source and application of funds method is based on the assumption that the amount by which a taxpayer's application of funds during a taxable period exceeds his reported source of funds for that same period has taxable origins. The taxpayer may show the excess application is attributable to such nontaxable items as loans, gifts, or cash on368 hand at the beginning of the period. Jones v. Commissioner, T.C. Memo. 1983-110. Petitioners do not contest the method used by respondent to recompute their income. Instead they challenge the figures respondent used in arriving at unreported income. Petitioners claim they had a substantial amount of cash on hand during 1984 and 1985 and that in calculating the application of funds respondent overestimated 5 areas; these are (1) $ 130 for the cost of meals out, (2) $ 260 for miscellaneous or other meals, (3) $ 300 for cost of repairs on their house, (4) $ 1300 for automobile gas, and (5) $ 500 for car repairs. Respondent determined the amount of unreported income by estimating petitioners' application of funds. Agent Sutherland talked with Mr. Cheesman about the family's lifestyle and computed totals for each expense. In determining income, Agent Sutherland did not include any figure for beginning cash on hand. Petitioner has the burden of proof to establish a cash hoard existed and the true amount of the living expenses in question. See Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933); Rule 142(a). To disprove respondent's determination, petitioners369 rely solely on their testimony. This Court is not bound to accept testimony at face value if it is inherently improbable or manifestly unreasonable. Quock Ting v. United States, 140 U.S. 417">140 U.S. 417, 420-421 (1891); Dougherty v. Commissioner, 60 T.C. 917">60 T.C. 917, 932-933 (1973). In the present case, petitioners' testimony is self-serving, uncorroborated, conflicting, and evasive. Accordingly, we conclude that petitioners have failed to meet their burden of proof. Petitioners claim that, in 1972, while living in Indiana, they acquired a substantial cash hoard, which they buried either under their home or in the backyard. Petitioners claim that this cash hoard amounted to about $ 90,000 in 1979 when they moved to Florida. Amazingly, petitioners claim they left the money in the vacant home in Indiana when they moved to Florida. To retrieve the money, petitioners took several trips to Indiana, collecting $ 15,000 - $ 20,000 each time. The last trip occurred in 1986. It seems incredible that a person would leave $ 90,000 in a vacant home when he or she were located hundreds of miles away. It is also hard to understand why a person would not retrieve all the370 money at one time, especially since it was supposedly kept in a safe-type box that could easily be carried. Several times Mrs. Cheesman refused to answer questions about how and where the cash hoard was kept in Indiana, and in Arcadia, Florida. This might be somewhat understandable if the cash hoard still existed or was in the same location; however, what remains of the supposed cash hoard has been moved to Bradenton, Florida. Furthermore, Mr. Cheesman testified that he and his wife were the only people to know the whereabouts and existence of the cash hoard. Mrs. Cheesman contradicted this statement when she testified that her husband had told one of their sons where the money was buried, and she observed the son take money from the cash hoard. Mr. Cheesman later corrected his testimony to match Mrs. Cheesman's but the son was not used as witness to support this claim. Failure to call the son as a witness to corroborate their testimony gives rise to a presumption that the son's testimony, if given, would have been unfavorable to petitioners' case. Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946), affd. 162 F.2d 513">162 F.2d 513 (10th Cir. 1947).371 Mr. Cheesman also testified that the location of the cash hoard in 1984 and 1985 was stated in his and Mrs. Cheesman's will. Although respondent suggested it, petitioners failed to bring the will to trial as evidence, leaving the conclusion that it did not exist or did not contain the stated information. Regarding the living expenses, petitioners testified they never ate out, drove only two miles a day, did all their own car repairs, and never repaired their home during the two years in question. For a family of four, with five cars, to drive only two miles a day seems remarkable. It is also hard to believe that the two boys never used the cars except to drive to work. Petitioners also testified that they did all their own car repairs. However, in calculating car repair expenses the revenue agent took this into account and included only the cost of parts, not labor. For calculating meals, the revenue agent testified that the Cheesmans had previously stated they ate out occasionally, so a minimal amount of $ 130 was expensed for "meals out". Since the Cheesmans had one son in school an amount of $ 260 was charged for school lunches in the "other meals" category. Petitioners372 now claim all meals were eaten at home, and these two amounts should not appear in the source and application figure. However, we find this testimony unconvincing. Petitioners also claim they never repaired their house in the two years in question. We find this unbelievable, since the house was described as a "dump." Furthermore, it is inconceivable that a family would live in a house they consider a "dump" if a cash hoard of $ 90,000 were available for repairs. Therefore, for all the reasons stated above, we find petitioners had unreported income of $ 28,543 in 1984 and $ 28,492 in 1985. We next consider whether petitioner Mr. Cheesman is liable for fraud under section 6653(b)(1) and 6653(b)(2). The existence of fraud is a question of fact to be resolved upon consideration of the entire record. Gajewski v. Commissioner, 67 T.C. 181">67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d 1383">578 F.2d 1383 (8th Cir. 1978); Estate of Pittard v. Commissioner, 69 T.C. 391">69 T.C. 391 (1977). Fraud is not to be imputed or presumed. Beaver v. Commissioner, 55 T.C. 85">55 T.C. 85, 92 (1970); Otsuki v. Commissioner, 53 T.C. 96">53 T.C. 96 (1969). Respondent373 has the burden of proving that some portion of the underpayment is due to fraud by clear and convincing evidence. Sec. 7454(a); Rule 142(b). To satisfy his burden of proof, respondent must show two things. First, respondent must prove that an underpayment exists; and second, respondent must show that the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Parks v. Commissioner, 94 T.C. (1990); Rowlee v. Commissioner, 80 T.C. 1111 (1983). In proving the first prong of the fraud test, respondent cannot rely on a taxpayer's failure to carry his burden of proof of the nonexistence of a deficiency. Petzoldt v. Commissioner, 92 T.C. 661">92 T.C. 661, 700 (1989); Estate of Beck v. Commissioner, 56 T.C. 297">56 T.C. 297, 363 (1971). Respondent must satisfy his burden of proving the first prong of the fraud test, i.e., an underpayment, when the allegations of fraud are intertwined with unreported and indirectly reconstructed income, in one of two ways. Respondent may prove an underpayment by proving a likely source of the unreported income. Holland v. United States, supra;374 Nicholas v. Commissioner, 70 T.C. 1057 (1978). Alternatively, where the taxpayer alleges a nontaxable source, respondent may satisfy his burden by disproving the nontaxable source so alleged. United States v. Massei, 355 U.S. 595">355 U.S. 595 (1958); Kramer v. Commissioner , 389 F.2d 236">389 F.2d 236, 239 (7th Cir. 1968), affg. a Memorandum Opinion of this Court. In this case, respondent has shown that a likely source of the unreported income was the three businesses petitioners operated. Petitioners operated these businesses on a cash basis and rarely accepted payment in any form other than cash. Furthermore, adequate records were not maintained to establish the exact amount of income earned by each business. Cash register receipts were discarded and the only record of income kept was a list noting purported receipts for the day. Because of the lack of records, it is very likely the businesses were the source of any unreported income. In disproving the nontaxable sources, respondent must show petitioner's allegation of a cash hoard is false. Respondent may disprove the cash hoard by showing that his reconstruction of income is accurate combined with375 a showing that petitioner's allegation of a cash hoard is inconsistent, implausible, and not supported by objective evidence in the record. Parks v. Commissioner, supra.Respondent's reconstruction of petitioners' income using the source and application of funds method was accurate and reliable. Petitioner stipulated to all of the reported sources of income and all of the applications of funds except for 5 small personal living expenses. Furthermore, petitioners' allegation of a nontaxable cash hoard is inconsistent and implausible. Other than petitioners' testimony, the record reveals no evidence that the cash hoard existed. Petitioners' claim to have hoarded the cash for safety reasons, rather than depositing it in a bank, is not credible in light of the fact that petitioners did have other bank accounts. Additionally, one wonders how it is safer to keep the money in a vacant home rather than a bank. Therefore, we conclude that petitioners' claim of a cash hoard is incredible, implausible, and contrary to the objective evidence. Under the second prong of the fraud test, respondent must prove by clear and convincing evidence that petitioner had the requisite fraudulent376 intent. Parks v. Commissioner, supra. Fraudulent intent may be proven by circumstantial evidence, because direct proof of the taxpayer's intent is rarely available. Rowlee v. Commissioner, supra.The taxpayer's entire course of conduct may be examined to establish the requisite fraudulent intent. Stone v. Commissioner, 56 T.C. 213">56 T.C. 213, 223-224 (1971); Otsuki v. Commissioner, supra at 105-106. The intent to conceal or mislead may be inferred from a pattern of conduct. See Spies v. United States, 317 U.S. 492">317 U.S. 492, 499 (1943). A pattern of consistent underreporting of income, Holland v. United States, supra at 137; the making of false and inconsistent statements to revenue agents, Grosshandler v. Commissioner, 75 T.C. 1">75 T.C. 1, 20 (1980); implausible or inconsistent explanations of behavior, Bradford v. Commissioner, 796 F.2d 303">796 F.2d 303 (9th Cir. 1986); and failure to maintain complete and accurate books and records all justify the inference of fraud. Parks v. Commissioner, supra; Cerilli v. Commissioner, T.C. Memo 1983-773">T.C. Memo 1983-773. In the present377 case, petitioners failed to maintain adequate books and records. All three businesses were equipped with cash registers that were used. However, petitioners did not keep the cash register tapes. Petitioners would total the registers at the end of each day and note the amount in a notebook, discarding the register tape. The intentional destroying of business documents indicates an intent to conceal income. Schwarzkopf v. Commissioner, 246 F.2d 731">246 F.2d 731, 734 (3d Cir. 1957), affg. a Memorandum Opinion of this Court; Catalanotto v. Commissioner, T.C. Memo. 1984-215. Additionally, petitioners' testimony concerning the cash hoard is inconsistent and unlikely. Several times during the trial they made contradictory statements, and other times they were purposely evasive. In addition, the record contains no documentary or other credible evidence supporting petitioners' claim that the cash hoard existed or when the cash was earned or otherwise obtained. Respondent presented evidence showing that for the past 10 years, 1973 to 1983, petitioners had small amounts of income and paid little or no income tax, and therefore could not have accumulated a $ 90,000378 cash hoard. After many requests by respondent, fourteen days before trial petitioner finally named 1972 as the date when the cash hoard was purportedly accumulated. Respondent was thus unable to obtain income tax records for 1972 before trial. Petitioners offered no evidence to corroborate their claim, and we do not believe it. Respondent has satisfied his burden of proving both prongs of the fraud test by clear and convincing evidence. We find petitioner Mr. Cheesman intentionally failed to report taxable income in 1984 and 1985, and he is liable for the additions to tax for fraud. The last issue we must decide is whether petitioners are liable for the addition to tax set forth in section 6661. Section 6661 imposes an addition to tax if there is a substantial understatement of income tax for a taxable year. The amount of such additions assessed after October 21, 1986, is equal to 25 percent of the amount of any underpayment attributable to such understatement. Sec. 6661(a); Pallottini v. Commissioner, 90 T.C. 498">90 T.C. 498 (1988). A substantial understatement is one which exceeds the greater of 10 percent of the tax required to be shown on the return or $ 5,000. Sec. 379 6661(b). If petitioners' understatement of income is substantial within the meaning of section 6661(b), they are liable for the section 6661 addition unless such understatement can be reduced by section 6661(b)(2)(B). Section 6661(b)(2)(B) provides that the understatement shall be reduced by the portion of the understatement which is attributable to (i) the tax treatment of an item if there is or was substantial authority for such treatment, or (ii) the tax treatment of items with respect to which relevant facts are adequately disclosed. By either test of section 6661(b), petitioners' understatements are substantial. Petitioners had no authority for failing to report cash income in 1984 or 1985, nor did they disclose any facts pertaining to such income on their 1984 or 1985 returns or in a statement attached to their returns for the two years. Therefore, the addition to tax cannot be reduced through application of section 6661(b)(2)(B) and petitioners are liable for the section 6661 addition to tax. For the foregoing reasons, Decision will be entered for the respondent. Footnotes1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended, and in effect for the years at issue. All Rule references are to the Tax Court Rules of Practice and Procedure. * 50 percent of the interest due on the deficiencies.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621980/	GEORGE DEUKMEJIAN and JEAN DEUKMEJIAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentDeukmejian v. CommissionerDocket No. 5237-79.United States Tax CourtT.C. Memo 1981-24; 1981 Tax Ct. Memo LEXIS 723; 41 T.C.M. (CCH) 738; T.C.M. (RIA) 81024; January 26, 1981. Charles S. Wulke, for the petitioners. Edward M. Robbins, Jr., for the respondent. SCOTT MEMORANDUM FINDINGS OF FACT AND OPINION SCOTT, Judge: Respondent determined a deficiency in petitioners' income tax for the calendar year 1974 in the amount of $ 20,692. In an amended answer respondent claimed an increase in the deficiency making the total deficiency $ 30,314.20. One of the issues raised by the pleadings has been conceded by petitioners, leaving for decision the following: (1) the fair market value of a parcel of real property donated by petitioners to the City of Glendora, California, on December 30, 1974, and (2) if the fair market value of the property exceeds petitioners' basis in the property, whether their charitable contribution is limited by section 170(e)(1)(A), I.R.C. 1954, 1 because the property had not been held for more than six months. FINDINGS OF FACT Some of the facts have been stipulated and are726 found accordingly. George Deukmejian (petitioner) and Jean Deukmejian, husband and wife, resided in Glendora, California, at the time of the filing of their petition in this case. Petitioners filed their joint Federal income tax return for the calendar year 1974 with the Internal Revenue Service. Petitioner is a businessman and during the year here has been conceded by petitioners, leaving for decision the following: (1) the fair market value of a parcel of real property donated by petitioners to the City of Glendora, California, on December 30, 1974, and (2) if the fair market value of the property exceeds petitioners' basis in the property, whether their charitable contribution is limited by section 170(e)(1)(A), I.R.C. 1954, 1 because the property had not been held for more than six months. FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. George Deukmejian (petitioner) and Jean Deukmejian, husband and wife, resided in Glendora, California, at the time of the filing727 of their petition in this case. Petitioners filed their joint Federal income tax return for the calendar year 1974 with the Internal Revenue Service.Petitioner is a businessman and during the year here in issue was employed by an automobile dealership. In late 1973 or early 1974, petitioner learned of a large tract of property (Girl Scout property) consisting of 257.83 acres located in the foothills of the San Gabriel mountains which was for sale. The property was owned by the Angeles Girl Scout Council and petitioner was told to contact Mr. H. Fred Christie, who was at that time the director and treasurer of the Angeles Girl Scout Council. Petitioner and Mr. Christie engaged in negotiations with respect to the property for a period of about four to five months. In early April 1974 petitioner's offer of $ 200,000 for the entire property was accepted. On April 11, 1974, the parties entered into an escrow agreement which contained the following terms of sale: $ 100,000 was to be paid on or before July 1, 1974, the stated date for the termination of escrow, of which $ 5,000 was to be paid on the signing of the escrow instructions and the remaining $ 95,000 to be paid prior to728 closing. The balance of the $ 200,000 was to be paid in the form of a $ 100,000 noninterest-bearing note secured by a deed of trust on the property which was due on or before February 1, 1975. The escrow instructions were signed by petitioner on April 21 and Mr. Christie signed them on April 22. On June 7, 1974, a representative for the Angeles Girl Scouts signed the Grant Deed for the conveyance of the Girl Scout property to petitioner and placed the deed into escrow. Petitioner paid the $ 5,000 deposit on May 7 and a check for $ 95,166 was given to the escrow agent on July 1. On July 5 the escrow agent used the cash deposited by petitioner to pay off the liens which encumbered the Girl Scout property. The deed transferring the property to petitioner and the deed of trust securing petitioner's purchase money note were both recorded by the Title Insurance and Trust Company on July 5, 1974, and escrow was closed on that date. The Girl Scout property is located in the foothills of the San Gabriel mountains in the City of Glendora, California. It had been the site of "Camp Aventura" but the property had not been used by the Girl Scouts for approximately three years prior to the729 time of purchase. The parcel contained 30 to 35 acres of flat to gently sloping land which was ideal for residential development and the balance of the property was steep mountainous land. The gently sloping portion of the property is bordered by Palm Drive to the south and Grand Avenue to the east but the balance of the property has no direct access. In March 1975, a new single family residential subdivision was being completed on Grand Avenue, south of Palm Drive approximately 1/2 mile from the property. At the time of trial, the property immediately to the south of Palm Drive was fully developed with residential houses ranging in value from $ 100,000 to $ 200,000. The Girl Scouts had built a number of structures on the flat to gently sloping land including a caretaker's house, mess hall, garage, bathhouse, and a swimming pool. Most all of these structures were in a state of disrepair as the buildings had not been used or maintained for a number of years and were therefore of negligible value. The accessible portion of the property was enclosed by a chain-link fence. There were four entrances to the property each of which had a gate which was locked at all times. In730 the latter part of April or the first part of May 1974, petitioner contacted the Girl Scout officials and asked them for a complete set of keys.Mr. Christie saw no reason why petitioner should not have a set and by the first part of May the Girl Scouts issued him a set of keys to the property. Between the first of May and the first of July, petitioner, his wife, his daughter and her family would travel to the property on weekends and would remove weeds and debris from the relatively flat parcel of land and then enjoy a family picnic. Petitioner's son-in-law also used a Ford tractor in May and June, which was owned by the Girl Scouts, to clear the property. The keys to the tractor were obtained from the caretaker employed by the Girl Scouts and were returned to him afterwards or were left on the tractor. This work was done in anticipation of moving trailer houses for petitioner and his daughter and son-in-law onto the property until their permanent residences could be built there. During the month of June 1974, the Girl Scouts removed from the Girl Scout property, with petitioner's permission, one refrigerator, one double stove and hood, one pot sink, one triple metal sink, one731 salad table, seven toilets, four single sinks, four triple sinks, one stainless sink, one double stainless sink, one triple stainless sink, two utility sinks, eight dishwashing tables, three sheepherder stoves, four redwood benches, two mirrors, and one medicine chest. On his return for the dalendar year 1974, petitioner claimed a charitable contribution deduction for these items in the amount of $ 2,211. 2Harold G. Denny was employed by a third party and, among his duties, he worked as a gardener on petitioner's property located in Studio City, California. In the first part of May 1974, petitioner asked Mr. Denny to visit the Girl Scout property and offered him the job of being the caretaker on the property. In the first week of June, Mr. Denny decided to accept petitioner's job offer. On June 21 Mr. Denny and his family started to move some of their personal belongings to the caretaker's house on the Girl Scout property and began to clean and paint the house732 at night and during the weekends. The move into the caretaker's home was completed on the 29th of June as Mr. Denny had to be out of his old house by June 30, 1974. At the time he began moving in, Mr. Denny was given keys to the buildings and to the entrance gates to the property. Petitioner incurred and paid bills for utilities used on the Girl Scout property beginning in the month of June 1974. Sometime prior to June 24, 1974, petitioner requested that the electricity be restored to the property and he received a bill in the amount of $ 154.05 for service from June 24 to August 22, 1974, from the Southern California Edison Company. Petitioner was billed by the Glendora Water Department for water service from June 27 to July 11, 1974, in the amount of $ 4.98. The septic tank attached to the caretaker's house was pumped out in the month of June and petitioner received a bill for $ 35 dated June 29, 1974. On December 30, 1974, petitioner donated a portion of the Girl Scout property (donated property) to the City of Glendora, California, a qualified charitable organization defined in section 170(c). The Grant Deed reflecting the transfer of the donated property was recorded733 in the County of Los Angeles on December 30, 1974. The Grant Deed contained the following restrictive language: This grant is upon condition that said property be used solely for open space and public utility purposes until January 1, 2025. If said property is not used solely for open space and public utility purposes until January 1, 2025, then George Deukmejian, his heirs, assigns and successors, without paying any compensation for any buildings or other improvements or betterments that may then be upon said premises, and without paying any compensation or incurring any liability for damages or losses of any kind, may re-enter in and upon, and take possession as if this conveyance had not been made. This restriction was placed in the deed at the insistence of city officials to insure that the property would not be used for any purposes other than for open space and public utilities. Petitioner by Grant Deed, recorded on May 2, 1978, conveyed his retained right of re-entry in the donated property to the City of Glendora. On January 6, 1975, the mayor of the City of Glendora wrote petitioner a letter thanking him for the gift of the land and attached a copy of the resolution734 passed by the City Council on December 10, 1974, in which the city officially accepted the gift. The donated property consists of 28.93 acres, of which 0.29 acres are subject to a Flood Control District easement, leaving a net area of 28.64 acres.The property has an "L" shape measuring 1,650 feet long and a width of 1,320 feet along the northern boundary and a width along the irregular southern boundary of 440 feet. The parcel is located about 0.25 miles north of Palm Drive and about 0.25 miles west of Grand Avenue, if it were extended which it had not been at the time of trial. The elevation of the property rises from approximately 1,200 feet on the southern border to 2,000 feet on the northwestern portion of the property. This translates into a slope of approximately 50 percent, meaning that for every 2 feet of distance the elevation falls 1 foot. The property is raw unimproved land which is very steep and covered with scrub brush, wild grasses, and a few small trees. As a result, the land would be difficult to walk on for any length of time. The property was zoned E-7-200,000 which would allow for residential development with minimum lot sizes of 200,000 square feet or735 5 acres. There were no utilities on the property in 1974. However, there were school buildings not more than 400 to 500 feet from the southern border of the property which did have electrical power. Due to the slope and elevation of the property, there was no reservoir which could directly feed water onto the property by gravity flow. Therefore, pipes would have to be laid and a pumping station would have to be constructed in order to provide running water to the property. There were no roads providing access to the donated property and there were no easements which would permit the construction of a road across the private or government owned property which surrounded it. In view of the terrain, even if an easement could be obtained, the construction of a road to the property would be very expensive. The following schedule sets forth sales of certain properties situated along the San Gabriel mountain range and located from 2-1/2 to 19 miles from the subject property, during the period from July 5, 1974, to March 4, 1977: TotalTotalPrice PerDateGrantorGranteeConsiderationAcreageAcre7-5-74Angeles GirlDeukmejian$ 200,000257.83$ 776Scout Council7-14-75FosterJeffrey40,00040.001,0005-13-73Garland Et alGrieve45,000160.002815-9-75Hixon andRomvary Et al75,000395.28190Security Pacific5-5-75MichelsNuccio10,00040.002502-28-75JoyceReynolds6,80035.861903-4-77Murphy Et alU.S. Forest17,200163.8105Service736 The first sale listed above was the purchase of the larger Girl Scout property by petitioner as described above. The remaining six sales were of rough open hillside property. There were differences among these properties principally as to size and location but also as to access, utilities, and zoning. The following schedule sets forth sales of certain properties in the foothills of the San Gabriel mountains in or near the City of Glendora, California, and in the general vicinity of the donated property during the period from July 25, 1972, to September 24, 1974: TotalTotalPrice PerDateGrantorGranteeConsiderationAcreageAcre12-24-73WarrenSenise$ 140,00039.6$ 3,5357-25-72Federal SavingsAngello35,0007.394,736and Loan5-29-74CoussoulisHacienda150,00067.752,214Enterprises9-24-74FosterChase50,00040.01,250At the time of sale, each property listed above was open land although each of the properties was suitable for residential development. There were differences among these properties as to size and access and also as to utilities and location. All of these properties had locations737 and access superior to the donated property and were more accessible to utilities. The 40 acres which were sold on September 24, 1974, had access by a road through a National Forest which was controlled by a gate during the fire season. At the time of sale this property had a cabin-type building on it. On his Federal income tax return for the calendar year 1974, petitioner claimed a deduction for the contribution of the donated property to the City of Glendora in the amount of $ 63,000. Attached to his return was a letter to petitioner from an appraiser which stated the fair market value of the property to be $ 2,200 per acre or $ 63,000 and a letter from the City of Glendora dated January 6, 1975, acknowledging the gift of the land. Respondent, in his notice of deficiency for the calendar year 1974, disallowed petitioner's charitable contribution of $ 63,000 to the extent it exceeded $ 22,225. 3738 In his amended answer, respondent alleged that the charitable deduction should be limited to $ 5,441, the fair market value of the property at the time of the donation. 4ULTIMATE FINDING OF FACT The fair market value of the donated property on December 30, 1974, was $ 22,225.OPINION There is no question that petitioner is entitled to a charitable deduction under section 170(a)(1). The deed transferring the real property to the City of Glendora was recorded on December 30, 1974, and the property was to be used exclusively for public purposes, thus qualifying as a739 "charitable contribution" as defined under section 170(c)(1). 5 The only question presented is the amount of the charitable contribution. 6Section 1.170A-1(c)(1), Income Tax Regs., provides that when a charitable contribution is made in property other than money, the amount of the contribution is the fair market value of the property740 at the date contributed reduced when necessary as provided in section 170(e)(1). The fair market value of property is defined as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts." Section 1.170A-(1)(c)(2), Income Tax Regs. The fair market value of property at any given date is a question of fact to be decided on the basis of all the evidence and no set rules, methods or formulas are controlling. Newaygo Portland Cement Co. v. Commissioner,27 B.T.A. 1097">27 B.T.A. 1097, 1106 (1933), affd. 77 F.2d 536">77 F.2d 536 (D.C. Cir. 1935). Respondent raised the issue of the fair market value of the contributed property being less than $ 22,225 in an amended answer. Therefore, respondent has the burden of proving that the fair market value was below $ 22,225, the amount of the deduction allowed in the deficiency notice. Rule 142(a), Tax Court Rules of Practice and Procedure.In considering the question of fair market value, it is necessary to decide whether the property should be valued as restricted property or as property owned741 in fee simple. The Grant Deed which conveyed the donated property to the City of Glendora stated that the grant was "upon condition that said property be used solely for open space and public utility purposes until January 1, 2025," and if the property was not so used then petitioner "may re-enter in and upon, and take possession as if this conveyance had not been made," without compensation. This language created a fee simple subject to a condition subsequent with a retained right of re-entry. See Cal. Civ. Code, sections 707, 708, and 1438 (West). Petitioner contends that the property should be valued in fee simple, which was the state of the title of the property in petitioner's hands immediately before he transferred it. This argument is based on the fact that petitioner offered to transfer the property in fee simple but the city officials requested that the restriction be placed in the deed. We disagree with petitioner's contention. It is well settled that the donor is entitled to a deduction for a charitable contribution of property equal to the fair market value of the contributed742 property or interest therein subject to any restrictions on marketability on the date of the contribution. See Cooley v. Commissioner,33 T.C. 223">33 T.C. 223, 225 (1959), affd. per curiam, 283 F.2d 945">283 F.2d 945 (2d Cir. 1960). In Fargason v. Commissioner,21 B.T.A. 1032">21 B.T.A. 1032, 1037-1038 (1930), after determining the fair market value of real property contributed to a charitable organization, we stated that the amount so determined should be reduced in view of the fact that the property was given subject to a condition subsequent. For the above reasons, we conclude that the property in the instant case should be valued as restricted property suitable only for use as open space or for public utility purposes. Petitioner contends that the value of the donated property on December 30, 1974, was $ 2,200 an acre or $ 63,000. Petitioner bases his contention on the testimony and written appraisal dated March 12, 1975, of a real estate appraiser. Petitioner's expert was well qualified and familiar with the area. His appraisal was based on the conclusion that the highest and best use for the donated property would be for development as low density, single family743 residential homesites. Since the property was vacant land, he used the comparable sales approach in determining the fair market value. Petitioner's expert, after 24 hours of research, determined that there were three sales which were comparable to the donated property and they ranged in price per acre from $ 2,214 to $ 4,736. He concluded that, with adjustment for the differences in location, size, and terrain from the donated property, the adjusted price per acre for these three sales would range from $ 2,000 to $ 2,400. On that basis, it was his opinion that the donated property had a fair market value of $ 2,200 per acre. Petitioner's expert concluded his report by stating that "The opinion of value assumes the property is free and clear of encumbrances * * ." Respondent's expert also had good credentials and used the comparable sales method of valuation. He was of the opinion that even though the donated property was zoned for low density, single family residential development, such use was not practicable due to the deed restriction limiting the use to open space or for public utility purposes. Based on the restriction and the fact that it would be difficult to provide744 access and water and electricity to the property, respondent's expert concluded that the highest and best use for the property would be as open space hillside. After approximately 200 hours of research, he selected three sales which he considered comparable and they ranged in value from $ 171 to $ 210 per acre. Based on these findings, it was his opinion that the fair market value of the donated property was $ 210 per acre or a total of $ 6,014. Based on all of the evidence presented, we do not agree with the conclusion of either expert. The opinion of petitioner's expert is incorrect not only because the comparables he used were properties better situated and more desirable than the subject proprty, but also because he valued the donated property on the assumption that it was free and clear of all liens and encumbrances. In fact, the property was restricted by a condition subsequent limiting the use to open space or for public utility purposes. Furthermore, this record shows that at the time of the gift the best usage of the property was for open space although it might, at a later time, have been suitable for other uses. On the other hand, the comparable sales selected by745 respondent's expert were remote parcels of land not in close proximity with the donated property. The three sales selected as most comparable ranged from approximately 11 to 19 miles west of the donated property. Also these properties were not located near a city whereas the subject property was in the City of Glendora. We could dispose of this case on the basis that petitioner has failed to show a value higher than the $ 22,225 determined by respondent in his notice of deficiency and respondent has failed to show a value lower than that amount. 7 However, in our view the record as a whole supports a value of $ 22,225 for the property. While both experts listed the purchase of the entire Girl Scout tract by petitioner as a potentially comparable sale, they each dismissed the sale as being a good indicator of the value746 of the donated property. Petitioner's expert did so because of the large size of the property and respondent's expert did so because, in his opinion, based on other sales in the area, the price petitioner paid for the property was well below the usual price for property of this type.The record is clear that the purchase and sale of this property was an arm's length transaction. In other words, petitioner was a willing buyer and the Girl Scout Council was a willing seller. There is no indication in the record that both parties were not knowledgeable at the time of negotiating the sale of prices of properties in the area. In view of all the facts and circumstances and using our best judgment, we find that the fair market value of the donated property on December 30, 1974, was $ 22,225. In our view, the per acre price paid for the larger parcel of Girl Scout property is highly relevant to our determination here of the fair market value of the donated property. In fact, the price determined for a piece of property in a sale between parties dealing at arm's length is persuasive evidence of747 the actual fair market value of that property. Narver v. Commissioner, 75 T.C. at p. 72 of slip opinion (Oct. 9, 1980). While in some instances the average price per acre of property of the size of the Girl Scout property might not be indicative of the value per acre of a smaller portion of the property, in the instant case this is offset by a number of factors. First, the relatively flat 30 to 35 acres of the property has been shown to be far more valuable than any other portion of the property. However, the record also shows that most of the remaining acreage was inferior to the donated property. In addition, on the negative side, the average price per acre should be reduced because the donated property is restricted as to use, but on the other hand, it should be increased because this particular portion of the property had a good location in the City of Glendora. A fair market value price of $ 776 per acre for the donated property is supported by two other factors. First, petitioner's expert stated that the donated property represented about the average of the entire Girl Scout tract in terms of slope and terrain.Second, it is well within a reasonable748 range of the highest per acre price paid for a property included in the report of respondent's expert of $ 1,000 and the lowest price for a property included in the report of petitioner's expert of $ 1,250. There were some advantages to the properties which sold for $ 1,000 and $ 1,250 per acre over the donated property as to access and utilities. Also the property which sold for $ 1,250 per acre had a building on it and the record does not show the value of the building. These two properties, though overall somewhat superior to the donated property, are more indicative of the value of the donated property than any other property for which a sale is shown in the record. Because the fair market value of the property was the $ 22,225 determined by respondent in the notice of deficiency, we do not reach the issue of whether petitioner's charitable contribution was limited by section 170(e)(1)(A). 8749 Decision will be entered under Rule 155. Footnotes1. All statutory references are to the Internal Revenue Code of 1954, as amended and in effect in the years in issue, unless otherwise stated.↩1. All statutory references are to the Internal Revenue Code of 1954, as amended and in effect in the years in issue, unless otherwise stated.↩2. The amounts of the items contributed actually added up to $ 2,210. This claimed deduction was not disallowed by respondent in the notice of deficiency or placed in issue by respondent in his amended answer.↩3. Petitioner on his tax return claimed a total charitable contribution deduction of $ 65,511 computed as follows: Cash contributions $ 50; Angeles Girl Scout Council, $ 2,211; Grace Episcopal, $ 250; City of Glendora - Land, $ 63,000. Respondent in his notice of deficiency disallowed $ 40,775 of petitioner's claimed charitable contribution deduction with the following explanation: It is determined that you are allowed a charitable contribution deduction in the amount of $ 24,736.00, the fair market value of land contributed, in lieu of $ 65,511.00 claimed on your tax return for the taxable year 1974 because it has not been established that land contributed to the City of Glendora is long-term capital gain property for purposes of computing the charitable contribution deduction in accordance with section 170 of the Internal Revenue Code of 1954. Therefore, your taxable income is increased $ 40,775.00 for the taxable year 1974. [[At the trial both parties recognized that respondent in his notice of deficiency had limited the claimed charitable deduction for the land to $ 22,225 which was the amount of the acreage donated multiplied by the mathematical average price per acre. ($ 200,000./. 257.83 = $ 776 -- $ 776 X 28.64 = $ 22,225.)]] If the determination set forth immediately above is not sustained, then it is determined in the alternative that the amount of allowable deduction for the taxable year 1974 is limited to thirty (30) per cent of your contribution base for the taxable year 1974.↩4. On brief, respondent conceded that the fair market value of the property contributed was $ 6,014 but also contended that petitioner's basis in the donated property did not exceed $ 6,014 if proper allocation of the purchase price of the property was made to acreage of different values.↩5. Sec. 170(c) provides in part as follows: (c) Charitable Contribution Defined.--For purposes of this section, the term "charitable contribution" means a contribution or gift to or for the use of-- (1) A State, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes. ↩6. The parties stipulated that the amount of the allowable charitable contribution is limited under section 170(b)(1)(D) to 30 percent of petitioner's contribution base as defined in section 170(b)(1)(E)↩.7. Petitioner in his brief argues that respondent in the notice of deficiency accepted the $ 63,000 value for the property. In footnote 3 we have quoted the portion of the deficiency notice dealing with the disallowance of a part of the charitable deduction claimed by petitioner. We do not interpret respondent's notice of deficiency as does petitioner.↩8. Although respondent argued in his brief that petitioner's basis in the donated property was less than $ 22,225, this issue was not raised in the pleadings. Furthermore, the evidence does not support the contention of respondent that petitioner's basis in the property was less than $ 22,225.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621981/	JAMES MICHAEL COLLINS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentCollins v. CommissionerDocket No. 10335-81.United States Tax CourtT.C. Memo 1984-104; 1984 Tax Ct. Memo LEXIS 568; 47 T.C.M. (CCH) 1211; T.C.M. (RIA) 84104; March 5, 1984. James Michael Collins, pro se. Fera Wagner, for the respondent. RAUMMEMORANDUM FINDINGS OF FACT AND OPINION RAUM, Judge: The Commissioner determined a $1,327.87 deficiency in petitioner's 1977 Federal income tax. After concessions, the part of this deficiency now in issue stems from the disallowance of certain deductions for expenses relating to the incarceration of petitioner's son. The questions remaining for decision are: (1) whether petitioner may deduct that portion of a $500 payment to the Orange County, California, Probation Department which is not attributable to medical expenses; and (2) whether petitioner may deduct certain attorney's fees and court appearance expenses. FINDINGS OF FACT Some of the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by reference.Petitioner in an unmarried head of household. At the date of the filing of the petition herein, his legal residence was 26481 Aracena Drive, Mission Viejo, California. During 1976 and 1977 petitioner's 16-year old son, Gary Dennis Collins (Gary), spent a total of 158 days incarcerated in various Orange County, California, 570 juvenile detention centers. On July 11, 1977, the Orange County Juvenile Court ordered petitioner to reimburse the county for the cost of maintaining Gary in these centers. Such expenses totaled $3,582.10, broken down as follows: 54 days in Juvenile Hall at $15.00per day$810.001 day in Youth Guidance Center at$15.00 per day15.00103 days in Juvenile Hall at $20.00per day2,060.00Public Defender Fees35.80Medical Services661.30Total$3,582.10Petitioner paid $500 of this amount during 1977, to the Orange County Probation Department, and included it as a part of a $540 deduction which he claimed for "personal property" taxes on his 1977 return. The Commissioner disallowed the entire $500 component of that deduction as "a nondeductible personal expense" under section 262, I.R.C. 1954, but he now concedes the deductibility of that portion of the $500 that is allocable to medical services. Petitioner also paid $1,088 in legal fees and claimed this amount as a miscellaneous deduction described as "Attorney fees" on his 1977 return. The record is vague as to exactly what services petitioner received from his attorney. However, it appears571 that the attorney was acting on behalf of petitioner and Gary in connection with the foregoing proceedings and Gary's incarceration. Petitioner also claimed a miscellaneous deduction in the amount of $1,045.80, described as "Court Appearance Expenses". These court appearance expenses "were for * * * time lost from work and cost of going to court and cost of visiting Gary". The Commissioner disallowed the deductions for both the $1,088 and $1,045.80 items as "nondeductible personal expenses" under section 262, I.R.C. 1954. OPINION The first issue to be decided is whether petitioner may deduct the nonmedical portion of the $500 paid to the Orange County Probation Department. Deductions from income are a matter of "legislative grace; and only as there is clear provision therefor can any particular deducticn be allowed": New Colonial Ice Co., Inc. v. Helvering,292 U.S. 435">292 U.S. 435, 440 (1934). See also Commissioner v. National Alfalfa Dehydrating and Milling Co.,417 U.S. 134">417 U.S. 134. 148-149 (1974); Deputy v. DuPont,308 U.S. 488">308 U.S. 488, 493 (1940). We are unable to find any statutory provision that would support petitioner's claim to a deduction for572 the disputed portion of the $500 payment. We do not agree with his contention that the charges reflected in such payment may be classified as a personal property or a state or local tax and thus deductible under section 164, I.R.C. 1954. 1 These fees can in no way be characterized as "an ad valorem tax which is imposed on an annual basis in respect of personal property", section 164(b)(1), I.R.C. 1954, or as a "levy and collection of revenue without relationship to a specific governmental privilege or service". Cox v. Commissioner,41 T.C. 161">41 T.C. 161, 164 (1963). Indeed, the amounts paid to the county were reimbursements for the cost to the county of Gary's "care, support and maintenance". See California Welfare and Institutions Code section 903, added by 1961 Calif. Stats., c. 1616 p. 3500, sec. 2. 573 Moreover, section 262, I.R.C. 1954, specifically states that "[e]xcept as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses". This provision is plainly applicable here. Petitioner was ordered to reimburse the county for the cost of his son's upkeep and maintenance expenses which are clearly "personal living or family expenses". Petitioner has offered no evidence establishing that the nonmedical portion of his payment of $500 was for anything other than for such costs. A like result is required in respect of the claimed deduction for legal expenses connected with Gary's incarceration. A taxpayer may deduct legal expenses only if such expenses relate to his business or income producing activities. Kornhauser v. United States,276 U.S. 145">276 U.S. 145 (1928). See also United States v. Patrick,372 U.S. 53">372 U.S. 53, 56 (1963); Trust of Bingham v. Commissioner,325 U.S. 365">325 U.S. 365, 376 (1945). In determining whether a legal expense relates to a business or income producing activity, one looks to "the origin and character of the claim with respect to which an expense was incurred". United States v. Gilmore,372 U.S. 39">372 U.S. 39, 49 (1963).574 See also Commissioner v. Tellier,383 U.S. 687">383 U.S. 687, 689 (1966). All of petitioner's legal expenses were purely personal expenses. They originated in the events involving Gary's incarceration and did not in any way arise out of any trade or business or income producing activity of petitioner. They are not deductible. 2Because of concessions, Decision will be entered under Rule 155.Footnotes1. SEC. 164. TAXES. (a) General Rule.--Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued: (1) State and local, and foreign, real property taxes. (2) State and local personal property taxes. (3) State and local, and foreign, income, war profits, and excess profits taxes. (4) State and local general sales taxes. * * In addition, there shall be allowed as a deduction State and local, and foreign, taxes not described in the preceding sentence which are paid or accrued within the taxable year in carrying on a trade or business or an activity described in section 212 (relating to expenses for production of income).(b) Definitions and Special Rules.--For purposes of this section-- (1) Personal property taxes.--The term "personal property tax" means an ad valorem tax which is imposed on an annual basis in respect of personal property. * * * (3) State or local taxes.--A State or local tax includes only a tax imposed by a State, a possession of the United States, or a political subdivision of any of the foregoing, or by the District of Columbia.↩2. We do not mean to suggest that all of such expenses would have been deductible even if they related to business or profit oriented activities. Thus, to the extent that the "court appearance expenses" included a component for "time lost from work" they would in any event be nondeductible.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621982/	GEORGE N. KLEMYER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. ARTHUR F. JACOBS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Klemyer v. CommissionerDocket Nos. 30615, 30629.United States Board of Tax Appeals20 B.T.A. 934; 1930 BTA LEXIS 2005; September 23, 1930, Promulgated 2005 Information returns for the years 1920 to 1924 were, under an erroneous conception of the requirements of law, made on a fiscal year basis by a partnership of which petitioners were members, although the petitioners intended, and the partnership articles pro vided for a calendar year accounting period, and the partnership books were kept and its income reported on that basis in the individual returns of the petitioners. Held, that the returns filed by the partnership did not, under the circumstances, constitute an election to establish a fiscal year accounting period for the partnership. Frank I. Ford, Esq., for the petitioners. John E. Marshall, Esq., for the respondent. MARQUETTE 935 These proceedings, which were duly consolidated for hearing and decision, are for the redetermination of deficiencies in income tax asserted by the respondent for the year 1924 as follows: George N. Klemyer, $5,811.99; Arthur F. Jacobs, $5,895.44. FINDINGS OF FACT. The petitioners are individuals residing in San Francisco, Calif. For each of the years 1919 to 1924 they made their returns of income on the calendar year basis. The Equitable Realty2006 Co., a corporation, was dissolved on May 31, 1919, and was succeeded by a partnership composed of the petitioners. Each of them had a one-half interest therein. The partnership agreement provided that: * * The said co-partners once each year during the continuance of the copartnership, as aforesaid, to-wit: On the 31st day of December, in each year, or oftener, if necessary, shall make, yield, and render, each to the other, a true and just and perfect inventory and account of all the profits and increase by them, or either of them, and all loss by them or either of them sustained; and also all payments, receipts, disbursements and all other things by them made, received, disbursed, noted and suffered in their said business; * * * and each of the petitioners understood that said articles of agreement required that the partnership books be kept and the partnership profits distributed on the calendar year basis, and they understood that said books and profits should be so kept and distributed. The books of the Equitable Realty Co., the corporation, were closed on May 31, 1919, and a final income-tax return was filed for the five-month period ended May 31, 1919. On or about2007 January 1, 1920, the books of the partnership were opened as of June 1, 1919. The partnership records for the seven-month period beginning June 1, 1919, were closed at December 31, 1919. No return of income was made by or for the partnership for the period June 1 to December 31, 1919. The books of the partnership were closed on May 31, 1920, and December 31, 1920, and on each May 31 and December 31 thereafter, to and including December 31, 1924. Returns of income 936 for the fiscal years ended May 31, 1921, May 31, 1922, May 31, 1923, and May 31, 1924, were filed for the partnership. These returns were prepared by one Brockhoff, an accountant, who also prepared returns for the petitioners. He was not at any time instructed by either of the petitioners to place the partnership on a fiscal year basis and he did not intend so to do, but filed the returns on the fiscal year basis in the belief that, since the partnership commenced operations on June 1, 1919, an information return should be filed by it for the twelve months ended May 31, 1920, and each twelve months thereafter. On October 11, 1927, the partnership filed amended returns for the period June 1 to December 31, 1919, inclusive, 2008 and for the calendar years 1920 to 1924, inclusive. In each of the years 1920 to 1924, inclusive, the income of the partnership was computed and divided between the petitioners on the calendar year basis and was reported by them in their individual returns for those years. Each of the petitioners in his return of income for the year 1924 reported as his distributive share of the income of the partnership the amount of $5,817.17, said partnership income being computed on the calendar year basis as above stated. The respondent, upon audit of the return, determined that the books of the partnership were kept on the basis of a fiscal year ending May 31 of each calendar year, and that the income of the partnership for the fiscal year ended May 31, 1924, was $70,809.02 and the share of each petitioner, $35,404.51. The respondent accordingly increased the income of each petitioner as shown on his return for the year 1924 by the amount of $29,587.34 and determined deficiencies as above set forth. OPINION. MARQUETTE: It appears to be the position of the respondent that: (1) The partnership accounting period is a fiscal year ending May 31; (2) that in any event the partnership, 2009 in filing returns on the fiscal year basis, has made an election which is binding upon the petitioners and that they must account for and return the partnership income computed on the basis of a fiscal year. The petitioners deny that the partnership has ever adopted or intended to adopt any accounting period other than the calendar year, and they say that returns for the partnership were made on the fiscal year basis under the erroneous belief that, as they were mere information returns, they should be filed at the end of each twelve months of the partnership life. It is our opinion that the position of the petitioners is well taken. The evidence clearly shows that they interpreted the partnership agreement as requiring the partnership books to be kept and its 937 income accounted for and distributed on the basis of the calendar year, and that they have consistently closed the partnership books at December 31 of each year and have computed and reported and paid taxes on the partnership income on that basis. The fiscal year returns of the partnership clearly were made and filed under a mistaken conception of the requirements of the income-tax law. We are satisfied that2010 the partnership accounting period was intended to be and was the calendar year, and that the partnership income has been computed and reported by the petitioners, in their individual returns, on the proper basis, and that the filing of fiscal year returns by the partnership did not, under the circumstances, constitute an election to change to a fiscal year accounting period. . The respondent has cited a number of cases in support of his position, but we do not deem them applicable to the facts herein. Judgment will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621983/	I. E. Doggett v. Commissioner. Doggett v. CommissionerDocket No. 49710.United States Tax CourtT.C. Memo 1958-176; 1958 Tax Ct. Memo LEXIS 48; 17 T.C.M. (CCH) 873; T.C.M. (RIA) 58176; September 24, 195848 Daniel R. Dixon, Esq., for the petitioner. Paul J. Weiss, Jr., Esq., for the respondent. OPPERMemorandum Findings of Fact and Opinion OPPER, Judge: Respondent determined the following deficiencies in income tax and additions to tax: Income taxAddition to taxYeardeficiencySection 293(b)1942$ 5,495.27$ 2,747.64194313,698.52 6,849.26194431,333.2115,666.61194514,575.627,287.8119467,526.823,763.41The disputed issues are: (1) Whether the deficiencies for the years 1942, 1944, 1945 and 1946 are barred by the statute of limitations, it being conceded by petitioner on brief that appropriate waivers were executed for the year 1943. (2) Whether petitioner's net income for each of the years 1942 through 1946 is correctly reflected by his books and records. (3) Whether petitioner suffered any loss due to embezzlement in the years 1942 through 1946. (4) Whether certain expenses attributable to petitioner's personal automobile are properly deductible as business expenses in the years 1942 through 1946. (5) Whether sums expended for flowers in the years 1942 through 1946 are49 properly deductible as business expenses. (6) $250Whether paid in 1943 for attorney's fees is properly deductible as a business expense. (7) Whether certain debits to petitioner's drawing account in the years 1942 through 1946 represented business expenses and are properly deductible as such. (8) Whether certain storage receipts for 1946, which were reported as income by one of petitioner's corporations, are petitioner's income rather than his corporation's. (9) Whether certain expenses which were accrued by petitioner's sole proprietorship and assumed by his corporations in 1946 are proper deductions in computing his net income. (10) Whether certain sums were expended for taxes and insurance in 1946 and are therefore deductible. (11) Whether any part of any deficiency is due to fraud with intent to evade tax. Findings of Fact Some of the facts were stipulated and are found accordingly. Petitioner, a resident of Raleigh, North Carolina, had his income tax returns for the years 1942 through 1946 prepared by a certified public accounting firm on the cash basis. These returns were filed timely with the collector of internal revenue for the district of North Carolina. 50 Respondent mailed to petitioner a statutory notice of deficiency, dated April 22, 1953, with respect to these years. Petitioner operated the Strop Taxi Company in Raleigh, North Carolina, as an individual proprietorship from 1933 to April 30, 1946, when he formed two corporations, the Yellow Cab Company, Inc., and the Strop Taxi Company, Inc. Petitioner's fleet of cabs grew from 8 in 1933 to 50 at the time of incorporation. Petitioner hired Linwood T. Hobgood as a bookkeeper in April 1941. Hobgood remained employed in that capacity until February 1947. He was 26 years of age at the time he was hired and had studied bookkeeping and typing for approximately 1 year at night school. Petitioner informed Hobgood within the first year of his employment that petitioner's income was getting so large that he did not feel that he should have to pay the Government income tax on all of it. Petitioner instructed Hobgood to reduce these income taxes in any way he could. To this purpose Hobgood used a number of different methods during the years 1942 through 1946. One method used by Hobgood to conceal income was to inflate the business expenses upon posting to the ledger. For example, in the51 months of August through December 1943, nine of the items posted to the gasoline account ledger exceeded by $100 each the amount correctly recorded in the journal. Some expense accounts were totaled before being posted, and Hobgood would overadd or overfoot these account columns in the journal and post the larger amount to the ledger. For example, the correct total of the "Parts" account in the journal for the month of October 1942 is $1,184.21; however the total recorded is $1,284.21. These footing errors in the expense accounts totaled $1,246 in 1942 and $2,895 in 1943. Hobgood credited many income items directly to petitioner's drawing account, thereby by-passing the "income" or "receipts" account. For example, income from the coca-cola machine, from the sale of book tickets, from the sale of old cabs and from the sale of junk or scrap was ordinarily credited directly to petitioner's drawing account. Checks for insurance recoveries amounting to $706.59, $703.98, and $676.50 were also so credited in 1942 through 1944, respectively. In addition, there were checks amounting to $930.41, $2,288.71, and $1,240.41 which were received from insurance and advertising companies in 1944 through52 1946, respectively, and which were not recorded at all. Hobgood endorsed some but not all of these checks. Another method of concealing income was by recording personal expenditures as business expenses. For example, on February 5, 1945, petitioner issued a check to the Heater Well Company for $376 to pay for a well drilled on his father-in-law's farm. This expenditure was recorded in the 1945 journal as a debit to the repairs account of the taxicab business. Petitioner's business furnished gasoline and made necessary repairs to his personal automobile. This automobile was included with the business automobiles on petitioner's books for the purpose of computing depreciation. One of the principal methods used to understate taxable income during the years 1944 and 1945 was to fail to record some of the receipts in the journal after having properly recorded them in the cash book. During the years 1944 and 1945, the variance between the receipts as recorded in the journal and receipts as reflected in the cash book aggregated $27,825 and $10,025, respectively. Hobgood placed the withheld cash on petitioner's desk, after attaching an adding machine tape showing the amount of the daily53 receipts and how much had been withheld. The adding machine tape would show a figure for the amount withheld and to the left of the figure Hobgood wrote the name "Red." Petitioner is commonly known as "Red" Doggett in Raleigh. The daily receipts were correctly recorded in the cash book, and in 1944 and 1945 a smaller amount was recorded in the journal, the difference being accounted for on the adding machine tapes. For example, the correct receipts for the "day shift" on Friday, March 30, 1945, were $391. This amount is properly recorded in the cash book. The amount recorded in the journal is $341. The difference of $50 appears on the adding machine tape opposite the word "Red." Petitioner or his wife checked the drivers' receipts almost every day. Petitioner understood the cash book. It was kept principally by Hobgood with occasional entries being made by both J. M. Neal, petitioner's personnel manager, and by petitioner. The cash book was kept for petitioner's information and was not maintained with the journals and ledgers in the filing cabinet but was kept separately in Hobgood's desk drawer. When a cash book was filled it was stored on the top shelf of a large wooden cabinet. 54 Only the journal and ledger were made available to the certified public accounting firm by Hobgood for the preparation of petitioner's income tax returns. The accountants were retained only to prepare returns and not to audit the books. The cash books were never made available to them. Petitioner accumulated the withheld cash in a safe in his office and periodically removed it. During the year 1944, petitioner made 5 deposits of currency, totaling $5,185, in his wife's account in the Security National Bank. During the year 1944, petitioner made 8 deposits of currency, totaling $6,080, in his wife's account in the Bank of Lillington. On January 19, 1945, petitioner paid $2,000 in currency to the Connell Realty and Mortgage Company as a deposit to purchase a lot, and on February 28, 1945, and March 24, 1945, petitioner made additional cash payments of $3,000 and $2,500, respectively. On February 1, 1945, petitioner paid $2,050 cash on a home. On one occasion petitioner asked Hobgood if he thought petitioner could "get away with" the understatements of income. Hobgood told petitioner that he could until the Government checked him. Petitioner did not offer Hobgood anything to falsify55 the books nor did petitioner threaten to discharge him if he failed to comply with petitioner's instructions. Hobgood told petitioner that petitioner would have to assume full responsibility for the practice. Hobgood once cautioned petitioner that entirely too much was being withheld and that he had better go easy, to which petitioner replied that Hobgood should let petitioner worry for he was the one getting the money and that he would pay off when the time came. Petitioner's reported net income, his net income as determined by respondent in the notice of deficiency and as subsequently corrected by respondent, using the "receipts and disbursement" method, and net income as computed in petitioner's brief according to the "receipts and disbursement" method are: Net incomeNet incomeNetper respondent'sas correctedNet income perYearincome reporteddeficiency noticeby respondentpetitioner's brief1942$25,425.71$34,459.92$33,334.70$28,623.80194350,766.59 68,524.91 64,944.8058,393.82194444,573.5184,006.4981,383.2366,655.19194544,351.1664,314.7258,015.5549,006.77194615,765.5430,702.8231,949.4916,480.0056 Petitioner computed his net income in his brief by deducting the following item from respondent's corrected net income computation: 19421943194419451946Embezzlement loss$1,418.35$4,095.00$12,838.65$7,950.59$ 2,706.91Personal living expenses which respondent es-timated were paid by petitioner's business600.00600.00600.00600.00200.00Depreciation on personal automobile - amountalleged by petitioner to be attributable tobusiness use355.91335.9159.32Gasoline for personal automobile - amount al-leged by petitioner to be attributable tobusiness use57.79Flowers purchased by business77.2658.21169.50166.7697.35Attorneys fees250.00Storage receipts4,880.40Accounts payable transferred to corporations7,144.98Taxes and insurance302.35Debits to petitioner's drawing account which pe-titioner alleges represent business expenses: Salary adjustment6.00Accounts receivable9.504.501.00Uniforms and advances79.99340.00Cash receipts and expenses1,937.85388.56277.81129.45Chicken feed168.25483.30357.9055.98137.50Wages - decedent420.36102.50Bad check2.50Totals$4,710.90$6,550.98$14,728.04$9,008.78$15,469.4957 Respondent also computed petitioner's net income by using the "net worth plus nondeductible expenditure" method, except for cash on hand. In doing so, respondent used as figures for petitioner's living expenses for 1945 and 1946, $20,232.26 and $20,936.94, respectively. Included in these figures are $5,284.28 and $5,734.06, respectively, which consist of cash collected and cash charged to petitioner's drawing account. When petitioner incorporated his taxi business in 1946, he transferred the following assets and liabilities to the corporations: AssetsCash in Banks$ 7,236.75Accounts Receivable201.50Advances and Uniforms2,079.54Automobiles71,664.98Furniture, Fixtures and Equipment7,085.13$88,267.90LiabilitiesNotes Payable, 1st Citizens Bank$ 649.25Notes Payable, Encyclopedia Bri-tannica414.16Employees' F.O.A.B. Victory Tax626.47Reserve for Depreciation63,933.04Accounts Payable7,144.98Capital Stock, Yellow Cab, Inc. &Strop Taxi, Inc.15,500.00$88,267.90 There was an additional liability of $5,813.83 for wages which accrued prior to the date of incorporation. An adjusting entry was made on the books of the corporation58 at the end of their fiscal years, April 30, 1947, crediting expense and debiting petitioner's account for this sum. During 1946 Yellow Cab Company, Inc., conducted its business without a lease and without payment of rent on real estate owned by petitioner. It reported $7,320.60 as income in 1947 for storage rentals which were received by petitioner personally between September 6, 1946 and February 4, 1947. This income belonged to petitioner and he owed no part of it to either of his corporations in 1946, because petitioner, and not his corporations, rented the real estate for storage purposes. Petitioner's net income, determined by computing the increase in net worth plus nondeductible expenditures, without considering unstipulated additional living expenses for 1945 and possible increases in cash on hand, was not less than $30,955.79, $62,019.04, $68,544.58 and $50,064.96 for the years 1942 through 1945, respectively. During the years 1942 through 1946, petitioner maintained a safety deposit box at the Wachovia Bank & Trust Company in Raleigh, North Carolina. During the initial stages of the investigation, on Friday, May 9, 1947, at approximately noon, respondent's revenue agent59 asked petitioner if he would accompany the agent to the Wachovia Bank & Trust Company to inventory the contents of petitioner's safety deposit box. Petitioner informed the agent that he could not leave his place of business. An appointment was made to inventory the contents of petitioner's box on the following Monday, May 12, 1947, and no cash was found. Petitioner entered his safety deposit box less than an hour after the agent left his place of business on Friday, May 9, 1947. On February 21, 1951, petitioner pleaded nolo contendere to and was convicted on a 3-count indictment charging the filing of false and fraudulent income tax returns with intent to evade for the years 1944 through 1946. On April 6, 1951, petitioner was fined $30,000 and the costs of prosecution. Petitioner's returns for each of the years 1942, 1944, 1945 and 1946 were false and fraudulent with intent to evade tax; and some part of each of the deficiencies in income tax for the years 1942 through 1946 was due to fraud with intent to evade income tax. Opinion After this case had been heard but before it could be decided, the judge who had presided at the trial died. The parties were given an opportunity60 to apply for a further hearing. 1 In the event that either considered it necessary for the deciding judge to see and hear the witnesses, they could have done so. No such application has ever been made in all the time that has elapsed since that opportunity was tendered. Nevertheless, the entire proceeding reduces to an irreconcilable conflict of testimony. 2 Petitioner accuses his bookkeeper of continuous and systematic embezzlements from petitioner's business. The bookkeeper categorically denies any misappropriations. He testified that petitioner instructed him to falsify the business records thereby reducing petitioner's apparent taxable income, and that the difference largely went to petitioner in cash. This account, naturally, is contradicted by petitioner's testimony. 61 Both versions, of course, cannot be true. Our primary responsibility is thus to marshal that arrangement of the facts, as they appear in the written record, which seems to us most nearly to accord with what actually happened. Our findings, which are dispositive of most of the issues, reflect the conclusion that the statements of the bookkeeper rather than those of petitioner are entitled to credence. This result has been reached on the whole record and for a number of reasons, among which are the following: First, the bookkeeper has no such apparent interest in the outcome as has petitioner. No charges against him are, or for all that appears, ever have been pending against him. 3 Any motive for departing from the truth would hence tend to tip the balance in favor of the bookkeeper's veracity. Second, petitioner's conviction on his plea of nolo contendere is at least a sufficient justification for doubting the truth of his statements. , affd. (C.A. 5) . Third, the other evidence, including testimony of presumably unbiased witnesses, supports for the most part the bookkeeper's statements. Fourth, the conceded62 understatements of income, 4 even on petitioner's "net worth" computations, 5 are so large for the period 1942 through 1945 that petitioner must have been aware of them and even without more they thus tend to support respondent and his witness and to lead to an inference of fraud which agrees with their theory. . The socalled "routine adjustments" do not by any means account for the difference nor rebut the evidence of guilt, even if they should, as petitioner contends, fail to add to implications of dishonesty. 63 There is a great deal of testimony as to whether it was petitioner or his accountant who finally produced the significant 6 cash books. We have made no finding on this point in view of the hopeless conflict of testimony. But one aspect of the case which petitioner makes no effort to justify is that the revenue agent had been working on the case for several weeks. Admittedly petitioner called in no outside assistance until at the conclusion of the examination a deficiency was proposed. Admittedly also, until this moment no offer of the cash books had been made to the examining agent. Yet on petitioner's own theory this was the one kind of book with which he was familiar. Why were they withheld throughout the investigation? And who but petitioner could have withheld them? There are, to be sure, discrepancies in the testimony of both principal witnesses. This is not surprising with reference to events by64 now much more than 10 years old. But the principal charges made by the bookkeeper are credible and consistent and we find no such infirmity in them as to require their complete repudiation. 7This is not a case where any question of burden of proof can successfully be raised. Cf. . Once the bookkeeper is believed as to petitioner's obeyed instructions to falsify the books in order to understate income, all the proof of fraud necessary is furnished. , affirmed per curiam (C.A. 2) , certiorari denied ; . The situation as to the year 1946 is somewhat different. The admitted understatement of income for that year is so small that possibly were it the sole evidence of fraud we should be inclined to hold that respondent65 had failed to sustain his burden. But in the context of all that had previously transpired, including the pattern of fraud for the prior years, Hobgood's continuing concealment under petitioner's instructions and the failure of petitioner to make any effective rebuttal of respondent's evidence, we think it would be impossible to conclude that fraud had not been proved for the year 1946 as well as for each of the preceding 4 years. Respondent's burden of proving fraud having been satisfactorily met for all of the years, the proposed deficiencies are not barred by the statute of limitations. The burden of proving error in the deficiencies determined consequently rests upon petitioner. . Petitioner relies heavily on the net worth computation of income to show that at least some funds were embezzled and that his income was not as large as contended by respondent. Although the parties have stipulated petitioner's net worth to a large degree there were no figures for cash on hand in any of the years, and this item was expressly left open for proof. Respondent having proved fraud in each of the years, the burden is upon petitioner to prove66 error in the deficiency notice. Petitioner has admitted to keeping cash on hand and has failed to prove that this did not increase in each of the years in issue. He has accordingly not proved that his income for these years is correctly reflected by the net worth computation. Respondent relies on the "receipts and disbursements" method to verify his deficiency determination. Petitioner has not shown that this method is less accurate than the net worth method. To the contrary, all of the evidence tends to indicate that respondent's computation of receipts and disbursements is the more precise method and should therefore be accepted. See . In addition to the net worth computation, petitioner uses two approaches to attack respondent's computations - his personal testimony and cross-examination of respondent's agent. Since we consider petitioner's testimony unworthy of belief, we have no evidence that petitioner suffered embezzlement losses and therefore no deduction of this nature may be allowed. There is likewise no evidence that the expenses relative to his personal automobile and the flowers are ordinary and necessary expenses of his67 business, and no proof that respondent's estimate of the personal expenses of petitioner which were paid by his business is in error. It is impossible to conclude from the record that any part of the "debits to drawing account" represent deductible expenses. Although the attorney fees might well be deductible if they were in fact expended for the purpose assumed by respondent's revenue agent, his examination is hardly proof of the nature and payment of the expense, and the same may be said in regard to the agent's testimony in regard to the item of "taxes and insurance." The attorney, to whom the fee was allegedly paid, was called as petitioner's witness and yet no attempt was made to elicit testimony on this point. The facts found involving the storage receipts in 1946 show that petitioner, and not his corporations, earned and received that income. Petitioner's contention that the transfer of accounts payable to his corporations in the same year constitutes payment of an expense, or that payment was made by the corporations as his agent, cannot be sustained even if it may be assumed that these accounts payable represent expenses which might be deductible. Petitioner, a cash basis68 taxpayer, did not pay the expenses in 1946. There being no evidence that petitioner was in the taxi business subsequent to the incorporation, he cannot be said to have been doing business through an agent. . The increased deficiency for that year, however, must be disapproved even if it could be said that this was validly claimed. As to this, the burden was on respondent and we find no adequate evidence to sustain his position as to the claimed increase. Petitioner, having failed in his burden of proof, the deficiencies as determined are sustained, except as respondent has conceded smaller deficiencies for 1942 through 1945. And for the reasons already stated, the additions to tax for each year are likewise approved. Decision will be entered under Rule 50. Footnotes. Note: This case was heard by Judge Stephen E. Rice and briefs were duly filed. After his death on February 9, 1958, the case, not having been disposed of, was reassigned to Judge Clarence V. Opper, and notice was given to the parties that any motions contemplated in connection with the proceeding should be addressed to Judge Opper and filed immediately, and that if no such motions were received within 30 days he would proceed with the disposition of the proceeding. No motions requesting rehearing or further hearing or relating in any other manner to this case have been received.↩. Includes Victory tax.↩. Victory tax net income reported in 1943 - $53,069.67. ↩*. Victory tax net income per deficiency letter - $70,364.73.↩1. "Judge Stephen E. Rice, to whom this proceeding was formerly assigned, having died on February 9, 1958, notice is hereby given that this proceeding will be reassigned to Judge Clarence V. Opper. "It is not anticipated that any rehearing or reargument will be necessary in connection with this proceeding, since the entire file and record herein, together with briefs, are being transferred to Judge Opper. However, should any motions be contemplated in connection with this proceeding they should be addressed to Judge Opper and be filed immediately. If no such motions are received within 30 days, Judge Opper will proceed with the disposition of this proceeding." ↩2. "Respondent states that either Hobgood or petitioner is a liar. To this, petitioner agrees wholeheartedly." (Petitioner's reply brief, p. 54.)↩3. Petitioner states in his brief (p. 32) that "[it] is to be borne in mind that the full disclosure of the extent of the embezzlement has only been discovered in preparing data for this proceeding." Petitioner quotes from the General Statutes of North Carolina and concludes "it is apparent that a prosecution for embezzlement may be initiated in North Carolina at any time after the offense has been committed." At the trial Hobgood gave the following answers to respondent's questions: "Q. Now, did you personally appropriate any of the money which you withheld for Doggett? "A. No, sir. "Q. Has Doggett ever accused you of doing so? "A. No, sir. "Q. Before this trial? "A. No, sir. "Q. Has he ever preferred criminal charges against you in any court? "A. No, sir. "Q. Has he ever brought any civil action against you seeking to recover any sum? "A. No, sir. "Q. Have you ever been convicted of a felony or a misdemeanor? "A. No, sir." ↩4. These understatements are set forth in petitioner's reply brief (p. 64) as follows: Net WorthStatementPer ReturnPer Petitioner1942$25,425.71$30,955.79194350,766.5962,019.04194444,573.5168,544.58194544,351.1650,064.96 According to these figures petitioner's understatement of net income in each of the years 1942 through 1945 is $5,530.08, $11,252.45, $23,971.07 and $5,713.80, respectively. The 4-year total of income per return, income per net worth statement, and understatement of income is $165,116.97, $211,584.37 and $46,467.40, respectively. ↩5. "It is further maintained that the net worth statement provides the only reliable determination of the incomes of the petitioner for the years involved." (Petitioner's brief, p. 102.)↩6. "Petitioner's position in respect to the fares reported in the cash book but not reported in the journal has been extensively developed. This item in the amount of $14,992.41 is the most important single item in this entire proceeding." (Petitioner's reply brief, p. 71.)↩7. Even if we assume on this branch of the case that some of the proceeds of the large understatements stuck to the bookkeeper's fingers, that would not be inconsistent with petitioner's fraud. Only if all of it was taken without petitioner's knowledge would the bookkeeper's testimony fail.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621984/	THE WINTERBOTTOM BOOK CLOTH COMPANY, LIMITED, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Winterbottom Book Cloth Co. v. CommissionerDocket No. 97416.United States Board of Tax Appeals43 B.T.A. 572; 1941 BTA LEXIS 1485; February 12, 1941, Promulgated 1485 Petitioner, a foreign corporation having no office or place of business in the United States and not engaged in business here, received dividends in 1936 from a wholly owned domestic corporation. After the dividends had been paid, Congress enacted the Revenue Act of 1936 which increased the rate of tax on foreign corporations such as petitioner. Held, that petitioner is liable for the tax on such dividends, pursuant to section 231(a) of the Revenue Act of 1936, notwithstanding the provisions of section 144 (b) of the act. William A. Graham, Esq., for the petitioner. W. Frank Gibbs, Esq., for the respondent. VAN FOSSAN 572 Respondent determined a deficiency in income tax for the year 1936 in the sum of $15,045. The single issue before the Board is whether a foreign corporation not engaged in business in the United States and having no office or place of business in the United States is liable for the tax imposed by section 231(a) of the Revenue Act of 1936, on dividends received during the taxable year but prior to the enactment of the Revenue Act of 1936. 573 FINDINGS OF FACT. The facts were stipulated substantially1486 as follows: Petitioner is a foreign corporation, organized under the laws of Great Britain, with its principal office located at 12 Newton Street, Manchester 1, Manchester, England. During the calendar year 1936, petitioner had no office or place of business in the United States of America, and it was not engaged in any trade or business therein. During the calendar year 1936, and for some years prior thereto, petitioner was the owner of the entire outstanding and issued capital stock of the Arkwright Finishing Co., a corporation organized and existing under the laws of the State of Rhode Island, United States of America, with principal office and place of business located in the city of Providence, State of Rhode Island. The certificates evidencing the shares of capital stock of the Arkwright Finishing Co. have, at all times since shortly after issuance, been in the actual or physical custody of petitioner at its offices in Manchester, England. During the calendar year 1936 and prior to July 2, 1936, the Arkwright Finishing Co. duly declared and paid certain dividends on its capital stock. During the month of March 1936 petitioner was paid and received as a dividend from1487 the Arkwright Finishing Co. the sum of $102,000, and during the month of June 1936 petitioner received another dividend from the Arkwright Finishing Co. in the amount of $75,000. With respect to these dividends, aggregating $177,000, the Arkwright Finishing Co. withheld and paid to the Federal collector of internal revenue, Baltimore, Maryland, a tax of $2,655. On June 8, 1937, petitioner filed with the Federal collector of internal revenue, Baltimore, Maryland, a nonresident foreign corporation income tax return for the calendar year 1936 (Treasury Department Form 1120NB) wherein the dividends aggregating $177,000 received by the petitioner from the Arkwright Finishing Co., Providence, Rhode Island, were reported as the gross amount of income and a total tax liability of $2,655, representing the amount of tax withheld at source. Respondent, in his audit of the return filed by petitioner, has determined that the income reported by petitioner on that return is subject to a total tax liability of $17,700 under section 231(a) of the Revenue Act of 1936. On January 4, 1939, respondent advised petitioner of its liability and determined a deficiency of $15,045, the difference between1488 the liability determined by the Commissioner under section 231(a) of the Revenue Act of 1936 and $2,655, the amount of tax withheld and paid by the Arkwright Finishing Co. 574 OPINION. VAN FOSSAN: The purpose of the revenue acts is to raise money for the support of government. By section 231(a) of the Revenue Act of 1936 1 Congress intended to provide that amounts received by every foreign corporation, not engaged in trade or business within the United States and not having an office or place of business therein, from sources within the United States as interest and dividends and from various other categories should be taxed for the year 1936 at the rates therein provided. Section 1 of the act provides that the provisions of Title I (which covers income tax and includes section 231(a)) "shall apply only to taxable years beginning after December 31, 1935." Clearly the act applies to any taxable year beginning thereafter. Petitioner was on the calendar year basis. Thus the act in terms covered any designated income received by it in 1936. Albeit, the act was not approved until June 22, 1936, there is nothing unusual in the fact that the provisions of the act and its1489 taxing scope dated back to the beginning of the year 1936. It seems clear to us that petitioner corporation was explicitly within the intendment of section 231(a). 1490 Petitioner places chief reliance on the argument, developed at length, that under decided cases the United States is without jurisdiction to impose a tax in personam and under the facts is impotent to impose a tax in rem. These principles, in their application to the present case, are not as formidable to us as apparently they are to petitioner. The statute purports to tax this foreign corporation. The Commissioner of Internal Revenue has determined that it owes additional taxes by virtue of section 231 of the Revenue Act of 1936. There is no question that the petitioner actually received the income in controversy from sources in the United States. The prayer of the taxpayer's petition is as follows: "Wherefore the petitioner prays that this Board may hear this proceeding and determine that the alleged deficiency in the amount of Fifteen Thousand Forty Five Dollars ($15,045) is not legally collectible and that the legal contentions of the taxpayer be sustained." 575 The Board of Tax Appeals is an independent agency in the executive branch of the Government. Although it has judicial powers, it also has certain specific duties and functions. In 1491 , it was stated: Section 907(b) of the Revenue Act of 1924, as amended by section 1000 of the Revenue Act of 1926, makes it the duty of the Board to make a decision in each case before it. It contemplates a decision on the merits except where the proceeding is dismissed, in which case the Board is required to enter a decision that the deficiency is the amount determined by the Commissioner. * * When, however, we read the provisions of the Act as a whole, it seems clear to us that either party has the right to insist that the Board shall enter an order redetermining the deficiency, either on the merits or on default. The Board is not concerned with the difficulties that may beset the Commissioner in collecting a deficiency in tax after redetermination. Our primary function is to determine the correct deficiency, if any, leaving to the Commissioner the enforcement or collection thereof. Here petitioner filed a return and Commissioner, on audit, determined a deficiency. Petitioner filed a petition invoking our jurisdiction. The Commissioner duly answered. The proceeding came on for hearing and was submitted1492 on stipulated facts, admitting receipt of the dividends in question. In this posture of the proceeding it seems clear to us that our first duty is to redetermine the deficiency. This we do by holding that the Revenue Act of 1936 applied to any income received after December 31, 1935, and that, accordingly, it applied to the two dividends received by petitioner. Petitioner also stresses the argument that under the facts here present, i.e., the payment of the dividends prior to July 2, 1936, (that being the tenth day after the enactment of the Revenue Act of 1936) and the transmission of the dividends abroad, the United States is impotent under section 144 2 to enforce collection. Wherefore, the tenor of its prayer above quoted. In our opinion, petitioner's counsel overlooks certain basic considerations. Section 144 is not a taxlevying 576 section but a tax-collecting section. The provisions for withholding income at the source were inserted to facilitate and implement collection. Section 231 levies a tax on foreign corporations receiving income from sources within the United States in 1936 and sectiom 144 provides a convenient and practical means of collecting the1493 same. It is not exclusive of any other means of collection available to the Commissioner. 1494 The reason behind section 144(b) is obvious. It was intended by this section to release the withholding agent from liability for failing to withhold at the new rate income due a foreign corporation during the period prior to 10 days after the enactment of the act. The injustice of a contrary provision requires neither demonstration nor example. But this provision for the protection of the withholding agent was not a limitation of the provisions of section 231, which levied the tax on the foreign corporation itself. Petitioner was liable for the tax on all amounts received from the specified sources during the entire year, irrespective of the release of the withholding agent. Respondent's regulation (art. 235-2, Regulations 94), that the foreign corporation "shall pay the balance of the tax shown to be due" is fair and reasonably interprets the Congressional mind. Reviewed by the Board. Decision will be entered for the respondent.LEECH concurs only in the result. Footnotes1. SEC. 231. TAX ON FOREIGN CORPORATIONS. (a) NONRESIDENT CORPORATIONS. - There shall be levied, collected, and paid for each taxable year, in lieu of the tax imposed by sections 13 and 14, upon the amount received by every foreign corporation not engaged in trade or business within the United States and not having an office or place of business therein, from sources within the United States as interest (except interest on deposits with persons carrying on the banking business), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income, a tax of 15 per centum of such amount, except that in the case of dividends the rate shall be 10 per centum, and except that in the case of corporations organized under the laws of a contiguous country such rate of 10 per centum with respect to dividends shall be reduced to such rate (not less than 5 per centum) as may be provided by treaty with such country. ↩2. SEC. 144. PAYMENT OF CORPORATION INCOME TAX AT SOURCE. (a) GENERAL RULE. - In the case of foreign corporation subject to taxation under this title not engaged in trade or business within the United States and not having any office or place of business therein, there shall be deducted and withheld at the source in the same manner and upon the same items of income as is provided in section 143 a tax equal to 15 per centum thereof, except that in the case of dividends the rate shall be 10 per centum, and except that in the case of corporations organized under the laws of a contiguous country such rate of 10 per centum with respect to dividends shall be reduced to such rate (not less than 5 per centum) as may be provided by treaty with such country; and such tax shall be returned and paid in the same manner and subject to the same conditions as provided in that section; Provided, That in the case of interest described in subsection (a) of that section (relating to tax-free covenant bonds) the deduction and withholding shall be at the rate specified in such subsection. (b) WITHHOLDING BEFORE ENACTMENT OF ACT. - Notwithstanding the provisions of subsection (a), the deduction and withholding for any period prior to the tenth day after the date of the enactment of this Act shall be upon the items of income and at the rates prescribed in section 144 of the Revenue Act of 1934, as amended, in lieu of the items and rates prescribed in such subsection. ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621985/	Ralph K. Gee v. Commissioner. Estate of Ralph Turner, Deceased, Samuel R. Turner, Administrator v. Commissioner.Ralph K. Gee v. CommissionerDocket Nos. 21804, 21888.United States Tax Court1950 Tax Ct. Memo LEXIS 36; 9 T.C.M. (CCH) 1092; T.C.M. (RIA) 50293; November 24, 195036 Claude L. Gray, Esq., P.O. Box 433, Orlando, Fla., for the petitioners. Percy C. Young, Esq., for the respondent. OPPERMemorandum Findings of Fact and Opinion OPPER, Judge: Respondent determined deficiencies in income tax as follows: 25%Docket No.PetitionerTaxable PeriodDeficiencyPenalty21804Ralph K. GeeCalendar year 1943$ 682.74Period Jan. 1,1944, to Nov. 30, 19447,265.6021888Estate ofRalph Turner,Fiscal year endedApril 30, 1944260.09DeceasedPeriod May 1, 1944,to Nov. 30, 19446,368.63$65.02Petitioners assail that portion of the deficiencies which result from attributing to them all of the net income of an enterprise instead of 25 per cent each as they reported. The sole issue turns upon the distribution of partnership income between husbands and wives. Certain adjustments are not contested. Some of the facts were stipulated. Findings of Fact The stipulated facts are hereby found accordingly. Petitioner Ralph K. Gee and Ralph Turner, deceased, filed their individual income tax returns for the periods involved with the collector of internal revenue for37 the district of Florida. Ralph Turner, deceased, hereinafter called Turner, and his wife Odessa Turner, hereinafter called Mrs. Turner, were residents of Orlando, Florida. During a period from some time prior to 1935 until December 1, 1938, Turner was engaged in the meat distributing business. In 1935 they acquired, in their joint names, property located at 802 Lake Davis Drive in Orlando, which they mortgaged in the same year in order to borrow $4,300. They used the money for the construction of a house upon the property, which subsequently they made their home. The house contained one room which was used as an office for the business. In 1938 they acquired property in Palm Beach in their joint names which Mrs. Turner managed, and upon its subsequent sale the proceeds were used to purchase a truck for the meat business. In October, 1938 petitioner Ralph K. Gee, hereinafter called Gee, and his wife Ruth D. Gee, hereinafter called Mrs. Gee, moved to Orlando from Pittsburgh, Pennsylvania, and they resided with their friends, the Turners, in the latter's home for about six or eight months. On December 1, 1938, a partnership was formed under the name of Turner & Gee, hereinafter38 called T & G, to conduct a meat distributing business. The assets of the Turner business, worth approximately several hundred dollars, were contributed to the partnership which assumed liabilities of about an equal amount owed by the Turner business. T & G borrowed $4,000 from Maude D. Atchison, Mrs. Gee's mother, receiving a check made out to the order of T & G, which was endorsed for T & G by Gee. That debt was repaid by a partnership check, dated February 26, 1945, signed for T & G by Gee and Turner. On December 3, 1938, T & G opened an account at the Citizens State Bank of St. Cloud, Florida, depositing $4,355.05, and Turner, Gee, Mrs. Gee, and Mrs. Turner signed the signature card authorizing withdrawals. At the same time T & G leased space from the Atlantic Ice Company at 250 Boone Street, Orlando, where refrigeration was available, and where they made use of a small office. They continued to lease space in that building until February 1945 when they moved into new quarters. In addition T & G made some use of the office located in the Turner home. The business operated without formal articles of partnership. No additional capital was subsequently contributed. Profits were39 allowed to accumulate except for a drawing account allowed to each family of $75 per week. Prior to December 1, 1943, the books of T & G showed Turner and Gee to be the sole partners. Turner devoted his time principally to purchasing, while Gee was largely responsible for sales. Mrs. Gee devoted her full time to the business as office manager. Her work included keeping the books, accepting telephone orders, receiving merchandise, and sending out truck shipments. Fifteen checks of varying dates between July 13, 1940, and July 27, 1940, and a check dated January 13, 1941, all drawn upon the Citizens State Bank of St. Cloud, Florida, and signed for T & G by Mrs. Gee and Turner, were issued in the regular course of the business of T & G. Mrs. Turner kept house and prepared meals at odd hours for Turner, Gee and Mrs. Gee. She rendered assistance in office work such as the reception of telephone orders and mailing of statements. All four participated in concluding the bookkeeping work for the week on Saturday evenings, and in making trips on Sunday to examine cattle and consummate cattle deals. All four participated in business discussions and decisions. Neither Mrs. Gee nor Mrs. 40 Turner was ever paid a salary by T & G. Neither Mrs. Gee nor Mrs. Turner filed Federal income tax returns for any taxable year beginning prior to December 1, 1943. The application of the partnership of T & G for an employer's identification number under the Social Security Act, on Treasury Department Form SS-4, dated April 28, 1939, shows the names of the employers as Ralph K. Gee and Ralph Turner, trading as T & G. 250 Boone Street, Orlando, Florida. An employer's identification number was assigned to Ralph K. Gee and Ralph Turner, trading as T & G, and all employer's tax returns filed under the Federal Insurance Contributions Act by T & G from January 1, 1943, through November 30, 1944, show the same identification number. On May 11, 1942, T & G received a loan of $950 from Maude D. Atchison, and on the same date the latter received a mortgage indenture and a note for $950 bearing six per cent interest per annum. The indenture described the mortgagors as "Ralph Turner and Ralph K. Gee, trading and doing business as Turner and Gee, a co-partnership and their respective wives." Both instruments were signed by Gee as "Partner" on behalf of "RALPH TURNER and RALPH K. GEE, trading41 and doing business as TURNER & GEE, a co-partnership", and were also signed by Turner, "Individually," by Mrs. Turner, by Gee, "Individually," and by Mrs. Gee. On April 19, 1943, T & G opened an account in the Florida Bank At Orlando. The signature card was signed by Turner, Gee, Mrs. Gee, and Mrs. Turner, and two signatures were required for withdrawals. At various times, all four signed checks withdrawing funds from the account, and executed promissory notes on behalf of the firm. The Florida Bank At Orlando dealt with all of them as members of the partnership. T & G also maintained a safe deposit vault in that bank to which Turner, Gee, Mrs. Gee, and Mrs. Turner had access, and in which, they kept personal, as well as partnership property. A "Deed And Bill of Sale" dated November 30, 1943, executed by Turner and Gee, stated that they were doing business under the name of T & G, that each owned an undivided one-half interest in that firm, and that they transferred to Mrs. Turner and Mrs. Gee, an undivided one-fourth interest each, to all of the assets of the firm. On December 1, 1943, an instrument entitled "Partnership Agreement" was executed by Turner, Gee, Mrs. Turner and42 Mrs. Gee, and by Turner and Gee on behalf of T & C, which provided, among other matters, that the individuals agreed to become equal partners in the business of wholesale slaughtering and sale of meat under the firm name of T & G; that the business should be carried on at the same premises on which it "is now being carried on by the said Ralph Turner and the said Ralph K. Gee"; that in the event of dispute in connection with management, differences should be referred to indifferent persons, one to be chosen by Turner and Mrs. Turner, another to be chosen by Gee and Mrs. Gee, and a third to be chosen by the two persons so named; that Turner and Gee "so long as they shall be alive shall pass upon and together decide all questions as to policies and general details in their executive capacities as heads of said business and shall as such act as an executive committee in all the details of the management and conduct of said business and no partner shall knowingly do any act in relation thereto contrary to the decisions and policies so established and determined"; that upon dissolution by reason of death or otherwise, the remaining partners might, if desired, continue the business and they43 should have the right to purchase the interest of the retiring partner; that should Turner or Gee die before the agreed partnership term of twenty-five years, the surviving partners should, for one year, operate the business before terminating it. Turner and Gee each filed a gift tax return reporting a gift of one-half of an undivided one-half interest in the net assets of the wholesale meat business known as T & G. Each of the gift tax returns was executed and filed with the collector of internal revenue on February 15, 1945. Subsequent to December 1, 1943, Turner, Gee, Mrs. Turner, and Mrs. Gee continued to render the same services to T & G, and all four participated in business discussions and decisions. The partnership returns of T & G for the fiscal years ending November 30, 1942, and November 30, 1943, which were executed and filed by Gee, reported Turner and Gee to be the sole partners. The individual income tax returns of Turner, Gee, Mrs. Turner, and Mrs. Gee, for the taxable period ending November 30, 1944, each reported the amount of $12,344.73 as income from the partnership of T & G. The books of account of T & G, after December 1, 1943, show Turner, Gee, Mrs. Turner44 and Mrs. Gee to be partners. The books and records of T & G show that, from January 1, 1943, through November 30, 1945, Mrs. Gee, with the exception of withdrawals in the amounts of $29.49 and $2.50, made no withdrawals except for the payment of Federal income taxes, and Mrs. Turner, with the exception of withdrawals in the amounts of $29.50 and $2.50, made no withdrawals except for the purposes of paying her Federal income taxes. Neither Mrs. Gee nor Mrs. Turner had an individual bank account in any bank during the period from January 1, 1943, to December 1, 1945. The drawing accounts on the T & G ledger show that during the period from December 1, 1943, to November 30, 1944, Turner drew a total of $10,177.66, including $4,702.48 for income taxes, while Gee drew a total of $9,131.72, including $4,002.11 for income taxes. Additional profits were left to accumulate with the ultimate purpose of purchasing a building for the business. Gee's weekly drawings from the business were used by Gee and Mrs. Gee for their living expenses. A deed, dated October 11, 1944, filed in Orange County, Florida, conveyed Lots 48, 49, 50 and 51 in the Tavares-Orlando and Atlantic Railway Addition to45 Orlando, Florida, from F. A. Mundis, and his wife, and W. H. Ingram, and his wife, to "Ralph K. Gee and Ruth D. Gee, his wife, and Ralph Turner and Odessa Turner, his wife, a co-partnership trading and doing business under the firm name and style of 'Turner & Gee'." Gee, Mrs. Gee, Turner and Mrs. Turner executed to the above grantors a mortgage indenture and a promissory note for $6,375 bearing 4 per cent annual interest, each dated October 11, 1944. A check of the same date to the order of W. H. Ingram in the amount of $6,173.60, drawn upon the Florida Bank At Orlando and signed by Gee and Turner for T & G, was delivered to Ingram in part payment of the purchase price. The property included a building. In February 1945, T & G occupied the property, and thereafter the business was conducted from those premises. A portion of the premises was leased to tenants, and the rentals were included in the income of T & G. A "Satisfaction of Mortgage," dated June 4, 1945, signed by F. A. Mundis and his wife, and W. H. Ingram and his wife, acknowledged satisfaction of the mortgage upon that property "given by Ralph K. Gee and Ruth D. Gee, his wife, and Ralph Turner and Odessa Turner, his wife. 46 " A check given in satisfaction of the mortgage, dated June 6, 1945, made out to the order of W. H. Ingram and F. A. Mundis, in the amount of $6,537.82, drawn upon the Florida Bank At Orlando, was signed for T & G by Gee and Turner. On January 31, 1945, T & G borrowed $2,500 from Gee and $2,500 from Turner. Turner and Gee each received a promissory note, dated February 9, 1945, signed by Gee, Mrs. Gee, Turner, and Mrs. Turner. On July 10, 1946, Ralph Turner died intestate, and Samuel R. Turner is the duly qualified and acting administrator of the estate. In November, 1946, pursuant to an order of the Probate Court, the interests in T. & G of the deceased and of Mrs. Turner were conveyed to Gee and Mrs. Gee in exchange for consideration paid. Petitioner Gee and petitioner estate's decedent actually intended to and did join together to conduct business in partnership with their wives during the period in controversy. Opinion Our ultimate finding of fact that the four individuals intended to and did conduct business in partnership is dispositive of the proceeding. It is based upon a consideration of a combination of all of the circumstances held to be relevant for consideration47 in such proceedings as this. . Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621986/	NASHUA & LOWELL RAILROAD CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Nashua & L. R. Corp. v. CommissionerDocket No. 9494.United States Board of Tax Appeals8 B.T.A. 496; 1927 BTA LEXIS 2863; October 4, 1927, Promulgated 2863 Many years prior to the taxable year petitioner leased its railroad and property for a term of years, the lessee agreeing to pay all Federal income taxes imposed upon the lessor with reference to the rental. The lessee paid the Federal tax upon the net income returned by petitioner for each year subsequent to the lease. Held, the amount of tax so paid constitutes additional income to the petitioner for the year in which such tax became due and was paid. J. S. Y. Ivins, Esq., and O. R. Folsom-Jones, Esq., for the petitioner. M. N. Fisher, Esq., and P. J. Rose, Esq., for the respondent. LITTLETON497 The Commissioner determined a deficiency in income and profits tax for the calendar year 1919 in the amount of $1,074.65. He determined an overassessment for the calendar year 1920 of $125.23, not arising from the denial of an abatement claim. The issues involved are (1) whether the payment, under the terms of a lease, of the lessor's income tax by the lessee constitutes additional income to the lessor; (2) whether the Commissioner correctly reduced invested capital for 1919 by the amount of 1918 profits tax prorated from the dates2864 of payment, and (3) whether the Commissioner erred in reducing invested capital for 1919 by a portion of dividends paid in 1919 claimed by the Commissioner to be in excess of available current earnings at the time of payment. FINDINGS OF FACT. During the taxable year the petitioner was a Massachusetts corporation with principal office at Boston. It was the owner of a railroad which it had leased to the Boston & Maine Railroad under a lease which provided, inter alia, that the lessee would pay the Federal income tax of the lessor. The income tax of the petitioner for each year was payable and was paid by the lessee in the following year. The Commissioner computed a Federal income tax of $7,080.68 on the petitioner's income for the calendar year 1919, as revised by him, and added the said amount of $7,080.68 to petitioner's taxable income for the year 1919. The income-tax return of petitioner for the calendar year 1918 showed a tax liability of $8,425.91, computed upon the income of petitioner for that year without the inclusion therein of any amount on account of tax paid by petitioner's lessee. This tax of $8,425.91 was paid by petitioner's lessee during the calendar2865 year 1919. Petitioner kept its books and rendered its return on an accrual basis. In determining the deficiency the Commissioner reduced petitioner's invested capital for the year 1919 in the amount of $4,523.83, representing the amount of petitioner's income and profits tax for 1918 prorated from the dates due and payable in 1919. The Commissioner, also, in computing the net earnings of petitioner available for the payment of dividends on each particular date 498 of payment during the year 1919 reduced the taxable year's book income in the amount of Federal income taxes accrued on the year's taxable income and treated the income, less taxes, as having been earned ratably throughout the taxable year. The net income however, was received from rentals semiannually and dividends were paid semiannually out of such rentals as received. The rentals in each case were sufficient to pay dividends, that is rentals receivable on April 1 and October 1, and dividends not in excess thereof, were paid on May 1 and November 1, 1919. OPINION. LITTLETON: In 2866 , the Board held that the amount of tax upon the income of the lessor and paid by the lessee, under the terms of a lease such as we have here, constituted additional taxable income to such lessor in the year in which such tax was paid by the lessee. On the authority of that decision petitioner's tax for 1919 should be recomputed by including in income the amount of $8,425.91 representing the tax upon petitioner's income for 1918 and paid by the lessee in 1919. The second issue is governed by the Board's decision in . The Commissioner's action in regard to this issue is therefore approved. The third issue is governed by the decisions of the Board in and . The Commissioner's action in regard to this issue is therefore reversed. Reviewed by the Board. Judgment will be entered on 15 days' notice, under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621987/	E. Morris Cox and Margaret S. Cox., et al., 1 Petitioners, v. Commissioner of Internal Revenue, RespondentCox v. CommissionerDocket Nos. 1534-63, 1535-63, 1536-63, 1537-63, 1538-63United States Tax Court43 T.C. 448; 1965 U.S. Tax Ct. LEXIS 141; January 21, 1965, Filed January 21, 1965, Filed 141 Decisions to be entered under Rule 50. T, an accrual basis corporation, performs investment management services for clients who pay quarterly fees measured from the date such services were first engaged by the particular client and based upon the appraised value of the client's account as of the beginning of each quarter. Held: (1) T may not "defer" as income those portions of the fees for the quarter extending beyond the close of T's taxable year where such fees have in fact been received or were otherwise properly accruable by T during that year. Schlude v. Commissioner, 372 U.S. 128">372 U.S. 128. Fees properly accruable determined.(2) Fees similarly chargeable to predecessor partnership as of beginning of T's first taxable period may not be included in T's income for that period.(3) T's expense items may properly be recomputed so as to allow deduction for those expenses already paid or accrued but "deferred" as of the end of T's taxable period and to disallow the corresponding expenses previously paid or accrued but "deferred" as of the beginning of that period.Julian N. Stern and Jerry H. Robinson, for the petitioners.Roger A. Pott, for the respondent. Raum, Judge. RAUM448 The Commissioner determined the following deficiencies in income taxes for the year 1960:Docket No.PetitionersDeficiency1534-63E. Morris Cox and Margaret S. Cox$ 11,636.461535-63Van Duyn A. Dodge and Helen H. Dodge9,174.071536-63Jack S. Logan and Wilmer G. Logan717.981537-63Joseph M. Fee and Elizabeth C. Fee717.971538-63Peter Avenali and Joan E. Avenali3,320.57The cases were consolidated for trial.Petitioners are the stockholders of Dodge & Cox, Inc., which elected to be taxed under subchapter S of the Internal Revenue Code of 1954 as amended. The issues presented143 herein for decision all concern the income of the corporation. They are as follows:(1) Whether an accrual basis taxpayer which contracts to furnish investment management services during a period extending beyond the close of the taxable year is required to accrue and report as gross income for the taxable year (a) cash received in that year as an advance payment of the management fee, (b) amounts contractually due in that year, although not received, and (c) amounts not contractually 449 due and not received, where the related services have not been performed.(2) To the extent the Court accepts respondent's position as to the items of income above relating to the close of the corporation's taxable year, whether petitioners are entitled to treat the corresponding items at the beginning of the taxable year in the same manner, thereby eliminating them from income.(3) If the corporation's method of reporting income is disapproved, whether expenses which had accrued in the taxable year but which had been "deferred" may now be deducted in the taxable year in question.FINDINGS OF FACTThe stipulated facts together with accompanying exhibits filed by the parties are incorporated144 herein by this reference.The petitioners in each case, husband and wife residing in the San Francisco area, filed their joint income tax returns for the calendar year 1960 with the district director of internal revenue at San Francisco, Calif. The husbands will hereinafter sometimes be referred to as petitioners.Petitioners owned all the outstanding stock of Dodge & Cox, Inc., a California corporation which was formed on February 4, 1959, and commenced business on March 1, 1959. Its books are maintained and its tax returns are filed on the basis of a fiscal year ending January 31. It employs the accrual method of accounting. Its income tax return for the 11-month period March 1, 1959, through January 31, 1960, was filed with the district director of internal revenue at San Francisco, Calif.The corporation elected to be taxed in accordance with subchapter S of the Interal Revenue Code of 1954, and accordingly a proportionate share of its income for the fiscal period ended January 31, 1960, was reported by each of the petitioners in the joint returns which he and his respective spouse filed for 1960.The business of the corporation was originated by a partnership in 1933, and145 was operated under the name of Dodge and Cox from 1933 until March 1, 1959. On or about March 1, 1959, the partners transferred the assets and liabilities to the corporation in exchange for its capital stock in a transaction that was treated as a nontaxable transfer under section 351 of the Internal Revenue Code of 1954. The same accounting system and method of reporting income employed by the partnership was adopted by the corporation, except that the partnership reported its income on a calendar year basis. Such system had consistently been employed since 1933. The partnership filed returns for each year through 1959.The business of the corporation is that of providing investment management services for its clients, and is operated in the same manner 450 as it had been operated by the predecessor partnership. In general a client, upon engaging the services of the corporation, turns over money or securities to a bank to be held in a custody account for him and the corporation directs what purchases and sales of securities are to be made in such account. The clients consist of individuals and trustees and in addition the Dodge & Cox Fund, a diversified open-end investment146 trust.The corporation's activities looking towards the ultimate objective of providing investment management for its clients may be regarded as being divided generally into three categories: Research, account administration, and general administration.The services of the "research department" are performed for all clients generally and without regard to the account of any single client. Its basic function is first to form an opinion with respect to the economic outlook for our country as it bears upon private business. This opinion is then used as a guide to overall diversification of the clients' accounts between bonds, preferred stocks, and common stocks. Finally, the research department must determine what particular lines of business or industry will be the subject of investment and in what proportions. The work of the research department culminates in what is called a "policy control account." This policy control account represents an application of the basic investment policy to an assumed dollar amount of investment and indicates by type of investment the amount that should be properly invested in each industry.The "account administration department" actually applies147 the findings of the research department to the individual clients' accounts. The object is to bring the clients' accounts into proper alignment with the corporation's overall investment policy. If the corporation deems it advisable, it will initiate purchases or sales of securities for the accounts.Services performed under the category of "general administration" consist principally of the following:(a) With respect to each client, the corporation receives a monthly statement from the bank reflecting the transactions which have taken place in that particular client's custody account.(b) The corporation maintains a separate ledger card for each client which reflects all transactions in the account. This ledger card is reconciled monthly with the statement received from the respective bank.(c) The corporation maintains a list of the cost of the investments in each client's account. This list is always consulted prior to initiating the sale of any security.(d) The corporation prepares a quarterly appraisal of each client's account. The date of each of the appraisals corresponds to the anniversary date of the opening of the particular account. However, the 451 prices 148 upon which the appraisal is based are those prevailing on the nearest Monday to the anniversary date of the account. This appraisal is used not only for purposes of analysis, but is also the basis upon which the management fees (hereinafter referred to) of the corporation are computed.(e) After each appraisal of an account, the corporation prepares a document entitled "Account Review." This document compares, on a percentage basis, the investments of the particular account with the investments indicated by the policy control account.(f) The corporation prepares a summary each year of the capital gains and losses in each account.All of the services are regularly performed by the corporation as a matter of course during the year.The services performed by the corporation are not dependent upon the demand or request of its clients. Purchases and sales of securities in the clients' accounts are initiated by the corporation; it is extremely rare for a client to suggest to the corporation a particular transaction.At the time any client other than the fund employs the corporation two separate contracts are executed, one between the client and the corporation (referred to as the "Managers") 149 and the other between the client and the bank selected for the custody account. The second contract, sometimes described as "Letter of Instructions to the Bank" is incorporated by reference in the first contract and a copy thereof is physically attached to the first contract. In regard to compensation of the corporation the first contract provides:The entire compensation of the Managers will be a quarterly fee, in advance, of $ 75 plus $ 1.25 on each $ 1000 of appraised value of the account up to $ 500,000 and $ 1.00 per $ 1000 over $ 500,000.And that fee arrangement is referred to in the contract between the client and the bank as follows:Upon presentation of the Managers' fee bill, a quarterly management fee of $ 75 plus $ 1.25 on each $ 1000 of appraised value of the account up to $ 500,000 and $ 1.00 per $ 1000 over $ 500,000 will be paid, in advance, by the Bank from the account to the Managers.Also, the corporation is obligated under its agreement with the client to pay the bank custody charges quarterly in advance.The corporation's billings to its clients reflect quarterly fees for the 3-month period commencing with the day on which the corporation's services are150 engaged and the corresponding day of every third month thereafter. Fees for clients other than the Dodge & Cox Fund bear the foregoing relationship to the appraised value of the account. Since it is necessary to appraise each client's account as of the close of business on the Monday nearest to the last day of the client's quarter and then to compute the fee, the quarterly bills are not sent out to the banks holding the respective custody accounts until 10 days to 2 weeks after 452 the end of the quarter being billed. The banks remit the fees to the corporation anytime from 2 days to 2 weeks after they receive the bill, depending on the bank involved.Rarely have clients canceled the services of the corporation or its predecessor partnership during a quarterly period for which they have been billed. If a client dies during a quarter, the estate generally retains the services of the corporation at least until the end of the quarter. However, in those rare cases where the corporation's services have been canceled prior to the end of the client's quarter the corporation has followed the policy of refunding to that client a pro rata portion of the fee paid.The corporation151 also receives a fee for each quarter of the calendar year from the fund equal to a percentage of the value of the assets of the fund as of the last day of the preceding quarter and subsequently adjusted to take into account daily fluctuations of the assets during the current quarter. This fee arrangement is spelled out in the agreement between the corporation and the fund as follows:4. The Manager shall receive as and for its entire compensation as such Trust Manager and Investment Adviser within fifteen (15) days after the first day of each quarter of the calendar year, a fee of one-eighth of one per cent (1/8 of 1%) of the value of the Trust Fund determined as provided in Article X of said Declaration of Trust as of the last day of the preceding quarter. Such compensation shall be payable out of the Trust Fund and all additions to or withdrawals from the Trust Fund during a quarterly period shall be prorated and an adjusted fee computed as of the end of such quarter.In respect of its clients generally the amounts billed by the corporation are, as of the last day of the particular calendar month, debited to accounts receivable and credited to an account entitled "Unearned fees." 152 This entry is not physically placed on the corporation's books until after the end of the quarter.As of the end of each of the corporation's quarters ending in January, April, July, and October, an entry is made on the corporation's books charging the "Unearned fees" liability account and crediting the "Earned fees" income account. The amount of the billed fees taken into income at this time is the total of computations of earned income for the quarter made with respect to each individual client. The earned income for each client represents the amount of that client's fee which was deferred at the beginning of the corporation's quarter plus that portion of the fee billed during the quarter which the number of days between the billing date (the date on which the corporation's services were engaged or the corresponding day of every third month thereafter) and the end of the corporation's quarter bears to the total number of days in the quarter. The result of this computation is to prorate each client's fee on a daily basis and thereby to take into earned income for any particular quarter that portion of a client's 453 fee which is attributable to the number of days actually153 within the quarter.When the corporation took over the business of the partnership on March 1, 1959, it set up as a credit on its books the amount of $ 37,800.36 representing the balance in the "Unearned fees" account of the partnership at that date. This amount was reported as ordinary income by the corporation in its fiscal period ending January 31, 1960. Of this amount $ 30,483.41 had been billed and received by the partnership, $ 2,170.88 had been billed by the partnership but was collected by the corporation, and $ 5,146.07 was billed and received by the corporation.The balance in the corporation's "Unearned fees" account at January 31, 1960, was $ 54,286.12. Of this amount $ 20,684.30 was billed and received by the corporation during the fiscal year ended January 31, 1960, $ 9,292.65 was billed during that fiscal year but not received until the following fiscal year, and $ 24,309.17 was neither billed nor received until the following fiscal year. Of the latter amount neither billed nor received until the following fiscal year, $ 6,047.73 was attributable to the fee of the fund (which was billed on February 12, 1960), and $ 18,261.44 represented bills for other clients. 154 In his adjustments giving rise to the deficiencies herein the Commissioner determined that all of the $ 54,286.12 fees which the corporation treated as "unearned" as of January 31, 1960, must be included in its gross income for the taxable period ending on that date.As expenses were incurred by the corporation, the transaction was entered in a vouchers payable register with a debit to "Prepaid expense" and a credit to "Vouchers payable." The corporation maintained a prepaid expense register for the purpose of accumulating the prepaid expense charges from the vouchers payable register. Each individual item of prepaid expense was then distributed as a charge against income of the corporation's fiscal quarter to which the expense was applicable.When the corporation took over the business of its predecessor partnership, it set up as a debit on its books the amount of $ 9,973.09 representing expenses incurred by the partnership, but for which the charge against income had been deferred. Of this amount, $ 8,754.67 had in fact been paid by the partnership prior to March 1, 1959.During the corporation's fiscal period ended January 31, 1960, expenses in the total amount of $ 23,374.86155 were incurred by the corporation and charged to the "Prepaid expense" account. During this period, total expenses in the amount of $ 21,075.65 were taken out of the "Prepaid expense" account and deducted by the corporation. Of the total expenses thus deducted during the year, $ 7,014 were items 454 which were reflected in the beginning balance in the "Prepaid expense" account.At January 31, 1960, the balance in the "Prepaid expense" account was $ 12,272.30, of which $ 9,908.85 had been paid prior to January 31, 1960.As of January 31, 1960, the corporation had deferred bank custody charges which had been incurred in the amount of $ 7,470.99 and under its method of accounting did not deduct said charges on its income tax return filed for this taxable period. The Commissioner in his adjustments reflected in the statutory notices of deficiencies allowed this amount as a deduction to the corporation for the taxable period ended January 31, 1960.OPINIONDodge & Cox, Inc., an accrual basis corporation with a fiscal year ending January 31, performs investment management services for a number of clients, including Dodge & Cox Fund, a diversified open-end investment trust. The 156 fees for its services are payable quarterly in advance and are measured by the appraised value of the clients' accounts. The fee for any particular client other than the fund is based upon the 3-month period commencing with the calendar day on which the corporation's services were engaged for that client and, upon reappraisal of the account, is recomputed for each subsequent 3-month period commencing on the corresponding day of every third month thereafter. The fee for the fund is determined for each quarter of the calendar year, equal to a percentage of the value of its assets as of the end of the preceding quarter and as subsequently adjusted to take into account daily fluctuation during the current quarter.The issues herein arise by reason of the method employed by the corporation in reporting its fees as income. In essence, as to each client, the corporation treats as "earned" or reportable income as of the end of any month only that portion of that client's quarterly fee that is arithmetically allocable to the number of days within that month that fall within the client's current quarter. Thus, if there are 92 days in the client's current quarter and if that quarter commenced157 20 days prior to the end of the current month, the corporation would treat as realized and reportable income as of the end of the month only 20/92 of the fee, 2 regardless of whether it had already received the fee in full and regardless of whether it had already presented its bill for that fee. The remainder of the fee would be treated as "unearned" income, and if there were 31 days in the following month, 31/92 of the fee would be taken out of "unearned" income as 455 of the end of such following month and included in "earned" or reportable income for that month. In substance, the corporation's method is to prorate each client's fee on a daily basis, and thus take into reportable income for any particular quarter of its own that portion of the client's fee which is attributable to the number of days within its own quarter. And that portion of the client's fee (even though already received or otherwise accrued) that spills over into the corporation's next quarter is treated as "unearned" and unreportable for the quarter just ended.158 As already noted, the corporation employs a fiscal year ending January 31. Thus, at the end of its final quarter for the taxable period ending January 31, 1960, there were on its books "unearned" fees in the amount of $ 54,286.12. These "unearned" fees represented in the aggregate those portions of its clients' fees that were allocable to those portions of the clients' current quarters that extended beyond January 31, 1960. The Commissioner determined that the entire $ 54,286.12 must be included in the corporation's gross income for its fiscal period ending January 31, 1960; and at the same time he allowed as a deduction related bank custody charges in the amount of $ 7,470.99 which had already been incurred but which the corporation had similarly allocated to the period following January 31, 1960, and had not deducted for the period ending January 31, 1960.The $ 54,286.12 item breaks down into several components. Of the total $ 54,286.12 fees involved, (a) $ 20,684.30 represents fees that were actually collected by the corporation during its fiscal period ending January 31, 1960; (b) $ 9,292.65 represents fees that were actually billed but not received during that period; and159 (c) $ 24,309.17 represents fees that had not yet been billed by January 31, 1960. We hold that the Commissioner was correct as to the first two components, and was correct only as to part of the third component, as hereinafter indicated.(1) The $ 20,684.30 and $ 9,292.65 Fees Received or Billed During the Fiscal Period Ending January 31, 1960. -- Whatever theoretical arguments might be urged in support of petitioners' position that the corporation properly allocated these fees to the following year, the matter has been authoritatively settled otherwise by the Supreme Court. Schlude v. Commissioner, 372 U.S. 128">372 U.S. 128; American Automobile Assn. v. United States, 367 U.S. 687">367 U.S. 687.Petitioners point to certain possible distinctions -- that here, unlike Schlude, the corporation's services were regularly performed and not "solely on demand of the customers," that here there was no income from cancellations, and that, unlike the present case, the studio in Schlude paid royalties and commissions that were deducted at once rather than being spread over the period during which the related income was earned. True, 160 these factual differences exist, and these 456 considerations were noted by the Supreme Court in Schlude. But the Court rested its decision also upon another and more sweeping ground, namely, that in the absence of a specific statutory provision authorizing such practice, it was not open to a taxpayer under the Internal Revenue Code of 1954 to "defer" income to a later period. 372 U.S. at 134-135. The distinctions relied upon by petitioners are entirely irrelevant in respect of this more fundamental ground that governs all attempts to "defer" or postpone the reporting of income that has actually been received or accrued.In this case the corporation is on the accrual basis and is therefore chargeable not only with the fees already in hand ($ 20,684.30) by the close of January 31, 1960, but also with those that had otherwise accrued at that time. The $ 9,292.65 fees that had already been billed were plainly then due and payable, and there can be no serious contention that they had not accrued by January 31, 1960. The Schlude case clearly requires that both the $ 20,684.30 and $ 9,292.65 items be treated as reportable income for the period161 ended January 31, 1960.(2) The $ 24,309.17 Fees Neither Billed nor Received. -- The third and final component of the $ 54,286.12 fees which the Commissioner charged to the corporation for the period ending January 31, 1960, consisted of $ 24,309.17 fees that it had neither received nor billed by the close of that fiscal period. That $ 24,309.17 item is in turn composed of two parts which require separate consideration and treatment, namely, $ 18,261.44 fees in respect of clients other than Dodge & Cox Fund, and $ 6,047.73 fee of the fund.(a) The $ 18,261.44 Unbilled Fees of Clients Other Than the Fund. -- In Schlude, following a concession by the Government, the Court remanded the case so that there could be excluded from income as not yet having been accrued those amounts "which were neither due as a matter of contract, nor matured by performance of the related services." 372 U.S. at 133 fn. 6, 137. We hold that the $ 18,261.44 fees herein fall within that description and should be accorded like treatment.The Government seeks to avoid that result here by arguing that these fees were due as a matter of contract during the fiscal period 162 ending January 31, 1960. To be sure, the clients' contracts with the corporation referred to the quarterly fees as payable "in advance," and the pertinent quarter of each client in respect of the $ 18,261.44 fees commenced prior to the close of that fiscal period. If that were all there was to the matter, the Government's position would probably be sound, and we would be constrained to conclude that these fees were due as a matter of contract during the fiscal period. However, the client's contract with the corporation incorporates by reference and has attached to it the client's instructions to the custodian bank, approved by the corporation. And those instructions authorize the 457 bank to pay the corporation's quarterly fee "in advance," "[upon] presentation of the * * [corporation's] fee bill."The words "in advance" in the client's contract with the corporation are susceptible of interpretation, and it is clear to us that they were used here to mean merely that the corporation would be entitled to the fee upon presentation of its bill even though that event may occur at the beginning or in the early part of the client's quarter. The two documents must be read together, 163 and when so considered, we conclude that the unbilled fees were not in fact payable under the contract with the corporation until billed, and, to the extent that they were not supported by services rendered, cf. Dally v. Commissioner, 227 F. 2d 724, 726-727 (C.A. 9), affirming 20 T.C. 894">20 T.C. 894, certiorari denied 351 U.S. 908">351 U.S. 908, they had therefore not yet accrued. 3(b) 164 The $ 6,047.73 Fee of the Fund. -- It must be remembered that the corporation's fee for its services to the fund was based upon each quarter of the calendar year; it was determined as of the last day of the preceding quarter, in this case December 31, 1959; it was payable "within fifteen (15) days after the first day" of the quarter, namely, not later than January 16, 1960; and it was subject to readjustment at the end of the quarter by reason of changing values during the quarter.The bill in respect of the fee for the quarter beginning January 1, 1960, was not in fact presented until February 12, 1960. However, unlike the situation in respect of the other clients, there does not appear to be any contractual provision susceptible of being interpreted as making the time of payment depend upon presentation of the bill. The $ 6,047.73 fee became due and payable by the fund not later than January 16, 1960, during the corporation's fiscal period ending January 31, 1960.Whether that amount had yet in fact been computed is of no moment. It was reasonably determinable during that period, cf. Continental Tie & Lumber Co. v. United States, 286 U.S. 290">286 U.S. 290.165 The corporation had a right to receive it at that time, and it was therefore accruable. As was said in Schlude (372 U.S. at 137):For an accrual basis taxpayer "it is the right to receive and not the actual receipt that determines the inclusion of the amount in gross income," Spring City Co. v. Commissioner, 292 U.S. 182">292 U.S. 182, 184; Commissioner v. Hansen, 360 U.S. 446">360 U.S. 446, and here the right to receive * * [this amount] had become fixed at least at the time * * * [it was] due and payable.458 Nor is it a matter of consequence that, as indicated by the evidence, the bill had not been presented until February 12, 1960, because of the delay occasioned by the independent auditors. The point is that petitioners have failed to show that billing was a condition precedent to liability in the case of the fund. That liability accrued and was payable no later than January 16, 1960. And the fact that the amount was subject to subsequent readjustment at the end of the fund's quarter was no bar to accrual. Cf. Continental Tie & Lumber Co. v. United States, supra.166 We hold that the $ 6,047.73 item accrued during the fiscal period ending January 31, 1960.(3) The $ 37,800.36 "unearned fees" on the Corporation's Books as of March 1, 1959, Taken Over From the "unearned fees" Account of the Partnership. -- Petitioners make the alternative argument that to the extent that they are unsuccessful in their contention that the $ 54,286.12 "unearned fees" as of January 31, 1960, should not be charged to the corporation for the fiscal period ending at that time, the opening balance in the "unearned fees" account ($ 37,800.36) as of March 1, 1959, was properly chargeable to the predecessor partnership and should be excluded from the corporation's gross income of the taxable period. We agree.The $ 37,800.36 "unearned fees" placed on the corporation's books as of March 1, 1959, consisted of $ 30,483.41 that had already been billed and received by the partnership, $ 2,170.88 that had been billed by the partnership but subsequently collected by the corporation, and $ 5,146.07 that was billed and collected by the corporation. In accordance with our decision relating to the "unearned fees" as of January 31, 1960, the first two of these components ($ 30,483.41167 and $ 2,170.88) were properly accruable by the partnership and the third component ($ 5,146.07) was properly accrued by the corporation. 4In respect of the first two components, if the statute of limitations had not run against taxing the partners' distributive shares of partnership earnings, the matter would simply call for revision of such distributive shares for the earlier year. But since the period of limitations appears to have expired the Commissioner insists168 that the 1959 partnership income that was not in fact included in the partners' taxable distributive shares for that year may properly be included in the corporation's income for its fiscal period ending January 31, 1960. However, that position is flatly in conflict with our decision in Heer-Andres Investment Co., 17 T.C. 786">17 T.C. 786, 788-789 (second issue).The Commissioner seeks to avoid the effect of Heer-Andres by calling 459 attention to the fact that it was decided under the 1939 Code and that section 481 of the 1954 Code 5 was enacted to meet just the type of situation presented by that case. But his argument is confusing and unconvincing. If he were to rely affirmatively upon section 481 to justify an adjustment including the untaxed 1959 partnership income in the corporation's income for the fiscal period ending January 31, 1960, he would be faced with the contention that section 481 is inapplicable here. That section deals with a situation where a taxpayer's income is computed under a method of accounting different from the method "under which the taxpayer's taxable income for the preceding taxable year was computed" (italics supplied). 169 And this Court has held these provisions inapplicable to the recomputation of the first year's income of a corporation that was the successor to a partnership, on the ground that the "taxpayer" had no "preceding taxable year." Ezo Products Co., 37 T.C. 385">37 T.C. 385, 393; cf. Estate of John A. Biewer, 41 T.C. 191">41 T.C. 191, 197-198.170 The Commissioner might have argued, but did not do so, that Ezo is not in point because the corporation herein is a subchapter S corporation and its income is attributed directly to its stockholders in the same manner that partnership income is attributed to the partners, with the consequence that the same taxpayers are involved and that the subchapter S corporation is merely a continuation of the old partnership for purposes of section 481 regardless of whether a subchapter S corporation itself may properly be treated as a taxpayer for other purposes elsewhere in the Code. Such argument would have a strong appeal in view of the underlying purpose of section 481, and the Commissioner might therefore have undertaken to justify his insistence that the "unearned fees" as of March 1, 1959, were correctly taken into account in computing the corporation's income under section 481. However, he made no such contention, and we express no opinion as to its merits. Instead, he made the strange argument that section 481 is inapplicable, citing Ezo; that section 481 provides the exclusive method for making adjustments; and that since section 481 is inapplicable petitioners were therefore171 not entitled to rely upon it in asking that the opening "unearned fees" account be eliminated in computing the corporation's income.The difficulty with this contention is that petitioners nowhere rely 460 upon section 481. Indeed, they explicitly disavow doing so. Their position simply is that the corporation's income for the period ending January 31, 1960, must be computed correctly, and that if the deferral method is wrong, the income for that period must be computed consistently without taking into account any deferred items. They do not seek to avoid the annual accounting system by asking for "adjustments" to income under section 481 that would not otherwise be appropriate under the annual accounting system, the situation dealt with by section 481. That was the kind of "adjustment" which the Government unsuccessfully sought in Heer-Andres and which would now be available to it under section 481; but it is entirely unlike petitioners' position herein that seeks only to have the corporation's income correctly computed for the year involved.We hold that the corporation is chargeable with the $ 5,146.07 fees that it both billed and collected; and that the predecessor172 partnership rather than the corporation was chargeable with the $ 30,483.41 fees billed and collected by the partnership as well as the $ 2,170.88 billed by the partnership but collected by the corporation. Both of the latter two items represented income that had accrued in the hands of the partnership, and petitioners are entitled to have them excluded in computing the income of the corporation for the period ending January 31, 1960.(4) Finally, petitioners make a further alternative contention that if the corporation's system of deferring income is to be rejected, then they should be entitled to the benefit of like treatment in respect of the $ 12,272.30 expenses incurred prior to the close of January 31, 1960, and deferred by the corporation to the following year. They concede that in such circumstances, the corresponding $ 9,973.09 expenses incurred by the predecessor partnership and appearing on the corporation's opening balance sheet must be offset against the $ 12,272.30 expenses deferred on the closing balance sheet for this taxable period, thus making a net additional deduction of $ 2,299.21. The Government has not objected to this contention. We think it is sound, and*173 it will be given effect under theDecisions to be entered under Rule 50. Footnotes1. Proceedings of the following petitioners are consolidated herewith: Van Duyn A. and Helen H. Dodge, docket No. 1535-63; Jack S. Logan and Wilmer G. Logan, docket No. 1536-63; Joseph M. Fee and Elizabeth C. Fee, docket No. 1537-63; and Peter Avenali and Joan E. Avenali, docket No. 1538-63.↩2. Of course, if this were not the client's initial quarter, there would also be included that portion of the fee for the client's preceding quarter that was allocable to the first part of the month.↩3. The evidence satisfies us that the billing process normally required about 10 days or 2 weeks, and that the amount here involved relates largely if not entirely to fees in respect of accounts whose anniversary dates occurred within such period immediately prior to Jan. 31, 1960. Thus, this is not a case where a taxpayer has deliberately manipulated its billing procedure so as to prevent income from accruing that it would otherwise have become entitled to prior to the end of the taxable period. We express no opinion as to the tax consequences in the latter situation.↩4. Unlike the third component as of Jan. 31, 1960, which in turn consisted of two parts (one relating to the corporation's clients generally and the other relating to the fund) calling for diverse treatment, the $ 5,146.07 item would seem to relate solely to fees of clients other than the fund and therefore could accrue only when billed, on or after Mar. 1, 1959. It must be remembered that the fund was on a calendar quarter basis and it seems highly probable that by Mar. 1, 1959, the fund had already been billed for its quarter beginning Jan. 1, 1959.↩5. SEC. 481. ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING.(a) General Rule. -- In computing the taxpayer's taxable income for any taxable year (referred to in this section as the "year of the change") -- (1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then(2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621990/	BERYL GUTNICK, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentGutnick v. CommissionerDocket No. 5959-80.United States Tax CourtT.C. Memo 1981-628; 1981 Tax Ct. Memo LEXIS 123; 42 T.C.M. (CCH) 1554; T.C.M. (RIA) 81628; October 26, 1981. Charles S. Wulke, for the petitioner. Ricardo A. Cadenas, for the respondent. TIETJENSMEMORANDUM OPINION TIETJENS, Judge: Respondent determined a deficiency of $ 1,335 in petitioner's Federal income tax for 1977. The sole issue for decision in whether, under the income averaging provisions of sections 1301-1305, 1 base period income can be less than the zero bracket amount for taxable years ending before January 1, 1977. This case was fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts and attached exhibits are incorporated herein by reference. At the time the petition was filed, petitioner124 resided in Los Angeles, California. Petitioner filed an individual Federal income tax return for 1977 with the Internal Revenue Service Center, Fresno, California. Petitioner's taxable income for 1973-1976 as reported in her Federal income tax returns is as follows: 2YearTaxable Income1973($ 3,200)1974( 5,761)1975( 4,171)19761,839 In Schedule G of her 1977 tax return, petitioner, who marked single filing status, claimed base period income (line 4 of Schedule G) equal to zero for the taxable years 1973, 1974, and 1975. Petitioner argues that the limitation imposed by section 1.1302-2(b)(1), Income Tax Regs., is to be applied subsequent to the adjustment specified by sectidn 1302(b)(3) so that base period income for the years beginning before January 1, 1977 may be as little as, but not less than, zero. Petitioner contends that he intent of section 1302(b)(3) 125 is to insure that base period income for the years prior to 1977 is computed in a manner essentially consistent with years commencing after December 31, 1976. Moreover, she asserts that it is illogical and contrary to congressional intent that a base period income for any year prior to 1977 may never be between zero and the zero bracket amount. Respondent, by contrast, maintains that section 1302 (b)(3) indicates that a taxpayer's zero bracket amount must be added to "base period income" as first determined under section 1302(b)(2). Since this latter amount cannot be less than zero, respondent contends, it follows that base period income for each of the pre-1977 years herein must be at least equal to $ 2,200 (petitioner's zero bracket amount). In Monson v. Commissioner, 77 T.C. 91">77 T.C. 91 (1981), we held that in computing base period income, the taxpayers first had to adjust their pre-1977 negative taxable income to zero before adding the zero bracket amount. We arrived at our decision by first examining the plain meaning of section 1302(b)(3) and then its legislative history. Just as the taxpayers in Monson misconstrued Congress' intent in enacting section 1302(b)(3), *126 petitioner makes a similar mistake. As we stated in Monson: the increase in base period income for pre-1977 years was necessary for income averaging purposes in order to equate taxable income for these years, which was reduced by a standard deduction, for comparison with taxable income after the change for zero bracket amount, which would not be so reduced. [77 T.C. at 96.] Petitioner's base period income for 1973, 1974 and 1975, therefore, is required to be at least equal to her 1977 zero bracket amount. 3Decision will be entered for the respondent. Footnotes1. All statutory references are to the Internal Revenue Code of 1954, as amended and in effect for the year in issue, unless otherwise stated.↩2. In her 1973 return, petitioner showed a net capital loss of $ 8,376. Petitioner claimed a net capital loss carryover from 1973 in the amount of $ 6,376 in her 1974 tax return, in the amount of $ 3,607 in her 1975 tax return, and in the amount of $ 1,106 in her 1976 tax return.↩3. See also Hackney v. Commissioner, T.C. Memo. 1981-534; Ferry v. Commissioner, T.C. Memo. 1981-533; and Ferguson v. Commissioner, T.C. Memo. 1981-470↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621991/	JOSEPH S. PIEKOS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent; DOLORES F. PIEKOS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentPiekos v. CommissionerDocket Nos. 13007-80, 13008-80.United States Tax CourtT.C. Memo 1982-602; 1982 Tax Ct. Memo LEXIS 140; 44 T.C.M. (CCH) 1401; T.C.M. (RIA) 82602; October 18, 1982. Arthur N. Nasser, for the petitioners. Lawrence C. Letkewicz, for the respondent. PARKERMEMORANDUM FINDINGS OF FACT AND OPINION PARKER, Judge: Respondent determined a deficiency in petitioners' 1976 income tax of $27,111.60, and an addition to tax of $13,555.80 for civil fraud under section 6653(b). 1 After concessions by both parties, two issues remain for our decision: (1) whether payments made by petitioner-husband's141 50 percent-owned corporation for part of the construction costs of petitioners' personal residence constitute bona fide loans from the corporation or taxable income to petitioners; and (2) whether any part of the underpayment of tax for 1976 was due to fraud. FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference. Petitioners Joseph S. Piekos and Dolores F. Piekos resided in Bloomingdale, Illinois, when they filed their petitions in these consolidated cases. 2 Petitioners timely filed a joint U.S. Individual Income Tax Return (Form 1040) for the taxable year 1976 with the Internal Revenue Service Center at Kansas City, Missouri. References to petitioner in the singular will be to Joseph S. Piekos, and where reference to the wife is necessary, she will be referred to as "Dolores." 142 During the years 1976, 1977, and 1978, petitioner was a 50 percent shareholder, a director, and the president of Mid-States Rigging, Inc. (Mid-States). During the years 1976 and 1977, and at least up to May 1978, Edgar Engler (Engler) was also a 50 percent shareholder, a director, and the secretary-treasurer of Mid-States. Mid-States was engaged in the business of moving heavy equipment and machinery, and petitioner and Engler were the only full-time employees of Mid-States. Mid-States maintained its corporate books and records and filed its Federal income tax returns on a fiscal year ending on the last day of February. Mid-States maintained a cash receipts and disbursements journal that recorded all corporate expenditures. Mid-States' books were kept at its business offices in Chicago. Both petitioner and Engler had equal and unrestricted access to Mid-States' books. Both petitioner and Engler were authorized to sign checks drawn on mid-States' account at the Western National Bank, Cicero, Illinois. Both petitioner and Engler wrote checks and made entries in the cash disbursements journal, although petitioner was primarily responsible for the day-to-day book-keeping. 143 On February 20, 1976, Dolores acquired title to a lot located at 143 Raven Lane in Bloomingdale, Illinois. Petitioner had negotiated to purchase that lot for a period of time prior to February 20, 1976. On March 9, 1976, Dolores applies for a permit from the Village of Bloomingdale to construct a single family residence and the permit was granted on March 15, 1976. The residence in Bloomingdale was completed in August of 1976. Petitioner acted as the general contractor for the construction of the residence. Sometime in March or April of 1976, petitioner told Engler that he was going to use some of Mid-States' funds to pay some of the costs of building his new residence, and Engler consented to this use of corporate funds. Petitioner agreed to render a full accounting to Engler. It is unclear whether this agreement was reached before or after petitioner began construction of his new residence, or before or after petitioner told his subcontractors and suppliers to send their bills to Mid-States' offices. At the time of this agreement, petitioner and Engler did not agree upon, nor even discuss, terms such as duration of the "loan," interest rate, security, or a repayment schedule. 144 Nor did they set a maximum limit on the corporation's payments on petitioner's behalf; petitioner was limited only to the extent of Mid-States' assets -- "He couldn't borrow more than what we [Mid-States] had." Petitioner had the contractors and suppliers send their invoices to Mid-States' business offices in Chicago. Most of the invoice contained internal indications, such as addresses and the like, that they were for costs and labor on a job at 143 Raven Lane. A couple of the invoices identified that address as petitioner's personal residence. Between April 23 and July 28, 1976, petitioner signed checks drawn on Mid-States' account to subcontractors and suppliers for services and supplies rendered in the construction of his residence. In addition to writing these checks, petitioner accounted for each payment in Mid-States' cash disbursements journal under the various classifications used to record the corporation's own business expenses. After returns, the net payments made by Mid-States for petitioner's benefit totaled $26,717.05. The schedule of payments and the classifications under which petitioner listed the disbursements in Mid-States' cash disbursements journal145 are as follows: CheckDatePayable toAmountClassification17374-23-76Industrial Steel$ 297.07Job Cost18215-18-76Paul Travelstead156.00Job Cost18225-18-76John Downes187.00Job Cost and Materials18235-18-76Components, Inc.345.98Job Cost and Materials18825-27-76AugustineConstruction3,375.00Job Cost Subcontractor19006-02-76Rockwood Co.175.00Insurance19096-03-76Don ConfortiPlumbing2,460.00Subcontractors20776-21-76Bartels Company1,594.00Job Cost and Supplies21016-22-76AugustineConstruction1,395.00Job Expense22036-25-76G.C. Kranz Heating& Cooling, Inc.3,500.00Repairs and Service22046-25-76G.C. Kranz Heating& Cooling, Inc.100.00Repairs and Service22116-30-76John Mullin Masonry3,875.00Subcontractor22257-07-76AugustineConstruction4,559.00Subcontractor22567-12-76G.M.A. Electric2,490.00Subcontractor22867-28-76Pli-O-Seal483.00Office Decorating22877-28-76Barnes Excavating2,325.00Job ExpenseTOTAL AMOUNT RECEIVED$27,317.05LESS AMOUNT RETURNED600.00NET AMOUNT RECEIVED$26,717.05146 Petitioner knew at the time he issued these checks that the payments were for his own personal expenses and that they did not represent deductible business expenses of Mid-States. In accounting for these payments in Mid-States' cash disbursements journal under various categories of corporate expenditures, such as "job cost," "materials," "subcontractor," "insurance," and "office decorating," petitioner did not make any marks or otherwise indicate in the journal that the checks were payments of his own personal expenses and should therefore be reclassified at some later date. Petitioner did not set up a loan account on the corporate books for the Mid-States' funds disbursed for his personal benefit, nor did he ask anyone whether he should set up such an account. 3 Petitioner did keep a "tally" of payments made by Mid-States for construction costs on his home which he submitted to Engler sometime after completion of the residence. This accounting showed a net of $26,717.05 paid by Mid-States on petitioner's behalf. 147 Petitioner also classified Mid-States' checks for corporate expenses (checks other than those issued to the subcontractors and suppliers on his personal residence) as subcontractor, job cost, or job expense in Mid-States' cash disbursements journal for the months of March through July of 1976. After subtracting the $26,717 paid on behalf of petitioner, the total amount paid by Mid-States for corporate job costs or job expense during its taxable year ended February 28, 1977, and before making adjusting journal entries, was $13,231.38. At the time Engler agreed to let petitioner use corporate funds to pay construction costs on his house, petitioner and Engler agreed that Engler would receive a distribution of cash from Mid-States in an amount equal to the payments made on petitioner's behalf for the construction costs of his house. Petitioner signed a check drawn on Mid-States' account dated February 26, 1977, to Ed Engler for $26,717, minus a deduction for FICA of $731.25. 4 This represented Engler's "loan" from Mid-States, to balance the distributions by Mid-States on petitioner's behalf. Petitioner entered the check to Engler on Mid-States' payroll sheets. Engler had no148 need to borrow money from Mid-States and the payment was merely to equalize his position with petitioner's. Sometime after the close of Mid-States' fiscal year of February 28, 1977, petitioner and Engler signed unsecured promissory notes dated March 1, 1977, each in the amount of $26,717, each bearing interest of six percent per annum, and each payable in 115 monthly installments, unless sooner paid. Those notes were executed well after March 1, 1977, possibly as late as September 1977. 5Mid-States accrued no interest on these "loans" until at least March 1, 1977. Likewise, petitioner paid no interest attributable to any period before March 1, 1977. 149 Mid-States employed Samuel Dikelsky (Dikelsky) as bookkeeper and account during the years 1975 through 1978. Dikelskly spent one or two days a month at Mid-States' offices doing the accounting and bookkeeping work for the corporation. He totalled or "footed" the corporation's books of original entry. In addition, Dikelsky prepared balance sheets, work sheets, statements of income and expense, profit and loss work sheets, and adjusting journal entries for the fiscal years ended on February 28, 1977, and February 28, 1978. Dikelsky had access to all Mid-States' records, including the cash disbursements journal, and all invoices. Dikelsky did not become aware of Mid-States' payments on behalf of petitioner until sometime after the close of the fiscal year on February 28, 1977. 6 Dikelsky only learned about the payments when petitioner told him about them and showed him the "tally" he had prepared. Dikelsky first reclassified the payments as additional salary to petitioner. Dikelsky advised petitioner that, in his opinion, the payments were salary income to him. When petitioner first informed Dikelsky that Mid-States' funds had been used to pay construction costs on his residence, 150 he did not provide Dikelsky with the original or copy of the promissory note signed by him and dated March 1, 1977. See Footnote 5 above. During June or July of 1977, the Internal Revenue Service began an audit of Mid-States for some year or years prior to the year ended February 28, 1977. On September 9, 1977, Dikelsky attended a meeting in the offices of Arthur Nasser, counsel for Mid-States, but the record does not disclose what transpired at that meeting. After that meeting, Dikelsky made adjusting journal entries reclassifying the payments on petitioner's behalf and the payments to Engler as loans rather than salary. 7 Before making this reclassification, Dikelsky was shown the notes and repayment schedules. Mid-States' Corporate Income Tax Return (Form 1120) for the fiscal year ending February 28, 1977, was dated September 12, 1977, and was filed with the Internal Revenue Service151 on September 14, 1977. Petitioner signed for Mid-States, and Dikelsky signed the return as the preparer. 8A document dated March 1, 1977, purportedly152 the minutes of a meeting of the board of directors of Mid-States, increased the weekly salaries of petitioner and Engler from $500 to $750, and approved the "loans" to petitioner and Engler. Mid-States' payroll ledgers showed that petitioner and Engler each received a weekly salary of $500 during each of the years 1976, 1977, and 1978. Federal withholding, FICA, and state withholding for both petitioner and Engler were calculated on the $500 weekly salary figure. Adjusting journal entries accounted for the $250 weekly salary increases that were applied against the "loans" to petitioner and Engler. This authorization increasing the salaries to petitioner and Engler, and approving the "loans," occurred well after March 1, 1977, possibly as late as September 1977. See Footnotes 5 and 7 above. At the close of Mid-States' taxable year ending February 28, 1978, both petitioner and Engler were credited with additional salary in an amount sufficient to pay off the balance of their "loans." This second salary increase was not formally authorized by the board of directors. 9153 Petitioner reported salary income from Mid-States on his calendar year 1977 Federal income tax return in the amount of $37,650. Of this amount, $10,000 represented the increased salary that was applied directly against the principal and interest due on the "loan" obligation to Mid-States. Petitioner reported salary income from Mid-States on his calendar year 1978 Federal income tax return in the amount of $53,814. Of this amount, $19,914.86 was applied directly against the principal and interest due on his "loan" obligation to Mid-States. He also deducted interest paid on his "loan" from the corporation in both years. On its corporate income tax returns for its taxable years ending February 28, 1977 and February 28, 1978, Mid-States deducted as compensation those increased salary amounts. 10Petitioner did not report as income in his calendar year return154 for the year 1976 any of the payments made by Mid-States on his behalf in 1976 for construction costs on his home. In his notice of deficiency, respondent determined that the corporate payments on petitioner's behalf constituted taxable income to him. 11 In addition, respondent determined that part of the underpayment for 1976 was due to fraud and therefore determined an addition to tax under section 6653(b). OPINION The first issue we must decide is whether payments made by Mid-States on petitioner's behalf constitute bona fide corporate loans. Petitioner was a 50 percent shareholder and an officer and director of Mid-States. Mid-States paid over $27,000 on petitioner's behalf to subcontractors and supplier for the new home petitioner was constructing. Petitioner argues that these corporate payments represent loans by Mid-States to him. Respondent155 argues that these distributions on petitioner's behalf constitute taxable income to him. Whether corporate payments to or on behalf of a shareholder constitute bona fide loans or taxable income is a question of fact that turns upon the intent of the parties. The parties must have intended the transaction as a loan, which requires both an intention upon the part of the taxpayer-shareholder to repay and a corresponding intention on the corporation's part to enforce the obligation. This intent must have existed at the time the payments were made. Pierce v. Commissioner,61 T.C. 424">61 T.C. 424 (1974); Haber v. Commissioner,52 T.C. 255">52 T.C. 255 (1969), affd. per curiam 422 F. 2d 198 (5th Cir. 1970). Petitioner has the burden of proving that the payments were intended to be loans to him. Rule 142(a); Welch v. Helvering,290 U.S. 111">290 U.S. 111 (1933). While there is no fixed rule for distinguishing income from loans, some general criteria are available to guide156 us in ascertaining the intentions of the parties at the time they entered into the transaction. See, e.g. Williams v. Commissioner,627 F. 2d 1032 (10th Cir. 1980), affg. a Memorandum Opinion of this Court; Berthold v. Commissioner,404 F. 2d 119, 112 (6th Cir. 1968), affg. a Memorandum Opinion of this Court; Chism's Estate v. Commissioner,322 F. 2d 956 (9th Cir. 1963), affg. a Memorandum Opinion of this Court; Dean v. Commissioner,57 T.C. 32">57 T.C. 32, 43 (1971). 12 See generally, Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, par. 7.05 (3d ed. 1971). We look beyond statements of subjective intent to objective factors such as the extent of stockholder control, the corporation's dividend history, the magnitude of the payments, the presence or absence of conventional indicia of debt (note, interest, security, repayment schedule, etc.), the treatment of the transaction in the corporate financial statements and records, the formal authorization by the corporation, the actual payment of interest, and the ultimate payment of the "obligation." No single factor is determinative. See Alterman Foods, Inc. v. United States,222 Ct. Cl. 218">222 Ct. Cl. 218, 611 F. 2d 866, 869 (1979).157 13 Of course, the self-serving testimony of the interested taxpayer that he intended a loan is in no way determinative. Fisher v. Commissioner,54 T.C. 905">54 T.C. 905 (1970). Furthermore, payments by a closely-held corporation require special and careful scrutiny; control and lack of adverse interest between taxpayers and their corporation require that we look beyond the mere form and self-serving testimony so that we may perceive the true nature of the transaction. Wilkof v. Commissioner,636 F. 2d 1139 (6th Cir. 1981), affg. per curiam a Memorandum Opinion of this Court; Haber v. Commissioner,supra;Roschuni v. Commissioner,29 T.C. 1193">29 T.C. 1193, 1202 (1958), affd. 271 F. 2d 267 (5th Cir. 1959), cert. denied 362 U.S. 988">362 U.S. 988 (1960); Baird v. Commissioner,25 T.C. 387">25 T.C. 387, 393 (1955).158 Although petitioner here owned only 50 percent of the stock, Engler's passive acquiescence in petitioner's use of corporate funds warrants the same careful scrutiny here. There is no precise formula for weighing and balancing the various factors which we consider in resolving this factual issue. Each case must be decided upon its own facts. After reviewing the evidence in this record, we are convinced the payments made by Mid-States on petitioner's behalf in 1976 were not bona fide loans. Accordingly, we hold for respondent on this issue. Several factors contribute to our holding. First, we note how petitioner accounted for this transaction on Mid-States' books. Petitioner did not, at the time of the transactions, create a loan account in the corporation's cash journal nor did he inquire whether he should do so. Indeed, petitioner recorded the various disbursements in various corporate expense accounts as if they were legitimate expenditures for corporate purposes. There was nothing in the cash journal that would in any way indicate that payments had ever been made on petitioner's behalf. The fact that petitioner kept a separate tally of the payments may have some bearing159 on the fraud issue, see p. 27, infra, but it does not diminish the significance of the initial failure to account for the transaction as a loan. While proper accounting does not per se establish a transaction as a loan, the absence of a proper accounting and other contemporaneous written records indicates that the transaction was not a loan. Dean v. Commissioner,supra;Berthold v. Commissioner,supra.14Second, we observe the absence of traditional indicia of a loan at the time the parties entered into the transaction. Even viewing the evidence most favorably to petitioner, there was a seven to ten month gap between the payments and the documentary evidence of debt. Petitioner and Engler testified that they agreed to petitioner's use of corporate funds for construction cost of his home sometime in March or April 23 and July 28 of that year. Even assuming that the promissory notes were executed and the board of directors meeting was held on March 1, 1977, which160 we do not believe and do not find, this gap seriously weakens any evidentiary value which the documents might otherwise provide. Even giving petitioner the fullest benefit of doubt, petitioner's "loan" from Mid-States was evidenced by nothing but his oral agreement with Engler until at least March 1, 1977. Nothing in the evidence of that oral agreement indicates terms such as interest, security, or time for repayment. Furthermore, although the note dated March 1 provided for interest, interest ran only from March 1, 1977. Petitioner had free use of the corporate funds from the time the payments were made in 1976 until at least March 1 of the following year. Finally, the only limit on petitioner's withdrawals was a practical one--the extent of the corporation's assets. As Engler testified, "He couldn't borrow more than what we had." The failure of petitioner and Engler to set a ceiling on petitioner's withdrawals weights against finding a bona fide corporate loan. Third, we note that the evidentiary value of the March 1, 1977 documents is further diminished by our finding that they were not in fact executed on that date. Indeed, most of the evidence suggests that these documents161 were not executed until at least September of 1977. Many factors justify this inference, including: (1) the fact that Dikelsky did not make his adjusting entries reclassifying the payments as a loan until after the September 9, 1977 meeting with the corporation's counsel; (2) the facts that the salary increase, purportedly authorized March 1, 1977 to pay the "loan" purportedly ratified on that date, was not reflected in the payroll ledgers, and indeed, was accounted for only by adjusting entries made in the books at the close of the taxable years; and (3) the fact that Dikelsky did not make the adjusting entries reclassifying the transaction as a loan until after he saw the note. We accord these documents even less weight because of the warranted suspicion that they were executed after, and in response to, the commencement of an IRS audit of Mid-States' return for some earlier fiscal year. The evidentiary value of loan documents, payments and the like, is substantially diminished when they occur in response to an IRS audit. Tollefsen v. Commissioner,52 T.C. 671">52 T.C. 671, 680 (1969),162 affd. 431 F. 2d 511 (2d Cir. 1970), cert. denied 401 U.S. 908">401 U.S. 908 (1971); Atlanta Biltmore Hotel Corp. v. Commissioner,349 F. 2d 677, 680 (5th Cir. 1965), affg. on this issue a Memorandum Opinion of this Court; Baird v. Commissioner,supra.15 Execution in September of 1977 or later would place the documents well after the commencement of the IRS audit in the summer of that year. Dikelsky could not state whether he was first told of the transaction before or after the IRS audit. Neither petitioner nor Engler was able to pin point the date when they so informed Dikelsky, except that it occurred of necessity after the close of the fiscal year on February 28, 1977. Accordingly, we attach little weight to the purported notes and authorizing resolution evidenced by the minutes of the board of directors meeting. Fourth, the purported loans were made in proportion to petitioner's and Engler's respective stock holdings. Pro rata distributions to or on behalf of shareholders tend to evidence taxable income (in the form of dividends) rather163 than bona fide loans, Harber v. Commissioner,supra, particularly where, as here, pro rata distributions were intended from the outset. This is further buttressed by Engler's own testimony that he had no need for a loan and that the distribution to him was simply to keep things even between him and petitioner. Furthermore, Engler's "loan" was part of the same planned transaction, and petitioner withheld FICA taxes from Engler's "loan" and recorded it in the payroll ledger as salary to Engler. These factors also strongly indicate that the transaction was not a bona fide loan. Petitioner's strongest argument in favor of treating the transaction as a bona fide loan is that the purported loan obligation was in fact repaid, with interest. Repayment is often a highly persuasive factor, 16 but it too is only one factor to be considered and it is not conclusive. Mellon v. Commissioner,36 B.T.A. 977">36 B.T.A. 977, 1060-1061 (1937). 17 Any weight we might accord to this "repayment" by petitioner is substantially diminished by the timing and manner in which it was effected. First, 164 we entertain a suspicion, as with the loan documents above, that the repayment plan was generated in response to an audit by the IRS. Furthermore, irrespective of the IRS audit, the manner in which the repayment was effected is itself suspicious. The repayment was made by increasing petitioner's "salary" to repay the "loan." This increase in salary was purportedly authorized by the board of directors on March 1, 1977, but, as noted above, actually occurred later, probably in September of 1977. Mid-States' payroll ledgers recorded only the old salary, not the new salary. The new salary was accounted for only by an adjusting entry in the books. Treatment of a transaction in a corporation's books is in no way conclusive but is a factor to consider. Doyle v. Mitchell Bros. Co.,247 U.S. 179">247 U.S. 179, 187 (1918); Dean v. Commissioner,57 T.C. 32">57 T.C. 32, 44 (1971); Chism Ice Cream Co. v. Commissioner,T.C. Memo. 1962-6, affd. sub nom. Chism's Estate v. Commissioner,322 F. 2d 956 (9th Cir. 1963). The fact that petitioner reported this165 increased salary on his tax returns and paid taxes on this increased salary amount is somewhat probative. However, in light of the timing of his actions and the other conflicting evidence, that fact is not sufficient to carry his burden of proof. Treatment of the purported salary increase in subsequent years was merely consistent with petitioner's whole course of conduct that began after the close of the fiscal year ended February 28, 1977 and probably in response to the IRS audit of Mid-States. Accordingly, we find that petitioner has failed to carry his burden of proof to establish that these payments on his behalf were bona fide corporate loans. We find for respondent166 on this issue and hold that the payments are taxable income to petitioner in 1976. It is not clear whether we are called upon to decide whether the corporate payments were salary of dividends. The issue as framed by both parties in their pleadings and at trial was whether the payments were loans or "taxable income," not whether the taxable income was salary or dividends. The first mention of "dividends" came in respondent's opening brief. Normally we do not consider issues raised for the first time on brief. Aero Rental v. Commissioner,64 T.C. 331">64 T.C. 331 (1975). 18 However, we do not accept petitioner's assertion in his reply brief that the issue is whether the payments were loans or "compensation." Respondent's notice of deficiency stated that the payments were "taxable income," not "salary" or "compensation." Indeed, in his opening statement at trial, petitioner's counsel stated the issue as whether the payments were loans or "taxable income," not whether they were loans or salary.167 Moreover, the description in the statutory notice of the disallowed item can fairly be read as describing a constructive dividend. 19 Indeed, were we called upon to decide the issue, we would be hard pressed to characterize these pro rata payments to the two shareholders as anything other than constructive dividends. There is no credible evidence in the record to suggest that the payments were for services rendered to the corporation. In any event, the parties have not clarified for the Court why a characterization need be made in this case. The distinction between salary or compensation, on the one hand, or dividends, on the other hand, could be important if petitioner were claiming the benefits of section 1348. That is because the maximum tax under section 1348 applies only to "earned income." In his recomputation of petitioner's tax liability in the notice of deficiency, 168 respondent applied the higher marginal rates of section 1 rather than the 50 percent maximum rate imposed by section 1348. If petitioner intended to claim the benefits of section 1348, he should have done so in his petition. "Any issue not raised in the assignment of errors shall be deemed to be conceded." Rule 34(b)(4). See also Rule 34(b)(3); Rule 34(a)(1). Here, however, petitioner had claimed income averaging on his 1976 return, and a taxpayer cannot have the benefits of both income averaging and the maximum tax. See section 1304(b)(4), as it read in 1976. However, it does not appear that respondent gave petitioner the benefit of income averaging in the statutory notice, and the parties may be able to attend to this matter in the computation under Rule 155 without the necessity of reopening the record. 20169 Since we hold that the payments by Mid-States constitute income to petitioner in 1976 that he did not report, we now must address the fraud issue. Section 6653(b)21 provides for a 50 percent addition to tax if any part of an underpayment of tax is due to fraud. The burden of proving fraud is upon respondent, a burden he must carry by clear and convincing evidence. Sec. 7454(a); Stone v. Commissioner,56 T.C. 213">56 T.C. 213, 220 (1971); Rule 142(b). The fraud envisioned by section 6653(b) is actual, intentional wrongdoing, and the intent required is the specific purpose to evade a tax believed to be owing. Wilson v. Commissioner,76 T.C. 623">76 T.C. 623, 634 (1981); Candela v. United States,635 F. 2d 1272 (7th Cir. 1980); Stoltzfus v. United States,398 F. 2d 1002, 1004 (3d Cir. 1968), cert. denied 393 U.S. 1020">393 U.S. 1020 (1969); Mitchell v. Commissioner,118 F. 2d 308 (5th Cir. 1941), revg. 40 B.T.A. 424">40 B.T.A. 424 (1939), followed on remand 45 B.T.A. 822">45 B.T.A. 822 (1941). 22 Fraud is a factual question170 to be determined on the basis of the entire record. Mensik v. Commissioner,328 F. 2d 147, 150 (7th Cir. 1964), affg. 37 T.C. 703">37 T.C. 703 (1962), cert. denied 379 U.S. 827">379 U.S. 827 (1964); Otsuki v. Commissioner,53 T.C. 96">53 T.C. 96, 105-106 (1969). Fraud can seldom be established by direct proof of the taxpayer's intention, and therefore petitioner's entire course of conduct can be relied upon to establish such fraudulent intent by circumstantial evidence. Spies v. United States,317 U.S. 492">317 U.S. 492 (1943); Stone v. Commissioner,supra at 223-224 (1971); Otsuki v. Commissioner,supra at 105-106. 171 In his answer to the petition in this case, respondent alleged as evidence of fraud all of petitioner's various understatements of income and underpayments of tax for the year 1976. 23 Except for the issue of the corporate distributions which we have held to be income to petitioner, all of the other items were settled by the parties before trial. See Footnote 11 above. Since respondent introduced no evidence on these points on trial, we shall not consider them in ruling on the fraud issue. Based on all the facts in this case, we conclude that respondent has not established fraud by clear and convincing evidence. As primary evidence of petitioner's alleged fraud, respondent points to petitioner's accounting in Mid-States' books for the corporate distributions made to pay construction costs on his home. Petitioner recorded these expenses as if they were legitimate corporate expenditures. He did not give any indication in the books that they were for his own personal benefit. Furthermore, 172 these same corporate accounts also included proper corporate expenditures, a factor that might serve to hide the personal payments recorded in those accounts. Respondent correctly notes that this Court has often referred to conduct calculated to mislead or conceal as a prime indication of fraud. See Gajewski v. Commissioner,67 T.C. 181">67 T.C. 181, 200 (1976), affd. without published opinion 578 F. 2d 1383 (8th Cir. 1978); Beaver v. Commissioner,55 T.C. 85">55 T.C. 85, 93 (1970). We agree that petitioner's treatment of these payments on the corporate books is some evidence of fraud. However, poor bookkeeping alone is not sufficient to establish fraud by the requisite clear and convincing evidence. Furthermore, the fact that petitioner kept a separate tally of the corporate payments reduces somewhat the significance of his failure to account properly for the payments. If he had really intended to cover up the payments, we do not believe that he would have kept a separate written record of them, except perhaps to account to Engler so that Engler too could173 take a like amount out of corporate funds. The record in this case reeks of suspicion. The Court found petitioner evasive and less than forthright in his testimony about the original agreement with the other stockholder, his treatment on the corporation's books of the purported loans from his corporation, and the facts and circumstances under which these purported loans came to light. There is a strong suspicion that the whole transaction came to light only after the IRS began an audit of the corporation. However, the Court did not wholly discount petitioner's story because the other stockholder testified unequivocally that petitioner asked his permission to use corporate funds to build his house and that he (Engler) agreed to that. While Engler too seemed evasive and less than candid on other matters, he was clear on that point. Moreover, mere suspicion does not prove fraud, and the fact that we do not find petitioner's testimony wholly credible is not sufficient to establish fraud. Cirillo v. Commissioner,314 F. 2d 478, 482 (3d Cir. 1963), affg. in part and reversing in part a Memorandum Opinion of this Court; Shaw v. Commissioner,27 T.C. 561">27 T.C. 561, 569-570 (1956),174 affd. 252 F. 2d 681 (6th Cir. 1958); see also DeClercq v. Commissioner,T.C. Memo. 1982-386. Respondent cites as further evidence of petitioner's alleged fraud the fact that his accountant, Dikelsky, advised him that the payments were income to him. Dikelsky gave petitioner this advice when Dikelsky first became aware of the payments, but that occurred substantially after the close of the corporation's taxable year of February 28, 1977. In fact, from the record it appears likely that it did not take place until sometime after the commencement of the IRS audit in the middle of the summer of 1977. Petitioner's income tax return for 1976 was timely filed and is dated April 12, 1977. It is difficult to see how advice from his accountant that payments constituted income, advice that the taxpayer received after he had already filed his income tax return for the year in question, constitutes evidence of fraud. Furthermore, the record is not clear whether Dikelsky advised petitioner that the payments were income to him in 1976 or 1977. In fact Dikelsky himself appeared to believe that the payments were income in 1977, not 1976. It is also difficult*175 to see how an accountant's advice to a taxpayer that certain payments constitute taxable income in 1977 prove that the taxpayer's failure to report such amounts as income in 1976 was fraudulent. We conclude that respondent has failed to carry his burden of proving by clear and convincing evidence that part of the underpayment of tax for 1976 was due to fraud. To reflect the foregoing and the concessions of the parties, Decisions will be entered under Rule 155.Footnotes1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended and in effect during the taxable year 1976, and all references to Rules are to the Tax Court Rules of Practice and Procedure.↩2. Joseph S. Piekos is petitioner in docket No. 13007-80. Dolores F. Piekos is petitioner in docket No. 13008-80. Dolores originally claimed protection in her separate petition as an innocent spouse under section 6013(e), but waived that issue at trial.↩3. In explaining why he had posted the disbursements for his house as Mid-States' business expenses rather than in a "loan" account, petitioner testified "That was the only way I knew of how to post it (sic)." We do not find his explanation credible.↩4. Petitioner could not explain why he withheld FICA taxes on Engler's "loan." We note that an entry was made on Engler's payroll records, in normal date sequence, reflecting this payment as salary. A similar entry was made on petitioner's payroll records, but out of proper date sequence, reflecting the $26,717 as salary to petitioner and a like amount of FICA, $731.25, for petitioner.↩5. While the notes are dated March 1, 1977, there was no testimony that in fact they were executed on that date. Although the date shown in the notes may evidence the date of execution, it is not determinative. From other evidence, we find that the notes were executed well after March 1, 1977. First, Dikelsky, Mid-States' accountant and bookkeeper, was not shown the notes when he first became aware of the disbursements (which event itself occurred sometime after February 28, 1977). When Dikelsky first became aware of the payments for petitioner's home and the equalizing payment to Engler, the accountant initially classified those expenditures as additional salary to the two shareholder-officers. Dikelsky later reclassified the payments from salary to loans only after seeing the notes. If the notes had been executed on March 1, there is no reason in the record why they were not shown to Dikelsky, and no explanation in the record why Dikelsy waited until September to reclassify the payments as loans. See n. 7, infra.↩ Second, the payroll ledger only accounts for petitioner's old salary of $500 rather than the new salary of $750 which was purportedly approved the same time Mid-States approved the loans (as evidenced by the minutes of a meeting ostensibly on March 1, 1977). If the meeting had taken place on March 1, 1977 approving the loan and salary raises, the payroll sheets should have recorded the new salary ($750) rather than the old one ($500). This indicates that the raises, and the notes, were not made until sometime later, and the fact that the salary increases to pay the loans were accounted for only as adjusting entries indicates that the notes and raises date much later than March 1, 1977, and possibly as late as September 1977. Although adjusting entries to the corporation's books were made in September, the payroll ledgers for petitioner and for Engler never reflected the purported salary increase from $500 to $750, in either 1977 or 1978.6. Other than the fact that it occurred after February 28, 1977, Dikelsky could not remember exactly when petitioner told him about the advances. Indeed, Dikelsky could not even remember whether he was so informed before or after the IRS audit of Mid-States that began in the summer of 1977.↩7. Petitioner argues that there is no evidence that this adjusting entry was made after the September 9 meeting, but the stipulated joint exhibit indicates otherwise. Dikelsky's work sheet lists adjusting entries 1 through 19. It then states, "Per instructions from Mr. Nasser & Arthur Samet (legal counsel for company) office visit 9/9/77." This statement is directly above adjusting entries Nos. 20-23, and it is No. 21 that changes the disbursements for petitioner's benefit from salary to a loan. We accept that entry as evidence that Dikelsky made the adjusting entry after the September 9 meeting. We are also satisfied that Dikelsky made the entry before September 12, since Mid-States' income tax return for fiscal year ended February 28, 1977, dated September 12, 1977 and filed September 14, 1977, reflects loans to stockholders in an amount of $53,434, the total payments for both petitioner and Engler. ↩8. Dikelsky prepared petitioner's individual tax returns for 1977 and 1978, but he did not prepare petitioner's 1976 return.↩9. While petitioner testified that he was the board of directors, apparently meaning that no formal authorization was necessary, his testimony is contradicted by the parties' stipulation that Engler served as a director until atleast↩ May of 1978 and by the payroll records that show that Engler was still with Mid-States until at least May 18, 1978.10. Because of the different time frame of petitioner's calendar yeawr return and the corporation's fiscal year return, the amounts are not exactly the same. Mid-States' returns also reported interest income, but the record does not disclose whether such amounts represented any of the "interest" paid by petitioner.↩11. Respondent also determined that petitioner had failed to report other items of income, including rental income from Mid-States, reimbursed business expenses from Mid-States, and unreported interest. Those issues are not before the Court, having been settled by the parties by their separate stipulation of settled issues.↩12. See also Johnson v. Commissioner,T.C Memo. 1979-7, affd. 652 F. 2d 615↩ (6th Cir. 1981). 13. See also Hardy v. Commissioner,T.C. Memo. 1982-225↩, on appeal (9th Cir. Sept. 1, 1982).14. See also Smith v. Commissioner,T.C. Memo. 1980-15↩.15. See also Granzotto v. Commissioner,T.C. Memo. 1971-106↩.16. See Ravano v. Commissioner,T.C. Memo. 1967-170; Went-worth v. Commissioner,T.C. Memo. 1966-167. Cf. Baird v. Commissioner,25 T.C. 387">25 T.C. 387↩ (1955). 17. See also Atlanta Biltmore Hotel Corp. v. Commissioner,T.C. Memo. 1963-255, affd. on this issue, 349 F. 2d 677 (5th Cir. 1965); Fender Sales, Inc. v. Commissioner,T.C. Memo. 1963-119, rev'd. on another issue, 338 F. 2d 924↩ (9th Cir. 1964).18. See also Wilson v. Commissioner,T.C. Memo. 1980-288; Astleford v. Commissioner,T.C. Memo. 1974-184↩.19. In part, that description read: It is further determined that these disbursements were not reimbursements for any expenses you incurred by or on behalf of the corporation but were funds used by you for your personal benefit. Therefore, your taxable income for 1976 is increased by $26,717.05.↩20. See Mannette v. Commissioner,69 T.C. 990">69 T.C. 990, 995 (1978); Hosking v. Commissioner,62 T.C. 635">62 T.C. 635 (1974); Pereira v. Commissioner,T.C. Memo. 1976-66 and particularly footnote 2. See also Combs v. United States,490 F. Supp. 19">490 F. Supp. 19, 21↩ n. 1 (E.D. Ky. 1978).21. Section 6653(b) provides: (b) Fraud.↩--If any part of any underpayment (as defined in subsection (c)) of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 50 percent of the underpayment. In the case of income taxes and gift taxes, this amount shall be in lieu of any amount determined under subsection (a). In the case of a joint return under section 6013, this subsection shall not apply with respect to the tax of a spouse unless some part of the underpayment is due to the fraud of such spouse. 22. See also B.B. Rider Corp. v. Commissioner,T.C. Memo. 1982-98; Diehl v. Commissioner,T.C. Memo. 1982-23; Jackson v. Commissioner,T.C. Memo. 1981-252↩.23. Respondent also alleged that petitioner had lied to respondent's agents and otherwise impeded the course of the audit. No evidence in support of those allegations was presented to the Court.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621992/	Perry Epstein and Mildred Epstein, Petitioners v. Commissioner of Internal Revenue, RespondentEpstein v. CommissionerDocket No. 6393-75United States Tax Court70 T.C. 439; 1978 U.S. Tax Ct. LEXIS 103; June 13, 1978, Filed 103 Decision will be entered for the respondent. At the time a pension plan was being terminated, the base for calculating benefits to be distributed was changed to include bonuses in addition to salaries paid to covered employees. Held, such change caused such plan not to be qualified under sec. 401(a)(4), I.R.C. 1954. Held, further, the entire amount of benefits received by petitioner is taxable as ordinary income. S. Sidney Mandel, for the petitioners.104 H. Stephen Kesselman and Richard S. Kestenbaum, for the respondent. Tannenwald, Judge. TANNENWALD439 OPINIONRespondent determined a deficiency of $ 12,389 in petitioners' 1971 Federal income tax. The sole issue for decision is whether an amount received upon the termination of a pension plan should be taxed as ordinary income or as a capital gain.All of the facts have been stipulated and are found accordingly. 440 The stipulation of facts and the exhibits attached thereto are incorporated herein by reference.Perry Epstein (petitioner) and Mildred Epstein are husband and wife. They resided in Miami Beach, Fla., at the time the petitioner herein was filed. 1Luanep Corp. (formerly Effanbee Doll Corp.) was a New York corporation which manufactured dolls. Hereinafter "the corporation" will refer to both Luanep Corp. and Effanbee Doll Corp. It was incorporated on February 26, 1953. 105 By 1964, its outstanding shares were owned in equal parts by Bernard Baum (Baum), Morris D. Lutz (Lutz), and petitioner. Baum died on November 10, 1966, and the corporation subsequently redeemed his stock interest.The corporation established a pension plan for the benefit of certain qualified employees which became effective on February 1, 1965. Simultaneously, a trust was created to receive the contributions to be made pursuant to the plan. On December 17, 1965, the District Director of Internal Revenue for the Brooklyn, N. Y., District determined that the plan as then amended was qualified for purposes of section 401(a). 2The plan provided that a participant, upon normal retirement, was to receive a monthly payment of 20 percent of his "basic compensation" received during the 5 consecutive years in which his compensation was highest, less 93.6 percent of social security payments. 106 For purposes of the plan, "compensation" was defined to exclude overtime pay, bonuses, commissions, contributions to pension or profit-sharing plans, and insurance benefits.The corporation's board of directors was empowered to terminate the plan. Upon termination, the trustee was required to set aside sufficient assets to meet liabilities other than those payable in the future to plan participants and to distribute the remaining assets to the plan participants. The distribution of the trust assets was subject to the following limitations:16.7 Notwithstanding any provisions in this Agreement to the contrary, if during the first ten years after the effective date hereof, the Plan is terminated * * * then the benefits provided by the Company's contributions for Participants whose annual benefit provided by such contribution will 441 exceed $ 1,500 but applicable only to the twenty-five Highest Paid Employees as of the time of establishment of the Plan (including any such Highest Paid Employees who are not Participants at the time but may later become Participants) shall be subject to the following conditions:(a) Such benefits shall be paid in full which have been provided 107 by the Employer's contributions for such Highest Paid Employees, not exceeding the larger of the following amounts:(1) $ 20,000; or(2) An amount equal to 20% of the first $ 50,000 of the Participant's average regular annual compensation multiplied by the number of years since the effective date of this Plan.* * * (e) In the event of the termination of the Plan within 10 years after the effective date, distributions to then unretired Participants other than the Participants described in the first paragraph of this Section shall include an equitable apportionment among such other Participants of all excess benefits purchased by Company contributions for the Participants described in the first paragraph of this Section, in the manner following: to each such other Participant in the ratio that the value of the accumulated reserve then credited to him bears to the total value of the accumulated reserve under the Plan.During the period in which it was effective, the plan covered between 10 and 12 participants. Approximately 100 employees were excluded by reason of their being covered by a collectively bargained pension plan, which exclusion was considered by respondent in his initial108 determination of plan qualification. After Baum's death in 1966, two plan participants, Lutz and petitioner, were officer-shareholders and highly compensated employees.Petitioner's health began to fail during 1969, and in October of that year he suffered a coronary attack. The corporation's gross sales declined from $ 2,020,531 for the fiscal year ending February 28, 1969, to $ 1,765,671 for the fiscal year ending February 28, 1970, and to $ 1,686,849 for the fiscal year ending February 28, 1971.By agreement dated October 7, 1971, the corporation sold its business and all of its assets to Royanlee Doll Corp. (Royanlee). The agreement provided that the pension plan was not to be conveyed to Royanlee and that the corporation was to terminate the plan and have the assets thereof distributed.On October 20, 1971, the corporation's board of directors amended certain provisions of the plan relating to termination and decided to make no further contributions under the plan. Section 16.7(a)(2) of the plan was amended to read as follows:442 (2) An amount equal to 20% of the first $ 50,000 of the Participant's annual compensation multiplied by the number of years since the effective109 date of the plan. The term "annual compensation" of a Participant means either such Participant's average compensation over the last five years, or such Participant's last annual compensation if such compensation is reasonably similar to his average regular compensation for the five preceding years.Salary, bonus, and total compensation received by petitioner and Lutz from the corporation are as follows:TotalYearSalaryBonuscompensation1967$ 25,000Petitioner$ 15,000$ 40,00025,000Lutz16,95041,950196830,00020,00050,000196930,00020,00050,000197030,00040030,400197135,40015,40050,800Petitioner and Lutz were the only plan participants to receive bonuses during the entire operation of the plan. Annual compensation excluding overtime, but including bonuses, was the base used for computing the amount received on termination for all plan participants. 3 The amounts actually distributed on termination to the plan participants and the percentage of distributions to total compensation for all plan years are as follows:PercentShareholderAmountof totalParticipantofficerSupervisordistributedcompensationLutzyesyes$ 46,579.8414.92Epsteinyesyes44,417.4514.37Kellernoyes4,827.056.22Caputonoyes2,584.282.55Kmetznoyes2,484.022.92Dukasnono1,297.101.73Goldsteinnono1,243.571.62Elkinnono4,325.475.88Becknono4,844.777.36Baileynono109.791.03Siegelnono4,213.739.01Davisnono625.075.24Hechtnono1,640.375.32110 Petitioner reported the amount received on termination as a 443 long-term capital gain. The respondent determined that the distribution was from a nonqualified plan and that the amount received should be treated as ordinary income.The primary issue herein is whether the amount received by petitioner is to be considered as a distribution from a qualified or nonqualified plan. Respondent contends that the plan was not qualified at the time of termination because it discriminated in operation, in accordance with the amendment, in favor of officers, shareholders, supervisors, or highly compensated employees in violation of section 401(a)(4). 4 We agree with respondent.111 It is clear that, from its inception until the October 1971 amendment, the plan provided that the computation of retirement benefits was to be based upon the participants' compensation, excluding bonuses. It is equally clear that at no time during the years in which the plan was in operation did any employee other than petitioner and Lutz receive a bonus. When the corporation amended the plan to provide that the limitation on benefits to be distributed to its 25 highest paid employees be changed to "annual compensation" from "average regular annual compensation" and proceeded to include bonuses in calculating the benefits to be distributed (and, in fact, distributed) to participants, a discrimination in favor of petitioner and Lutz obviously occurred.Petitioner concedes that the purpose of the amendment to the plan was to permit larger distributions to him and Lutz, but seeks to justify such action on the ground that the amendment merely brought their rights up to the limit of existing law. Such an argument misses the point. The question herein is, not whether the plan conformed to the limits permitted by respondent's regulations ( sec. 1.401-4(c), Income Tax Regs.), but whether, 112 by virtue of the October 1971 amendment, a change occurred which produced a prohibited discrimination even though those limits were not exceeded. The inclusion of bonuses and salary in the actual calculation of the benefits paid to 444 petitioner and Lutz, but only salary in respect of other employees, 5 assured petitioner and Lutz of receiving a more favorable treatment than the other participants. Cf. Bernard McMenamy Contractor, Inc. v. Commissioner, 54 T.C. 1057">54 T.C. 1057, 1062 (1970), affd. 442 F.2d 359">442 F.2d 359 (8th Cir. 1971). Nor can petitioner derive any sustenance from the fact that the plan was once qualified; the key is whether the amendment caused the plan to lose such status. See Greenwald v. Commissioner, 366 F.2d 538">366 F.2d 538, 540 (2d Cir. 1966), affg. on this issue 44 T.C. 137">44 T.C. 137 (1965). 6113 In the foregoing context, no purpose would be served by dissecting petitioner's semantical analysis of the phrases "average regular annual compensation," "average compensation," or "last annual compensation," as used in the amendment to the plan or in respondent's regulations (see sec. 1.401-4(c)(2)(ii)(c), Income Tax Regs.). If these phrases are interpreted to include bonuses, the change in the base for determining benefits caused a discrimination because it favored petitioner and Lutz. If they are interpreted as not including bonuses, 7 then the benefits paid violated the plan and were equally discriminatory in light of the stipulation that the bonuses were in fact used in the base for computing such benefits. Nor should we attempt to reconstruct the benefits, as petitioner would have us do, in order to bring the distributions, and therefore the plan as amended, within the boundaries of respondent's regulations. Cf. Quality Brands, Inc. v. Commissioner, 67 T.C. 167">67 T.C. 167, 175 (1976).114 Finally, petitioner contends that even if the plan is held not qualified at the time of distribution for purposes of section 401(a) (with the result that the trust was not exempt from tax under section 501(a)), we should nevertheless treat a portion of the distributions to petitioner as long-term capital gain rather than as ordinary income. Relying on Greenwald v. Commissioner, supra, and Pitt v. United States, an unreported case ( M.D. Fla. 1975, 35 AFTR 2d 75-1492, 75-1 USTC par. 9472), petitioner argues that he should be entitled to capital gain treatment for that portion of the distribution which is not in excess of the 445 amount he would have received had the plan been operated in a nondiscriminatory manner. This argument is without merit.In Greenwald v. Commissioner, supra, the changed circumstances came about through the implementation of the plan in accordance with its original terms after the business was sold, and the Second Circuit felt that it would be a harsh result to preclude the taxpayer from receiving the benefits of capital gain treatment on amounts115 which would have been entitled to such treatment if the plan had been terminated and he had received his distributions at the time of sale. 8 By way of contrast, the change in circumstances herein came about through a deliberate act of amending the plan. That case is, therefore, clearly distinguishable. Pitt arguably is more in point because the "prohibited transaction," which caused the trust therein to lose its exempt status, could be characterized as a deliberate action. Nevertheless, such action did not involve a change in the base for calculation of benefits paid, as is the case herein, and, therefore, that case is also distinguishable. In view of the foregoing analysis, we need not decide whether we agree with the reversal of our decision in Greenwald or the district court's decision in Pitt.Granted that variations in benefits may be provided under a qualified plan, it is a requisite for retention of qualification116 that such benefits not discriminate in favor of employees in the prohibited group. See sec. 1.401-4(a)(2)(iii), Income Tax Regs. Compare Rev. Rul. 71-26, 1 C.B. 120">1971-1 C.B. 120. By amending the plan herein, the corporation sought to walk as close to the edge of the cliff as possible in an attempt to obtain the maximum benefits for petitioner and Lutz and still stay within the requirements of the statute and respondent's regulations. The corporation stumbled and the plan fell over the cliff. Its deliberate action produced the result that the plan no longer was qualified and the distribution to petitioner should be taxable as ordinary income. Cf. Bernard McMenamy Contractor, Inc. v. Commissioner, 54 T.C. at 1063, wherein we stated:It seems clear to us that to carry out the purposes of the nondiscrimination requirements of section 401, we must hold that the deliberate adoption of a formula for allocating contributions under a profit-sharing plan that favors 446 members of the prohibited group is discriminatory within the meaning of such section, irrespective of the reasons for adopting such a formula.Decision117 will be entered for the respondent. Footnotes1. Mildred Epstein is a party to this proceeding only by virtue of having filed a joint return with petitioner.↩2. All section references are to the Internal Revenue Code of 1954, as amended and in effect during the taxable years in issue.↩3. The record indicates that petitioner and Lutz each received a salary of $ 23,000 in 1965 and $ 25,000 in 1966, but there is no indication as to whether either of them received bonuses during those years.↩4. Sec. 401(a)(4)↩ provides for qualification of a pension plan "if the contributions or benefits provided under the plan do not discriminate in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees."5. The record reveals that at least some of the other employees received compensation other than salary -- presumably overtime.↩6. Thus, petitioner's attempt to rely on respondent's apparent concession in other litigation that the plan was qualified for the fiscal year ending Feb. 28, 1971, is totally misplaced.↩7. In this connection, we note that the definition of "compensation" contained in par. 1.8 of the plan specifically excluded "bonuses" for purposes of the plan "except where the contrary is expressly stated" and that this definition was not changed at the time the plan was amended.↩8. See also Enright v. Commissioner, T.C. Memo. 1976-393↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621993/	Max Leshnick v. Commissioner.Leshnick v. CommissionerDocket No. 50879.United States Tax CourtT.C. Memo 1958-1; 1958 Tax Ct. Memo LEXIS 234; 17 T.C.M. (CCH) 1; T.C.M. (RIA) 58001; January 8, 1958234 David Lemelman, Esq., for the petitioner. Roger L. Davis, Esq., for the respondent. WITHEYMemorandum Findings of Fact and Opinion WITHEY, Judge: The Commissioner has determined a deficiency in income tax against petitioner Max Leshnick for the year 1947 in the amount of $10,091.16. The only issue presented is whether respondent erred in determining that certain loans made by petitioner to a corporation constituted nonbusiness bad debts. Findings of Fact Such facts as are stipulated are found. Petitioner is a resident of Miami, Florida. He filed his Form 1040 income tax return for the year 1947 with the collector for the third district of New York. In 1932, when petitioner was about 25 years of age, he and Irving Podolnik learned that a 10-year lease was obtainable on a hotel property situated in Swan Lake, New York, and known as the President Hotel. The hotel was a summer resort hotel and had 155 guest rooms and a dining room which would seat about 375 persons. Petitioner and Podolnik obtained a 10-year lease on the property and at or about that time they each advanced $2,500 as their contributions to the capital of a partnership composed of themselves which235 they formed to operate the hotel. Before opening the hotel for the season they found that additional money would be required for operations. They then interested Abraham Ellner in the business and he became a member of the partnership. However, the amount he contributed to the capital of the partnership is not disclosed. In order to make certain alterations of the hotel property prior to opening, the petitioner advanced $3,500 to the partnership as a loan. The amount was subsequently repaid to him. After operating the hotel as a partnership for a year or two, the parties organized a corporation which operated it thereafter. In its operation, entertainment was furnished dining room patrons. Operation of the business proved profitable. Podolnik and Ellner continued to own their interest in the corporation until about 1944. The petitioner continued to own his interest in it until sometime in 1947 when he "took over the Glenn Hotel in High Mount, New York," which "was a summer place." The petitioner served as general manager of the President Hotel and of the other hotels referred to hereinafter, the actual management of all of them being carried out by assistant managers under petitioner's236 general supervision. About 1932 the petitioner ascertained that a lease was obtainable on a property known as Belfour Hotel in Lakewood, New Jersey. This hotel had less than 50 rooms and was operated as a weekend resort. A lease was taken on the property and it was operated by a partnership, composed of petitioner, Sam Mishkin and Nathan Gordon, which was formed for that purpose. The petitioner contributed $2,500 to the capital of the partnership. Mishkin and Gordon also made contributions to partnership capital of undisclosed amounts. The petitioner terminated his connection with the enterprise at the end of the second year of operations. About 1934, the petitioner found that a 5-year lease could be obtained on a 60-room hotel property known as the Madison Hotel in Lakewood, New Jersey. A partnership composed of petitioner, Sam Cooperman and one Esack was formed and took a lease on and operated the property for about 3 years when the lease was sold and the partnership was terminated. The initial capital of the partnership was $10,000 of which the petitioner contributed one-third. At the time the partnership took over the hotel it was in need of some refurbishing and the petitioner237 advanced $5,000 to the partnership as a loan for that purpose. Subsequently the amount was repaid to petitioner. In 1937 and after the termination of the partnership which operated the Madison Hotel, the petitioner was introduced to one Blumenkranz who was operating the Blumenkranz Hotel in Lakewood, New Jersey. This hotel contained more than 50 rooms. Blumenkranz's operation of the hotel was not profitable and he desired to have the petitioner associated with him in its operation and to serve as manager. The petitioner was agreeable. He invested $6,500 or $7,500 in the enterprise and they operated the hotel as a partnership until 1939. The Balfour, the Madison and the Blumenkranz Hotels each had restaurants in them which were operated as a part of those enterprises. In 1939, after severing his connection with the Blumenkranz Hotel, the petitioner went to Miami, Florida, to look for a hotel which he could operate during the winter months. In Miami he found a vacant lot, and negotiated for and acquired in his individual capacity a 99-year lease thereon. He thereafter entered into a partnership with Bernie Coleman and Irving Miller which was formed for the purpose of constructing238 a hotel building on the lot and operating it as such. Following its formation in 1940 the partnership constructed on the lot a 72-room hotel building with a coffee shop and bar. The building was known as the Cardozo Hotel. Partnership funds were insufficient to complete the construction of the building and the petitioner advanced $12,500 as a loan to complete its construction. The loan was evidenced by notes from Coleman and Miller. Petitioner, however, looked to the profitable operation of Cardozo for the repayment of the loan. The amount loaned was repaid to the petitioner. Coleman and Miller "did not get along." In 1941 Coleman "broke away" from the partnership and petitioner and Miller disposed of their interests in Cardozo. After Coleman withdrew from the Cardozo partnership, the petitioner and Irving Miller negotiated for and acquired a lease upon a likely site for the construction of a hotel in Miami Beach, Florida. The petitioner, Miller and Sam Kulok entered into a partnership which was formed for the purpose of constructing a hotel building on the lot and operating it as a hotel. Each made an initial contribution to partnership capital of $35,000. Further funds necessary239 to construct the hotel, afterwards known as Haddon Hall, were obtained by a mortgage on the building. After completion of the building, it was necessary for the petitioner to advance to Miller and Kulok, as members of Haddon Hall partnership, $13,000 or $14,000, as a loan in order to properly furnish the building before opening for operation. "After the season" the loan was repaid to petitioner. Petitioner thereafter, in partnership with John Shapiro and Max Kinsbrunner, purchased a 4-year lease on the Whitehart Hotel in Miami Beach. Petitioner invested $3,500 for the lease and loaned $6,500 to Kinsbrunner to enable him to acquire an interest in the partnership. The petitioner made no further advances of money in connection with Whitehart. The lease was sold and the partnership discontinued its operation of the hotel about 1946. Kinsbrunner, under the supervision of the petitioner, managed the hotel during the period the partnership operated it. After the sale of the lease on the Whitehart Hotel, the petitioner, in partnership with Shapiro and Kinsbrunner, obtained a lease on the Coral Reef Hotel in Miami Beach and thereafter operated it. In 1945, while petitioner was still interested240 financially in and was still managing the President, Haddon Hall, Whitehart and Coral Reef Hotels, he and Irving Miller obtained a lease upon land and a building in Miami Beach theretofore operated as a mess hall for military personnel. The petitioner made an investment of his own funds in an undisclosed amount to acquire the lease in the joint names of himself and Miller. It was their intention to operate the premises as a supper club or restaurant with a band for entertainment of customers. In order to rebuild and properly equip the building for that purpose it became necessary to obtain additional capital. To that end one Levi, "a sort of supper club operator," became associated in the venture with petitioner and Miller and they proceeded to rebuild and equip the premises. The venture was conducted as a partnership until some undisclosed date prior to October 1945, when a corporation known as Mocamba, Inc., was organized and took over and conducted the business until its dissolution in January 1946. Thereafter until July 1946 the venture was conducted as a partnership. In July 1946 Mocamba Restaurant, Inc., was organized and took over and conducted the business theretofore conducted241 by the partnership. Mocamba Restaurant, Inc., continued in business until March or April 1947 when due to unprofitable operations it ceased business. However, it has never been formally dissolved. For convenience, the venture, whether conducted as a partnership or as a corporation, is hereinafter referred to as Mocamba unless otherwise designated. The petitioner's original investment in Mocamba was $7,500. Business was bad during the first season and before the season was over Levi sold his interest in the venture to Jack Friedlander and terminated his connection with the venture. About the time Levi disposed of his interest the petitioner made a loan to Mocamba in an undisclosed amount. Following several months of operation, business again began to go bad. About that time Michael Rosenberg became interested in the venture and Mocamba ceased to be operated as a supper club and thereafter was operated as a restaurant only. Also about that time petitioner made an additional loan to Mocamba in an undisclosed amount. Subsequently, Rosenberg "fell out" of Mocamba and Jerry Brooks acquired an interest therein. About that time the venture was taken over and conducted by Mocamba Restaurant, 242 Inc. During its operation, Mocamba was managed by petitioner, and while he had an interest therein, Friedlander. Mocamba was the first supper club or restaurant business distinct from such a business as part of a hotel operation in which petitioner had been interested in a business way. On several occasions during the period from July 1946 when Mocamba Restaurant, Inc., was organized until it ceased business in March or April 1947, the petitioner made loans to enable it to pay its current expenses. In making such loans, the petitioner made deposits in its bank account. Upon some occasions other parties interested in the corporation made loans equal to those made by petitioner. In other instances the petitioner's loans exceeded theirs, in which case the other interested parties delivered to petitioner "IOU's" in the form of letters for the excess amounts. With respect to the excess amounts loaned, the petitioner expected to be repaid from the profits of the corporation. In his income tax return for 1946, the petitioner reported income of $3,000 as having been received as salary from "President on Swan Lake, Inc." As his only other income the petitioner reported as distributive243 shares of partnership income or loss the following amounts: President Hotel Operating Co. - SwanLake$ 8,321.68Whitehart Hotel - Miami Beach5,770.09Haddon Hall Hotel - Miami Beach15,340.98Mocamba Restaurant - Miami Beach(Loss)18,521.68In his income tax return for 1947 the petitioner reported as income the amount of $925.24 received as an annuity or pension, and $4,792.23 as his share of net capital gains from partnerships. As his only other income the petitioner reported as his distributive share of partnership income or loss, the following amounts: President Hotel Operating Co. - SwanLake$ 1,586.41Whitehart Hotel - Miami Beach (Loss)23.47Haddon Hall Hotel - Miami Beach20,264.04Coral Reef Hotel - Miami Beach15,899.03Mocamba Club - Miami Beach (Loss)2,342.64In his income tax return for 1947 the petitioner deducted as a miscellaneous deduction the amount of $18,458.62 which was explained as follows: "Bad Debts - Advances to Mocamba Restaurant, Inc. - uncollectible." In determining the deficiency here involved the respondent determined that the petitioner was not in the business of loaning money and that the amount244 deducted was not allowable as a business bad debt. He further determined that the amount represented a nonbusiness bad debt and allowed it as such. Opinion In his petition the petitioner assigns the following errors: "(a) The Commissioner erroneously determined that the bad debt in the sum of $18,458.62 due from Mocamba Restaurant Inc. was improperly deducted as a business bad debt on the petitioner's 1947 tax return on the ground that the petitioner is not in the business of lending money. "(b) That the amount disallowed is a nonbusiness bad debt." In his answer the respondent generally and in particular denied the petitioner's assignments of error. Neither party has filed any amendment to his pleading. The parties suggest on brief that the proceeding involves an issue as to whether the $18,458.62 represented a contribution by petitioner to the capital of Mocamba Restaurant, Inc., and the respondent also suggests that an issue as to the existence of an indebtedness of $18,458.62 and the worthlessness thereof is involved. As we view the pleadings neither of the foregoing issues is presented. Accordingly we regard the issue presented as being the narrow question of whether245 the respondent erred in determining that the $18,458.62 was deductible as a nonbusiness bad debt instead of a business bad debt as deducted by petitioner in his return. The petitioner makes no contention that at any time during the period 1932 through 1947 he was engaged in the business of loaning money and on brief concedes that the record does not show that he was engaged in that business during that period. However, the petitioner takes the position that during that period his sole business "was that of investing his money in the purchasing and leasing of hotels and restaurants, for the purpose of managing and operating the same as a business of dealing in enterprises" and contends that the $18,458.62 in controversy represented an indebtedness arising in his conduct of such business, that it was a business indebtedness proximately related to the business carried on by him in 1947 and therefore was deductible by him as a business bad debt. The respondent contends that during 1947 the petitioner was not engaged in any trade or business to which the indebtedness proximately related. Beginning in 1932 and continuing for one or two years, the petitioner was a member of a partnership246 which operated the President Hotel under lease. After having operated that hotel as a partnership for a year or two the petitioner and the other partners organized a corporation which thereafter operated the hotel. The petitioner disposed of his interest in that corporation in 1947. At some undisclosed time in 1947 the petitioner "took over the Glenn Hotel in High Mount, New York," which "was a summer place." Aside from the foregoing, the record is silent as to the Glenn Hotel and the petitioner's relationship to it. In his income tax return for 1946 the petitioner reported as income a salary from "President on Swan Lake, Inc., Swan Lake, N. Y." We are not otherwise informed as to this corporation or its activities or operations and it may well be that it was the corporation that was formed by petitioner and his partners and which operated the President Hotel following its operation by the partnership. In his income tax returns for 1946 and 1947 the petitioner reported certain sums as his distributive shares of partnership income from "President Hotel Operating Co., Swan Lake, N. Y." The record is also silent as to when this partnership was formed and as to what activities or operations247 it conducted. In view of the foregoing state of the record we can only conclude that the petitioner's relationship to the President Hotel from about 1933 to 1947 was that of a stockholder in and officer or employee of the corporation which operated the hotel during that period. From about 1932 until about 1934 the petitioner was a member of a partnership which operated the Balfour Hotel under lease. From about 1934 until about 1937 the petitioner was a member of a partnership which operated the Madison Hotel under a lease. The latter operation was terminated upon the sale of the lease about 1937. From that time until 1939 the petitioner was a member of a partnership which operated the Blumenkranz Hotel. The record is silent as to whether the hotel was operated under lease or whether it was owned by the other partner, Blumenkranz. From 1939 until 1941 the petitioner was a member of a partnership which constructed and operated the Cardozo Hotel. The petitioner's connection with this hotel and its operation was terminated by the petitioner's disposition of his interest in the property and the termination of the partnership in 1941. In 1941 the petitioner entered into a partnership248 which constructed and operated the Haddon Hall Hotel. The partnership continued to operate the hotel during 1947. Beginning at an undisclosed prior time and continuing until 1945 or 1946, the petitioner was a member of a partnership which operated the Whitehart Hotel under a 4-year lease. The partnership and its operation of the hotel were terminated upon the sale of the lease about 1945 or 1946. The petitioner was also a member of a partnership which operated the Coral Reef Hotel under lease. The partnership continued to operate the hotel during 1947. The petitioner served as general manager of the foregoing hotels during the time they were operated by the partnerships of which he was a member. The foregoing comprises all of the business connections and activities of the petitioner during the period 1932 through 1947, except for the Mocamba venture. That venture originally was a partnership, then it was operated by Mocamba, Inc., then again conducted as a partnership from January 1946 to July 1946 and then operated by Mocamba Restaurant, Inc., from July 1946 until March or April 1947. The President Hotel operated a dining room and the Balfour, Madison and Blumenkranz Hotels each249 operated a restaurant. The Cardozo Hotel in Miami, with which petitioner's connection terminated in 1941, operated a coffee shop and bar. None of the other hotels in Florida which were operated by partnerships of which the petitioner was a member are shown to have operated a dining room or a restaurant, or a coffee shop. The petitioner claims that , reversing a Memorandum Opinion of this Court, decided October 29, 1954 [; , supports his contention that he was in the business of dealing in enterprises. In that case the taxpayer on 11 or 12 occasions during 1925 through 1945 had engaged in various business ventures. In determining that in 1945 the taxpayer was engaged in the business of "dealing in enterprises" the Court of Appeals described the taxpayer's business as follows: "he was regularly engaged in the business of seeking out business opportunities, promoting, organizing and financing them, contributing to them substantially 50% of his time and energy and then disposing of them either at a profit or loss * * " In the Giblin case the taxpayer was regularly attempting250 to acquire and promote business enterprises with the intent of future disposal. In the instant case there is nothing to indicate that the petitioner promoted any enterprise for the purpose of future disposal. Instead, his aim was to promote enterprises for the purpose of operating them through the instrumentality of partnerships and obtain a share of the profits derived from the operations. The petitioner's activities over the period from 1932 through 1947 were those of one who was operating enterprises rather than those of one who was dealing in them as a business. As a further ground to support his contention that he was entitled to deduct the amount in controversy as a business bad debt, the petitioner urges that the business conducted by Mocamba Restaurant, Inc., was so closely connected with the business conducted by him, that it was a separate business of his and was not in a strict sense the business of the corporation. Although the record does not clearly indicate the petitioner's relationship to Mocamba Restaurant, Inc., the petitioner states on brief that he was "an officer, director and stockholder and principal actor" in that corporation. In ,*251 the Supreme Court made it plain that the business of a corporation is not the business of its stockholders and officers. Consequently, the petitioner cannot appropriate to himself as his own business the business conducted by Mocamba Restaurant, Inc. As was said in , to escape classification as a nonbusiness bad debt, a debt and the loss from its worthlessness must bear a proximate relation to a business in which the taxpayer is engaged at the time the debt becomes worthless. From the record presented, we are unable to find a proximate relationship of the indebtedness of Mocamba Restaurant, Inc., to the petitioner to any business in which the petitioner was engaged in 1947 when the indebtedness became worthless. The respondent's determination that such indebtedness constituted a nonbusiness bad debt is sustained. Decision will be entered for the respondent.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621994/	Richard A. Brown v. Commissioner.Brown v. CommissionerDocket No. 5932-67.United States Tax CourtT.C. Memo 1969-99; 1969 Tax Ct. Memo LEXIS 197; 28 T.C.M. (CCH) 542; T.C.M. (RIA) 69099; May 15, 1969, Filed John S. Mahle, Jr., Tower Bldg., Baltimore, Md., for the petitioner. Gerald D. Babbitt, for the respondent. KERN Memorandum Findings of Fact and Opinion Respondent determined a deficiency in petitioner's federal income tax liability for the year 1963 in the amount of $3,141.60. This deficiency arises by reason of respondent's determination that petitioner "realized ordinary income in the amount of $6,924.10 * * * from collections of purchased receivables in lieu of long term capital gain reported." Among the "purchased receivables" referred to by respondent were "hypothecations" in the amount of $1,242.79. At the trial herein respondent conceded that "the gain of $1,242.79 * * * derived * * * from the hypothecations purchased on November 30, 1962 constitute198 capital gain and not ordinary income." Findings of Fact The parties have filed a stipulation of certain facts. We find the facts to be as stipulated and incorporate herein by this reference the stipulation and the exhibits attached thereto. Petitioner at all pertinent times lived in Severna Park, Maryland. He filed his federal income tax return for 1963 with the district director of internal revenue at Baltimore, Maryland. Petitioner was the president and a minority stockholder of Monumental Engineering, Inc., a Maryland corporation. In 1963 he was also president of Consolidated Securities Savings and Loan Association in Glen Burnie, Maryland. At some time prior to November 30, 1962, the assets of Monumental Engineering, Inc. (hereinafter referred to as Monumental) passed into the hands of Jerome M. Asch as Trustee in Insolvency. Prior to the assignment of these assets to Asch as Trustee, petitioner as president of Monumental had "had dealings" with Asch. On November 30, 1962, petitioner purchased from the Trustee in Insolvency certain notes receivable, accounts receivable, hypothecations receivable and a mortgage receivable owned by Monumental. Petitioner intended to make199 a profit from the receivables thus acquired from the Trustee by (1) collecting from the obligors from whom the receivables were owing more than he paid therefor or (2) selling the receivables to third parties at a discount but for more than he paid therefor. In order to induce some of the obligors from whom he was unable to collect in full to pay to him amounts greater than the amounts paid by him for the several obligations, petitioner offered to accept from them in satisfaction of the obligations amounts less than the face value thereof but in excess of the amounts which he had paid therefor. With regard to 1 note receivable, 2 accounts receivable and the mortgage receivable, the obligors made the agreed payments in installments. With regard to the other receivables the obligors made lump-sum payments. When the agreed payments were made by the obligors, any instruments evidencing the debts were delivered to them. With regard to the notes receivable, accounts receivable and the mortgage receivable, the following schedule discloses the names of the obligors, the face amount of each obligation as of November 30, 1962, the amounts received from the respective obligors during 1963, 200 the amount of petitioner's cost in the respective obligations which is deductible in arriving at petitioner's taxable gain, and the taxable gain or loss derived by petitioner in 1963 with respect to each obligation: 544 (A) Obligors(b) Face Amountof Obligation on November 30, 1962(C) Amounts Receivedfrom Obligorsin 1963(E) Petittioner's Taxable Gainin 1963Notes Receivable:W.L. McMillion$ 700.00$ 195.00$ 168.63$ 26.37B. Sewell38.0038.009.1528.85J. Ray125.00120.0030.1189.89J. McIver341.00166.6785.1584.52166.6782.1584.52R. Meyers1,100.00610.00264.99 345.01 10 Gain in 1963 from Notes Receivable$ 574.64Accounts Receivable:M. Rharrington$ 160.00$ 65.00$ 34.11$ 30.89G. Blucher100.00100.0021.3278.68R. Sonderman20.0020.004.2615.74W. Gribble400.00350.0085.28264.72F. Orlando153.00153.0032.61120.39W. Thomas67.0835.0014.3020.70C. Strawbridge45.0045.009.59 35.41 10 Gain in 1963 from Accounts Receivable$ 566.53Mortgage Receivable:H. Kilgore$ 952.73$ 585.43$ 245.79$ (2.95) 10Less: Expense (342.59)242.84 10Loss in 1963 from Mortgage Receivable $ (2.95)Total Net Taxable Gain in 1963 from Notes Receivable, Accounts Receivable and Mortgage Receivable $ 1,138.22201 On March 11, 1963, petitioner purchased from the Trustee in Insolvency of Monumental a mortgage known as the Porter Mortgage securing an indebtedness of Harry B. Porter and his wife to Monumental incurred by them in 1961. This indebtedness assigned by the Trustee to petitioner on February 1, 1963, arose from a construction contract between the Porters and Monumental calling for the payment of a "cash price" of $5,092.00. It is stipulated that the amount of $8,870.40 represents the "time payment sale price" of the home to be constructed by Monumental for the Porters on property owned by them in Delaware and that the "time payment sale price" secured by the mortgage was payable in 83 equal monthly installments of $105.60 and an 84th installment in the amount of the balance. The Porters were not satisfied with the work done by Monumental in connection with the construction of their home and they paid none of the installments called for under their agreement to pay the time payment sales price of $8,870.40. Accordingly, the amount still due and owing on the Porter mortgage was $8,870.40 on March 11, 1963. At the time petitioner acquired this mortgage he was aware of the Porters' defaults202 and the reasons therefor. Shortly after March 11, 1963, the petitioner, through Jackson W. Raysor, his attorney in Georgetown, Delaware, entered into settlement negotiations with the Porters. The outcome of these negotiations was that in April of 1963 the Porters paid $5,390.82 to the petitioner's attorney in full settlement of their obligation of $8,870.40. On April 4, 1963 the petitioner's attorney transmitted to the petitioner the amount he had received from the Porters, namely, $5,390.82 less his attorney fee and costs of $545.61, or a net of $4,845.21. The parties agree that the amount of $5,108.68 reflected in Exhibit A of the statutory notice of deficiency as having been received by the petitioner in 1963 with respect to the Porter mortgage is actually $4,845.21 and that the petitioner's gain in 1963 with respect to the Porter mortgage is $4,279.62 rather than $4,543.09 as indicated in Exhibit A of the statutory notice of deficiency. It is also agreed that the face amount of the Porter mortgage as of March 11, 1963 was $8,870.40 rather than $5,198.42 as indicated in Exhibit A of the statutory notice of deficiency. The petitioner concedes that the respondent has properly203 determined his cost basis in all of the accounts receivable, notes receivable, hypothecations and mortgage receivable purchased by the petitioner on November 30, 1962 and that the amount of cost basis allowed by the respondent as a deduction in computing the petitioner's taxable gain in 1963 with respect to each one of these individual items is also correct. The petitioner concedes that the respondent has properly determined his cost basis in the Porter Mortgage and that the amount allowed by the respondent as a deduction in computing the petitioner's gain from the Porter Mortgage in 1963 is also correct. 545 Opinion KERN, Judge: The question before us is whether the proceeds of various choses in action acquired by petitioner from the Trustee in Insolvency of a corporation of which he was an officer and stockholder were taxable to him as capital gains realized by him from "the sale or exchange" of such choses in action where the proceeds represented payments made by the obligors on the choses in action in amounts equal to or less than the amounts of their original obligations. If the proceeds received by petitioner from the obligors are to be considered as the collection204 of the choses in action in full or in lessor amounts agreed upon as settling the indebtedness there would be no "sale or exchange" giving rise to any gain realized within the meaning of section 1222(1) and (3), Revenue Act of 1954, 1 since immediately upon the collection or settlement of the choses in action they cease to exist and consequently cannot be considered as property or assets sold or exchanged by petitioner to the obligors. Therefore any gain realized by petitioner as a result of the receipt by him of payments made by obligors in satisfaction or settlement of their debts which were in excess of the amounts paid by petitioner as the purchase price of such obligations would not be capital gains but would, to the contrary, constitute ordinary income. See Hale v. Helvering, 85 F. 2d 819 (C.A.D.C.); Charles E. McCartney, 12 T.C. 320">12 T.C. 320 (1949); Pat N. Fahey, 16 T.C. 105">16 T.C. 105 (1951); Mace Osenbach, 17 T.C. 797">17 T.C. 797 (1951), aff'd. 198 F. 2d 235 (C.A. 4); Galvin Hudson, 20 T.C. 734">20 T.C. 734 (1953); and Arthur E. Wood, 25 T.C. 468">25 T.C. 468 (1955). 205 With regard to all of the choses in action here involved, with the exception of the so-called "Porter Mortgage," petitioner testified that he intended to "sell" and "sold" the debts to the original obligors. Obviously we are not bound by the nomenclature which petitioner chooses to give to the transactions clearly portrayed by the record. These were the receipt by petitioner from the obligors of certain indebtedness, pursuant to agreements negotiated between them, of amounts equal to or less than the amounts of the original indebtedness and in satisfaction or in settlement thereof followed by the delivery to the obligors of any instrument evidencing such obligations thus satisfied or settled. Thus the only things passing from petitioner to the obligors were valueless papers purporting to evidence satisfied and therefore non-existent debts (and with regard to the accounts receivable there were not even those valueless papers). It may well be that petitioner intended to sell whatever choses in action he was unable to collect from or settle with the original obligor, but the fact was that he206 did effect the collection or settlement of each of the choses in action here involved and consequently made no sale or exchange from which he realized gain. With regard to the so-called Porter Mortgage, petitioner contends that there was a renegotiation of the contract by him rather than a collection and that the Porters, by giving up claimed defenses as to their liability on the original contract, were in effect transferring property rights to petitioner in return for which he "sold" at least some part of the original indebtedness. Confining ourselves to the facts shown by the record as distinguished from the characterization of those facts found in petitioner's self-serving, opinion testimony, we are unable to conclude that petitioner has proved that his receipts from the Porters were anything other than collections from original obligors in settlement and satisfaction of the original obligations. Specifically we conclude that petitioner has not proved that these receipts were derived from "the sale or exchange of a capital asset." Because of concessions made by respondent, Decision will be entered under Rule 50. 546 Footnotes1. SEC. 1222. OTHER TERMS RELATING TO CAPITAL GAINS AND LOSSES. For purposes of this subtitle - (1) Short-term capital gain. - The term "short-term capital gain" means gain from the sale or exchange of a capital asset held for not more than 6 months, if and to the extent such gain is taken into account in computing gross income. * * (3) Long-term capital gain. - The term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing gross income.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621995/	CARL N. PEHLKE and BARBARA D. PEHLKE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent JAMES A. LUKSCH and MARGARET T. LUKSCH, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentPehlke v. CommissionerDocket Nos. 8909-76, 8910-76.United States Tax CourtT.C. Memo 1978-254; 1978 Tax Ct. Memo LEXIS 264; 37 T.C.M. (CCH) 1088; T.C.M. (RIA) 78254; July 10, 1978, Filed J. Michael Frost, for the petitioners. Elsie Hall, for the respondent. SCOTT MEMORANDUM FINDINGS OF FACT AND OPINION SCOTT, Judge: Respondent determined the following deficiencies in petitioners' Federal income taxes and additions thereto: Docket No. 8909-76 Petitioners Carl N. Pehlke and Barbara D. Pehlke Tax YearAdditions to Tax, I.R.C. 1954, 1 EndedDeficiencySec. 6651(a)(1)Sec. 6651(a)(2)12/31/71$ 5,381.6012/31/72929.55$ 9.39$ 171.9712/31/733,963.00266 Docket No. 8910-76 Petitioners James A. Luksch and Margaret T. Luksch Tax YearAdditions to Tax, EndedDeficiencyI.R.C. 1954, Sec. 6651(a)(2)12/31/71$ 5,061.6012/31/723,302.39$ 1,458.7512/31/734,363.68Both petitioners and respondent have made concessions, leaving the following issues for decision: (1) Whether petitioners sustained any bad debt losses during 1971 in excess of the amounts allowed by respondent; (2) whether any bad debt losses that may have been sustained resulted from nonbusiness debt.s, and (3) whether petitioners James A. Luksch and Margaret T. Luksch are liable for an addition to tax under section 6651(a)(2). FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. At the time of the filing of their petition in this case Carl N. Pehlke and Barbara D. Pehlke, husband and wife, maintained their legal residence in Indianapolis, Indiana. For the taxable years in issue, the Pehlkes filed joint individual income tax returns with the Internal Revenue Service Center in267 Cincinnati, Ohio, or Memphis, Tennessee. At the time of the filing of their petition in this case James A. Luksch and Margaret T. Luksch, husband and wife, resided in Indianapolis, Indiana. For the taxable years at issue, the Luksches filed their joint individual income tax returns with the Internal Revenue Service Center in Cincinnati, Ohio, or Memphis, Tennessee. Carl N. Pehlke was born in 1927. He is a 1949 graduate of Purdue University, where he majored in industrial engineering and received a Bachelor of Science degree. He subsequently graduated from the University of Chicago with a Master of Business Administration degree. Following his graduation from Purdue, Mr. Pehlke was employed in the Microwave Department of Motorola, Inc. in Chicago. The final position he held at Motorola was Operations Manager of the company's Microwave Department. Between 1961 and 1963 Mr. Pehlke was employed in the telephone division of ITT-Kellogg as Industrial Products Manager. Subsequently he served as the Product Planning Manager of ITT-Kellogg's Military Division. Thereafter he was employed by Telonic Industries, Inc., Beech Grove, Indiana, from 1963 to 1965. Initially he served268 as Assistant General Manager, and finally, as General Manager. James A. Luksch was born in 1930. He received a Bachelor of Science degree from the State University of New York at Buffalo in 1957, having majored in electrical engineering. In 1960 he received a Master of Science degree from the University of Pennsylvania where his studies were also concentrated in the field of electrical engineering. From 1960 to 1963 Mr. Luksch was employed in the Missile and Surface Radar Division of Radio Corporation of America, where he held various positions, the final one being Senior Systems Engineer. In 1963 Mr. Luksch commenced working for Telonic Industries, Inc. as the Director of Engineering. In 1965, being dissatisfied with their employment at Telonic Industries, five employees 2 including Mr. Pehlke and Mr. Luksch decided to form a business of their own. These five employees met with a Mr. Groshans with regard to the possibilities of starting a business, the activity of which would encompass the design, manufacture and sale of electronic test equipment. Mr. Groshans, a broker in the Indianapolis area, aided the Telonic Industries employees in raising money for their proposed269 business venture. To that end, the five Telonic Industries' employees and Mr. Groshans decided to form Texscan Corporation (hereinafter Texscan). They arranged for a Small Business Investment Corporation loan of between $ 175,000 and $ 200,000. Texscan was incorporated under the laws of Indiana in May 1965. Mr. Pehlke and Mr. Luksch both purchased as much Texscan stock as they felt they could afford at the time. At trial neither could recall the precise amount of stock purchased at the time of Texscan's formation but estimated that the total amount purchased by the two of them was less than 10 percent of the outstanding stock. Mr. Pehlke and Mr. Luksch served as directors of Texscan from its inception and were still serving as directors at the time of the trial on this case. During this entire period Mr. Pehlke served as president of Texscan and Mr. Luksch served as executive vice president and treasurer. From 1970 to the time of trial, Mr. Luksch also served as secretary of Texscan. Mr. Groshans was a director of Texscan from 1965 through 1969. From May 1963 through December 1967 and from January 1970 through and including the time of trial, Mr. Pehlke and Mr. Luksch were270 also employees of Texscan, each receiving a salary of a little over $ 22,000 in 1967.Soon after the formation of Texscan, Telonic Industries filed a civil antitrust action against Messrs. Pehlke, Luksch, and others. Telonic Industries alleged that Mr. Pehlke and Mr. Luksch had misappropriated trade secrets, had wrongfully hired employees away from Telonic Industries and had taken Telonic Industries' customer lists. In December of 1967, I-Tel, Inc., another company engaged in the production of electronic test equipment, filed a similar lawsuit against Texscan. These two lawsuits were matters of general knowledge in the electronic test equipment industry. As a result of these lawsuits, for a period of two or three years Texscan had to pay a royalty to I-Tel, Inc. on all filters Texscan manufactured. In June 1971, Texscan agreed to pay $ 135,000 to Telonic Industries in full settlement of the lawsuit filed against Messrs. Pehlke, Luksch, and others. For the fiscal year ended April 30, 1967, Texscan's net sales totaled $ 996,517. The net income of Texscan for that fiscal year, however, 271 was only $ 2,094. Upon learning this, Mr. Luksch and Mr. Pehlke concluded that Texscan's profit margin was not sufficient to justify their salaries. After meeting with Mr. Groshans, they decided to form another company, VTC, Incorporated (hereinafter VTC), 3 which would manage a number of diversified companies, including Texscan and Versatek Industries (hereinafter VI), and thereby spread over a larger base the general and administrative costs of such companies, including the salaries of Mr. Pehlke and Mr. Luksch. VTC was incorporated under the laws of Indiana on or about October 24, 1967. Mr. Pehlke and Mr. Luksch served both as officers and directors of VTC from its inception until about September 26, 1970. During 1968 and 1969, Texscan was managed under a contract with VTC, which provided management and accounting services for Texscan. During its fiscal years ended April 30, 1969, and April 30, 1970, Texscan paid fees of $ 56,900 and $ 85,323, respectively, to VTC under this contract. From the time of VTC's formation in October 1967 until the end of that calendar year, Mr. Pehlke and Mr. Luksch were paid no salary272 by VTC. During the calendar year 1968 Mr. Pehlke and Mr. Luksch were substantially full-time employees of VTC. Each received a salary of $ 25,192.34. During the same year, each was paid remuneration of $ 473.16 by Texscan. During the calendar year 1969 Mr. Pehlke and Mr. Luksch were again substantially full-time employees of VTC, and in that year each received a salary of $ 26,538.51 from VTC. During the same year Mr. Pehlke and Mr. Luksch each received remuneration of $ 120 from Texscan. After December 31, 1969, Mr. Pehlke and Mr. Luksch received no further salary payments from VTC. In January 1970 VTC's management contract with Texscan was terminated, and VTC ceased operations. On or about January 1, 1970, Mr. Pehlke and Mr. Luksch again became substantially full-time employees of Texscan, each receiving a salary of $ 31,461.79 from Texscan for the year 1970. On or about October 24, 1967, when VTC was first being organized, Mr. and Mrs. Pehlke contributed the following money and other property to VTC in exchange for 50,000 shares of VTC common stock: (1) $ 1,126.67 in cash. (2) 2,000 shares of Texscan common stock. The Pehlkes' basis in this stock was $ 4,140. 273 (3) 100 shares of TEMCO (Texscan Electronic Manufacturing Company, Inc.) stock. TEMCO was a corporation formed by petitioners and others to produce inexpensive stereo equipment. TEMCO went through Chapter 11 and final bankruptcy in September 1969. The Pehlkes' basis in the TEMCO stock was zero. (4) 18,000 shares of common stock issued by Limited (Texscan Limited, Inc.). Limited was a company organized by petitioners and others to market Texscan products overseas. The Pehlkes' basis in the Limited stock was $ 6,000. The Pehlke's total basis in the money and stock contributed by them in exchange for VTC stock was $ 11,266.67. Mr. and Mrs. Pehlke never acquired any additional VTC common stock. They disposed of only 253 shares of the VTC common stock they received, 250 shares on or about April 9, 1968, and 3 shares on or about January 10, 1969. When VTC was organized the Luksches also contributed money and property in exchange for 50,000 shares of VTC common stock. On or about October 24, 1967, Mr. Luksch contributed $ 1,126.67 in cash, 2,000 shares of Texscan common stock, 100 shares of TEMCO common stock, and 18,000 shares of Limited common stock to VTC. The Luksches' 274 total basis in the money and other property contributed to VTC for common stock was $ 11,266.67. The Luksches never acquired any more VTC stock and never disposed of any of the VTC common stock which they held. On August 26, 1968, VTC obtained a working capital loan in the principal amount of $ 240,000 from Anthony Wayne Bank of Ft. Wayne, Indiana. As a condition to making the loan, the bank required that petitioners and Mr. and Mrs. Groshans, as co-makers, execute a promissory note evidencing the loan. The lending bank also required that the loan to VTC be secured by the following collateral, some of which was pledged with the bank at the time the loan was made, and some of which was pledged with the bank from time to time thereafter: (1) 5,000 shares of common stock of Bio-Dynamics, Inc. owned by Willard D. Eason, a friend of Mr. Pehlke and Mr. Luksch. (2) 12,600 shares of Texscan common stock owned by VI; (3) A $ 68,000 non-interest-bearing certificate of deposit issued by the bank to VI; (4) 31,500 shares of Texscan common stock owned by VTC; (5) 6,000 shares of Texscan common stock owned by Mr. Pehlke; (6) 6,000 shares of Texscan common stock owned by Mr. Luksch; 275 and (7) The rights of VTC under an "earnout" agreement dated February 25, 1970, between VTC and Texscan. Mr. Pehlke and Mr. Luksch induced Mr. Eason to pledge his 5,000 shares of common stock of Bio-Dynamics, Inc. to the Anthony Wayne Bank as security for the loan by entering into written agreements with Mr. Eason pursuant to which Mr. Pehlke and Mr. Luksch each pledged with Mr. Eason 12,500 shares of their Texscan common stock. On or about October 23, 1968, the principal amount of the loan was increased to $ 340,000. As a result of repayments between April 21, 1969, and June 9, 1970, the principal amount of the loan was reduced to $ 312,000. On or about June 19, 1970, Anthony Wayne Bank released the 12,600 shares of Texscan common stock owned by VI and pleged as collateral for the loan to VTC. Throughout the period from about June 10, 1970, to about August 10, 1970, the principal amount of the loan was $ 267,000. On or about August 10, 1970, VTC defaulted on the loan from Anthony Wayne Bank. On or about August 11, 1970, Anthony Wayne Bank applied toward reduction of the principal amount of the loan VI's $ 68,000 certificate of deposit which had been pledged as collateral,276 thereby reducing the principal amount of the loan to $ 199,000. Thereafter Mr. Eason entered into negotiations with the bank concerning the release of the collateral pledged as security for the VTC loan, so that the bank would not foreclose on the 5,000 shares of Bio-Dynamics, Inc. common stock pledged by Mr. Eason as collateral. On November 20, 1970, Mr. Eason entered into an agreement with the Anthony Wayne Bank whereby he paid the bank $ 130,000 and the bank transferred the VTC note co-signed by the Pehlkes and the Luksches to him. The bank also released to Mr. Eason the existing collateral for the loan, which at that time consisted of 5,000 shares of Bio-Dynamics, Inc. common stock pledged by Mr. Eason, 31,500 shares of Texscan stock owned by VTC, 6,000 shares of Texscan stock owned by Mr. Pehlke, 6,000 shares of Texscan stock owned by Mr. Luksch, and the rights of VTC under the "earnout" agreement between VTC and Texscan. In addition, the bank released its claims against VTC, the Pehlkes and the Luksches. When VTC defaulted on its payment on the note to the Anthony Wayne Bank, Mr. Pehlke and Mr. Luksch were not financially able to pay the note. They discussed with Mr. 277 Eason his purchase of the note and prior to Mr. Eason's negotiations with the bank for release of the collateral in exchange for the $ 130,000 payment, Mr. Pehlke and Mr. Luksch had orally agreed with Mr. Eason to reimburse him for his payment to the bank. In exchange, Mr. Pehlke and Mr. Luksch were to receive the 25,000 shares held by Mr. Eason as collateral for his Bio-Dynamics, Inc. shares 4 together with all the collateral surrendered by the bank to Mr. Eason except Mr. Eason's 5,000 shares of Bio-Dynamics, Inc. stock. On February 19, 1971, Mr. Pehlke, Mr. Luksch and Mr. Eason executed an agreement which provided in part: The Seller [Mr. Eason] on November 20, 1970 purchased a certain note which has been in default since August 10, 1970, the existing balance thereon in the amount of $ 199,000.00 excluding interest, together with all of its collateral which included 43,500 shares of Texscan Corporation stock278 as well as an Agreement between Texscan Corporation and VTC, Inc. dated February 25, 1970. Since the purchase of the note and the collateral, the Seller has attempted to sell the note and/or the collateral. The Buyers [Mr. Pehlke and Mr. Luksch] are co-makers of the note and desire to purchase the collateral and be released from all of their obligations to the Seller as co-makers of the note. Both the Buyers and the Seller are aware of the status of the shares posted as collateral and do not intend that any distribution of the shares be made to the public without complying with the Securities Act of 1933 or the General Rules and Regulations promulgated under said Act and the Securities Laws of any pertinent jurisdiction in which the shares might be sold. In consideration of the promises recited in this instrument, the parties agree that on or before February 20, 1971 the Buyers shall purchase all of the shares of Texscan Corporation common stock heretofore posted as collateral including all of the Seller's interest in the Agreement between Texscan and VTC, Inc. dated February 27, 1970 in the manner described therein evidenced by an assignment in the form attached and marked279 Appendix I for $ 130,000.00. Upon payment of $ 43,334.00 in cash on or before February 20, 1971, the Buyers shall receive 14,500 Texscan common shares from the Seller as agent for the registered owner of the shares and as the pledgee thereof. The Seller shall loan to the Buyers $ 86,666.00 to cover the balance of the purchase price and the Buyers shall execute two notes in the form attached as Appendix II, each in the amount of $ 43,333.00, the first note to be due on February 20, 1972, the second note to be due on February 20, 1973, the Buyers pledging as collateral approximately 14,500 shares of Texscan stock on each note thereto received by them. Upon payment of each note in full, the Buyers shall repossess the shares posted as collateral on each note. Upon execution of the two notes, the Seller, as holder, shall release forever all of the obligations of the Buyers as comakers of a certain note dated June 10, 1970 due August 10, 1970, in the face amount of $ 267,000.00 in the principal amount of $ 199,000.00 and executed by Versatek Texscan Corporation as well as all of the Buyers. The Buyers agree that all of the shares purchased are taken for investment and not with a280 view to distribute the shares to the public and that any subsequent sale shall be made only if the Buyers comply with the Securities Act of 1933 and the General Rules and Regulations promulgated thereunder. During 1971 Mr. Pehlke and Mr. Luksch each made payments to Mr. Eason of $ 21,667 of principal and $ 2,599.86 of interest. In that year Mr. Eason released to Mr. Pehlke the 6,000 shares of Texscan common stock owned by Mr. Pehlke and pledged with Anthony Wayne Bank as collateral for the loan to VTC and released to Mr. Pehlke 1,250 of the 31,500 shares of Texscan common stock which VTC had pledged with Anthony Wayne Bank as collaterial for VTC's loan. Also, in 1971 Mr. Eason released to Mr. Luksch the 6,000 shares of Texscan common stock owned by Mr. Luksch and pledged by him with Anthony Wayne Bank as collateral for the loan to VTC, and 1,250 of the 31,500 shares of Texscan common stock pledged by VTC with Anthony Wayne Bank as collateral for the loan to VTC. In addition, on or about February 20, 1971, Mr. Eason assigned to Mr. Pehlke and Mr. Luksch the rights of VTC under the "earnout" agreement that VTC had earlier pledged as collateral for the loan to VTC. On or about281 July 16, 1971, Mr. Pehlke and Mr. Luksch executed a waiver, pursuant to which all of any remaining contingent liability of Texscan under the "earnout" agreement was canceled in consideration of Texscan's cancellation of a demand promissory note dated December 23, 1970, from Mr. Pehlke to Texscan in the principal amount of $ 8,742.36, bearing interest at 4 percent, and a promissory note from Mr. Luksch to Texscan of the same date and in the same amount. These notes had been given to Texscan by Mr. Pehlke and Mr. Luksch for the purchase of 5,907 shares each of Texscan stock by exercise of stock options for the stock under an option price of $ 1.48 per share. In 1972 Mr. Pehlke made payments of principal to Mr. Eason in the amount of $ 21,666.50 and interest of $ 2,044.72. In 1972 Mr. Luksch made payments to Mr. Eason of principal in the amount of $ 21,666.50 and interest of $ 2,044.73. On or about January 17, 1972, Mr. Pehlke received from Mr. Eason 6,000 more of the 31,500 shares of Texscan common stock which VTC had originally pledged to Anthony Wayne Bank as collateral for the VTC loan and which the bank had released to Mr. Eason pursuant to its agreement with him. Mr. Luksch282 also received 6,000 shares of such Texscan common stock. On or about July 7, 1972, Mr. Pehlke and Mr. Luksch each received from Mr. Eason an additional 1,250 shares of the 31,500 shares of Texscan stock. In 1973 Mr. Pehlke and Mr. Luksch each made payments of principal to Mr. Eason totaling $ 21,666.50 and payments of interest of $ 1,055.76. As of June 29, 1973, Mr. Pehlke and Mr. Luksch had each paid Mr. Eason the full amount of the principal payments due him under the agreement executed on February 19, 1971. Consequently, on June 29, 1973, Mr. Eason released to Mr. Pehlke 7,250 shares and to Mr. Luksch 7,250 shares of the Texscan stock which he had acquired from Anthony Wayne Bank. This 14,500 shares of Texscan stock was the remaining balance of the stock Mr. Eason had received from the bank pursuant to his agreement with the bank of November 20, 1970. On or about March 5, 1969, the Pehlkes obtained a loan of $ 26,000 from the Merchants National Bank and Trust Company of Indianapolis, Indianapolis, Indiana (hereinafter Merchants National Bank and Trust). The full amount of this loan was reduced by interest of $ 503.75, leaving net proceeds of the loan of $ 25,496.25. On283 or about March 6, 1969, Mr. Pehlke loaned to VTC the net proceeds of this loan. At that time Mr. Pehlke and Mr. Luksch agreed that if VTC failed to repay all or any part of this loan which Mr. Pehlke had made to VTC, Mr. Luksch would pay Mr. Pehlke 50 percent of the installments of principal and interest which thereafter became due on the loan from Merchants National Bank and Trust and Mr. Pehlke assigned to Mr. Luksch a 50-percent interest in the $ 25,496.25 loan which he had made to VTC. VTC never made any cash payments to Mr. Pehlke on account of the loan he had made to VTC. On or about June 29, 1970, however, VTC transferred to Mr. Pehlke 8,237 shares of Texscan common stock which had been owned by VTC. On the same date VTC's general ledger account No. 202, relating to VTC's notes payable to Mr. Pehlke, was debited in the amount of $ 28,328.10; VTC's general ledger account No. 115, relating to VTC's investments, was credited in the amount of $ 26,465.48; and VTC's general ledger account No. 325, relating to VTC's losses on investments, was credited in the amount of $ 1,862.62. Mr. Pehlke transferred to Mr. Luksch 3,828 of the 8,237 shares of Texscan common stock that VTC284 had transferred to him in return for the agreement Mr. Luksch had made to pay to Mr. Pehlke 50 percent of the installment payments on the Pehlkes' note to the Merchants National Bank and Trust. Mr. Pehlke made the following payments to Merchants National Bank and Trust on account of the loan to the Pehlkes: (a) On June 5, 1969, a payment of interest in the amount of $ 509.35. (b) On August 29, 1969, a payment of interest in the amount of $ 520. (c) On November 28, 1969, a payment of interest in the amount of $ 525.80. (d) On March 2, 1970, a payment of interest in the amount of $ 531.56. (e) On June 4, 1970, a payment of principal in the amount of $ 2,000 and a payment of interest in the amount of $ 480. (f) On August 31, 1970, a payment of principal in the amount of $ 1,000 and a payment of interest in the amount of $ 500. (g) On December 7, 1970, a payment of principal in the amount of $ 2,550 and a payment of interest in the amount of $ 450. (h) On March 18, 1971, a payment of principal in the amount of$ 600 and a payment of interest in the amount of $ 397. (i) On June 18, 1971, a payment of principal in the amount of $ 1,631 and a payment of interest285 in the amount of $ 369. (j) On September 17, 1971, a payment of interest in the amount of $ 368.44. (k) On December 14, 1971, a payment of interest in the amount of $ 227.75. (l) On January 17, 1972, a payment of principal in the amount of $ 18,219. On the same date he received a rebate of interest in the amount of $ 94.89. Pursuant to his agreement with Mr. Pehlke with regard to the repayments of the loan from Merchants National Bank and Trust, Mr. Luksch made the following payments to Mr. Pehlke: (a) On August 31, 1970, a payment of principal in the amount of $ 500 and a payment of interest in the amount of $ 250. (b) On December 4, 1970, a payment of principal in the amount of $ 1,275 and a payment of interest in the amount of $ 225. (c) On March 13, 1971, a payment of principal in the amount of$ 300 and a payment of interest in the amount of $ 198.50. (d) On June 18, 1971, a payment of principal in the amount of $ 815.50 and a payment of interest in the amount of $ 184.50. (e) On September 17, 1971, a payment of interest in the amount of $ 184.22. (f) On December 14, 1971, a payment of interest in the amount of $ 113.88. (g) On December 16, 1971, a286 payment of principal in the amount of $ 9,109.50. On that date Mr. Luksch received a rebate of interest in the amount of $ 47.45. On or about May 15, 1969, Mr. Pehlke obtained a loan from Peoples Bank and Trust Company, Indianapolis, Indiana, in the principal amount of $ 5,028.60. He then loaned to VTC $ 5,000 of the net proceeds of this loan. Mr. Pehlke agreed to repay the loan in 29 monthly installments of $ 167.62, commencing on June 28, 1969, and ending on November 28, 1972. Between June 30, 1969, and July 27, 1970, Mr. Pehlke made 13 monthly payments of principal and interest in the amount of $ 167.62 and one payment in the amount of $ 264.46. On August 31, 1970, he made a final payment of principal and interest in the amount of $ 2,551.18. Between September 29, 1969, and June 29, 1970, VTC made 10 regular monthly payments to Mr. Pehlke on account of the $ 5,000 loan from Mr. Pehlke. These payments consisted of principal payments only. The monthly installments were $ 166.67. On or about July 19, 1968, Mr. Pehlke and Mr. Luksch each loaned $ 11,930 to VTC.Receipt of this loan is reflected in VTC's cash receipts journal. These loans are reflected as credits in the287 portion of VTC's general ledger concerning VTC's general ledger account No. 202 for the fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Pehlke and Mr. Luksch. On July 19, 1968, both the Pehlkes and the Luksches sold 1,000 shares of Texscan stock, on which sales each petitioner recognized a gain of $ 11,930. In August 1968 Mr. Pehlke and Mr. Luksch each loaned another $ 11,930 to VTC. Receipt of these loans is reflected in VTC's cash receipts journal as a credit in the portion of VTC's general ledger concerning VTC's general ledger account No. 202, for the fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Pehlke and Mr. Luksch.On August 1, 1968, both the Pehlkes and the Luksches had sold another block of 1,000 shares of Texscan stock, on which they realized a gain of $ 11,930. VTC's cash receipts journal reflects, under date of August 27, 1968, cash received from Mr. Pehlke in the amount of $ 55,962.40 and cash received from Mr. Luksch in the same amount. These figures are reflected as credits in the portion of VTC's general ledger concerning VTC's general ledger account No. 202 for the288 fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Pehlke and Mr. Luksch. The following amounts are reflected as credits in VTC's cash receipts journal and the portion of VTC's general ledger concerning VTC's general ledger account No. 202 for the fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Pehlke: DateAmount of EntryAugust 27, 1968$ 55,962.40February 4, 19698,333.34March 13, 19691,766.93Mr. Pehlke could not recall the specific sources of funds for these credit entries. The following amounts are also reflected as credits in VTC's cash receipts journal and the portion of VTC's general ledger concerning VTC's general ledger account No. 202 for the fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Luksch: DateAmount of EntryAugust 27, 1968$ 55,962.40February 4, 19698,333.33March 13, 19691,766.93 Mr. Luksch could not recall the specific sources of funds for these credit entries. A number of erroneous credit entries were made to the VTC notes payable accounts of Mr. Pehlke and Mr. 289 Luksch.Among the erroneous credit entries made to the VTC notes payable account for Mr. Pehlke were the following: Date of EntryAmount of EntryOctober 1968$ 33,333.34December 19688,333.34October 196978,799.00$ 120,465.68 Among the erroneous credit entries made to the VTC notes payable account for Mr. Luksch were the following: Date of EntryAmount of EntryOctober 1968$ 33,333.33December 19688,333.33October 196978,799.00$ 120,465.66The erroneous credit entries to the VTC notes payable account for Mr. Pehlke are offset by the following debit entries to that account: Date of EntryAmount of EntryJanuary 1969$ 8,333.34April 197074,950.00June 197081,050.00$ 164,333.34 Similarly, the erroneous credit entries to the VTC notes payable account for Mr. Luksch are offset by the following debit entries to that account: Date of EntryAmount of EntryJanuary 1969$ 8,333.33April 197074,950.00June 197081,050.00$ 164,333.33The VTC notes payable account for Mr. Pehlke shows a credit entry in the amount of $ 2,137 for June 1970. The VTC notes payable account for290 Mr. Luksch also reflects a credit entry in the same amount for June 1970.These entries reflect accrued interest. This interest was never reported as income by either the Pehlkes or the Luksches on their Federal income tax returns. VTC made payments to Mr. Pehlke in reduction of its indebtedness to him. The amounts of these payments as reflected by debits on VTC's general ledger account No. 202 for the fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Pehlke are as follows: DateAmount of DebitApril 1969$ 3,333.34April 1969666.67June 1969150.00July 19691,650.00August 1969200.01September 19697,500.00October 19692,500.00November 19693,000.00$ 24,000.02 In October 1969, in connection with a spin-off, a credit in the amount of $ 350 was made to the notes payable account for Mr. Pehlke. VTC made payments to Mr. Luksch in reduction of its indebtedness to him. The amounts of these payments as reflected by debits on VTC's general ledger account No. 202 for the fiscal years ended April 30, 1969, and April 30, 1970, relating to VTC's notes payable to Mr. Luksch are as follows: DateAmount of DebitApril 1969$ 8,333.33April 1969666.67July 19691,500.00September 19697,500.00October 19692,500.00November 19693,000.00$ 23,500.00291 In October 1969, in connection with a spin-off, a credit in the amount of $ 350 was made to the notes payable account for Mr. Luksch. As of June 1970 VTC's notes payable account for Mr. Pehlke reflected a credit balance in the amount of $ 25,041.99, including $ 2,137 in accrued interest. On or about July 1, 1970, VTC executed and delivered to Mr. Pehlke a promissory note in the amount of $ 25,041.99. As of June 1970, VTC's notes payable account for Mr. Luksch also reflected a credit balance in the amount of $ 25,041.99, including $ 2,137 in accrued interest. On or about July 1, 1970, VTC executed and delivered to Mr. Luksch a promissory note in the amount of $ 25,041.99. On the following dates the total number of issued and outstanding shares of Texscan common stock were as follows: No. of Shares DateOutstandingJune 29, 1970512,597February 19, 1971533,816February 20, 1971533,816January 17, 1972646,908July 7, 1972685,408June 29, 1973783,053During the following months the total number of shares of Texscan common stock which were transferred of record as a result of sales were as follows: No. of Shares DateOutstandingJune 19707,661February 197114,373January 197144,953July 19724,275June 19734,449292 On the following dates, the bid and asked prices per share of freely transferrable Texscan common stock in the over-the-counter market were as follows: DateBid PriceAsked PriceJune 29, 1970$ 3-1/2$ 3-7/8February 19, 19714-1/44-1/2February 20, 19714-1/44-1/2January 17, 19726-1/46-1/2July 7, 19724-1/25June 29, 19732-3/82-7/8In connection with an offering of 8-1/2 percent convertible subordinated debentures due December 1, 1981, and 20,000 shares of common stock, Texscan issued a prospectus to which were attached financial statements of the company for the five fiscal years ended April 30, 1971, and the six-month period ended October 31, 1971. The financial statements contained in this prospectus are consolidated statements of Texscan and its subsidiaries and show the following income (loss) from continuing operation before extraordinary items for the years indicated: Fiscal Year Ended April 30Income (Loss)1967$ 94196863,204196999,791197080,234197126,641 These figures were then reduced by losses from discontinued operations less tax benefits for the year 1971 in the amount of $ 142,148293 and were increased by income (loss) for extraordinary items for each of the years resulting in net income or loss for the years indicated in the following amounts: Fiscal Year Ended April 30Net Income (Loss)1967$ 2,0941968111,4041969197,791197080,2341971(133,328) The financial data for the fiscal years 1967 through 1971 were certified by Lybrand, Ross Bros. and Montgomery. The report also contained unaudited figures for the period ended October 31, 1971, which show for that period income from continuing operations before extraordinary items of $ 57,657, extraordinary items of $ 27,000, and net income of $ 84,657. In this prospectus the following appears under the title "Management": Directors and Officers. The Directors and Officers of the Company are as follows: Name OfficeCarl N. PehlkePresident and DirectorJames A. LukschExecutive Vice President,Treasurer and Secretary, and DirectorDaniel F. LitterskiVice President--ManufacturingRobert J. ShevlotVice President--MarketingGregory D. BuckleyAssistant Secretary and DirectorEach of the individuals named above has served the Company for more294 than five years in an executive capacity except for Gregory D. Buckley, who was elected Director and Assistant Secretary of the Company in 1970. Mr. Buckley is a member of the law firm of Buckley & Frost, Indianapolis, Indiana, general counsel for the Company.The prospectus shows that during the fiscal year 1971 Mr. Pehlke and Mr. Luksch were each being compensated at the rate of $ 35,000 per year. This prospectus also contained the following statement: As approved by the Board of Directors of the Company on December 15, 1971, Messrs. Pehlke and Luksch each agreed to cancel their options granted to them, pursuant to the 1968 loan, to purchase a total of 49,850 shares of common stock in consideration for the payment of $ 6,231.25 to each and the adoption of the Executive Bonus Plan (See "Management--Remuneration"). In addition, under stock subscription agreements dated January 8, 1971, Messrs. Pehlke and Luksch subscribed for 10,000 shares each and Gregory D. Buckley subscribed for 5,000 shares of the Company's common stock at the then current market value of $ 3.00 per share. The agreements provide for payment at any time within three years from their date, with the unpaid295 balance of the purchase price bearing interest at the rate of four per cent per annum. * * The prospectus also shows that as of December 27, 1971, Mr. Pehlke owned 39,677 shares or 6.2 percent and Mr. Luksch owned 42,013 shares or 6.6 percent of the stock of Texscan. It also shows that 10,000 shares were being sold by each Mr. Pehlke and Mr. Luksch to the underwriter indicating that Mr. Pehlke would own 29,677 shares and Mr. Luksch 32,013 shares after the sale. The statement showed that the number of shares owned by Mr. Pehlke excluded 11,457 shares owned by his wife individually and 984 shares owned by her as custodian for their three children, and excluded 3,405 shares owned by the wife of Mr. Luksch. It also showed that the statement of shares excluded 10,000 shares for each Mr. Pehlke and Mr. Luksch which had been subscribed for under stock subscription agreements. The prospectus contained the following statement: Carl N. Pehlke and James A. Luksch may be deemed to be "parents" of the Company within the meaning of the Securities Act of 1933. The prospectus also contained the following statement: On July 14, 1971, the Company settled an obligation of $ 25,142 for296 legal services rendered, due and owing to a law firm of which Gregory D. Buckley was a member. As his part of the settlement and in lieu of the cash payment of $ 12,571, Mr. Buckley was issued 4,200 shares of the Company's common stock. The last recitation in the prospectus was in respect to "Registration Statement." This statement said that the company had filed with the Securities and Exchange Commission in Washington, D.C. a registration statement under the Securities Act of 1933, as amended, for the registration of the securities being offered in the prospectus. On their Federal income tax return for 1971 the Pehlkes claimed deductions totaling $ 57,647 for business bad debt losses incurred in connection with the Eason agreement, the Merchants National Bank and Trust loan, the Peoples Bank and Trust loan and the VTC notes payable account. On their 1971 return the Luksches claimed business bad debt deductions with respect to these same transactions totaling $ 56,808. These claimed deductions were comprised of the following amounts: 5PehlkeLukschEason Agreement$ 26,259$ 26,258Payments on Merchantsand Peoples Loans6,3465,508VTC Notes PayableAccounts25,04225,042Totals$ 57,647$ 56,808297 Respondent disallowed all of the losses set forth above claimed by the Pehlkes and the Luksches on their 1971 respective tax returns except the allowance of a short-term capital loss of $ 1,937 to the Pehlkes and a short-term capital loss of $ 1,680 to the Luksches. Respondent explained his disallowance of the losses claimed by the Pehlkes as follows: It is determined that the deductions which you claimed in the amounts of $ 25,042.00, $ 6,346.00 and $ 26,259.00 as losses in 1971 for loans or payments made to or on behalf of Versatec Texscan Corporation, are not allowable except for $ 1,000 as short-term capital loss in 1971 and $ 937.00 in 1972 because it has not been established that these losses were incurred by you or that, to the extent of any loss shown in this connection, the amount thereof was deductible as other than a non-business bad debt, to be treated as a298 short-term capital loss. Accordingly, your taxable income for 1971 is increased $ 57,647.00. (See Schedule #2 for computation.) The exact same explanation was given in the notice of deficiency issued to the Luksches except that the amount of the loss claimed by the Luksches on the Merchants loan was slightly less than that claimed by the Pehlkes on the Merchants and Peoples loans and the short-term capital loss allowed by respondent with respect to this loss was less than that allowed the Pehlkes. In Schedule 2 of the deficiency notice to the Pehlkes respondent computed the short-term capital loss allowed as follows: Amount paid Merchants & Peoples$ 15,164.00Received 4,409 shares of Texscanat $ 3 per share =13,227.00Short-term capital loss$ 1,937.00Schedule 2 appearing in the deficiency notice to the Luksches showed the following: Amount paid Merchants$ 13,164.00Received 3,828 shares of Texscanat $ 3 per share =11,484.00Short-term capital loss$ 1,680.00Amount deductible in 19711,000.00Carryover to 1972$ 680.00Petitioner James A. Luksch employed Coopers and Lybrand to prepare his and his wife's joint Federal299 income tax return for 1972. Coopers and Lybrand had prepared returns for the Luksches for prior years. Coopers and Lybrand sends a form to its clients in January requesting the pertinent information necessary for the preparation of the client's tax return for the preceding year. Mr. Luksch received such a form in early 1973 and within a few weeks thereafter supplied the information requested by Coopers and Lybrand. The Luksches gave a power of attorney to their accountant, Charles R. Meyer, a member of the firm of Coopers and Lybrand, authorizing him to request an extension of time within which to file their 1972 tax return. Mr. Meyer, on behalf of the Luksches, filed a Form 4868, "Application for Automatic Extension of Time to File U.S. Individual Income Tax Return," on April 11, 1973. The extension expired on June 15, 1973. The 1972 income tax return prepared by Coopers and Lybrand for the Luksches was mailed to them on June 21, 1973, and signed by them on June 24, 1973, and mailed to the Memphis Service Center of the Internal Revenue Service where it was received on June 29, 1973. The return filed by the Luksches for 1972 showed no tax due but a refund of tax due to the300 Luksches. In his notice of deficiency to the Luksches respondent determined that for 1972 they were liable for an addition to tax under section 6651(a) (2), giving the following explanation: Since your income tax return for 1972 was not filed, or the amount of tax due paid, within the time prescribed by law and you have not shown that such failure to timely file your return was due to reasonable cause, additions to tax have been applied on the deficiency in tax, computed as provided by sections 6651(a). The parties stipulated with respect to respondent's determination of addition to tax under section 6651(a) (2) as follows: The addition to tax for the calendar year 1972 under Code Sec. 6651(a) (2) which was set forth in the notice of deficiency, a copy of which is Exhibit 16-P hereto, was $ 1,458.75 but was incorrectly computed. Respondent contends that the correct net Code Sec. 6651(a) (2) addition to tax should have been $ 597.36. The Luksches do not contest the accuracy of the arithmetic involved in the computation of such revised net Code Sec. 6651(a) (2) addition to tax, but do contend that there should be no imposition of such addition, because they assert that their301 failure to file the required return on or before the date prescribed therefor or to pay the required amount of tax on or before the date prescribed therefor was due to reasonable cause and not to willful neglect. * * OPINION The issues involved in the instant case are all factual. As both parties recognize, section 166(a) (1) allows as a deduction any debt which becomes wholly worthless during the taxable year, but section 166(d) (1) provides that in the case of an individual taxpayer the loss resulting from the wrothlessness of a nonbusiness bad debt is treated as a short-term capital loss. Petitioners take the position that except for the $ 2,137 of interest which each of them concedes was included in the note in the amount of $ 25,041.99 which each received on or about July 1, 1970, from VTC, the losses claimed by them in 1971 have been shown to be accurate and allowable as business losses. In fact, petitioners argue that the losses claimed with respect to the VTC notes payable account by Mr. Pehlke and Mr. Luksch were understated. On brief petitioners do argue that the loss in connection with the Eason payout agreement should be spread over the three years 1971, 1972302 and 1973. Respondent contends that petitioners had no bad debt losses in connection with the Eason agreement but that this agreement provided for the purchase by Messrs. Pehlke and Luksch of assets from Mr. Eason. Respondent argues that his computations of the losses of Mr. Pehlke and Mr. Luksch from payments on the Merchants and Peoples loans allow larger amounts than are properly allowable, and that petitioners have totally failed to show any losses with respect to the advances made by them to VTC which were listed in the VTC notes payable account. In this connection respondent argues that the note received by Mr. Pehlke and that received by Mr. Luksch from VTC on or about July 1, 1970, were worthless when they were received. Petitioners argue that all the losses they claimed for advances they made to VTC and from their becoming accommodation co-makers of VTC's note at the Anthony Wayne Bank were business losses because their dominant motivation in making the advances and co-signing the notes was to keep their salaried positions with VTC. We will discuss the amount, if any, of the losses sustained by petitioners on each of the three transactions separately and then deal with303 the issue of whether these losses, if any, were business bad debts or nonbusiness bad debts. 1. Agreement between Mr. Eason and Messrs. Pehlke and Luksch of February 19, 1971.We have recited in some detail the facts leading up to Mr. Eason's purchase of the VTC note from the Anthony Wayne Bank and the assignment to him at that time of the collateral securing that note. From these facts we consider it clear that Mr. Eason received for the $ 130,000 he paid to the Anthony Wayne Bank the VTC note and that the collateral securing this note was transferred to him by the bank solely as collateral securing the note he purchased. We likewise consider it clear, and have in our findings so found, that the bank merely waived any right it had to proceed on collection of any portion of the note against VTC, the Pehlkes or the Luksches.In our view the voluminous facts in this record do not support respondent's contention that Mr. Eason purchased the collateral held by the Anthony Wayne Bank. We conclude that the record shows that this collateral was transferred to him as security for the note he purchased. Therefore, in our view, after his transaction with the bank Mr. Eason was the304 owner of the VTC note and had whatever rights the bank would have had to foreclose on the collateral securing that note and to proceed against VTC as well as the Pehlkes and the Luksches as co-makers of the note. With these facts in mind, we consider the agreement between Mr. Eason and Messrs. Pehlke and Luksch to clearly be an agreement of Mr. Pehlke and Mr. Luksch to pay Mr. Eason on the note the $ 130,000 he had paid to the Anthony Wayne Bank because of their liability as co-makers of the note. We agree with respondent that Mr. Pehlke and Mr. Luksch were undoubtedly anxious to have returned to them the collateral they had pledged with Mr. Eason to induce him to post his Bio-Dynamics, Inc. stock as security for the VTC note, to regain the collateral they themselves had pledged to the bank as security for that note, and to obtain the other assets securing the VTC note. However, in our view this fact does not change the nature of the agreement. The agreement itself recites that Mr. Pehlke and Mr. Luksch are co-makers of the note and desire to be released from their obligation to Mr. Eason as co-makers of the note, as well as reciting their desire to obtain the collateral securing305 the note. We therefore conclude that petitioners sustained a loss from the transaction with Mr. Eason to the extent that the value of the collateral they obtained, other than that which they had posted to secure the VTC note, did not equal their payment to Mr. Eason. Since respondent does not contend that petitioners had any possibility of collecting this excess, if any, from VTC when they made the payment, we conclude the loss, if any, they sustained was at the time the payment was made. While at no point until briefs in this case were filed did either party contend that Mr. Eason had not been paid on the note in full at the time of the February 19, 1971, agreement and was holding the collateral which he did not release to secure a note given to him personally at that time by Mr. Pehlke and Mr. Luksch, petitioners do apparently on brief contend to the contrary of this fact. We recognize that ordinarily a cash basis taxpayer does not sustain a loss by merely substituting his note for a corporate note on which he is liable until such time as he has paid his note. However, in the instant case the agreement recites that Mr. Eason lent to Messrs. Pehlke and Luksch the $ 86,666 with306 which to pay, as of February 19, 1971, the balance of the note which was not paid at that time in cash and for this loan each of them had executed a note to Mr. Eason for $ 43,333 payable in two installments due on February 20, 1972, and February 20, 1973. Because respondent has made no contention that this was not in fact a bona fide loan or borrowing of funds by Mr. Pehlke and Mr. Luksch from Mr. Eason on February 19, 1971, and a payment by them at that time to Mr. Eason in full of the $ 130,000 they recognized they owed to him as co-makers of the VTC note, and petitioners did not raise any issue with respect to this until brief, we accept the recitation in the agreement of February 19, 1971, as it is stated and consider no issue properly before us as to whether in fact Mr. Eason was not paid his full $ 130,000 by Mr. Pehlke and Mr. Luksch on February 19, 1971. This brings us to the most difficult of the factual issues which is the amount, if any, of loss each Mr. Pehlke and Mr. Luksch sustained in 1971 in connection with their agreement with Mr. Eason. Mr. Pehlke and Mr. Luksch, in return for the $ 65,000 each paid to Mr. Eason on February 19, 1971, each received 15,750 shares307 of Texscan stock which they had not previously owned and in addition received a one-half interest in the "earnout" agreement between Texscan and VTC dated February 25, 1970. While it is not completely clear from this record that the value on February 19, 1971, of one-half of the "earnout" agreement was the $ 8,742.36 note for which each Mr. Pehlke and Mr. Luksch released his interest to Texscan on July 16, 1971, this release is the best evidence in the record as to the value of the earnout agreement and we accept it. The record shows that on February 19, 1971, and February 20, 1971, the bid price on the over-the-counter market of Texscan common stock was $ 4-1/4 and the asking price $ 4-1/2. Respondent contends that the $ 4-1/4 bid price of stock on the over-the-counter market on February 19, 1971, is the price that should be used in computing the value of the stock received by Messrs. Pehlke and Luksch and that therefore the value of this asset alone exceeds the $ 65,000 each paid to Mr. Eason. Petitioners contend that this stock was "legend" (restricted) stock and therefore did not have the value of unrestricted stock which might be sold on the over-the-counter market at $ 308 4-1/4 on February 19, 1971. Mr. Pehlke testified without objection by respondent that this stock was restricted and in fact this same fact is recited in the agreement between Mr. Eason and Messrs. Pehlke and Luksch dated February 19, 1971. The testimony in this case not only contains one statement by Mr. Pehlke in this respect but is replete with such statements. Mr. Pehlke testified that the stock received by him and Mr. Luksch under the agreement with Mr. Eason was "legend" stock and stated that he meant by this statement that the stock had a legend on the certificates stating that it is insider stock and restricted as to trading. He stated further that the stock was not registered with the Securities and Exchange Commissionor any state securities commission. He specifically stated that the stock which had been pledged by VTC as well as the stock pledged by him and Mr. Luksch in connection with the VTC loan was "legend" stock and that the 25,000 shares he and Mr. Luksch had pledged with Mr. Eason was also "legend" stock. He even went on to explain that it was difficult to have a bank accept "legend" stock as collateral since it was not as readily salable as non-legend stock.309 He further pointed out that in 1971 Texscan had issued "legend" stock to Mr. Buckley and to Mr. Friedberger (a former attorney of Texscan) in payment of legal fees and pointed to the statement in the prospectus with respect to Mr. Buckley who was the only one of the two at the time of the prospectus connected with Texscan. Respondent's counsel at no time objected to the testimony given in this respect by Mr. Pehlke without the production of stock certificates to shw the legend contained thereon and in fact upon cross-examination of Mr. Pehlke did not challenge this testimony which he had given. In this state of the record we conclude that the 15,750 shares of stock received by each Mr. Pehlke and Mr. Luksch was restricted stock. Our conclusion that the stock received by Mr. Pehlke and Mr. Luksch was restricted stock does not, however, cause us to conclude that its value was only one-half of the value of unrestricted stock as petitioners contend. To support their contention that the value of the restricted stock was only one-half of the value of unrestricted stock, petitioners offered the testimony of a securities expert who stated as his opinion that restricted stock generally310 sold at less than unrestricted stock and that in some cases there was a substantial difference. He pointed out that the owner of restricted stock who wishes to sell such stock has the alternatives of registering the stock himself, which is generally prohibitively expensive; asking the issuer of the stock to register the stock at the time of offering other registered stock, which he referred to as "piggybacking;" or disposing of the stock to a buyer who is willing to take it with the restrictions of the legend. He stated that perhaps a purchaser would be happy to hold for two years stock of a company that was doing very well and the prospects of which were bright, particularly if it was clear that the company would do substantially better over the next two years, and in such case the discount might be small. He stated that it might be difficult to sell the stock at all if the purchaser concluded from the record of the company that the company would not do well over the following two years. He testified that if stock is below average in quality, or is speculative, a higher discount is justified for the legend than is justified for higher quality stock. In fact, he stated the more311 speculative the stock, the greater the discount. This expert then testified that he would estimate a discount of Texscan legend stock at between 40 and 50 percent of the bid price.While petitioners' expert witness was well qualified as a securities analyst and had testified as an expert in a number of cases, we do not accept the opinion he gave in this case. He testified that he had not examined any financial statements of Texscan for any period prior to 1970 and was basing his opinion of the stock solely on reports from 1970 through 1974. He did not explain why he concluded from these reports that as of February 19, 1971, the prospects of Texscan were not bright. To the extent we might be justified in concluding that the actual performance of Texscan for two future years could be accurately predicted by a prospective buyer of its stock, the financial results of the company for 1972 and 1973 would indicate that its prospects as of February 1971 were bright. He also was not familiar with the stock involved in the instant case, the length of time it might have been held by VTC prior to its transfer to Messrs. Pehlke and Luksch, or the effects of this holding period on their right312 to sell the stock. Mr. Pehlke had given some testimony with respect to what he stated to be the "fungibility" rule as it related to "legend" stock, but when petitioners' expert was asked what this so-called rule was he stated: I'm not sure I can give you a clear definition, but I've always understood that it's as attached to something -- some other stock or so. Because of the unfamiliarity of petitioners' expert witness with respect to the financial data of Texscan, as well as his unfamiliarity with the stock received by Messrs. Pehlke and Luksch, we do not accept his estimate of the value of the Texscan stock transferred to Messrs. Pehlke and Luksch on February 19, 1971. The record in this case leaves unexplained how Messrs. Pehlke and Luksch went about having transferred to them the stock which was registered in the name of VTC when they received it. How this transfer was made might well affect the marketability of the stock.Respondent in his notice of deficiency used the value of $ 3 per share for the Texscan stock transferred by VTC to Mr. Pehlke and Mr. Luksch on June 29, 1970, at which time the bid price of unrestricted Texscan stock was $ 3-1/2 and the asking price313 $ 3-7/8. Also, in 1971 when the "legend" stock was issued to Mr. Buckley in payment of his legal fee, it was issued at $ 3 a share. Mr. Pehlke testified that the stock issued to Mr. Buckley was "legend" stock. The record also shows that on January 8, 1971, Mr. Pehlke and Mr. Luksch each exercised an option to purchase 10,000 shares of Texscan stock at $ 3 a share. From Mr. Pehlke's testimony it is clear that this was "legend" stock. On the basis of this record we conclude that the value of the 15,750 shares of Texscan stock which Mr. Pehlke and Mr. Luksch each received in connection with their agreement of February 19, 1971, with Mr. Eason was $ 3 a share. We have reached this conclusion from an examination of all the evidence in the record including the numerous financial statements, the prospectus and other documentary evidence, as well as all the testimony. We therefore conclude that Mr. Pehlke and Mr. Luksch each received property of a value of $ 55,992.36 in return for the $ 65,000 they paid to Mr. Eason on February 19, 1971, as co-makers of the VTC note and therefore that each of them sustained a loss in connection with the VTC note of $ 9,007.64. 2. Merchants and314 Peoples Bank Loans.The second item on which Mr. Pehlke and Mr. Luksch each have sustained a loss is with respect to the Merchants and Peoples Bank loans. Here the facts with respect to Mr. Pehlke and Mr. Luksch differ somewhat. Also, it was with respect to these loans that respondent allowed to each Mr. Pehlke and Mr. Luksch a short-term capital loss in his notice of deficiency. The record shows that on March 5, 1969, Mr. Pehlke obtained a loan of $ 25,496.25 after deduction of prepaid interest from the Merchants National Bank and Trust Company of Indianapolis, Indiana, and lent this amount to VTC on May 6. Mr. Luksch agreed that he would repay Mr. Pehlke one-half of any payments Mr. Pehlke made on this loan which were not repaid to Mr. Pehlke by VTC.On May 15 Mr. Pehlke obtained a loan from Peoples Bank and Trust Company, Indianapolis, Indiana, in the principal amount of $ 5,028.60 and lent VTC $ 5,000 of this amount. Mr. Luksch was not involved in any way in this loan. The record further shows that of the $ 30,496.25 which Mr. Pehlke lent to VTC from the proceeds of the Merchants Bank loan and the Peoples Bank loan he was repaid a principal amount of $ 12,000 by Mr. 315 Luksch with respect to the Merchants Bank loan and $ 1,666.70 by VTC with respect to the Peoples Bank loan. Although no cash repayment was made to Mr. Pehlke by VTC with respect to the Merchants Bank loan, on June 29, 1970, VTC transferred to Mr. Pehlke 8,237 shares of Texscan common stock which it owned in repayment of the Merchants Bank loan. Therefore, of the $ 30,496.25 which Mr. Pehlke lent to VTC from these two loans he was reimbursed in cash by Mr. Luksch and by VTC a total amount of $ 13,666.70, leaving a net of $ 16,829.55 for which he was not reimbursed except through the transfer to him of the 8,237 shares of stock. In accordance with his agreement with Mr. Luksch under which Mr. Luksch paid him the $ 12,000, Mr. Pehlke transferred to Mr. Luksch 3,828 shares of the Texscan stock which he received from VTC on June 29, 1970. It is with respect to these loans that respondent allowed a short-term capital loss. However, the record shows that instead of repaying Mr. Pehlke the one-half of the principal amount of the $ 25,496.25 loan Mr. Luksch only repaid Mr. Pehlke $ 12,000 of the principal amount. Therefore the record substantiates the amount of $ 16,829.55 as the portion316 of the loans made to VTC by Mr. Pehlke from the Merchants Bank and Peoples Bank loans for which he was not repaid in cash. There is nothing in this record to justify using any value other than the $ 3 per share used by the respondent to apply to the Texscan stock received from VTC by each Mr. Pehlke and Mr. Luksch in arriving at their net loss.Although the record shows that the bid price of unrestricted Texscan stock on June 29, 1970, was $ 3-1/2 a share and also shows that VTC in offsetting the loan apparently valued this stock at $ 3.213 per share, there is nothing to show that this would be the value of restricted stock. While the record is not as clear that this stock was restricted as it is with respect to the stock received by petitioners under the Eason agreement, there is testimony by Mr. Pehlke to the effect that all the stock he and Mr. Luksch received was restricted stock. It was in that connection that he referred to the "fungibility rule." In any event, in our view the record here totally fails to show that any value other than the$ 3 a share used by respondent is proper. Therefore, the $ 16,829.55 of the advances made by Mr. Pehlke which were repaid only through the317 stock transfer should be reduced by $ 13,227 as respondent did in his deficiency notice, thus leaving a net loss to Mr. Pehlke of $ 3,602.55. Actually the loss sustained by Mr. Luksch properly should be $ 516 instead of the $ 1,680 determined by respondent. Respondent in fact on brief points out that he overallowed the amount of loss to Mr. Luksch with respect to this transaction. However, respondent made no claim that the loss he determined be reduced. So in the case of Mr. Luksch we conclude that the short-term capital loss with respect to this transaction of $ 1,680 as determined by respondent is properly allowable to Mr. Luksch. We do note that there is evidence in this record which would tend to indicate that the losses sustained by Mr. Luksch and Mr. Pehlke in connection with the Merchants Bank and Peoples Bank loan transactions were sustained in 1970 rather than in 1971.However, respondent has made no such contention and in fact, as petitioners point out with respect to the loss sustained on the VTC notespayable account where respondent in effect made such a contention, no such determination was made in the deficiency notice, no such allegation was made in the answer318 or in an amended answer, and no such contention was made at the trial. It would be totally unfair to petitioners at this stage for us to consider such a contention. They were in no way alerted at the trial to defend against or offer evidence to contradict a claim that the debt of VTC to petitioners became worthless prior to 1971. See Nash v. Commissioner,31 T.C. 569">31 T.C. 569, 574 (1958); Swope v. Commissioner,51 T.C. 442">51 T.C. 442, 452 (1968). 3. VTC Notes Payable Account.The third loss claimed by petitioners was in connection with their notes payable account on the books of VTC. Petitioners placed great reliance on the fact that each of them was issued promissory notes in the amount of $ 25,041.99 dated July 1, 1970. However, the fact that the notes were issued does not, standing alone, establish that the advances were made by petitioners to VTC or that a bona fide debt existed. Wolff v. Commissioner,26 B.T.A. 622">26 B.T.A. 622, 625 (1932). Petitioners concede errors in the VTC notes payable account to Mr. Pehlke and Mr. Luksch. They concede errors in the credit entries which should represent advances from Mr. Pehlke and Mr. Luksch to VTC with319 respect to a $ 33,333.34 entry in each account in October 1968, a $ 8,333.34 entry in each account in December 1968, and a $ 78,799 entry in each account in October 1969. They recognize these errors because there are no journal entries to support these entries. Petitioners claim that the following entries in each of these accounts represent actual advances made by each Mr. Pehlke and Mr. Luksch to VTC: Advances to VTC Date of AdvanceMr. PehlkeMr. LukschJuly 19, 1968$ 11,930.00$ 11,930.00August 196811,930.0011,930.00August 27, 196855,962.4055,962.40February 4, 19698,333.348,333.33March 13, 19691,766.931,766.93Total$ 89,922.67$ 89,922.66Clearly, the record as a whole supports the fact that advances were made by each Mr. Pehlke and Mr. Luksch of $ 11,930 on July 19, 1968 and August 1968. Not only are these items shown in journal entries as having been advanced, but also the record shows that Mr. Pehlke and Mr. Luksch each reported two capital gains of $ 11,930 on the sale of Texscan stock at about the time of the advances, accounting for a source of funds from which they could have made the advances. In spite of320 petitioners' strong arguments to the contrary, in our view the record is clear that the entries under date of August 27, 1968, of $ 55,962.40 in each account did not represent a cash advance by either Mr. Pehlke or Mr. Luksch on that date even though a journal entry to this effect does appear in VTC's journal. This entry was made one day after the Pehlkes and the Luksches signed as co-makers VTC's loan for $ 240,000 from the Anthony Wayne Bank and the amount of each entry is approximately the value of the collateral pledged by each Mr. Pehlke and Mr. Luksch to guarantee that loan with the bank and to persuade Mr. Eason to put up his 5,000 shares of Bio-Dynamics, Inc. stock. If the 18,500 shares of Texscan stock is considered at a value of $ 3 a share, the amount of collateral placed by each Mr. Pehlke and Mr. Luksch with the Anthony Wayne Bank and with Mr. Eason would equal $ 55,500. When this fact is considered in conjunction with the fact that the October 1968 $ 33,333.34 admittedly incorrect entry in each account is at about the time of an increase in the loan from the Anthony Wayne Bank and other errors in the VTC account, the clear indication is that the $ 55,962.40 entries321 did not represent cash advances. The record is replete with testimony by Mr. Pehlke and Mr. Luksch of their lack of funds with which to buy Texscan stock or make advances to VTC. Furthermore, they were unable in any way to account for the source of the funds for an advance of $ 55,962.40. On the basis of the record as a whole we conclude that the $ 55,962.40 credit in the account of each Mr. Pehlke and Mr. Luksch was an incorrect entry on the books of VTC. While it is not completely clear that the entry shown on the VTC notes payable account of each Mr. Pehlke and Mr. Luksch of $ 8,333.34 6 on February 4, 1969, and $ 1,766.93 on March 13, 1969, represented actual cash advances, we have concluded, considering the journal entries showing such an advance, the April repayment to each Mr. Pehlke and Mr. Luksch of $ 8,333.34 6 and the July repayment to Mr. Pehlke of $ 1,650 after a June repayment of $ 150 and the July repayment to Mr. Luksch of $ 1,500, that the record as a whole does not support the fact that these amounts were actually advanced by Mr. Pehlke and Mr. Luksch to VTC. This results in total advances made by each Mr. Pehlke and Mr. Luksch to VTC of $ 33,960.27.The records322 of VTC show total repayments to Mr. Pehlke of $ 24,350.02 and to Mr. Luksch of $ 23,850.00. This leaves a total amount of $ 9,610.25 of advances by Mr. Pehlke and $ 10,110.27 by Mr. Luksch to VTC for which they were not repaid. As we heretofore pointed out, the record contains some indications that these advances became worthless in 1970 rather than in 1971. However, respondent did not question in his deficiency notice, in his answer or at the trial the year of the claimed worthlessness of any advances petitioners made to VTC for which they were not reimbursed. We do not therefore consider properly before us the issue of whether in fact the VTC advances became worthless in 1970 rather than 1971. Having concluded that petitioners did sustain losses with respect to their advances to VTC as above set forth, we must decide whether these losses were ordinary losses or were in fact nonbusiness bad debt losses which are treated for the tax purposes under section 166(d)(1) as short-term capital losses. 7 Section 166(d)(2) 8 defines a nonbusiness bad debt as a debt other than one created or acquired in connection with a trade323 or business of a taxpayer or one the loss from the worthlessness of which is incurred in the taxpayer's trade or business. 324 Clearly, VTC's debts to petitioners were not connected with petitioners' trade or business as distinguished from that of the corporation unless, as petitioners contend, they co-signed the VTC note and made the advances in order to enable them to retain employment with VTC. Section 1.166-5(b)(2), Income Tax Regs., provides in part as follows: SEC. 1.166-5 Nonbusiness debts. * (b) Nonbusiness debt defined. For purposes of section 166 and this section, a nonbusiness debt is any debt other than-- (1) A debt which is created, or acquired, in the course of a trade or business of the taxpayer, determined without regard to the relationship of the debt to a trade or business of the taxpayer at the time when the debt becomes worthless; or (2) A debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. The Supreme Court in United States v. Generes,405 U.S. 93">405 U.S. 93 (1972), held that the standard to be applied in determining whether a guarantee of a corporate loan or an advance to a corporation by a shareholder-employee is proximately related to the trade or business of the employee as distinguished from the corporation325 is to be based on the dominant business motivation of the employee in giving the guarantee or making the advance. The Supreme Court made it clear that the selfserving statement of the employee-stockholder that the advances were made in order to maintain his corporate employment is not, standing alone, sufficient to show that his dominant motivation for making an advance was to maintain his corporate employment. The determination must be made from all the facts in the case. In the Generes case the Court recognized that an unrepaid advance made by a stockholder-employee through a dominant motivation of maintaining his employment might result in a business bad debt connected with the individual's trade or business of being an employee. However, the Court stressed that a statement by an employee that such was his dominant motivation should be carefully analyzed in light of all the facts of record. Upon such an analysis of the facts here we conclude that the dominant motivation of neither Mr. Pehlke nor Mr. Luksch was to maintain a salaried income from VTC but rather was to protect his investment in the corporation. Petitioners argue that because of the lawsuits brought against326 them and Texscan by Telonic Industries and I-Tel, Inc. their reputations in the industry were harmed and therefore they were fearful that they could not obtain employment in their field. Mr. Pehlke further contended that because he had had surgery for an ulcer in April of 1967 in which a large portion of his stomach was removed he was not readily employable. Considering the educational background and the type of positions that Mr. Pehlke and Mr. Luksch each had held prior to the formation of Texscan, in our view the record does not support these contentions.However, under the particular facts of this case which show that Mr. Pehlke and Mr. Luksch were founders of Texscan and the primary contributors to the success of that company, it is unmistakably clear that at any time they left the employ of VTC they would be re-employed by Texscan. In fact, the record shows that they were effectively doing the management work at Texscan as employees of VTC and the prospectus filed by Texscan in 1971 in substance so states. Also, the fact that upon the demise of VTC both Mr. Pehlke and Mr. Luksch returned to the payroll of Texscan with higher salaries than they had received from VTC is a clear327 indication that the employment was always available to them should VTC not prosper. Petitioners argue that Texscan did not have funds available to pay Mr. Pehlke and Mr. Luksch. However the record shows that the management fee paid by Texscan to VTC in the two-year period that VTC furnished management services to Texscan exceeded the salaries paid by VTC to Mr. Pehlke and Mr. Luksch. We recognize that Texscan obtained some services other than its management by Mr. Pehlke and Mr. Luksch for the fees paid to VTC, but clearly the payment was sufficient to pay adequate salaries to Mr. Pehlke and Mr. Luksch and also discharge the cost of the other necessary services for which the management fee was paid. We conclude on the basis of this record as a whole that the dominant motivation of neither Mr. Pehlke nor Mr. Luksch in co-signing VTC's loan and making advances to VTC was to maintain their positions as employees of VTC. 9 We therefore conclude that the entire losses sustained by Mr. Pehlke and Mr. Luksch in connection with the co-signing of VTC's loa and advances made to VTC must be treated under section 166(d) as nonbusiness bad debts and deductions for these losses allowed only328 to the limited extent that short-term capital losses are allowable under section 1211(b). 4. Section 6651(a)(2) Addition to Tax of the Luksches.The final issue is whether the Luksches have shown error on the part of respondent in determining an addition to their tax under section 6651(a)(2). Section 6651(a)(2) provides as follows: SEC. 6651. FAILURE TO FILE TAX RETURN OR TO PAY TAX. (a) Addition to the Tax.--In case of failure-- * (2) to pay the amount shown as tax on any return specified in paragraph (1) on or before the date prescribed for payment of such tax (determined with regard to any extension of time for payment), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount shown as tax on such return 0.5 percent of the amount of such tax if the329 failure is for not more than 1 month, with an additional 0.5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate; * * * Since the return filed by the Luksches showed no tax due but rather that an overpayment of tax had been made, clearly they are not liable for an addition to tax under section 6651(a)(2). Petitioners argue that since this is the only section under which respondent determined an addition to tax they have shown error in respondent's determination. Respondent argues that even though the addition to tax was determined under section 6651(a)(2) the explanation given made it clear that the determination was made because the Luksches' income tax return for 1972 was not filed "or the amount of tax due paid" within the time prescribed by law. Petitioners point out that section 6651(a)(1) provides for the addition to tax for failure to timly file. Respondent, however, argues that the Luksches were not misled by his determination in that they alleged in their petition that any failure to file or to pay the amount due before the prescribed date was due to reasonable cause and not to willful neglect330 and at the trial introduced evidence with respect to the reason for the late filing of their return. In this regard Mr. Luksch basically testified that Coopers and Lybrand had prepared his tax return for the year 1971 and in accordance with the custom of Coopers and Lubrand when they prepared a tax return for a client in a prior year, he received in January 1973 a form to fill in with respect to his 1972 tax liability to enable Coopers and Lybrand to prepare his return. He testified that within 2 or 3 weeks after receiving this form he returned it with the requested information to Coopers and Lybrand, but that he could not remember the exact date on which he had returned the information. The record shows that the Luksches gave to Mr. Meyer, who was the accountant of Coopers and Lybrand handling their return, a Power of Attorney authorizing him to apply for an extension of time within which to file their return. Under date of April 11, 1973, Mr. Meyer did apply for an automatic extension on Form 4868 which extended the time within which to file the return to June 15, 1973. No further request for an extension was filed. Mr. Luksch testified that he had understood from Mr. Meyer331 that an extension of time "had been taken care of" and had relied on Mr. Meyer to send him the return to sign and file within the period of the extension. However, the return was not sent to Mr. Luksch until shortly after the June 15, 1973, extension date had expired. This is a difficult case, both as regards respondent's use of the wrong section under which he determined the addition to tax and petitioner's failure to personally determine whether in fact a proper extension had been obtained. In a number of cases we have refused to hold a taxpayer's reliance on an accountant to timely prepare a return to be reasonable cause for the late filing of the return. See Mauldin v. Commissioner,60 T.C. 749">60 T.C. 749, 762 (1973), and cases there cited. However, in Mauldin, as well as in many other cases involving late filing of returns, the time between the due date of the return and the filing date is far greater than was the situation in the instant case. Had respondent's determination of addition to tax been clearly under section 6651(a)(1), which concerns late filing of the return, rather than under section 6651(a)(2), we would consider ourselves impelled to determine332 whether the factual circumstances present in this case caused it to be distinguishable from the Mauldin case and similar cases. However, the only determination made by respondent in this case was an addition to tax under section 6651(a)(2). The fact that no tax was shown to be due in the return filed is reasonable cause for section 6651(a)(2) to be inapplicable. In fact, until certain issues were disposed of by agreement of the parties at the trial, the Luksches were contending in this case that they owed no additional tax for 1972. Considering the situation as a whole, we conclude that the Luksches have shown error in respondent's determination of an addition to tax under section 6651(a)(2). Decisions will be entered under Rule 155. Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.↩2. The three additional employees were a Mr. Shevlot, a Mr. Litterski and a Mr. Cox.↩3. VTC was formerly named Versatek Texscan Corporation.↩4. Although the record is not completely clear in this respect, it appears that Mr. Eason returned to each Mr. Pehlke and Mr. Luksch the 12,500 shares he held as collateral for the Bio-Dynamics, Inc. stock when the agreement of February 19, 1971, was entered into.↩5. Although neither the Pehlkes nor the Luksches claimed any bad debt loss on account of their payments under the Eason agreement on their income tax returns for 1972 and 1973 or in their petition or at trial, on brief they claim a portion of these losses occurred in each of the years 1971, 1972 and 1973.↩6. The entry for Mr. Luksch was actually $ 8,333.33.↩7. Section 1211(b) provides with respect to the amount of capital losses allowable as deductions as follows: SEC. 1211. LIMITATION ON CAPITAL LOSSES. * (b) Other Taxpayer.-- (1) In general.--In the case of a taxpayer other than a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such gains) whichever of the following is smallest: (A) the taxable income for the taxable year, (B) $ 1,000, or (C) the sum of-- (i) the excess of the net short-term capital loss over the net long-term capital gain, and (ii) one-half of the excess of the net long-term capital loss over the net short-term capital gain. ↩8. SEC. 166. BAD DEBTS. * (d) Nonbusiness Debts.-- * *(2) Nonbusiness debt defined.--For purposes of paragraph (1), the term "nonbusiness debt" means a debt other than-- (A) a debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer; or (B) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.↩9. While we have discussed the primary evidence causing us to form this conclusion, we should also point out that in addition the record shows a total disproportion in the amount which Mr. Pehlke and Mr. Luksch each had at risk from advances to or co-signing notes of VTC and the amount of salaries they received from that company.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621997/	MR. AND MRS. EDWARD WALSDORF, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Walsdorf v. CommissionerDocket No. 2410.United States Board of Tax Appeals4 B.T.A. 367; 1926 BTA LEXIS 2302; July 24, 1926, Decided 2302 Books of account of the taxpayers held to reflect gross profits from sales of merchandise. Isom J. Guillory, Esq., and E. Barrett Prettyman, Esq., for the petitioners. J. Arthur Adams, Esq., for the respondent. SMITH 368 Before SMITH. This is a proceeding for the redetermination of deficiencies in income tax for the years 1918 to 1922, inclusive, in the amount of $1,590.45. The principal point in issue is whether the books of account of the taxpayer reflect the gross profits from sales of merchandise. FINDINGS OF FACT. The taxpayers are citizens and residents of New Orleans, La. E. H. Walsdorf owned and conducted one or more drug stores in the City of New Orleans during the taxable years in question. He made income-tax returns for each of the years 1918 to 1922, inclusive, and for the years 1920, 1921, and 1922 his wife also made income-tax returns reporting a portion of the income received from the community. In each of the returns filed the taxpayers set out in detail the gross sales and purchases of merchandise and inventories at the beginning and close of each year. E. H. Walsdorf was actively engaged in the sale2303 of war savings stamps during the years 1918 and 1919, was secretary-treasurer of the local pharmacists board and, in his capacity as an officer of this board and of other organizations with which he was connected, he received considerable amounts of money, which he deposited with his other funds and checked out in payment of his obligations in connection therewith. A deputy collector examined the taxpayer's returns for the years 1918 to 1922, inclusive, discovered that Walsdorf's bank deposits were much in excess of his sales, and, owing to his inability to check the tax returns with the single entry set of books kept by the taxpayer, and acting upon the statement of Walsdorf that, if his sales exceeded a certain amount, 33 per cent of the gross sales represented gross profits, and, if less than that amount, 34 per cent of gross sales represented gross profits, the deputy collector ignored the books of account for the purpose of determining gross profits on the sales of merchandise, excluded from the bank deposits certain deposits ascertained not to represent income, and determined gross profits by applying to what he determined the gross sales the percentage indicated by the taxpayer. 2304 Business expenses claimed as deductions by the taxpayer were generally undisturbed, except that amounts claimed as bad debts ascertained to be worthless and charged off during the year were disallowed as deductions. This was upon the ground that the deputy collector could not discover that these bad debts had been charged off as worthless upon the taxpayer's books. In Walsdorf's tax return for 1918, the deputy collector excluded from the gross income $15.60 shown on the original return to have 369 been income, increased the amount claimed as a deduction for repairs and depreciation in the amount of $104, and disallowed a deduction for bad debts in the amount of $291.22. For the year 1919 the deputy collector increased the depreciation allowance by the amount of $14 and disallowed the deduction for bad debts in the amount of $481.29. For the year 1920 the deputy collector reduced the repairs and depreciation deduction claimed in the amount of $225.55, and disallowed the deduction for bad debts of $150. For 1921 he disallowed a deduction for taxes in the amount of 50 cents and for bad debts in the amount of $283.68, increased income from rents in the amount of $150, and2305 increased the allowance for repairs and depreciation in the amount of $160. For 1922 he disallowed a deduction for bad debts in the amount of $508.22 and increased the deduction for repairs and depreciation in the amount of $233.60. The deputy collector prepared amended returns for the taxpayers for the years 1918 to 1922, inclusive, which amended returns were accepted by the Commissioner as reflecting the true net income of the taxpayers for the years in question. The deficiency determined by the Commissioner is predicated solely upon the amended returns prepared. The original returns filed by the taxpayer and his wife for the years 1918 to 1922, inclusive, accurately reflect the taxpayers' net income for the years in question. OPINION. SMITH: The question in issue in this appeal is whether the original returns of the taxpayers or the amended returns made by a deputy collector and accepted by the Commissioner represent the correct net income. As indicated in the findings of fact, the deputy collector was unable to check the taxpayers' returns from the taxpayers' books of account and, upon the statement alleged to have been made to him by Walsdorf, determined the gross2306 profits from the sale of merchandise by taking a certain percentage of the gross sales. The gross sales determined by the deputy collector were determined, not from the taxpayers' books of account showing sales, but by excluding from the taxpayer's bank deposits certain amounts which he determined were not income from his business. He determined that the total deposits for 1918 were $45,415.42, and that deposits from other than sales of merchandise amounted to $14,479.43. The taxpayers have introduced evidence, however, that satisfies the Board that of the total of deposits $18,127.88 represented deposits of moneys which were not from sales of merchandise. 370 From the evidence of record the Board is satisfied that the books of account of the taxpayers accurately reflect sales of merchandise and gross profits from such sales. It is true that the inventory sheets are not of record at this time, but the taxpayers took physical inventories at the close of each year, and the Board is convinced that the amounts of the inventories shown upon the taxpayers' returns represent the true inventories. The taxpayers have introduced evidence which shows that bad debts in the amount*2307 claimed for the years 1919 and 1921 were actually charged off during those years. Other changes in the taxpayers' returns are of a minor character, some favoring the taxpayer and some not. From a consideration of the entire record the Board is of the opinion that the original returns reflect the true net income and that there is no deficiency in tax for any of the years involved. Judgment for the petitioners.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4621999/	PETER R. ELLIS and ROSALIND O. ELLIS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentEllis v. CommissionerDocket No. 8368-79.United States Tax CourtT.C. Memo 1981-45; 1981 Tax Ct. Memo LEXIS 698; 41 T.C.M. (CCH) 813; T.C.M. (RIA) 81045; February 4, 1981. Peter R. Ellis, pro se. Thomas N. Tomashek, for the respondent. TIETJENSMEMORANDUM OPINION TIETJENS, Judge: Respondent determined a deficiency of $ 683 in petitioners' Federal income tax for 1976. The only issue for our decision is whether petitioners, who used their boat less than 50 percent of the time for business purposes, are entitled to a deduction for depreciation and operating expenses attributable to the business use of their boat. This case was fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation and attached exhibits are incorporated herein by this reference. At the time they filed their petition, petitioners resided699 in Ketchikan, Alaska. On June 20, 1977, petitioners filed a joint Federal income tax return for 1976 with the Ogden Service Center, Ogden, Utah. During 1976, petitioner Peter R. Ellis practiced law in Ketchikan, Alaska. In the same year, petitioners purchased a boat, "The Sunshine," which they used for both business and pleasure. If such day that petitioners used the boat in 1976 is classified according to the predominant purpose of its use on a particular day, there were 46 days of personal use and 25 days of business use, representing 64.8 percent personal use and 35.2 percent business use. Based upon engine hours during 1976, petitioners used the boat 23.1 percent for business purposes; based upon hours aboard, in 1976, they used the boat 32.9 percent for business purposes. Petitioners, who did not submit a brief, argue in their petition that while they did not establish that the primary use of their boat was for business purposes, they have established, by adequate records, that they are entitled to a deduction of that percentage of boat expenses attributable to business use. Respondent, by contrast, contends that petitioners' boat is a facility under section 274(a)(1) 700 1 and because it was used less than 50 percent for business purposes, expenses relating to the boat, under section 274(a)(1) are nondeductible. Section 274(a)(1) provides: SEC. 274(a). Entertainment, Amusement, or Recreation.-- (1) In general.--No deduction otherwise allowable under this chapter shall be allowed for any item-- (A) Activity.--With respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, unless the taxpayer establishes that the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that such item was associated with, the active conduct of the taxpayer's trade or business, or (B) Facility.--With respect to a facility used in connection with an activity referred to in subparagraph (A), unless the taxpayer establishes that the facility was used primarily for the furtherance of the taxpayer's trade or business and701 that the item was directly related to the active conduct of such trade or business, and such deduction shall in no event exceed the portion of such item directly related to, or, in the case of an item described in subparagraph (A) directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), the portion of such item associated with, the active conduct of the taxpayer's trade or business. In determining primary use, section 1.274-2(e)(4), Income Tax Regs., provides for the application of a "facts and circumstances" test; however, the regulation states that a taxpayer will be deemed to have established that a yacht or other pleasure boat "was used primarily for the furtherance of the taxpayerhs trade or business" if he establishes that more than 50 percent of the total calendar days of use of the facility were days of business use. Sec. 1.274-2(e)(4)(iii), Income Tax Regs.From petitioners' own admission and from a simple application of the law to the stipulated facts of this case, we find that it is clear that petitioners' boat was not used primarily for business purposes in 1976. Accordingly, they702 are not entitled to deduct any operating expenses or depreciation in connection with their boat. Decision will be entered for the respondent. Footnotes1. All statutory references are to the Internal Revenue Code of 1954, as amended and in effect for the year in issue, unless otherwise stated.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/6113489/	IN THE TENTH COURT OF APPEALS No. 10-19-00226-CV ALLIANCE AUTO AUCTION OF DALLAS, INC., Appellant v. LONE STAR CLEBURNE AUTOPLEX, INC., Appellee From the 18th District Court Johnson County, Texas Trial Court No. DC-C201900316 MEMORANDUM OPINION Lone Star Cleburne Autoplex, Inc., a company that operated an auto dealership in Cleburne, Texas, sued two of its former employees, Robert Russell and Robert Hansen, alleging various breaches of fiduciary duty that resulted in millions of dollars in losses for Lone Star. Lone Star also sued Alliance Auto Auction of Dallas, Inc. alleging it knowingly participated in Russell and Hansen’s activities. Alliance moved to compel arbitration. Because the trial court did not abuse its discretion in denying Alliance’s motion to compel arbitration, the trial court’s order is affirmed. BACKGROUND Lone Star registered its employees, Russell and Hansen, with AuctionACCESS, a third-party service provider that allows its members to remotely access information about vehicles and auctions across America prior to an auction. The purpose of the registration was to permit Russell and Hansen to act on behalf of Lone Star as its agents at auto auctions like ones held by Alliance so that they could “buy and sell automobiles.” AuctionACCESS is not a party to the underlying lawsuit. The registrations incorporated by reference AuctionACCESS’s terms and conditions. Alliance argued to the trial court that the arbitration clause included in AuctionACCESS’s terms and conditions entitled Alliance to compel Lone Star to arbitrate its claims against Alliance. The trial court disagreed. ISSUES AND REVIEW In three issues, Alliance argues that the arbitration clause included in AuctionACCESS’s terms and conditions is enforceable against Lone Star by Alliance under the Federal Arbitration Act; the clause assigns the issue of arbitrability to an arbitrator, not the trial court; and to the extent the trial court could decide arbitrability, the trial court incorrectly concluded that Lone Star’s claims were not arbitrable. A party seeking to compel arbitration under the FAA, as Alliance is here, must establish that (1) there is a valid arbitration clause, and (2) the claims in dispute fall within that agreement's scope. In re Rubiola, 334 S.W.3d 220, 223 (Tex. 2011); In re Kellogg Brown & Root, Inc., 166 S.W.3d 732, 737 (Tex. 2005). If the party seeking to compel arbitration meets this burden, the burden then shifts, and to avoid arbitration, the party opposing it Alliance Auto Auction of Dallas, Inc. v. Lone Star Cleburne Autoplex, Inc. Page 2 must prove an affirmative defense to the provision's enforcement, such as waiver. Henry v. Cash Biz, LP, 551 S.W.3d 111, 115 (Tex. 2018). We review a trial court's order denying a motion to compel arbitration for an abuse of discretion. Id.; In re Labatt Food Serv., L.P., 279 S.W.3d 640, 642-43 (Tex. 2009). We defer to the trial court's factual determinations if they are supported by evidence but review its legal determinations de novo. Id. Whether the claims in dispute fall within the scope of a valid arbitration agreement is a question of law, which is also reviewed de novo. Id.; Perry Homes v. Cull, 258 S.W.3d 580, 598 & n.102 (Tex. 2008). TRIAL COURT OR ARBITRATOR Initially, we address Alliance’s second issue regarding whether the trial court or an arbitrator should determine the underlying dispute’s arbitrability. The case law on this issue is clear. The question of whether a case should be sent to arbitration is a gateway issue that courts must decide at the outset of litigation. See Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79, 84, 123 S. Ct. 588, 154 L. Ed. 2d 491 (2002) (citations omitted) ("[A] gateway dispute about whether the parties are bound by a given arbitration clause raises a 'question of arbitrability' for a court to decide."); see also Perry Homes v. Cull, 258 S.W.3d 580, 589 (Tex. 2008) (citations omitted) (explaining that courts decide "gateway matters regarding 'whether the parties have submitted a particular dispute to arbitration'"). Such circumstances are limited to (1) whether the parties have a valid arbitration agreement at all and (2) whether an arbitration clause in a concededly binding contract applies to a particular type of controversy. Robinson v. Home Owners Mgmt. Enters., 590 S.W.3d 518, 525 (Tex. 2019). Referral of a gateway dispute to the court Alliance Auto Auction of Dallas, Inc. v. Lone Star Cleburne Autoplex, Inc. Page 3 avoids the risk of forcing parties to arbitrate a matter they may well not have agreed to arbitrate. Id. Thus, because this is a gateway issue for the courts to decide, Alliance’s second issue is overruled. SCOPE OF THE AGREEMENT Next, assuming without deciding there is a valid arbitration agreement between the parties, we determine whether Lone Star’s claims fall within the scope of the agreement. When we determine whether a particular claim is within the scope of an arbitration agreement, we examine the terms of the arbitration agreement and the factual allegations pertinent to the claims rather than legal causes of action asserted. See In re Rubiola, 334 S.W.3d 220, 225 (Tex. 2011); In re FirstMerit Bank, N.A., 52 S.W.3d 749, 754 (Tex. 2001); Dennis v. Coll. Station Hosp., L.P., 169 S.W.3d 282, 285 (Tex. App.—Waco 2005, pet. denied). Generally, if the facts alleged “touch matters,” have a “significant relationship” to, are “inextricably enmeshed” with, or are “factually intertwined” with the contract that is subject to the arbitration agreement, the claim will be arbitrable. Dennis, 169 S.W.3d 282 at 285. In this case, the arbitration clause which is contained within AuctionACESS’s terms and conditions is limited to any controversy or claim “related directly or indirectly to this Agreement[.]” The “Agreement” is defined to include “these terms and conditions, our registration application and any other agreements between you and us, any membership policies or operating procedures that we may post on our website from time to time, and our Privacy Policy.” All of Lone Star’s claims against Alliance flow from its allegations that Russell and Alliance Auto Auction of Dallas, Inc. v. Lone Star Cleburne Autoplex, Inc. Page 4 Hansen embezzled large amounts of money from Lone Star and then attempted a cover- up through activities with Alliance. Examples of the allegations include: Russell and Hansen stopped using other auctions and dealers to sell used cars and strictly used Alliance; Alliance “wined and dined” Russell and Hansen; Russell would hide vehicles at Alliance and sold vehicles at a loss; fees Alliance charged were greatly increasing; and vehicles were sold multiple times. After reviewing the briefs, the petition, the motion for arbitration, and the response thereto, there were no facts alleged that related directly or indirectly to AuctionACCESS’s Agreement as that term is defined. Therefore the facts of Lonestar’s petition cannot reasonably be said to “touch matters,” have a “significant relationship” to, are “inextricably enmeshed,” or are “factually intertwined with,” AuctionACCESS’s Agreement. Accordingly, the allegations asserted by Lone Star are outside the scope of the arbitration clause, and Alliance’s third issue is overruled. CONCLUSION Because Alliance could not meet one step of the two-step burden to compel arbitration, the trial court did not abuse its discretion in denying Alliance’s motion to compel, and we need not specifically discuss Alliance’s first issue. Accordingly, the trial court’s July 2, 2019 Order Denying Motion to Compel Arbitration and Stay Case Filed by Defendant Alliance Auto Auction of Dallas, Inc. is affirmed. TOM GRAY Chief Justice Alliance Auto Auction of Dallas, Inc. v. Lone Star Cleburne Autoplex, Inc. Page 5 Before Chief Justice Gray, Justice Johnson, and Justice Smith Affirmed Opinion delivered and filed January 26, 2022 [CV06] Alliance Auto Auction of Dallas, Inc. v. Lone Star Cleburne Autoplex, Inc. Page 6	01-04-2023	01-28-2022
https://www.courtlistener.com/api/rest/v3/opinions/4621950/	Jerome E. Casey, Transferee of the Assets of Bankers Development Corporation v. Commissioner.Casey v. CommissionerDocket No. 59388.United States Tax CourtT.C. Memo 1957-226; 1957 Tax Ct. Memo LEXIS 23; 16 T.C.M. 1024; T.C.M. (RIA) 57226; December 10, 19571957 Tax Ct. Memo LEXIS 23">23 Held: 1. Bankers did not accumulate its earnings and profits beyond the reasonable needs of its business during the years ended April 30, 1948 and April 30, 1949, and that Bankers was not availed of for the purposes of avoiding the surtax upon its shareholders within the meaning of section 102, I.R.C. 1939. 2. Bankers accumulated its earnings and profits beyond the reasonable needs of its business during the year ended April 30, 1950 and was availed of for the purpose of preventing the imposition of surtax upon its shareholders and, accordingly, is liable for the surtax under section 102 for that year. Robert W. Brady, Esq., for the petitioner. William G. O'Neill, Esq., for the respondent. TIETJENSMemorandum Findings of Fact and Opinion TIETJENS, Judge: The Commissioner determined that the petitioner is liable as a transferee of the assets of the Bankers Development Corporation (hereinafter referred to as Bankers), for deficiencies in surtax under section 102 of the Internal Revenue Code of 1939 for the years ended April 30, 1948 through April 30, 1950, as follows: Year EndedSection 102 Surtax4-30-48$ 8,272.074-30-4912,297.994-30-5018,372.58 The only issue for decision is whether 1957 Tax Ct. Memo LEXIS 23">24 Bankers was availed of during the taxable years for the purpose of preventing the imposition of surtax upon its shareholders through the medium of permitting earnings or profits to accumulate instead of being distributed within the meaning of section 102. Findings of Fact Some of the facts are stipulated. Such facts are found as stipulated and with the pertinent exhibits are included herein by reference. The petitioner is an individual residing at Sag Harbor, New York. It is stipulated that he is a transferee of the assets of Bankers and is liable for the deficiencies in income tax (Section 102 Surtax) which may be determined in this proceeding as being due and payable by Bankers for the taxable years ended April 30, 1948 through April 30, 1950. Bankers filed its income tax returns for those years with the then collector of internal revenue for the second district of New York. Bankers was organized in 1920. At that time it exchanged preferred and common stock with a par value of $26,589.60 and cash in the amount of $40.10 for certain new account solicitation contracts which had been made with banks throughout the country. Under the terms of the contracts, Bankers would be paid a certain 1957 Tax Ct. Memo LEXIS 23">25 amount for each new account it secured for the banks. George Carhart was Bankers president and chief stockholder during the early years of its existence. Jerome Casey, the petitioner, was employed by Bankers in 1920 as a new account solicitor. In 1923 he became a manager of a crew of new account solicitors and in 1928 became the supervisor of new account solicitation contract operations. During the 1920's Bankers derived income from the promotion and sale of an audit system for banks. However, Bankers' major line of service until 1939 was conducting new account campaigns for banks, and such service produced most of Bankers' income during that period. During the 1930's economic conditions and changing banking practices cut the demand for Bankers' new account campaign services. In the early part of 1939 Bankers was in a precarious financial condition. Casey, who was supervising contract operations in the field found that Bankers was not able to supply him with the necessary materials for operating because its suppliers would no longer deliver to it on credit. Casey made an arrangement whereby he paid for the supplies himself, operated the contracts in the field, and reimbursed himself 1957 Tax Ct. Memo LEXIS 23">26 out of collections made by his crew. Collections in excess of his advances were remitted to Bankers. In the early part of April 1939, Casey, along with George Pace, Bankers' only salesman of its new account solicitations contracts, went to Bankers' New York office to investigate its financial situation. Bankers' "Tentative Balance Sheet" dated March 31, 1939, showed that Bankers' bank account was overdrawn $1,574, that it had accounts receivable from customers of $855.68, and inventory of $5,758.66; also that it had current liabilities of $33,789.62, which included advances from Casey of $5,572.60. Bankers had an operating loss of $3,903.36 for the year ended April 30, 1939. At that date its surplus account showed a deficit of $41,487.02, which was principally due to writing off, or writing down, the value of certain assets. At the end of April 1939, Casey loaned Bankers $7,500 and several months later Casey and Clifford Owen, an attorney, purchased all of Bankers' stock from Carhart. About that time Casey became the president of Bankers. From that time until the year 1951, Casey and Owen each owned 50 per cent of Bankers' stock. The following schedule shows the number of personal 1957 Tax Ct. Memo LEXIS 23">27 solicitation contracts in existence at the end of each of the years April 30, 1939 through April 30, 1950 and the gross profit earned by Bankers on the personal solicitation contracts during each of the years ended April 30, 1939 through April 30, 1950: Number ofYear EndedContractsGross Profit4-30-3910$17,236.274-30-401218,224.174-30-41611,134.024-30-4248,527.794-30-4332,999.714-30-4421,922.334-30-4531,883.904-30-462(1,402.95) 4-30-4728,159.854-30-483,975.564-30-498,001.544-30-506,791.42On its Balance Sheets for the years ended April 30, 1948 through April 30, 1950, Bankers listed "Unoperated Portion of Signed Contracts" as an asset with a value of $26,640.60. During the early 1930's banks began to impose service charges upon checking accounts in which the depositors' daily balance was insufficient to justify the banks' cost of operating the account. A demand arose for a system which would render checking account service to depositors without requiring a minimum balance, yet which would 1957 Tax Ct. Memo LEXIS 23">28 pay the banks the cost of operating it and also be acceptable to the public. The first no minimum balance checking account plans used checks which were marked "Special Checking Account" and had account numbers on them, for purposes of identification. In 1937, the Empire Trust Company of New York (hereinafter referred to as Empire Trust) employed Bankers to make a survey regarding its method of operating no minimum balance checking accounts. Empire Trust had been using punch card checks, but they proved unsatisfactory in operation. About that time Bankers discovered a plan used by the Trust Company of North America (hereinafter referred to as The Trust Company) which met with the public's approval. The latter bank used checks with the individual's name printed on them. There were no other markings on the checks to show that they came from a no minimum balance checking account. Bankers began negotiations with The Trust Company with the idea of becoming its sales agent of the plan. However such negotiations were discontinued when The Trust Company investigated Bankers' financial position and found how weak it was at that time. Pace, meantime, had tried to interest some banks in the system 1957 Tax Ct. Memo LEXIS 23">29 used by The Trust Company. The Granite Trust Company (hereinafter referred to as Granite Trust) of Quincy, Massachusetts was particularly interested and was ready to sign a contract with Bankers. Bankers therefore decided to duplicate the system used by The Trust Company. The main problem facing Bankers was finding a machine which would imprint the checks with the customer's name while the account was being opened. The Trust Company had never disclosed its method of imprinting the checks. Bankers learned of a machine furnished to stationery stores by a large paper manufacturer which enabled the stores to print the names and addresses of its customers on their stationery. The paper manufacturer had an exclusive contract for the machine with the Multigraph-Addressograph Company (hereinafter referred to as Multigraph-Addressograph), the company that manufactured the machine, however it agreed to release Multigraph-Addressograph from the exclusive contract for Bankers' limited purposes since it was not competitive. On February 11, 1939, Bankers and Granite Trust executed a contract which permitted the latter company to use Bankers' Special Service Checking Plan for a period of 3 years. 1957 Tax Ct. Memo LEXIS 23">30 Bankers agreed to furnish Granite Trust with a printing press, checks, deposit tickets, passbooks, ledger cards, advertising materials, and many other items necessary to operate the system. Granite Trust agreed to pay Bankers $1.50 for the first book of 20 checks sold when an account was opened, and 20 cents for each additional book of 20 checks ordered by a depositor. Bankers installed its Special Service Checking Plan at Granite Trust on May 1, 1939, using a machine rented from the paper manufacturer, at which time it was negotiating with Multigraph-Addressograph for the purchase of similar machines. In June 1939, Bankers agreed to purchase 50 such machines (10 per year for 5 years) from Multigraph-Addressograph at a cost of approximately $136 per machine. Shortly thereafter Bankers changed the name of its special service checking plan to ThriftiCheck. The ThriftiCheck system was installed and operated under contracts with customer banks. Generally the contracts were similar to the one which Bankers executed with Granite Trust. Many of the contracts were for 5-year periods and were automatically extended for additional 5-year periods unless proper notice of termination was given 1957 Tax Ct. Memo LEXIS 23">31 by one of the parties. Such contracts usually provided that the customer banks could discontinue the operation on any anniversary date after the second, without penalty, if they gave Bankers at least 6 months written notice. The following schedule shows the number of ThriftiCheck accounts installed and cancelled during each of the years ended April 30, 1940 through 1950, and the total number of ThriftiCheck accounts in operation at the end of each of those years: Thrifti-AccountsCheckCan-Accounts inYear EndedInstalledcelledOperation4-30-405054-30-41140194-30-42130324-30-43150474-30-44130604-30-45290894-30-461201014-30-472801294-30-482301524-30-492041684-30-50108170During the taxable years involved here, some of the automatic renewal periods of contracts had run out, and of these some had been renewed by express agreement, while others were continued without explicit undertaking on the part of either the customer bank or Bankers and were dealt with by Bankers as if renewed automatically for a further term. Still other contracts had been terminated at the end of the original term and were being carried on a month-to-month basis by express agreement. All the contracts in force at the 1957 Tax Ct. Memo LEXIS 23">32 end of each of the taxable years involved here were terminable at the customer bank's option on notices varying from 1 to 12 months in length (6 months for the most part) if the contracts had been in effect for periods varying in length from 1 month to 3 years. Bankers has derived in excess of 90 per cent of its annual income since at least 1943, from its operation of the ThriftiCheck system. All expenses incurred by Bankers in operating the ThriftiCheck system, including the cost and upkeep of imprinting machines, were charged directly against current earnings. Casey and all of Bankers' salesmen were paid on a straight commission basis during the taxable years. The salesmen were not paid their commissions until the income was received by Bankers. At April 30, 1943, Bankers had 47 contracts in operation. The 50 machines ordered in 1939 were almost all in use. As new accounts were opened, Bankers supplied them with rebuilt machines, new ones not being available due to the shortage of materials caused by World War II. During 1944 Bankers considered the desirability of obtaining an imprinter which would be power operated and would contain an automatic feeding device. Multigraph-Addressograph 1957 Tax Ct. Memo LEXIS 23">33 however would not consider building such an imprinter for Bankers. Bankers therefore made efforts to contact various concerns and individuals who might be in a position to develop such an imprinter. Meantime Bankers needed additional machines and it ordered 50 more from Multigraph-Addressograph at a total cost of $11,188 ($223.76 per machine). Bankers attempted to borrow from a bank in order to finance the purchase, but the bank would not make the loan unless Casey and Owen endorsed the note. No bank loan was made by Bankers at that time. In 1946, a man named Riley built a model imprinter for Bankers. It was power operated, had an automatic feed, and used a name tube. The name tube was a device for permanently setting a depositor's name in type so that it could be used repeatedly, thus avoiding the time consuming task of resetting a depositor's name each time he reordered checks. Riley formed the Ball Square Corporation (hereinafter referred to as Ball Square) to manufacture similar imprinters. However, due to internal difficulties Ball Square was not able to undertake manufacture of the imprinters. Bankers paid Riley for the development work and turned the model over to the Matheson 1957 Tax Ct. Memo LEXIS 23">34 Machine & Tool Company (hereinafter referred to as the Matheson Company) for further development and production. During the early part of 1948 the Matheson Company delivered 12 of the automatic imprinters to Ball Square. That corporation then shipped the imprinters to banks according to instructions given it by Bankers. The imprinters proved unsatisfactory and continuing efforts were made by Bankers to locate a satisfactory imprinter. Bankers received estimates of anywhere from $150 to $1,000 each for the manufacturing of imprinters. Meantime Bankers needed more imprinters and it ordered an additional 25 "improved" automatic imprinters from the Matheson Company. About that time the ThriftiMatic Corporation (hereinafter referred to as ThriftiMatic) was incorporated. It had a capital structure of $10,000, which was contributed equally by its four stockholders: Casey, Owen, Pace and John Virgin, who was one of Bankers' chief salesmen. ThriftiMatic was formed for the purpose of procuring an imprinter which would meet the standards required by Bankers. Upon securing an imprinter ThriftiMatic was to furnish it to Bankers as well as other firms which needed such imprinters. In the fall of 1957 Tax Ct. Memo LEXIS 23">35 1948 a competitor of Bankers displayed an automatic imprinter at the American Bankers Association Convention which proved quite satisfactory in operation. Commencing at that point and covering a period up to March 30, 1950, Bankers lost at least 8 customer banks due to competition from the above-mentioned firm. During this same period Bankers lost several other customer banks due to reasons such as a merger causing a change in personnel or where the dominant merged bank had either its own plan or some plan other than Bankers. In early 1949 Bankers entered into an agreement with a firm called Seal-O-Matic, whereby that firm agreed to develop an imprinter for Bankers and furnish it with 6 models, which Bankers planned to unveil at the American Bankers Association Convention to be held in October 1949. At the convention the display proved successful, though some defects were discovered while operating the imprinters. Subsequent to the convention Bankers negotiated with Seal-O-Matic for improvement and production of the imprinters. Seal-O-Matic's terms for perfecting and producing the imprinters however were unreasonable (in the opinion of Bankers) and negotiations between the parties 1957 Tax Ct. Memo LEXIS 23">36 ceased. Seal-O-Matic was paid $6,000 for its services. Seal-O-Matic's engineer resigned from that company and offered, if financed, to perfect and produce the imprinter which Seal-O-Matic had built for Bankers. Casey estimated that it would take about $180,000 to produce and install 300 of those imprinters. ThriftiMatic did not have the means of financing such production and although Bankers had the means of financing, Owen was definitely not interested in financing the construction of the imprinters. In fact, Owen, as early as 1948, wanted to liquidate Bankers, and in lieu thereof, in several years, he was in favor of paying dividends. Casey persuaded Owen to allow Bankers to lend $50,000 to ThriftiMatic to help that company finance the production of imprinters. The loan was made on April 27, 1950, and on that date Bankers and ThriftiMatic executed a rental agreement. The agreement provided that ThriftiMatic would deliver 150 imprinters to Bankers within 90 days, which Bankers agreed to rent for a period of 2 years at $400 per month per imprinter. ThriftiMatic also agreed that it would not deliver imprinters to any other customers until Bankers' initial requirement was met, which 1957 Tax Ct. Memo LEXIS 23">37 was estimated to be an additional 150 imprinters. ThriftiMatic loaned the above-mentioned $50,000 to the C & M Engineering & Manufacturing Company (hereinafter referred to as C & M), a corporation which had been formed for the purpose of manufacturing the imprinters. Subsequently ThriftiMatic loaned an additional $25,000 to C & M. Further financing of C & M was done by Casey to the extent of about $50,000 or $60,000. C & M manufactured only about 130 imprinters instead of the 150 originally ordered. Between April 30, 1950 and April 30, 1952, ThriftiMatic paid C & M and others $108,807.75 for 128 imprinters ( $425 each), 232 name tube locking machines ($52.79 each), and all other accessory items acquired during that period. ThriftiMatic delivered the imprinters to Bankers and that company in turn credited the rental of $400 per imprinter per year against the $50,000 loan balance until it was repaid in full in that manner. During 1951 Casey bought Owen's stock in Bankers and became the sole stockholder of that corporation. The imprinters manufactured by C & M proved unsatisfactory in operation and Bankers commenced looking for another source of imprinters. During the summer of 1951 Bankers 1957 Tax Ct. Memo LEXIS 23">38 discovered a manufacturer of imprinters in West Virginia. A trial order was placed and deliveries were made to Bankers in May 1952, for field testing. The imprinters proved successful. ThriftiMatic started purchasing the imprinters in quantity in March 1953. The cost of the imprinters was $350 with an automatic feed, and $300 without it. ThriftiMatic in turn leased the imprinters to Bankers. On January 15, 1952, C & M submitted a bill to ThriftiMatic in the amount of $99,200 as its charge for cancellation of a contract for 300 imprinters. C & M was dissolved in 1952. On April 30, 1953, Casey dissolved Bankers and sold the business to the ThriftiCheck Service Corporation. Bankers' gross sales and net income after taxes as shown on its books and records for the years ended April 30, 1939, through April 30, 1951, and its surplus as shown on its books and records at the end of those years, were as follows: Net IncomeYear EndedGross SalesAfter TaxesSurplus4-30-39$ 84,871.35[3,903.36) [41,487.02) *4-30-4077,713.962,956.27(34,853.87)4-30-4171,447.96(1,298.23)(37,023.61)4-30-4275,422.973,203.87(32,425.23)4-30-4382,172.2910,123.98(25,952.72)4-30-44113,908.8313,106.65(12,846.17)4-30-45149,324.3610,126.10(2,067.97)4-30-46176,778.8015,833.4520,582.264-30-47261,879.6017,856.3933,576.534-30-48275,616.5124,415.6261,793.864-30-49336,838.4537,647.37119,654.524-30-50388,716.3459,681.30146,657.874-30-51462,349.9634,829.67181,526.311957 Tax Ct. Memo LEXIS 23">39 During the years ended April 30, 1948 through April 30, 1950, Bankers had profits from miscellaneous sales in the following amounts: Profit fromYear EndedMiscellaneous Sales4-30-48$1,538.554-30-493,938.504-30-501,697.95 Such profits were derived from sales of Lucite Signs, Coinmaster Banks, Beeline Calculators, Walpole Calculators, Interleaf Messages, and Duratex Covers. In 1940 Brian T. Moran was employed by Bankers as a salesman and remained so until his death in 1945. He worked solely on a commission basis. After Moran's death, his estate claimed commissions were due him so long as contracts secured by him were in existence. Litigation arose between the estate and Bankers concerning the claim for commissions. Such litigation was terminated in Bankers' favor, in the Court of Appeals for the State of New York, in 1954. As of April 30, 1947, Bankers had accrued as a contingent liability due to Moran's estate, the sum of $8,013.39. On its income tax returns for the years ended April 30, 1948 through April 30, 1950, Bankers claimed deductions for a contingent liability due to Moran's estate, as follows: Deduction Claimed forYear EndedContingent Liability4-30-48$11,547.944-30-4912,484.984-30-5011,778.831957 Tax Ct. Memo LEXIS 23">40 The Commissioner disallowed such deductions and Casey, as transferee of Bankers, agreed to the disallowances (as well as to other minor adjustments to Bankers' returns), and income tax deficiencies attributable to the disallowances and adjustments were paid as follows: Income TaxYear EndedDeficiency Paid4-30-48$5,944.454-30-494,218.474-30-504,646.13For the taxable years ended April 30, 1948 through April 30, 1950, Bankers was entitled to and was allowed deductions, in addition to those claimed on its tax returns, for New York State franchise taxes, in the respective amounts of $332, $1,383.75 and $40.02. Bankers' net income, Federal income taxes, and net income after taxes, for each of the taxable years ended April 30, 1948 through April 30, 1950, as shown on Bankers' income tax returns, after correction for the erroneous deduction of the contingent liability for Moran commissions and allowance of additional New York State franchise taxes, were as follows: Year Ended4-30-484-30-494-30-50Net income$47,228.32$99,291.14$106,225.28Federal incometaxes17,148.0837,051.2339,415.90Net incomeafter taxes$30,080.24$62,239.91$ 66,809.38 During the taxable year ended April 30, 1949, Bankers paid 1957 Tax Ct. Memo LEXIS 23">41 a net Federal tax deficiency for the taxable year ended April 30, 1946, in the amount of $1,779.52. In computing the deficiency for that year Bankers was allowed an additional deduction for New York State franchise taxes in the amount of $112.79. Bankers' Balance Sheets at the end of the years April 30, 1947 through April 30, 1950, as shown on its income tax returns (after separating the reserve for contingent liability to Moran's estate from accounts payable, and adding, as a liability, accrued Federal income taxes) were as follows: ASSETS4/30/474/30/484/30/494/30/50Cash$ 49,475.10$ 70,262.60$ 82,527.63$ 82,429.71Notes and Accts. Rec.20,183.7524,082.4036,787.4246,209.74Inventories6,078.488,117.8410,123.567,084.72Investments (including Savings and LoanA/Cs)30,233.1954,293.6169,234.2180,596.98Furn. and Fixt. (less Deprec.)6,678.407,559.578,985.727,462.69Goodwill (including unoperated portion ofsigned contracts)26,641.6026,641.6026,641.6021,641.60Other Assets447.28541.67311.95701.14Loans Rec. from affiliated Company50,000.00Total$139,737.80$191,499.29$234,612.09$301,126.58LIABILITIES AND CAPITALAccts. Pay. and Due Salesmen$ 52,584.48$ 63,418.88$ 35,455.18$ 24,847.42Accrued Taxes1,189.451,613.771,594.634,999.62Accrued Fed. Income Taxes7,782.3011,203.6332,832.7634,769.77Deposits on Machines737.501,487.501,487.50Res. for Salesmen's Doubtful Accounts573.95573.95573.95573.95Contingent Liability to Moran's Estate8,013.3919,561.3332,046.3143,825.14Capital Stock43,800.0043,800.0043,800.0043,800.00Earned Surplus25,794.2350,590.2386,821.76146,823.18Total$139,737.80$191,499.29$234,612.09$301,126.581957 Tax Ct. Memo LEXIS 23">42 The liquid assets of Bankers, its current liabilities , and the excess of liquid assets over current liabilities for each of the years ended April 30, 1947 through April 30, 1950, were as follows: 4/30/474/30/484/30/494/30/50Cash$49,475.10$ 70,262.60$ 82,527.63$ 82,429.71Investments (including Sav-ings and Loan A/Cs)30,233.1954,293.6169,234.2180,596.98Loans Receivable59,534.10Total Liquid Assets$79,708.29$124,556.21$151,761.84$222,560.79Current Liabilities61,556.2376,973.7871,370.0266,104.31Excess of Liquid Assets$18,152.06$ 47,582.43$ 80,391.82$156,456.48As of April 30, 1947, 1948, 1949 and 1950, Bankers had on deposit in various Federal Savings & Loan Associations, and owned stocks of other corporations acquired at cost, as follows: 4/30/474/30/484/30/494/30/50Federal Savings and Loan A/Cs$25,608.19$26,181.11$25,000.00$25,564.91Stock of other Corpns.4,625.0028,112.5044,234.2155,032.07$30,233.19$54,293.61$69,234.21$80,596.98 The deposits were maintained 1957 Tax Ct. Memo LEXIS 23">43 in Savings & Loan Associations which were customers of Bankers. Bankers would have withdrawn the funds from them without hesitancy if it were necessary to do so for the normal operation of its business. None of the corporations whose stocks were held by Bankers was engaged in a business similar to Bankers. Bankers' Board of Directors held a meeting on April 18, 1949. The following excerpts are taken from the minutes of that meeting: "The board then proceeded to consider the advisability of the declaration of a dividend to be paid out of the earnings of the company for the corporation's fiscal year ended April 30, 1949. It was called to the attention of the Board that the check imprinting machines now in the possession of the corporation's client banks are of an old and outmoded design and within the near future, and very probably within the next year, it will be necessary for the corporation to replace these machines with a new and improved model which is now being developed for this company. It is estimated that approximately 207 of these new machines will be required, involving an estimated expense to the company of $70,000. "After carefully reviewing the financial condition of the 1957 Tax Ct. Memo LEXIS 23">44 company and the results of its operation for the present fiscal year, the Board was of the opinion there were funds available for the payment of a dividend upon the company's capital stock of $10 per share and upon motion duly made, seconded and unanimously carried, it was thereupon resolved thereby and hereby is declared a divided $10of per share on the company's capital stock payable in cash on April 28, 1949 to stockholders of record at the close of the business on April 26, 1949." The total amount paid as a result of the dividend declared at the above mentioned meeting was $17,520. This was the only dividend paid by Bankers from the time of its incorporation through the taxable years involved herein. The additional income taxes due and payable by Casey for each of his taxable years 1948 through 1950, had the excess of Bankers' net income over Federal taxes for the respective years been distributed 50 per cent to him and 50 per cent to Owen, would have been as follows: AdditionalYearIncome Taxes1948$ 5,477.98194911,169.10195019,703.51Total$36,350.59Bankers did not permit its earnings or profits to accumulate beyond the reasonable needs of its business and was not availed of for 1957 Tax Ct. Memo LEXIS 23">45 the purpose of preventing the imposition of surtax upon its shareholders during the taxable years ended April 30, 1948 and April 30, 1949. Bankers did permit its earnings or profits to accumulate beyond the reasonable needs of its business and was availed of for the purpose of preventing the imposition of surtax upon its shareholders during the taxable year ended April 30, 1950. Opinion The only issue for decision is whether the petitioner, a conceded transferee of Bankers, is liable for surtax determined under section 102. We must decide whether Bankers was availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its earnings and profits to be accumulated instead of being distributed, within the meaning of section 102(a). Section 102(c) provides that the fact that the earnings or profits of a corporation were permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon the shareholders unless the corporation by the clear preponderance of the evidence shall prove to the contrary. What the reasonable needs of a business are is a question of fact which 1957 Tax Ct. Memo LEXIS 23">46 must be determined from the evidence as a whole. Helvering v. Chicago Stock Yards Co., 318 U.S. 693">318 U.S. 693 (1943). In determining whether accumulations of earnings or profits in a particular year are within the reasonable needs of a corporation, it is necessary to consider prior accumulations, since such accumulations may have been sufficient to cover the corporation's needs and additional accumulations during the year involved would therefore not be reasonably necessary. See Gus Blass Co., 9 T.C. 15">9 T.C. 15 (1947). However, if the accumulated earnings tax is to apply, the corporation must have funds or other property available during the taxable years which it can divide or distribute to its stockholders as a dividend. Sauk Investment Co., 34 B.T.A. 732">34 B.T.A. 732 (1936). In so far as this latter requirement is concerned, it is sufficient to call attention to the fact that Bankers had liquid assets in excess of current liabilities in the respective amounts of $47,582.43, $80,391.82, and $156,456.48, at April 30, 1948, April 30, 1949, and April 30, 1950. The parties disagree as to the amount of Bankers' earnings and profits at the end of each of the taxable years. The Commissioner contends that Bankers' 1957 Tax Ct. Memo LEXIS 23">47 earnings and profits were $70,151.56 at April 30, 1948, $118,868.07 at April 30, 1949, and $190,648.32 at April 30, 1950. The petitioner contends that adjustments should be made to those figures to take into account Federal income tax and New York franchise tax deficiencies applicable to the taxable years or prior years which were paid during the taxable years or in subsequent years. The petitioner also contends that adjustments should be made for the contingent liability for commissions to Moran's estate. The following schedule shows earnings and profits as computed by the Commissioner, adjustments made by the petitioner, and earnings and profits as computed by the petitioner: Earnings and Profits at4-30-484-30-494-30-50Bankers' earnings and profits as computedby the Commissioner$70,151.56$118,868.07$190,648.32Less, adjustment for Federal income taxand New York franchise tax deficiencies8,168.7611,991.4616,677.61$61,982.80$106,876.61$173,970.71Less, adjustment for contingent liabilityfor commissions to Moran's estate19,561.3332,046.3143,825.14Bankers' earnings and profits as computedby the petitioner$42,421.47$ 74,830.30$130,145.57We agree with the petitioner that Bankers' earnings 1957 Tax Ct. Memo LEXIS 23">48 and profits should be reduced by the Federal income tax and New York franchise tax deficiencies which are applicable to the taxable years or prior years. Corporate Investment Co., 40 B.T.A. 1156">40 B.T.A. 1156, 40 B.T.A. 1156">1173 (1939). However, we think it is clear that Bankers' earnings and profits should not be reduced by the contingent liabilities for commissions to Moran's estate since Bankers disputed its liability and, in fact, in 1954 it was determined in a legal proceeding that Bankers was not liable for commissions to Moran's estate which accrued subsequent to Moran's death. See Paulina duPont Dean, 9 T.C. 256">9 T.C. 256 (1947). This is not to say that an accumulation of earnings and profits for the purpose of providing a reserve for contingent liabilities to Moran's estate is not within the reasonable needs of Bankers' business. That is a different question and is discussed infra. We hold that Bankers had accumulated earnings and profits at April 30, 1948, April 30, 1949, and April 30, 1950, in the respective amounts of $61,982.80, $106,876.61, and $173,970.71. Bankers' principal service was providing banks with all the equipment and materials necessary for operating no minimum balance checking accounts - 1957 Tax Ct. Memo LEXIS 23">49 the ThriftiCheck system. It was not until after the taxable years that Bankers obtained a check imprinter which would operate satisfactorily. Nevertheless, its business increased steadily throughout the years. However, the record indicates that the degree of Bankers' ultimate success hinged to some extent upon the quality of the check imprinter furnished the banks. The petitioner's main contention is that the earnings and profits of Bankers were permitted to accumulate for the purpose of enabling Bankers to acquire check imprinters which would meet its requirements, thus making it possible for Bankers adequately to promote its banking service. The record indicates that up to about 1949 or 1950 it was Bankers' policy to purchase imprinters as it needed them with funds derived from current operating revenues. The costs of the imprinters were written off in the year of purchase as normal operating expenses. Evidently Owen was in favor of continuing this policy. On the other hand, it appears that Casey was in favor of replacing all of its hand operated imprinters with automatic imprinters as soon as it could find an automatic imprinter which would meet its requirements. In 1949 Bankers 1957 Tax Ct. Memo LEXIS 23">50 estimated that it would require about $70,000 to replace approximately 200 imprinters and later petitioner estimated that it would cost about $180,000 to acquire and install $300 new automatic imprinters. However it is clear from the petitioner's own testimony that Owen would not allow Bankers to undertake any such mass imprinter replacement program. The petitioner testified that as early as 1948 Owen was in favor of liquidating Bankers or if not liquidated, he was in favor of its distributing some dividends. He also testified that Owen was strongly opposed to using Bankers' funds to replace its hand operated imprinters with automatic imprinters though in 1950 he finally agreed to allow Bankers to lend a maximum of $50,000 to ThriftiMatic to help that company procure the type of imprinter which Bankers needed in order to keep abreast with its competitors. An accumulation of earnings for the purpose of replacing equipment may be reasonable under certain conditions. Newman Machine Co., 26 T.C. 1030">26 T.C. 1030 (1956). One of those conditions is the likelihood that the equipment replacement will actually occur. See KOMA, Inc. v. Commissioner, 189 Fed. (2d) 390 (C.A. 10, 1951), affirming a memorandum 1957 Tax Ct. Memo LEXIS 23">51 opinion of this Court [8 TCM 1064,], and Bride v. Commissioner, 224 Fed. (2d) 39 (C.A. 8, 1955), affirming a memorandum opinion of this Court [12 TCM 1230]. Owen was strongly opposed to Bankers' using any of its funds for such purpose and since he was a 50 per cent stockholder he had the power to enforce his convictions. However, in April of 1950, Owen finally consented to allow Bankers to lend $50,000 to ThriftiMatic on the condition that ThriftiMatic would procure imprinters, rent them to Bankers, and credit the rentals against the loan. We think the record clearly establishes that Owen would not allow Bankers to expend funds in excess of $50,000, other than funds derived from current operating revenues, in replacing its hand operated imprinters. Furthermore, it appears that no more than that amount would be needed since funds derived from Bankers' steadily increasing current earnings (in spite of increased competition) would provide substantial funds for replacing imprinters. In view of these circumstances and considering the record as a whole, it is our opinion that during the taxable years any accumulations of earnings by Bankers in excess of $50,000, for the purpose of replacing 1957 Tax Ct. Memo LEXIS 23">52 imprinters, were beyond its reasonable needs for such purpose. In 1948, Moran's estate instituted litigation claiming commissions were due Moran so long as contracts secured by him were in existence, and it was not until 1954 that such litigation was terminated in Bankers' favor in the Court of Appeals for the State of New York. The outcome of the litigation was, of course, uncertain during the taxable years. It is our opinion that Bankers' accumulation of surplus during the taxable years to the extent of the liability it might reasonably expect to suffer under the pending lawsuit ($19,561.33 at April 30, 1948; $32,046.31 at April 30, 1949; and $43,825.14 at April 30, 1950), was within the reasonable needs of its business. See William C. Atwater & Co., 10 T.C. 218">10 T.C. 218 (1948). We conclude that an accumulation of earnings in the amount of $69,561.33 for the purpose of replacing imprinters and providing a reserve for pending litigation was within the reasonable needs of Bankers' business as of April 30, 1948. Since Bankers' earnings and profits at that date were less than that amount, it is clear that the accumulation of earnings and profits by Bankers during the year ended April 30, 1948, 1957 Tax Ct. Memo LEXIS 23">53 were not beyond the reasonable needs of its business and that Bankers was not availed of for purposes of avoiding the surtax upon its shareholders within the meaning of section 102. At April 30, 1949, Bankers' earnings and profits were $106,876.61. We conclude that an accumulation of earnings in the amount of $82,046.31 for the purpose of replacing imprinters and providing a reserve for pending litigation was within the reasonable needs of Bankers' business as of April 30, 1949. Thus Bankers' earnings and profits exceed its reasonable needs for the above purposes by $24,830.30. However, the petitioner argues that in determining whether Bankers improperly accumulated earnings, we should take into consideration the fact that "Unoperated Portion of Signed Contracts" carried on Bankers' books at a value of $26,640.60 was in fact an asset which had no value whatsoever. We think there is merit in the petitioner's argument. Depreciation in the value of any of Bankers' assets is evidence to be considered in determining whether the accumulation of earnings was in excess of the reasonable needs of the business. Helvering v. Nat. Grocery Co., 304 U.S. 282">304 U.S. 282 (1938). When Bankers was incorporated 1957 Tax Ct. Memo LEXIS 23">54 in 1920 it exchanged stock for personal solicitation contracts and recorded them on its books at the above mentioned value of $26,640.60. Such contracts resembled wasting assets. As the years passed the contracts decreased in value. This is evident from the fact that until 1939 solicitation contracts produced most of Bankers' income, but since 1943 they have produced less than 10 per cent of its income, and many, if not all, of the original solicitation contracts were not in existence during the taxable years. In view of these circumstances we think the value of the solicitation contracts, if any, is negligible. When the book value of the solicitation contracts is written off, or written down, by Bankers, there will be a consequent reduction in accumulated earnings and profits. It is our opinion, therefore, that to accumulate earnings and profits to offset the decrease in value of the asset denominated "Unoperated Portion of Signed Contracts" was within the reasonable needs of Bankers' business. C. H. Spitzner & Son, Inc., 37 B.T.A. 511">37 B.T.A. 511 (1938). Accordingly, we conclude that the accumulations of earnings or profits by Bankers during the year ended April 30, 1949, were not beyond the 1957 Tax Ct. Memo LEXIS 23">55 reasonable needs of its business and that Bankers was not availed of for purposes of avoiding the surtax upon its shareholders within the meaning of section 102 during that year. Bankers' accumulated earnings and profits at April 30, 1950, totalled $173,970.71. It is apparent from our discussion above that it was within Bankers' reasonable needs to accumulate earnings and profits in the amount of $120,465.74 for the purpose of replacing imprinters, providing a reserve for pending litigation, and providing for the eventual decrease in accumulated earnings and profits which would result from writing off, or writing down, the value of the asset denominated "Unoperated Portion of Signed Contracts." Thus Bankers' earnings and profits exceed its reasonable needs for the above purposes by $53,504.97. Petitioner makes the argument that Bankers needed accumulations of earnings so that it could diversify its services and thus protect itself from sudden disaster should it become unable to successfully operate the ThriftiCheck system. Petitioner does not indicate the manner in which Bankers intended to diversity its services. It is clear to us from examining the record as a whole, that any intentions 1957 Tax Ct. Memo LEXIS 23">56 which Bankers had for diversifying its services were indefinite and nebulous. Under such circumstances the accumulations are not within the reasonable needs of the business. See Bride v. Commissioner, supra. Petitioner tries to establish that Bankers' competitors, using superior imprinters, could cause Bankers' sales income to decline sharply, which provides another reason for accumulating earnings. It was stipulated that Bankers lost at least 8 customer banks during the years ended April 30, 1949, and April 30, 1950, due to competition from a firm with a satisfactory automatic imprinter. However, we think it is perfectly clear from the record that Bankers was not in any danger of losing most of its customers within a short period of time as the petitioner would have us believe. For example, at the beginning of the year ended April 30, 1949, Bankers had 152 accounts in operation. During that year it acquired 20 new accounts, but had 4 accounts cancelled, resulting in an overall gain of 16 accounts. During the year ended April 30, 1950, Bankers acquired 10 new accounts, but had 8 accounts cancelled. Even so, Bankers had more accounts in operation at the end of the year than at the 1957 Tax Ct. Memo LEXIS 23">57 beginning. Furthermore, Bankers' gross sales in the year ended April 30, 1949, were $336,838.45 and its net income after taxes was $37,647.37. Both amounts were much higher than those of any other prior year in which Bankers was operating the ThriftiCheck system. And in the year ended April 30, 1950, a year when Bankers was being pushed hard by competitors, its gross sales and net income after taxes both rose substantially higher than in the prior year, i.e. gross sales were $388,716.34 and net income after taxes was $59,681.30. Petitioner's contention that Bankers was in danger of losing most of its customers during the taxable years which would cause its sales income to decline sharply, is so remote that it can not constitute a reasonable need for accumulating earnings and profits. In our opinion, the record considered as a whole warrants the conclusion that Bankers permitted its earnings and profits to accumulate beyond the reasonable needs of its business during the taxable year ended April 30, 1950. Since our conclusion rests on a consideration of the record as a whole, it is unnecessary for us to determine under section 534 of the Internal Revenue Code of 1954 where the burden 1957 Tax Ct. Memo LEXIS 23">58 of proving business necessity lies. Our conclusion that Bankers permitted its earnings and profits to accumulate beyond the reasonable needs of its business during the taxable year ended April 30, 1950, establishes the presumption, under section 102(c), that it was the purpose of Bankers to avoid surtax upon its shareholders for that year. It is provided, however, under further provisions of section 102(c), that the presumption can be overcome by a clear preponderance of the evidence to the contrary. The petitioner testified that his personal income tax bracket had nothing to do with his decisions about declaring dividends. Nevertheless he intimated that he was aware of the tax consequences which would have resulted had Bankers distributed its earnings and it is stipulated that had Bankers distributed its net income after taxes for the year ended April 30, 1950, petitioner would have paid additional income tax in the amount of $19,703.51, in that year. We note that the only minutes of Directors' Meetings introduced into evidence were those quoted in our Findings of Fact pertaining to the dividend declared on April 18, 1949. Thus there is very little in the record in the way of formal 1957 Tax Ct. Memo LEXIS 23">59 manifestations of the intentions of Bankers' Board of Directors in accumulating its earnings and profits. After considering the record as a whole, we think that the petitioner has failed to overcome, by a clear preponderance of the evidence to the contrary, the presumption established under section 102(c) that Bankers was availed of for the purpose of preventing the imposition of surtax upon its shareholders for the year ended April 30, 1950, and accordingly we approve the imposition of the surtax on Bankers under section 102. Decision will be entered under Rule 50. Footnotes. Loss.↩. The number of personal solicitation contracts are not separately identifiable from other sources of income shown on Bankers' Balance Sheets or operating statements for these years. ↩. Loss ↩. Deficit↩. Current Liabilities is computed without including the contingent liability to Moran's estate for commissions, and without including the additional tax liabilities which arose from the disallowance of the Moran commissions as a deduction.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622054/	APPEAL OF MECHANICS REALTY CO., INC., AND MECHANICS REALTY CO. OF PENNSYLVANIA.Mechanics Realty Co. v. CommissionerDocket No. 2351.United States Board of Tax Appeals2 B.T.A. 170; 1925 BTA LEXIS 2500; June 26, 1925, Decided Submitted May 29, 1925. 2500 Ferdinand Tannenbaum, Esq., for the taxpayers. B. G. Simpich, Esq., for the Commissioner. 170 Before JAMES, LITTLETON, and TRUSSELL. This is an appeal from the determination of a deficiency in income and profits taxes for the year 1919, in an amount of $4,674.94. FINDINGS OF FACT. The Mechanics Realty Co., Inc., is a New York corporation, and the Mechanics Realty Co., of Pennsylvania, is a Pennsylvania corporation. The principal office of both companies is in Philadelphia, Pa. During the taxable year here in question the companies above mentioned were affiliated corporations. The capital stock of the above companies was, during the taxable years, $6,000 each, divided into 60 shares of $100 par value, and was owned in equal parts by Henry Feldman, Maurice N. Sufrin, and Maurice Dain, who were, respectively, president and treasurer, secretary, and vice president of both companies, and constituted their boards of directors. In or about July, 1919, the taxpayers acquired approximately 100 acres of land in or around Lonsdale, Pa., a suburb of Philadelphia, 171 and divided the said property into approximately 1,800 lots, which they then2501 proceeded to develop and sell. During the year they sold about 1,450 lots of the above total amount for a gross sale price of $124,393.45. The three officers of the taxpayers above mentioned were experienced real-estate operators accustomed to earn, and who had earned prior to the year here in question, annual incomes in excess of $10,000 from commissions on the sale of real estate. During the year they devoted themselves exclusively to the operation of the taxpayer companies as executive officers, managers, and also as salesmen. The ordinary commissions paid to real-estate salesmen in connection with operations of the kind here in question were about 35 per cent of the gross selling price, and commissions of that amount were actually paid by the taxpayer company to salesmen employed by them during the taxable year. Salary was credited to each of the above-mentioned officers in the amount of $8,400 for the year 1919, of which $6,900 was drawn during the year. The accounts of the taxpayers were kept and the returns made upon the accrual basis. In their income-tax return the taxpayers claimed as a deduction a total amount of $25,200 so credited, and the return filed by them*2502 after such deductions showed net income of $3,710.50. The Commissioner in auditing the return of the taxpayers disallowed as unreasonable $3,400 of the compensation of each of the said officers in a total amount of $10,200, added the said sum to income and determined the deficiency above mentioned. Not all of the above deficiency is in issue. DECISION. The deficiency should be computed by allowing $25,200 as compensation to officers during the taxable year. Final determination will be settled on 10 days' notice, under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622001/	L. H. MANNING & CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.L. H. Manning & Co. v. CommissionerDocket No. 10230.United States Board of Tax Appeals10 B.T.A. 633; 1928 BTA LEXIS 4057; February 10, 1928, Promulgated 4057 The crediting of certain amounts on the corporation's books to its sole stockholder constituted distributions of profits. H. H. Tooley, Esq., for the petitioner. A. H. Fast, Esq., for the respondent. TRAMMELL633 This is a proceeding for the redetermination of a deficiency in income and profits taxes for the years 1919 and 1920 in the amounts 634 of $5,994.11 and $9,950.30, respectively. The petition contained two assignments of error, namely (1) that in determining invested capital for each of the years involved the Commissioner failed to include in invested capital an amount which had been credited to the sole stockholder on the books of the corporation in prior years, and (2) that the Commissioner prorated and deducted 1919 income and profits taxes in determining the invested capital for 1920. The latter assignment of error was withdrawn at the hearing, leaving only the one question to be determined. FINDINGS OF FACT. The petitioner is a corporation organized under the laws of Arizona, the date of incorporation being April 1, 1908. During the years 1909 to 1911, the corporation did not have any surplus account set up4058 on its books. The corporation, on the dates and in the amounts shown below, transferred on its books profits from the corporation's loss and gain account to the account of L. H. Manning: DateAmountApr. 10, 1909$11,666.66Nov. 15, 191020,250.00Dec. 30, 191112,500.00June 30, 191630,438.85Dec. 31, 191644,096.39Total118,951.90On December 31, 1919, the above amount was transferred from the account of L. H. Manning on the books of the corporation to a surplus account which was set up on the books for the first time. The said amount of $118,951.90 has not been included by the Commissioner in the invested capital of the petitioner for the years 1919 and 1920. The corporation had never formally declared any dividends, but credited the above amounts on its books to L. H. Manning, who owned all the stock except qualifying shares. The corporation did not have the cash on hand available for the payment of the above amounts which were credited on the books to Manning on the dates on which they were credited to him. The corporation, however, did have earnings and profits at the time the credits were made to Manning sufficient to have paid the4059 above amounts as dividends on the respective dates on which they were credited to Manning. The corporation had a running account with Minning, various amounts being debited and credited to that account. Manning actually 635 withdrew various amounts from the corporation during the years involved and advanced them to other corporations of which he was the sole stockholder. When the amount of $118,951.90, which is the sum of the credits to his account, was transferred back to the corporation and his account debited to that extent, the running or open account that he had with the corporation had a total debit of $466,562.78. There were credits to that account as of December 31, 1919, in the amount of $205,717.01. This left Manning owing the corporation a substantial sum of money at the close of 1919. The first three items credited to Manning's account, that is, those credited in 1909, 1910, and 1911, represented only a portion of the profits of the corporation for those years. The balance of the profits for those years remained in the profit and loss account. The amounts were credited to the account of Manning upon the advice and suggestion of a revenue agent, who4060 advised that the profits should not be permitted to accumulate but that they should be credited to the personal account of the sole stockholder who should pay taxes thereon. The petitioner, acting upon this advice, made the transfers to Manning's account and Manning paid the taxes upon such amounts credited to his account as being income to him. Subsequently, in 1919, when the books were audited by certified public accountants, and after the petitioner had been advised by another revenue agent that it was not necessary that the earnings and profits be distributed or credited to Manning's account, the corporation charged Manning's account with the total of the amount credited thereto from 1909 up to December 31, 1916, or a total amount of $118,951.90 and credited surplus account with the same amount at the same time. OPINION. TRAMMELL: The question here involved is whether the amounts credited to Manning's account constituted distributions of profits. If they were, the earned surplus of the corporation should be reduced to the extent of such distributions. We think from all the facts and circumstances of the case, the credits to Manning's account did constitute distributions4061 of the earnings and profits of the corporation. Manning was the sole stockholder of the company and had a running account with the corporation. He withdrew funds from the corporation to finance other corporations in which he was the sole stockholder. The crediting to his account reduced to that extent the indebtedness of Manning to the corporation. Manning received the benefit of the credits in the reduction of his liability or indebtedness to the same extent as if he had 636 received the money in cash, and the assets of the corporation were correspondingly reduced. We have heretofore held that it was not necessary that formal action be taken by a corporation in order to declare dividends or to make distributions of the earnings and profits. This may just as effectually be done informally, and is frequently so done in the case of close corporations. We must look to the substance of what was done rather than to the form. If the effect of the action of the corporation is to distribute its earnings and profits by the method pursued it is not necessary that formal action declaring dividends be taken. The real question is, Were the earnings and profits effectually distributed4062 to the stockholders? See ; ; ; ; certiorari denied May 31, 1927. We are strengthened in the view that the action of the petitioner was a distribution of profits by the testimony to the effect that the purpose of the crediting of the amounts on the books was to avoid the accumulation of profits and by the action of Manning, the sole stockholder, in treating the amounts as his taxable income in the prior years and the payment of the taxes due thereon. With respect to the year 1920, a different situation is presented. On December 31, 1919, Manning's account was debited with $118,951.50, the amount which had been credited to his account on account of profits from 1909 to 1916, and a credit made to surplus in the same amount. The function of this bookkeeping entry was to reverse all prior entries by which the profits of the years 1909 to 1916 had been distributed to Manning. The distributions of 1909 to 1916 were evidenced by bookkeeping entries but were just as effective4063 as though they had been made in cash or other property. When made, invested capital was decreased by their respective amounts. The effect of the entry of December 31, 1919, was to restore Manning's account, in so far as it was affected by the distributions, and surplus to precisely their same conditions as prior to the distributions. Manning became obligated to the petitioner for the profits of 1909 to 1916 which had been distributed to him and surplus became correspondingly greater. As the latter was reduced by the distributions of 1909 to 1916, so it was correspondingly increased when the amounts distributed to Manning were released to the petitioner by the entry of December 31, 1919, and invested capital became correspondingly greater with the unqualified return of these distributions to the uses of the petitioner company. In view of the foregoing, 637 we are of the opinion that the respondent erred in failing to include the amount in question in invested capital for 1920. Reviewed by the Board. Judgment will be entered on 15 days' notice, under Rule 50.ARUNDELL concurs in the result. LANSDON and TRUSSELL dissent.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622002/	Jacob's Fork Pocahontas Coal Company, Petitioner, v. Commissioner of Internal Revenue, RespondentJacob's Fork Pocahontas Coal Co. v. CommissionerDocket No. 26298United States Tax Court24 T.C. 60; 1955 U.S. Tax Ct. LEXIS 206; April 21, 1955, Filed 206 Decision will be entered for the respondent. Collateral Estoppel in Excess Profits Tax Cases. -- In a prior suit involving claims for excess profits tax relief for 1940-1942, petitioner based its claim under section 722 (b) (4) (1939 Code) on the grounds, inter alia, that during or immediately prior to the base period (a) it had commenced business or (b) had changed the character of its business. At the hearing in the prior suit petitioner did not argue the former claim but directed its argument to showing that it had changed the character of its business; the Court entered its decision that petitioner was not entitled to relief under the provisions of section 722 (b) (4). Held, petitioner is precluded by the principle of collateral estoppel from litigating in this suit claims for relief under section 722 (b) (4) for later taxable years (1943-1945). Dewey R. Roark, Jr., Esq., and George E. H. Goodner, Esq., for the petitioner.Philon Wigder, Esq., for the respondent. Tietjens, Judge. Kern, J., dissents. TIETJENS60 This proceeding involves applications for excess profits tax relief for the calendar years 1943, 1944, and 1945, and a related claim for refund for 1943. In an earlier proceeding, 17 T. C. 357 (1951), we denied petitioner's applications for relief for 1940, 1941, and 1942. By amendment to his answer here the respondent has asserted that our prior judgment bars a consideration of the merits of petitioner's present applications. After a hearing before a commissioner of this Court, findings of facts necessary to determine the collateral estoppel issue were made by the commissioner and the case was referred here for a determination of this issue.FINDINGS OF FACT.The petitioner is a corporation organized under the laws of West Virginia with its principal place of business at Welch, West Virginia. Its income and excess profits tax returns were filed on a calendar year basis with the collector of internal revenue for the district of West Virginia. 208 On or about September 14, 1943, petitioner filed with respondent its applications for excess profits tax relief under section 722 of the Internal Revenue Code of 1939 for the taxable years 1940, 1941, and 1942. In Schedule B of such applications petitioner checked section 722 (b) (1), (2), (4), and (5) as the bases for the relief claimed. The grounds upon which petitioner relied to establish eligibility for relief under section 722 were summarized in principal part as follows in the statement accompanying its applications for relief:61 (1) The taxpayer began coal mining operation in 1935, just prior to the beginning of the base period, and on account of the difficulties encountered in developing the mine, did not reach a normal level of production until the year 1940. 722 (b) (1) (4). The difficulties encountered consisted of bad top conditions and irregularities in the coal seam which retarded the work of developing the mine. During 1937 and 1938 a serious fault in the seam of coal was encountered which made it necessary to abandon former workings and open up at a new entry more than a mile from the former opening. Sec. 722 (b) (4).* * * (2) During 1939 the unionized209 employees of the company went out on a strike which lasted six weeks. It is estimated the diminution in output caused by this interruption amounted to at least 25,000,00 [sic] tons of coal. Sec. 722 (b) (1).(3) During 1939 the company acquired by lease, a new boundary of coal land, containing more than 1000 acres, and at once began the development of the same. The opening of this new area together with the purchase of the necessary additional equipment shown in the above table were largely responsible for the increase in coal output and profits for the years 1940, 1941 and 1942. 722 (b) (4) (5).(4) During the base period the business of the taxpayer was depressed on account of being a member of an industry whose sales agents were engaged in a price war, as a result of which the company lost $ 186,417.53, or $ 0.8052 per ton on 231,497.81 tons of slack, being 45.32% of total output of coal shipped during the base period. Despite the unusual loss on slack coal, the average profit on coal during the base period was $ 0.02570 per ton. Section 722 (b) (2).(5) On account of the depressing effect of this enormous loss on slack during the base period the taxpayer contends that210 the provisions of Section 722 (b) (5) are applicable, and that relief in this situation would not be inconsistent with the spirit of Section 722.The above-quoted grounds for relief, together with the facts alleged in support of the applications, were incorporated by reference, as Exhibits A to D, inclusive, in a petition subsequently filed with this Court, as will hereinafter appear.Under date of March 7, 1946, respondent duly notified petitioner that its applications for relief under section 722 for 1940, 1941, and 1942 were disallowed.On June 5, 1946, petitioner filed a petition with this Court, Docket No. 11174, in which it sought, inter alia, a review of respondent's action and an allowance of its section 722 claims for relief for 1940, 1941, and 1942. The allegation of error with respect to its section 722 claims was set forth in paragraph 4 (i) of the petition, which reads as follows:(i) Respondent has erroneously disallowed the applications for relief filed by petitioner under section 722 of the Internal Revenue Code upon the grounds set out in said applications for relief (attached hereto as Exhibits A to D, inclusive) and has erroneously failed to grant the relief211 from excess profits taxes requested in said applications.Paragraph 5 (k) of the petition in Docket No. 11174 sets forth the following allegations of fact in support of the allegation or error in paragraph 4 (i):62 (k) Petitioner has filed applications for relief from excess profits taxes as set forth in paragraph 2 above. The grounds for relief and the facts relied upon in support thereof are set forth in Exhibits A to D, inclusive, hereto attached and the grounds and facts set forth therein are reasserted herein by reference and made a part of this petition by incorporation as fully as if set out herein at length. The grounds and facts set forth in Exhibits A to D, inclusive, were considered by respondent together with a protest filed by petitioner on or about February 26, 1945, and other information furnished at a conference held by the parties on August 27, 1945. Petitioner is entitled to the relief requested by it in its aforesaid applications.On July 9, 1946, respondent filed an answer in Docket No. 11174 in which he denied that he erred as alleged in paragraph 4 (i) of the petition, and admitted and denied with respect to paragraph 5 (k) of the petition as follows: 212 5 (k) Admits that petitioner has filed applications for relief from excess-profits taxes under the provisions of Section 722 of the Internal Revenue Code, as amended, for the years 1940, 1941 and 1942; admits that the alleged facts upon which petitioner relies to support its claims for relief are set forth in Exhibits A to D attached to the petition; and that the Commissioner in making his determination has considered said data; however, the correctness of such alleged facts and data is denied. Denies the remaining allegations contained in subparagraph (k) of paragraph 5 of the petition.On September 26, 1950, Docket No. 11174 was heard on the merits. At the hearing all issues were waived or stipulated except one, namely, petitioner's right to relief under section 722 (b) (4). In response to an inquiry from the Court as to possible reliance by petitioner upon section 722 (b) (1) or (b) (2) factors, petitioner's counsel specifically stated: "No, your Honor. We are relying on section 722 (b) (4). * * * we are not relying on section 722 (b) (1) or section 722 (b) (2), and our case is based on the acquisition of this new lease in the fall of 1939." And to the Court's further inquiry, 213 "That is your change of business?", counsel replied, "Yes, your Honor."Briefs by the parties in Docket No. 11174 were filed seriatim, the petitioner's on November 10, 1950, the respondent's on December 11, 1950, and petitioner's reply on January 5, 1951. The argument of each party was addressed to the question of whether petitioner qualified for relief under section 722 (b) (4) because it changed the character of its business during the base period. The specific "change in the character of the business" to which the parties directed their arguments was "a difference in the capacity for production or operation," the petitioner contending that a substantial increase in capacity for production had resulted from the acquisition of leaseholds on additional coal acreage and the respondent denying it.On September 21, 1951, this Court promulgated its opinion in Docket No. 11174, which is reported in 17 T.C. 357">17 T. C. 357. We there held that the petitioner was not entitled to relief under section 722 (b) (4) of the Internal Revenue Code. On September 27, 1951, we entered our 63 decision accordingly. In our Opinion, at page 362, appears the following:Under section214 722 (b) (4) the petitioner must show that during or immediately prior to the base period it either commenced business or changed the character of its business. Though the petitioner was incorporated on June 21, 1935, it makes no claim that it commenced business "during or immediately prior to the base period." Petitioner's case is based primarily upon the contention that it "changed the character of the business" by the acquisition of a new mining lease in the fall of 1939, which change petitioner contends resulted from a "difference in the capacity for production or operation" within the language of section 722 (b) (4). * On September 27, 1951, the Court entered its decision in Docket No. 11174, which, in the pertinent part reads as follows:Ordered and Decided: That there is no refund of excess profits tax due the petitioner under the provisions of Section 722 (b) (4) of the Internal Revenue Code for the calendar years 1940, 1941 and 1942; * No rehearing or reconsideration was sought by petitioner after promulgation of the opinion or entry of the above decision.On or before July 29, 1944, March 10, 1948, and March 8, 1949, petitioner filed applications for relief under215 section 722 of the Internal Revenue Code for the taxable years 1943, 1944, and 1945, respectively. In Schedule B of the application for relief for 1943, petitioner checked section 722 (b) (1), (2), (4), and (5) as the bases for the relief claimed. In Schedule A of such application, items 1 and 6 directed respondent's attention to its application for relief for the year 1940. In its application for relief for 1944 and 1945 petitioner failed to check any of the subsections of section 722 in Schedule B thereof, but attached to each application substantially identical statements to the effect that the taxpayer had previously filed applications for relief (Form 991) for the years 1940 to 1944, inclusive, that all "that is set out in those applications which is in any way material or applicable to" its applications for 1944 and 1945, "together with all the additional and supplemental information and data heretofore filed in connection with any of such applications, is incorporated herein by reference and made a part hereof."Under date of September 29, 1949, respondent duly notified petitioner that its applications for relief under section 722 for the taxable years 1943, 1944, and 1945216 were disallowed.On December 28, 1949, petitioner filed the petition now before this Court, Docket No. 26298, in which it seeks a review of respondent's action and an allowance of its section 722 claims for relief for the taxable years 1943, 1944, and 1945. The allegations of error, paragraph 4 (a) to (f), inclusive, of the petition, read as follows:(a) Respondent erred in denying petitioner's applications for relief (Exhibits A, B, and C) without giving his reasons therefor.64 (b) Respondent erroneously failed to determine the average base period income credit to which petitioner is entitled, in an amount not less than $ 69,591.95.(c) Respondent erroneously failed to determine that normal production, output, and operation were interrupted during the base period because of the unusual and peculiar events set forth in the applications for relief and the supplemental information filed therewith.(d) Respondent erroneously failed to determine that petitioner was a member of an industry which was depressed during the base period because of temporary and unusual economic events.(e) Respondent erroneously failed to determine that petitioner's capacity for production increased217 during the base period.(f) Respondent erred in failing to reduce the excess profits tax liability determined by him by 10 per cent, as provided in sections 780 and 781 of the Internal Revenue Code.The allegations of fact upon which petitioner relies to support the errors alleged in paragraph 4 are set forth in paragraph 5 (a) to (j), inclusive. Pertinent hereto is the following statement contained in subparagraph 5 (e), which is admitted in the answer:5. The facts upon which petitioner relies as the basis of this proceeding are those set out in the said applications for relief (Exhibits A, B, and C), the supplemental data incorporated herein by reference, and the following additional facts: * * (e) Petitioner has filed applications for relief from excess profits taxes as set forth in paragraph 2 above.Paragraph 2 of the petition, aforementioned, the allegations of which were also admitted by the answer, reads in material part as follows:2. Applications for relief from excess profits taxes for the taxable years 1943, 1944, and 1945 on Form 991 were filed by petitioner on or before July 29, 1944, March 10, 1948, and March 8, 1949, respectively, under section 722 of 218 the Internal Revenue Code. True copies of said applications are attached hereto as Exhibits A, B, and C, respectively. Said applications make reference to the application for relief filed for the year 1940, which application (Form 991) with one supplemental document dated November 3, 1943, are attached to the petition for 1940 filed by this petitioner at Tax Court Docket No. 11,174 and designated as Exhibits A and D thereof; said Exhibits A and D are incorporated herein by reference. * * At the hearing of this proceeding on October 13, 1953, petitioner amended paragraph 4 of its petition by adding the following subparagraph:(g) Respondent erroneously failed to determine that petitioner commenced business during or immediately prior to the base period and did not reach by the end of the base period the earning level which it would have reached if it had commenced business two years before it did so.Respondent denied this allegation in his answer to amendment to petition filed November 27, 1953.At the hearing of this proceeding on October 13, 1953, respondent amended his answer by adding paragraph 7 thereto. Respondent affirmatively alleges in such amendment to his answer219 (a) that one of 65 the issues sought to be litigated is whether the petitioner is entitled to excess profits tax relief under section 722 (b) (4) for 1943, 1944, and 1945; (b) that, heretofore, respondent determined that petitioner was not entitled to excess profits tax relief for 1940, 1941, and 1942; (c) that, thereafter, petitioner appealed to this Court, Docket No. 11174, where there was put in issue and litigated with respect to 1940, 1941, and 1942 the identical issue which is one of the issues sought to be litigated in this cause with respect to 1943, 1944, and 1945, namely, whether petitioner is entitled to relief under the provisions of section 722 (b) (4) of the Internal Revenue Code; that this Court held that petitioner was not entitled to relief under section 722 (b) (4) for 1940, 1941, and 1942 (17 T. C. 357) and entered its decision accordingly on September 27, 1951; (d) that the parties in the present proceeding are identical with those in Docket No. 11174; and (e) that petitioner is precluded, under the doctrine of collateral estoppel, from further litigating its contentions under the provisions of section 722 (b) (4) for 1943, 1944, 220 and 1945.On December 11, 1953, petitioner filed its reply to respondent's amendment to answer. The reply admits the allegations contained in subparagraphs 7 (a), 7 (b), and 7 (d), and denies the allegations contained in subparagraph 7 (e). With respect to subparagraph 7 (c) petitioner's reply admits it appealed to this Court in Docket No. 11174, that the Court promulgated its opinion September 21, 1951, and entered its decision September 27, 1951, wherein relief was denied for 1940, 1941, and 1942. The remaining allegations contained in subparagraph 7 (c) were denied by petitioner's reply.The evidence relied on by petitioner to substantiate its claims for relief for 1943-1945 consists of the exhibits to the petition and the transcript of the testimony of witnesses in the prior suit, petitioner's tax returns with attached waivers for the years in question here, and a revenue agent's report dated April 14, 1948.At the hearing of this case on October 13, 1953, petitioner specifically waived its contentions under section 722 (b) (1) and (b) (2), and stated that section 722 (b) (5) was "more of a catch-all" and it did not "intend to offer any evidence as such on that issue." In its221 brief on the collateral estoppel issue, filed June 1, 1954, petitioner waived its contention under section 722 (b) (5), and relied solely on section 722 (b) (4).OPINION.On brief the petitioner narrowed its grounds for relief from those set forth in the petition to the following two, both of which are based on section 722 (b) (4) of the Internal Revenue Code of 1939: (a) That it commenced business during or immediately prior to the base period, or (b) that in the same period it changed the 66 character of its business. The relevant portions of section 722 (b) (4) are set forth below. 1222 The respondent argues that we are precluded from considering the merits of petitioner's case by the doctrine of collateral estoppel; that is, the questions for decision in this case were put in issue and decided by this Court in the previous case involving petitioner's claims for relief from excess profits taxes for the calendar years 1940, 1941, and 1942, there having been no intervening change in the controlling facts and the applicable legal principles. In opposition the petitioner makes two arguments: (1) That collateral estoppel is not applicable to this proceeding because " * * the situation [has been] vitally altered between the time of the first judgment and the [present] * * ," Commissioner v. Sunnen, 333 U.S. 591">333 U.S. 591, 600 (1948); and (2) If collateral estoppel is applicable here, it bars only a "change in the character of the business" argument under section 722 (b) (4), which, petitioner contends, was the only question put in issue, litigated, and decided in the prior proceeding. At the hearing the petitioner argued also that collateral estoppel does not preclude a showing of a change in the character of its business if the change is for223 reasons other than those relied on in the prior proceeding, but this argument was not pursued in petitioner's brief.When the Supreme Court in Commissioner v. Sunnen, supra, referred to the situation's being "vitally altered" since the judgment in the prior suit, it was stating one of the limitations on the application of the principle of collateral estoppel -- viz, when the same issue is presented in a second suit between the same parties the principle of collateral estoppel should not be applied to preclude a consideration of the merits of this issue if there has been an intervening change in the 67 applicable legal principles, statutory law, or Treasury regulations; but the facts should be examined anew in light of the change in the law and a fresh determination made. The change in the law relied on by petitioner here is the fact that, at the time of the hearing of this case there was pending in Congress a bill to provide judicial review of decisions of this Court in World War II excess profits tax cases. (S. 984, 83d Cong., 1st Sess.) Petitioner pointed out that at the time of the hearing this bill had passed the Senate and had been introduced224 in the House of Representatives. We might add that this bill was not enacted into law in the last Congress. We do not think this contention of petitioner warrants extended discussion. It is apparent from the Court's opinion in the Sunnen case that what it meant by a change in the law was a change in the legal principles, statutory law, or regulations that would determine the legal consequences of the factual situation in both cases. The proposal relied on by petitioner has nothing to do with the law applicable to the merits of petitioner's claims for excess profits tax relief.Addressing himself to the petitioner's second argument the respondent contends that petitioner is attempting to relitigate here the "change in the character of business" issue under the guise of "commencement of business"; in other words, that petitioner has changed merely the name and not the substance of the argument presented in the prior proceeding.Further, the respondent insists that the "commencement of business" issue was in fact presented and decided in the prior proceeding and, accordingly, that the petitioner is collaterally estopped from litigating it again. We agree.The commencement issue225 was covered in the assignment of errors in the earlier case and whatever evidence petitioner thought was available with reference to the issue was there introduced. At least no further evidence is here sought to be put in on the merits, and the old record only is relied upon to establish a basis for relief. The petitioner emphasizes, however, the Court's statement in the earlier opinion that "it [petitioner] makes no claim that it commenced business 'during or immediately prior to the base period,'" but we do not think this statement is to be taken literally. Had no "claim" for relief been made based on commencement of business, petitioner would have been precluded from litigating it in this Court in the first place. Blum Folding Paper Box Co., 4 T.C. 795">4 T. C. 795. We think the Court was simply pointing out why the "commencement" issue was not otherwise specifically commented on in the opinion. True, it was not further discussed in the opinion, but we think that was because it was not argued by the petitioner. This does not mean to us, however, that the claim was not before the Court and was not determined by the Court. The broad determination in the 226 prior case can be summed up 68 by quoting from the first and last paragraphs of the Court's Opinion there, as follows:The petitioner claims relief in this proceeding solely under section 722 (b) (4), Internal Revenue Code. * * We conclude and hold that petitioner has not shown it is entitled to relief under section 722 (b) (4) of the Internal Revenue Code.We also point out that the decision entered by the Court in the prior case was not couched in terms referring to but one clause contained in section 722 (b) (4). The decision was not that petitioner was not entitled to relief because of a change in the character of its business. Rather, the decision broadly stated that petitioner was not entitled to a refund of excess profits taxes "under the provisions of Section 722 (b) (4)."In reaching our conclusion that the "commencement" factor was before the Court in the prior case and there determined we have consulted the entire record in that case, including the pleadings. In our opinion, the failure of the petitioner to rely on the "commencement" factor or to argue the matter on brief did not take that factor out of the case. We are not willing to subscribe to the contention227 that having raised an issue and having presented evidence bearing on it, a petitioner can remove that issue from the case by failing to argue it and thereby preserve to himself an opportunity to litigate the question in a subsequent proceeding if he fails to get a favorable decision on the legal theories which he does argue. If such a contention prevailed, litigation could be continued indefinitely depending upon the ingenuity of counsel in marshalling the facts and rearranging the points of his arguments. The policy of the law is to the contrary. Cf. Harley Alexander, 22 T. C. 318. 2It228 seems to us that all the petitioner now attempts to do is again to call the Court's attention to the facts which were in evidence in the prior proceeding, but now, shifting emphasis and changing the course of its argument on those same facts, to have the Court find a basis for relief which, although it must have foundation in the same set of facts, in some way was passed over before. The Supreme Court in Chapman v. Smith et al., 57 U.S. 114">57 U.S. 114, 133, pointed out long ago that "one criterion for trying whether the matters or cause of action be the same as in the former suit, is, that the same evidence will sustain both actions." In our opinion, what petitioner does here is to ask us again to look at virtually the same evidence on which relief was previously 69 denied and to see if this time we cannot give relief. In our opinion this is the very thing that the Sunnen case, supra, says petitioner cannot do.Paraphrasing slightly the language of this Court in George Kemp Real Estate Co., 17 T. C. 755, affd. (C. A. 2) 205 F. 2d 236, a section 722 case: The parties in both proceedings229 are the same. The matter raised in both proceedings is the same, namely, whether the petitioner is entitled to relief under the provisions of Internal Revenue Code section 722, subsection (b) (4), and there has been no change in the applicable legal rules since the decision in the prior proceeding was rendered. Under these circumstances, we conclude that the petitioner is not entitled again to litigate before this Court its claim for relief.Decision will be entered for the respondent. Footnotes1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.(a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. * (b) Taxpayers Using Average Earnings Method. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because -- * * (4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time.↩2. An observation by Mr. Justice Holmes is here apposite. In United States v. California & Ore. Land Co., 192 U.S. 355">192 U.S. 355, 358, he said: "the whole tendency of our decisions is to require a plaintiff to try his whole cause of action and his whole case at one time. He cannot even split up his claim * * and, a fortiori↩, he cannot divide the grounds of recovery."	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622003/	ROBERT L. DUNCAN AND HARRIET P. DUNCAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentDuncan v. CommissionerDocket Nos. 11235-76, 9762-77.United States Tax CourtT.C. Memo 1978-398; 1978 Tax Ct. Memo LEXIS 115; 37 T.C.M. (CCH) 1653; T.C.M. (RIA) 78398; October 4, 1978, Filed Lloyd Taylor, for the petitioners. James M. Kamman, for the respondent. DAWSONMEMORANDUM OPINION DAWSON, Judge: Respondent determined deficiencies in petitioners' Federal income tax for the taxable years 1974 and 1975 in the amounts of $ 1,003.01 and $ 1,045, respectively. Due to concessions by petitioners 1 the sole issue for decision is whether Harriet P. Duncan is entitled under section 162 2 to deduct the cost of traveling between her residence and place of employment. 116 These consolidated cases were submitted fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference. The pertinent facts are summarized below. Petitioners Robert L. Duncan (hereinafter Robert) and Harriet P. Duncan (hereinafter Harriet), husband and wife, resided in Ukiah, California, at the time they filed the petition in these cases. Petitioners timely filed joint individual income tax returns for the calendar years 1974 and 1975 with the Internal Revenue Service Center, Fresno, California. Petitioners are members of the Pomo Indian tribe, which is indigenous to the Ukiah Valley in Northern California. Petitioners were born in and have always resided in the area of Ukiah, California. Petitioners have owned their home in Ukiah since 1963. Robert was employed in the construction industry in the area of Ukiah but retired in 1965 because of an arthritic condition. Since 1968, Harriet has been continuously employed as a psychiatric technician by the California Department of Mental Health. Harriet worked in this capacity until October 1, 1971, at Talmadge117 State Hospital in Ukiah. In late 1971, however, the State Department of Mental Health closed Talmadge State Hospital and offered all the employees an opportunity to transfer permanently to other State hospitals. Harriet accepted this offer and was transferred to Sonoma State Hospital which is eighty miles from petitioners' residence in Ukiah. The closing of Talmadge State Hospital was pursuant to a general plan of the State of California to reduce costs and shift the major burden for mental health services to State-funded county programs. The State had no plans to reopen the closed State hospitals and has not reopened Talmadge State Hospital. Since the closing of the hospital, no employment opportunities for psychiatric technicians have existed in the immediate vicinity of Ukiah. During 1974 and 1975, Harriet's work schedule at Sonoma State Hospital was six days on and two days off, with three days off every six weeks. During this period Harriet never remained overnight in the immediate vicinity of Sonoma State Hospital. Instead, she returned to her residence in Ukiah at the end of each working day. On their 1974 and 1975 Federal income tax returns petitioners deducted118 the cost of Harriet's travel between Ukiah and Sonoma State Hospital. Respondent disallowed these deductions on the ground that the costs incurred were nondeductible commuting expenses which did not qualify for a deduction as an ordinary and necessary business expense. We agree with respondent. Section 162 3 allows as a deduction all ordinary and necessary traveling expenses incurred while away from home in the pursuit of a trade or business. Deductible expenses include those incurred in the trade or business of being an employee. See, e.g., Primuth v. Commissioner,54 T.C. 374">54 T.C. 374, 377 (1970), appeal dismissed per stipulation (7th Cir., Sept. 4, 1970). As noted by the Supreme Court in Commissioner v. Flowers,326 U.S. 465">326 U.S. 465, 470 (1946), each of three distinct requirements must be satisfied if a deduction for traveling expenses is to be sustained: 119 (1) The expense must be a reasonable and necessary traveling expense, as that term is generally understood. This includes such items as transportation fares and food and lodging expenses incurred while traveling. (2) The expense must be incurred "while away from home." (3) The expense must be incurred in pursuit of business.This means that there must be a direct connection between the expenditure and the carrying on of the trade or business of the taxpayer or of his employer. Moreover, such an expenditure must be necessary or appropriate to the development and pursuit of the business or trade. Whether a travel expense qualifies under these tests is a question of fact. The law is settled that the cost of commuting between one's residence and his place of employment is a personal expense which fails to qualify for deduction under these tests. See, e.g., Commissioner v. Flowers,supra; Anderson v. Commissioner,60 T.C. 834">60 T.C. 834 (1973); Green v. Commissioner,59 T.C. 456">59 T.C. 456 (1972); secs. 1.162-2(e), 1.262-1(b)(5), Income Tax Regs. Such commuting expenses are incurred neither in pursuit of business, Commissioner v. Flowers,supra at 473,120 nor while away from "home", which this Court has consistently defined as the taxpayer's principal place of employment. Kroll v. Commissioner,49 T.C. 557">49 T.C. 557, 561-62 (1968). Accord, Wills v. Commissioner,411 F.2d 537">411 F.2d 537, 540 (9th Cir. 1969), affg. 48 T.C. 308">48 T.C. 308 (1967). The cost of traveling to a new place of employment outside the vicinity of the taxpayer's residence may be deductible by an employee, however, if the work assignment is temporary. Under those circumstances it would be unreasonable to expect a taxpayer to move his residence and it can fairly be said that incurring attendant travel expenses is in pursuit of business. Thus, for taxpayers with temporary assignments an exception to the definition of tax home is made and a deduction for travel expenses is allowed. Michaels v. Commissioner,53 T.C. 269">53 T.C. 269, 273 (1969). If, on the other hand, the work assignment is for an indefinite or indeterminate period, a taxpayer's failure to move to his new place of work must be attributed to his personal desires rather than the exigencies of business and the resulting travel costs are nondeductible personal commuting expenses. 121 Tucker v. Commissioner,55 T.C. 783">55 T.C. 783, 786 (1971); Kroll v. Commissioner,supra at 562. This Court has held that for purposes of the temporary/indefinite distinction temporary employment is that which can be expected to last only a short period of time. Tucker v. Commissioner,supra at 786; Albert v. Commissioner,13 T.C. 129">13 T.C. 129, 131 (1949). The Ninth Circuit, to which appeal in this case would lie, has held that even if the duration of employment for an employee is not fixed it may be temporary unless "there is a reasonable probability known to him that he may be employed for a long period of time at his new station." Harvey v. Commissioner,283 F.2d 491">283 F.2d 491, 495 (9th Cir. 1960), revg. 32 T.C. 1368">32 T.C. 1368 (1959). See generally Stricker v. Commissioner,54 T.C. 355">54 T.C. 355, 361-62 (1970), affd. 438 F.2d 1216">438 F.2d 1216 (6th Cir. 1971). Applying the foregoing principles to the facts here, we find no basis for allowing a deduction for the expenses incurred by Harriet. There is no indication in the record that her employment at the Sonoma State Hospital was of a temporary nature. 122 Harriet was transferred to Sonoma State Hospital in late 1971 and was still employed there during the taxable years 1974 and 1975.Apparently she knew that the state had no plans to reopen Talmadge State Hospital and that her employment at Sonoma State Hospital would be for an indefinite period. No evidence here suggests that there was not a reasonable probability known to her that she would be employed for a long period of time at her new station. We conclude that Harriet's choice to live in Ukiah and commute eighty miles was motivated by her personal desires rather than the exigencies of business. Consequently, we hold that the expenses incurred by Harriet in traveling between her residence in Ukiah and the Sonoma State Hospital are commuting expenses which fail to qualify for deduction as travel expenses under section 162. Decisions will be entered for respondent. Footnotes1. Petitioners have conceded that they are not entitled to deduct certain expenses for meals and lodging. Apparently they are also no longer pursuing various meritless constitutional arguments raised in their petition. ↩2. Unless specified otherwise, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue.↩3. SEC. 162. TRADE OR BUSINESS EXPENSES. (a) IN GENERAL.--There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including-- * *(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business;↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622004/	NIBLEY-MIMNAUGH LUMBER COMPANY, BY J. F. RAVENSCROFT, TRUSTEE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Nibley-Mimnaugh Lumber Co. v. CommissionerDocket No. 85966.United States Board of Tax Appeals37 B.T.A. 617; 1938 BTA LEXIS 1011; April 5, 1938, Promulgated 1011 A notice of deficiency was sent to a corporation, and a petition for redetermination was filed by an individual as trustee for the corporation. The corporation was dissolved more than five years prior to the filing of the petition, and under local law its existence terminated completely five years after dissolution. Held, that the petition herein is not the petition of the taxpayer to whom the notice of deficiency was sent and must be dismissed for lack of jurisdiction. Allan A. Smith, Esq., for the petitioner. John H. Pigg, Esq., for the respondent. ARUNDELL617 The basis for this proceeding is the respondent's determination of a deficiency in income tax for the year 1923. Upon the filing of a petition for redetermination the respondent moved to dismiss for lack of jurisdiction. That motion, after hearing thereon, was denied 618 by order entered March 29, 1937. Thereupon the respondent answered the petition, denying the petitioner's jurisdictional allegations. The proceeding then came on for trial on the merits and at the hearing counsel for respondent renewed the motion to dismiss. We are now of the opinion that there1012 is no statutory petition before us in this proceeding, and our findings of fact will be confined to the jurisdictional question. FINDINGS OF FACT. On May 6, 1936, the respondent mailed a notice of deficiency in income tax for the year 1923 to: Nibley-Mimnaugh Lumber Company, c/o Mr. J. F. Ravenscroft, Box 198, Baker, Oregon. On August 1, 1936, a petition for redetermination of that deficiency was filed with the Board bearing the caption: Nibley-Mimnaugh Lumber Company, by J. F. Ravenscroft, Trustee. The first numbered allegation of the petition reads: The petitioner is the Trustee appointed by the Nibley-Mimnaugh Lumber Company on the 1st day of October, 1923, for the purpose of taking charge and possession of all of its affairs, closing up its business and making distribution to the stockholders of that company, all in accord with a contract, copy of which is hereto annexed, marked as Exhibit "A" and by such reference made a part hereof; that the said Nibley-Mimnaugh Lumber Company was thereafter dissolved and the said company is no longer in existence and in its own name is to initiate or carry on an appeal to this Board; that petitioner's residence is1013 2517 N.E. 13th Street, Portland, Oregon. The verification is signed by J. F. Ravenscroft, who states therein in part: That he is a former stockholder, formerly a director and formerly secretary of the Nibley-Mimnaugh Lumber Company, and also is the trustee for said company; that as such trustee he is duly authorized to verify the foregoing Petition; * * The Nibley-Mimnaugh Lumber Co. was formerly a corporation incorporated under the laws of Oregon in 1907. On August 1, 1923, the stockholders of Nibley-Mimnaugh Lumber Co. designated J. F. Ravenscroft "as trustee to hold, operate or sell the assets of the Nibley-Mimnaugh Lumber Company * * ." The next day a resolution was adopted by the directors authorizing "J. F. Ravenscroft, as Liquidating Trustee" to sell and convey the company's assets. A contract to sell the assets was executed the same day and in that contract the vendor is described as "The Nibley-Mimnaugh Lumber Company, an Oregon corporation, First Party, acting herein by and through J. F. Ravenscroft as Liquidating Trustee of said 619 Nibley-Mimnaugh Lumber Company." In September 1923 the stockholders and directors formally ratified the acts of Ravenscroft. 1014 Resolutions were adopted to dissolve the corporation and the directors appointed Ravenscroft as trustee to wind up the affairs of the corporation and carry out the terms of the contract of August 2, 1923. On October 1, 1923, a contract was entered into between the corporation and Ravenscroft wherein Ravenscroft as trustee was instructed to carry out the terms of the contract of August 2, to collect all sums of money due under that contract, and was authorized to take charge of all the property of the corporation. The contract further authorized Ravenscroft to emplop such legal and clerical assistants as might be necessary to carry out the provisions of the trust or any other matter in connection with the closing up of the affairs of the corporation. On March 7, 1924, the Corporation Commissioner of the State of Oregon issued a certificate of dissolution of the Nibley-Mimnaugh Lumber Co.OPINION. ARUNDELL: The question for consideration at this time is whether there is before us a proper petition to bring the proceeding within our jurisdiction. As set out in the findings of fact, the notice of deficiency was addressed to "Nibley-Mimnaugh Lumber Company, c/o J. F. Ravenscroft. 1015 " The petition was filed by Ravenscroft, purporting to be trustee for the corporation to whom the deficiency notice was sent. The corporation itself obviously could not file a petition, as it was dissolved on March 7, 1924, and under the holding in , its corporate existence completely terminated five years after that date. The Standifer case, like this, involved an Oregon corporation. More than five years after dissolution a review of the Board's decision was sought in the Circuit Court of Appeals for the Ninth Circuit. The Circuit Court dismissed the petition for review. It was there pointed out that upon dissolution of a corporation the corporate existence is continued for five years for purposes of liquidation, winding up the business and disposing of property. After the expiration of that period of time the corporation was as if it did not exist and even suits commenced within that period abate upon the expiration thereof. In the present case the corporation became completely defunct five years after March 7, 1924, that is, on March 7, 1929. 1016 Consequently it could not file the petition that was filed herein purportedly in its behalf on August 1, 1936. The petition therefore is not the petition of the taxpayer against whom the deficiency was determined, and we have no jurisdiction to hear the proceeding. ; ; affirmed March 11, 1933, by the Circuit Court of Appeals for the Fifth Circuit without opinion. 620 The contract of October 1, 1923, between the corporation and Ravenscroft does not give validity to the petition filed herein. It can not breathe life into the dead corporation, so as to make it the petitioner. If there are Oregon statutes that continue the existence of a corporation under such a contract, the petitioner has not brought them to out attention, and the petitioner has the burden of establishing jurisdiction. See . The petitioner contends that section 272(k) of the Revenue Act of 1934 gives the petition validity. That section provides as follows: (k) ADDRESS FOR NOTICE OF DEFICIENCY. - In the absence of notice to the Commissioner*1017 under section 312(a) of the existence of a fiduciary relationship, notice of a deficiency in respect of a tax imposed by this title, if mailed to the taxpayer at his last known address, shall be sufficient for the purposes of this title even if such taxpayer is deceased, or is under a legal disability, or, in the case of a corporation, has terminated its existence. The quoted provision is designed to give validity to the notice of deficiency under certain circumstances and relates to a question not present here. Neither party questions the notice of deficiency; the question here is whether the petition is a proper one. For reasons given above, we hold that there is no proper petition before us. Accordingly, the order entered in this proceeding on March 29, 1937, will be vacated and respondent's motion to dismiss for lack of jurisdiction is granted. Order of dismissal will be entered.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622005/	Clarence Wood and Mary Louise Wood, Petitioners, v. Commissioner of Internal Revenue, RespondentWood v. CommissionerDocket No. 85316United States Tax Court37 T.C. 70; 1961 U.S. Tax Ct. LEXIS 51; October 23, 1961, Filed 51 Decision will be entered for the petitioners. Held, that legal and accounting fees paid by petitioners in 1958 in contesting and settling their income tax liability for prior years, including civil fraud penalties, are expenses attributable to their trade or business within the meaning of section 162(a), I.R.C. 1954, and therefore do not come within the nonbusiness deductions limitation of section 172(d)(4), I.R.C. 1954, in computing net operating loss for 1958. John L. Dorsey, Jr., Esq., for the petitioners.Arthur N. Mindling, Esq., for the respondent. Mulroney, Judge. MULRONEY 70 OPINION.The respondent determined a deficiency in the petitioners' income tax for 1955 in the amount of $ 16,108.71. The sole issue is whether certain attorneys' 54 and accountants' fees totaling 71 $ 45,000 paid by petitioners in 1958 in contesting and settling their income tax liability for the years 1944, 1945, and 1946 are allowable as business expense deductions in 1958 and in computing their net operating loss carryback from 1958 to 1955.All of the facts have been stipulated and are so found.Clarence Wood and Mary Louise Wood, husband and wife, are residents of Henderson County, Kentucky. Petitioners file their income tax returns on a calendar year basis and on a cash method of accounting. They filed their Federal joint income tax returns for the years 1955 and 1958 and all other pertinent years with the district director of internal revenue, Louisville, Kentucky. Clarence Wood will hereinafter be called the petitioner.During the year 1955 petitioner was engaged in the business of oil producer and farmer. During the years 1944, 1945, and 1946 petitioner was engaged in an oil-producing business, farming operations, and the operation of nightclubs, and he also realized income from investments in slot machines, rental property, and stocks and bonds.On August 15, 1956, respondent sent a statutory notice of deficiency to petitioner55 with respect to the years 1944, 1945, and 1946, advising petitioner that deficiencies, additions to tax under sections 293(b) and 294(d)(2) of the Internal Revenue Code of 1939, 1 and interest thereon in the total amount of $ 657,402.30 had been assessed against him on June 20, 1956, under a jeopardy assessment. This total was made up as follows:Income TaxAdditions to taxYearDeficiencyInterest toJune 20, 1956Sec. 293(b)Sec. 294(d)(2)1944$ 75,408.36$ 48,682.73$ 5,786.58$ 50,962.48194563,894.5736,829.442,865.7339,347.561946158,823.4479,255.227,268.9488,277.25Totals298,126.37164,767.3915,921.25178,587.29The amounts so assessed were based upon computations made by respondent under the net worth plus personal expenditures method.Petitioner filed a petition with this Court on November 13, 1956 (Docket No. 64893), and among56 the issues in dispute were the following:(1) The correct amounts of undeposited cash on hand to be used in computing petitioner's income under the net worth method for each of the years 1944 through 1946;(2) Whether attorneys' fees of $ 10,388.90 paid by petitioner in 72 1944 in connection with his successful defense of a suit in Federal court for the alleged wrongful death of a person was properly treated as a nondeductible personal expenditure in computing petitioner's income by the net worth method for such year; and(3) Whether certain payments in 1944 and 1945 in the amounts of $ 14,796.18 and $ 12,890.26 were nondeductible personal expenditures in the net worth computation on the ground that they were made to secure political influence.The above-mentioned Tax Court case under Docket No. 64893 was terminated in December 1958 by an agreed settlement, and a final decision was entered by this Court on December 19, 1958, pursuant to such settlement. The decision ordered and decided that, without taking into account the jeopardy assessment made prior to the issuance of the deficiency notice, there were no deficiencies in income tax due from petitioner for the years 1944 57 and 1945 and on that same basis there were deficiencies in income tax and additions to tax under sections 293(b) and 294(d)(2), I.R.C. 1939, for the year 1946 in the respective amounts of $ 84,875.51, $ 42,437.76, and $ 2,686.73.In December 1958 petitioner paid attorneys' and accountants' fees in the amount of $ 45,000 for services rendered in contesting and settling petitioner's income tax liability for the years 1944, 1945, and 1946. Petitioner claimed this amount as a business expense deduction on his 1958 joint income tax return, which reported a net operating loss of $ 30,833.78, and he filed an application for tentative carryback adjustment on March 23, 1959, to carry back a loss in this amount to the year 1955.Respondent disallowed the deduction of the attorneys' and accountants' fees of $ 45,000 as a business expense in computing the adjusted gross income of petitioner and his wife in their joint return for 1958 and consequently refused to allow them any net operating loss carryback deduction for 1955. Respondent explained in his statutory notice of deficiency that the amount of $ 45,000 was deductible by petitioner in 1958 only as a nonbusiness expense deduction under 58 section 212(3) of the Internal Revenue Code of 1954.It has been stipulated that if the $ 45,000 expenditure in 1958 for attorneys' and accountants' fees is allowable as a business expense deduction by petitioner in 1958, there will be a net operating loss in 1958 in the amount of $ 30,833.78 which may be carried back to 1955, resulting in no additional income tax being due by the petitioner for 1955. It has also been stipulated that if such expenditures are not allowed as a business expense deduction in 1958, there will be no net operating loss to be carried back to 1955 and there will be a deficiency of $ 16,108.71 for 1955.73 Section 62(1) 2 defines adjusted gross income as follows:SEC. 62. ADJUSTED GROSS INCOME DEFINED.For purposes of this subtitle, the term "adjusted gross income" means, in the case of an individual, gross income minus the following deductions: (1) Trade and business deductions. -- The deductions allowed by this chapter (other than by part VII of this subchapter) which are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.59 The parenthetical cross-reference to "part VII of this subchapter" refers insofar as material here to the following section:PART VII -- ADDITIONAL ITEMIZED DEDUCTIONS FOR INDIVIDUALS * * SEC. 212. EXPENSES FOR PRODUCTION OF INCOME.In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year -- (1) for the production or collection of income;(2) for the management, conservation, or maintenance of property held for the production of income; or(3) in connection with the determination, collection, or refund of any tax.Section 212(3) is new under the Internal Revenue Code of 1954. Sections 212(1) and (2) correspond to section 23(a)(2) of the Internal Revenue Code of 1939.Section 172 allows a net operating loss deduction and section 172(c) defines "net operating loss" as "the excess of the deductions allowed by this chapter over the gross income," but provides that "Such excess shall be computed with the modifications specified in subsection (d)." Section 172(d)(4) provides that "In the case of a taxpayer other than a corporation, the deductions allowable by this chapter which are 60 not attributable to a taxpayer's trade or business shall be allowed only to the extent of the amount of the gross income not derived from such trade or business." Section 172(d)(4) is substantially the same as section 122(d)(5) of the Internal Revenue Code of 1939.Respondent's main contention is that legal and accounting expenses incurred in a Federal income tax controversy are deductible by an individual taxpayer under the Internal Revenue Code of 1954 only as nonbusiness expenses and therefore fall within the limitation of section 172(d)(4) in computing net operating losses.Petitioner contends the $ 45,000 is deductible in the year paid under section 162, which provides in part as follows:SEC. 162. TRADE OR BUSINESS EXPENSES.(a) In General. -- There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *74 The above section of the 1954 Code corresponds to section 23(a)(1)(A) as it appeared in the Internal Revenue Code of 1939.Under the Internal Revenue Code of 1939 it was held that where legal and accounting expenses were incurred by an individual taxpayer in 61 an income tax controversy growing out of and proximately related to his business, such expenditures were deductible by him under section 23(a)(1)(A) of the Internal Revenue Code of 1939 as business expenses in computing his adjusted gross income under section 22(n)(1) of the Internal Revenue Code of 1939. James J. Standing, 28 T.C. 789">28 T.C. 789, affd. 259 F. 2d 450. It was also held under the Internal Revenue Code of 1939 that legal fees incurred by an individual taxpayer in connection with Federal and State income tax investigations concerning his business income were deductible by him as business expenses and were properly deductible in computing a net operating loss carryback under section 122 of the Internal Revenue Code of 1939. Elmer Reise, 35 T.C. 571">35 T.C. 571; see also Frank Polk, 31 T.C. 412">31 T.C. 412, affd. 276 F.2d 601">276 F. 2d 601.Respondent argues that the Internal Revenue Code of 1954 changes the result of these cases. He attaches great significance to the language in section 62(1) which excludes from the computation of "adjusted gross income" those deductions62 allowed by part VII of the Internal Revenue Code of 1954 (sections 211 through 217) and to the appearance of section 212(3) for the first time in the Internal Revenue Code of 1954. Respondent attaches "real legal significance" to these Code changes and states on brief that "Notable changes in the wording of tax statutes are not ordinarily made in the absence of a congressional purpose to accomplish a change in the application or operation thereof." 3 This change, argues respondent, was to allow 75 individual taxpayers to deduct legal and accounting expenses in tax controversies only as nonbusiness deductions under section 212(3) in all instances, even where such tax controversies grow out of and are proximately related to the individual taxpayer's business.63 We find nothing in the Internal Revenue Code of 1954 or its legislative history to show that Congress intended any such limitation. Apart from some changes in wording and arrangement, there is a marked similarity in sections 62(1) and 212(1) and (2) with their counterparts in the Internal Revenue Code of 1939 and the committee reports clearly show that no substantive changes were intended. 4Section 172(d)(4) is different from section 122(d)(5) of the Internal Revenue Code of 1939 only in that the new section eliminates certain items from the scope of nonbusiness deductions for the purpose of computing net operating loss, but this change in no way touches upon the issue before us.Section 212(3) is new in the Internal Revenue Code of 1954 and it allows an individual to deduct all ordinary and necessary expenses incurred "in connection with the determination, collection, or refund of any tax." Although there64 was no statutory authority for similar deductions under the Internal Revenue Code of 1939, the respondent's regulations 5 under section 23(a)(2) had been amended in 1946 (T.D. 5513, May 14, 1946) to allow as nonbusiness deductions "Expenses paid or incurred by an individual in the determination of liability for taxes upon his income * * ." The 1946 amendment to the regulations denied any deduction for expenditures incurred by an individual in the determination of gift tax liability, except to the extent that such expenses were allocable to interest on a refund of gift taxes. In 1952 the Supreme Court held that legal fees paid by an individual in contesting the amount of his gift tax liability were not deductible under section 23(a)(2), I.R.C. 1939. Lykes v. United States, 343 U.S. 118">343 U.S. 118.It is obvious that the only effect of new section 212(3) was to change the result of the Lykes case and to broaden the scope of deductible nonbusiness expenses65 by individuals. The Senate Finance Committee report stated as follows:Existing law allows an individual to deduct expenses connected with earning income or managing and maintaining income-producing property. Under regulations costs incurred in connection with contests over certain tax liabilities, such as income and estate taxes, have been allowed, but these costs have been disallowed where the contest involved gift-tax liability.A new provision added by the House and approved by your committee allows a deduction for expenses connected with determination, collection, or refund of any tax liability. [S. Rept. No. 1622, 83d Cong., 2d Sess., p. 34.]76 In James J. Standing, supra, the year of the claimed business expense deduction was 1951, and in Elmer Reise, supra, the year was 1949. In both cases the expenses were incurred in income tax disputes, and although in both years the regulations allowed the deductibility by an individual of his expenses in income tax controversies as nonbusiness expenses, this Court and the Court of Appeals for the Fourth Circuit held that such expenses, if incurred in connection with66 the individual's business, were deductible as business expenses. We do not believe that new section 212(3) changes this result. In enacting this section Congress was concerned only with nonbusiness expenses of individuals and there is nothing to suggest that it sought to deprive individuals of business deductions which they had hitherto enjoyed. We believe that the statutory scheme under the Internal Revenue Code of 1954 permits an individual taxpayer to deduct his expenses in any tax controversy either as a business expense under section 162(a) or as a nonbusiness expense under section 212(3), depending upon the facts of the particular case.Respondent next argues that even if an individual taxpayer may claim a business expense deduction for tax litigation expenses in connection with business income, the petitioner has failed to show that the tax controversy for which the legal and accounting fees were incurred was related to his business. This case was fully stipulated. The legal and accounting fees here in question were in connection with the tax controversy involving the years 1944, 1945, and 1946 and in those years the petitioner was engaged in an oil-producing business, 67 farming operations, the operation of nightclubs, and he also had income from coin or slot machines, rental property, and stocks and bonds. All of these operations were certainly business activities with the possible exception of the rental property and the securities. Some idea of the relative insignificance of petitioner's income from these nonbusiness activities may be gathered from the amounts reported by him from various sources in his income tax returns for the years 1944 through 1946, which showed the following:194419451956Oil production($ 16,823.05)($ 47,260.21)($ 56,967.28)Owner's royalty1,644.15 Coin machines92,254.77 92,816.47 69,639.23 A.A.A. payments244.00 101.00 1040F (farm)(2,332.66)Farm partnership4,554.68 3,057.70 4,191.01 Tobacco sales267.63 Salaries6,000.00 Campsite rent70.00 Government bond interest22.30 155.93 Total adjusted gross incomereported80,300.40 49,004.89 22,330.38 Respondent used the net worth plus personal expenditures method to compute petitioner's income for these years and on this basis determined 77 deficiencies, additions to tax, and interest68 for this period totaling $ 657,402.30. Under the settlement reached by respondent and petitioner there were no deficiencies in income tax due for the years 1944 and 1945, but there were deficiencies in income tax and additions to tax under sections 293(b) and 294(d)(2) of the Internal Revenue Code of 1939 for 1946 in the respective amounts of $ 84,875.51, $ 42,437.76, and $ 2,686.73. Obviously, under the net worth method the sources of income cannot be identified. But we are satisfied from the nature of petitioner's activities during the years 1944 through 1946, the source of income listed on his returns, the extent of the proposed deficiencies for this period as compared to the list of his income-producing activities, and other indications gleaned from the pleadings filed in this Court in Docket No. 64893 as to the nature of the disputed items between the parties, that the asserted deficiencies were based for all significant purposes on adjustments to business income.Finally, respondent makes the contention on brief that the "central issue" in the tax controversy for the years 1944 through 1946 was whether or not the petitioner had filed a false and fraudulent return with the69 willful intent to evade tax for one or more of such years, and that "Under such circumstances, * * * the settlement of this prior litigation on the basis of an agreement to deficiencies which specifically included substantial fraud penalties and aggregated $ 130,000.00, exclusive of interest, provides ample justification for concluding that the legal and accounting fees incurred in effecting such settlement were not ordinary and necessary business expenses." Respondent then adds that "the filing of false and fraudulent income tax returns has not yet come to be one of the ordinary and usual incidents of engaging in any trade or business."There is no merit in respondent's contention. In James J. Standing, supra, a net worth statement was made the basis of a settlement under which the individual taxpayer paid a deficiency of $ 63,601.32 for the years 1945 through 1949, additions to tax for fraud in the amount of $ 26,074.87 (for the years 1945 to 1948), and an addition to tax for negligence (for 1949) of $ 762.76. The presence of the civil fraud penalties did not affect the deductibility of the legal and accounting fees incurred by the taxpayer in the70 tax controversy as business expenses under sections 22(n)(1) and 23(a)(1)(A) of the Internal Revenue Code of 1939. In Greene Motor Co., 5 T.C. 314">5 T.C. 314, we said:The liability for the deficiencies in tax, together with that for the fraud penalties authorized by section 293(b), supra, is purely a civil and not a penal liability. Such penalties are not imposed as "personal punishment on violators." See Commissioner v. Heininger, 320 U.S. 467">320 U.S. 467. Rather they are "provided primarily as a safeguard for the protection of the revenue and to reimburse the 78 Government for the heavy expense of investigation and the loss resulting from the taxpayer's fraud." Helvering v. Mitchell, 303 U.S. 391">303 U.S. 391. The expenses in connection with settling that liability are to be considered as "ordinary and necessary," we think, under the authority of Commissioner v. Heininger, supra, and Bingham v. Commissioner, 325 U.S. 365">325 U.S. 365. In the latter the Supreme Court approved the deduction, as ordinary and necessary "non-trade or non-business" expense, 71 of legal expenses incurred in contesting unsuccessfully a deficiency in income tax. In Longhorn Portland Cement Co., 3 T.C. 310">3 T.C. 310, we allowed deduction of attorneys' fees and legal expenses paid in compromising a suit brought by the State of Texas to recover penalties for the violation of state antitrust law. We also allowed deduction of the amounts paid the State of Texas in compromise of the action. The Commissioner acquiesced in our allowance of the attorneys' fees and expenses, though he appealed the allowance for the amounts paid in compromise, and we were on that question reversed, Commissioner v. Longhorn Portland Cement Co., 148 Fed. (2d) 276.See also Commissioner v. Shapiro, 278 F. 2d 556, affirming a Memorandum Opinion of this Court.We hold that the legal and accounting fees paid by petitioner in 1958 in contesting and settling his income tax liabilities for the years 1944 through 1946 were attributable to his trade or business within the meaning of section 162(a) and therefore do not come within the limitation of section 172(d)(4) in computing his net operating loss72 for 1958 and the net operating loss carryback from 1958 to 1955.Decision will be entered for the petitioners. Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise noted.↩2. The Ways and Means Committee report (H. Rept. No. 1337, 83d Cong., 2d Sess.) states as follows at page A19:"Section 62. Adjusted Gross Income Defined"This section corresponds to section 22(n) of the 1939 Code. Paragraph (1) corresponds to paragraph (1) of section 22(n)↩ of the Code of 1939. No substantive change is made."3. In Rev. Rul. 58-142, 1 C.B. 147">1958-1 C.B. 147, the respondent ruled as follows:"In the case of an individual, state income taxes, interest on state and Federal income taxes, and litigation expenses in connection with such income taxes, even where related to income derived from his trade or business and even though deductible under section 212 of the Internal Revenue Code of 1954 in determining taxable income as defined in section 63 of the Code, are not "attributable to a trade or business carried on by the taxpayer" and are, therefore, not deductible for the purpose of determining adjusted gross income as defined in section 62(1) of the Code. Section 1.62-1(d) of the Income Tax Regulations. However, a state tax on gross income directly attributable to a trade or business carried on by an individual, as distinguished from a state tax on net income (whether or not derived from the conduct of a trade or business), is deductible for the purpose of determining adjusted gross income as defined in section 62(1) of the Code * * ."Further, section 172(d)(4) of the Code provides that, in determining a net operating loss of a taxpayer other than a corporation, the deductions allowed by Chapter 1 of the Code, "which are not attributable to a taxpayer's trade or business shall be allowed only to the extent of the amount of the gross income not derived from such trade or business." Here also, state income taxes (except a state tax on gross income such as mentioned above), interest on state and Federal income taxes, and litigation expenses in connection with such taxes, even though related to income derived from a trade or business carried on by the taxpayer, are not "attributable to a taxpayer's trade or business," and under section 172(d)(4)↩ of the Code are allowable as deductions in determining a net operating loss of a taxpayer, other than a corporation, only to the extent of the amount of the gross income not derived from such trade or business. * *"4. H. Rept. No. 1337, 83d Cong., 2d Sess., pp. A19, A59; S. Rept. No. 1622, 83d Cong., 2d Sess., pp. 169, 218.↩5. Regs. 118, sec. 39.23(a)-15(k).↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622006/	George A. Croft v. Commissioner.Croft v. CommissionerDocket No. 1432.United States Tax Court1944 Tax Ct. Memo LEXIS 83; 3 T.C.M. (CCH) 1064; T.C.M. (RIA) 44330; October 11, 194483 Thomas L. Brown, Esq., for the petitioner. James J. Waters, Esq., for the respondent. ARNOLD Memorandum Findings of Fact and Opinion ARNOLD, Judge: The respondent determined a deficiency in income tax for 1941 in the amount of $2,769.79 upon the theory that petitioner operated the business as a sole proprietorship. Petitioner challenges this determination and alleges that his wife owned a one-half interest in the manufacturing and farming business in question. Findings of Fact Petitioner and his wife, Esther Lena Croft, were married in 1915. During the taxable year they were living together as husband and wife in Kansas City, Missouri. Petitioner's income tax return for 1941 was filed with the collector of internal revenue for the sixth district of Missouri. Prior and subsequent to his marriage petitioner engaged in farming. He was one of 12 children who assisted their father in the operation of a large farm or ranch near Hastings, Nebraska. All of the children had the same bank account and each was entitled to write a check thereon. The wives of the boys who married, including petitioner's wife, had the same privilege of drawing on the joint account. When they were married petitioner84 and his wife agreed that they would be "partners all the way through". She worked as a farm hand and did everything on the farm that he did, operated the various farm machines, milked the cows, and fed the pigs. They resided with his parents for three years, and thereafter lived across the road in a house built on the farm. Five or six years after petitioner's marriage his father divided the farm among his children. Petitioner and his wife received 160 acres of land subject to their pro rata part of an existing mortgage. Petitioner and his wife jointly executed the note and the mortgage which secured the note. Payments on the note were made from their joint funds. Soon after the farm was divided petitioner, who had a patent on a few items, began selling them at a time when he and his wife were not harvesting or sowing grain. Petitioner's wife accompanied him most of the time except when the children had to be in school. At Jackson, Miss., petitioner was selling and his wife worked in an overall factory. At Mercedes, Texas, where petitioner was working on a contract, his wife worked for the telephone company. Their earnings were deposited in the same bank account. In 1932 petitioner85 moved to Kansas City where he engaged in selling trailer equipment. His wife bought out a rooming house, the lower part of which was occupied by the family, and the upstairs was rented. Petitioner's wife took a bookkeeping course in a Kansas City business school and late in 1932 she took over the book work of the business and has since continued to keep the books. The business office was maintained at the residence while the manufacture of trailers and trailer equipment was jobbed out. In 1937 or 1938 petitioner and his wife invested $1,500 of their joint funds in the business and began the manufacture of trailers and trailer equipment at the present location under the trade name of Croft Trailer Hitch Company. The office was then transferred from the residence to the plant where it has since remained. When petitioner was out of the city his wife operated the entire business. When petitioner was home he managed the factory, which employed five men, and she looked after the office. She also sold and rented trailers to customers. He depended upon her for all information pertaining to collections, sales, credits and the operation of the office. Petitioner and his wife exercised equal86 authority and devoted their entire time to the manufacturing business. Neither of them drew a salary but each withdrew funds, as needed, from the bank account maintained in petitioner's name. The wife never had a separate bank account; she drew checks against the account by signing "Mrs. George A. Croft" under his name. Neither petitioner nor his wife were under social security. In 1939 petitioner and his wife opened branch offices of the Croft Trailer Hitch Company in Denver, Colorado, and Boise, Idaho. Each branch office was opened with a $1,000 investment consisting mainly of equipment from the Kansas City factory. The manager of each branch office was given 50 percent of his profits after operating expenses. At some time, undisclosed by the record, the 160 acre farm near Hastings, Nebraska, was taken over by the U.S. Navy. Petitioner and his wife bought another farm of almost a halfsection nearby, which they sow in wheat or small grain in the fall and harvest in the summer. One man from the shop is taken up to Nebraska to work on the farm. The income from the Croft Trailer Hitch Company was never divided by petitioner and his wife. All returns were prepared by an accountant. 87 Petitioner's individual income tax return for 1939 showed a net loss of $3,495.98 from the business and for 1940 a net taxable income from the business of $8,510.17. The accountant prepared an individual return for the business for 1941 which was not filed. A partnership return was prepared and filed for 1941 which showed a net taxable income from the business of $19,668.43. Petitioner's wife filed her first income tax return in 1941 and reported thereon one-half of the partnership income. The deficiency notice herein was mailed on or about January 26, 1943. Subsequent thereto a friendly suit was instituted in the state courts wherein it was adjudged that petitioner and his wife were partners. The judgment of court was entered June 22, 1943. Thereafter, and on June 30, 1943, petitioner filed an amended petition with this Court setting up the decree of the state court. Petitioner and his wife were equal partners in the Croft Trailer Hitch Company and in their farming operations. Opinion Respondent concedes that the laws of Missouri recognize a business partnership between husband and wife, but he denies that the evidence herein proves the existence of a partnership. He contends88 that petitioner and his wife considered themselves partners because of the obligations under their marital vows and not because of any specific agreement to be partners in business enterprises. We have found as a fact that petitioner and his wife were partners. Our finding is based upon the oral agreement of the parties at the time of their marriage that they "would be partners all the way through", and upon their subsequent acts and conduct. While the husband and wife testified to the conclusion that a partnership existed rather than to the substance and terms of a partnership agreement, we are of the opinion, considering the manner in which the business was conducted, the conduct of the parties and all facts and circumstances, the record supports their testimony that they agreed to be and were partners in a business as well as marital sense. The history of their joint efforts from 1915 through the taxable year squares with the partnership concept. They worked together doing manual labor on the farm and pooled their resources. While petitioner was on the road selling, the wife was gainfully employed and cared for the children. As soon as petitioner established a place of business, 89 she took a business course and managed the office and kept the books. When their business required or permitted them to manufacture the trailers and trailer parts, her money and his provided the necessary capital. Thereafter she gave her time and attention to the business and risked her capital in the enterprise to the same extent that petitioner did. We are satisfied that petitioner and his wife joined together to carry on a trade or adventure for their common benefit, that each contributed property and services, and that they had a community of interest in the profits. . The several points urged by respondent to be fatal to the existence of the partnership have been considered and held indecisive in ; ; ; and cases cited therein. , on appeal CCA-6, , on appeal CCA-6; ,90 on appeal CCA-3; , on appeal CCA-3; , and other cases cited by respondent, are in our opinion distinguishable. No useful purpose would be served by reviewing these authorities in view of our finding on the present facts that a partnership existed between petitioner and his wife during the taxable year. In so deciding the judgment of the state court has been considered as a factor to be weighed along with the other facts, but such adjudication was not deemed to be conclusive. , on appeal CCA-8, and cases there cited. Decision will be entered for the petitioner.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4537564/	Nebraska Supreme Court Online Library www.nebraska.gov/apps-courts-epub/ 05/29/2020 08:07 AM CDT - 680 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 State of Nebraska, appellee, v. David E. Degarmo, appellant. ___ N.W.2d ___ Filed May 1, 2020. No. S-19-015. 1. Constitutional Law: Search and Seizure: Motions to Suppress: Appeal and Error. In reviewing a trial court’s ruling on a motion to suppress based on a claimed violation of the Fourth Amendment, an appellate court applies a two-part standard of review. Regarding histori- cal facts, an appellate court reviews the trial court’s findings for clear error, but whether those facts trigger or violate Fourth Amendment protections is a question of law that an appellate court reviews indepen- dently of the trial court’s determination. 2. Constitutional Law: Search and Seizure: Appeal and Error. When reviewing whether a consent to search was voluntary, as to the histori- cal facts or circumstances leading up to a consent to search, an appel- late court reviews the trial court’s findings for clear error. However, whether those facts or circumstances constituted a voluntary consent to search, satisfying the Fourth Amendment, is a question of law, which an appellate court reviews independently of the trial court. And where the facts are largely undisputed, the ultimate question is an issue of law. 3. Constitutional Law: Search and Seizure: Blood, Breath, and Urine Tests. The Fourth Amendment prohibits unreasonable searches and seizures, and it is well-established that the taking of a blood, breath, or urine sample is a search. 4. Search and Seizure: Warrantless Searches. Searches without a valid warrant are per se unreasonable, subject only to a few specifically estab- lished and well-delineated exceptions. 5. Warrantless Searches. The warrantless search exceptions Nebraska has recognized include: (1) searches undertaken with consent, (2) searches under exigent circumstances, (3) inventory searches, (4) searches of evidence in plain view, and (5) searches incident to a valid arrest. - 681 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 6. Constitutional Law: Search and Seizure: Duress. Generally, to be effective under the Fourth Amendment, consent to a search must be a free and unconstrained choice, and not the product of a will overborne. 7. Warrantless Searches: Duress. Consent for a warrantless search must be given voluntarily and not as a result of duress or coercion, whether express, implied, physical, or psychological. 8. Constitutional Law: Search and Seizure. The determination of whether the facts and circumstances constitute a voluntary consent to a search, satisfying the Fourth Amendment, is a question of law. 9. Search and Seizure. Whether consent to a search was voluntary is to be determined from the totality of the circumstances surrounding the giving of consent. 10. Police Officers and Sheriffs: Warrantless Searches. While there is no requirement that police must always inform citizens of their right to refuse when seeking permission to conduct a warrantless consent search, knowledge of the right to refuse is a factor to be considered in the vol- untariness analysis. 11. Police Officers and Sheriffs: Search Warrants. A statement of a law enforcement agent that, absent a consent to search, a warrant can be obtained does not constitute coercion. Appeal from the District Court for Lancaster County, Andrew R. Jacobsen, Judge, on appeal thereto from the County Court for Lancaster County, Thomas E. Zimmerman, Judge. Judgment of District Court affirmed. Mark E. Rappl for appellant. Douglas J. Peterson, Attorney General, Nathan A. Liss, and Mariah J. Nickel for appellee. Heavican, C.J., Miller-Lerman, Cassel, Stacy, Funke, Papik, and Freudenberg, JJ. Stacy, J. David E. Degarmo was convicted of driving under the influ- ence based largely on the testimony of a certified drug recogni- tion expert who concluded Degarmo was under the influence of marijuana. A subsequent chemical test of Degarmo’s urine confirmed the presence of marijuana. Degarmo challenges the admission at trial of the results of the warrantless urine test, - 682 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 relying on the U.S. Supreme Court’s opinion in Birchfield v. North Dakota. 1 Because we conclude Degarmo consented to the urine test and the results were thus admissible, we do not address the Birchfield issue. I. FACTS 1. Traffic Stop On the morning of December 26, 2016, Degarmo was driv- ing on a highway in Lancaster County, Nebraska, when he was stopped by Lancaster County Deputy Sheriff Jeremy Schwarz for an expired registration. Degarmo was the only occupant of the vehicle. Schwarz noticed the odor of burnt marijuana com- ing from inside Degarmo’s vehicle, and he asked Degarmo to accompany him back to his cruiser. Schwarz patted Degarmo down before placing him in the cruiser and found a baggie containing a small amount of mari- juana in Degarmo’s front pocket. While seated inside the cruiser with Degarmo, Schwarz again smelled marijuana and noticed Degarmo had slow speech and bloodshot eyes. Degarmo admit- ted that, within the prior 20 minutes, he had smoked a “pinch” of marijuana in his vehicle before he began driving. Schwarz subsequently searched Degarmo’s vehicle and found a mari- juana pipe in the center console. The pipe contained both burnt and unburnt marijuana. Schwarz noticed Degarmo had a dis- tinct green hue on his tongue with heat-raised taste buds, which Schwarz testified are indicators of recent marijuana inhalation. Schwarz also observed Degarmo to be relaxed and calm and to have fluttering eyelids, and he testified those were also signs of marijuana ingestion. 2. Field Sobriety Tests Based on his observations, Schwarz decided to administer field sobriety tests. He conducted a horizontal gaze nystagmus test, a vertical gaze nystagmus test, an eye convergence test, 1 Birchfield v. North Dakota, ___ U.S. ___, 136 S. Ct. 2160, 195 L. Ed. 2d 560 (2016). - 683 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 a “modified Romberg test,” a walk-and-turn test, and a one- legged stand test. Degarmo did not show any signs of impair- ment on the nystagmus tests, but Schwarz testified that is not unusual when the suspected impairment is due to marijuana. Degarmo showed signs of impairment on all of the remain- ing tests. After conducting the field sobriety tests, Schwarz had Degarmo return to the cruiser and took his pulse, which mea- sured at 140 beats per minute. Schwarz testified an average normal pulse is 60 to 90 beats per minute. Schwarz arrested Degarmo for driving under the influence and took him to a detoxification center in Lincoln, Nebraska, for a drug recog- nition evaluation (DRE). A DRE is a nationally standardized protocol for identifying drug intoxication. 2 3. Drug Recognition Evaluation Schwarz, who is a certified DRE expert, conducted the DRE. It was performed in a testing room with only Schwarz and Degarmo present. Most of the DRE was video recorded, and Degarmo waived his Miranda rights prior to the examination. (a) Breath Test At the beginning of the DRE, Schwarz requested a breath sample from Degarmo. In doing so, he read part A of a stan- dardized postarrest chemical test advisement to Degarmo. This form provided: You are under arrest for operating or being in actual physical control of a motor vehicle while under the influence of alcoholic liquor or drugs. Pursuant to law, I am requiring you to submit to a chemical test or tests of your breath or urine to determine the concentration of alcohol or drugs in your breath or urine. Refusal to submit to such test or tests is a separate crime for which you may be charged. 2 See State v. Daly, 278 Neb. 903, 775 N.W.2d 47 (2009). - 684 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 I have the authority to direct whether the test or tests shall be of your breath or urine and may direct that more than one test be given. A. Request for test: I hereby direct a test of your ü breath ___ urine to determine the ü alcohol ___ drug content. Schwarz checked the blank space in front of “breath” and “alcohol” on the advisement, and both Schwarz and Degarmo signed the advisement form at 11:08 a.m. Schwarz testified that when he went through the form, he explained to Degarmo that it pertained only to testing for alcohol ingestion. Degarmo’s breath test was completed at 11:27 a.m. and showed no alcohol in his system. (b) Opinion of Impairment After taking the breath test, Schwarz conducted the remain- der of the DRE according to the standardized protocol. 3 Schwarz testified, summarized, that Degarmo showed impair- ment consistent with use of marijuana on most of the DRE tests he administered. Schwarz further testified that the tests on which Degarmo showed no impairment were tests on which marijuana use would not be expected to result in impairment. Schwarz formed the opinion that Degarmo was under the influ- ence of marijuana and was unable to safely operate a motor vehicle. After forming this opinion, Schwarz asked Degarmo to consent to a urine test. (c) Urine Test In connection with requesting consent for a urine test, Schwarz read Degarmo another standardized form. This form was entitled “Consent to Search for Blood/Urine Alcohol or Drug Evidence,” and it provided: I, David E. Degarmo, located at 721 K St., Lancaster County, Nebraska, have been informed of my constitu- tional right not to have a search made of my blood or 3 See id. - 685 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 urine, which is under my control, without a search war- rant. I also have been informed of and understand my right to refuse to consent to such search. I understand that if I refuse to give consent to search my blood or urine, a search warrant for my blood or urine will be sought. With this understanding, I hereby authorize [Deputy] Schwarz, who had identified himself/herself as a law enforcement officer in the State of Nebraska, to conduct a search of my body for blood or urine for alcohol and/or drugs. I understand that such a search may include the drawing of my blood and/or the collection of my urine. I understand that this may be used as evidence against me in crimi- nal proceedings. I have read and/or have been read this form; I under- stand it; and I give the officer permission to search my blood or urine. This permission is being given voluntarily and without threats or promises of any kind. After this consent to search form was read to him, Degarmo signed and dated the form at 12:04 p.m., and he provided the requested urine sample. The signed consent to search form was received into evidence at trial without objection. Degarmo’s urine sample was sent to the Nebraska State Patrol Crime Laboratory for testing. The test results confirmed the presence of the metabolite for tetrahydrocannabinol (the active drug in marijuana) in Degarmo’s urine. 4. Motion to Suppress Degarmo was charged in the county court for Lancaster County with driving under the influence (one prior conviction), possession of 1 ounce or less of marijuana, and possession of drug paraphernalia. He moved to suppress the results of the urine test, arguing that he did not voluntarily consent to the test and that the urine sample was obtained without a warrant in violation of Birchfield, 4 his rights under the 4th and 14th Amendments to the U.S. Constitution, and article I, § 7, of the 4 See Birchfield, supra note 1. - 686 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 Nebraska Constitution. The county court denied the motion to suppress, reasoning in part that Degarmo “freely, voluntarily, knowingly and intelligently” gave consent for the urine test by signing the consent to search form. The matter proceeded to trial. 5. Trial During the jury trial, Schwarz generally testified to the events as set out above. He also testified that after conduct- ing all but the final step of the DRE (the urine test), it was his opinion that Degarmo was under the influence of marijuana and was not able to safely operate a motor vehicle. He testi- fied that he formed his opinion on the cause and extent of Degarmo’s impairment prior to conducting the urine test, and he described the urine test in this case as “confirmation” or “corroborat[ion]” of his opinion on Degarmo’s impairment. The toxicologist who tested Degarmo’s urine sample also testified at trial. She explained the urine testing process and testified that she performed the test in accordance with “Title 177.” Over Degarmo’s objection, the toxicologist testified that her testing showed the active drug metabolite for marijuana was present in Degarmo’s urine. Her report to that effect was received into evidence, also over Degarmo’s objection. The toxicologist admitted that it was not scientifically possible to determine impairment based only on the presence of drug metabolites in urine, and she explained that the purpose of urine testing was simply to “corroborate the drug recogni- tion evaluator’s opinion” as to the substance contributing to any impairment. Degarmo testified in his own defense. As relevant to the issues on appeal, he admitted that on the morning he was stopped by Schwarz, he had smoked a small amount of mari- juana inside his vehicle before driving. 6. Verdicts and Sentences The jury found Degarmo guilty on all three charges. On the conviction for driving under the influence, Degarmo was - 687 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 sentenced to 45 days in jail, fined $500, and his license was revoked for 18 months. On the conviction for possession of marijuana, Degarmo was fined $300. And on the convic- tion for possession of drug paraphernalia, Degarmo was fined $25. 7. Appeal to District Court Degarmo filed a timely appeal through new court-appointed counsel. He assigned error to the admission of the warrantless urine test result. The district court, sitting as an intermediate court of appeals, affirmed. 5 In doing so, it examined the total- ity of the circumstances and found that Degarmo voluntarily consented to the urine test. Degarmo appealed again, and we granted his petition to bypass the Court of Appeals. II. ASSIGNMENT OF ERROR Degarmo assigns that the district court erred in affirming the county court’s order overruling his motion to suppress the results of the urine test. III. STANDARD OF REVIEW [1] In reviewing a trial court’s ruling on a motion to sup- press based on a claimed violation of the Fourth Amendment, an appellate court applies a two-part standard of review. 6 Regarding historical facts, an appellate court reviews the trial court’s findings for clear error, but whether those facts trig- ger or violate Fourth Amendment protections is a question of law that an appellate court reviews independently of the trial court’s determination. 7 [2] Likewise, we apply the same two-part analysis when reviewing whether a consent to search was voluntary. 8 As to the historical facts or circumstances leading up to a consent 5 See State v. Hatfield, 304 Neb. 66, 933 N.W.2d 78 (2019). 6 State v. Brye, 304 Neb. 498, 935 N.W.2d 438 (2019). 7 Id. 8 State v. Schriner, 303 Neb. 476, 929 N.W.2d 514 (2019). - 688 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 to search, we review the trial court’s findings for clear error. 9 However, whether those facts or circumstances constituted a voluntary consent to search, satisfying the Fourth Amendment, is a question of law, which we review independently of the trial court. 10 And where the facts are largely undisputed, the ultimate question is an issue of law. 11 IV. ANALYSIS [3-5] The Fourth Amendment prohibits unreasonable searches and seizures, and it is well-established that the tak- ing of a blood, breath, or urine sample is a search. 12 Searches without a valid warrant are per se unreasonable, subject only to a few specifically established and well-delineated excep- tions. 13 The warrantless search exceptions Nebraska has rec- ognized include: (1) searches undertaken with consent, (2) searches under exigent circumstances, (3) inventory searches, (4) searches of evidence in plain view, and (5) searches inci- dent to a valid arrest. 14 Both the county court and the district court devoted consid- erable analysis to whether the search incident to arrest excep- tion can apply to a urine test after the U.S. Supreme Court’s decision in Birchfield. 15 This case does not require us to answer that question. As explained below, we conclude that Degarmo voluntarily consented to the search of his urine and that his motion to suppress was properly overruled. As such, we do not address the applicability of any other recognized exception to the warrant requirement. 9 Id. 10 Id. 11 Id. 12 See, Birchfield, supra note 1; Skinner v. Railway Labor Executives’ Assn., 489 U.S. 602, 109 S. Ct. 1402, 103 L. Ed. 2d 639 (1989); Schmerber v. California, 384 U.S. 757, 86 S. Ct. 1826, 16 L. Ed. 2d 908 (1966). 13 State v. Garcia, 302 Neb. 406, 923 N.W.2d 725 (2019). 14 Id. 15 See Birchfield, supra note 1. - 689 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 1. Legal Standard and Historical Facts As a threshold matter, we emphasize that our analysis in this case is focused exclusively on whether Degarmo volun- tarily gave consent for the search of his urine. 16 We thus do not address whether, in the wake of the U.S. Supreme Court’s holding in Birchfield, Degarmo can also be deemed to have impliedly consented to the urine test pursuant to Nebraska’s implied consent laws. 17 [6-9] Generally, to be effective under the Fourth Amendment, consent to a search must be a free and unconstrained choice, and not the product of a will overborne. 18 Consent must be given voluntarily and not as a result of duress or coercion, whether express, implied, physical, or psychological. 19 The determination of whether the facts and circumstances con- stitute a voluntary consent to a search, satisfying the Fourth Amendment, is a question of law. 20 Whether consent to a search was voluntary is to be determined from the totality of the circumstances surrounding the giving of consent. 21 Here, the county court made several findings of historical fact related to its determination that Degarmo voluntarily con- sented to the urine test. It found that Degarmo was in custody at the time, having been arrested on suspicion of driving under the influence of drugs and transported to a detoxification cen- ter for purposes of a DRE. It found that as part of the DRE, Schwarz read Degarmo part A of the postarrest chemical test 16 See State v. Hoerle, 297 Neb. 840, 901 N.W.2d 327 (2017) (concluding Birchfield did not categorically invalidate warrantless blood draw based on actual consent when driver was incorrectly advised he was required to consent or face criminal penalties and finding totality of circumstances test proper). 17 See Neb. Rev. Stat. § 60-6,197(1) and (3) (Cum. Supp. 2018). 18 Schriner, supra note 8. 19 Id. 20 Id. 21 Id. See, also, Hoerle, supra note 16. - 690 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 advisement form and directed a test of his breath, and that Degarmo signed part A of that form at 11:08 a.m. It found that about an hour later, Schwarz read Degarmo the consent to search form asking for permission to search his urine, and that Degarmo signed that form at 12:04 p.m. It noted Degarmo’s testimony that he signed the forms because he understood that he was going to be “guilty no matter what.” It also noted Degarmo’s testimony that he felt “belittled” during the entire course of the DRE. Degarmo does not challenge any of these findings of histori- cal fact, and we agree they are supported by the record and not clearly erroneous. After considering the totality of the circum- stances, both the county court and the district court concluded that Degarmo voluntarily consented to the search of his urine. Because this determination presents a question of law, we con- sider it independently. 22 2. Totality of Circumstances As stated, whether consent to a warrantless search was voluntary is to be determined from the totality of the cir- cumstances surrounding the giving of consent. On appeal, Degarmo advances two reasons why his written consent to the urine test was not voluntary. First, he argues his consent was “coerced out of him by a claim of lawful authority.” 23 Next, he argues his consent was not voluntary because he was “in a police-dominated atmosphere.” 24 We address each argument in turn. In arguing that his consent was coerced by a claim of law- ful authority, Degarmo claims that after he read and signed the postarrest chemical test advisement form (which directed him to submit to a breath test), he was left with the “‘impression’” that if he did not also sign the consent to search form and agree to a search of his urine, that he “‘was going to be guilty no 22 Schriner, supra note 8. 23 Brief for appellant at 20. 24 Id. - 691 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 matter what.’” 25 We find this argument unavailing in light of the plain language of the consent to search form. [10] The consent to search form expressly advised Degarmo that he had a constitutional right not to have a search made of his blood or urine without a search warrant, and the form unequivocally stated that Degarmo had a right to refuse to consent to such a search. While there is no requirement that police must always inform citizens of their right to refuse when seeking permission to conduct a warrantless consent search, knowledge of the right to refuse is a factor to be considered in the voluntariness analysis. 26 Here, the fact that Degarmo was told he had a constitutional right to refuse a warrantless search of his urine is a factor that weighs heavily in favor of finding his consent to such a search was voluntary. [11] The consent to search form also told Degarmo that if he refused to give consent to search his blood or urine, then offi- cers would seek a search warrant. In his reply brief, Degarmo suggests that the threat of being “detained even further for the possible issuance of a search warrant” 27 was itself coercive, but we disagree. As we explained in State v. Tucker, 28 “A statement of a law enforcement agent that, absent a consent to search, a warrant can be obtained does not constitute coercion.” Having considered the language of the postarrest chemical test advisement form in conjunction with the plain language of the consent to search form, we reject Degarmo’s suggestion that an objectively reasonable person would be left with the impression he or she had to consent. Nor are we persuaded by Degarmo’s claim that his con- sent was coerced simply by being “in a police-dominated atmosphere.” 29 Degarmo suggests his consent to the urine 25 Id. 26 See United States v. Drayton, 536 U.S. 194, 122 S. Ct. 2105, 153 L. Ed. 2d 242 (2002). 27 Reply brief for appellant at 3. 28 State v. Tucker, 262 Neb. 940, 948, 636 N.W.2d 853, 860 (2001). 29 Brief for appellant at 20. - 692 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. DEGARMO Cite as 305 Neb. 680 search was not voluntary because he “had been arrested, placed in handcuffs, put into a police cruiser, driven to detox, [and] subjected to various tests.” 30 All these are factors to consider in a totality of the circumstances analysis, but having done so, we do not agree with Degarmo that any of these factors vitiate the voluntariness of his written consent. The U.S. Supreme Court has held the “fact of custody alone has never been enough in itself to demonstrate a coerced con- fession or consent to search.” 31 And this court has similarly recognized that “[t]he mere fact that the individual is in police custody, standing alone, does not invalidate the consent if, in fact, it was voluntarily given.” 32 Here, the record shows Degarmo’s arrest and transport to a detox center were part of a routine DRE investigation, which was video recorded. There is no evidence that police conducted either the arrest or the DRE in a threatening or coercive manner. 33 Having considered the totality of the circumstances, we determine Degarmo’s written consent to the warrantless search of his urine was voluntary and not coerced. The motion to sup- press was properly denied by the county court, and that denial was properly affirmed by the district court. V. CONCLUSION Because Degarmo voluntarily consented to the warrantless search of his urine, the search fell within a recognized excep- tion to the warrant requirement. Finding no error in the district court’s decision to affirm the county court’s overruling of Degarmo’s motion to suppress, we affirm. Affirmed. 30 Brief for appellant at 20-21. 31 United States v. Watson, 423 U.S. 411, 424, 96 S. Ct. 820, 46 L. Ed. 2d 598 (1976). 32 State v. Christianson, 217 Neb. 445, 449, 348 N.W.2d 895, 898 (1984). 33 See Schriner, supra note 8 (finding consent for warrantless search was voluntary when there was no evidence of police pressure and police body camera recorded interaction).	01-04-2023	05-29-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622007/	ISRAEL OLEET, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Oleet v. CommissionerDocket No. 9622.United States Board of Tax Appeals8 B.T.A. 826; 1927 BTA LEXIS 2797; October 15, 1927, Promulgated 2797 Certain promissory notes received in payment of goods sold were debts ascertained to be worthless and charged off within the taxable year. Lawrence Koenigsberger, Esq., for the petitioner. R. A. Littleton, Esq., for the respondent. LANSDON 826 This proceeding is for the redetermination of a deficiency asserted by the respondent for the year 1921, of $1,276.83, resulting from the disallowance by the respondent of certain deductions from gross income taken by the petitioner in his income-tax return for that year, and claimed to be bad debts ascertained to be worthless and charged off within said year. The deductions so taken by the petitioner in his 1921 return amounted to $10,796.01. The petitioner conceded that $1,164.98 of this amount was properly disallowed, leaving as the amount of deductions in controversy in this proceeding, the sum of $9,631.03. FINDINGS OF FACT. The petitioner is a diamond merchant, having his place of business at 87 Nassau Street, New York City. His sole business for some 20 years has consisted in the purchase and sale of diamonds and other precious stones. His sales are made either by himself, personally, 2798 or through agents or brokers. The sales are made sometimes for cash, but usually on time, the petitioner receiving the purchaser's promissory notes due from four to seven months after date. A separate promissory note is given for each payment. The agent or broker received one per cent commission on all goods sold by him, and was permitted to represent himself to the prospective purchasers as owner of the goods he was handling for the petitioner. When the agent, or broker, ascertained that he had a prospective customer, he secured possession of the stones from the petitioner for a short period in order to effectuate the sale. He then went to the customer, exhibited the goods, and, if a sale was effected, received from him cash or a promissory note or notes, or both, in the full amount of the sales price. Title to the property so sold passed to the purchaser on execution and delivery of his notes to the agent or broker. The broker was permitted by the petitioner to have, and did have, the notes executed in his own favor and an unwritten 827 agreement existed between the petitioner and broker that the latter was not liable on said notes after having endorsed and delivered2799 them to the petitioner. The broker's commission of one per cent was paid by the petitioner coincidently with the delivery to him of the cash or with endorsement and delivery to him by the broker of the promissory notes involved in the sale. Upon delivery of the cash, or upon endorsement and delivery of the notes, by the broker to the petitioner, the broker's financial responsibility in the transaction terminated as between himself and the petitioner. The majority of the notes taken in payment for the goods sold were discounted by the petitioner at banks in the city of New York. Others were placed in banks in said city for collection. On failure of the makers of the notes to pay at the maturity thereof, said notes were protested and returned to the petitioner, the latter making payment to the bank in those cases where the notes had already been discounted by him. Time payment sales made to purchasers residing in the City of New York, whether made through agents or otherwise, were not consummated until approved by the petitioner; but for such sales as were made by agents to purchasers beyond the city limits, the petitioner accepted the word of said agents that the purchasers2800 were financially responsible. The petitioner had no bookkeeper, but kept a record of notes received by him in two notes receivable books. All deposits were entered by the petitioner in the deposit side of his check books. The total of the notes received by the petitioner in a given year, as recorded in the notes receivable books, plus the cash sales for the same year, as recorded in the check books, represented the petitioner's gross sales for that year and was so reported by him in his return for said year. All of the sales giving rise to the items here involved were made in the years 1920 and 1921 and, in each instance, the entire sales price received by the petitioner in the form of cash and/or promissory notes was reported by him as gross income in the year of sale. At the close of and within the year 1921, the petitioner charged off as bad debts certain accounts due him on promissory notes received from vendees to whom he himself had made sales; and also certain amounts due him on promissory notes executed by other vendees in favor of petitioner's agent or broker, and endorsed and delivered by said agent or broker to him under the arrangement above set forth. Of the notes2801 here in controversy, the original amounts charged on, the payments received thereon, and the amounts charged off in 1921 as bad debts were as follows: DebtorAmount of debtAmount receivedAmount charged offFor sales made by petitioner himself:George Crystal$4,062.50$812.50$3,250.00Davidson Diamond Jewelry Co3,557.351,778.682,134.39Harry Elkin400.00400.00Frank Cohen230.00230.008,249.852,591.186,014.39For sales made through an agent:R. Steiner1,697.931,697.93Liberty Loan Shop650.00650.00West Side Diamond Shop454.00454.00Louis A. Cohen534.71534.71Joseph Weiss540.00260.00280.003,876.64260.003,616.64828 George Crystal, the Davidson Diamond Jewelry Co., the Liberty Loan Shop, and the West Side Diamond Shop, each went into voluntary or involuntary bankruptcy during the year 1921. George Crystal paid 20 per cent and the Davidson Diamond Jewelry Co. 50 per cent to their creditors on composition agreements confirmed in 1921 by the court having jurisdiction of the bankruptcy proceedings. The Liberty Loan Shop and the West Side Diamond Shop paid nothing to their creditors, 2802 all of their known assets being used in defraying the expenses of the bankruptcy proceedings; the petitioner was apprised of their financial conditions prior to the charge-off in 1921. The remaining five debtors removed from their respective places of business within the year 1921, without notifying the petitioner thereof, and diligent search before the close of the year 1921, failed to disclose their whereabouts; none of them left any property from which recovery could be made, and no payment has since been received from any of them. The following debts were ascertained by the petitioner to be worthless and were charged off by him within the year 1921: George Crystal, $3,250; Davidson Diamond Jewelry Co., $1,778.67; Harry Elkin, $400; Frank Cohen, $230; and R. Steiner, $1,697.93; Liberty Loan Shop, $650; West Side Diamond Shop, $454; Louis A. Cohen, $534.71; and Joseph Weiss, $280; making a total of $9,275.31. OPINION. LANSDON: At the close of the year 1921, petitioner charged off $10,796.01 as bad debts ascertained to be worthless and deducted said amount from the gross income reported by him for that year. According to the deficiency notice, the respondent disallowed2803 said deduction for lack of evidence as to whether certain items included therein had been reported as income during the current year or some 829 prior year, and on account of insufficient evidence as to whether the remaining items were, in fact, ascertained to be worthless and charged off during the taxable year 1921. The petitioner conceded that $1,164.98 of the deductions so taken was erroneous, leaving the sum of $9,631.03 as the amount involved in this proceeding. As indicated by our findings of fact, the petitioner deducted $2,134.39 as representing a worthless account resulting from the bankruptcy of the Davidson Diamond Jewelry Co. The court order confirming the composition offered by the bankrupt to its creditors discloses that the petitioner received in 1921, 50 per cent of the debt. We are therefore of the opinion that in 1921 the petitioner actually ascertained that only the remaining 50 per cent (or $1,778.67) of the Davidson Diamond Jewelry Co. account was worthless. The petitioner's bad debt claim with respect to the Davidson Diamond Jewelry Co. account is therefore allowed to the extent of $1,778.67 and disallowed as to the remainder, or $355.72. The2804 debts owing to the petitioner from R. Steiner, Liberty Loan Shop, West Side Diamond Shop, Louis A. Cohen, and Joseph Weiss, resulted from sales negotiated by an agent or broker (Toepfer). Inasmuch as the promissory notes of these debtors held by the petitioner had been made payable to the agent or broker and endorsed by him, on delivery thereof, to the petitioner, it seems advisable to determine whether the petitioner held a legal claim against said agent as endorser. There was an unwritten agreement between the petitioner and said agent that the latter would not be liable on these notes after having endorsed and delivered them to the former. The true intention of endorsers to a negotiable instrument, as between themselves, can always be shown by oral evidence. ; ; . On the facts disclosed by this proceeding it is clear that the petitioner held no legal claim against his agent on presentation of the promissory notes to their makers for payment and default in payment. We are of the opinion that the petitioner*2805 has established that debts in the amount of $9,275.31 were ascertained by him to be worthless and charged off at the end of the taxable year 1921 and, as such, are allowable deductions from gross income for that year. Judgment will be entered on 15 days' notice, under Rule 50.Considered by GREEN and ARUNDELL.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622010/	John D. Robertson and Ethel G. Robertson v. Commissioner.Robertson v. CommissionerDocket No. 51911.United States Tax CourtT.C. Memo 1955-282; 1955 Tax Ct. Memo LEXIS 56; 14 T.C.M. (CCH) 1097; T.C.M. (RIA) 55282; October 20, 195556 The petitioner, John D. Robertson, was furnished food and housing by his employer, a California state hospital. Although these items were furnished as convenience to the employer, they were also furnished and received by petitioner as part of his compensation. Held, that the value of the food and housing, being part of compensation, constituted part of gross income regardless of the fact that the items were furnished for the convenience of the employer. Charles A. Brasher, 22 T.C. 637">22 T.C. 637 followed. Rodney H. Robertson, Esq., Russ Building, San Francisco, Calif., for the petitioners. Ralph H. Tracy, Esq., for the respondent. HARRON Memorandum Findings of Fact and Opinion The Commissioner determined deficiencies in income tax for the years 1950-1952, inclusive, as follows: YearDeficiency1950$233.821951247.521952178.22The question to be decided is whether the value of food and lodging furnished by the employer to the petitioner, John D. Robertson, is includable in gross income under section 22(a) of the 1939 Code. The petitioners contend that no deficiencies are due, and, in addition, that because of an error, the tax for 1952 has been overpaid. All of the facts have been stipulated. Findings of Fact The stipulated facts are found, and the stipulation is incorporated herein by this reference. The question to be decided relates only to the petitioner, John D. Robertson, and he is referred to hereinafter as the petitioner. Joint returns for the taxable years were filed by the petitioners with the collector for the first58 district of California. Agnews State Hospital, located at Agnew, California, is an institution operated by the State of California. Walter Rapaport, M.D., was the superintendent and medical director during the taxable years. The petitioner was the duly appointed business manager of the hospital during the taxable years. He was required by the superintendent of the hospital, pursuant to regulations of the Department of Mental Hygiene, to live upon the grounds of the hospital, and he was subject to call and required to be available for duty at all times, i.e., 24 hours a day, unless he was absent by official approval. Among his duties, he was responsible for the maintenance and preservation of the hospital plant and equipment, for the safety of the patients, and for fire and police protection. He had other emergency duties. During each of the taxable years the petitioner lived on the hospital grounds in housing provided by the hospital, and, in addition, he received laundry service and commissary withdrawals. The gross salary of the petitioner in each of the taxable years was as follows: YearGross Salary1950$7,728.0019518,256.2519528,881.27The59 petitioner's employer, i.e., the State of California, deducted from his gross salary for each year for rent, commissary withdrawals, and laundry service, the amounts set forth below, and petitioner received the net amounts of cash set forth below: Deductions forRent, Commissary,Net Amount ofYearand LaundrySalary Received1950$1,297.75$6,430.2519511,227.767,028.491952804.968,076.31In the payroll records of petitioner's employer, petitioner's gross salary was stated in the amounts set forth above, and withholding of Federal income tax was based upon those gross amounts. Section 18539 of the Government Code of California provides as follows amount of money or credit received as compensation for service rendered exclusive of mileage, traveling allowances, and other sums received for actual and necessary expenses incurred in the performance of the State's business, but including the reasonable value of board, rent, housing, lodging, or similar advantages received from the State. [Added by Stats. 1945, ch. 123, § 1, p. 540. Based on Stats. 1937, ch. 753, § 21, p. 2087.]" In each income tax return, the petitioner reported the net60 amount of his salary. Each return disclosed the amount which petitioner's employer had withheld from gross salary during the year for rent, commissary withdrawals, and laundry service. The commissioner determined that petitioner's compensation for services each year was the gross amount of his salary. Opinion HARRON, Judge: The petitioner contends that the amount withheld each year from his gross salary by his employer for rent, commissary withdrawals, and laundry service is excludable from his gross income for each year under the "convenience of the employer" doctrine which was enunciated in Jones v. United States, 60 Ct. Cl. 552">60 Ct. Cl. 552. Petitioner relies entirely upon Diamond v. Sturr, (C.A. 2, decided March 28, 1955) 221 Fed. (2d) 264. The respondent takes the position that the amount which was deducted each year from petitioner's gross salary for rent, commissary withdrawals, and laundry service is includible in petitioner's gross income under section 22(a) of the 1939 Code because under the applicable state statute and state regulations the value of such maintenance was considered by petitioner's employer as part of the compensation for his services. That61 is to say, the respondent contends that in this case it is evident that the living quarters and other items were furnished as compensation for services rendered. The respondent relies upon his ruling in Mimeograph 6472, C.B. 1950-1, p. 15, the pertinent part of which is quoted in the margin. 1 The respondent also relies upon Joseph L. Doran, 21 T.C. 374">21 T.C. 374, and Charles A. Brasher, 22 T.C. 637">22 T.C. 637. 62 The evidence in this case is quite limited. It consists of a brief stipulation of facts, and we do not have the testimony of petitioner or of anyone representing his employer about petitioner's contract of employment, about the circumstances under which he worked and received lodging, commissary withdrawals, and laundry service, or about petitioner's living arrangements, in general. The evidence establishes that the value of the maintenance items in question was accounted for and regarded by the State of California as part of the compensation for petitioner's services. The petitioner's employer charged him for these benefits, withdrawing the value thereof from his gross salary. The provisions of section 22(a) are very broad, including in the definition of gross income "income derived from salaries, wages, or compensation for personal service * * , of whatever kind and in whatever form paid, * " The Commissioner's determination places upon the petitioner the burden of proving that the amounts in dispute did not constitute part of his compensation for personal services. We said in Arthur Benaglia, 36 B.T.A. 838">36 B.T.A. 838, 840, " * * If the Commissioner finds that it [the63 value of food and lodging] was received as compensation and holds it to be taxable income, the taxpayer contesting this before the Board must prove by evidence that it is not income." Upon consideration of all of the evidence before us, we must conclude that petitioner has failed in meeting his burden of proving that the amounts in dispute were not part of his compensation. Cf. Saunders v. Commissioner, 215 Fed. (2d) 768, reversing 21 T.C. 630">21 T.C. 630, where the Court pointed out that a rations allowance was not regarded or accounted for as compensation by the taxpayer's employer. Lacking any other specific evidence about the terms of petitioner's contract of employment with the Agnews State Hospital, or the State of California, we are obliged to consider the provisions of section 18539 of the Government Code of California, as well as the State's accounting with respect to petitioner's gross salary, as clear evidence that petitioner's compensation for his services included the value of the lodging and other items which were provided and for which the petitioner was charged through deductions from his gross salary. In Joseph L. Doran, supra, and64 Charles A. Brasher, supra, this Court expressed the view that it does not necessarily follow from the fact that the taxpayer lives at the place of his employment for his employer's convenience that the value of the living quarters and like benefits is not compensation. We adhere to that view here in view of the state of the evidence in this case. Careful consideration has been given to Diamond v. Sturr, supra. The facts of the Diamond case serve to distinguish it from this proceeding, in our opinion, but if it is indistinguishable, then we respectfully decline to apply the reasoning of the court here. Decision will be entered for the respondent. Footnotes1. Mimeograph 6472. 2. * * * The "convenience of the employer" rule is simply an administrative test to be applied only in cases in which the compensatory character of such benefits is not otherwise determinable. It follows that the rule should not be applied in any case in which it is evident from the other circumstances involved that the receipt of quarters or meals by the employee represents compensation for services rendered. This position is in accord with I.T. 2692 (C.B. XII-1, 28 (1933)) and the decision of the United States Board of Tax Appeals (now The Tax Court of the United States) in Herman Martin v. Commissioner (44 B.T.A. 185">44 B.T.A. 185). 3. For example, a State civil service employee is employed at an institution in which the conditions of employment require him to live at the institution and be available for duty at any time. In connection with his employment, he is furnished living quarters and meals. Under the applicable State statute, the civil service rules and regulations of the State, or the individual contract of employment, the value of the living quarters and meals is considered as part of the employee's compensation. Regardless of whether living quarters and meals are furnished in addition to the cash salary, or the value thereof is deducted from the total salary, established for the particular position, it is evident that the living quarters and meals are furnished as compensation for services rendered. Consequently, the value of the living quarters and meals is includible in his gross income and is subject to withholding of income tax at the source by the employer, notwithstanding the fact that the employee is required to live at the institution and be available for duty at any time.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622011/	MUTUAL CHEMICAL COMPANY OF AMERICA, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Mutual Chem. Co. v. CommissionerDocket No. 10083.United States Board of Tax Appeals12 B.T.A. 578; 1928 BTA LEXIS 3512; June 13, 1928, Promulgated 3512 1. That portion of petitioner's inventory of raw materials on hand at December 31, 1918, required to fill firm sales contracts for finished goods on that date must be priced at cost in determining net income for that period. 2. Petitioner is entitled to have its taxes computed under the provisions of sections 210 and 328 of the Revenue Acts of 1917 and 1918, respectively. Charles H. Cowenhoven, Esq., for the petitioner. Alva C. Baird, Esq., for the respondent. MORRIS 578 This is a proceeding for the redetermination of deficiencies in income and profits taxes of $13,189.29 and $423,083.78 for the taxable years 1917 and 1918, respectively. The errors alleged to have been committed by the respondent are: 1. That he reduced invested capital for the years 1917 and 1918 on account of income and profits taxes for the years immediately preceding; 2. His failure to allow as a deduction in the year 1918 an inventory adjustment of $406,838.32 on the ground that the inventory was held by the petitioner for delivery under firm sale contracts; and 3. His failure to grant the petitioner relief for the year 1917 under the provisions of section3513 210 of the Revenue Act of 1917 and for 1918 579 under the provisions of sections 327 and 328 of the Revenue Act of 1918. FINDINGS OF FACT. The petitioner is a corporation organized and incorporated under the laws of the State of New Jersey in 1908 to engage in the manufacture of chemicals. Upon incorporation the petitioner acquired the assets of three other chemical manufacturers, consisting of tangible and intangible property, in consideration of the entire issue of its capital stock of $4,000,000. No recent appraisals had been made of all those assets. The company's officers, in recording the values in the books of account, arbitrarily allocated $1,450,000 to the tangible assets and $2,550,000 to the intangible assets. The intangible assets consisted of brands, patents, good will, and processes of manufacture. While the processes of manufacture are not of a secret nature, continuous improvements, which are carefully guarded, have been made therein from time to time by chemists. The three companies comprising the original consolidation were the Henry Bauer Chemical Manufacturing Co., which had been in existence since 1847 and had enjoyed a rather large business, 3514 the Mutual Chemical Co., which had been in business since about 1895, and the American Chrome Co., which had been in business since about 1898. The records of some of these companies have been lost or destroyed. At the time of the reorganization in 1908 petitioner acquired a mixed aggregate of tangible and intangible assets the respective values of which can not be determined. The value of good will of the petitioner has been augmented in a measure by the manner in which its customers have been treated and the quality of chemicals produced and sold. Petitioner has always made deliveries contracted for even when the market has adversely affected it and when the customer is adversely affected by changes in market prices it has modified its contract prices accordingly. During the World War the price of bichromates was as high as 65 and 70 cents on bichromate of soda. The petitioner had sales contracts at that time at 7 1/s cents, and, notwithstanding this great disparity in price, deliveries were made according to contract. The respondent's final determination resulted in the following: 19171918Net income$5,605,842.77$2,857,263.62Statutory invested capital3,449,971.434,966,031.79Profits taxes2,948,909.101,788,001.18Ratio of profits tax to net income52%62%Ratio of net income to invested capital162%57%Value of good will (per books)$1,995,664.50$1,995,664.50Good will included in above invested capital by respondent666,840.00833,550.00Part of good will excluded1,328,824.501,162,114.503515 580 Petitioner's competitors are the Natural Products Refining Co. and the Martin Dennis Co. The petitioner purchases chrome ore and manufactures therefrom bichromate of soda and bichromate of potash and sells the finished products to its customers under contracts and on spot sales. Contracts are first arranged between the petitioner and its customers and then the chemicals are manufactured to fill them. Although these chemicals were sold under contracts arranged prior to manufacture thereof, there was no attempt made to allocate the chrome ore to particular contracts nor were the chemicals, as finally produced therefrom, allocated to any particular sales contracts. In fact it was not necessary for the petitioner to allocate any of its raw materials for completion of finished products under any particular sales contract, because the products are standard and the business is a continuous process in which the ore is worked through to the finished product and then packed in casks for shipment. The petitioner purchased its chrome ore sufficiently in advance so that it customarily had on hand about one year's supply. As the ore was received in ships it was dumped in3516 the petitioner's yards in piles, from where it was removed as needed for the manufacture of chemicals. Since the shipment arriving last was usually dumped on the top of the piles the last shipment was frequently placed in process of manufacture first. The sales contracts of 1918 were not carried out according to their original terms in that the petitioner granted reductions of about 7 cents a pound in the sales prices due to a decline in the market price of the finished product and a desire to maintain the good will of its customers and to protect them against these declines. The respondent found that the petitioner had about fourteen million pounds of finished product under contract on December 31, 1918. The inventory as of December 31, 1918, of raw materials, goods in process, finished goods, and supplies, on the basis of cost, as computed by the petitioner and respondent was $1,593,771.92 and $1,612,191.91, respectively. These figures were determined as follows: Inventory of - By petitionerBy respondentChrome ore:In United States yards$654,776.54$673,196.53Elsewhere274,546.04274,756.04Total929,532.58947,952.57Goods in process207,889.79207,889.79Finished goods on hand228,857.91228,857.91Supplies227,491.64227,491.64Total1,593,771.921,612,191.913517 581 The petitioner adjusted the inventory hereinabove, valued on the basis of cost, to cost or market whichever was lower, arriving at the following figures after said adjustments: Inventory of:Chrome ore - By petitionerIn United States yards$252,713.76Elsewhere130,723.12Total383,436.88Goods in process154,171.24Finished goods on hand177,756.32Supplies227,491.64Total942,856.08Said inventory, showing a reduction in valuation of $650,915.84 was used by the petitioner in its return for 1918 as the closing inventory. That reduction was allocated to the various articles as follows: Chrome, ore:In United States yards$402,062.78Elsewhere114,032.92Total546,095.70Goods in process53,718.55Finished goods on hand51,101.59SuppliesNoneTotal650,915.84The respondent allowed $244,077.52 of the reduction of $650,915.84 claimed by the petitioner, allocated to the components of the inventory as follows: Chrome ore:In United States yards$118,464.59Elsewhere125,612.93Total244,077.52Goods in processNone.Finished goods on handNone.SuppliesNone.Total244,077.523518 The respondent increased the closing inventory by $406,838.32, the difference between $650,915.84 and $244,077.52, allocated to the various ous articles as follows: Amount disallowed by respondent. Inventory of:Chrome ore -In United States yards$302,018.18ElsewhereNone.Total302,018.18Goods in process53,718.55Finished goods on hand51,101.59SuppliesNone.Total406,838.32582 The respondent arrived at this increase as follows: He held that 71.82653 per cent of the chrome ore inventory in the United States was required for the manufacture of goods under firm sales contracts; consequently the petitioner, in valuing this part of the inventory, was limited to the basis of cost. To place this part of the inventory on the cost basis respondent added to the market value of chrome ore in the United States the sum of $302,018.18, which is 71.82653 per cent of the difference between his total cost of $673,196.53 of chrome ore in the United States, and the market value of $252,713.76 of that same ore. The balance of the increase results from the respondent placing that part of the inventory of goods in process and finished goods on a3519 cost basis instead of market, thereby adding $53,718.55 and $51,101.59, respectively. The petitioner does not now contest the correctness of the respondent's action in regard to that part of the inventory relating to goods in process and finished goods on hand, thus leaving in dispute only the increase of $302,018.18. The market value of chrome ore on December 31, 1918, was lower than cost. The respondent denied the petitioner's application for apecial assessment. OPINION. MORRIS: The petitioner's counsel has conceded the correctness of the respondent's action in reducing invested capital for the years 1917 and 1918 by an amount of income and profits taxes for prior years. Therefore, we shall address ourselves to the second and third allegations of error set forth herein. The second allegation of error alleged to have been committed is the failure of the respondent to allow as a deduction, in the computation of net income for the year 1918, an inventory adjustment of $406,838.32. At the hearing of this proceeding the petitioner conceded the correctness of the respondent's adjustment with respect to goods in process amounting to $53,718.55 and finished goods on hand3520 amounting to $51,101.59. The amount of the inventory adjustment here in dispute is, therefore, $302,018.18 instead of $406,838.32, as pleaded. Section 203 of the Revenue Act of 1918 provides: That whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income. Pursuant to the authority vested in the respondent by section 203, supra, Regulations 45 was promulgated. Article 1584 thereof, as amended by T.D. 3296, provides in part as follows: 583 Under ordinary circumstances, and for normal goods in an inventory, "market" means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer, and is applicable in the cases (a ) of goods purchased and on hand, and (b ) of basic elements of cost (materials, labor and burden) in3521 goods in process of manufacture and in finished goods on hand: exclusive, however, of goods on hand or in process of manufacture for delivery upon firm sales contracts (i.e., those not legally subject to cancellation by either party) at fixed prices entered into before the date of the inventory, which goods must be inventoried at cost. * * * The question presented reduces itself to whether the foregoing article of the regulations is applicable to raw materials on hand when, as in the instant case, the petitioner has contracted for future delivery of finished products, but neither the raw materials nor finished products have been allocated or apportioned to any particular contracts. The petitioner's counsel contends that as matter of law the term "goods on had" as used in the regulations does not include raw materials and he cites as authority for his contention Cumpston v. Haigh, 2 Bing N.C. 449. In our opinion that case is wholly inapplicable to the peculiar facts and circumstances which must be considered in determining the amount of income subject to taxation under the revenue acts. Indeed it is conceivable that the term" goods on hand" may mean any class3522 of goods entering to and becoming a part of an inventory which is used for the purpose of determining profits for a given taxable period. The petitioner's counsel contends further that as a matter of fact the raw materials in question were not held "for delivery upon firm sales contracts" for the reason that the term "for delivery" necessarily implies an allocation of the goods to such contracts, and, furthermore, article 1584, supra, does not require any goods to be held at cost in the inventory unless those goods have been sold under a "sales contract." He argues that the sales contracts here under consideration called for finished products only, and that since no raw materials were sold by it, either by contract or otherwise, there is no reason why those raw materials should not be reduced to cost or market, whichever is lower. Section 203 of the Revenue Act of 1918 gives the Commissioner Section 203 of the Revenue Act of 1918 gives the Commissioner authority to prescribe the basis upon which inventories must be taken, when in his opinion their use is necessary in order clearly to determine the income of the taxpayer. The purpose of the regulations promulgated under3523 that section of the Act of allowing taxpayers to compute inventories on the basis of cost or market, whichever is lower, as distinguished from the cost basis, is to allow an accounting for any reduction in the value of the inventory which has in fact taken place during a taxable year, thereby more clearly 584 reflecting income. Where the inventories on hand, whether in the form of raw materials, goods in process, or finished goods, are required to fulfill legally enforcible contracts, it is obvious that the taxpayer is protected against any reduction in value occasioned by declining market prices; and to allow a taxpayer, where he is protected by sales contracts at a price in excess of cost or market, to inventory those items at market, would distort his income in that he would show a loss in one year when in fact none was sustained and a greater gain than the true gain in the following year when the sales were executed. The mere fact that the petitioner voluntarily reduced the sales price under contracts held by it in 1918 does not render those contracts any the less firm sales contracts should it choose to enforce the obligations created thereby. 3524 The petitioner relies on Ewing-Thomas Converting Co.,1 B.T.A. 121">1 B.T.A. 121, to support the proposition that as there had been no allocation of the raw materials to any sales contract such materials may be inventoried at the lower of cost or market. In that case the taxpayer's inventory was taken at cost. The taxpayer sought to value that part of its goods on hand which were required to complete certain firm sales contracts at a price approximating the contract prices, which were lower than either cost or current bid (market) prices at the close of the year, under the provisions of article 1584 of the regulations 45 permitting the taxpayer, who has regularly sold merchandise "at prices lower than the current bid price" to value such merchandise at the lower selling prices. The Board denied the relief sought mainly because of the insufficiency of the evidence, the taxpayer having failed to prove the sale of the merchandise at prices less than "current bid price" or even that the merchandise in question had been definitely allocated to firm sales contracts at prices less than "current bid price." The fact that the merchandise in question had not been allocated to the firm sales3525 contracts was not determinative of the question there at issue; and our decision was not based on the fact that there had not been such an allocation. Considering the facts and circumstances of this case in the light of the spirit and intent of the law and the regulations promulgated thereunder, we are of the opinion that the action of the respondent should be approved. The third allegation of error urged by the petitioner is the failure of the respondent to compute its profits taxes under the provisions of section 210 of the Revenue Act of 1917 and sections 327 and 328 of the Revenue Act of 1918. Section 210, supra, provides: That if the Secretary of the Treasury is unable in any case satisfactorily to determine the invested capital, the amount of the deduction shall be the sum of (1) an amount equal to the same proportion of the net income of the trade or business received during the taxable year as the proportion which the 585 average deduction (determined in the same manner as provided in section two hundred and three, without including the $3,000 or $6,000 therein referred to) for the same calendar year of representative corporations, partnerships, and individuals, 3526 engaged in a like or similar trade or business, bears to the total net income of the trade or business received by such corporations, partnerships, and individuals, plus (2) in the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000. * * Section 327 supra, insofar as applicable to the instant case, provides: That in the following cases the tax shall be determined as provided in section 328: (a) Where the Commissioner is unable to determine the invested capital as provided in section 326; (b) In the case of a foreign corporation; (c) Where a mixed aggregate of tangible property and intangiblep roperty has been paid in for stock or for stock and bonds and the Commissioner is unable satisfactorily to determine the respective values of the several classes of property at the time of payment, or to distinguish the classes of property paid in for stock and for bonds, respectively. The undisputed testimony shows that the petitioner when organized in 1908 acquired the assets of three other companies consisting of a mixed aggregate of tangible and intangible property for its entire3527 issue of capital stock of $4,000,000; that the petitioner's officers arbitrarily allocated $1,450,000 to the tangible assets and $2,550,000 to the intangible assets. Therefore, we have only to determine whether the respondent could have satisfactorily determined the respective values of the several classes of property at the time of payment and if we find that he could not, relief under the provisions of section 210 supra, and 328 supra, should be granted. Davis & Andrews co.,2 B.T.A. 328">2 B.T.A. 328. Assuming that the $4,000,000 paid for the assets acquired by the petitioner upon organization represented the correct value of those assets, we are confronted with the further difficulty of establishing the correct values of the two classes of property, viz, tangible and intangible, which were placed upon the books of account at arbitrary figures. This difficulty was recognized in The Viscose Co.,3 B.T.A. 444">3 B.T.A. 444, wherein it was said: How is it possible for the Commissioner to determine the respective values of the several classes of tangible and intangible property acquired by the taxpayer in exchange for stock? * * The book value of the tangible property3528 acquired from the predecessor corporation is the basis or starting point for the Commissioner's computation of invested capital. The evidence shows that the books and records of some of the corporations entering into the consolidation in 1908 have been lost or destroyed. It is, therefore, impossible to gain from those records knowledge of the financial history and success of those corporations 586 for the purpose of aiding in the determination of the value of the intangible assets and also for the purpose of learning the values at which the tangible assets were recorded prior to acquisition by the petitioner. We are satisfied that the respective values of the tangible and intangible assets taken over by the petitioner at the time of the reorganization can not be determined. We are, therefore, of the opinion that the petitioner is entitled to have its taxes computed under the provisions of section 210 of the Revenue Act of 1917 and section 328 of the Revenue Act of 1918. Reviewed by the Board. Recomputation of the deficiency should be made under Rule 62(c).GREEN GREEN, dissenting: I am unable to concur in that portion of the prevailing opinion*3529 that approves the Commissioner's action as to inventories. TRUSSELL agrees with the dissent.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622012/	ESTATE OF LEON ISRAEL, JR., DECEASED, BARRY W. GRAY, EXECUTOR, AND AUDREY H. ISRAEL, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent; JONATHAN P. WOLFF AND MARGARET A. WOLFF, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentEstate of Israel v. CommissionerDocket Nos. 31588-88, 13142-89United States Tax Court108 T.C. 208; 1997 U.S. Tax Ct. LEXIS 12; 108 T.C. No. 13; April 1, 1997, Filed 12 Decisions will be entered under Rule 155. Held: Fees paid in connection with "cancellation" of legs of commodity forward contracts treated as capital losses, not ordinary losses. The opinion of the U.S. Court of Appeals for the District of Columbia Circuit in Stoller v. Commissioner, 994 F.2d 855">994 F.2d 855 (D.C. Cir. 1993) (in its treatment of losses from cancellation and replacement, and cancellation and termination, of legs of commodity forward contracts as ordinary losses) not followed, and our opinion in Stoller v. Commissioner, T.C. Memo 1990-659">T.C. Memo. 1990-659, affd. in part and revd. in part 994 F.2d 855">994 F.2d 855 (D.C. Cir. 1993) (in its treatment of losses from cancellation and termination of legs of commodity forward contracts as ordinary losses),13 modified. Herbert Stoller and William L. Bricker, Jr., for petitioners. Steven R. Guest, Mark J. Miller, and Edward G. Langer, for respondent. SWIFT, COHEN, CHABOT, JACOBS, GERBER, PARR, WELLS, RUWE, COLVIN, BEGHE, LARO, FOLEY, VASQUEZ, GALE, HALPERNSWIFT208 OPINION SWIFT, Judge: Respondent determined deficiencies in petitioners' Federal 14 income taxes and increased interest as follows: Estate of Leon Israel, Jr., Deceased, and Audrey H. IsraelIncreased InterestYearDeficiencySec. 6621(c)1977$ 9,837 197914,442 198062,482 * 120 percent of interestaccruing after Dec. 31,1984, on portion of theunderpayment attributableto a tax-motivatedtransaction.209 Jonathan P. and Margaret A. WolffIncreased InterestYearDeficiencySec. 6621(c)1979$ 55,114 198082,369 19812,294 * 120 percent of interestaccruing after Dec. 31,1984, on portion of theunderpayment attributableto a tax-motivatedtransaction.15 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. After settlement, the sole issue for decision is whether losses incurred in connection with closing forward contracts in Government securities should be treated as capital losses or as ordinary losses. The parties submitted these consolidated cases fully stipulated under Rule 122. More specifically, as factual evidence in these cases, the parties stipulated the admissibility of the entire trial record of Stoller v. Commissioner, T.C. Memo. 1990-659, 60 T.C.M. (CCH) 1554">60 T.C.M. (CCH) 1554, 1990 T.C.M. (P-H) par. 90,659, affd. in part and revd. in part 994 F.2d 855">994 F.2d 855 (D.C. Cir. 1993). That case involved Herbert Stoller (Stoller), petitioners' counsel in the instant cases and also a partner in Holly Trading Associates (Holly), a partnership in which Leon Israel, Jr. (Israel), Jonathan P. Wolff (Wolff), and other petitioners herein also invested, and the treatment, for Federal income tax purposes, of the identical losses of16 Holly relating to the same forward contracts that are at issue in 210 the instant cases. A number of additional issues that were addressed in Stoller v. Commissioner, supra, are not at issue herein. We expressly incorporate into our findings of fact the background facts relating to Holly's investments in forward contracts and commodity straddle transactions as well as the specific facts relating to the particular commodity forward contracts that are at issue herein as those facts were found in our opinion in Stoller v. Commissioner, supra, with one exception as to the ultimate finding of fact that we made in our Stoller opinion with regard to the tax treatment of the losses incurred on the commodity forward contracts that were closed by cancellation and termination as explained further below. We also attach hereto and incorporate into our findings of fact as Appendixes A-1 and A-2, certain schedules that were attached to our opinion in Stoller v. Commissioner, 60 T.C.M. (CCH) at 1569-1571, 1990 T.C.M. (P-H) at 90-3223 to 90-3227. (We note that Appendixes A-1 and A-2 attached hereto were labeled Appendixes B-1 and17 B-2 in our above Stoller opinion.) These schedules, among other data, set out data relating to the three groups of forward contracts that are at issue in the instant cases. The schedule below identifies lines of Appendixes A-1 and A-2 that reflect specific information with regard to each of the three groups of forward contracts in issue and the amount of the losses claimed by Holly with respect thereto: Transaction & LossesClaimedAppendixes A-1 and A-2 Line Nos.First Contracts--($ 837,500)A-1,Lines 5, 7, 9, 11, 17-24, 26, 28Second Contracts--($ 816,219)A-2,Lines 1, 3, 5, 7-12, 24-26, 29, 30Third Contracts--($ 10,000)A-2,Lines 13-20The opinion of the U.S. Court of Appeals for the District of Columbia Circuit in Stoller v. Commissioner, supra, provides only an abbreviated explanation of the particular forward contracts that were the subject of the appeal of our opinion in Stoller v. Commissioner, supra, and that are at issue herein. We also, in light of the essentially legal nature of the issue before us, set forth herein a somewhat abbreviated explanation of the details of the particular forward contracts that 211 are at issue, but 18 we emphasize particular aspects of these forward contracts, the significance of which appears to have been overlooked by the Court of Appeals in its analysis and opinion in Stoller v. Commissioner, supra.We believe that the aspects of these transactions that we emphasize herein are significant and determinative of the narrow issue before us (namely, whether the losses in question are deductible as capital or as ordinary losses). We also note that respondent has conceded the increased interest under section 6621(c) and makes no contention herein that the forward contracts at issue were sham transactions or lacked a business purpose or profit motive. Further, no issue is raised as to petitioners' cost basis in the forward contracts in question. As indicated, from 1979 to 1982, Israel, Wolff, Stoller, and other individuals were partners in Holly, which partnership invested nominally in interest-bearing Government securities, such as U.S. Treasury Bonds (T-Bonds) and Government National Mortgage Association Bonds (GNMA's) by way of unregulated commodity forward contracts. Holly utilized forward contracts to conduct an arbitrage program involving the simultaneous purchase in one19 market and sale in another market with the expectation of making a profit on price differences in the different markets. Holly's program involved the establishment of long positions in Government securities and the simultaneous establishment of short positions in different Government securities, with a difference in the interest rates, or repurchase rates, on the two positions that was calculated to yield a nominal net profit to Holly when the positions were liquidated. In this instance, a long position represents a contract to purchase a Government security in the future, and a short position represents a contract to sell a Government security in the future. The establishment of both long and short positions in the same type of commodity is called a spread or a straddle. In the minds of the partners of Holly, in actuality and in substance, Holly's investments in commodity forward contracts involved nothing more than contracts to speculate in or to arbitrage -- for the short length of time that the forward contracts remained outstanding -- changes or shifts in the interest and discount rates associated with the particular 212 type of Government securities to which the forward contracts20 were pegged. By entering into offsetting forward contracts to purchase and to sell these Government securities, Holly effectively created synthetic short-term security investments by means of the straddles, even though the underlying Government securities to which the interest rate speculation was pegged constituted long-term Government securities. For example, by entering into a contract to purchase, at the current market or other specified price, 15-year T-Bonds for delivery in 3 months and simultaneously entering into a contract to sell, at the current market or other specified price, 15-year T-Bonds for delivery 6 months later, Holly "created" the economic equivalent of a contract to purchase a 6-month T-Bond. Holly then arbitraged these contracts against simultaneous contracts to sell GNMA's on the same specified date in 3 months and to purchase GNMA's 6 months later. In economic terms, and as between the parties, the only important factors in such a straddle transaction are the initially specified price differential between the legs of the forward contracts or straddle and changes in interest and discount rates associated with the particular Government securities to which 21 the contracts are pegged that occur during the period of time that the contracts remain outstanding. Those factors will determine the entire net gain or loss whenever the position is settled or closed out. No actual purchase or sale of the Government securities to which the forward contracts are pegged is ever contemplated. In fact, no specific Government securities are identified as being associated with the forward contracts. In actuality, the Government securities to which the forward contracts are associated are more accurately described as hypothetical Government securities that, if they existed, would have the same interest rates and other features as the type of Government securities to which the forward contracts are pegged. Pricing of the forward contracts entered into by Holly occurred in the following manner. Mr. Wolff, on behalf of Holly, negotiated with ACLI Government Securities, Inc. (AGS), a dealer in Government securities and a broker of commodity futures contracts, the price differential -- as of the date the contracts were entered into -- between the long and short positions of each straddle and, once that differential was agreed upon, left it to AGS to assign 22 prices to the two 213 legs of the straddle reflecting the initial price differential agreed upon. When Mr. Wolff negotiated with AGS regarding offsetting positions, again he would negotiate with AGS only the price differential as of the date the offsetting contracts were entered into. In the context of the straddle transactions of the type involved in these cases, commodity forward contracts (as with futures commodity contracts) are not consummated by actual sale or purchase and delivery of the underlying securities or commodity. Actual delivery of the underlying securities is not contemplated. Rather, forward contracts are generally closed by offset, that is by entering into opposite forward contracts in the same commodity with the same or similar settlement dates. When such opposite forward contracts in the same commodity are entered into, the rights and obligations of the investor in the initial contracts are simply regarded as terminated. The parties agree that in the above situation the termination by offset of the investor's respective positions constitutes a capital transaction. We emphasize that all that has happened in closing the transaction by way of offset is that the investor23 (at whatever time during the length of the contract the investor chooses to terminate or lock in the gain or loss that has occurred with respect thereto as a result of changes in the price differential and in interest and discount rates relating to the relevant Government securities from the day the forward contracts were first entered into until the day the contracts are closed) simply notifies the other party of the investor's desire to close the transaction by offset and, in effect, the contracts or positions are terminated as of that point in time. Occasionally, an investor may wish to terminate or "lock in" the gain or loss on only a particular leg of a commodity forward contract or straddle. The procedure is essentially the same, and the transaction is essentially the same, regardless of which of a number of available methods is utilized to lock in the gain or loss on a particular leg of a commodity straddle transaction that has occurred up until that point in time. True cancellations of forward contracts, where the transaction or contracts are vitiated ab initio, only occur when forward contracts contain errors. 214 When interest rates change at any time during the period of24 time that forward contracts are open, the value of the straddle increases or decreases, but that increase or decrease is moderated by the fact that as one leg of the straddle increases in value, the other leg decreases in value by a similar amount. Although the change in value of a given straddle remains fairly constant, one particular leg of a straddle may reflect a large loss and the other leg may reflect a large gain when interest rates fluctuate widely and when the other leg of the straddle is not considered. It was at such a point in time that Holly, for income tax purposes, occasionally would close by offset or by "cancellation" only a loss leg of a straddle and simultaneously replace the loss leg with a new contract for a slightly different delivery date, thereby locking in the loss on the first leg and the gain on the second leg of the straddle that had occurred from the day the contracts had initially been entered into until the day the initial loss leg of the contract is closed. In the above scenario, when the loss leg is closed by "cancellation" and simultaneously replaced with a new forward contract, the purpose of going through the formality of "canceling" the loss leg25 of the forward contract and replacing it (instead of directly "offsetting" the loss leg) was to attempt to convert the capital loss that petitioners concede would have been associated with the offset procedure into an ordinary loss that Holly claims is associated with a "cancellation." When a loss leg of a straddle is closed by cancellation and terminated (i.e., no replacement or offset contract is purchased), as well as when a loss leg of a straddle is closed and a replacement contract is purchased (as distinguished from closing by offset), the loss leg of the contract is closed or terminated as of the date of the closing, and the parties have effectively locked in the "loss" on that leg of the straddle, reflecting simply the change, due to shifts in the interest rates, in the nominal value of that leg from the day the leg was entered into until the day of the closing of the leg. When Holly closed a loss leg of a straddle and no replacement or offset contract was purchased, Holly paid AGS what was referred to as a "cancellation" fee equal to and representing the loss that had been realized on just that leg of the straddle. 215 When Holly closed a loss leg and replaced it, Holly also26 paid AGS a "cancellation" fee equal to and representing the loss that had been realized on just that leg of the straddle (and without taking into account the offsetting gain that also was realized and locked in as of that point in time via the replacement leg of the straddle), which cancellation fee represented the loss realized on the loss leg that was closed. The closing or liquidation of loss legs of forward contracts by way of offset or by way of "cancellation" (and whether or not "cancellation" is followed by replacement contracts) is economically the same. Where "cancellation" of loss legs is followed by replacement contracts, the replacement contracts simply serve to lock in the offsetting gain on other legs of the straddle that has occurred from the day the straddle was first entered into until the day the loss legs are closed. The replacement contracts simply relate to the need to lock in the large gain in order to offset the large loss that is going to be claimed for tax purposes. The replacement contracts in no way alter the character of the loss realized on the legs that are closed. Holly typically, in the following year, closed the gain legs of the straddle transactions27 by offset in order to qualify the gain as capital gain. The so-called cancellation fees that were due on closing the loss legs of forward contracts (at least with regard to the first and second groups of forward contracts in issue) were not paid by Holly at the time the investors' loss positions were locked in. Mere bookkeeping entries were made to reflect the so-called cancellation fees. Just prior to the end of each year, the individual partners of Holly obtained bank loans and made contributions to their partnership capital accounts in Holly in amounts sufficient to pay the cancellation fees owed by Holly. Holly then used such funds to pay the cancellation fees to AGS and treated the fees as ordinary losses at the partnership level and passed through the claimed ordinary losses to the individual partners. Just after the first of each year, AGS paid to Holly an amount essentially equivalent to the cancellation fees that Holly had paid AGS at the end of the prior year -- reflecting the gains that were locked in on the straddle transactions. Holly then distributed these funds to the individual partners 216 as a return of capital, and the partners used these funds to repay their bank28 loans approximately 1 to 2 weeks after having been loaned the funds. On its Federal income tax returns for the years in issue, Holly treated losses arising from forward contracts closed by offset as capital losses. Holly, however, reported losses arising from forward contracts closed by "cancellation" (regardless of whether or not replacement contracts were purchased) as ordinary losses. In 1979, Holly reported a capital gain of $ 1,875 from trading in commodity forward contracts and an ordinary loss of $ 837,500 relating to the "cancellation" of the first group of forward contracts in issue. In 1980, Holly reported capital gains in the amount of $ 850,000 (relating to the straddle the above loss leg of which was closed in 1979 to produce the $ 837,500 loss claimed in 1979) and an ordinary loss of $ 826,219 relating to "cancellation" of the second and third forward contracts in issue that were "canceled" in 1980 (an $ 816,219 loss relating to the second group of forward contracts closed by "cancellation" and replacement, and a $ 10,000 loss relating to the forward contract "canceled" and terminated). In 1981, Holly reported a cumulative net short-term capital loss of $ 349,46829 from trading in forward contracts. The record is not clear as to the amount of the capital gain Holly reported in 1981 with respect to closing in 1981 the replacement contracts that Holly acquired in 1980. On audit, insofar as is pertinent to the sole issue before us in the instant cases, respondent determined that Holly's claimed ordinary losses (relating to the forward contracts "canceled" and replaced and to the forward contracts "canceled" and terminated) should be treated as capital losses. DiscussionThe parties herein agree on two important points: (1) That the commodity forward contracts that Holly entered into and created with AGS constituted capital assets; and (2) that locking in, by offset -- at any point in time during the duration or length of forward contracts -- the gain or loss relating to the overall straddle transaction (or the gain or loss relating to a 217 leg of the straddle transaction) constitutes the sale or exchange of a capital asset. The issue in the instant cases is whether locking in -- at any point in time during the duration or length of a forward contract -- a loss relating to a leg of a straddle transaction by two methods slightly different30 from the offset method (namely, by cancellation and replacement and by cancellation and termination) also constitutes a sale or exchange of a capital asset, as respondent contends, or whether the taxpayers can convert the capital loss into an ordinary loss by the use of either of such two different methods, as petitioners contend. As is often the case, critical to resolution of the issue before us is the statement of the issue. If the industry label and nomenclature are accepted at face value, and if the issue herein is stated simply in terms of whether "cancellation" of a leg of a forward contract gives rise to capital gain or loss, as distinguished from ordinary gain or loss, one is directed quickly to certain case authority (discussed below) that addresses tax consequences of unexpected "cancellations" of commercial contracts, which cases generally turn on whether property rights relating to or arising out of the original contract survived the cancellation and whether all rights relating to the contract "vanished" with the cancellation. As explained below, we believe such "cancellation" cases do not control the cancellation of commodity forward contracts by which investors simply31 settle or close out their position in a straddle or in a leg of a straddle transaction. As stated, the parties agree that forward contracts in commodity markets held for investment constitute capital assets under section 1221. Commissioner v. Covington, 120 F.2d 768">120 F.2d 768 (5th Cir. 1941), affg. in part and revg. in part 42 B.T.A. 601">42 B.T.A. 601 (1940); Vickers v. Commissioner, 80 T.C. 394">80 T.C. 394 (1983); Hoover Co. v. Commissioner, 72 T.C. 206">72 T.C. 206 (1979). Although no delivery or physical exchange of the underlying commodity is contemplated, the monetary settlements that occur between the respective parties holding the contra positions in forward contracts have long been recognized to constitute "sales or exchanges" under the tax laws. As we explained in Vickers v. Commissioner, supra at 409, involving futures contracts, for our purposes not significantly different from forward contracts -- 218 both the Supreme Court and the Congress have had occasions to deal with commodity futures transactions, have treated them as capital transactions thus presupposing a "sale32 or exchange," and have never questioned our [Commissioner v.] Covington, [supra] or Battelle [v. Commissioner, 47 B.T.A. 117">47 B.T.A. 117 (1942)] cases in which we found a "sale or exchange" in the "netting" or "offsetting" mechanism of the commodity exchanges. * We went on in Vickers v. Commissioner, supra at 409, to explain further: In the landmark Corn Products [Refining Co. v. Commissioner, 350 U.S. 46">350 U.S. 46 (1955)] case in 1955, the Supreme Court even then was facing a consistent 20-year practice by respondent and the lower courts, whereby speculative transactions in commodity futures received capital treatment * . The Supreme Court cited our Battelle [v. Commissioner, supra,] case as part of that consistent practice. 350 U.S. at 53 n.8. Moreover, the Congress, too, has assumed that gains and losses from speculative commodity futures transactions are capital in nature as shown by the 1950 legislative history of the predecessor of section 1233 dealing with short sales of property and by the legislative history of the recent legislation dealing with33 commodity futures and eliminating certain abusive practices involving commodity tax straddles. [Fn. refs. omitted.]In Commissioner v. Covington, supra at 769-770, an early opinion of the Court of Appeals for the Fifth Circuit, involving a taxpayer's losses from commodity futures contracts, the fundamentals of such transactions, from a tax standpoint, were explained, and it was concluded that such transactions in essence constitute sales or exchanges, as follows: [The taxpayer argues that the investor] doesn't, by its dealing, become the owner of any property, it merely enters into executory contracts which are executed, not by transfer of property, but by closing them out at a profit or loss, under the rules of the exchange, without a sale or exchange of property being involved. * * * The clearing house of the exchange to which all contracts are transferred, extinguish[es] offsetting contracts and makes a money settlement of the price difference. There is then neither the sale nor exchange of the commodity or of the contract. There is only the extinguishment of a contract to buy and a contract to sell, and a money settlement for the34 price difference. This, says the * * [taxpayer], is not a selling or buying of property. Speaking plainly [the taxpayer argues], it is simply an arrangement or device by which gains or losses are chalked up and settled for, between speculators who have taken opposite positions in a rising and falling market. It is difficult to see how, if * * * [the taxpayer] is right in this naive reduction to fundamentals, of the transactions in which it has been engaged, its activities can be distinguished from mere wagering or to be equally naive, betting or gambling. But they are so distinguished in law and in business contemplation, and they are so distinguished, because 219 implicit in the transactions is the agreement and understanding that actual purchases and sales, and not mere wagering transactions, are being carried on. [Commissioner v. Covington, 120 F.2d at 769-770; emphasis added.]We believe the above statement from this early opinion is apropos to the facts of the transactions before us in this case and succinctly distills the essence of what is going on -- namely, the "purchase and sale" of forward contracts or "positions" in a particular35 market (in this case the market for interest-sensitive Government securities). Whenever the investor (during the length or duration of the forward contracts that have been purchased) elects to settle, close out, extinguish, or cancel the contracts or positions, or one of the legs thereof, and to realize the gain or loss associated with the contracts, or with one of the legs thereof, and regardless of whether the investor "closes out" or "locks in" the gain or loss by way of offset, by way of cancellation and replacement contracts, or by way of cancellation and termination, the transaction is exactly the same -- in purpose, in effect, and in substance -- and produces exactly the same type of taxable gain or loss -- in the instant cases capital gain or capital loss. As the U.S. Court of Appeals for the Fifth Circuit stated, implicit in the realization or "lock in" of the gain or loss associated with straddle transactions or with legs thereof (whether the lock in is effected by way of offset, cancellation and replacement, or cancellation and termination) is the agreement and understanding that actual purchases and sales have occurred with respect to the price-differential and interest-sensitive36 risk for T-Bonds and GNMA's that each party accepted when the commodity straddle transaction was first entered into. In each case, the investor assumed the risk of swings in the price of such Government securities for whatever time each leg of the contract was outstanding. Regardless of when and how a loss position in a commodity forward contract is extinguished, closed, settled, terminated, or canceled, at any one point in time during the length or duration of the contract, the investor in fact has participated in exactly the transaction for which the investor contracted from the time the transaction was first entered into until the day the investor chooses to close or terminate that leg. The investor got exactly what was bargained for (participation in this interest-sensitive risk transaction for a period of time) 220 and when the investor closed the leg or the position (by whichever of the various "alternative liquidation techniques" that are made available to investors in commodities forward contracts (see Ewing v. Commissioner, 91 T.C. 396">91 T.C. 396, 418 (1988), affd. without published opinion 940 F.2d 1534">940 F.2d 1534 (9th Cir. 1991)), the investor37 effectively sold off or extinguished and exchanged that right to participate and realized the gain or loss associated therewith up to that point in time. When the investor chooses to dispose of or terminate that risk, or any part thereof, and to lock in the gain or loss that has occurred on any leg of the straddle, because of swings in interest rates on Government securities that have occurred, the investor elects a method to do so, but each method produces exactly the same economic event and consequence, only nominal differences in form, and certainly, as between the parties to the forward contracts, a sale or exchange of the respective price-differential and interest-sensitive risk positions that their contracts represented from the time they first entered into the forward contracts up until the time that the risk is terminated and the gain or loss is locked in. As we stated in Hoover Co. v. Commissioner, 72 T.C. 206">72 T.C. 206, 249 (1979), in analyzing payments labeled as "compensating" payments and in concluding that offsetting forward contracts in foreign currency constituted capital transactions: These offsets clearly constitute both "closure" under38 section 1233 and a sufficient sale or exchange under the general capital provisions to mandate capital treatment here. * * * [Id.]As use of the term "compensate" was not controlling in Hoover Co. v. Commissioner, 72 T.C. at 249, use of the term "cancellation" by petitioners in connection with the settlement of loss legs of their forward contracts is not controlling and should not mislead us here. Respectfully, we believe that the Court of Appeals for the District of Columbia Circuit in Stoller v. Commissioner, 994 F.2d 855">994 F.2d 855, 856-857, erred in not recognizing the above case authority and holdings that establish the "closure" or "sale or exchange" nature of the termination of offsetting forward contracts. Upon closing by offset of forward contracts, the transaction is terminated and extinguished, settlement between the parties occurs at that time, and no contracts remain in effect. This is illustrated clearly in Appendix A-1 221 hereto under the caption "Straddles Opened And Closed -- 1980". The four forward contracts under this caption were opened on June 20, 1980, and were settled and closed 10 days later on June 30, 39 1980, by four offsetting forward contracts. After June 20, 1980, in spite of the fact that four offsetting forward contracts were entered into with specified settlement dates in 1981 and 1982, the offsetting contracts extinguished each other. The transactions were settled, terminated, and closed. Nothing survived as between the parties to these particular forward contracts into 1981 and 1982. Whether 6-months' offsetting forward contracts, all of the legs of an entire straddle, or simply one leg thereof, are settled or closed 1 week or 1 month after they are entered into, or not until the initially specified settlement date, and by whatever method used to settle or close the contracts (in the instant cases, by offset, by cancellation and replacement, and by cancellation and termination), in each situation the capital transaction that the parties entered into through the forward contracts, the straddle, and the legs thereof, has been closed and the payment received (if a gain is realized) or made (if a loss is realized) represents exactly the same type of income or loss earned with regard to the contracts, the straddle, or the legs thereof, for the length of time the forward contracts40 were outstanding. Other legs of the straddle may remain open, and the parties may continue to be exposed to continuing shifts in interest rates and in price fluctuations of Government securities for the duration or length of time that other legs of the straddle remain open, but with regard to the leg that has been closed, or canceled, or offset, the transaction is closed, and a completed sale or exchange has occurred under section 1221 with regard to the rights of the parties associated with that portion of the straddle that was closed. With the benefit of further analysis, it is our conclusion that our opinion in Stoller v. Commissioner, T.C. Memo. 1990-659, affd. in part and revd. in part 994 F.2d 855">994 F.2d 855 (D.C. Cir. 1993) (in its treatment of a cancellation and termination of a leg of a straddle transaction) and the opinion of the Court of Appeals for the District of Columbia Circuit in Stoller v. Commissioner (in its treatment of both cancellation and replacement and cancellation and termination of legs of straddle transactions) erred in not recognizing the fundamental 222 sale or exchange nature41 of these transactions in which, simply stated, the gain or loss -- at a certain point in time -- is locked in with regard to the portion of the straddle that is closed. As the Court of Appeals for the Fifth Circuit early recognized in Commissioner v. Covington, 120 F.2d at 769-770, "closing" of the contracts at a profit or loss is the sum and substance of the transactions before us. We perceive no difference, for income tax purposes and in determining the character of the gain or loss, between closing a leg of a straddle and closing the entire straddle. Both events lock in the gain or loss on the interest rate shift that has occurred as of the point in time that a leg or legs of the straddle are closed. Courts often must address taxpayers' "artful devices" to convert ordinary gain into more favorable capital gain or to convert capital loss into more favorable ordinary loss. See Commissioner v. P.G. Lake, Inc., 356 U.S. 260">356 U.S. 260, 265 (1958) (citing Corn Prods. Ref. Co. v. Commissioner, 350 U.S. 46">350 U.S. 46, 52 (1955)). That task should be accomplished on the basis not of the "cancellation" label used by42 the parties but on the realities of the transactions and expectations of the parties. We reiterate what we stated in Stoller v. Commissioner, supra, when presented with the identical facts as in the instant cases, that to call the closing transactions in issue "cancellations" is a misnomer and is misleading. As stated earlier, we believe that cases involving unexpected and true cancellations of commercial contracts and "vanishing" or "disappearing assets" are not particularly helpful. See Leh v. Commissioner, 260 F.2d 489 (9th Cir. 1958), affg. 27 T.C. 892">27 T.C. 892 (1957); Commissioner v. Pittston Co., 252 F.2d 344">252 F.2d 344, 347-348 (2d Cir. 1958), revg. 26 T.C. 967">26 T.C. 967 (1956); General Artists Corp. v. Commissioner, 205 F.2d 360">205 F.2d 360, 361 (2d Cir. 1953), affg. 17 T.C. 1517">17 T.C. 1517 (1952); Commissioner v. Starr Bros., 204 F.2d 673">204 F.2d 673, 674 (2d Cir. 1953), revg. 18 T.C. 149">18 T.C. 149 (1952). Those cases involve regular commercial contracts for the provision of goods or services and the unexpected43 cancellation of the contracts in midstream due to unusual circumstances not consistent with the continuation of the original contracts that had been entered into. Leh v. Commissioner, supra (termination of petroleum supply contract); 223 Commissioner v. Pittston Co., supra (termination of exclusive coal purchase contract); General Artists Corp. v. Commissioner, supra (cancellation of performance contract); Commissioner v. Starr Bros., supra (termination of exclusive pharmaceutical sales contract). It seems obvious to us that the cancellations involved in the above cases are fundamentally different from the "cancellations" of forward contracts that are involved herein where the "cancellations", lock in, settlement, or closing that occurred are exactly what the parties contemplated when they entered into the forward contracts (namely, Holly and AGS contemplated that Holly would have the risk of price fluctuations on each leg of the straddle from the day the straddle was first opened until whatever day Holly chooses to lock in the gain or loss). Holly received the 44 benefit of that contract and now becomes liable for the burden (namely, the loss incurred on the legs Holly chose to close). Holly received exactly what it contracted for. AGS did likewise. In this sense, the transactions in question with respect to the loss legs do not represent cancellations. They represent consummations. The cases, therefore, involving unexpected cancellations of commercial contracts are of limited applicability. In a number of cases, taxpayers and respondent have sought to invoke the "disappearing asset" theory, but that theory was found to be inapplicable where a close scrutiny of the substance and reality of the transaction in issue indicated that much more was involved than mere "vanishing assets." In Commissioner v. Ferrer, 304 F.2d 125">304 F.2d 125, 131 (2d Cir. 1962), revg. and remanding 35 T.C. 617">35 T.C. 617 (1961), the cancellation of a contract entitling the taxpayer to produce the play "Moulin Rouge" (so that rights to produce the play could be transferred to another producer) was treated as a sale or exchange. In Bisbee-Baldwin Corp. v. Tomlinson, 320 F.2d 929">320 F.2d 929, 931-932 (5th Cir. 1963),45 a cancellation fee was treated as arising from a sale or exchange where, in substance, the underlying mortgage servicing contract was transferred to a third party. That is the situation before us. Particularly with regard to the loss legs that were "canceled" and immediately replaced, little, if anything, "vanished" upon Holly's closing or settling the loss legs. To the contrary, Holly and the Holly partners stayed around, continued to participate in the straddle transactions, 224 postponed even paying the loss until the very end of the year with funds borrowed by Holly, closed or settled the offsetting gain leg of the forward contracts just after the new year, and used the gain to repay the bank. The last thing the investors would have wanted -- upon the "cancellations" in question -- is to vanish or disappear from the rest of these straddle transactions, the consequence of which is that the investors might actually have had a real loss to pay. More than anything else, the investors wanted to stay around, to be a part of the straddle transactions as they came to their predictable, inevitable, intended, and planned closing. We agree with the analysis set forth in our prior opinion in46 Stoller v. Commissioner, 60 T.C.M. (CCH) at 1566, 1990 T.C.M. (P-H) at 90-3220 -- the substance of the alleged cancellation transactions [will be determined] by looking to the entire spread arbitrage transaction and the economic consequences sought by the parties. * * * When * * * [the taxpayer] requested the cancellation of a contract or series of contracts, it was part of an ongoing straddle and was for the purpose of changing Holly's window of risk. He did not want to terminate Holly's straddle with AGS, he just wanted to change the delivery date of one leg and accelerate the loss to be recognized by Holly and its partners. * * * [Citation omitted.]Respectfully, we also believe that in Stoller v. Commissioner, 994 F.2d at 858, the Court of Appeals for the District of Columbia Circuit erred in its interpretation of the 1981 legislative history accompanying the addition of section 1234A to the Internal Revenue Code. Id. The legislative history concerning section 1234A states the following: Present LawThe definition of capital gains and losses in section 1222 requires47 that there be a "sale or exchange" of a capital asset. Court decisions have interpreted this requirement to mean that when a disposition is not a sale or exchange of a capital asset, for example, a lapse, cancellation, or abandonment, the disposition produces ordinary income or loss. * * [See Leh v. Commissioner, 260 F.2d 489">260 F.2d 489 (9th Cir. (1958) and Commissioner v. Pittston Co., 252 F.2d 344">252 F.2d 344 (2d Cir. 1958); fn. ref. omitted.] Reasons for ChangeThe committee believes that the change in the sale or exchange rule is necessary to prevent tax-avoidance transactions designed to create fully-deductible ordinary losses on certain dispositions of capital assets, which if sold at a gain, would produce capital gains. * * * 225 Some taxpayers and tax shelter promoters have attempted to exploit court decisions holding that ordinary income or loss results from certain dispositions of property whose sale or exchange would produce capital gain or loss. * * * * * * Some of the more common of these tax-oriented ordinary loss and capital gain transactions involve cancellations of forward contracts for currency or securities. The committee48 considers this ordinary loss treatment inappropriate if the transaction, such as settlement of a contract to deliver a capital asset, is economically equivalent to a sale or exchange of the contract. * * [S. Rept. 97-144, at 170-171 (1981), 2 C.B. 412">1981-2 C.B. 412, 480.]According to the Court of Appeals for the District of Columbia Circuit, the above language from the legislative history indicates that Congress thought that it was changing the law and that this change in the law is strong evidence that "cancellation" of commodity forward contracts before the change in the law produced ordinary losses. Stoller v. Commissioner, 994 F.2d at 858. We respectfully disagree with the Court of Appeals for the District of Columbia Circuit's analysis of the above legislative history. See our explanation of the above legislative history in Stoller v. Commissioner, 60 T.C.M. (CCH) at 1565, with which we agree. It suffices here to reiterate what we stated in Vickers v. Commissioner, 80 T.C. 394">80 T.C. 394, 410-411 (1983) (in the context of commodity futures 49 contracts), with regard to section 1234A: Whether new section 1234A is viewed as a change in the law in some areas or as merely removing all doubt that sales or exchange treatment is to be accorded to certain dispositions of property, we think Congress clearly did not intend to upset the sale or exchange treatment that had long been accorded to speculative commodity futures transactions of the type involved in the present case. [Citation omitted.]Petitioners argue that the proper venue for appeal of these cases is to the U.S. Court of Appeals for the District of Columbia Circuit and therefore that under Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742 (1970), affd. 445 F.2d 985">445 F.2d 985 (10th Cir. 1971), we are bound to follow the opinion of the U.S. Court of Appeals for the District of Columbia Circuit in Stoller v. Commissioner, supra.At the time the respective petitions in these cases were filed, however, petitioners resided as follows: PetitionersResidenceAudrey H. IsraelNew JerseyBarry W. Gray, Executor representingthe Estate of Leon Israel, Jr.New YorkJonathan P. and Margaret A. WolffNew York* Leon Israel, Jr., died a resident of New Jersey.50 Petitioners' counsel argues that docket No. 31588-88, involving the Estate of Leon Israel, Jr., is appealable to the U.S. Court of Appeals for the District of Columbia Circuit because petitioners' counsel, Herbert Stoller, is also a coexecutor of the Estate of Leon Israel, Jr., and resided in Bermuda at the time the petition was filed. In this regard, we note that the petition in docket No. 31588-88 was filed not by Herbert Stoller, as executor of the Estate of Leon Israel, Jr., but by Barry W. Gray, as executor of the Estate of Leon Israel, Jr. Section 7482(b)(1)(A) provides that decisions of the Tax Court may be reviewed by the U.S. Court of Appeals for the circuit in which is located: (A) in the case of a petitioner seeking redetermination of tax liability other than a corporation, the legal residence of the petitioner,Because Herbert Stoller is not a petitioner in docket No. 31588-88, it is unclear whether said docket would be appealable to the U.S. Courts of Appeals for the Second and/or Third Circuit or to the U.S. Court of Appeals for the District of Columbia Circuit. Accordingly, we are not bound by the opinion of the U.S. Court of Appeals for the District of Columbia51 Circuit in Stoller v. Commissioner, supra.Decisions will be entered under Rule 155. COHEN, CHABOT, JACOBS, GERBER, PARR, WELLS, RUWE, COLVIN, BEGHE, LARO, FOLEY, VASQUEZ, and GALE, JJ., agree with this majority opinion. 227 APPENDIX A-1 CHRONOLOGY OF HOLLY'S STRADDLE TRANSACTIONS Explanation of Columns:ACLIX # = ACLI Contract #Trade Date = DateSettlement Date =Face = Face Value ofPosition EstablishedDelivery DateSecurityL/S = Long or ShortScrty. = GovernmentRate = Rate of SecurityPrice - Purchase orSecurityO/C = Closed by Offset orSale PriceG/L Disp = Gain orCanceledLine Tr. Beg/Cl = Line #Loss onTransaction BeginsDisposition Whenor ClosesPosition ClosesOther Abbreviations:MM = Millions of $GNMA = Ginnie MaeTBond = US Treasury BondCAN = CanceledCertificate1979-1980 STRADDLE TRANSACTIONSTradeSettleACLIX #Line #DateDateFaceL/SScrty.Rate929772110/12/799/16/813MMLGNMA77 9/32929773210/12/793/18/813MMSGNMA77 30/32918904310/12/793/813MMLTBond83 11/32918903410/12/799/813MMSTBond83 1/32929768510/12/799/16/815MMLGNMA77 7/32929770610/12/793/18/815MMSGNMA77 28/32929769710/12/799/16/815MMLGNMA77 8/32929771810/12/793/18/815MMSGNMA77 29/32918907910/12/793/815MMLTBond83 12/329189051010/12/799/815MMSTBond83 2/329189081110/12/793/815MMLTBond83 11/329189061210/12/799/815MMSTBond83 1/320200941310/23/793/18/813MMLGNMA73 30/320200931410/23/799/16/813MMSGNMA73 17/320200531510/23/799/813MMLTBond79 16/320200521610/23/793/813MMSTBond79 20/32CAN9297681710/24/799/16/815MMLGNMACAN9297691810/24/799/16/815MMLGNMACAN9189071910/24/793/815MMLTBondCAN9189082010/24/793/815MMLTBond0200732110/24/796/17/815MMLGNMA73 14/320200742210/24/796/17/815MMLGNMA73 14/320200502310/24/796/815MMLTBond78 30/320200512410/24/796/815MMLTBond78 30/32105623251/23/803/18/8110MMLGNMA77 25/32105622261/23/806/17/8110MMSGNMA77 21/32105625271/23/809/1/8110MMLTBond79 13/32105624281/23/806/1/8110MMSTBond79 15/32STRADDLES OPENED AND CLOSED -- 198014784816/20/8012/16/816MMLGNMA30 10/3214784726/20/806/19/826MMSGNMA76 26/3214734936/20/806/1/826MMLTBond83 8/3214735046/20/8012/1/816MMSTBond83 20/3215008156/30/806/16/826MMLGNMA76 5/3215008266/30/8012/16/816MMSGNMA76 15/3215008376/30/8012/1/816MMLTBond79 14/3215008486/30/806/1/826MMSTBond79 12/3252 1979-1980 STRADDLE TRANSACTIONSLine Tr.ACLIX #PriceG/LO/CBeg/Cl9297722,318,437.50O14929773(2,338,125.00)O139189042,500,312.50O16918903(2,490,937.50)O159297683,860,937.50C17929770(3,893,750.00)O259297693,862,500.00C18929771(3,895,312.50)O259189074,168,750.00C19918905(4,153,125.00)O279189084,167,187.50C20918906(4,151,562.50)O270200942,218,125.00120,000.00O2020093(2,205,937.50)(112,500.00)O10200532,385,000.00105,937.50O4020052(2,388,750.00)(111,562.50)O3CAN929768(200,000.00)C5CAN929769(201,562.50)C7CAN918907(218,750.00)C9CAN918908(217,187.50)C110200733,671,875.00O260200743,671,875.00O260200503,946,875.00O280200513,946,875.00O281056237,778,125.0010,937.50O6 & 8105622(7,765,625.00)421,875.00O21 & 221056257,940,625.00364,062.50O10 & 12105624(7,946,875.00)53,125.00O23 & 24STRADDLES OPENED AND CLOSED -- 19801478484,818,750.00O6147847(4,788,750.00)O51473494,995,000.00O8147350(5,017,500.00)O71500814,569,375.00219,375.00O2150082(4,588,125.00)(230,625.00)O11500834,766,250.00251,250.00O4150084(4,762,500.00)(232,500.00)O353 APPENDIX A-2 1980-1982 STRADDLE TRANSACTIONSTradeSettleACLIX #Line #DateDateFaceL/SScrty.Rate16494118/29/809/16/8110MMLGNMA70 6/3216494028/29/803/17/8210MMSGNMA70 6/3216494338/29/803/01/8210MMLTBond72 20/3216494248/29/809/18/8110MMSTBond72 10/32178424510/22/809/16/812.9MMLGNMA70 23/32178425610/22/803/17/822.9MMSGNMA70 22/32CAN178424710/28/809/16/812.9MMLGNMACAN164941810/28/809/16/8110MMLGNMACAN164943910/28/803/8210MMLTBond1802861010/28/8012/16/812.9MMLGNMA67 8/321802851110/28/8012/16/8110MMLGNMA67 8/321802871210/28/8012/16/8110MMLTBond68 10/321814671311/05/8012/801MMLTBond681814661411/05/803/811MMSTBond68 20/321822501511/07/8012/801MMLTBond671822511611/07/803/811MMSTBond67 20/32CAN1814671711/25/8012/801MMLTBondCAN1814661811/25/803/811MMSTBondCAN1822501911/25/8012/801MMLTBondCAN1822812011/25/803/811MMSTBond390801219/18/813/17/822.5MMLGNMA58 1/32390800229/18/813/17/82.9MMLGNMA58390799239/18/816/16/829.5MMLGNMA53 2/32390802249/18/8112/16/815.6MMSGNMA57 25/32390803259/18/8112/16/812.4MMSGNMA57 26/32390804269/18/8112/16/814.9MMSGNMA57 27/32390805279/18/819/18/815.1MMLTBond59390806289/18/819/18/814.9MMLTBond58 24/32390808299/18/8112/1/814.9MMSTBond59 11/32391075309/18/8112/1/815.1MMSTBond59 16/32436789313/4/823/17/829.5MMLGNMA63 5/32436790323/4/826/16/829.5MMSGNMA62 13/3254 1980-1982 STRADDLE TRANSACTIONSLine Tr.ACLIX #PriceG/LO/CBeg/Cl1649417,018,750.00C8164940(7,018,750.00)O21,22,311649437,262,500.00C9164942(7,231,250.00)O27 & 281784242,050,843.75C7178425(2,049,937.50)O31CAN178424(100,593.75)C5CAN164941(293,750.00)C1CAN164943(421,875.00)C31802861,950,250.00O24,25,261802856,725,000.00O24,25,261802876,831,250.00O29 & 30181467680,000.00C17181466(686,250.00)C18182250670,000.00C19182251(676,250.00)C20CAN18146710,000.00C13CAN181466(15,000.00)C14CAN18225020,000.00C15CAN182281(25,000.00)C163908011,450,781.25O2390800522,000.00413,593.75 1O23907995,515,937.50O32390802(3,235,750.00)O10 & 11390803(1,387,500.00)O10 & 11390804(2,834,343.75)(1,217,656.25) 2O10 & 113908053,009,000.00O43908062,878,750.001,343,500.00 3O4390808(2,907,843.75)O12391075(3,034,500.00)(888,906.25) 4O124367895,999,843.75682,468.75 555 O2 & 6436790(5,928,593.75)412,656.25O23BEGHE231 BEGHE, J., concurring: Having joined the majority opinion, I write separately to respond to some of the strictures in the dissenting opinion. With all due respect, the author of the dissenting opinion and the Court of Appeals for the District Columbia Circuit in Stoller v. Commissioner, 994 F.2d 855 (D.C. Cir. 1993), revg. in part T.C. Memo. 1990-659, have not paid proper heed to the body of judge-made law in the Second and Third Circuits, as well as this Court, that treats even true cancellations of some types of contracts as capital gain or loss transactions; this is just another area in which the capital character of the asset and other circumstances properly focus the analysis upon the nature of the contract rights in question, rather than merely upon the structure of the transaction as a "sale or exchange", as opposed to a cancellation, termination, or relinquishment. See, e.g., Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962), revg. in part and remanding 35 T.C. 617">35 T.C. 617 (1961); Commissioner v. McCue Bros. & Drummond, Inc., 210 F.2d 752 (2d Cir. 1954),56 affg. 19 T.C. 667">19 T.C. 667 (1953); Commissioner v. Golonsky, 200 F.2d 72 (3d Cir. 1952), affg. 16 T.C. 1450">16 T.C. 1450 (1951); see also Sirbo Holdings, Inc. v. Commissioner, 509 F.2d 1220 (2d Cir. 1975), affg. 61 T.C. 723">61 T.C. 723 (1974); Maryland Coal & Coke Co. v. McGinnes, 225 F. Supp. 854">225 F. Supp. 854 (E.D. Pa. 1964), affd. 350 F.2d 293">350 F.2d 293 (3d Cir. 1965). Other special circumstances present in the cases at hand provide a principled basis for looking beyond the conceded facts that the transactions in question were bona fide, had economic substance, and were entered into for profit--all of which only go to the economics of the amount of gain or loss--to recognize the also inescapable facts that Holly and AGS were related parties with no adverse interests insofar as the treatment of the closing transactions as offsets or cancellations was concerned. The custom or usage of the trade among dealers and traders in forward contracts and the underlying commodities, which Holly and AGS arbitrarily ignored, is that true cancellations57 are only employed to correct mistakes, not to close out forward contracts entered into and disposed of in the ordinary course of business. 1 See 232 Brown v. Commissioner, 85 T.C. 968">85 T.C. 968, 994 (1985), affd. sub nom. Sochin v. Commissioner, 843 F.2d 351">843 F.2d 351 (9th Cir. 1998); Stoller v. Commissioner, T.C. Memo. 1990-659, 60 T.C.M. (CCH) 1554">60 T.C.M. (CCH) 1554, 1566, 1990 T.C.M. (P-H) par. 90,659, at 3220-90; majority op. p. 9.58 In these circumstances, the analysis in the majority opinion of the forward contracts in question and the ways in which they were handled by Holly and AGS is consistent with and supported by Judge Friendly's analysis in Commissioner v. Ferrer, supra, and its ancestors and descendants. The cases at hand, then, are the latest ones in which it is appropriate to observe that "the 'formalistic distinction' between two-party and three-party transactions that was criticized in Ferrer is fast becoming a footnote to history." Bittker & McMahon, Federal Income Taxation of Individuals par. 32.1[5] at 32-5, 6 (1995). CHABOT, JACOBS, and PARR, JJ., agree with this concurring opinion. HALPERNHALPERN, J., dissenting: I. IntroductionI dissent because I believe that the majority is not justified in disregarding the actual transactions engaged in by Holly (the partnership) in favor of hypothetical transactions that yield the largest tax for the Government. The majority justifies treating a cancellation as a sale on the ground that cancellations and offsets are economically equivalent. Even were I to accept that proposition, the majority has failed59 to persuade me that a common "reality" of the two transactions is a sale. In searching for that reality, it is important to keep in mind that respondent has made the following concession: 233 Respondent concedes for purposes of these cases that Holly Trading Associates' transactions in forward contracts with ACLI Government Securities, Inc. during the years at issue were bona fide, had economic substance, and were entered into for profit. [Emphasis added.]I cannot join in an opinion that taxes a cancellation as a sale without specific statutory authority and under what I consider a drastic extension of the doctrine of substance over form. II. Anticipatory Commodities TransactionsI believe that, in part, the majority misunderstands some of the complex arrangements by which persons arrange for the future purchase or sale of a commodity. A certain amount of detail is necessary to appreciate what I believe the majority misunderstands. Many of the factual details of the various anticipatory arrangements for the purchase or sale of a commodity can be found in our opinion in Stoller v. Commissioner, T.C. Memo. 1990-659,60 affd. in part and revd. in part 994 F.2d 855">994 F.2d 855 (D.C. Cir. 1993). 1 Following are pertinent terms and concepts.A. Regulated Futures ContractsA regulated futures contract (RFC) is a standardized executory contract to buy or sell a designated commodity at a specific price on a fixed date in accordance with the rules of a commodity exchange. The date the contract is to be performed is normally identified by its delivery month, e.g., "a January61 1997 contract". All RFCs start out as a contract between a buyer and seller. At the end of each trading day, the exchange's clearing organization substitutes itself as the "other side" of each contract, so the clearing organization becomes the buyer to each seller and the seller to each buyer. The agreement made by or on behalf of the two parties on the floor of the exchange is thus broken down into a "long" RFC, in which one party is the buyer and the clearing organization is the seller, and a "short" RFC, in which the 234 other party is the seller and the clearing organization is the buyer. Trading in RFCs for a specific commodity and delivery month continues until the day of the month set by the exchange on which trading in contracts for that delivery month stops. Thereafter, delivery of the commodity is made by holders of open short RFCs to holders of open long RFCs on the matched-up basis established by the clearing organization. Up until the date trading stops, the holders of both long and short RFCs can close out their contracts without making or taking delivery of the commodity by entering into inverse purchase or sale contracts on the exchange. Thus, the holder of a long RFC62 can eliminate the risk of, or "offset", his obligation to purchase and pay for the commodity by acquiring from another the promise to purchase and pay for the same commodity on the same exchange for the same delivery month, that is, by entering into an inverse, short RFC. Such a transaction has been held to meet the Code requirement of a "sale or exchange", which can give rise to capital gain or loss, on the ground that a "fictional" delivery is made on the offsetting inverse, short RFC with the commodity "acquired" under the long RFC. Commissioner v. Covington, 120 F.2d 768">120 F.2d 768, 770, 772 (5th Cir. 1941), affg. in part and revg. in part 42 B.T.A. 601">42 B.T.A. 601 (1940). The holder of a short RFC can, likewise, offset his obligation to sell the commodity at the agreed price by acquiring from another a commitment to sell and deliver the same commodity on the same exchange for the same delivery month, that is, by entering into an inverse, long RFC. The commodity to be delivered under the long RFC is deemed received and used to satisfy the delivery obligation under the short RFC, thus satisfying the sale or exchange requirement necessary for capital63 gain or loss treatment. Id. The special short sale rules of section 1233 are applicable to RFCs. Unless certain exceptions apply, the gain or loss is capital. Sec. 1233(a). It appears that, under the usual exchange rules applicable to RFCs, the offsetting contracts, which are both with the exchange, immediately cancel and are terminated, with a money settlement for the difference in value. Commissioner v. Covington, supra at 769. Gain or loss is, thus, realized on that (the offset) date. 235 B. Forward ContractsA forward contract is also an executory agreement calling for future delivery of a commodity. Forward contracts, however, are privately negotiated; they are not traded on commodity exchanges or subject to the rules of any board of trade. If the parties to any particular forward contract agree, the contract can be canceled before the delivery date. Normally, any unrealized gain or loss in the contract would then be accounted for because the party on the profitable end of the contract would demand payment for giving up a valuable right. The character of that gain or loss is the question in this case. A party may fix the amount of unrealized64 gain or loss in a forward contract by entering into an inverse contract to buy or sell the same commodity for delivery on the same date (the settlement date), but at the then current market price for delivery on such date. In Hoover Co. v. Commissioner, 72 T.C. 206">72 T.C. 206, 249-250 (1979), we described the consequence of entering into offsetting forward contracts. Finally, we note that the most common method of settling a forward sale contract has traditionally been to enter into a purchase contract and to offset the contractual obligations to sell and purchase. Meade v. Commissioner, T.C. Memo. 1973-46; Muldrow v. Commissioner, 38 T.C. 907">38 T.C. 907, 910 (1962); Sicanoff Vegetable Oil Corp. v. Commissioner, 27 T.C. 1056">27 T.C. 1056, 1059, 1063 (1957), revd. 251 F.2d 764">251 F.2d 764 (7th Cir. 1958). Offset of the contractual obligations by the seller has been held to be delivery under the sale contract ( Chicago Bd. of Trade v. Christie Grain & Stock Co., 198 U.S. 236">198 U.S. 236, 248 (1905); Lyons Milling Co. v. Goffe & Carkener, Inc., 46 F.2d 241">46 F.2d 241, 247 (10th Cir. 1931)),65 satisfying the sale or exchange requirement on the date the contract is settled. See Covington v. Commissioner, 42 B.T.A. 601">42 B.T.A. 601 (1940), affd. in part 120 F.2d 768">120 F.2d 768 (5th Cir. 1941), cert. denied 315 U.S. 822">315 U.S. 822 (1942).There is, thus, an important distinction between the operation of offset in the contexts of RFCs and forward contracts. By exchange rules, offsetting RFCs cancel and are terminated on the offset date, with a money settlement then for any difference in values. Offsetting forward contracts, being privately negotiated, do not automatically cancel and terminate on the offset date but, unless the parties agree to the contrary, coexist until the settlement date, when both contracts are deemed to have been executed, with delivery taken (on the long contract) and delivery made (on the short contract). Although not perfectly clear on that point, Hoover suggests 236 that, unless the parties earlier agree to settle up, the settlement date, not the offset date, is the date that gains and losses are realized with respect to forward contracts settled by offset. In Hoover, there were 13 forward contracts66 in issue that were settled by entering into inverse forward contracts. Of that number, a debit or credit (settlement payment) was made after the offset date, on the settlement date, in nine situations. In one situation, a settlement payment was made after the offset date, but in advance of the settlement date, and, in one situation, a settlement payment was made after the settlement date. In two situations, a settlement payment was made on the offset date. In one situation, it is clear that the settlement payment was made in a year beginning after the offset date. Nothing indicates that the taxpayer did not report, and both the Commissioner and the Court accepted, the date of the settlement payment as the date that gain or loss was realized. Indeed, the Court calculated the holding period with respect to those transactions from the offset date; those calculations seem to belie any assertion that the offset date is the date of realization. Hoover Co. v. Commissioner, supra at 250-251. C. StraddleA person who has entered into either a RFC or a forward contract (when no distinction is intended, an "anticipatory contract") assumes the risk that the67 market price for delivery of the commodity on the agreed date will change. Changes in the market price for delivery of the commodity will result in changes in the value of an anticipatory contract for delivery in that month. An anticipatory contract holder is described as being in a "naked" position when he bears the unalloyed risk of changes in the market price for delivery of the commodity (market risk). A "straddle", in its simplest terms, is the simultaneous entry into two anticipatory contracts with respect to the same commodity; one is a long contract, to buy a given amount of the commodity for delivery at a specific time, and the other is a short contract, to sell the same amount of the commodity for delivery at a different time. A straddle reduces market risk because, as the value of one leg decreases, the value of the other leg increases. Because the legs are for deliveries at 237 different times, the value changes will not necessarily be exactly offsetting. There is, thus, the potential for profit or loss in a straddle. D. Replacing a LegA participant in a straddle may replace one leg of the straddle with another contract of the same kind (i.e., long or short) for68 a different delivery date (such replacement of one leg being referred to as a switch). For example, here, in Stoller v. Commissioner, T.C. Memo 1990-659">T.C. Memo. 1990-659, with respect to the cancellations in question (except for one group, the November 25th group), we found that the partnership wished to change delivery dates in order to shorten the window of risk of the straddle. In the case of a straddle built on RFCs, the mechanics of a switch would involve the taxpayer simultaneously entering into (1) an inverse contract with respect to the long or short RFC being switched and (2) a like (long or short) RFC to replace the RFC being switched. Except perhaps in the case of certain tax-motivated straddles, see, e.g., Smith v. Commissioner, 78 T.C. 350 (1982), gain or loss on the long RFC component of the offsetting pair would immediately be realized and recognized. Commissioner v. Covington, 120 F.2d 768">120 F.2d 768 (5th Cir. 1941). In the case of a straddle built on forward contracts, the parties to the contract to be switched may agree to cancel that contract, settling up with respect69 to any gain or loss in the contract. To avoid being naked with respect to the remaining leg of the straddle, the straddling party would immediately enter into a contract to replace the canceled contract and complete the switch. The character of any gain or loss to be accounted for on the cancellation is the issue in this case, but there seems to be no disagreement that cancellation is an event giving rise to an allowable loss. In the case of a switch made by first entering into an inverse contract with the same party, the suggestion of Hoover Co. v. Commissioner, 72 T.C. 206">72 T.C. 206 (1979), is that gain or loss is realized upon the hypothetical delivery under the short contract of the offsetting pair on the settlement date or on any earlier date that the parties consummate a cash settlement. That suggestion as to timing, however, is thrown into doubt by the majority. There seems to be no disagreement, however, 238 that the gain or loss is realized from a sale or exchange. The second step in the switch would be exactly the same as if the switch were initiated by canceling the to-be-switched-leg, i.e., entering into a replacement contract. E. Canceling Both Legs70 The majority has not made clear that what it has called the Third Contract, see majority op. p. 4 (the November 25th group), involved straddles consisting of contracts that were all closed by cancellation on the same date. There was no switch of any leg and, consequently, no continuing straddle investment after the cancellations, all of which took place on November 25, 1980. III. Majority's Theory of EquivalenceI believe that the key to understanding the majority's error is contained in the following sentence: Whenever the investor (during the length or duration of the forward contracts that have been purchased) elects to settle, close out, extinguish, or cancel the contracts or positions, or one of the legs thereof, and to realize the gain or loss associated with the contracts, or with one of the legs thereof, and regardless of whether the investor "closes out" or "locks in" the gain or loss by way of offset, by way of cancellation and replacement contracts, or by way of cancellation and termination, the transaction is exactly the same -- in purpose, in effect, and in substance -- and produces exactly the same type of taxable gain or loss -- in the instant cases 71 capital gain or capital loss. [Majority op. pp. 17-18; emphasis added.]That sentence follows almost immediately after the majority's citation to, and quotation from, Commissioner v. Covington, supra. The majority emphasizes those parts of the court's opinion (1) describing the taxpayer's argument that, pursuant to exchange rules, offsetting RFCs are extinguished and a money settlement made and (2) finding that implicit in an exchange regulated offset is the "agreement and understanding" that an actual purchase and sale of the underlying commodity has taken place. Majority op. p. 17. The majority finds that the agreement and understanding implicit in the exchange rules governing offsets of RFCs is apropos to the cancellations of the forward contracts here in issue. Id.The majority states: 239 Courts often must address taxpayers' "artful devices" to convert ordinary gain into more favorable capital gain or to convert capital loss into more favorable ordinary loss. * * * That task should be accomplished on the basis not of the "cancellation" label used by the parties but on the realities of the transactions and expectations of the parties. 72 [Majority op. pp. 22-23; emphasis added.]The majority obviously concludes that the common reality of (1) exchange regulated offsets, (2) the bilateral relationship of the two parties to offsetting forward contracts, and (3) the terminated relationship of the parties to a canceled forward contract is a sale or exchange. Indeed, the majority states that, in Stoller v. Commissioner, T.C. Memo. 1990-659, affd. in part and revd. in part 994 F.2d 855">994 F.2d 855 (D.C. Cir. 1993), both this Court and the Court of Appeals for the District of Columbia Circuit erred in not recognizing "the fundamental sale or exchange nature" of cancellations of forward contracts. Majority op. p. 22. The majority's perception of fundamental reality is bottomed on the treatment accorded RFCs settled by offset, as articulated in Covington v. Commissioner, supra. There, the taxpayer argued that the reality of an exchange regulated offset is the lack of any actual sale or exchange because there is an extinguishment of the RFC settled by offset. The Court of Appeals for the Fifth Circuit, 73 however, forced the taxpayer to abide by the form of the transaction he had chosen (as sculpted by the exchange rules dealing with offsets) and held that, in effect, he had entered into two contracts and realized a gain on closing the short contract. That is a perfectly appropriate result. See, e.g., Legg v. Commissioner, 57 T.C. 164">57 T.C. 164, 169 (1971), affd. 496 F.2d 1179">496 F.2d 1179 (9th Cir. 1974), in which we stated: "A taxpayer cannot elect a specific course of action and then when finding himself in an adverse situation extricate himself by applying the age-old theory of substance over form." The fiction imposed on a taxpayer that settles RFCs by offset, however, is not a ground to conclude that, in reality, a taxpayer not engaging in an exchange regulated offset (indeed, not engaging in an offset at all) entered into a hypothetical contract to complete the purchase and sale of a commodity that he never owned. Assume, for instance, that the taxpayer has constructed a straddle in X commodity, entering into a long May forward contract and a short 240 September forward contract. Assume further that there is an unrealized loss 74 in the short contract, and, for legitimate business reasons, the taxpayer wishes to switch the short contract to a December forward contract. The taxpayer cancels the short September contract, makes a cash settlement payment, and enters into a short December contract. The reality that the majority would impose is that the taxpayer entered into a long September contract under which, hypothetically, he took delivery of the commodity, which was used to satisfy the short September contract. To me, that is not reality; it is a fiction built upon a fiction. As a matter of tax policy, perhaps the cancellation of a forward contract should be treated as a zero dollar sale so as to satisfy the sale or exchange requirement of section 1222. Congress thinks so and has added section 1234A, which, however, is not effective with respect to the facts of this case. The majority's understanding of the "nature of the termination of offsetting forward contracts", majority op. p. 20, is illustrated by certain forward contracts in this case. That perspective is set forth as follows: "Upon closing by offset of forward contracts, the transaction is terminated and extinguished, settlement between the parties75 occurs at that time, and no contracts remain in effect." Id. If that is intended as a general statement of fact or of legal consequence, it is unsupported by any authority and is in apparent contradiction to our findings and opinion in Hoover Co. v. Commissioner, 72 T.C. 206">72 T.C. 206 (1979). Certainly, it is in contradiction to the understanding of the facts in this case by the Court of Appeals for the District of Columbia Circuit. In reversing us in part, the court said: The problem with the Tax Court's reasoning is that cancellation and offset are different in substance as well as in form. When a contract is cancelled it simply ceases to exist. When a contract is offset, both the original contract and the offsetting contract remain in effect until the date for delivery. * * [Stoller v. Commissioner, 994 F.2d at 857-858; emphasis added.]The majority may be misled by the way the partnership accounted for offset transactions. It appears that the partnership accounted for unrealized gains and losses in forward contracts as of the offset date, the date of the inverse contract. That may or may not have been correct, 76 but it is not evidence that the contracts were, by agreement, terminated 241 on the offset date. More to the point, it is not evidence of general industry practice. In addition, the majority suggests that, since "little, if anything, 'vanished' upon Holly's closing or settling the loss legs", sale or exchange treatment of those contract cancellations is appropriate. Majority op. p. 25. The majority recognizes that some contracts were not replaced (the November 25th group). Nevertheless, the majority explains that what remained after the contract cancellations was Holly's continued participation in straddle transactions: "The last thing the investors would have wanted -- upon the 'cancellations' in question -- is to vanish or disappear from the rest of these straddle transactions, the consequence of which is that the investors might actually have had a real loss to pay." Id.By juxtaposing cases involving "unexpected and true cancellations" of "regular commercial contracts for the provision of goods or services" (true cancellations) with the forward contract cancellations in issue, the majority purports to discern a fundamental difference that distinguishes true cancellations and77 explains the capital loss treatment appropriate for the contracts in issue. Id. at 23-24. The majority rejects true cancellation treatment for the contracts in issue by invoking what it considers Judge Friendly's "substance and reality" analysis in Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962), revg. and remanding 35 T.C. 617">35 T.C. 617 (1961). Believing that the "situation" here is the same as in the Ferrer case, the majority slaps together the whole of the partnership's straddle activities into a unitary endeavor that justifies disregarding (partially) each individual step. I believe that the majority has failed to appreciate the significance of Judge Friendly's analysis in the Ferrer case and, therefore, may not seek its blessing. In that case, involving the purported termination of certain dramatic production contract rights, Judge Friendly stated: Tax law is concerned with the substance, here the voluntary passing of "property" rights allegedly constituting "capital assets," not with whether they are passed to a stranger or to a person already having a larger "estate." So we turn to an analysis of what rights78 Ferrer conveyed. [Id. at 131.]242 Judge Friendly then engaged in an examination of the nature of the various rights in issue in that case. He believed that the principal distinction between a termination of contract rights that gives rise to capital gain and a termination that does not is the existence of an "equitable interest" in the holder of the rights being terminated, which interest is evidenced by the availability of equitable relief in the enforcement of the contract rights. Id. at 131-134. 2 It is, thus, insufficient for the majority to consider all of the partnership's straddle investments, each straddle transaction, or even each forward contract and to pronounce baldly that the partnership "received exactly what it contracted for." Majority op. pp. 24-25. Nor is it sufficient to rely on the parties' stipulation that the forward contracts in issue constitute capital assets. What is required is a careful consideration of the partnership's property interests in the subject matter of the contracts in question, in light of Congress' admittedly indistinct purpose in providing for the exceptional treatment of capital79 gains and losses. In sum, the majority has failed to examine the nature of the contract rights terminated by the cancellations of the forward contracts in issue in the manner contemplated by Judge Friendly and, therefore, is foreclosed from relying on Commissioner v. Ferrer, supra, to support its substance and reality analysis.Another difficulty with the rationale of the majority is the majority's failure to explain the steps by which it proceeded to conclude that the cancellation losses were losses from the sale or exchange of capital assets. Section80 1001 addresses the determination of gains and losses on the disposition of property. The sale or exchange requirement for capital gain or loss treatment is introduced in section 1222. The majority has failed to explain exactly what property was disposed of when a forward contract was canceled, how the partnership's adjusted basis in the disposed-of property was determined, or what amount was realized on such disposition. I must admit that I am puzzled by those questions, as I am puzzled by how Judge Friendly's "equitable interest" analysis could be applied to find a capital loss in a situation where the last 243 thing the partnership intended was actual delivery of the underlying securities that were the subject of the forward contracts in question. Given Congress' enactment of section 1234A, I see no reason to engage in an analysis that may result in consequences we cannot foresee. IV. ConclusionProfessors Bittker and Lokken, in their treatise on Federal income, gift, and estate taxation, address the principle that substance must govern over form in taxation. Bittker & Lokken, Federal Taxation of Income, Estates and Gifts, par. 4.3.3, at 4-33, (2d ed. 1989). They begin their81 discussion by noting that the substance-over-form principle has been referred to as "the cornerstone of sound taxation" (quoting Estate of Weinert v. Commissioner, 294 F.2d 750">294 F.2d 750, 755 (5th Cir. 1961), revg. and remanding 31 T.C. 918">31 T.C. 918 (1959)). Id. In the course of their discussion, they state (without citation of authority, but none is needed): "If a transaction is consummated in a form that fairly reflects its substance, it ordinarily passes muster despite the conscious pursuit of tax benefits; in this case, the choice of form resembles an election provided by statute." Id. at 4-38. They caution, however: A rogue offshoot of the substance-over-form doctrine suggests that when a taxpayer selects one of several forms that have identical practical consequences in the real world, the government can disregard the chosen form and tax the transaction as though the most costly of the alternatives had been employed. * * [Id. at 4-41.]They continue: "On close inspection, the most-costly-alternative theory turns out to be a drastic extension, rather than a mere restatement, of the substance-over-form doctrine." 82 Id. at 4-42. The majority has not invoked much of the substance-over-form jurisprudence. It has, however, looked for the "realities of the transactions" and raised the specter of "artful devices". I believe that it is fair to say that the majority has looked to tax the cancellation transactions on the basis of what it considers to be their substance. In searching for that substance, however, the majority has dug no deeper than the fiction that accounts for the tax treatment of exchange regulated offsets and forward contracts settled by offset and payment. Indeed, with respect to offsetting forward contracts, 244 the majority appears to conclude, wrongly, that all such contracts cease to exist on the offset date. The reality of the settlement of anticipatory contracts by offset is not that the contract holder took delivery under a long contract of a commodity that he then used to satisfy his delivery obligation under a short contract. That is a fiction imposed on the taxpayer because of the way he chose to cast his transaction. To impose that fiction on a taxpayer who, for whatever reason, chose not to cast his transaction that way seems to me to be wrong, at least without 83 some better explanation than what the majority gives. From a policy perspective, I can sympathize with the majority's concern that a taxpayer should not be able to lower his tax bill simply on the basis of which form, as between two economically equivalent (or similar) forms, he chooses. The majority's concern is apparent in how, in part, it frames the issue in this case: "whether the taxpayers can convert the capital loss into an ordinary loss". Majority op. p. 14 (emphasis added). That statement suggests that the proper inquiry is the proper tax characterization of the cancellations, not whether, tax questions aside, form and substance agree. To me, that is a troublesome inquiry for the reasons stated by Professors Bittker and Lokken. Footnotes. Briefs amicus curiae were filed on behalf of Martin B. and Marilyn G. Boorstein, and Allan D. and Lesley Yasnyi, other partners against whom respondent has determined income tax deficiencies relating to the same issue involved herein. These other partners have filed petitions in this Court, and they have filed stipulations to be bound by the final resolution of the instant cases.↩1. Gain figure represents gain realized by offsetting $ 3.4 million of Contract # 164940 (line 2) by lines 21 and 22.↩2. Loss figure represents total loss realized on closing transactions on lines 10 and 11 by transactions shown on lines 24 through 26.↩3. Gain figure represents total gain realized by offsetting transaction shown on line 4 by transactions shown on lines 27 and 28.↩4. Loss figure represents total loss realized by offsetting transaction shown on line 12 by transactions shown on lines 29 and 30↩5. Gain figure represents gain realized by offsetting $ 6.6 million of Contract # 164940 (line 2) and line 6 by line 31.↩1. Another fact, shown in the stipulated record, that points up the arbitrary treatment of the transactions between Holly and AGS, insofar as the choice of tax consequences was concerned, is that, in the case of offsetting transactions, Holly and AGS agreed to recognize both gains and losses as of the trade date of the offset. This would seem to be contradicted by the fact that both contracts remain in existence, and a net profit or loss is locked in, but remains unrealized until the settlement date when the securities are deemed delivered and received pursuant to both contracts, and the net profit or loss debited or credited to the trader's account. I don't understand how agreement of the parties could change the tax consequences. If such an agreement were efficacious, the validity of short sales against the box in not only locking in gain but also postponing realization would seem to be thrown into doubt.↩1. My research has also led me to two helpful articles dealing with both the mechanical and tax aspects of anticipatory commodities transactions, at least as those matters stood in 1981, which is about the date of the transactions involved herein. Donald Schapiro, Commodities, Forwards, Puts and Calls--Things Equal to the Same Things Are Sometimes Not Equal to Each Other, 34 Tax Lawyer 581↩ (1980-81); Donald Schapiro, Tax Aspects of Commodity Futures Transactions, Forward Contracts and Puts and Calls, 39th Annual N.Y.U. Institute 16-1 (1981).2. That understanding of Judge Friendly's analysis has been stated by two commentators: Marvin A. Chirelstein, Capital Gain and the Sale of a Business Opportunity: The Income Tax Treatment of Contract Termination Payments, 49 Minn. L. Rev. 1">49 Minn. L. Rev. 1, 20-23 (1964); James S. Eustice, Contract Rights, Capital Gain, and Assignment of Income--the Ferrer Case, 20 Tax L. Rev. 1">20 Tax L. Rev. 1, 7-9↩ (1964).	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622013/	THOMAS C. AND RITA HARRISON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentHarrison v. CommissionerDocket No. 17252-84.United States Tax CourtT.C. Memo 1987-52; 1987 Tax Ct. Memo LEXIS 213; 52 T.C.M. (CCH) 1503; T.C.M. (RIA) 87052; January 22, 1987. Philip W. Sandler, for the petitioner. Robert F. Simon, for the respondent. FAYMEMORANDUM OPINION FAY, Judge: This case is before the Court on petitioners' motion for litigation costs pursuant to Rule 231 and section 7430. 1 The issue is whether petitioners should be awarded reasonable litigation costs pursuant to section 7430. The parties have submitted a stipulation of services rendered by counsel for petitioners in the event we grant214 petitioners' motion. 2Petitioners Thomas C. Harrison and Rita Harrison resided in Park Ridge, Illinois, when they filed the petition herein. Respondent issued a notice of deficiency with respect to petitioners' Federal income tax liability for taxable year 1980. The entire amount of deficiency determined in the notice of deficiency herein arose from respondent's disallowance of partnership losses claimed by petitioner Thomas C. Harrison in his capacity as a limited partner of Triangle215 Village Associates, Ltd. (herein "Triangle"), a limited partnership. Respondent had conducted an examination of Triangle's information return for 1979, 1980, and 1981. The statute of limitations under section 6501(a) for petitioners' 1980 Federal income tax return would expire on April 15, 1984. On April 2, 1984, respondent sent a Consent Form 872A -- Special Consent to Extend the Time to Assess Tax -- to petitioners requesting that they execute such form for taxable year 1980. On April 4, 1984, petitioners executed the Form 872A and mailed it to respondent. Respondent never received the executed document. On April 11, 1984, respondent issued the notice of deficiency with respect to petitioners' 1980 Federal income tax liability. A statement issued with such statutory notice states: The above respective claimed losses are disallowed because you have not substantiated that the entity was engaged in an activity entered into for profit or that deductible expenses were incurred by the entity in excess of its income. Furthermore, you have failed to establish any basis in the entity which would permit you to deduct an otherwise distributable loss. * * * * * * It is determined216 that you failed to show that you are entitled to a share in qualified investment in excess of $0 from Triangle Village Assoc. * * Petitioners timely filed the petition herein on June 6, 1984. Respondent thereafter filed an answer to the petition. On December 17, 1984, petitioners' counsel notified respondent's counsel that respondent's Newark, New Jersey, District Director concluded the examination of Triangle's information return, and issued a "no-change" letter on November 28, 1984. That is to say, the examination had been closed without adjustment. Respondent's counsel thereupon offered to concede the deficiency in the instant case pending verification of the issuance of the no-change letter and the information contained therein. The telephone call on December 17, 1984, was the first communication between counsel after the pleadings were filed. In January of 1985, after receipt of a copy of the "no-change" letter issued to Triangle, respondent executed a stipulation of settled issues, thereby conceding the amount of deficiency in the instant case. The parties subsequently filed with the Court the stipulation of settled issue with respect to petitioners' Federal tax217 liability for 1980. Petitioners then filed a motion for litigation costs pursuant to section 7430. A hearing was held on petitioners' motion. Section 7430 states, in pertinent part, 3(a) In General. -- In the case of any civil proceeding which is -- (1) brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty under this title, and (2) brought in a court of the United States (including the Tax Court and the United States Claims Court), the prevailing party may be awarded a judgment for reasonable litigation costs incurred in such proceeding. * * (c) Definitions-For purposes of this section- * * * (2) Prevailing party. -- (A) In general. -- The term "prevailing party" means any party to any proceeding described in subsection (a) (other than the United States or any creditor of the taxpayer involved) which -- (i) establishes that the position of the United States in the civil proceeding was unreasonable, and (ii)(I) has substantially prevailed with respect to the amount in controversy, or (II) has substantially prevailed with respect to the most significant issue or218 set of issues presented. (B) Determination as to prevailing party. -- Any determination under subparagraph (A) as to whether a party is a prevailing party shall be made -- (i) by the court, or (ii) by agreement of the parties. Respondent concedes that petitioners had exhausted their available administrative remedies and that petitioners have substantially prevailed with respect to the amount in controversy on the most significant issue or set of issues presented in the notice of deficiency. Petitioners argue that respondent's position in the civil proceeding was unreasonable in the issuance of the notice of deficiency and in his failure to initiate communication between the parties prior to conceding the case. Petitioners argue therefore that they are entitled to an award of litigation costs pursuant to section 7430. 4219 Our inquiry herein turns on whether the position of the United States in the civil proceedings was unreasonable within the meaning of section 7430(c)(2)(A)(i). We have held that the clear meaning of the specific language of the phrase, "position * * * in the civil proceeding," and of the statute as a whole, supported by legislative history, requires us to examine the reasonableness of respondent's position during the litigation, that is to say, from the time of the filing of the petition in this Court. , vacated and remanded on other grounds ; . We followed that standard in , and therein limited our inquiry concerning the reasonableness of the Commissioner's position to the post-petition period of the case. . 5220 The determination of reasonableness requires an examination of all post-petition facts and circumstances. . The factors we may consider here are: (1) Whether the government used the costs and expenses of litigation against its position to extract concessions from the taxpayer that were not justified under the circumstances of the case; (2) Whether the government pursued the litigation against the taxpayer for purposes of harassment or embarrassment, or out of political motivation; and (3) other factors as the Court finds relevant. H. Rept. No. 97-404, at 12 (1981); See also . Furthermore, concession of a case does not mean that the conceding party's position in the civil proceeding was unreasonable. . Petitioners have the burden of proof with respect to this issue. Rule 232(e). With that in mind, we now examine the facts as established in this case to determine whether respondent's position in the civil proceeding was unreasonable under section 7430. We first address petitioners' contention that221 respondent did not initiate contact with petitioners after the petition and the answer herein were filed. As respondent states in his reply memorandum of law to petitioners' motion, it was petitioners' burden and responsibility to come forward with evidence to sustain their allegations of error. Rule 142(a). That communication was not initiated between counsel for the parties is more telling of petitioners' conduct than that of respondent. We are not prepared to find respondent's failure to initiate communication between the parties after the pleadings were filed to indicate an unreasonable position in the civil proceeding. We also refuse to hold that the insistence of counsel for respondent in obtaining verification of the "no-change" letter before conceding the case indicates an unreasonable position in the civil proceeding. The petition herein was filed on June 6, 1984. Respondent indicated his willingness to concede the case on December 17, 1984, immediately upon notification from petitioners' counsel that the transaction giving rise to the deficiency had been resolved by respondent's Newark, New Jersey, District Director, in petitioners' favor. Petitioners made much of the*222 fact that respondent did not initiate contact with petitioners between the filing of the pleadings and the concession, and that respondent delayed in conceding the case. We note that only one month elapsed between respondent's receipt of notification of the "no-change" letter and his final concession of the case. Furthermore, we do not find counsel's insistence on verification before final concession of the case unreasonable conduct. If petitioners' counsel relied on the issuance of the "no-change" letter, he most likely had in his possession a copy of such letter, and respondent's counsel's request of such a copy was not unreasonable. We hold that respondent's position in the civil proceeding herein is not unreasonable and petitioners' motion for an award of litigation costs under section 7430 is therefore denied. An appropriate order and decision will be entered.Footnotes1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended and in effect at the time of the commencement of this case, and all Rule references are to the Tax Court Rules of Practice and Procedure. ↩2. The parties only agreed in the stipulation of services to the amount of litigation costs incurred and paid prior to the filing of the motion. The parties agree that, in the event the motion for litigation costs is granted, petitioners are entitled to litigation costs paid or incurred in connection with the motion of litigation costs. However, the parties have not agreed as to the amount of service performed by petitioners' counsel in that regard.↩3. Section 7430 has been amended by section 1551 of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2752. However, cases which commenced before January 1, 1986, such as the instant case, are governed by section 7430 as in effect before January 1, 1986. H. Rept. 99-841, at II-802 (Conf. 1986).↩4. Petitioners have made no argument that respondent's legal position is unreasonable.↩5. Petitioners have cited cases wherein the court decided that the position of the United States in the civil proceeding includes the Internal Revenue Service's position before litigation. For example, the Fifth Circuit Court of Appeals held that the inquiry should focus on the Internal Revenue Service's position at the time the petition was filed and that if the Internal Revenue Service takes an arbitrary position and forces the taxpayer to file a suit, then the taxpayer should be permitted to recover the cost of suing. , remanding a Memorandum Opinion of this Court. In , the First Circuit held that the government's prelitigation conduct as well as its conduct in litigation-related proceedings after a suit is initiated should be considered in setting attorney's fees. We note that the Seventh Circuit, wherein lies the appeal of the instant case, has not yet addressed this issue. In any event, we do not find the issuance of the notice of deficiency unreasonable. . (The Commissioner's issuance of a statutory notice where a taxpayer refuses to extend the statutory period for assessment does not, per se, render the notice arbitrary or invalid.)↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622014/	JUDITH L. BRAMLAGE, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentBramlage v. CommissionerDocket No. 26004-84.United States Tax CourtT.C. Memo 1985-621; 1985 Tax Ct. Memo LEXIS 10; 51 T.C.M. (CCH) 150; T.C.M. (RIA) 85621; December 23, 1985. John W. Thyson, on behalf of petitioner. Christopher Kane, for the respondent. RAUMMEMORANDUM FINDINGS OF FACT AND OPINION 1RAUM, Judge: The Commissioner determined a deficiency in petitioner's 1981 income tax in the amount of $1,994. The parties have stipulated that "[t]he only remaining issue in this case is whether [petitioner's] use of a computer in her home [in 1981] constituted the carrying on of a trade or business within the meaning of section 162 [I.R.C. 1954]". The answer to this question will determine the deductibility11 of $3,523 of "business expenses" 2 claimed on Schedule C of petitioner's 1981 income tax return as well as the correctness of a $335 investment credit. The Commissioner's $1,994 deficiency determination was based on the disallowance of the foregoing items as well as on the disallowance of other deductions unrelated to Schedule C. The petition filed herein stated that the amount of deficiency disputed is $507, and that amount would appear to be further reduced by reason of petitioner's concession in the stipulation of facts herein of the disallowance of a portion of the claimed Schedule C deductions in addition to her concession in respect of the disallowance of other deductions unrelated to Schedule C. 12 Petitioner has been engaged professionally in computer activities for some 15 years, and has attained considerable expertise in the field. At all times relevant to this proceeding she has been employed by Computer Sciences Corporation (Computer Sciences or the corporation). During 1981 and at least since then her position was that of a Senior Computer Scientist. The corporation appears to have a significant role nationally in the computer industry and is involved in designing and working out major projects for its clients. It was characterized by petitioner as "the largest software house in the world". Its clients are generally Government departments or agencies and large business organizations; it is not ordinarily concerned with the problems of small businesses. As a Senior Computer Scientist petitioner translates ideas that her employer's clients have for the use of a computer into "a set of requirements, then translate[s] the requirements into a design, the design into code, [and then] test[s], evaluate[s], and deliver[s]" -- a series of functions that can be described in the aggregate as "software engineering". She is a generalist, a person who is competent13 to perform functions at any point in the development of software. As such her employer tends to use her as a trouble shooter. Petitioner is employed by Computer Sciences on a full-time basis, generally working 40 hours a week, from 8:30 a.m. to 5:30 p.m. daily. However, she makes herself available to her employer for substantially longer workdays (often consuming almost all her waking hours) when a problem arises that requires her personal attention. Her compensation from the corporation in 1981 was $32,310.72. Petitioner's brother, Richard Flamer, is a small businessman who conducts a mail order used book business. In 1978 petitioner began discussions with him about the possibility or desirability of using a computer in his business. It was thought that a suitable computer with appropriately designed software could maintain and integrate three important aspects of his business: (1) a mailing list of his customers, presumably with notations indicating their areas of interest, (2) a record of his inventory, and (3) a list of details or descriptive materials with respect to the various items of his inventory. By tying these elements together such a computer could selectively14 prepare promotional communications for distribution to the customers tailored to the separate interests of each such customer or group of customers. Finally, a computer could be useful to Flamer by providing data for the pricing of his inventory through access to a central data base maintained in a distant city that furnishes to booksellers generally recent auction prices of books. Flamer was interested in obtaining the use of such a computer. Petitioner's discussions and planning with him continued from 1978 into 1979 when, in August of 1979, she purchased a "Heathkit" -- an unassembled kit of computer components that must be put together. She spent some four or five months building the computer, which was completed about January, 1980. After assembling the hardware, she translated Flamer's needs into a requirements document, and converted his mailing list data. She has also been shopping for and tailoring software for him, shopping for additional hardware (which she purchased in 1982 or 1983), updating his mailing list, further defining his needs in connection with collecting inventory data, and writing an instruction manual. In November of 1983 petitioner delivered to Flamer15 a modem and a terminal. These pieces of equipment have since then been used by him to gain access to inventory pricing information from a data base called "Bookline". Since November of 1983 Flamer has been renting from petitioner the equipment thus supplied by her for $25 a month. Prior to that time she received nothing from him for her work or use of the computer. Petitioner's activities in respect of the Flamer project were carried on in her spare time (evenings, weekends, etc.). She continued to work full time for Computer Sciences throughout the entire period of years from 1978 at least until the present, and does not appear to have any firm plans or intention to cease being thus employed, at least for the foreseeable future. As of the time of trial, in May 1985, petitioner had not yet completed the Flamer project. Petitioner kept no records of the number of hours she used the computer during the tax year 1981 or the purposes for which she used it. At least some portion of that use was for her personal benefit, such as maintaining data with respect to her own taxes. She claims to have spent approximately 18 hours a week on the project during most of 1981. Part of that16 time was spent in preparing a manual for use of the computer. At some undisclosed point during their business relations, petitioner and her brother orally agreed on the general terms of her compensation, which, however, apart from the $25 a month beginning in November 1983, was not to start until petitioner completed the entire project and delivered all the equipment to him. That time had not yet been reached when this case was tried in May 1985. There is no indication in the record that petitioner expected to realize any profit from the Flamer project. Indeed, it appears that she expected at most to be reimbursed for her costs. At no point since petitioner began discussing the project with her brother did she seek business or professional advice with respect to the project except in connection with tax preparation. Neither did she investigate the salability of her software nor attempt otherwise to market the project. However, she did have in mind an ultimate goal of obtaining customers, particularly dealers in books, whom she could service in her spare time. Indeed, there was even the possibility that at some point, such activities might become sufficiently profitable so17 as to warrant her leaving Computer Sciences and conducting her own business on a full-time basis. It is because of such possibility that petitioner has claimed that her part-time activities in 1981 in connection with her brother's project qualified as the conduct of a trade or business. The question is one that is largely factual, and we are not convinced that petitioner has carried her burden of proof. To the extent that petitioner's activities related to her brother's book business -- and that's all that was involved during the years 1978 through 1985 at least up to the time of trial -- such activities could hardly be characterized as undertaken for profit. The record is clear in this respect, and if all that were involved here was the Flamer project itself we would have no hesitancy in finding that petitioner's activities in question did not constitute the carrying on of a trade or business, certainly not in 1981, the year before us. More troublesome, however, is petitioner's contention that she had in mind or hoped to be able to obtain other clients or customers whose projects would be profitable to her. We were nevertheless left with serious doubts as to the nature of18 such expectations. They appeared to us to be altogether too elusive, and related at best only to some vague future time. During 1981 -- and for that matter up until the time of trial -- petitioner did not actively seek any other clients, by advertising, word of mouth, or otherwise. To be sure, she had an explanation for failing to seek clients -- i.e., that she wanted to be able to show them the completed job that she had done for her brother. But we were unpersuaded. She was a Senior Scientist with a distinguished corporation doing high level work on projects that were plainly of a considerably higher order of complexity than would be presented by the average small businessman to whom she might expect to target her services. Her status and experience alone could have been a strong attraction for small businessmen whose computer needs could easily have been regarded as those of a considerably lower order than those of the clients of Computer Sciences serviced by petitioner. In such circumstances, it would seem that if she were seriously engaged in her alleged part-time business she would have made some effort, even on a tentative or exploratory basis, to make contact with some*19 potential paying customers. Furthermore, petitioner's activities had few, if any, of the trappings of a business then being carried on in 1981.There was no systematic maintenance of records; no holding out to the public or even a small segment of the public; no gross receipts from her activities up to late in 1983; and even then no gain, nor did she expect any at that time. Whatever her uncrystallized hopes might have been as to some remote future time, her activities in 1981 did not then, in our judgment, rise to the level of carrying on a trade or business. We so find as a fact. Decision will be entered for the respondent.Footnotes1. For convenience, the findings of fact and opinion are combined herein.↩2. The major component of those "business expenses" was a claimed depreciation deduction of $1,963 in respect of petitioner's computer. However, the deduction for depreciation is governed by section 167. In view of the fact that the same "trade or business" requirement appears in both sections 162 and 167, we will likewise adopt the same "expense" terminology in this opinion to refer to both expenses and depreciation. The availability of the investment credit in dispute will follow automatically from the disposition of the "trade or business" issue.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622015/	Eli Lilly and Company and Subsidiaries, Petitioners v. Commissioner of Internal Revenue, RespondentEli Lilly & Co. v. CommissionerDocket No. 5113-76United States Tax Court84 T.C. 996; 1985 U.S. Tax Ct. LEXIS 73; 84 T.C. No. 65; May 28, 1985; Affirmed in part; Reversed in part and Remanded August 31, 1988 May 28, 1985, Filed 73 Decision will be entered under Rule 155. CONTENTSPageHeadnote999Introduction and Statement of Issues1001Findings of Fact1002I.History and Background of Eli Lilly & Co.1002A. Petitioner1002B. Lilly P.R.1004II.History and Background of Darvon and Darvon-N Products1004A. Propoxyphene and Propoxyphene Hydrochloride1004B. Propoxyphene Napsylate1006C. Success of Darvon and Darvon-N Products1007III.Manufacture of Darvon and Darvon-N Products1009A. Overview of Petitioner's Manufacturing Operations1009B. Manufacture of Darvon Products1010C. Manufacture of Darvon-N Products1012D. Development of Manufacturing Know-How10121. Chemical Manufacture10122. Pharmaceutical Manufacture1014E. Foreign Manufacture of Propoxyphene Products1015IV.Historical Development of the Puerto Rican Operations of Petitioner and Lilly P.R.1015A. Puerto Rico's "Operation Bootstrap"1015B. Petitioner's 1961-62 Study of Possible Puerto Rican Operations1016C. Petitioner's Second Puerto Rican Study 1965-661017V.Lilly P.R.'s Puerto Rican Tax Exemptions1025VI.Background and Documents Concerning Lilly P.R.1027A. Organization of Lilly P.R. and Initial Capitalization1027B. Technical Assistance Agreement1027C. Private Letter Ruling1028D. Assignment of Patents and Manufacturing Know-How1031E. Distribution Agreements1034F. Joint Research Agreement1035G. Agreements Regarding Empty Capsules1037VII.Lilly P.R.'s Manufacturing Activities1037A. Temporary Leased Facility1037B. Carolina Facility1038C. Mayaguez Facility1039D. Personnel10401. Organization of Initial Work Force10402. Training of Employees10413. Board of Directors, Officers, and Management Committees10424. 1971-73 Lilly P.R. Personnel1042E. Manufacturing Activities 1971-7310421. Production Planning10422. Chemical Manufacturing at Mayaguez10433. Pharmaceutical Manufacturing at Carolina1045F. Manufacturing Tickets and Related Procedures1046G. Raw Material Purchases1048H. Equipment Purchases1049I. Technical Assistance1049J. Quality Control1050K. Sample and Identi-dose Packaging1051VIII.Petitioner's Marketing Operations1051A. Introduction1051B. Organization10521. Marketing Research and Marketing Planning10522. Sales Force1053C. Regulation of Promotional Claims1055D. Marketing of Darvon and Darvon-N Products1056E. Pricing of Darvon and Darvon-N Products1056F. Significance of Marketing Intangibles1058IX.Petitioner's Research and Development Activities1060A. Introduction1060B. Food and Drug Administration Requirements1064C. Research and Development of Propoxyphene Products 1967-7310681. General10682. Research Projects10683. NDAs1070X.Litigation Related to Propoxyphene Products1072XI.Intercompany Pricing of Darvon and Darvon-N Products1073A. General1073B. Initial Pricing Policy1076C. Pricing Policy 1971-731078XII.Financial Information1080A. Overview of Petitioner's Accounting System1080B. Lilly Research Laboratories' Accounting Systems1081C. Propoxyphene Research and Development Expenses10831. Pre-1967 Research Activities10832. 1967-73 Research Activities1085D. Lilly P.R. Financial Statements 1971-731086E. Lilly P.R. Sales of Darvon and Darvon-N Products1089F. Petitioner's Pharmaceutical Division Income Statements1089G. Combined Income Statements for Darvon and Darvon-N Products 1971-7310911. General10912. Lilly P.R.10933. Petitioner1094a. Cost of Goods Sold1094b. Operating Expenses1094i. General Administration Expenses1094ii. Selling Expenses1095iii. Merchandising Expenses1098iv. Shipping Expenses1098H. Technical Assistance Fees1098I. Lilly P.R. Purchases From Petitioner10991. Raw Materials10992. Equipment and Machine Parts1100XIII.Generic Propoxyphene Products1100A. General1100B. Zenith Laboratories, Inc.1101C. Rachelle Laboratories, Inc.1102D. Smith Kline & French Laboratories11021. Milan Pharmaceuticals, Inc.11022. SK-65 Compound1103XIV.Respondent's Proposed Adjustments1105A. Notice of Deficiency1105B. Amendment to Answer1107Opinion1107Introduction1107Issue 1. Ownership of Intangibles for Section 482 Purposes1108A. Background of Relevant Provisions11091. Tax Incentives for Companies Operating in Puerto Rico1109a. Section 9311109b. Puerto Rico's Operation Bootstrap11122. Nonrecognition Provision of Section 3511113B. Interrelationship of Section 482 and Sections 351 and 93111141. Introduction1114a. History and Purpose of Section 4821114b. Scope of Respondent's Authority11152. Income From Manufacturing Intangibles1116a. Section 482 Allocations Involving NonrecognitionTransfers1116i. National Securities Corp. and Avoidance ofTaxes1118ii. Central Cuba Sugar, Rooney, ClearReflection of Income1121iii. Substance Over Form1125b. Arm's-Length Consideration1127Issue 2. Respondent's Section 482 Adjustments1130Issue 3. Determination of Arm's-Length Prices Between Petitionerand Lilly P.R.1133A. Section 482 Regulations11341. 1971 and 1972 Taxable Years1134a. Pricing Methods1135i. Comparable Uncontrolled Price Method1136ii. Resale Price Method1136iii. Cost Plus Method1145b. Profit Split Approach1147i. Cost of Goods Sold1153ii. Operating Expenses1156iii. Applicable Profit Split Percentage11632. 1973 Taxable Year1168a. Comparable Uncontrolled Price Method1169i. Petitioner's Adjustments to Milan's Prices1171ii. Respondent's Expert Economic Evidence1173iii. Determination of Arm's-Length Price1176B. Revenue Procedure 63-1011861. 1971 and 1972 Taxable Years11862. 1973 Taxable Year119174 1. Petitioner is engaged in the manufacture and sale of pharmaceutical products. Petitioner created and patented propoxyphene hydrochloride (Darvon) during the early 1950's and propoxyphene napsylate (Darvon-N) during the early 1960's. Darvon was first introduced into the U.S. market in 1957, and was manufactured by petitioner from 1957 to 1966. Darvon-N was not introduced into the U.S. market until 1971 and was never manufactured by petitioner. In 1965, petitioner organized Lilly P.R. as a wholly owned Puerto Rican subsidiary qualifying for the benefits of sec. 931, I.R.C. 1954. In December 1966, petitioner transferred the Darvon and Darvon-N patents and related manufacturing know-how to Lilly P.R. in a sec. 351, I.R.C. 1954, nonrecognition transaction. After 1966 and throughout the years in issue, Lilly P.R. manufactured Darvon and Darvon-N for sale to petitioner who in turn marketed the products throughout the United States. Held, Lilly P.R.'s ownership of the manufacturing intangibles is recognized in determining arm's-length prices between Lilly P.R. and petitioner. Held, further, the 75 prices Lilly P.R. charged petitioner caused a distortion of income justifying reallocations.2. Held, although reallocations of income were warranted, respondent's adjustments to prices under sec. 482, which denied Lilly P.R. any income from the manufacturing intangibles, were unreasonable.3. During 1971 and 1972, Lilly P.R. was the sole manufacturer of Darvon and Darvon-N. These drugs were nonnarcotic analgesics which competed in the prescription pain relief market with combinations of codeine with aspirin or acetaminophen. At the end of 1972, the Darvon patent expired and, shortly thereafter, several companies began to compete directly with Darvon by manufacturing and marketing generic propoxyphene hydrochloride products. Held, arm's-length prices determined for 1971 and 1972 under sec. 1.482-2(e)(1)(iii), Income Tax Regs.Held, further, arm's-length prices for 1973 determined under sec. 1.482-2(e)(2), Income Tax Regs.Thomas M. Haderlein, John C. Klotsche, Michael Waris, Jr., Gregg D. Lemein, Paul J. Linstroth, and James M. O'Brien, for the petitioners.Joel V. Williamson, Charles S. Triplett, and Joseph R. Goeke, for the respondent. Wiles, Judge. WILES1000 Respondent determined 76 deficiencies in petitioners' Federal income taxes as follows:YearDeficiency1971$ 7,622,44919727,340,86719736,853,8161001 By amendment to his answer, respondent asserted increased deficiencies in the following amounts:YearDeficiency 11971$ 11,711,792197211,626,363197310,882,192The entire amounts of the deficiencies determined by respondent for 1971 and 1972 are in dispute, and petitioners claim refunds for 1971 and 1972 in the amounts of $ 1,700,038 and $ 1,697,257, respectively. For 1973, all but $ 189,048 of the deficiency determined by respondent is in dispute.Pursuant to petitioners' motion, this Court severed from the case all issues other than the propriety of respondent's allocations of gross income under section 4822 from Eli Lilly & Co., Inc. (hereinafter Lilly P.R.) to petitioner Eli Lilly Co. (hereinafter petitioner) with respect to Darvon Registered TM and Darvon-N Registered TM products. The severed issues were consolidated with docket No. 19606-80 for purposes of trial, briefing, and opinion; consequently, 77 a final decision as to the income tax deficiencies of petitioners for the taxable years 1971, 1972, and 1973 will not be possible based upon the opinion of this case.The section 482 allocations of gross income from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products determined by respondent in his notice of deficiency and amendment to answer are as follows:Notice ofAmendmentYeardeficiencyto answer1971$ 18,522,924$ 26,620,387197217,820,98626,314,918197310,717,18718,078,205These allocations raise the following questions for our consideration:1. Whether petitioner's 1966 transfer pursuant to section 351 of certain Darvon and Darvon-N income-producing intangibles to Lilly P.R., a wholly owned subsidiary corporation 1002 engaged in manufacturing in Puerto Rico and qualifying as a possessions corporation within the meaning of section 931, should be recognized for the purposes of determining arm's-length prices for Darvon and Darvon-N products purchased by petitioner from Lilly P.R. during 1971, 1972, and 1973;2. Whether respondent's 78 determinations that gross income should be allocated from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products for the years 1971, 1972, and 1973 were arbitrary, capricious, or unreasonable;3. Whether Lilly P.R.'s prices to petitioner for Darvon and Darvon-N products manufactured by Lilly P.R. and sold to petitioner during 1971, 1972, and 1973 were prices at which those products would have been sold between unrelated parties dealing at arm's length.FINDINGS OF FACTSome of the facts have been stipulated and are found accordingly.I. History and Background of Eli Lilly & Co.A. PetitionerPetitioner is an Indiana corporation whose principal place of business at the time of filing the petition herein was Indianapolis, Indiana. During the years 1971, 1972, and 1973, petitioner and its consolidated subsidiaries maintained their books and records on the accrual method of accounting with taxable years beginning on January 1 and ending on December 31. Petitioner and its consolidated subsidiaries filed consolidated Federal income tax returns on Forms 1120 for the taxable years 1971, 1972, and 1973, at the Memphis Service Center, Memphis, Tennessee.Petitioner is engaged in the 79 United States in the invention, development, manufacture, marketing, and sale of a wide variety of ethical (i.e., prescriptions) and other pharmaceutical products, as well as certain agricultural, chemical, and cosmetic products. Petitioner is engaged in similar activities in approximately 145 countries throughout the world through a network of approximately 70 partially and wholly owned domestic and foreign corporations. During the time period 1003 1960 through 1975, petitioner and its subsidiaries employed from 10,000 to 24,000 individuals.During the years 1971 through 1973, the relevant divisions and subsidiaries of petitioner and their respective responsibilities were as follows:(a) Pharmaceutical Division: Marketing and sale of pharmaceutical products in the United States.(b) Elanco Products Co.: Marketing and sale of animal health and agricultural products in the United States.(c) Elizabeth Arden, Inc.: Marketing and sale of cosmetic products in the United States.(d) Lilly Research Laboratories: Fundamental and developmental research in the life sciences.(e) Production Operations Division: Operation of all manufacturing facilities in the United States.(f) Lilly P.R.: Manufacture 80 and sale of ethical pharmaceutical products in Puerto Rico.(g) Lilly Industries Ltd.: Fundamental and developmental research in the life sciences and manufacturing, marketing, and sale of pharmaceutical, animal health, and agricultural products.(h) Eli Lilly S.A., Geneva: International marketing, licensing, and holding company.The consolidated net sales (excluding intercompany sales) of petitioner and its worldwide subsidiaries and the United States pharmaceutical net sales of petitioner for the years 1965 through 1973 were as follows (000's omitted):ConsolidatedU.S. pharmaceuticalYearnet salesnet sales1965$ 316,600$ 176,3581966366,700196,4821967408,400212,8291968479,600257,6101969537,200284,5011970592,300304,9331971723,300338,3211972819,700351,0441973972,500368,915During the years 1971 through 1973, approximately 60 percent of the consolidated sales of petitioner and its worldwide subsidiaries was attributable to the sale of pharmaceutical 1004 products. 3 During those years, petitioner marketed approximately 750 pharmaceutical products in the United States. Petitioner's pharmaceutical sales during that time accounted for approximately 7.5 percent of the total pharmaceutical industry 81 sales in the United States, and its pharmaceutical products accounted for approximately 6.5 percent of the new and refilled prescriptions written in the United States.B. Lilly P.R.Lilly P.R. was organized under the laws of the State of Indiana on June 9, 1965, as a wholly owned subsidiary corporation of petitioner. Lilly P.R.'s principal place of business is located in the Commonwealth of Puerto Rico. During 1971, 1972, and 1973, Lilly P.R. maintained its books and records on the accrual method of accounting with taxable years beginning on January 1 and ending on December 31. Lilly P.R. filed Federal income tax returns on Forms 1120 for the taxable years 1971 through 1973 with the Office of International Operations, Philadelphia, Pennsylvania.Lilly P.R. was organized by petitioner, among other reasons, to take advantage of the benefits provided by section 931 relating to income from sources within possessions of the United States. Since its inception, Lilly P.R. has been engaged in the manufacture of propoxyphene and other pharmaceutical 82 products in the Commonwealth of Puerto Rico. During each of the years in issue, Lilly P.R.'s gross income satisfied the conditions set forth in subsections (1) and (2) of section 931(a).II. History and Background of Darvon and Darvon-N ProductsA. Propoxyphene and Propoxyphene HydrochlorideThe search for a nonaddictive synthetic analgesic having the pain relieving properties of morphine began in the late 1920's and was accelerated in later years by two events. The first of those events was the scarcity of morphine during World War II. The second came at the close of World War II when American scientific intelligence teams investigated German1005 wartime work on synthetic analgesics and published a report, referred to as the "Kleiderer Report," summarizing that work for the American scientific community. The Kleiderer Report dealt with a number of synthetic substances, one of which subsequently became known as methadone. Although methadone proved to be as effective an analgesic as morphine, it also proved to be as addictive as morphine. In response to the Kleiderer Report, an intensive research effort was mounted in the United States and abroad for a nonnarcotic, synthetic analgesic 83 of the morphine class. Several major pharmaceutical companies, including petitioner, participated in that effort.In 1951, Dr. Albert Pohland, a research chemist working at Lilly Research Laboratories, discovered propoxyphene and propoxyphene hydrochloride. Propoxyphene hydrochloride, the principal active ingredient in Darvon products, proved to be the first synthetic analgesic that acted on the central nervous system with only a negligible potential of addiction. U.S. Patent 2,728,779 (hereinafter the propoxyphene patent) was issued to petitioner as Dr. Pohland's assignee on December 27, 1955, pursuant to an application filed on December 3, 1952. The propoxyphene patent covered the chemical substance propoxyphene and the acid addition salts of propoxyphene, including propoxyphene hydrochloride. The propoxyphene patent expired on December 27, 1972.Propoxyphene is an oral prescription analgesic medication that relieves pain by acting upon the pain receptors in the brain. Propoxyphene is prescribed by physicians for the relief of mild to moderate pain, such as severe headache pain, postsurgical pain, and pain from bone fractures. It is often prescribed for patients with pain who 84 have unsuccessfully self-medicated with over-the-counter drugs such as aspirin and acetaminophen. 4 Aspirin and acetaminophen are peripherally acting analgesics that relieve pain by acting at the site in the body where the pain arises.Although propoxyphene was discovered in 1951 and the propoxyphene patent was issued to petitioner in 1955, petitioner did not obtain its first approval to market a propoxyphene product in the United States from the Food and Drug Administration, Department of Health and Human Services (hereinafter 1006 the FDA) until September 9, 1957. Petitioner sold its propoxyphene hydrochloride products under the trademark Darvon, which trademark it registered on July 29, 1958.During the period from 1957 through 1973, petitioner sold the following products containing propoxyphene hydrochloride as their principal active ingredient:IdentificationcodeDescriptionPU 364 Darvon 32 mg.PU 365 Darvon 65 mg.PU 366 Darvon with A.S.A.PU 368 Darvon CompoundPU 369 Darvon Compound-65PU 377 Darvo-Tran Registered TMTA 1855Stero-Darvon Registered TMThe letters "PU" in the identification code 85 of a product indicate that the product is sold in capsule, or "Pulvule Registered TM," form. The letters "TA" indicate that the product is sold in tablet form. The propoxyphene hydrochloride products listed above are hereinafter referred to collectively as "Darvon products."B. Propoxyphene NapsylatePropoxyphene napsylate, another salt of propoxyphene, is a nonnarcotic analgesic closely related to propoxyphene hydrochloride. Propoxyphene napsylate was discovered by Dr. Verlin C. Stephens, a research chemist of Lilly Research Laboratories. U.S. Patent 3,065,261 (hereinafter the napsylate patent) was issued to petitioner as Dr. Stephens' assignee on November 20, 1962, pursuant to an application filed on December 14, 1960. The napsylate patent, covering the napsylate acid addition salts of propoxyphene, expired on November 20, 1979.Propoxyphene napsylate and propoxyphene hydrochloride are medically identical as far as pain relief is concerned. However, because the molecular weight of propoxyphene napsylate is greater than that of propoxyphene hydrochloride, a dose of 100 milligrams of propoxyphene napsylate is required to supply an amount of propoxyphene equivalent to that present 86 in 65 milligrams of propoxyphene hydrochloride. Also, whereas propoxyphene hydrochloride is freely soluble in water, propoxyphene napsylate is only slightly soluble in 1007 water. As a result of that difference, the napsylate salt has certain advantages over the hydrochloride salt. First, suspension (i.e., liquid) and tablet formulations of the napsylate salt are more stable than those of the hydrochloride salt. The greater stability of the napsylate salt thus makes it easier to disguise propoxyphene's intensely bitter taste. Second, the napsylate salt does not react with aspirin and, as a result, combinations of aspirin and the napsylate salt do not present the same problems as those that occur in combinations of aspirin and the hydrocholoride salt. 587 Finally, because the napsylate salt is less soluble than the hydrochloride salt, it is not absorbed into the bloodstream as quickly as the hydrochloride salt, which results in less stomach irritation than that occurring in some patients using the hydrochloride salt and which allows more time for emergency measures in overdose situations.Petitioner obtained its first FDA approval to market a propoxyphene napsylate product in the United States on September 9, 1971. Petitioner sold its propoxyphene napsylate products under the trademarks Darvocet-N Registered TM and Darvon-N, which were registered by petitioner on January 1, 1973, and February 6, 1973, respectively.During the years 1971 through 1973, petitioner sold the following products containing propoxyphene napsylate as their principal active ingredient:IdentificationcodeDescriptionTA 1883Darvon-NTA 1884Darvon-N with A.S.A.MS 135Darvon-N SuspensionTA 1890Darvocet-N 50The letters "MS" in the identification code indicate that the product is sold in the form of a liquid suspension. The propoxyphene napsylate products listed above are hereinafter referred to collectively as "Darvon-N products."C. Success of Darvon and Darvon-N ProductsDarvon and Darvon-N products were the most often prescribed 1008 ethical pharmaceutical products in the United States during the period 1960 through 1973. During each of 88 the years 1958 through 1973, Darvon or Darvon-N products were among the 10 largest selling ethical pharmaceutical products in the United States.During the years 1971 through 1973, Darvon and Darvon-N products competed in the market for medications for the relief of mild to moderate pain, and their principal competitors were combinations of codeine with aspirin, acetaminophen, or other peripherally acting analgesics. During the years 1958 through 1972, while the propoxyphene patent was in effect, Darvon and Darvon-N products occupied 100 percent of the propoxyphene market in the United States. In 1973, after the propoxyphene patent expired, Darvon and Darvon-N products occupied approximately 98 percent of the propoxyphene market in the United States.Petitioner's sales of Darvon and Darvon-N products in the United States during the years 1958 through 1973 were as follows (000's omitted):YearDarvonDarvon-NTotal1958$ 6,9000$ 6,90019599,70009,700196014,000014,000196119,700019,700196224,800024,800196324,400029,400196436,700036,700196538,800038,800196644,600044,600196750,300050,300196860,400060,400196965,100065,100197069,300069,300197169,800$ 4,10073,900197266,5009,30075,800197353,40016,60070,000Petitioner's 89 net income before taxes on U.S. sales of Darvon products for the years 1958 through 1965, based upon petitioner's method of allocating expenses, was as follows (000's omitted): 1009 Net incomeYearbefore taxes1958$ 1,60019594,20019605,100196113,000196217,900196322,200196428,200196530,200Petitioner's and Lilly P.R.'s consolidated net income before taxes on U.S. sales of Darvon and Darvon-N products (Darvon-N products in 1971 through 1973 only) for the years 1966 through 1973, based upon petitioner's method of allocating expenses, was as follows (000's omitted):Net incomeYearbefore taxes1966$ 32,700196737,600196843,700196943,400197047,100197150,500197249,100197340,700III. Manufacture of Darvon and Darvon-N ProductsA. Overview of Petitioner's Manufacturing OperationsDuring the 1950's and 1960's, petitioner maintained bulk chemical manufacturing facilities in Indianapolis, Indiana, at which chemical synthesis, antibiotic fermentation, and insulin manufacturing operations were conducted. Pharmaceutical manufacturing operations (i.e., product formulation, encapsulation or tableting, and packaging), were also conducted at the Indianapolis facilities. In 1953, petitioner started an antibiotic 90 fermentation operation at its new Tippecanoe Laboratories facility in West Lafayette, Indiana. Chemical synthesis operations were begun at Tippecanoe Laboratories in 1958.Because the manufacturing techniques and technology and the training of production personnel in chemical manufacturing are vastly different from those involved in pharmaceutical manufacturing, it is a common industry practice to physically 1010 separate chemical and pharmaceutical manufacturing operations. Chemical synthesis operations involve continuous reactions that cannot be stopped, thereby requiring 24-hour-a-day operations. They also entail water and air pollution problems, the handling of dangerous chemicals, and a substantial demand for utilities such as water and steam. Furthermore, chemical manufacturing operations are capital intensive. In contrast, pharmaceutical manufacturing operations are labor intensive, are conducted in very clean environments, and do not place a great demand on utilities or require 24-hour-a-day operations.During the years 1971 and 1973, petitioner maintained separate chemical and pharmaceutical manufacturing facilities. Its pharmaceutical manufacturing operations were conducted 91 in its plants on Kentucky Avenue and McCarty Street in Indianapolis, Indiana, and its chemical manufacturing operations for pharmaceutical products were conducted at its plants in West Lafayette and Clinton, Indiana. The Clinton plant became operational in 1971.B. Manufacture of Darvon ProductsThe manufacture of Darvon products consists of two distinct phases: (a) the chemical manufacturing phase, involving the production of the bulk chemical propoxyphene hydrochloride; and (b) the pharmaceutical manufacturing phase, involving formulating or mixing the bulk chemical with other active and/or inactive ingredients, encapsulating the formulated product or compressing it into tablets, and packaging and labeling the capsules or tablets.Prior to full-scale commercial production of Darvon products, petitioner developed manufacturing techniques at its chemical and dry products pharmaceutical pilot plants in Indianapolis, Indiana. Petitioner's pilot plants were departments of Lilly Research Laboratories during the years 1955 through 1973.The functions of petitioner's chemical pilot plant were to scale up the chemical manufacturing processes for new chemicals from laboratory quantities to commercial 92 quantities and to provide materials for clinical trials and toxicological testing. (Clinical trials and toxicological testing, both of which are important in the development and FDA approval of a new 1011 pharmaceutical product, will be discussed later in detail.) When a new chemical is first identified and undergoes its initial testing, only small quantities of the chemical are produced in the laboratory. The new chemical is transferred to the pilot plant for the development of an economical process for manufacturing the chemical in commercial quantities. The pilot plant development also identifies any special equipment that might be required to perform the process. When the chemical is placed in production at the chemical manufacturing plant, pilot plant personnel ordinarily will participate in the startup of the full-scale manufacturing process.Upon the completion of pilot plant development of propoxyphene hydrochloride, petitioner in 1957 began full-scale commercial production of propoxyphene hydrochloride at a chemical manufacturing facility in Indianapolis, Indiana. The chemical manufacture of propoxyphene hydrochloride was transferred from Indianapolis to petitioner's Tippecanoe 93 Laboratories in West Lafayette, Indiana, in 1960. Chemical manufacture of other products had begun at Tippecanoe Laboratories as early as 1958, when petitioner designated that facility as its site for future expansion of chemical manufacturing. Eventually, petitioner closed its Indianapolis chemical manufacturing facility.From 1960 through 1965, petitioner produced propoxyphene hydrochloride in various buildings at Tippecanoe Laboratories. As a result of its need for additional chemical manufacturing facilities, petitioner, in 1965, constructed a new building (called Building T28) to house the production of propoxyphene hydrochloride, which by then had become a substantial product. Building T28 was constructed at an approximate cost of $ 2 million and occupied 12,000 square feet, excluding warehouse and central services. From January 1, 1966, to December 5, 1966, 694 bulk propoxyphene hydrochloride was produced in Building T28, requiring a total of approximately 20 direct manual and machine operators for all three 8-hour shifts plus numerous support and management personnel.1012 During the years 1957 through 1965, bulk propoxyphene hydrochloride was transported from the chemical manufacturing facility at either Indianapolis or Tippecanoe to petitioner's Kentucky Avenue plant in Indianapolis for use in the pharmaceutical manufacture of Darvon products. During that period, petitioner also manufactured the empty capsules for Darvon products at the Kentucky Avenue plant.During the period 1957 to December 5, 1966, petitioner manufactured and sold Darvon products only in bottles of 100 and bottles of 500 capsules. The following Darvon products were manufactured and sold by petitioner during that period:IdentificationcodeDescriptionPU 364Darvon 32 mg.PU 365Darvon 65 mg.PU 366Darvon with A.S.A.PU 368Darvon CompoundPU 369Darvon Compound-65PU 377Darvo-TranC. Manufacture of Darvon-N ProductsDarvon-N products were first sold by petitioner in 1971. Petitioner never commercially manufactured 95 bulk propoxyphene napsylate or Darvon-N products in the United States. The Darvon-N products sold by petitioner in 1971, 1972, and 1973 were manufactured solely by Lilly P.R.D. Development of Manufacturing Know-How1. Chemical ManufactureAs stated earlier, petitioner manufactured bulk propoxyphene hydrochloride from 1957 to December 5, 1966. The actual chemical synthesis involved was done in a six-step sequence: (1) Propiophenone, (2) iso butyro phenone derivative base, (3) carbinol derivative crude, (4) dextro carbinol camphor sulfonate, (5) dextro carbinol base, and (6) propoxyphene hydrochloride.The processes and techniques used by petitioner to manufacture the bulk chemical propoxyphene hydrochloride generally were standard in the pharmaceutical industry. However, over a period of several years, petitioner in the chemical pilot plant of Lilly Research Laboratories and in its chemical manufacturing 1013 plants developed 796 methods of production allowing increased batch size, fewer raw materials, and lower unit costs. As a result of petitioner's efforts, its cost of producing propoxyphene hydrochloride declined from about $ 125 per kilogram in 1957 to about $ 30 per kilogram in 1960. The basic chemistry underlying each of the chemical reactions involved in the manufacture of propoxyphene hydrochloride is well known in the pharmaceutical industry. A skilled chemist could ascertain the basic chemical reactions involved once he knew the molecular structure of the final product. However, the details of the processes used by petitioner in carrying out those reactions could not be ascertained by analysis of the finished product and is not known outside of petitioner and certain of its subsidiaries.The processes used by petitioner to manufacture propoxyphene hydrochloride were not discussed in the propoxyphene patent, and, in fact, the patent application was filed in 1952, long before the processes themselves were developed. The propoxyphene patent was not a so-called 97 "process" patent, but rather covered the chemical substances propoxyphene and propoxyphene hydrochloride, which are not produced until the sixth and final step. Petitioner did not attempt to patent the processes it developed to manufacture propoxyphene hydrochloride, which may or may not have been patentable, because process patents disclose the details of the processes they cover and are difficult and costly to enforce. Petitioner, instead, relied upon secrecy to preserve the value of the manufacturing know-how involved in its manufacture of propoxyphene hydrochloride.Petitioner disclosed its manufacturing know-how to production employees in documents called manufacturing or work tickets, which contained detailed processing instructions. The manufacturing tickets were kept in secure cabinets when not in use by the plan operators, and access to the production areas where the processes were performed was restricted.The chemical reactions involved in the manufacture of bulk propoxyphene napsylate are precisely the same as those involved in the manufacture of bulk propoxyphene hydrochloride, from the first step through the production of propoxyphene 1014 base in the final step of the process. 98 The only differences in the manufacture of the two salts are the agents and the manners of acidification of the propoxyphene base used in the last reactions to produce the salts.The chemical manufacturing processes used in the manufacture of propoxyphene napsylate were developed in the chemical pilot plant of Lilly Research Laboratories during the period 1960 through 1963, soon after the discovery of propoxyphene napsylate. The napsylate patent, like the propoxyphene patent, was not a process patent, but rather covered the chemical substance itself. Accordingly, petitioner relied on secrecy to preserve the value of the manufacturing know-how involved in the manufacture of propoxyphene napsylate.2. Pharmaceutical ManufactureThe last phase in the manufacture of Darvon products is the phase in which the bulk material, propoxyphene hydrochloride, is made into the pharmaceutical product, Darvon (and its various formulations).Pharmaceutical manufacturing is primarily a mixing operation and rarely involves sophisticated chemical processes. The critical aspect of pharmaceutical manufacturing is the quality control and attention to detail necessary to perform each step accurately so that 99 the final product is precisely what it is intended to be and conforms to the FDA-approved New Drug Application (hereinafter NDA) 8 for that product. The manufacturing know-how necessary for the pharmaceutical manufacture of Darvon products was developed by petitioner during the years 1957 through 1966. In general, the processes and techniques so used by petitioner during those years were standard in the pharmaceutical industry. During the early 1960's, however, petitioner developed a method allowing it to improve its formulations of Darvon products containing aspirin. In the presence of moisture, propoxyphene hydrochloride causes aspirin to decompose and to form acetic acid and free salicylic acid. The FDA has established limits on the level of free salicylic acid, a highly irritating substance, allowed in products containing aspirin. Moreover, the presence of acetic acid in those products causes them to have the 1015 odor of vinegar. To prevent the decomposition of aspirin, petitioner developed a method whereby the propoxyphene hydrochloride was formed into a coated pellet, called a sphercote, which, when placed in a capsule 100 with aspirin, prevented the interaction of the propoxyphene hydrochloride and the aspirin. Petitioner also developed a mechanical means of inspecting every capsule to insure that every capsule contained one, and only one, pellet of propoxyphene hydrochloride.The pharmaceutical manufacturing of Darvon-N products is generally the same as that for Darvon products. Their only difference is that Darvon-N products are primarily in tablet, rather than capsule, form.E. Foreign Manufacture of Propoxyphene ProductsPropoxyphene products have never been patented in any foreign country. However, since 1963, petitioner and Lilly Industries Ltd. (hereinafter Limited), a wholly owned United Kingdom subsidiary of petitioner, have made available to each other patents, manufacturing know-how, and other scientific and technical data pursuant to a cross license agreement entered into by them on January 1, 1965. In the cross license agreement, petitioner granted to Limited the exclusive license to make, use, and sell petitioner's products in the United Kingdom. Pursuant to that license, Limited manufactured the bulk chemicals propoxyphene hydrochloride and propoxyphene napsylate and sold propoxyphene 101 hydrochloride and propoxyphene napsylate final dosage form products in the United Kingdom through 1973.IV. Historical Development of the Puerto Rican Operations of Petitioner and Lilly P.R.A. Puerto Rico's "Operation Bootstrap"In the 1940's, an economic development program began in Puerto Rico that later became known as "Operation Bootstrap." At first the program concentrated on land reform, public services, and Government ventures into industry. Later, its emphasis shifted to stimulating private investment. Under the Puerto Rican Industrial Incentive Act of 1954, eligible companies were entitled to a 10-year tax exemption from 1016 Puerto Rican income taxes measured from the start of their manufacturing operations in Puerto Rico. In addition, exemptions were provided from certain property taxes, license fees, and excise taxes. A company was eligible for those exemptions if its proposed Puerto Rican operation would manufacture in Puerto Rico a product not manufactured there before January 2, 1947, or if it met other limited criteria.On June 13, 1963, the Puerto Rican Industrial Incentive Act of 1963 was enacted. The new act retained virtually all of the provisions of the 1954 Act 102 and added a number of new and more liberal provisions. One of the major new provisions provided for exemption periods of longer than 10 years if the Puerto Rican operations were conducted in a less developed area of Puerto Rico.B. Petitioner's 1961-62 Study of Possible Puerto Rican OperationsFrom approximately June 1, 1961, through June 1, 1962, petitioner studied the possibility of establishing manufacturing operations in Puerto Rico. Petitioner had, at that time, received numerous visits from representatives of the Economic Development Administration of Puerto Rico attempting to interest petitioner in the economic development of that area. The visits included discussions of the tax advantages of doing business in Puerto Rico. As a result of those contacts, and in an effort to find out more about the possibilities of operating in Puerto Rico, petitioner designated a three-man team to visit Puerto Rico and to investigate the subject in detail.During the 1961-62 study, petitioner considered the possible conduct in Puerto Rico of a wide range of manufacturing operations, including the manufacture of bulk chemicals, empty gelatin capsules, and finished capsule products. The study 103 included consideration of the possibility of performing the chemical manufacture of propoxyphene hydrochloride in Puerto Rico.In January 1962, the project team traveled to Puerto Rico to investigate the establishment of a manufacturing plant there. During that trip, the project team had extensive discussions with the law firm of McConnell, Valdes & Kelley; the accounting firm of Ernst & Ernst; branch banks of First National City Bank and Chase Manhattan Bank, as well as two Puerto Rican 1017 banks, Banco Popular and Banco Ponce; the Economic Development Administration of Puerto Rico; and personnel of the Puerto Rican pharmaceutical manufacturing operations of Parke, Davis & Co. and Baxter Laboratories, Inc.After returning from Puerto Rico, the project team developed an economic analysis of the proposed Puerto Rican manufacturing operations. In a memorandum dated April 30, 1962, the team recommended that petitioner file an application for a Puerto Rican industrial tax exemption for the pharmaceutical manufacture of capsule products in general. Although petitioner decided not to proceed with an operation in Puerto Rico at that time, due to the anticipated length of time required to obtain 104 approval of an application for Puerto Rican tax exemption, it did decide to file an application for such an exemption. Petitioner filed its application for a Puerto Rican industrial tax exemption on June 20, 1962. The application was broadly drafted to cover the pharmaceutical manufacture of all petitioner's capsule products.Petitioner's June 20, 1962, application for an industrial tax exemption was approved and the requested exemption was granted on May 29, 1963. The required commencement date of operations, May 29, 1964, was subsequently extended to May 29, 1965, and later to May 29, 1966.C. Petitioner's Second Puerto Rican Study 1965-66During 1964, petitioner initiated an exhaustive study project to develop an expansion program to meet adequately its projected 1975 requirements for dry pharmaceutical products. 9 Forecasts were prepared of product needs and the facilities necessary to meet those needs. Several alternatives were developed, including utilizing existing facilities with some additional construction as well as selecting a new plant site for current and future expansion. The presentation of the study to management in February 1965 precipitated a renewed interest 105 in the possibility of Puerto Rico being the site of expanded facilities, although the original study did not contain that suggestion.1018 Petitioner's primary purpose for considering construction of a manufacturing plant in 1965 was to provide additional capacity to meet its projected 1975 production requirements. Petitioner attempted to operate its chemical and pharmaceutical manufacturing facilities at about 80 percent of full capacity. Petitioner traditionally operated its chemical manufacturing facilities three 8-hour shifts per day, five days a week, and its pharmaceutical manufacturing facilities one 8-hour shift per day, five days a week, thereby allowing petitioner to accommodate sudden demands for full capacity resulting from epidemics or the introduction of a new product by working overtime on weekends. In 1964 and 1965, petitioner's chemical and pharmaceutical manufacturing facilities were operating at more than 80 percent of full capacity and were becoming overcrowded.Petitioner's 106 need for additional manufacturing facilities continued throughout the period 1965 through 1973. As noted previously, Building T28 was built in 1965 at Tippecanoe Laboratories to relieve the overcrowding at that chemical manufacturing facility. Tippecanoe Laboratories again was expanded after 1965 to accommodate the transfer of chemical manufacturing operations to that facility from Indianapolis. In 1969, petitioner began construction of a new chemical manufacturing facility on a 684-acre site at Clinton, Indiana, which facility became operational in 1971. Petitioner's Kentucky Avenue facility, where all its pharmaceutical manufacturing operations for dry products were located, was especially overcrowded and the extent to which it could be expanded was limited. Therefore in 1973, petitioner began construction of a new manufacturing facility on a 160-acre site adjacent to its existing Kentucky Avenue facility.Petitioner elected to locate the needed manufacturing operations in Puerto Rico for a variety of reasons. One reason for that decision was petitioner's desire to obtain the tax benefits provided by the Puerto Rican Industrial Incentive Act of 1963 and section 931. In addition, 107 the establishment of manufacturing operations in Puerto Rico would geographically disperse petitioner's manufacturing facilities, which in 1965 were concentrated in Indianapolis and nearby communities in Indiana. During the 1960's, petitioner was concerned that its concentrated manufacturing facilities were overly exposed to 1019 the risks of natural and man-made (i.e., nuclear) disasters. The concentration of all capsule and dry products pharmaceutical manufacturing operations at the Kentucky Avenue plant in Indianapolis was of special concern. A disaster at that location would have severely affected petitioner's ability to supply products to a substantial market segment. The possibility of such a disaster became apparent in April 1965, when a tornado caused great damage to an area just north of Indianapolis.Finally, the establishment of manufacturing operations in Puerto Rico would allow petitioner to isolate the manufacture of a major product in a separate facility, thereby eliminating the possibility of cross-contamination problems.From February 1965 to August 1966, petitioner conducted a second study specifically focusing on the development of Puerto Rican manufacturing operations. 108 In March 1965, petitioner appointed a special project team to gather and evaluate information on the establishment and operation of a Puerto Rican manufacturing plant. The project team recognized that there were some disadvantages associated with a Puerto Rican operation. Puerto Rico's distance from the continental United States would create coordination and logistical problems in moving products to the market. There was concern with respect to the availability of a qualified labor force and the extent of training and development of employees that would be required. The team was also aware of the possibilities that natural disaster, political unrest, or labor strife would close the shipping lanes to Puerto Rico. Furthermore, a Puerto Rican operation would create additional governmental reporting requirements with their associated administrative expenses.In view of the business objectives and the perceived disadvantages of operating in Puerto Rico, the project team recommended that a small number of large volume products should be selected for the Puerto Rican operation. Accordingly, the project team selected for further study Darvon and Ilosone Registered TM products, petitioner's 109 largest volume dry products at that time.The initial proposal considered by the project team in 1965 was an updated version of the proposal considered by petitioner in 1962. That proposal contemplated the establishment of a facility in Puerto Rico to manufacture empty capsules and 1020 perform the pharmaceutical manufacture of all petitioner's Darvon and Ilosone capsule products for sale to petitioner. Under that proposal, the Puerto Rican operation would purchase its bulk chemicals from petitioner.One of the significant problems the project team faced was the issue of intercompany pricing under section 482. In 1965, the Internal Revenue Service (hereinafter the Service) had not issued, in either proposed or final form, detailed regulations under section 482 relating to the sale of goods between related parties. The project team for the 1962 study had also recognized the existence of the section 482 issue. Essentially, the only guidance available to the 1962 project team was the statutory language of section 482, although it hoped that representatives of the Puerto Rican and U.S. Government would issue a set of ground rules relative to intercompany pricing prior to any actual decision 110 to construct facilities in Puerto Rico. Subsequent to the conclusion of the 1962 study and prior to the inception of the second study in 1965, the Service issued Technical Information Release 441, later reprinted as Revenue Procedure 63-10, which set forth guidelines for the application of section 482 to transactions between mainland parents and Puerto Rican affiliated corporations. While the members of the project team in 1965 were familiar with the revenue procedure, they found that it did not eliminate all the uncertainty with respect to intercompany pricing.On or about March 30, 1965, shortly after its formation, the project team obtained the assistance of petitioner's outside tax counsel, the law firm of Baker McKenzie & Hightower, and the accounting firm, Ernst & Ernst. In April 1965, at the suggestion of the outside tax counsel, the project team considered two variations of the initial proposal. First, the team considered the possible sale of the products manufactured in Puerto Rico direct to unrelated wholesalers in the United States rather than to petitioner for resale to such wholesalers. Second, the project team considered the possible manufacture of bulk chemicals 111 in Puerto Rico by the Puerto Rican operation rather than in Indiana by petitioner. The two variations of the original proposal gave the project team the following four alternatives to analyze:1021 (a) Chemical manufacture in Indiana, pharmaceutical manufacture in Puerto Rico, and sales to petitioner (i.e., the original proposal);(b) Chemical manufacture in Indiana, pharmaceutical manufacture in Puerto Rico, and sales direct to wholesalers;(c) Chemical and pharmaceutical manufacture in Puerto Rico and sales to petitioner; and(d) Chemical and pharmaceutical manufacture in Puerto Rico and sales direct to wholesalers.For the purpose of analyzing these alternatives, the team assumed that the Puerto Rican operation would be a wholly owned subsidiary corporation, and that it would manufacture Darvon products only.Members of the project team discussed the four alternatives with petitioner's outside tax counsel. Alternatives (c) and (d) were viewed as the most desirable because the Puerto Rican corporation would be using the propoxyphene patent in its chemical manufacturing operations, and the patent thus could be transferred to it in a nonrecognition transfer under section 351. Because the 112 Puerto Rican corporation would own the patent, the outside tax counsel opined that it would be deemed to have earned the income attributable to the patent. Also, because the Puerto Rican corporation would own the patent and would manufacture the basic chemicals, the issue of the appropriate intercompany prices for bulk chemicals sold by petitioner to the Puerto Rican corporation would be eliminated. Furthermore, the transfer of the patent and chemical process to Puerto Rico would effect a complete separation of the manufacturing and marketing functions with respect to Darvon products, thus petitioner would be performing a pure marketing function and an appropriate transfer price from Puerto Rico could be determined by reference to third-party evidence of the value of that marketing function.In comparing alternatives (c) and (d), the project team recognized that both involved the transfer of the propoxyphene patent to a corporation operating outside the United States. The team did not consider that a disadvantage, however, because the patent: (1) Would be owned by a wholly owned subsidiary corporation; (2) would be physically in the United States; (3) could be recovered by collapsing 113 the subsidiary and merging it into petitioner; and (4) would not be subject to 1022 expropriation. Although alternative (d) (sales direct to wholesalers) would enable the Puerto Rican operation to earn the larger amount of net income and would provide the greater number of arm's-length dealings with petitioner, the fact that wholesalers would have to deal with a second organization (the Puerto Rican operation) whenever they ordered, received, and paid for products manufactured in Puerto Rico was considered a major disadvantage and caused the project team to reject that alternative.At a special meeting of petitioner's board of directors on May 5, 1965, the project team presented its proposal to establish facilities in Puerto Rico for the manufacture of chemicals and empty capsules and the pharmaceutical manufacture of capsule products. After discussion, the board approved the following resolutions:Resolved, That the establishment by Eli Lilly and Company (or a subsidiary or subsidiaries thereof) in the Commonwealth of Puerto Rico of facilities for the manufacture of chemicals and capsules and the filling and finishing of Pulvules Registered TM with an investment of up to approximately 114 six and one-half million dollars ($ 6,500,000), be, and it is hereby, approved in principle.Further Resolves, That the proper officers of the Company be, and they hereby are, authorized for and on behalf of the Company:a. to make such investigations, formulate such plans and to make such commitments as they may deem necessary to expedite the establishment of such facilities.b. to negotiate, with the Commonwealth of Puerto Rico, its agencies, subdivisions or municipalities in order to obtain necessary authorizations and a grant or grants of tax exemption pursuant to the Industrial Incentive Act of 1963, and to execute any and all documents that in their opinion may be necessary or proper for such purposes.c. to enter into lease(s) of facilities for use in the manufacture of products for a term not exceeding three (3) years.d. to execute option(s) to purchase real estate in the Commonwealth of Puerto Rico.Further Resolved, That nothing contained in the foregoing resolutions shall be deemed to authorize or approve the appropriation of funds for capital expenditures.Shortly after the special board of directors meeting on May 5, 1965, representatives of petitioner traveled to Puerto Rico115 to investigate possible sites for the construction of manufacturing facilities there. At that time, petitioner planned first to establish pharmaceutical manufacturing operations in a 1023 leased facility in order to gain experience in operating a Puerto Rican plant and to begin taking advantage of the potential tax savings. Petitioner next intended to establish empty capsule manufacturing and pharmaceutical manufacturing on a permanent site owned by the Puerto Rican operation. To those ends, during May 1965, petitioner selected leased facilities in Hato Rey, Puerto Rico, and a permanent plant site in Carolina, Puerto Rico. Petitioner tentatively planned as its third step to establish chemical manufacturing facilities in a permanent site owned by the Puerto Rican operation; however, no definite decision was made to transfer all or part of the chemical manufacture of Darvon, or the propoxyphene patent, to the Puerto Rican operation at that time.On May 25, 1965, members of the project team met with petitioner's outside tax advisers and discussed three aspects of the Puerto Rican operation: corporate structure, financial structure, and intercompany pricing. At that meeting, it was decided 116 that the Puerto Rican operation would be conducted through a new, wholly owned Indiana subsidiary of petitioner that would qualify as a possessions corporation under section 931. It was also decided that the subsidiary corporation would be sufficiently capitalized so that it could borrow funds to maintain its operations until it was in full production without the necessity of a guarantee from petitioner. Although the issue of intercompany pricing was discussed extensively at that meeting, final intercompany pricing decisions were deferred until a decision was made with respect to the extent of the chemical manufacturing operations that would be conducted by the subsidiary.Petitioner organized Lilly P.R. on June 9, 1965, as a wholly owned subsidiary corporation. On August 3, 1965, members of the project team and other employees of petitioner met to discuss the scope of Lilly P.R.'s chemical manufacturing operations and the related intercompany pricing issues. At that meeting it was informally decided that at least the last step in the propoxyphene hydrochloride manufacturing process (step 6 (propoxyphene hydrochloride)) and the propoxyphene patent should be transferred to Puerto 117 Rico. There was still a question, however, with respect to whether step 1 1024 (propiophenone), and to a lesser extent steps 2 through 5, should be transferred to Puerto Rico.At a meeting on August 19, 1965, members of the project team and other employees of petitioner concluded that the entire chemical manufacturing process for propoxyphene hydrochloride should be transferred to Puerto Rico. That decision enabled the participants at the meeting to reach final decisions with respect to the transfer pricing of Lilly P.R.'s products. The participants decided that the Darvon products sold by Lilly P.R. to petitioner should be priced on a basis that would permit petitioner to recover its selling and distribution expenses plus a profit of 90 to 100 percent of those expenses, which was achieved by discounting petitioner's net wholesale prices for Darvon products by approximately 27.5 to 35 percent. The participants also decided that Lilly P.R. and petitioner should enter into a sales contract that would be reviewed periodically and would provide for rebates from Lilly P.R. to petitioner for sales of Darvon products by petitioner to the U.S. Government.Petitioner's project team considered 118 the profit margins of other companies selling finished pharmaceuticals in an attempt to determine an appropriate transfer price for Lilly P.R.'s products. The project team ideally was looking for a company that purchased finished pharmaceutical products from unrelated manufacturers and marketed such products to unrelated customers. The only company performing those functions that petitioner could identify was Marion Laboratories, Inc. The prospectus of that company indicated that its operating income expressed as a percentage of its operating expenses ranged from 5 to 53 percent for the years 1961 through 1965. The project team also examined the operating income to operating expense ratios of petitioner's international affiliates, which purchased finished pharmaceutical products and sold those products to unrelated customers. The ratios for those affiliates ranged from 65 percent to 108 percent during the years 1961 through 1964. 10 Based on that information, the project team concluded that petitioner should earn operating income on its sales of Darvon products purchased 1025 from Lilly P.R. equal to 90 to 100 percent of its operating expenses related to the marketing of Darvon 119 products.The project team recognized that, under its three-step plan for commencing manufacturing operations in Puerto Rico, 11120 Lilly P.R. would not begin full manufacturing operations in Puerto Rico immediately, and petitioner would have to sell propoxyphene hydrochloride and other raw materials to Lilly P.R. while its permanent facilities were being constructed. Therefore, the team decided that Lilly P.R. should pay petitioner a price equal to petitioner's standard cost of manufacture, plus 100 percent. The 100-percent markup was chosen to provide petitioner the same markup over costs as it would receive for its marketing functions.The project team also recognized that petitioner would be providing technical assistance to Lilly P.R. during the transition period while Lilly P.R.'s operations were being established. In June 1965, petitioner had established new procedures for the regular reporting of time spent by petitioner's personnel on Lilly P.R. projects and travel to Puerto Rico on behalf of Lilly P.R., so that the costs of those activities could be charged to Lilly P.R. At the meeting on August 19, 1965, the project team concluded that Lilly P.R. and petitioner should execute a technical assistance agreement pursuant to which Lilly P.R. would reimburse petitioner for its direct costs of providing such assistance.V. Lilly P.R.'s Puerto Rican Tax ExemptionsAs stated previously with respect to petitioner's first Puerto Rican study, an industrial tax exemption was granted by the Commonwealth of Puerto Rico to petitioner on May 29, 1963, covering the pharmaceutical manufacture of capsule products. The tax exemption grant was transferred from petitioner to Lilly P.R. effective as of December 14, 1965. The period of that exemption was 121 10 years, commencing on April 1, 1966.1026 The May 1963 tax exemption grant was the first of six such grants under which Lilly P.R. conducted manufacturing operations in Puerto Rico during the years 1966 through 1973. The second industrial tax exemption, covering the manufacture of empty capsules, was granted to petitioner on August 5, 1965, pursuant to an application filed by petitioner on May 13, 1965. That exemption grant was transferred from petitioner to Lilly P.R. effective as of December 24, 1965. The period of the exemption was 10 years, commencing on January 1, 1968.A Puerto Rican industrial tax exemption covering the chemical manufacture of propoxyphene hydrochloride and certain other chemicals was granted to Lilly P.R. on October 14, 1966, pursuant to an application filed by Lilly P.R. on March 15, 1966. The period of that exemption was 12 years, commencing on January 1, 1967.A Puerto Rican industrial tax exemption covering the pharmaceutical manufacture of tablet products was granted to Lilly P.R. on October 17, 1969, pursuant to an application filed by Lilly P.R. on August 15, 1968. The period of the exemption was 10 years, commencing on June 1, 1969. On March 5, 1973, 122 the exemption was amended to include the production of plastic bottles and containers.A Puerto Rican tax exemption covering the pharmaceutical manufacture of liquid products (i.e., suspensions) was granted to Lilly P.R. on September 17, 1969, pursuant to an application filed by Lilly P.R. on August 15, 1968. The period of that exemption was 10 years, commencing on February 1, 1970.A Puerto Rican industrial tax exemption covering the chemical manufacture of propoxyphene napsylate and other salts of propoxyphene was granted to Lilly P.R. on October 17, 1969, pursuant to an application filed by Lilly P.R. on August 16, 1968. The period of that exemption was 15 years, commencing on January 1, 1970.In accordance with the terms of the six Puerto Rican industrial tax exemption grants mentioned above, Lilly P.R. during the years 1966 through 1973 was exempt from Puerto Rican income tax on its qualified income (i.e., income from manufacturing activities), municipal, and commonwealth taxes on real and personal property, license fees, and excise and other municipal taxes. Lilly P.R.'s qualified income included 1027 all income generated by sales of Darvon and Darvon-N products to petitioner.VI. 123 Background and Documents Concerning Lilly P.R.A. Organization of Lilly P.R. and Initial CapitalizationAs stated earlier, Lilly P.R. was organized under Indiana law as a wholly owned subsidiary of petitioner on June 9, 1965. Pursuant to the authorization of petitioner's executive committee, Lilly P.R. was initially capitalized with an investment of $ 1,000 on June 11, 1965, at which time 1,000 shares of Lilly P.R. common stock with no par value were issued to petitioner. By the end of 1965, petitioner had contributed a total of $ 500,000 cash to the capital of Lilly P.R.In 1965, Lilly P.R. negotiated a $ 4.5 million line of credit with the San Juan branch of the Chase Manhattan Bank. Petitioner did not assist Lilly P.R. in those negotiations, nor did it guarantee repayment of any amounts loaned to Lilly P.R. under the line of credit. The purpose of the line of credit was to finance the operations of Lilly P.R. until it commenced the manufacture and sale of products to petitioner. During the years 1965 and 1966, Lilly P.R. borrowed from the Chase Manhattan Bank an aggregate amount of $ 1,650,000. Lilly P.R. repaid the loans in full by July 1966.B. Technical Assistance AgreementOn 124 April 8, 1966, petitioner and Lilly P.R. executed an agreement entitled "Technical Assistance Agreement," which was effective from January 1, 1966, to December 31, 1975. The execution of that agreement was ratified by Lilly P.R.'s board of directors on April 28, 1966.In article II of the agreement, petitioner stated that it would, so far as practicable without unreasonable interference with its own business:make available [its] scientists, engineers, technicians, research experts, industrial designers and other technical personnel, including if necessary supervisory personnel, for the purpose of providing to [Lilly P.R.] training for its employees and other technical assistance and advice in connection with the manufacture of [Lilly P.R.] products, including the design, construction and operation of factories and other installations, and the installation, operation, and maintenance of the equipment therein.1028 Article II further provided that petitioner would make its manufacturing facilities available to Lilly P.R. for the training of Lilly P.R. personnel. For the purposes of that agreement, Lilly P.R. products included all products manufactured by Lilly P.R., or which it had a right 125 to manufacture, whether or not manufactured by Lilly P.R. in 1966.Under article III of the agreement, Lilly P.R. obligated itself to pay petitioner the sum of: (a) The cost to petitioner attributable to the services of its personnel rendering technical assistance to Lilly P.R. in accordance with article II of the agreement, other than engineering services; (b) a technical assistance fee equal to 5 percent of the cost described in (a); and (c) petitioner's standard charge for engineering services performed on behalf of Lilly P.R.C. Private Letter RulingOn April 7, 1966, petitioner applied to the Service for a ruling that petitioner's proposed assignment to Lilly P.R., as a contribution to capital, of the patents and manufacturing know-how related to propoxyphene and certain other products would qualify for nonrecognition treatment under section 351. The ruling application stated that, because of the current and anticipated demand for certain of its products, petitioner had found it necessary to expand its manufacturing facilities, and that its present plans were to establish full-scale manufacturing facilities in Puerto Rico for Darvon, Darvon-N, and other products. The ruling application 126 notified the Service that during the construction of Lilly P.R.'s permanent manufacturing facilities, Lilly P.R. would purchase its requirements for bulk chemicals from petitioner, but that after such facilities were in operation, Lilly P.R. would manufacture the basic chemicals in Puerto Rico and would no longer purchase such chemicals from petitioner. The ruling application also advised the Service that Lilly P.R. would sell essentially all its finished products to petitioner. Attached to the ruling application were a form of agreement providing for the transfer of the patents and manufacturing know-how from petitioner to Lilly P.R. and a copy of the technical assistance agreement between petitioner and Lilly P.R.In a letter dated July 20, 1966, petitioner supplied additional information to the Service with respect to its section 3511029 ruling request and requested a ruling on the source of the income that would be generated by Lilly P.R.'s sales to customers in the United States. In that letter, petitioner described the business reasons for the transfer of patent rights and manufacturing know-how as follows:The fundamental business reasons for the transfer of Eli Lilly Patent Rights 127 and Eli Lilly Technology to [Lilly P.R.] is that [petitioner] has decided to vest in [Lilly P.R.] the complete responsibility for the manufacture of the subject products. Since [Lilly P.R.] will have the complete responsibility for manufacturing the subject products it should have the complete right to do so under the Eli Lilly Patent Rights and Eli Lilly Technology. Thus, the business substance which motivates the transfer of rights to [Lilly P.R.] is the fact that these rights will be used exclusively by [Lilly P.R.]. In addition, as mentioned in the request for ruling, the formation of [Lilly P.R.] and the location of manufacturing facilities in Puerto Rico was prompted by [petitioner's] need for additional manufacturing facilities. It should be noted that [petitioner] currently has under active consideration further expansion of its manufacturing facilities in other areas in the United States. The transfer of complete responsibility for the manufacture of the subject products to [Lilly P.R.] will not in any way result in a reduction in the facilities now employed by [petitioner] in the United States. The [Lilly P.R.] facilities will clearly be an expansion of the manufacturing 128 facilities now available to manufacture [petitioner's] products. In this sense, the business motivation was clearly to provide additional manufacturing facilities for [petitioner's] products.As support for the source of income ruling request, petitioner submitted with that letter the proposed terms of sale for Lilly P.R. sales to petitioner and other U.S. customers.By a letter dated September 16, 1966, petitioner submitted additional information to the Service regarding the issue of whether the secret processes to be transferred to Lilly P.R. constituted property within the meaning of section 351. Attached to that letter was a memorandum prepared by petitioner's technical personnel which described in detail the secret processes to be transferred to Lilly P.R.On December 5, 1966, the Service issued the following private letter ruling to petitioner:This is in reply to a request for ruling with respect to the Federal income tax consequences of a proposed transaction. Information was submitted in letters dated April 7, July 20, and September 16, 1966. The pertinent facts may be summarized as set forth below.1030 Eli Lilly and Company ("Lilly"), account number 35-0470950, is an Indiana 129 corporation engaged in the manufacture and sale of pharmaceuticals and related products and agricultural and industrial chemical products.Due to current and anticipated demand for certain of its drugs, Lilly finds it necessary to establish a plant in Puerto Rico to expand the manufacturing capability for these products. The operation in Puerto Rico will be conducted by Eli Lilly and Company, Inc. ("P.R."), account number 66-0262012, as a wholly owned subsidiary of Lilly. For its contribution of $ 500,000, Lilly was issued 1,000 shares of no par value common stock of P.R. Additional capital for the purchase of land and the construction of plants will be raised by P.R. by borrowing on its own credit.P.R. will manufacture Darvon, 12 Dymelor, Valmid and Ultran, which are the trademarks for four of the products presently manufactured and sold in the United States by Lilly. A ten-year tax exemption has been granted in Puerto Rico for the pharmaceutical formulation of two of these products and application will be made for such exemption for the other two drugs.Lilly proposes to transfer to P.R. as a contribution to capital all right, title and interest in and to U.S. Patents 2,728,779, 130 2,812,363 and 3,065,26113134 and U.S. patent application 25,209 (relating to Darvon, Dymelor, Ultran and Valmid). In addition Lilly will grant and assign to P.R. the exclusive and perpetual right to use the existing technical information and manufacturing secrets and processes relating to the manufacture and formulation of these products. By these transfers, Lilly will convey to P.R. the exclusive right to make, use and sell under the patents and technical information and to license others to use such patents and technical information upon terms and conditions as P.R. may decide.The patents to be transferred, except for Ultran, reveal the chemical reactions employed but do not disclose certain steps or the processes utilized in their manufacture in commercial quantities. These processes, which could generally be patented, are maintained as a secret by Lilly and cannot be learned by an analysis of the finished product. They relate to such aspects of manufacture as the solvent employed, the temperature and time duration of certain steps, the use of dangerous reagents in large quantities, the substitution of less expensive chemicals, and methods of recovering certain costly chemicals 131 from the process. The processes employed in the manufacture of Ultran are completely embodied in its patent.Lilly will transfer to P.R. the technical reports on the processes. However, the manufacture of certain of the products is so complex that Lilly does not believe that a written description will be sufficient to accomplish the desired results. Lilly has therefore transferred to P.R., as a full-time employee, the head of one of its chemical manufacturing plants who was involved as a trouble shooter in these processes. In addition, Lilly has entered into an agreement with P.R. on April 8, 1966, under which Lilly will assist P.R. in the establishment of manufacturing facilities in Puerto Rico and render technical assistance, to the extent requested, in connection with the manufacture of the products. P.R. will reimburse Lilly for all costs incurred 1031 plus five percent and will pay for engineering services on the basis of Lilly's standard charges for such services.P.R. will manufacture the products in Puerto Rico. Other than what may be sold in Puerto Rico to related and unrelated parties, the products will be sold to Lilly in Puerto Rico for trans-shipment to the United States132 and resale by Lilly in the ordinary course of its business. The sales by P.R. will be in accordance with a statement of conditions of sale which accompanied the request for ruling and is incorporated in this ruling letter by reference.Lilly does not intend to cause P.R. to sell or license any of the patent rights or technology to third parties. Lilly intends to operate P.R. as a subsidiary and has no intention of selling or otherwise disposing of the stock of P.R.Based solely on the information submitted, it is held as follows:(1) No gain or loss will be recognized to Lilly upon the transfer to P.R. as a contribution to capital of all substantial rights to the patents, patent application, secret processes and technology relating to the manufacture of Darvon, Dymelor, Ultran and Valmid (section 351).(2) The basis of the stock of P.R. in the hands of Lilly will include the adjusted basis of the property transferred (section 358(a)(1)).(3) Based on the assumption that P.R. will be established and operated in accordance with the above representations, and that the sale of its products will be made in the manner indicated, the gross income realized by P.R. from the manufacture and sale 133 of pharmaceutical products to Lilly and other United States purchasers will constitute gross income from sources within a possession of the United States within the meaning of section 931(a)(1) of the Code.No opinion is expressed as to the possible application of section 482 in the event it is subsequently determined that the amounts to be paid by P.R. for the technical assistance to be provided by Lilly does not represent adequate consideration for such assistance or as to whether part of the stock of P.R. was, in fact, received by Lilly for such assistance.No opinion is expressed as to the tax treatment of the transaction under the provisions of any of the other sections of the Code and Regulations which may also be applicable thereto or to the tax treatment of any conditions existing at the time of, or effects resulting from, the transaction which are not specifically covered by the above rulings.A copy of this ruling should be attached to the Federal income tax returns of the taxpayers involved for the taxable year in which the transaction is consummated.D. Assignment of Patents and Manufacturing Know-HowOn December 5, 1966, in accordance with the private letter ruling issued to petitioner on that date, petitioner and Lilly P.R. entered into an agreement entitled "Assignment of Patents and Related Technical Data." That agreement provided as follows:This Agreement, made the 5th day of December, 1966, by and between ELI LILLY AND COMPANY, a corporation organized and existing under 1032 and by virtue of the laws of the State of Indiana, with offices at 740 South Alabama Street, Indianapolis, Indiana (hereinafter referred to as "ELI LILLY"), and ELI LILLY AND COMPANY, INC., a corporation organized and existing under and by virtue of the laws of the State of Indiana, with offices at 301 East McCarty Street, Indianapolis, Indiana (hereinafter referred to as "P.R."),Witnesseth:Whereas, ELI LILLY is engaged in the business of manufacturing and selling pharmaceutical and biological products, andWhereas, ELI LILLY in the course of its operations in the United States has acquired certain technical data, consisting principally of reports, drawings, specifications, blueprints, written descriptions of manufacturing 135 processes, and production information with respect to the manufacture of its Darvon Registered TM product line and related product lines, including combinations, andWhereas, ELI LILLY has obtained two United States patents relating to its Darvon Registered TM product line, andWhereas, ELI LILLY is willing to grant P.R. the exclusive right to use such technical data in conjunction with an assignment of such patents, andWhereas, P.R. has been formed to conduct the manufacture of the Darvon Registered TM line of products for sale in the United States market, andWhereas, P.R. desires to acquire said patents and technical data from ELI LILLY as a contribution to its share capital:Now ThereforeIn consideration of the mutual promises and covenants herein contained, the receipt and sufficiency of which are hereby acknowledged, it is understood and agreed by and between the parties as follows:Article IELI LILLY hereby assigns to P.R. all right, title and interest in and to U.S. Patents 2,728,779 [the propoxyphene patent] and 3,065,261 [the napsylate patent]. By such grant, ELI LILLY conveys to P.R. the exclusive right to make, use and sell under said patents for their full lives and any extensions 136 or renewals thereof, and to license others to use the same upon such terms and conditions as P.R. may decide. ELI LILLY agrees to execute any documents and authorizations which may be legally required to enable the use of said patents by P.R. Article IIEli Lilly hereby assigns and grants to P.R. the exclusive and perpetual right to use and to license others to use the existing technical information and manufacturing secrets and processes of Eli Lilly relating to the manufacturing and formulation of its Darvon Registered TM product line within the United States and Puerto Rico. By said grant Eli Lilly conveys to P.R. the exclusive and perpetual rights to make, use and sell under said technical data and to license others to use the said technical data upon such terms and conditions as P.R. may decide.Article IIIIn consideration for the rights, titles and interests set forth in Articles I and II above, P.R. agrees to receive said patents and related technical data as additional consideration for P.R.'s stock which has already been issued to Eli 1033 Lilly and to reflect in its corporate records said patents and technical data as contributions to share capital provided by Eli Lilly.In Witness 137 Whereof, the parties hereto have caused this Agreement to be signed and sealed by their duly authorized officers at the places and on the dates set forth below.Eli Lilly and CompanyBy: (S) Burton E. BeckExecutive Vice PresidentSigned and sealed atIndianapolis, Indianathis 5th day of December, 1966.(S) C. H. Bradley, Jr.AttestEli Lilly and Company, Inc.By: (S) W. B. FortuneChairman of the Board of DirectorsSigned and sealed atIndianapolis, Indianathis 5th day of December, 1966.(S) Walter C. Taylor, Jr.AttestThe December 1966 Assignment of Patents and Related Technical Data contained the same terms as the form of assignment attached to petitioner's ruling request dated April 7, 1966. On December 19, 1966, petitioner's board of directors ratified the assignment to Lilly P.R., as a contribution to capital, of the propoxyphene patent, the napsylate patent, and the related manufacturing know-how. On the same date, Lilly P.R.'s board of directors ratified the acceptance of that assignment. The Assignment of Patents and Related Technical Data was recorded in the U.S. Patent Office on February 14, 1969.In December 1966, immediately after the execution of the Assignment of Patent Rights 138 and Related Technical Data, petitioner ceased performance of step 6 of the propoxyphene hydrochloride manufacturing process. During the phase-in of Lilly P.R.'s chemical manufacturing facility in 1967, petitioner continued to produce dextro carbinol base (steps 1 through 5) 1034 for sale to Lilly P.R. Petitioner did not perform any of the steps in the production of propoxyphene hydrochloride after 1967.E. Distribution AgreementsIn accordance with the decisions made in 1965 and 1966 by petitioner's project team that the distribution of Lilly P.R.'s products would be made through petitioner's U.S. marketing organization, petitioner and Lilly P.R. entered into a "Distribution Agreement," effective as of January 1, 1966. In that agreement, Lilly P.R. appointed petitioner its nonexclusive distributor for the sale of Darvon products throughout the world. The distribution agreement provided that: (a) Petitioner would purchase all its requirements for Darvon products from Lilly P.R. and would promote those products through its marketing organization; (b) Lilly P.R.'s selling price to petitioner for each of the Darvon products was equal to petitioner's net wholesale price 14 for such product 139 less a 35-percent discount; (c) petitioner was entitled to charge back to Lilly P.R. (i.e., receive rebates from Lilly P.R.) 25 percent of the net wholesale prices of Darvon products sold by petitioner to U.S. Government agencies or exported by petitioner from the United States; (d) petitioner would make payments to Lilly P.R. within 180 days after the dates of Lilly P.R.'s invoices; (e) Lilly P.R. would supply reasonable quantities of Darvon products to petitioner at no charge for use by petitioner as samples; and (f) the agreement was for a term of 5 years, cancelable by either party upon 90 days' notice. The provisions of the distribution agreement regarding the place of sale and passage of title of the products were the same as the terms of sale submitted to the Service as support for petitioner's source of income ruling request in its letter to the Service dated July 20, 1966.As of January 1, 140 1971, petitioner and Lilly P.R. entered into a new "Distribution Agreement," which superseded the 1966 distribution agreement. The terms and conditions of the 1971 agreement were the same as in the 1966 agreement, except that it provided that: (a) Lilly P.R.'s selling prices to petitioner for Darvon products were equal to petitioner's net wholesale 1035 prices less 45 percent; and (b) petitioner was entitled to chargebacks on Government and export sales of 15 percent of petitioner's net wholesale prices.During the years 1971 through 1973, petitioner and Lilly P.R. executed 9 amendments to the 1971 distribution agreement. In general, those amendments added new products (e.g., Darvon-N) to be sold by Lilly P.R. to petitioner, modified the selling prices of products sold by Lilly P.R. to petitioner, 15 and provided that, effective January 1, 1973, Lilly P.R. would supply petitioner with Darvon and Darvon-N products for use as samples at Lilly P.R.'s cost. The selling prices as applicable to the years before us will be discussed at length in a later portion of our findings. F. Joint Research AgreementAlthough the technical assistance agreement between petitioner 141 and Lilly P.R. was sufficiently broad to cover research and development activities performed by petitioner for Lilly P.R., petitioner's research and development expenses related to propoxyphene products were not billed to Lilly P.R. pursuant to that agreement. In 1968, petitioner determined that those research and development expenses should be charged to Lilly P.R., so it entered into an agreement with Lilly P.R. entitled "Joint Research Agreement." The agreement was retroactively effective to January 1, 1967, and had a term of 7 years ending on December 31, 1973.In pertinent part, the joint research agreement, provided as follows:ARTICLE I.RESEARCH COMMITMENTSSection 1.1. [Petitioner] hereby agrees to undertake projects on behalf of [Lilly P.R.] and to arrange for clinical trials and all related activities in connection with the development and testing of the pharmaceutical and biological products.Section 1.2. [Petitioner] agrees to undertake research, development and related activities under this Agreement only to the extent that --(a) [Petitioner's] facilities and personnel permit, without interfering with [petitioner's] own research and development progress, the undertaking 142 of 1036 such activities without requiring any significant capital expenditures for alteration of [petitioner's] existing research and development facilities;(b) [Petitioner] has complete control over the scheduling of any such activities within its research and development facilities;(c) [Petitioner] does not become liable or responsible for the results of any such research and development activities.ARTICLE IICONSIDERATIONSSection 2.1. The parties agree that [Lilly P.R.] shall have the exclusive and perpetual right to use any of the data developed by [petitioner] under the terms of this Agreement (including any items of a patentable nature and any patents which may issue thereon) within the United States and the Commonwealth of Puerto Rico and that [petitioner] will have the exclusive and perpetual right to use any of the data developed under the terms of this Agreement (including any items of a patentable nature and any patents which may issue thereon) in all areas of the world outside of the United States and the Commonwealth of Puerto Rico.Section 2.2. [Lilly P.R.] agrees to pay [petitioner] the cost of any research, development and clinical trials undertaken by [petitioner] at the 143 request of [Lilly P.R.] under this Agreement.Section 2.3. The cost of the research, development, and clinical trials undertaken by [petitioner] for [Lilly P.R.] shall be determined for the purpose of this Agreement in accordance with accounting practices which are consistent with sound accounting principles generally accepted in the United States. Without in any way limiting the foregoing, it is understood that such "research expenses" shall include the following expenses:2.31. Salaries and wages of all employees working full time on such activities.2.32. The cost of employee benefits pertaining to such employees.2.33. Research grants.2.34. The fees of research consultants.2.35. The costs of biochemical analyses, chemical analyses, clinical expense, and all veterinary testing relating to such activities.2.36. Cost of chemicals, accessories, glassware, and other supplies used directly in such activities.2.37. Legal and other expenses spent in connection with obtaining and maintaining patents covered by this contract or in connection with patent interference proceedings related thereto.2.38. Communication and travel costs, including stationery, postage, cable, phone, and travel expenses 144 of [petitioner's] personnel when such expenditures are in connection with [petitioner's] research, development, and clinical trials for [Lilly P.R.].2.39. Depreciation or amortization of capital items used in such activities.2.391. Any other expenses of occupancy and general administration appropriately attributable to such activities.1037 Section 2.4. [Petitioner] will submit to [Lilly P.R.] twice annually its statement of expenses incurred under the terms of this Agreement, and [Lilly P.R.] agrees to make payment thereof in United States dollars within thirty (30) days after receipt of each such statement.G. Agreements Regarding Empty CapsulesIn a license agreement dated January 1, 1968, petitioner granted Lilly P.R. a nonexclusive license to make, use, and sell empty capsules covered by two U.S. patents owned by petitioner. Under that license, Lilly P.R. was obligated to pay petitioner a royalty of 5 cents per 1,000 commercially acceptable empty capsules manufactured by Lilly P.R. and covered by either of the two patents. The agreement provided that it would terminate upon the expiration of both of the licensed patents or 30 days after either party gave written notice of termination 145 to the other party.During the years 1970 through 1973, petitioner and Lilly P.R. entered into three agreements pursuant to which Lilly P.R. manufactured and sold empty capsules to petitioner.VII. Lilly P.R.'s Manufacturing ActivitiesA. Temporary Leased FacilityIn May 1965, and pursuant to the May 5, 1965, resolution of petitioner's board of directors approving the establishment of manufacturing operations in Puerto Rico, petitioner entered into a lease with Valencia Realty Corp. for 67,000 square feet of floor space on two floors in a new five-story building located in the Valencia section of San Juan, Puerto Rico. Petitioner's interest in that lease was assigned to Lilly P.R. in June 1965.On August 5, 1965, a contract was executed between Lilly P.R. and a Puerto Rican construction company calling for the modification of the leased premises to accommodate the pharmaceutical manufacture of Lilly P.R.'s products. The first floor of the leased facility was used for office and warehouse space. The fifth floor was used to perform the pharmaceutical manufacture of Lilly P.R.'s products. In addition, Lilly P.R. installed air-conditioning, dehumidification, dust-collection, and power equipment 146 on the roof of the facility.Pharmaceutical manufacturing operations became completely operational at the Valencia facility in January 1966. 1038 Prior to that time, pilot runs were made at that facility to test equipment and to train personnel.During 1966, the pharmaceutical manufacture of Darvon products was performed both by Lilly P.R. in Puerto Rico and by petitioner in Indiana. By the end of 1966, petitioner had discontinued all pharmaceutical manufacturing operations for Darvon products with the exception of certain sample packaging operations. During the years 1967 through 1973, the entire pharmaceutical manufacturing process for Darvon and Darvon-N products was performed by Lilly P.R., except for certain sample packaging and, during the years 1968 through 1973, Identi-dose Registered TM 16 packaging of Darvon and Darvon-N products, which was performed or contracted by petitioner. The Valencia site was designed to serve as a temporary facility while permanent facilities were under construction.B. Carolina FacilityIn May 1965, petitioner entered into an agreement 147 to purchase approximately 13 acres of land in an industrial park in Carolina, Puerto Rico, to be used as the site for Lilly P.R.'s permanent pharmaceutical manufacturing facilities. At a meeting on December 14, 1965, Lilly P.R.'s board of directors approved the acceptance of the assignment of that purchase agreement from petitioner.In June 1965, Lilly P.R. entered into an agreement with a Puerto Rican architectural firm for the performance of architectural and engineering work in connection with the design and development of the Carolina plant. Construction of the Carolina facility started on September 1, 1966.The manufacture of empty capsules was begun at the Carolina facility in October 1967. The period between October 1, 1967, and January 1, 1968, was a shakedown period but some marketable products were produced. As of January 1, 1968, Lilly P.R.'s investment in capsule manufacturing machinery and equipment was $ 1,499,739. At the time that empty capsule production was begun, approximately 92,000 square feet of the Carolina facility were completed, consisting of the common service building (the powerhouse), the warehouse, and the empty capsule manufacturing department.1039 Pharmaceutical 148 manufacturing operations were completely operational at the Carolina facility by May 15, 1968. At that time, the facility occupied approximately 175,000 square feet, divided functionally as follows:Square feetCommon services19,000Warehouse40,000Empty capsule manufacturing department33,000Office building17,000Capsule filling50,000Capsule finishing16,000Total175,000As of June 1, 1968, the total investment in pharmaceutical manufacturing operations at Carolina was $ 2,468,462, of which $ 568,327 represented direct production equipment and $ 1,900,135 represented supportive equipment. As of June 1, 1968, the total cost of the Carolina facility was $ 8,917,499, of which $ 531,276 was invested in land, $ 5,037,098 in buildings, and $ 3,349,125 in machinery and equipment. An additional $ 619,075 of machinery and equipment transferred from the Valencia operation was also used at the Carolina facility.C. Mayaguez FacilityAt a meeting on January 20, 1966, Lilly P.R.'s board of directors authorized the officers of that company to select a plant site in Puerto Rico for Lilly P.R.'s chemical manufacturing facility and to develop plans and cost estimates for that facility. After the meeting, 149 Lilly P.R.'s officers began looking for sites for the proposed chemical manufacturing plant with the assistance of the Puerto Rican government. After negotiations with more than one government agency, Lilly P.R. obtained the necessary government approvals to build a plant at a site in Mayaguez, Puerto Rico, at the western end of the island. In June 1966, Lilly P.R. purchased a 25-acre site in Mayaguez.Construction of the Mayaguez facility was started in August 1966, pursuant to contracts between Lilly P.R. and a Puerto Rican construction firm. The construction of the Mayaguez plant was completed in October 1967.The performance of step 6 (propoxyphene hydrochloride) in the production of bulk propoxyphene hydrochloride was started 1040 at Lilly P.R.'s Mayaquez facility in December 1966, subsequent to the execution on December 5, 1966, of the Assignment of Patents and Related Technical Data. Lilly P.R. began production of step 1 in August 1967, step 2 in September 1967, and steps 3, 4, and 5 in October 1967.In December 1966, when production of step 6 began, the Mayaquez facility occupied approximately 14,340 square feet as follows:Square feetBuilding 1, office building3,840Building 2, warehouse7,000Building 3, manufacturing3,500Total14,340Upon 150 completion of the Mayaguez facility in October 1967, the following additional structures were utilized in the manufacturing operation:Square feetBuilding 4, sewage plant1,600Building 5, fire pump house900Building 6, major manufacturing building24,000Building 7, warehouse10,000Tank farm consisting of eighteen 12,000 gallon tanks30,000Total66,500The total amount invested in the Mayaguez chemical facility as of October 1, 1967, was $ 6,192,257, of which $ 302,316 was invested in land, $ 2,708,028 in buildings, and $ 3,181,913 in machinery and equipment. During the years 1969 through 1973, the manufacturing capacity of both the Mayaguez and Carolina facilities of Lilly P.R. was substantially expanded. Construction of additional facilities for the manufacture of propoxyphene napsylate at Lilly P.R.'s Mayaguez facility began in 1969 and was completed in 1970 at a total cost of approximately $ 1 million. As of December 31, 1973, Lilly P.R.'s total investment in physical facilities was $ 26,404,782, of which $ 978,756 was invested in land, $ 13,945,669 in buildings, and $ 11,480,357 in machinery and equipment.D. Personnel1. Organization of Initial Work ForceThe initial management of Lilly 151 P.R. consisted of five former employees of petitioner who moved to Puerto Rico to become 1041 permanent employees of Lilly P.R. One of the principal assignments of that management team was to train the Puerto Rican work force of Lilly P.R. and to develop Puerto Rican employees capable of taking over the management of Lilly P.R.Soon after the management team arrived in Puerto Rico, it began the process of interviewing and employing Puerto Ricans to staff the temporary facility at Valencia. The team worked closely with the Puerto Rican Employment Service, a government agency which screened all applications to determine which applicants were best qualified to meet the job descriptions supplied by Lilly P.R., and performed background checks and applicant health examinations. By January 1966, Lilly P.R. employed 56 Puerto Ricans; by January 1968, Lilly P.R. employed over 400 Puerto Ricans. The hiring of those employees was accomplished without petitioner's assistance. When Lilly P.R.'s pharmaceutical manufacturing operations were transferred from Valencia to Carolina in 1968, all the employees at the Valencia facility moved to the Carolina facility.2. Training of EmployeesAt the beginning 152 of Lilly P.R.'s operations in Valencia, small teams of petitioner's employees traveled to Puerto Rico, at the request of Lilly P.R., for 2 or 3 weeks at a time to assist in the training of the employees at that facility. The teams were small, less than 10 in number, because Lilly P.R.'s management team was experienced in production, and because Lilly P.R. rapidly developed a group of Puerto Rican employees who were capable of assisting in the training function.The training of the work force at Lilly P.R.'s Mayaguez facility required more assistance from petitioner because the chemical manufacturing process for propoxyphene hydrochloride was complicated and dangerous, and because employees in the Mayaguez area generally were less fluent in English than those in the San Juan area. Consequently, 12 to 14 of petitioner's chemical manufacturing employees were residents in Mayaguez for a period of from 6 to 12 months to train Lilly P.R.'s Puerto Rican chemical manufacturing operators.In 1968, because the work force at the Valencia facility had over 2 years' experience in the pharmaceutical manufacture of 1042 Lilly P.R.'s products, and because the entire work force moved from Valencia to the 153 Carolina facility in that year, Lilly P.R. did not require any great amount of assistance from petitioner in training its employees at the Carolina facility.3. Board of Directors, Officers, and Management CommitteesDuring the years 1965 through 1973, Lilly P.R.'s board of directors consisted of from 9 to 11 individuals. Throughout that period, two of the directors were management employees, the general manager and treasurer, of Lilly P.R. living in Puerto Rico. The remaining members of Lilly P.R.'s board of directors were officers and/or employees of petitioner.During the years 1965 through 1973, Lilly P.R. had an executive committee, which had 5 members through 1972 and 6 members in 1973. During the years 1971 through 1973, Lilly P.R. also had the following committees: operations, salary, budget, safety and housekeeping, and benefits and retirement.During the years 1971 through 1973, Lilly P.R.'s general manager had authority to approve capital expenditures of less than $ 1,000; the operations committee had authority to approve capital expenditures of less than $ 5,000; the executive committee had authority to approve capital expenditures of less than $ 25,000; Lilly P.R.'s board 154 of directors had the authority to approve capital expenditures of between $ 25,000 and $ 50,000; and proposed capital expenditures in excess of $ 50,000 were submitted for approval to petitioner's executive committee or board of directors. The division of authority for the approval of capital expenditures was the same as that followed by every other domestic and foreign subsidiary of petitioner.4. 1971-73 Lilly P.R. PersonnelDuring the years 1971, 1972, and 1973, Lilly P.R. had a total of 608, 612, and 651 employees, respectively. During that period, all employees below the management level were Puerto Rican.During the years 1971, 1972, and 1973, Lilly P.R. had 22, 25, and 23 management employees, respectively. In 1971, 15 of those management employees were Puerto Ricans.E. Manufacturing Activities 1971-731. Production Planning1043 The planning and scheduling of Lilly P.R.'s manufacturing operations were conducted in Puerto Rico by employees of Lilly P.R. without the assistance of petitioner. Lilly P.R.'s production planning process involved the scheduling of raw material purchases and the scheduling of production on a day-to-day basis consistent with Lilly P.R.'s policy of keeping 155 a stable and fully occupied work force.Petitioner's finished stock planning department in Indianapolis provided Lilly P.R. with annual projections of the quantities of each package size of each product that petitioner would purchase from Lilly P.R. during the coming year. 17From the annual projections, Lilly P.R.'s production planning group at the Carolina facility prepared production schedules for the pharmaceutical manufacture of the finished products to be sold to petitioner, and determined the quantities of propoxyphene hydrochloride and propoxyphene napsylate necessary to manufacture those products. Based upon the production schedule, the empty capsule manufacturing manager produced a schedule for the manufacture of empty capsules. Also, materials-purchasing personnel determined whether and when to purchase raw materials for the empty capsule manufacturing operation based upon inventory levels of materials on hand.The projections of annual requirements for propoxyphene hydrochloride and 156 propoxyphene napsylate prepared at Carolina were sent to the Mayaguez facility and used as the starting point for its production planning. Personnel at Mayaguez determined the quantities of intermediate chemicals necessary to produce the final chemicals and projected the amount of basic raw materials needed during the year. The purchasing department of Mayaguez issued purchase orders throughout the year based upon the projected requirements for raw materials.2. Chemical Manufacturing at MayaguezDuring the years 1971 through 1973, propoxyphene hydrochloride and propoxyphene napsylate were manufactured in bulk form at Lilly P.R.'s Mayaguez facility and transported to Lilly P.R.'s Carolina facility for use in the pharmaceutical 1044 manufacture of Darvon and Darvon-N products. The chemical manufacturing processes at the Mayaguez facility involved numerous continuous reactions, and as a result, that facility was generally operated 24 hours per day, 5 days per week. The manufacturing activities at Mayaguez were conducted according to a campaigning program. For example, a 2-week campaign might have been conducted to build up stock of propiophenone (step 1) which was then used during a 157 subsequent 2-week campaign to produce iso butyro phenone derivative (step 2).Each of the steps in the manufacturing process was covered by a separate manufacturing ticket (manufacturing tickets are defined in section F under this heading, infra), and generally was performed independently of the other steps. Although each step took only 1 to 3 days to complete, in the normal sequence of operations at Mayaguez, an entire series of campaigns from the beginning (step 1) to the end (step 6) took approximately 60 to 90 days to complete.The chemical manufacturing processes performed by Lilly P.R. at the Mayaguez facility were complicated. Each of the 6 steps in the production of propoxyphene hydrochloride and propoxyphene napsylate was in itself a multistep process requiring the utilization of approximately 28 reaction tanks and the services of approximately 35 operators, working on a three-shift basis. The processes involved the use of highly corrosive and flammable chemicals, and as a result, Lilly P.R.'s operators wore acid goggles, air line respirators, and rubber gloves while handling those chemicals. Most of the chemical reactions involved in the processes had to be performed within 158 narrow ranges of variables such as temperature and quantity. For example, if too little heat was applied to the reaction of propionic anhydride and dextro carbinol base in the final step of producing propoxyphene hydrochloride, some of the dextro carbinol base would remain in the propoxyphene base as a contaminant. If too much heat was applied to that reaction, the propoxyphene base was decomposed. The operators were required to exercise judgment during the manufacturing processes, such as using a sight glass to determine whether separations of solutions had been made. Operators also were required to perform temperature and pH tests during the processes.1045 Lilly P.R.'s operators involved in the manufacturing processes at Mayaguez were all at least high school graduates. As a result of the complexity of the manufacturing processes, it generally took an operator 1 year to learn the skills necessary to perform properly all the procedures involved in only one of the 6 steps. It was not necessary, however, for each operator to be familiar with every step in order for the processes to function properly.The intermediate chemicals produced at Mayaguez in steps 1 through 4 were analyzed 159 in the plant laboratory and subjected to as many as 8 quality control tests. Steps 5 and 6 were performed as one continuous process, during which samples were taken to the laboratory for analysis. The final product, propoxyphene hydrochloride or propoxyphene napsylate, was subjected to 28 quality control tests lasting a period of 2 days. After satisfactory completion of the quality control tests, the finished product was shipped to the Carolina facility in accordance with that facility's request for bulk chemicals.3. Pharmaceutical Manufacturing at CarolinaDuring 1971, 1972, and 1973, Lilly P.R.'s Carolina facility was engaged in the pharmaceutical manufacture of Darvon and Darvon-N products. Its manufacturing operations were divided into the manufacture of empty capsules, the formulation and encapsulation or tableting of the mixed material, 18 and the packaging and labeling of the finished products.Lilly P.R.'s empty capsule manufacturing department operated 24 hours a day, 7 days a week, and employed approximately 65 to 80 people. The manufacturing process involved the 160 mixture of gelatin melts, using protocols (similar to manufacturing tickets, see pages 1046-1048) prepared and issued by Lilly P.R., and the actual production of the empty capsules on the capsule manufacturing machines. The empty capsules were tested throughout the manufacturing process to ensure the absence of physical defects and bacteria. The capsules passing those tests were stored for later use in Lilly P.R.'s pharmaceutical manufacturing operations.The pharmaceutical manufacture of capsule products at Carolina entailed mixing the raw chemical materials and 1046 filling the empty capsules with the mixed, or formulated, materials. For the manufacture of tablet products, the dry chemical ingredients were mixed with a lubricant, compressed by machine into tablets, and coated with a colored material. The products were periodically tested and analyzed for physical defects, weight, and the amount of active ingredients.The finished capsules and tablets were moved to the finishing department, where they were counted and filled into plastic bottles, 10 bottles at a time. The bottles were capped, labeled, and packaged in corrugated boxes for shipment to Indianapolis.The entire pharmaceutical 161 manufacturing process for capsule products normally took approximately 1 month per lot. The filling operation, alone, took approximately 10 days per lot on a two-shift operation. Approximately 150 to 175 employees were involved in the production process, although at any one time, as few as 15 people might have been working on a particular lot. The pharmaceutical manufacture of tablet products, because of the additional steps of mixing the ingredients with liquids and coating, required approximately 1 1/2 to 2 months per lot to complete.F. Manufacturing Tickets and Related ProceduresA manufacturing ticket is a document listing the step-by-step procedures for manufacturing one lot of a specific pharmaceutical product. A separate manufacturing ticket was issued by petitioner for each lot of each chemical intermediary and final bulk chemical product manufactured by Lilly P.R. at its Mayaguez facility and for each finished product manufactured at its Carolina facility. The manufacturing tickets, in essence, were oversized recipes listing the names and quantities of all of the ingredients to be used in the manufacturing process, the step-by-step actions required to combine them in perfect 162 order, and the specifications for the final product produced under the manufacturing ticket. They specified the checks and audits to be carried out by production workers and by quality control personnel, as well as the tests to be conducted at critical points by laboratory scientists. Manufacturing tickets for chemical manufacturing processes also indicated temperatures, pressures, and reaction times for the chemical reactions covered by those manufacturing tickets.1047 The manufacturing tickets were numbered to correspond with given lots of the product and were initialed by the operators of Lilly P.R. responsible for each step in the various manufacturing processes so that any problem that arose with respect to a lot could be traced back to the operators involved. FDA regulations required the use of documents such as manufacturing tickets to provide control and accountability in the manufacture of pharmaceutical products. The manufacturing ticket procedures used by petitioner and Lilly P.R. satisfied that FDA requirement, although manufacturing tickets were used by petitioner even before such documents were required by the FDA.During the years 1966 through 1973, the manufacturing tickets 163 used by Lilly P.R. in its manufacturing processes were issued to Lilly P.R. by petitioner's ticket issuance department in Indianapolis, Indiana. The ticket issuance department was the custodian of the master formula for each product manufactured by petitioner and Lilly P.R. The ticket issuance department produced duplicates of the master formulas using a large 19 copying machine pursuant to instructions from petitioner's finished stock planning department that tickets were needed by Lilly P.R.'s Carolina facility or upon receiving requests for tickets from Lilly P.R.'s Mayaguez facility. The ticket issuance department assigned the lot number to each manufacturing ticket and produced tags or stickers called manufacturing tags which bore the lot number and were to be placed on containers to identify raw and work-in-process materials to that lot. The manufacturing tags, required by FDA regulations, were sent to Lilly P.R. along with the manufacturing tickets for the lot. After the manufacturing tickets were used by Lilly P.R. in its chemical and pharmaceutical manufacturing processes, they were returned to petitioner's ticket issuance department in Indianapolis for microfilming 164 and storage.The manufacturing tickets used by Lilly P.R. for the production of Darvon products were essentially the same as those developed by petitioner prior to 1967 for use in its manufacture of those products. The manufacturing tickets for Darvon-N products were developed jointly by petitioner and 1048 Lilly P.R. The master manufacturing tickets for Darvon and Darvon-N products were modified from time to time, based upon recommendations by employees of Lilly P.R. Generally, those modifications were made to remedy a problem or implement improved manufacturing procedures developed by Lilly P.R.During the years 1971 through 1973, Lilly P.R. personnel recommended approximately 55 modifications of the manufacturing tickets for Darvon and Darvon-N products, 2 of which were the subject of a supplemental NDA. (See pages 1067-1068.) All the manufacturing ticket modifications recommended were adopted, even though there were some comments by petitioner that resulted in further testing by Lilly P.R. prior to their adoption.In addition to the manufacturing tickets, Lilly P.R., during the years in issue, 165 used master packaging orders issued by petitioner's ticket issuance department in Indianapolis. Those master packaging orders were used by Lilly P.R.'s Carolina facility to produce the packaging orders it used in the packaging of Darvon and Darvon-N products.During the years 1971, 1972, and 1973, Lilly P.R. also used numerous written procedures (called protocols) that had been developed by Lilly P.R. to cover manufacturing and other activities that were not covered by manufacturing tickets or packaging orders. For example, the Mayaguez facility of Lilly P.R. developed protocols to cover the reworking of chemicals it produced that did not meet specifications, and the Carolina facility developed standard procedures for the preparation of gelatin solutions. Both the Mayaguez and Carolina facilities developed procedures that covered virtually every aspect of their operations, including administrative and financial functions. In this respect, Lilly P.R. had the use of numerous manuals prepared by petitioner in its manufacturing and other operations.G. Raw Material PurchasesDuring the years 1968 through 1973, Lilly P.R.'s chemical and pharmaceutical manufacturing activities respectively 166 required the use of approximately 35 and 140 different raw materials. Lilly P.R.'s established policy was to purchase most of its raw materials from unrelated suppliers located in Puerto 1049 Rico; to purchase raw materials from unrelated suppliers located outside of Puerto Rico if Puerto Rican suppliers could not be located; and to purchase raw materials from petitioner only in rush situations, when it had trouble locating or obtaining materials from another source, or when petitioner was the only source. Lilly P.R.'s purchases of raw materials from third-party suppliers accounted for 80 percent, 81 percent, and 87 percent of its total raw material purchases in dollars for 1971, 1972, and 1973, respectively. The remainder of Lilly P.R.'s purchases of raw materials in those years were from petitioner. Among the purchases of materials from petitioner were all labels and literature used by Lilly P.R. for its Darvon and Darvon-N products.Although petitioner provided Lilly P.R. with a list of suppliers of raw materials, Lilly P.R. was not required to purchase only from the suppliers on the list. During the years in issue, Lilly P.R. selected and evaluated its suppliers of raw materials 167 without petitioner's assistance.H. Equipment PurchasesDuring the years 1965 through 1973, Lilly P.R. purchased equipment and machine parts either directly from third party suppliers or through petitioner. The procedures for those purchases are discussed in detail at pages 1099-1100.Although equipment purchases by Lilly P.R. in excess of $ 50,000 were submitted to petitioner's executive committee or board of directors for approval, none of Lilly P.R.'s requests for authorization to purchase equipment was rejected during the years 1965 through 1973.I. Technical AssistanceDuring the years 1971, 1972, and 1973, Lilly P.R. received and paid for certain technical assistance from petitioner under the technical assistance agreement. Such assistance included the following:a. Installation of new chemical and pharmaceutical manufacturing equipment, and instruction relative to the use of said equipment;b. Maintenance and repair of chemical and pharmaceutical manufacturing equipment;c. Managerial assistance relative to industrial health programs;d. Expert industrial relations assistance;e. Consultations with personnel relative to Lilly P.R.'s Credit Union;1050 f. Expert assistance relative to the 168 engineering and long term planning of manufacturing operations;g. Expert assistance and coordination with public officials relative to waste treatment and the environmental impact of facilities;h. Expert assistance relative to financial organization, payroll accounting and computerization of data;i. Training in the areas of laboratory testing, accounting and managerial skills;j. Assistance with problems in quality control laboratory;k. Review of inventories and assistance in inventory planning;l. Maintenance of Lilly P.R. aircraft;m. Supervision of telephone communication system installation; andn. Assistance in cafeteria and food service operations.Petitioner provided technical assistance to Lilly P.R. only upon request. Lilly P.R. was free to and did retain unrelated outside consultants and advisers having mechanical, electrical, architectural, accounting, and legal expertise.J. Quality ControlIn the normal course of its operations, Lilly P.R. performed all required quality control tests on raw materials and in-process materials without the need for assistance from or coordination with petitioner. With one exception, Lilly P.R. also normally performed all quality control tests 169 on finished products. Lilly P.R.'s Mayaguez facility did not have the capability to perform toxicity tests on the final products, bulk propoxyphene hydrochloride and bulk propoxyphene napsylate. That testing was performed on samples of the products by petitioner's quality assurance department in Indianapolis, Indiana.While petitioner did not routinely perform quality control tests on materials and products of Lilly P.R., it did perform a limited number of quality control tests at the request of Lilly P.R. For example, if Lilly P.R. encountered problems in performing a particular quality control test, it might have had petitioner perform the same test in order to compare results. The testing performed by petitioner took place in petitioner's quality control laboratories in Lilly Research Laboratories. Lilly P.R. reimbursed petitioner for the cost of the quality control testing performed at its request. In addition, petitioner performed quality control tests on raw materials that it manufactured or purchased for sale to Lilly P.R.1051 During the years in issue, petitioner provided to Lilly P.R. and all its other subsidiaries copies of petitioner's standard procedures for the performance 170 of quality control tests. Lilly P.R., however, developed some of its own procedures for testing raw materials. Also during the years in issue, Lilly P.R. sent copies of its assay reports on the final bulk products propoxyphene hydrochloride and propoxyphene napsylate produced by its Mayaguez facility and on certain raw materials and finished products produced by its Carolina facility to petitioner's quality assurance department in Indianapolis.K. Sample and Identi-dose PackagingDuring the years 1966 through 1972, under the terms of the distribution agreement, petitioner received from Lilly P.R. at no charge Darvon and Darvon-N capsules and tablets in bulk which petitioner packaged as samples. Commencing in 1973, petitioner purchased those samples at cost. During the period 1968 through 1973, petitioner purchased from Lilly P.R. at Lilly P.R.'s cost, Darvon and Darvon-N capsules and tablets in bulk which petitioner packaged in Identi-dose packages for resale to wholesalers.VIII. Petitioner's Marketing OperationsA. IntroductionThe U.S. ethical pharmaceutical industry has three characteristics that distinguish it from other industries. First, the pharmaceutical industry is research 171 intensive. Pharmaceutical companies spend relatively greater amounts on research and development than do companies in many other industries. Second, the pharmaceutical industry is very competitive. Although petitioner has always been a leader in the pharmaceutical industry, its U.S. pharmaceutical sales accounted for only approximately 7 1/2 percent of total pharmaceutical industry sales in the United States during the years 1971 through 1973. Third, the pharmaceutical industry is unique in that promotional efforts for ethical pharmaceutical products are directed to health care professionals such as physicians and dentists, the actual users of the products.During the years 1971 through 1973, the primary business of petitioner's pharmaceutical division was the sale of ethical pharmaceutical products to wholesale distributors. Unlike 1052 most companies in the pharmaceutical industry, which sell both to wholesalers and direct to certain large accounts, petitioner sold its ethical pharmaceutical products almost exclusively through a network of approximately 400 wholesalers located throughout the United States. The products sold by petitioner in 1971 through 1973 included all those manufactured 172 by Lilly P.R. Petitioner's wholesalers generally paid petitioner's invoices within 30 days, and petitioner rarely had credit problems with its wholesalers.During the years 1971 through 1973, petitioner's marketing efforts generally involved personal contacts by petitioner's sales representatives (called detail men) with physicians, dentists, hospitals, pharmacists, and wholesalers. In addition, petitioner's marketing operations included supportive promotional activities such as the distribution of printed literature by sales representatives, direct mail advertising, operation of exhibits at medical conventions and schools, and journal advertising.B. OrganizationDuring the years 1971 through 1973, petitioner's pharmaceutical marketing operations in the United States were organized into two functions: the "inside" function of marketing research and planning and the "outside" function of the sales force calling on health care professionals.1. Marketing Research and Marketing PlanningDuring the years 1971, 1972, and 1973, petitioner employed approximately 160 individuals in marketing administration at its Indianapolis headquarters. Those individuals were engaged in marketing research, 173 marketing planning, and certain staff functions for petitioner's U.S. pharmaceutical marketing operations. The function of petitioner's marketing research was to study the historical and present conditions in the U.S. pharmaceutical market and to make judgments about the future marketing activities of both petitioner and its competitors. This was done primarily by reviewing statistical data gathered by independent information services. The function of marketing planning was to develop specific strategies for the promotion of petitioner's products based upon the information produced by petitioner's marketing research. The marketing planning function also involved the preparation of printed 1053 advertising materials to be distributed by sales representatives, by direct mail, in medical journals, and at medical conventions.Petitioner's inside marketing function employed individuals possessing university or graduate degrees, usually in scientific areas such as pharmacy. The majority of petitioner's inside marketing personnel had experience as sales representatives.2. Sales ForcePetitioner's marketing philosophy emphasized the interpersonal interaction between the sales representative 174 and the health care professionals. Consequently, petitioner's marketing efforts were concentrated around the activities of its sales representatives. During the years 1971 through 1973, petitioner employed approximately 1,000 sales representatives throughout the United States. Those sales representatives were distributed geographically based upon petitioner's assessment of the market potential for its products in various areas of the country as well as on the distribution of the physician population within the country.The principal function of petitioner's sales representatives was the presentation of scientific information to health care professionals about the nature and appropriate use of petitioner's pharmaceutical products. Health care professionals are a very select and well-informed group, are highly trained in their fields, and are capable of making discriminating judgments about pharmaceutical products. As a result of the scientific nature of petitioner's pharmaceutical products, and the qualifications of the audience to which petitioner's promotional efforts were directed, petitioner's sales representatives had to have scientific training. Each of petitioner's sales 175 representatives was a college graduate, 80 percent were pharmacists, and the remainder generally had degrees in one of the life sciences. Approximately 6 percent of petitioner's sales representatives had masters degrees.The process of calling on physicians and other health care professionals is relatively standardized in the pharmaceutical industry. The physician audience for each product is defined, and a regular schedule of periodic visits with the physicians in that audience is developed. Because physicians have a limited amount of time to meet with sales representatives of pharmaceutical 1054 companies, the usual visit of a sales representative with a physician occupies only 5 to 10 minutes. The frequency of such visits ranges from approximately 4 times a year to as many as 10 or 12 times a year. Due to the limited time involved in a call on a physician, the sales representative has to have a well-developed message with respect to the products he is discussing, including both the benefits of the products and their potential side effects. Generally, a sales representative visits a physician with the primary objective of discussing one particular product (called a primary detail). 176 The sales representative also might spend a limited amount of time during the same visit on another product (called a secondary detail).During the years in issue, petitioner's sales representatives made calls on physicians, interns, and residents in their offices or in hospitals; pharmacists in drug stores and in hospitals; the nonphysician staffs of hospitals, such as hospital administrators, nurses, and laboratory technicians; dentists; industrial clinics and nursing homes; and pharmacy, dental, medical, and nursing schools. The contacts with students in those schools were made to acquaint them with petitioner's name and products, and were informational rather than sales oriented. Petitioner's sales force was considered one of the most effective sales forces in the pharmaceutical industry in the United States.Approximately 200 of petitioner's 1,000 sales representatives concentrated their knowledge and sales efforts in certain areas of medical specialty in order to become familiar with the special interests, problems, needs, and language of those areas of medicine. Those medical specialities included surgery, internal medicine, pediatrics, and urology. The "specialty" sales 177 representatives were responsible for contacting physicians, residents, pharmacists, and paramedical staffs in large multidepartment hospitals, major metropolitan areas, and other places with high concentrations of specialized medical practices.During 1972, petitioner formed a second sales force in addition to its 1,000 man regular sales force. The new sales force, called Dista, consisted of approximately 150 sales representatives and was formed to market products directed to primary care physicians, that is, general practitioners, family 1055 practitioners, and other physicians working in office-based, non-hospital environments. The management personnel for the Dista sales force came from petitioner's existing sales force. The Dista sales representatives primarily were new employees hired by petitioner, although some Dista sales positions were filled by existing sales representatives of petitioner. The educational background of the Dista sales force was similar to the educational background of petitioner's regular sales force.C. Regulation of Promotional ClaimsDuring the years in issue, the FDA placed specific constraints on the content of promotional claims for ethical pharmaceutical 178 products. When an NDA was approved by the FDA, the FDA and the manufacturer agreed on the content of a document called a "package insert," which accompanied each package of the product sold by the manufacturer. The package insert was a very comprehensive document that described, in scientific terms, the chemical composition of the drug, its medical actions, its indications (i.e., the medical conditions for which it was to be used), and its contraindications (i.e., the medical conditions for which the drug should not be used). The insert also provided information with respect to administration and dosage, the dangers of using the drug, precautions that should be taken by the physician, adverse reactions, interactions with other drugs, and the treatment of overdose situations. The claims for the drug as set forth in the package insert had to be demonstrated to the satisfaction of the FDA on the basis of clinical studies performed with the drug. Federal law prohibited the promotion of a drug for uses other than those included in the package insert.In addition, pharmaceutical manufacturers submitted to the FDA copies of all promotional materials for clearance prior to use. After 179 the drug was on the market, the FDA periodically reviewed all promotional materials. Package inserts could be amended from time to time to add new uses for the drug established by clinical studies or to add additional warnings and information with respect to adverse reactions. The package inserts used by petitioner were developed by the medical and scientific personnel of petitioner's Lilly Research Laboratories.1056 D. Marketing of Darvon and Darvon-N ProductsBy 1971, Darvon products had been sold for 13 years and were well established in the market place as leading analgesic drugs. During the years 1971 through 1973, petitioner introduced Darvon-N products. Darvon and Darvon-N products together were the most frequently prescribed ethical pharmaceutical products in the United States during the years 1960 through 1973.During the years 1971 through 1973, Darvon and Darvon-N products were petitioner's largest selling product line and as such received a major share of petitioner's marketing attention and efforts. Physicians at that time knew what Darvon products were and how they fit into their practices of medicine. Consequently, petitioner's marketing efforts for Darvon products during 180 those years were in the nature of advising physicians of new developments concerning Darvon products and attempting to expand their uses of those products. As Darvon-N products had been introduced only recently, petitioner concentrated its marketing efforts for propoxyphene products during the years 1971 through 1973 upon Darvon-N in order to inform physicians and other health care professionals of that new product line.Petitioner's marketing efforts for Darvon and Darvon-N products were directed principally to primary care physicians, that is, physicians who treat patients initially as opposed to specialists to whom patients are referred. However, almost all physicians were candidates for the promotion of analgesic drugs because of the broad incidence of pain resulting from many types of illnesses and injuries. Consequently, petitioner's target audience for Darvon and Darvon-N products was very broad. Petitioner promoted Darvon and Darvon-N products primarily through its regular sales representatives rather than through its specialty sales representatives or Dista sales force.E. Pricing of Darvon and Darvon-N ProductsPetitioner's prices to wholesalers for its pharmaceutical 181 products were determined primarily by petitioner's assessments of what the marketplace was willing to pay for those products. Although the profitability of a product was a factor 1057 in pricing decisions, the prices of petitioner's products were not directly related to its costs of producing those products.Health care professionals generally categorize drugs as either relatively expensive or relatively inexpensive. The price of a drug can be a material concern to the health care professional when choosing among relatively expensive drugs; price, however, is usually not a material concern to the health care professional when choosing among relatively inexpensive drugs. Oral analgesics, and particularly propoxyphene products, were viewed by health care professionals as being relatively inexpensive drugs. During the years in issue, the average prescription price (i.e., the price paid by the patient at the drug store) for a bottle of 30 Darvon capsules was approximately $ 4. Thus, Darvon products cost the patient approximately 13 cents per capsule or about 50 cents per day (the recommended dose of Darvon products was four capsules per day).The reason why health care professionals are 182 not concerned when choosing among relatively inexpensive drugs such as Darvon products is that the differences in the wholesale prices for the drugs are not fully reflected in their retail prices. Pharmacists in drug stores rarely determine their prices for less expensive drugs based on a markup over cost, but rather charge a dispensing fee of approximately $ 2 for each prescription. For example, if a prescription for a Darvon products costs the patient $ 4 in the drug store, the pharmacist's ingredient cost would be approximately $ 2 (the $ 4 price less the $ 2 dispensing fee). Therefore, if the pharmacist's ingredient cost was produced by 50 percent to $ 1, the pharmacist's price to the patient would be reduced only 25 percent from $ 4 to $ 3.Although petitioner anticipated that competitors would enter the market with generic propoxyphene products after the propoxyphene patent expired in 1972, petitioner did not decrease its prices for Darvon products. Petitioner expected that its competitors would price such generic products at levels lower than petitioner's prices but no less than half of petitioner's prices. If the price of a generic propoxyphene product was half that of 183 the Darvon product, the difference in the prescription price to the patient, using the figures in our example, would be approximately $ 1 for a prescription of 30 capsules or only about 3 cents a capsule. Petitioner believed that, given 1058 the small difference in the prescription price to the patient, physicians would continue to prescribe the Darvon product, a known product which they had used over several years, rather than a new generic product.F. Significance of Marketing IntangiblesFor many years, petitioner has enjoyed a favorable reputation in the marketplace as a result of bringing to the market a succession of therapeutically successful products. Petitioner also has developed over the years a marketing organization that is highly skilled in the promotion of pharmaceutical products. The fact that petitioner marketed several successful pharmaceutical products and enjoyed a good reputation made it easier for petitioner's sales representatives to obtain access to health care professionals in order to discuss petitioner's other products.Although petitioner's reputation gave it access to health care professionals, such access was no assurance that a new product marketed by petitioner 184 would be successful. Health care professionals, as stated earlier, are a sophisticated and discriminating audience, and they will not automatically accept any new product marketed by petitioner. Petitioner, in fact, marketed several products during the 1960's and 1970's that were unsuccessful despite the fact that those products were heavily promoted by petitioner's sales force under petitioner's well-known and respected name.It often takes several years to determine whether a new drug will prove to be successful in the marketplace. In petitioner's experience, health care professionals ordinarily will try a new drug only if it promises to perform more satisfactorily than the drugs already available and used by them. If a health care professional tries the drug and finds that it works satisfactorily, he then gradually may broaden his use of the drug in his practice. In addition, although new drugs undergo extensive clinical testing before marketing, it is not uncommon to discover new information about the drug, such as adverse reactions, after it has been on the market and in general use. Furthermore, as the marketing of a new drug is usually more expensive in the early years 185 due to the marketing effort required to inform health care professionals about 1059 the new drug, a new drug may not produce substantial economic returns to the manufacturer for many years.It was clear by 1966 that the Darvon product line was an extraordinarily successful product line. It then had an 8-year demonstrated history of substantial sales, establishing its position as a leader in the prescription oral analgesic market. The Darvon product line was well known among health care professionals and others. It was also extremely profitable. For those reasons, the Darvon product line had a substantial intangible value in 1966.If petitioner had lost the right to use the Darvon trademark at some point during the period 1966 through 1971, the sales and profit performance of petitioner's propoxyphene hydrochloride products would not have been materially affected, provided petitioner had the exclusive right to market those propoxyphene hydrochloride products. Because propoxyphene hydrochloride products had been on the market since 1957, those products were well known in the medical community. Health care professionals were aware that the generic name for the active ingredient in Darvon 186 products was propoxyphene hydrochloride because labels, product information, and other literature regarding Darvon products all prominently displayed that fact.The loss of the trademark would have caused petitioner to incur only a minor amount of additional marketing costs for a short period of time. Petitioner would have had to inform health care professionals that the propoxyphene hydrochloride products previously marketed by it under the trademark Darvon were no longer available under that trademark but only under a new trademark. More importantly, petitioner would have had to advise retail pharmacists of the trademark change. Pharmacists were legally prohibited during those years from substituting, without the consent of the prescribing physician, a generic drug for the drug prescribed by the physician. If a pharmacist had received a prescription for a Darvon product, he probably would have called the prescribing physician, advised him that propoxyphene hydrochloride products were no longer sold under that trademark but under a new one, and requested permission from the physician to fill the prescription with the new trademarked product. Such a procedure was generally standard 187 among pharmacists. The 1060 physician in most instances would have granted the permission requested because he was interested in prescribing for his patient the therapeutic agent, propoxyphene hydrochloride, and the Darvon trademark as such was of little importance to him.IX. Petitioner's Research and Development ActivitiesA. IntroductionDuring the years 1971, 1972, and 1973, petitioner's Lilly Research Laboratories conducted research and development in the life sciences with the objectives of inventing, developing, and improving pharmaceutical, agricultural, and cosmetic products. All the products manufactured by Lilly P.R. during those years, as well as most of the ethical pharmaceutical products of petitioner, were developed by Lilly Research Laboratories, a division of petitioner, solely or in conjunction with research facilities of petitioner's subsidiaries.During the years 1971 through 1973, the research and development facilities of Lilly Research Laboratories were located at McCarty Street in Indianapolis, at the Wishard Memorial Hospital in Indianapolis, and at Greenfield, Indiana.Petitioner's research and development facilities at McCarty Street in Indianapolis occupied approximately 188 775,000 square feet of space and had a book value of approximately $ 23.3 million at the end of 1973. In 1972, petitioner completed and occupied a new building at McCarty Street (called Building 88) that approximately doubled petitioner's research facilities. The pharmaceutical pilot plant on Kentucky Avenue in Indianapolis also was considered part of the McCarty Street research facilities.The Lilly Laboratory for Clinical Research (often called the Lilly Clinic) was located on the seventh floor and half of the sixth floor of the Wishard Memorial Hospital in Indianapolis and occupied approximately 67,000 square feet of space. Petitioner's assets at that location had a book value of approximately $ 698,000 at the end of 1973. Wishard Memorial Hospital was a government-owned institution staffed by the University of Indiana Medical School. The Lilly Clinic was a 40-bed facility responsible for initial tests of new pharmaceutical compounds in human volunteers. Approximately 125 1061 employees of Lilly Research Laboratories worked at the Lilly Clinic.Petitioner's Greenfield Laboratories were located on a 750-acre site near Greenfield, Indiana. The facility occupied approximately 420,000 189 square feet of space, and had assets with a book value of approximately $ 11.6 million at the end of 1973.During the years 1971 through 1973, Lilly Research Laboratories employed approximately 2,000 persons. Approximately 8 percent of those employees were research executives, 13 percent were senior scientists who held Ph.D. degrees, 35 percent were scientists not holding Ph.D. degrees, and the remaining 44 percent were technicians, secretaries, animal caretakers, and other support personnel. The executives and scientists at Lilly Research Laboratories included physicians, chemists, biologists, microbiologists, physiologists, and pharmacologists.The activities of Lilly Research Laboratories were directed by four general committees during the years 1971 through 1973. Those committees were: (1) The research projects committee; (2) the product development committee; (3) the product introduction committee; and (4) the product addition committee. The objective of those committees was to create new compounds that could be recommended for clinical or field trial testing. The recommendation of those committees was forwarded with accumulated data relative to the compound involved to a research 190 management group. If the research management group agreed with the recommendation of the committees and the evaluations of the chemical work done with respect to the recommendation, the compound was forwarded for development.The research and development work on each compound was done by designated teams drawn from the four divisions of Lilly Research Laboratories. The divisions were organized into two major categories. The first category contained the research, development, and control divisions. The second category consisted of the medical research division.The research division of Lilly Research Laboratories was responsible for creating new compounds, screening compounds for potential product development, and studying the initial toxicological effects of those compounds. That division performed 1062 the general or basic research function of Lilly Research Laboratories. A research team was established to search for new compounds in each general area of interest to petitioner, such as cardiovascular drugs, anti-cancer drugs, or analgesic drugs. A research project number was established to cover the work of each of those research teams. The research division synthesized thousands 191 of new chemical compounds every year. In the pharmaceutical industry, approximately 8,000 new compounds are synthesized for each compound that finally is marketed as a new drug.The development division of Lilly Research Laboratories was responsible for developing compounds that had been screened by the research division and that appeared to have marketing potential. Such development activities included performance of short- and long-term toxicology studies, development of a manufacturing process, production of clinical trial materials, and performance of clinical studies. When a new compound identified by the research division was forwarded by the research committees for development, a product development team was established for that compound and a product development number was established to cover the work of that team.The control division of Lilly Research Laboratories was responsible for the performance of analytical assays on research materials, purchased materials, and manufactured items. That division was basically a service operation providing analytical testing for the research, development, and medical research divisions of Lilly Research Laboratories. The primary function 192 of the control division was to perform the required quality control tests on each lot of each product manufactured by petitioner in the United States.The medical research division of Lilly Research Laboratories was responsible for conducting, coordinating, and evaluating human clinical tests to establish the safety and efficacy of new pharmaceutical compounds. Its activities also included the preparation and submission of NDAS.During the years 1971, 1972, and 1973, the research and development expenses of Lilly Research Laboratories were $ 53,513,000, $ 59,502,000, and $ 65,551,000, respectively. Those amounts represented all of petitioner's research and development expenditures with the exception of certain development 1063 expenditures for petitioner's antibiotic development division that were not incurred by Lilly Research Laboratories. The expenses of the control division of Lilly Research Laboratories were included in the above amounts only to the extent that assays were performed by the control division on materials used or produced by the research, development, or medical research divisions. The remaining expenses of the control division were transferred to petitioner's production 193 departments and were included in petitioner's cost of products sold.Petitioner generally performed three types of research. One was fundamental research, which included the basic research necessary to synthesize and screen new chemical compounds. The fundamental research laid the groundwork for the second type of research, product-oriented, or defined, research. That research included activities related to the development of pharmaceutical compounds and the preparation of NDAs. Defined research covered the time period from the establishment of a product development team for a promising compound to the approval of an NDA for that compound. The third type of research, support research, involved activities performed after the compound had been marketed. During the years 1971 through 1973, the fundamental research category accounted for approximately 60 percent of the total research and development expenditures of Lilly Research Laboratories. Defined research accounted for approximately 20 percent of those expenditures, and support research accounted for approximately 20 percent.The research and development expenses of Lilly Research Laboratories for pharmaceutical, agricultural, 194 and cosmetic research and development projects for the years 1971, 1972, and 1973 were as follows (000's omitted):Area of research197119721973 20Pharmaceutical$ 40,393$ 45,397$ 49,632Agricultural12,83013,97915,765Cosmetic290126153Total53,51359,50265,5511064 B. Food and Drug Administration RequirementsThe Federal Food, Drug, and Cosmetic Act (21 U.S.C. secs. 301-392) requires the submission and FDA approval of an NDA 21 prior to the introduction into interstate commerce of any new drug, including patented drugs. Subsequent to 1962 and throughout the years 1971 through 1973, the process for obtaining an NDA involved as a prior step the filing of a document known as an Investigatory New Drug Application (hereinafter IND).An IND contained the background of the new drug at the point in 195 time at which it was filed. It described the method and chemistry of synthesizing the new drug; the procedures and tests for controlling the quality of the drug; summaries of animal pharmacology tests performed to assess the drug's therapeutic potential; results of animal toxicology studies performed to assess the safety of the drug; the labeling the developer intended to use to ship the drug in interstate commerce; the names of the investigators who would be conducting the clinical studies in humans; and the plans or protocols to be used in those studies.Petitioner's INDs were prepared by the regulatory affairs department of Lilly Research Laboratories' medical research division. During the years in issue, the regulatory affairs department had approximately 60 employees. The preparation of an IND was largely a process of collating finished packages of materials received from other areas of Lilly Research Laboratories. It took two or three of the clerical personnel in that department approximately 2 to 3 days to collate and duplicate an IND.Assuming that the FDA did not have serious objections with respect to the IND, the pharmaceutical company was free to begin clinical studies 196 in humans after a 30-day waiting period. The clinical studies for a new drug generally were divided into three phases referred to as phase I, phase II, and phase III. Although there were qualitative distinctions in the nature of the clinical studies performed in each phase, the three phases were not performed in strict chronological order and often overlapped in time.1065 Phase I clinical studies consisted largely of dose ranging studies in normal human subjects. During the years in issue, phase I clinical studies usually involved 20 to 50 subjects and took from 3 to 6 months to complete, depending upon the new drug being tested. Petitioner's phase I studies ordinarily were performed in the Lilly Clinic.Phase II clinical studies were the initial efficacy studies for the new drug. The purpose of those studies was to demonstrate that the drug had some valuable, therapeutic activity. In those studies, the new drug was given to a small number of patients who had the disease or medical condition that the new drug was intended to treat.At some point during phase II, sufficient information with respect to the efficacy and toxicity of the new drug was accumulated to permit a decision as 197 to whether the new drug would be able to complete successfully the FDA approval process or whether the testing of the new drug should be abandoned. That point in a new drug's development was referred to as the NDA decision point. The NDA decision point was important because it was at that time that it was decided whether to commit the considerable resources necessary to complete the phase II and phase III clinical studies for the new drug. The amount of time between the end of phase I and the NDA decision point varied greatly depending upon the new drug being tested, but generally ranged between 1 and 2 years.Phase III studies were similar to and essentially a continuation of phase II studies. Phase III studies, however, were more extensive. They involved more patients than were involved in phase II studies, and more attributes of a new drug were assessed. The drug was tested under various dosage schedules and in conjunction with other drugs. A major objective of phase III studies was to expose large numbers of patients to the new drug to collect information with respect to potential side effects or abnormalities in the patients and for the large body of safety data necessary 198 to support an NDA.Petitioner generally attempted to have its new drugs investigated by well-known clinical investigators, outside physicians who were paid by petitioner to study the new drugs. The testing usually was done at large teaching hospitals in various locations around the country to provide test data under various conditions. Petitioner contracted with those clinical 1066 investigators and provided them with case report forms on which to report the data produced by the clinical studies. The case report forms completed by the clinical investigators were forwarded to petitioner's regulatory affairs department where they were entered into a computer. The regulatory affairs department worked with petitioner's computer analysts and statisticians to devise computer-generated tables summarizing the clinical data, which tables eventually became part of the applicable NDAs. The time from the NDA decision point to the completion of phase III clinical studies varied greatly depending on the drug being tested but generally ranged between 2 and 3 years.The NDA was in large part a duplication and elaboration of the material included in an IND. The NDA included the information originally 199 submitted in the IND and all additional information the applicant had collected relative to the new drug, including but not limited to: (1) Detailed descriptions of the manufacturing and quality control procedures; (2) any animal pharmacology studies done subsequent to the filing of the IND; (3) any animal toxicology studies done subsequent to the filing of the IND; (4) all information relative to phases I, II, and III clinical studies on humans during the IND process, including the names of the investigators and the results of their research; (5) the labels and labeling information; and (6) the package insert for the new drug. The NDA material submitted to the FDA generally was voluminous.By regulation, the FDA had 180 days from the filing of an NDA within which to respond. The FDA could and often did ask questions with regard to the clinical, toxicology, and pharmacology studies reported in the NDA. When such questions were raised with respect to NDAs filed by petitioner, personnel of petitioner's regulatory affairs department or the individuals in Lilly Research Laboratories who prepared the data submitted with the NDA discussed those questions with the FDA. If necessary, petitioner 200 supplied additional information to the FDA. During that interaction period, a regional office of the FDA conducted an inspection of the manufacturing facilities to be used to produce the new drug. Inspections of Lilly P.R.'s manufacturing facilities were conducted by the local Puerto Rican office of the FDA.1067 When the FDA completed its review of the NDA, and if the FDA was satisfied, it issued a letter stating that the new drug was approvable contingent upon a review of final printed labeling and package inserts. When petitioner received an approvable letter from the FDA, it printed final labeling and package inserts for the new drug and submitted those materials to the FDA. At that point, petitioner also submitted to the FDA the promotional materials it planned to use to market the drug. If the FDA found those materials satisfactory, it issued a letter to petitioner approving the NDA and giving petitioner the right to market the new drug.During the years 1971 through 1973, the average period from the filing of an NDA to its final approval by the FDA was approximately 2 years. Only 1 in every 10 new drugs for which an IND was filed, successfully completed the process and received 201 FDA approval. While the time frame leading to an NDA varied extensively, the entire procedure from the initial chemical synthesis and identification of a new drug to the approval of an NDA for the new drug ranged from approximately 7 years to 13 years.The approval letters issued by the FDA contained specific provisions and conditions relative to the maintenance of that approval. The pharmaceutical companies were required to maintain certain records and to make certain periodic reports to the FDA. The companies were required to report every 3 months for the first year, every 6 months the second year, and annually thereafter. In addition, the pharmaceutical companies were required to submit to the FDA any information concerning accidents or certain complaints relative to a drug on a priority basis. Immediate notification was required of labeling mix-ups, bacteriological contamination, or chemical degradation; notification was required within 15 days of receiving complaints or learning of serious, unexpected side effects of a drug.If a pharmaceutical company desired to make any major change in the manufacturing or marketing of a drug, such as the addition of a new indication for 202 the drug or a change in its dosage schedule, additional materials were submitted to the FDA in the form of a supplemental NDA. The supplemental NDA described the desired change and included data supporting that change.1068 FDA approved NDAs cannot be assigned or transferred by pharmaceutical companies. The approved NDA is peculiar to the pharmaceutical company that obtained it because it contains information specific to that company. A second pharmaceutical company desiring to market the same drug would be required to file and obtain approval of its own NDA for the drug. If the pharmaceutical company that originally obtained FDA approval to market the drug granted the second pharmaceutical company the right to refer to the information in the first company's NDA file, the second company could obtain FDA approval of an NDA simply by submitting to the FDA the appropriate labeling, manufacturing, and quality control information. The first company's NDA file in that situation is referred to as a "master file." During the years 1971 through 1973, a master file could be referred to only with the permission of its sponsor. A "sponsor," in the FDA context, is the company that submitted the 203 IND and NDA, and is the party responsible for maintaining records and submitting the periodic reports to the FDA.C. Research and Development of Propoxyphene Products 1967-731. GeneralDuring the years 1967 through 1973, Lilly Research Laboratories conducted research and development activities with respect to propoxyphene products for the benefit of Lilly P.R. The expenses of those activities, as determined using Lilly Research Laboratories' accounting system, were billed to and paid by Lilly P.R. pursuant to the joint research agreement.Because propoxyphene products had been on the market since 1957, the propoxyphene research and development activities of Lilly Research Laboratories generally were categorized by petitioner as support research. The support research primarily consisted of the development of new formulations of propoxyphene products. Lilly P.R. participated by producing some materials for testing by Lilly Research Laboratories, and by working with Lilly Research Laboratories to develop manufacturing processes and manufacturing tickets for the new product formulations.2. Research ProjectsDuring the years 1967 through 1973, the research and 1069 development activities of 204 Lilly Research Laboratories with respect to propoxyphene products primarily were conducted under nine research and product development projects established by Lilly Research Laboratories. 22 Four of the product development projects (PD 1464, PD 1627, PD 2204, and PD 2308) were established by Lilly Research Laboratories prior to 1967. Research and development activities on those projects during the years 1967 through 1973 primarily consisted of formula revisions to improve product stability and the attempted development of a sustained release drug delivery system. Lilly Research Laboratories focused on the use of propoxyphene products in sustained release form from 1971 through 1973, when it terminated all work on sustained release formulations. Petitioner never marketed a propoxyphene product in sustained release form.The remaining five research and 205 product development projects (PD 3012, PD 3016, RP 1638, 0805, and 0694) were established by Lilly Research Laboratories during the years 1967 through 1973. PD 3012 (Darvon-N and combination products) was established to cover the development of formulations and manufacturing processes for Darvon-N products. Approximately one-half of the research and development expenses of Lilly Research Laboratories incurred with respect to propoxyphene products during the years 1967 through 1973 were incurred under that project number.PD 3016 (Sphercotes Darvon) was a product development project established after 1966 for the purpose of developing new formulations of Darvon products containing aspirin. Prior to 1970, the interaction of propoxyphene hydrochloride and aspirin in Darvon products was prevented by forming the propoxyphene hydrochloride into a coated tablet, called a sphercote. During the 1960's, it was discovered that that formulation was subject to misuse because the sphercote of propoxyphene hydrochloride could be extracted from the Darvon capsule. The objective of PD 3016 was to eliminate the use of the sphercote by developing new all-powder formulations of Darvon products containing 206 aspirin. In 1970, Dr. 1070 Walter D. Walkling, a research chemist at Lilly Research Laboratories, discovered a method of stablizing aspirin in the presence of propoxyphene hydrochloride by incorporating glutamic acid hydrochloride in pharmaceutical compositions of aspirin and propoxyphene hydrochloride. The addition of glutamic acid hydrochloride to those formulations had a stablizing effect on the formulation and prevented the decomposition of the aspirin. A U.S. patent (4,044,125) covering that formulation was issued to petitioner as assignee of Dr. Walkling on August 23, 1977. The glutamic acid hydrochloride formulation was used by Lilly P.R. in the manufacture of Darvon with A.S.A. (PU 366), Darvon Compound (PU 368), and Darvon Compound-65 (PU 369) during the years 1971 through 1973.RP 1638 was a research project established for the purpose of developing a formulation and manufacturing process for Darvocet Registered TM, a product that petitioner ultimately never manufactured or marketed. Project numbers 0805 and 0694 were short-term projects for the revision of the formulas for Darvon products.3. NDAsPetitioner filed with the FDA the following NDAs covering its Darvon and Darvon-N 207 products:ProductNDA numberDate filedDate approvedDarvon 32 mg. (PU 364)10-977Mar. 25, 1957Sept. 9, 1957Darvon 65 mg. (PU 365)10-977Mar. 25, 1957Sept. 9, 1957Darvon with A.S.A. (PU 366)10-996Jan. 24, 1964Sept. 24, 1964Darvon Compound (PU 368)10-996Mar. 25, 1957Sept. 23, 1957Darvon Compound-65 (PU 369)10-996July 5, 1960Sept. 22, 1960Darvo-Tran (PU 377)12-032June 26, 1959Sept. 4, 1959Stero-Darvon (TA 1855)14-768June 17, 1963May 3, 1967Darvon-N (PU 391 and PU 392)16-827Nov. 13, 1968Sept. 9, 1971 23Darvon-N (TA 1883)16-862May 19, 1969Sept. 9, 1971Darvon-N with A.S.A. (TA 1884)16-863May 19, 1969Sept. 9, 1971Darvon-N Suspension (MS 135)16-861May 19, 1969Sept. 9, 1971Darvocet-N 50 (TA 1890) 24208 17-122Dec. 17, 1971Dec. 19, 19721071 Petitioner was the sponsor for all the NDAs for Darvon and Darvon-N products. 25 Petitioner informed the FDA in those NDAs or in supplemental NDAs that the products covered by those NDAs would be manufactured in Puerto Rico by Lilly P.R. However, as sponsor, petitioner was still the entity responsible for maintaining records and reports and the entity accountable for problems with Darvon and Darvon-N products. The NDAs for all Darvon and Darvon-N products approved by the FDA during the years 1965 through 1973 referred, directly of indirectly, to the basic Darvon NDA master file NDA NO. 10-977). Petitioner did not permit a third party seeking to market a new pharmaceutical product to refer to any of its master file NDAs during the years 1971 through 1973.If Lilly P.R. had had to compile and submit its own NDAs for Darvon and Darvon-N products, the time and expense necessary would have been substantial. The typical NDA submission for a new drug was 209 sizable due to the large number of clinical studies necessary to show its safety and efficacy. For example, petitioner's NDA NO. 16-827 consisted of 23 volumes containing a number of pharmacology, toxicology, and pain studies. Those studies were performed prior to the filing of NDA NO. 16-827 on November 15, 1968.Although NDA NO. 16-827 was a large submission, it was not as extensive as an NDA for an entirely new drug. NDA NO. 16-827 would have been required to contain substantially more clinical studies if it had been the first NDA for a propoxyphene product. In 1969, petitioner filed an NDA for an oral cephalosporin antibiotic sold under the trademark Keflex Registered TM. The Keflex NDA contained 88 volumes. NDAs for antibiotics ordinarily are less extensive than NDAs for analgesic drugs. There are objective measurements of effectiveness of an antibiotic drug, and as a result it is easier to develop evidence of efficacy. In contrast, the effects of an analgesic drug are more subjective and, therefore, more difficult to measure. If NDA NO. 16-827 had been the first NDA for a propoxyphene product, it probably would have been larger than, and perhaps twice as large as, petitioner's 210 NDA for Keflex.1072 X. Litigation Related to Propoxyphene ProductsDuring the years 1966 through 1973, petitioner or Lilly P.R. brought three patent infringement actions to defend the propoxyphene patent. Those actions were Eli Lilly & Co. v. Generic Formulas, Inc., 66 Civil Action File 576 (E.D.N.Y. Sept. 30, 1966); Eli Lilly & Co. v. Milan Pharmaceutical, Inc., No. C-68 13F, 169 U.S.P.Q. (BNA) 32">169 U.S.P.Q. 32 (N.D.W.Va. 1968); and Eli Lilly & Co. v. Generix Drug Sales, Inc., No. 69-1241- Civ., 324 F. Supp. 715">324 F. Supp. 715 (S.D. Fla. 1971), affd. in part and vacated and remanded in part 460 F.2d 1096">460 F.2d 1096 (5th Cir. 1972). The validity of the propoxyphene patent was upheld in each of those actions, and injunctions were issued prohibiting further infringement of the patent by each defendant. The legal fees for the Generic Formulas, Inc., action, which was concluded prior to the execution of the Assignment of Patents and Related Technical Data on December 5, 1966, were paid by petitioner. Lilly P.R. bore the legal fees incurred in connection with the Milan Pharmaceutical, Inc., and Generix Drug Sales, Inc., actions. The legal fees and related costs billed to Lilly P.R. by petitioner with respect to the Milan and Generix211 actions during the years 1968 through 1973 were as follows:ActionYearAmountMilan1968$ 42,822196935,984Total78,806Generix1970276,1491971473,6251972120,547197325,744Total26 896,065Total for both Milan and Generix actions974,871 During the period from 1957 through 1973, a total of six lawsuits were filed against petitioner or Lilly P.R. for damages allegedly resulting from the use of Darvon or Darvon-N products. Petitioner settled the first suit by paying the plaintiff $ 1,000. The remaining five lawsuits were dismissed and no damages were paid to the plaintiffs by petitioner or 1073 Lilly P.R. Petitioner's legal fees paid in defense of all six lawsuits aggregated approximately $ 51,000. Those legal fees were not reimbursed by Lilly P.R. but were included in petitioner's general and administrative expenses.XI. Intercompany Pricing of Darvon and Darvon-N ProductsA. GeneralDuring the years 1971 through 1973, petitioner purchased its complete line of Darvon and Darvon-N products from Lilly P.R. Listed below are the Darvon and Darvon-N products purchased by petitioner for 212 resale to customers in the United States during those years:Identificationcode DescriptionPackaging size(s) 27PU 364 Darvon 32 mg.100,500PU 365 Darvon 65 mg.100,500, 25/30, 20/50PU 366 Darvon with A.S.A.100,500PU 368 Darvon Compound100,500PU 369 Darvon Compound-65100,500, 25/30, 20/50PU 377 Darvo-Tran100,500TA 1855Stero-Darvon50TA 1883Darvon-N100,500, 25/30, 20/50TA 1884Darvon-N with A.S.A.100,500, 25/30, 20/50TA 1890Darvocet-N 50100,500, 20/50MS 135 Darvon-N SuspensionPint, ID 10ccPetitioner also received finished Darvon and Darvon-N capsules and tablets in bulk packages from Lilly P.R. for use as samples or to be packaged in unit-dose packaging. Petitioner's unit-dose packagings were (a) an ID 100 Identi-dose package consisting of 100 strips of 10 individually 213 labeled blisters, each containing 1 capsule or tablet, and (b) a DS 1000 package containing 10 dispenser rolls, each consisting of 100 capsules in individual unit-dose packages. The unit-dose packaging was performed or contracted in the United States by petitioner and was not performed by Lilly P.R. at any time prior to 1974. 1074 Petitioner's cost of Identi-dose packaging was included in its cost of sales of Darvon and Darvon-N products.During the years 1965 through 1973, all pharmaceutical products sold by petitioner in the United States were listed in petitioner's published price lists. The prices in petitioner's price lists were its suggested prices to retail pharmacies and were referred to as "net trade prices." During that period, drug wholesalers of petitioner's products received a standard discount of 17 percent from petitioner's net trade prices. Petitioner's prices to drug wholesalers were referred to as "net wholesale prices."Petitioner's net trade prices and net wholesale prices for the Darvon and Darvon-N products manufactured and sold by Lilly P.R. during the years 1966 through 1973 were as follows:NetNetIdentificationPackagetradewholesalecodesizeDescriptionpricepricePU 364 100Darvon 32 mg.$ 3.72$ 3.10PU 364 500Darvon 32 mg.17.6714.72PU 365 100Darvon 65 mg.7.025.85PU 365 500Darvon 65 mg.33.3527.79PU 365 25/30Darvon 65 mg.52.5343.77PU 365 20/50Darvon 65 mg.68.8057.33PU 366 100Darvon with A.S.A.7.115.92PU 366 500Darvon with A.S.A.33.7728.14PU 368 100Darvon Compound4.023.35PU 368 500Darvon Compound19.1015.92PU 369 100Darvon Compound-657.326.10PU 369 500Darvon Compound-6534.7728.97PU 369 25/30Darvon Compound-6554.6645.55PU 369 20/50 1Darvon Compound-6571.6059.67PU 377 100Darvo-Tran5.404.50PU 377 500Darvo-Tran25.6521.37TA 185550Stero-Darvon3.623.02TA 1883100Darvon-N7.025.85TA 1883500Darvon-N33.3527.79TA 188325/30Darvon-N52.5343.77TA 188320/50Darvon-N68.8057.33TA 1884100Darvon-N with A.S.A.7.115.92TA 1884500Darvon-N with A.S.A.33.7728.14TA 188425/30Darvon-N with A.S.A.53.1644.30TA 188420/50Darvon-N with A.S.A.69.6058.00TA 1890100Darvocet-N 504.103.42TA 1890500Darvocet-N 5019.4816.23TA 189020/50Darvocet-N 50$ 41.00$ 34.17MS 135 PintDarvon-N Suspension4.793.99MS 135 ID 10ccDarvon-N Suspension21.9818.32214 1075 During the years 1966 through 1973, Lilly P.R. sold Darvon products to petitioner at the following discounts from petitioner's net wholesale prices:YearDiscount 28196635%196740196840196945197045197140 1197246 1197358 1Pursuant to the distribution agreement between Lilly P.R. and petitioner, Lilly P.R. granted petitioner "chargebacks," or rebates, for export and U.S. Government sales of Darvon and Darvon-N products by petitioner. During the years 1971 through 1973, the chargebacks were equal to 20 percent of petitioner's net wholesale price for the volume of material sold in export and to the Government. 29 During the years 215 1971 through 1973, petitioner's export and Government sales of Darvon and Darvon-N products were 3 to 4 percent of its total sales of those products.During the years 1966 through 1972, the distribution agreements between petitioner and Lilly P.R. provided that Lilly P.R. would provide free samples of Darvon and Darvon-N products to petitioner. In practice, that was accomplished by Lilly P.R. granting chargebacks to petitioner for Darvon and 1076 Darvon-N products used as samples by petitioner. For samples packaged by petitioner from bulk capsules or tablets purchased from Lilly P.R., the chargeback was equal to the price petitioner paid Lilly P.R. for the bulk capsules or tablets, plus petitioner's costs of packaging the bulk capsules and tablets in sample packages. For trade packages (such as bottles of 100 capsules or tablets) used as samples, the chargeback was equal to the price petitioner paid Lilly P.R. for the trade package. Effective January 1, 1973, the distribution agreement was amended to provide that petitioner would reimburse Lilly P.R. for its costs of manufacturing Darvon and Darvon-N products 216 used as samples by petitioner. That provision was effectuated by Lilly P.R. granting petitioner chargebacks for Darvon and Darvon-N products used as samples equal to Lilly P.R.'s manufacturing profit for such products.In 1973, Lilly P.R. manufactured and sold to petitioner Ilosone products, the pricing of which is in dispute but has been severed from the trial of this case. Lilly P.R. also manufactured and sold a small amount of certain other pharmaceutical products in 1971, 1972, and 1973, the pricing of which is not in dispute in this case. In addition, in late 1973, Lilly P.R. manufactured and sold to petitioner Darvocet-N 100 (TA 1893), but that product was not sold by petitioner until 1974.B. Initial Pricing PolicyIn 217 1965, petitioner's second project team for Puerto Rico decided that Lilly P.R.'s prices to petitioner should allow petitioner to recover its selling and distribution expenses related to Lilly P.R. products and to earn a profit equal to 90 to 100 percent of those expenses. In accordance with that decision, Lilly P.R.'s prices to petitioner for Darvon products initially were established at a 35-percent discount from petitioner's net wholesale prices for those products.Lilly P.R.'s prices to petitioner for Darvon products were reduced for 1967 and 1968 to petitioner's net wholesale prices, less a 40-percent discount. That action was taken in order to conform Lilly P.R.'s prices with the objective of providing petitioner with operating income equal to 90 to 100 percent of its selling and distribution expenses related to those products.1077 During the period from late 1969 through February 1972, the Service audited petitioner's returns for the 1966 through 1968 taxable years. As a result of that audit, the Service and petitioner agreed upon certain allocations of income from Lilly P.R. to petitioner on the basis of adjustments to the transfer price of Darvon products sold to petitioner by 218 Lilly P.R. in 1966 and 1967. For the taxable year 1968, the Service and petitioner agreed to a pricing formula for Darvon products (hereinafter the 1968 audit formula), the result of which was to divide the combined profit earned by Lilly P.R. and petitioner and to use such division for purposes of establishing the price at which Darvon products should be sold by Lilly P.R. to petitioner.The first step in the application of the 1968 audit formula was a determination of the combined net income of petitioner and Lilly P.R. attributable to the intangible property related to the manufacture and sale of Darvon products. The combined net income attributable to intangibles was determined by subtracting from the total combined net income of petitioner and Lilly P.R. from the manufacture and sale of Darvon products (a) a manufacturing profit equal to 100 percent of Lilly P.R.'s manufacturing costs (i.e., cost of goods sold) less Lilly P.R.'s operating expenses; (b) the cost savings resulting from operating in Puerto Rico rather than in the United States; and (c) a marketing profit equal to 25 percent of petitioner's expenses attributable to its marketing of Darvon products in the United States. 219 The location savings portion of the formula represented the reduced cost of operating in Puerto Rico as compared to the United States and was attributable primarily to lower labor rates in Puerto Rico and Lilly P.R.'s exemptions from Puerto Rican property and other non-income taxes.Under the 1968 audit formula, 60 percent of the net income attributable to intangibles was considered as being attributable to manufacturing intangibles such as the propoxyphene patent and propoxyphene manufacturing know-how and was allocated to Lilly P.R. The remaining 40 percent of the net income attributable to intangibles was considered to be attributable to marketing intangibles, such as the Darvon trademark and petitioner's name and marketing organization, and was allocated to petitioner.1078 On April 12, 1972, petitioner and the Service entered into a closing agreement for the 1966 through 1968 taxable years, reflecting the adjustments referred to above. As stated, the 1968 audit formula was applied to 1968 only; an alternative method of disposing of the 1966 and 1967 years was agreed to by the Service and petitioner. Petitioner and respondent at no time entered into an agreement that would legally 220 bind the other party to apply the 1968 audit formula to the years 1971 through 1973.C. Pricing Policy 1971-73On June 30, 1972, petitioner and Lilly P.R. amended their distribution agreement in order to adjust Lilly P.R.'s prices for Darvon and Darvon-N products. The discount from petitioner's net wholesale prices on Darvon and Darvon-N products was increased from 40 percent to 46 percent effective July 1, 1972. That amendment to the distribution agreement provided, in pertinent part:Whereas, [petitioner] has agreed with the Internal Revenue Service that the price [petitioner] will pay for DARVON Registered TM Products manufactured by [Lilly P.R.] cannot exceed certain guidelines; andWhereas, it has been understood between the two companies that as soon as a preliminary analysis of 1972 results provided some indication that prices paid for DARVON Registered TM Products were not within such guidelines, adjustments would be made to correct prior pricing for such Products purchased on or after January 1, 1972, and to establish new intercompany prices for the remainder of 1972; andWhereas, it is now apparent that prices charged [petitioner] for DARVON Registered TM Products during the 221 period January 1, 1972, through June 30, 1972, exceed the agreed upon guidelines, and that to keep the prices paid for DARVON Registered TM Products within the guidelines for the remainder of 1972, it will be necessary to increase discounts to [petitioner] as set forth in the attached price schedule.In February 1972, as the expiration of the propoxyphene patent on December 27, 1972, approached, petitioner began to consider Lilly P.R.'s pricing of Darvon and Darvon-N products for 1973. Such consideration consisted of several discussions involving officers of petitioner and petitioner's outside tax advisers.Petitioner's consideration of the 1973 pricing of Lilly P.R.'s Darvon and Darvon-N products was conducted in the context of the 1968 audit formula. Because the propoxyphene patent 1079 would no longer be in existence in 1973, petitioner's objective was to determine what intangible property would remain in Lilly P.R. in 1973 and the value of that property. In that respect, petitioner considered the alternative of Lilly P.R. selling directly to wholesalers in the United States, accompanied by the transfer of the Darvon and Darvon-N trademarks to Lilly P.R. Petitioner rejected that alternative 222 in 1972 as it had in 1965 and 1966.Petitioner determined that, after the expiration of the propoxyphene patent, three intangible elements would remain in Lilly P.R. Those elements were: (a) Manufacturing know-how, (b) the glutamic acid hydrochloride formula for Darvon compound products, and (c) the napsylate patent.Petitioner believed that the 100-percent markup allowed Lilly P.R. under the 1968 audit formula probably included compensation to Lilly P.R. for such things as capital investment, going concern value, and goodwill. However, petitioner believed that the 100-percent markup did not allow Lilly P.R. sufficient compensation for the manufacturing know-how that had been developed over the years by Lilly P.R. and petitioner. The manufacturing cost of Darvon products as a percentage of sales historically had declined from a high of 28.2 percent to 13.9 percent, a 14 percentage point difference. Petitioner assumed that part of that cost reduction was attributable to increases in volume and to the savings attributable to operating in Puerto Rico rather than in the United States. Accordingly, petitioner concluded that only 6.9 percent of the 14 percentage point difference was properly 223 attributable to manufacturing know-how. Assuming sales to wholesalers of Darvon and Darvon-N products of $ 70 million, petitioner concluded that between $ 4.5 million and $ 5 million of income was attributable to Lilly P.R.'s manufacturing know-how.Petitioner also believed that the glutamic acid hydrochloride formula used by Lilly P.R. in the manufacture of Darvon products containing aspirin had a significant intangible value. That formula allowed Lilly P.R. to make a stable product that was difficult to abuse. Petitioner believed that it was reasonable to attribute a 3-percent royalty value to that formula. Because the Darvon products using that formula respresented approximately 65 percent of $ 54 million of petitioner's total sales of Darvon and Darvon-N products, petitioner estimated 1080 that approximately $ 2 million of income was attributable to the glutamic acid hydrochloride formula.Petitioner also considered the napsylate patent to be a valuable intangible that would remain in Lilly P.R. in 1973. Sales of Darvon-N products were projected to be approximately 15 to 20 percent of total sales of propoxyphene products in 1973, and total income for 1973 attributable to intangibles 224 under the 1968 audit formula was projected to be $ 30 million. Petitioner concluded that it was reasonable to attribute to the napsylate patent between 5 to 10 percent or $ 1.5 to $ 3 million of the total income attributable to intangibles.In summary, petitioner concluded that $ 8 to $ 10 million of income could be attributable to the intangibles remaining in Lilly P.R. in 1973. As the income attributable to all intangibles under the 1968 audit formula was projected to be approximately $ 30 million, petitioner concluded that approximately 30 percent 30225 of that intangible value could be allocated to Lilly P.R. for the purpose of determining Lilly P.R.'s prices to petitioner for Darvon and Darvon-N products. Thus, in applying the 1968 audit formula to the 1973 taxable year, petitioner allocated to Lilly P.R. 30 percent of the income attributable to intangibles, rather than 60 percent as in prior years. The distribution agreement between Lilly P.R. and petitioner accordingly was amended to increase the discount from net wholesale prices for Darvon and Darvon-N products from 46 percent to 58 percent, effective January 1, 1973. XII. Financial InformationA. Overview of Petitioner's Accounting System1081 Petitioner's financial statements for the years 1971 through 1973 were a consolidation of the financial records of petitioner and its subsidiaries, including Lilly P.R.Petitioner and each of its subsidiaries accounted for expenses on a departmental basis. Petitioner maintained a departmental accounting system, with every individual who worked for petitioner assigned to a specific department.In the departmental accounting system, petitioner maintained three primary groupings of departments and accounts: manufacturing, operating, and service. Petitioner's manufacturing departments worked directly on the manufacture of a product. The accounting for expenses of manufacturing departments was accomplished by establishing cost center rates within each department which were then applied to the product flowing through the department on the basis of time spent or on an absorption-rate 226 basis. When the product was completed, it was placed in inventory. When the product was ultimately sold, it was released from inventory, and its cost was charged to manufacturing cost of sales.The second grouping was petitioner's nonmanufacturing operating departments. The expenses of those departments were recorded in several separate subledgers such as selling, merchandising, shipping, research and development, and general administration.The third primary grouping consisted of those departments of petitioner that serviced other departments. The service departments included quality control, engineering, personnel, buildings and ground maintenance, and industrial relations. The expenses of those departments were recorded in service ledger accounts and ultimately were allocated either to a manufacturing cost account or to an operating expense account.B. Lilly Research Laboratories' Accounting SystemsLilly Research Laboratories had two separate but closely related accounting systems: a general departmental accounting system and a project accounting system.The general departmental accounting system accumulated costs by expense class (e.g., compensation and benefits, supplies, and 227 materials) for each department in Lilly Research Laboratories. Under the project accounting system, expenses 1082 were recast from a departmental basis to a research project basis which enabled petitioner to track, monitor, and manage the various research projects of Lilly Research Laboratories. The system also provided the management of Lilly Research Laboratories with information to assist it in establishing priorities for and planning and control of research activities.As stated earlier, Lilly Research Laboratories had a general research project for each broad area of interest to petitioner, such as anti-cancer drugs, cardiovascular drugs, and analgesic drugs. Each of those projects was monitored by a research project committee. Projects in the general research area had "RP" numbers, that is, research project numbers.Generally, when a promising compound was identified by one of the research projects, a product development or "PD" number was established for the new compound. 31 Thereafter, the research activity carried out with respect to the new compound was to be charged to its PD number rather than to a general RP number. A development project team also was established at that 228 time to monitor the particular project. There were two basic methods for allocating expenses in the project accounting system. The simplest method was the direct charging method. Certain expenditures, such as materials bought specifically for a particular research project could be identified with and directly charged to specific projects. The determination of which project to charge was not an accounting function but was made by research management personnel. The second method of charging expenses to research projects was based on research time reports. The scientific personnel of Lilly Research Laboratories filled out time sheets on a monthly basis. Those time sheets showed the projects to which the employee charged time the previous month, and contained space 229 for the addition of new projects in the current month. The employee was required to allocate to those projects his total time on the job that month. The total time allocated by all employees to each one of the projects was accumulated at the end of each month. The expenses of each department, 1083 other than those expenses directly charged to projects, were allocated to the various projects based on the time spent on the projects by the employees in that department. The expenses allocated included compensation, benefits, overhead, and utilities.As a general rule, only the technicians and scientists, that is, the professional researchers working directly on research projects, filled out time sheets. Senior scientists and research management people normally did not fill out time sheets, as they tended to be involved more in supervisory or administrative functions, and their time was allocated on the basis of the time of the people they supervised. The support staff (e.g., secretaries, animal caretakers, and clerical help) also did not fill out time sheets. During the years 1971 through 1973, approximately 800 persons filled out time sheets. There were approximately 1,700 employees 230 in Lilly Research Laboratories (exclusive of the control division) in those years, so approximately 45 to 50 percent of the research and development personnel filled out time sheets.The Lilly Research Laboratories project accounting system has been in existence since at least 1951. Since that time, there have been no significant changes in the system of reporting time and direct charging of expenses to projects. There have been some refinements and enhancements over the years, however, such as the establishment of more, and more specific, project numbers; the direct charging of clinical grants to the related project; more frequent reporting of time; and computerization.C. Propoxyphene Research and Development Expenses1. Pre-1967 Research ActivitiesFor the period 1951 through 1966, the total expenses of Lilly Research Laboratories relating to propoxyphene, by project number, were as follows (000's omitted):TotalResearch project1951-571958-661951-66RP 1195 AnalgesicsGeneral$ 848$ 765$ 1,613RP 1513 Propoxyphene01414PD 1464 Darvon & Novrad0797797PD 1627 Darvo-Tran066PD 2204 Stero-Darvon$ 0$ 604$ 604Propoxyphene05454Price list items04141Compound 31518 Darvon Analog039398482,3203,1681084 During 231 the period 1951 through 1957, there were no PD project numbers for propoxyphene in existence, and only one analgesic project. Therefore, all the propoxyphene activity reported was captured by RP 1195. However, other non-propoxyphene analgesic activity also was charged to RP 1195 during those years, although petitioner is unable to quantify that non-propoxyphene activity in RP 1195.The propoxyphene expenses for 1951 through 1957 contained in RP 1195 did not include clinical grants to outside investigators relative to propoxyphene products because grants were not charged directly to specific projects during that period. Petitioner's total clinical grants, including propoxyphene-related grants, during 1951 through 1957 averaged approximately $ 200,000 per year or 2 to 3 percent of petitioner's total research and development expenditures. Petitioner is unable to identify specifically the propoxyphene-related clinical grants for those years.In 1958, research management at Lilly Research Laboratories established additional project numbers for Darvon products in order to isolate propoxyphene expenses from the rest of the general analgesic research. However, RP 1195 continued to include 232 both some propoxyphene and non-propoxyphene research activity; petitioner again is unable to quantify that non-propoxyphene activity in RP 1195. No propoxyphene research was charged to RP 1195 after 1962.The propoxyphene expenses for 1958 through 1966 did not include clinical grants relative to propoxyphene products because, during that period, grants again were not charged directly to specific projects. Petitioner's total clinical grants, including propoxyphene-related grants, during 1958 through 1966 averaged approximately $ 800,000 to $ 1 million per year, or 3 to 4 percent of total research and development expenditures. Petitioner is unable to identify specifically the propoxyphene-related grants for those years.1085 2. 1967-73 Research ActivitiesIn 1968, pursuant to the joint research agreement between Lilly P.R. and petitioner, Lilly P.R. began reimbursing petitioner for certain research and development expenses relative to Darvon and Darvon-N products. The following amounts were billed by petitioner to Lilly P.R. for research performed during the calendar years 1967 through 1973. In 1973, the amount billed included Ilosone-related research performed in 1973.Amounts of petitioner'sYearresearch and developmentbilledexpenses billed to Lilly P.R.1968$ 419,9861969485,8901970505,1561971506,9371972661,1971973891,963Total3,471,129The 233 research and development expenses billed by petitioner to Lilly P.R. were the expenses attributed by Lilly Research Laboratories' project accounting system to those research projects and clinical grants 32234 related to products manufactured by Lilly P.R., including Darvon and Darvon-N products. The expenses incurred in any 6-month period attributed to such products and grants were billed to Lilly P.R. during the following 6-month period. For example, expenses incurred by petitioner during the last 6 months of 1972 were billed to Lilly P.R. during the first 6 months of 1973. Research and development expenses shown on the books and records of Lilly P.R. generally exceeded in any year the research and development expenses billed to Lilly P.R. by petitioner because Lilly P.R. charged to research and development expense the expenses of producing materials for use in the research activities of 1086 petitioner and the expenses of research related activities of Lilly P.R. The research and development expenses of Lilly Research Laboratories billed to Lilly P.R. during the years 1968 through 1973 were attributable to the following research and product development projects, clinical grants, and materials:ProjectnumberDescriptionTotalPD 1464Darvon & Novrad$ 526,137PD 1627Darvo-Tran3,003PD 2204Stero-Darvon with A.S.A.70,368PD 2308Actimets Darvon (1971-73)195,051PD 3012Darvon-N & Combination Products1,708,055PD 3016Sphercotes Darvon357,267RP 1638Darvocet136,7500805Pulvules Darvon7,1440694Pulvules Darvo-Tran7,250PD 1544Ilosone180,228Grants (1967-69)245,845Materials34,0313,471,129D. Lilly P.R. Financial Statements 1971-73For the years 1971 through 1973, Lilly P.R.'s statement of income, as reflected in its Ernst & Ernst audited financial statements, 235 was as follows:197119721973Net sales to affiliated companies$ 55,573,774$ 57,188,297 $ 50,785,895Cost of goods sold12,754,74414,387,345 18,669,17042,819,03042,800,952 32,116,725Expenses:Administrative and general1,316,1081,075,313 1,241,112Samples1,042,2151,297,190 194,762Research and development522,891712,633 929,8492,881,2143,085,136 2,365,72339,937,81639,715,816 29,751,002Other income:Interest on certificates ofdeposit2,503,0342,890,985 7,091,162Income from Governmentguaranteed securities2,176,0492,101,277 2,465,225Sundry16,27042,951 50,2074,695,3535,035,213 9,606,59444,633,16944,751,029 39,357,596Other deductions:Prior years' price adjustments$ 30,780,507 $ 5,826,399Amortization of bond premiumsand bank fees$ 103,57384,450 37,693Idle plant cost35,145Sundry35,29421,828 30,569174,01230,886,785 5,894,661Income before income taxes44,459,15713,864,244 33,462,935Income taxes:Puerto Rico594,045(560,816)845,873Federal166,034139,964 218,882760,079(420,852)1,064,755Net income43,699,07814,285,096 32,398,1801087 The Forms 1120 filed by Lilly P.R. for the years 1971 through 1973 report tax-exempt possession source income in the following amounts:Exempt possessionYearsource income1971$ 40,914,829197242,037,274197336,537,408For 236 the years 1971 through 1973, Lilly P.R.'s balance sheet, as reflected in its Ernst & Ernst audited financial statements, was as follows:AssetsAt December 31 --197119721973Current assetsCash$ 654,639 $ 353,196 $ 1,220,930 Certificates of deposit41,300,000 85,700,000 107,700,000 Government securities88,993,655 62,884,710 70,600,000 Accounts receivable:Affiliated companies28,498,967 24,358,172 21,166,295 Interest1,459,565 2,155,520 2,771,120Other37,756 634,333 160,516 29,996,288 27,148,025 24,097,931 Inventories:Finished65,509 13,166 307,361 Work in process2,141,997 1,206,419 2,220,854 Raw materials4,788,151 3,795,136 5,348,207 Packaging$ 264,858 $ 387,476 $ 696,536 Supplies275,082 434,258 505,289 7,535,597 5,836,455 9,078,247 Total current assets168,480,179 181,922,386 212,697,108 Prepaid expenses andother assets191,212 195,525 196,427 Property, plant, and equipment:Buildings11,718,630 11,787,169 13,945,669 Machinery and equipment9,046,290 9,609,287 11,480,357 20,764,920 21,396,456 25,426,026 Allowances for depreciation(3,436,701)(4,445,457)(5,671,741)17,328,219 16,950,999 19,754,285 Land998,541 978,756 978,756 Construction445,126 1,841,819 522,744 18,771,886 19,771,574 21,255,785 187,443,277 201,889,485 234,149,320 LiabilitiesAt December 31 --197119721973Current liabilitiesAccounts payable:Parent company$ 471,489 $ 617,010 $ 70,909 Other493,488 424,832 533,472 964,977 1,041,842 604,381 Accrued payrolls, payrolltaxes and amountswitheld from payrolls319,145 485,523 595,912 Other accrued expenses17,020 16,182 28,713 Taxes on income:Puerto Rico103,757 Federal10,759 33,223 103,857 450,681 534,928 728,482 Total current liabilities1,415,658 1,576,770 1,332,863 Stockholder's equityCommon stock, no par value:Authorized, issued, andoutstanding 1,000 sharesat stated capital amount(no change)500,000 500,000 500,000 Reinvested earnings185,527,619 199,812,715 232,316,457 186,027,619 200,312,715 232,816,457 187,443,277 201,889,485 234,149,320 237 1089 E. Lilly P.R. Sales of Darvon and Darvon-N ProductsLilly P.R.'s sales of each Darvon and Darvon-N product marketed by petitioner during the years 1971 through 1973, expressed as percentages of Lilly P.R.'s total sales of Darvon and Darvon-N products to petitioner during those years, were as follows:IdentificationTotalcodeDescription1971197219731971-73PU 364Darvon 32 mg.1.6%1.1%1.4%1.4%PU 365Darvon 65 mg.20.5 22.8 15.2 19.9 PU 366Darvon with A.S.A.3.1 2.1 2.0 2.5 PU 368Darvon Compound2.3 1.8 2.2 2.1 PU 369Darvon Compound-6560.7 60.6 50.7 58.6 PU 377Darvo-Tran1.2 1.0 1.0 1.1 TA 1855Stero-Darvon0.5 0.4 0.6 0.5 TA 1883Darvon-N3.8 3.9 8.7 4.9 TA 1884Darvon-N with A.S.A.5.7 4.0 8.1 5.6 MS 135Darvon-N Suspension0.6 0.2 (0.3)0.3 TA 1890Darvocet-N 502.1 10.4 3.1 Totals100.0 100.0 100.0 100.0 F. Petitioner's Pharmaceutical Division Income StatementsPetitioner's accounting records for sales were maintained on the basis of two divisions, Elanco and the parent (pharmaceutical division). The Elanco division conducted the marketing and sale of animal health and agricultural products while the pharmaceutical division conducted all petitioner's pharmaceutical operations in the United States, including 238 research and development. All petitioner's expenses were charged to one or the other of those two divisions.For the years 1971 through 1973, the operating income of petitioner's pharmaceutical division was as follows:197119721973Net sales$ 338,321,035$ 351,043,948$ 368,914,571Cost of goods sold135,365,180135,781,325136,096,900Gross profit202,955,855215,262,623232,817,671Operating expenses:Merchandising29,449,27925,492,16427,508,217Selling31,927,37133,844,26939,377,260Shipping8,586,0389,658,00411,243,576General administrative31,739,84935,068,69338,018,471Loss on returned goods2,600,0543,076,3673,324,777Total operating expenses104,302,591107,139,497119,472,301Operating income98,653,264108,123,126113,345,3701090 The operating income statement above was not prepared contemporaneously with the years 1971 through 1973, but the information contained therein was derived from the contemporaneous financial records of petitioner.Net sales, cost of goods sold, and gross profit of the pharmaceutical division represented the entire activity of petitioner, exclusive of the Elanco division and those charges that were directly incurred on behalf of sales to petitioner's international operations.Merchandising 239 and selling expenses of the pharmaceutical division included all expenses of petitioner's merchandising and selling departments assigned to the pharmaceutical division. Excluded from those expenses were the merchandising and selling expenses of departments of the Elanco division, which were incurred directly by that division and charged to its separate general ledger.Shipping expenses of the pharmaceutical division included principally freight and warehousing. Those expenses were not reported through either the pharmaceutical or Elanco division but rather through the corporate division. The shipping department maintained records of all freight charges and those charges were assigned directly to the proper division based on the nature of the product being shipped. With respect to warehousing, if a facility was used exclusively for a product of either the pharmaceutical or Elanco division, then the cost of the facility was charged directly to such division. If, however, the facility was jointly used, the cost was allocated to the divisions on the basis of the floor space utilized.General administrative expenses of the pharmaceutical division included the expenses of petitioner's 240 corporate affairs, financial, legal, and data processing departments, plus the expenses of petitioner's top management and all management of the pharmaceutical division. General administrative expenses were gross figures and were not net of administrative and technical service fees from petitioner's subsidiaries, which were booked as "other income," a nonoperating income item.Also included in the general administrative expenses of petitioner's pharmaceutical division were the activities and services performed for Lilly P.R. which petitioner considered to be stewardship expenses. The following activities were not billed to Lilly P.R. but were charged to general administrative 1091 expense: (a) Services performed for Lilly P.R. by petitioner's corporate tax, legal, 33 corporate insurance, accounting, and financial departments; (b) activities performed in Indianapolis 34241 on Lilly P.R. matters by any member of petitioner above the level of assistant division director; 35 and (c) periodic audits, conducted every 12 to 18 months by petitioner's quality assurance department.During the years in issue, Lilly P.R. had the use of manuals prepared by petitioner in its manufacturing and other operations. The manuals were provided to Lilly P.R. without its reimbursing petitioner for the cost of preparing the manuals. Petitioner charged the cost of developing the manuals to general administrative expenses, but did not specifically delineate them as stewardship expenses.Loss on returned goods for the pharmaceutical division represented products returned from the field, principally from outdating where the product in the field exceeded its expiration date. Petitioner's returned goods experience with respect to Darvon and Darvon-N products historically has been very favorable due to the products' long dating period and rapid shelf turnover.G. Combined Income Statements for Darvon and Darvon-N Products 1971-731. GeneralDuring the normal course of its business, petitioner did not maintain accounting records that reflected net income for the pharmaceutical 242 division or by various product lines. During the years 1971 through 1973, petitioner contemporaneously prepared consolidated net income statements (hereinafter the combined income statements) for all products, including Darvon and Darvon-N, manufactured and sold by Lilly P.R. Those combined income statements were prepared to enable petitioner's management to determine and evaluate the intercompany transfer prices for products sold by Lilly P.R. to petitioner.1092 The combined income statements of petitioner and Lilly P.R. for the years 1971 through 1973 with respect to Darvon and Darvon-N products were as follows:1971Lilly P.R.PetitionerSales ofLilly P.R.Sales toSales toproducedpetitionerLilly P.R.merchandiseTotalNet sales$ 53,968,400 $ 654,833 $ 73,861,799$ 74,516,632 Cost of goods sold11,569,396 381,102 47,059,79247,440,894 Gross profit42,399,004 273,731 26,802,00727,075,738 Adjustment for changein inventory(6,258,854)(140,258)(140,258)Adjusted gross income36,140,150 133,473 26,802,00726,935,480 Operating expense:Research & development522,891 General administration1,295,050 31,159 1,204,1771,235,336 Selling4,150,5584,150,558 Merchandising3,898,8113,898,811 Shipping551,898551,898 Sample expense1,041,308 Total operating expense2,859,249 31,159 9,805,4449,836,603 Operating income33,280,901 102,314 16,996,56317,098,877 Other income:Royalties86,687 86,687 Net income33,280,901 189,001 16,996,56317,185,564 243 1972Lilly P.R.PetitionerSales ofLilly P.R.Sales toSales toproducedpetitionerLilly P.R.merchandiseTotalNet sales$ 54,793,500 $ 603,140$ 75,827,232$ 76,430,372Cost of goods sold12,697,303 374,59146,686,72347,061,314Gross profit42,096,197 228,54929,140,50929,369,058Adjustment for changein inventory(6,984,591)77,92177,921Adjusted gross income35,111,606 306,47029,140,50929,446,979Operating expense:Research & development712,633 General administration1,048,430 31,4131,530,3541,561,767Selling6,331,7876,331,787Merchandising4,082,4194,082,419Shipping516,894516,894Sample expense1,234,433 Total operating expense$ 2,995,496 $ 31,413$ 12,461,454$ 12,492,867Net income32,116,110 275,05716,679,05516,954,1121093 1973Lilly P.R.PetitionerSales ofLilly P.R.Sales toSales toproducedpetitionerLilly P.R.merchandiseTotalNet sales$ 32,598,070 $ 429,394$ 70,026,591$ 70,455,985Cost of goods sold10,739,954 258,89738,387,72638,646,623Gross profit21,858,116 170,49731,638,86531,809,362Adjustment for changein inventory5,549,170 203,114203,114Adjusted gross income27,407,286 373,61131,638,86532,012,476Operating expense:Research & development749,621 General administration845,197 20,7512,175,7992,196,550Selling8,025,5828,025,582Merchandising1 6,378,5616,378,561Shipping498,587498,587Total operating expense1,594,818 20,75117,078,52917,099,280Net income25,812,468 352,86014,560,33614,913,196244 2. Lilly P.R.Lilly P.R.'s net sales were computed by abstracting from invoices its gross sales less returns and chargebacks. The adjustment for change in inventory was computed by petitioner to remove from the combined income statements any intercompany profit or loss on Lilly P.R.'s sales to petitioner. Lilly P.R.'s general administration expenses were allocated as a percentage of sales, and research and development expenses were calculated in accordance with the joint research agreement.1094 3. PetitionerPetitioner's net sales, cost of goods sold, and gross profit on the combined income statements were taken directly from the audited books and records of petitioner's pharmaceutical division and no allocations were made.a. Cost of Goods SoldCost of goods sold included the transfer or invoice price from Lilly P.R., plus pro rata shares of the actual freight and insurance expenses associated with bringing the goods from Puerto Rico to Indianapolis. In 1971, none of the expenses of petitioner's ticket issuance and stock planning departments were included in petitioner's cost of goods sold of Darvon and Darvon-N products. In 1972 and 1973, cost 245 of goods sold included some portion of the expenses of those departments.The total department expenses of petitioner's ticket issuance department were $ 285,000, $ 300,000, and $ 311,000 in 1971, 1972, and 1973, respectively. In 1972 and 1973, 5 percent ($ 15,000) and 7 percent ($ 22,000), respectively, of the expenses of petitioner's ticket issuance department were charged to and included in petitioner's cost of goods sold of Darvon and Darvon-N products. The percentages of ticket issuance expenses charged to cost of goods sold of Darvon and Darvon-N products were based on the ratio of the number of manufacturing tickets for Darvon and Darvon-N products issued to Lilly P.R. over the total number of manufacturing tickets issued during each year.The total department expenses of petitioner's finished stock planning department were $ 438,000, $ 425,000, and $ 450,000 in 1971, 1972, and 1973, respectively. In 1972 and 1973, 12 percent ($ 51,000) and 14 percent ($ 63,000), respectively, of those expenses were charged to and included in petitioner's cost of goods sold of Darvon and Darvon-N products. The percentages of finished stock planning expenses charged to Darvon and Darvon-N cost 246 of goods sold were based on the ratio of the number of persons handling all Puerto Rico source products to the total number of persons in the finished stock planning department.b. Operating Expensesi. General Administration Expenses1095 In allocating general administrative expenses, petitioner first obtained the total general administrative expenses for its 1971, 1972, and 1973 pharmaceutical division from its consolidated financial statements. Petitioner then arrived at an "administrative expense factor," which was the percentage of total general administrative expenses relative to certain total expenditures of petitioner. The denominator of that fraction included manufacturing costs less material costs, research and development expenses, and selling, merchandising, and shipping expenses of petitioner. The next step was to total the various expenses that previously had been directly incurred or allocated in the combined income statements, i.e., the selling, merchandising, and shipping expenses. The administrative expense factor percentage then was applied to those expenses, which resulted in a total administrative expense allocable to Darvon and Darvon-N products.ii. Selling ExpensesFor 247 1971, petitioner's selling expenses were allocated to Darvon and Darvon-N products on the basis of the ratio of primary details of those products to total primary details. 36 The method of allocating selling expenses used by petitioner for the years 1972 and 1973 was as follows.Petitioner's selling expenses were first analyzed by segregating total calls by sales representatives into six categories. Each sales representative of petitioner reported on a daily call card the number and types of calls he made on various health care representatives. The total calls of the sales representative were categorized as follows: physicians, interns, and residents; drug stores; hospitals; nonmedical; dentists; and miscellaneous. The total number of calls and a percentage of total calls were determined for each category.The total U.S. selling expenses of petitioner's pharmaceutical division, less selected accounts, 37 then were extracted from the general ledger. That total was multiplied by the percentage factor for each call category to arrive at the total amount of selling expenses for all products properly attributable to each particular category 248 of calls.1096 The next step was a determination of the proper allocation factor or percentage for each call category as it related to Darvon and Darvon-N products. The allocation factor then was multiplied against the total amount of selling expenses for each category to determine the proper Darvon/Darvon-N allocation.The first type of call category, physicians, interns, and residents, involved calls on physicians, interns, and residents at their private offices or in hospitals. Those calls were allocated on the basis of annual primary detail calls made by petitioner's sales representatives on physicians, interns, and residents for Darvon and Darvon-N products as a percentage of total primary detail calls for all of petitioner's products. The number of such annual primary detail calls was ascertained from the internal call data reports submitted by the sales representatives to petitioner's marketing department. Primary detail calls represented the most reliable information to measure selling activity for 249 physician, intern, and resident calls.The next category, drug store calls, was determined by reference to petitioner's price list for its top 100 items (based on sales). The top 100 items represented 92 percent of petitioner's pharmaceutical products sold for 1973. Petitioner determined that, according to the price list, sales of Darvon and Darvon-N products represented 10 percent of the total number of sales of the top 100 items. Accordingly, a 10-percent allocation factor was applied for drug store calls. Petitioner used that methodology to allocate drug store calls because that type of call was essentially a service call on the pharmacist and, unlike calls on physicians, did not relate to any specific product.Hospital calls involved calls on hospital pharmacists. Those calls were allocated on the basis of total Darvon and Darvon-N products sales to hospitals as a percentage of total pharmaceutical sales by petitioner to hospitals. Because petitioner had no actual data on sales of its products to hospitals, because it sold only to wholesalers, the data for that method were derived from an external independent audit conducted by International Marketing Services (hereinafter 250 IMS). The audit was based on a significant statistical sample, and IMS used techniques that petitioner believed provided a good representation of the 1097 movement of products from the wholesaler to the hospital. Petitioner believed the IMS data to be accurate and reliable.Nonmedical calls involved calls in a hospital atmosphere on nonphysician health care individuals, such as hospital administrators or nurses. As with hospital calls, the percentage allocation factor was determined on the basis of total sales of Darvon and Darvon-N products to hospitals as a percentage of total pharmaceutical sales by petitioner to hospitals. Therefore, the source of data used for the allocation was again the IMS audit.Dentist calls involved calls by petitioner's sales representatives on privately practicing dentists in their offices. Petitioner's methodology was to calculate total Darvon and Darvon-N prescription dollars as a percentage of petitioner's total dental prescription dollars to arrive at an expense allocation for Darvon and Darvon-N products. Because petitioner had no internal records regarding dental prescriptions, it again used data derived from an external independent audit. The audit 251 used was the R.A. Gosselin Prescription Audit (hereinafter the Gosselin audit). Whereas the IMS audit was a breakdown of retail sales, primarily to hospitals, the Gosselin audit was an audit of actual prescription activity. Petitioner believed the Gosselin data to be accurate and reliable.Miscellaneous calls involved calls by petitioner's sales representatives on industrial clinics; pharmacy, dental, and medical schools; and nursing homes. The methodology used to arrive at an allocation factor for miscellaneous calls was to calculate petitioner's total sales of Darvon and Darvon-N products to wholesalers as a percentage of petitioner's total sales of pharmaceutical products to wholesalers. The data for that allocation were generated internally.The final item of allocation of selling expenses was administrative support. Administrative support represented expenditures exclusive of direct selling, such as sales management, district and regional sales directors, secretarial support, and sales service training. The methodology used to determine the allocation factor was the same as that used for miscellaneous calls, that is, the percentage factor was calculated based on petitioner's 252 total sales of Darvon and Darvon-N products to wholesalers as a percentage of petitioner's total pharmaceutical 1098 sales to wholesalers. The data for that allocation also were internally generated.iii. Merchandising ExpensesPetitioner's allocation of merchandising expenses in the combined income statements was first determined by identifying the total merchandising expenses reported on the books and records of petitioner's pharmaceutical division as accumulated in its consolidated financial statements for the years 1971, 1972, and 1973. Those figures were comprised of direct promotion expenses and indirect merchandising expenses.The direct promotion expenses were those expenses directly related to particular product groups. At the time such expenditures were incurred, they were coded in such a manner that they could be accumulated in a promotional group, and, therefore, were identified directly with such group.The indirect merchandising expenses were those not directly identifiable with any particular product group and represented the balance of the merchandising expenses of the pharmaceutical division. Because petitioner had determined that the indirect expenses were incurred for 253 the benefit of all pharmaceutical products sold by it, those expenses were allocated on the basis of total sales of those particular product groups to total wholesaler sales.iv. Shipping ExpensesPetitioner's total shipping expenses were derived from the consolidated expenses of petitioner's pharmaceutical division for the years 1971 through 1973. From the various distribution departments, data were obtained to determine the total number of shipments made and those shipments then were divided into the total cost of shipping expenses to get a per-unit cost of shipping. The resulting unit number then was applied to the number of units of Darvon and Darvon-N products shipped to determine the portion of shipping expenses allocable to Darvon and Darvon-N products.H. Technical Assistance FeesDuring the years 1971, 1972, and 1973, Lilly P.R. was billed for certain technical assistance that it received from petitioner. The amounts of technical assistance fees billed to Lilly P.R. by petitioner for each of those years were as follows: 1099 YearAmount1971$ 166,4811972129,0541973131,969During the years 1965 through 1973, petitioner determined the technical assistance fees charged to Lilly P.R. 254 by multiplying the number of hours of technical assistance reported by petitioner's employees by the technical assistance fee rates applicable to those employees. In addition, an amount equal to 5 percent of those hourly charges was added to each technical assistance invoice. The hourly technical assistance fee rates were equal to the average hourly compensation costs (including benefits and employment taxes) for petitioner's employees. One rate was used for all nonexempt employees, a second rate was used for all exempt employees below the level of director, and individual rates were used for employees at the director levels and above. Petitioner also billed Lilly P.R. for the travel expenses of petitioner's employees who traveled to Puerto Rico and for engineering services according to petitioner's standard rates.The amounts billed by petitioner to Lilly P.R. during the years 1971 through 1973 represented all the technical assistance rendered by petitioner for the benefit of Lilly P.R. except for certain activities labeled as stewardship functions by petitioner. Petitioner's employees had no incentive to understate the amount of technical assistance fees chargeable to Lilly P.R. 255 Indeed, the opposite was true because all amounts for technical assistance fees charged to Lilly P.R. reduced petitioner's department expenses for budgetary and profit performance purposes.I. Lilly P.R. Purchases From Petitioner1. Raw MaterialsLilly P.R.'s purchases of raw materials from third-party suppliers accounted for 80 percent, 81 percent, and 87 percent of its total raw material purchases in dollars for 1971, 1972, and 1973, respectively. The remainder of Lilly P.R.'s purchases of raw materials in those years were from petitioner.Petitioner's prices for raw materials sold to Lilly P.R. were cost plus 100 percent for materials manufactured by petitioner and petitioner's cost for materials purchased by petitioner. 1100 Petitioner's cost for both manufactured and purchased materials included its costs of packaging materials and material handling (e.g., freight in, freight to Puerto Rico, analytic assays on incoming materials, and warehousing).2. Equipment and Machine PartsAs stated earlier in our findings of fact, Lilly P.R. purchased equipment and machine parts either directly from third-party suppliers or through petitioner during the years 1971 through 1973.In cases in which 256 Lilly P.R. purchased equipment directly from third-party suppliers, petitioner had no involvement whatsoever. In cases in which Lilly P.R. purchased equipment and machine parts through petitioner, Lilly P.R. was billed by petitioner for the requested items plus transportation and related services of petitioner (i.e., handling charges and costs of purchasing and engineering personnel) without any additional charges.XIII. Generic Propoxyphene ProductsA. GeneralIn 1973, after the propoxyphene patent expired, at least 24 pharmaceutical manufacturers and/or distributors entered the United States market with generic propoxyphene hydrochloride products. The suggested prices to retail pharmacies for the generic propoxyphene hydrochloride products generally were about one-half of petitioner's net trade prices for the comparable Darvon products.In February 1973, Lilly Research Laboratories began a program of evaluating generic propoxyphene hydrochloride products that were in direct competition with Darvon 65 mg. (PU 365) and Darvon Compound-65 (PU 369). The quality of the generic products was compared with that of petitioner's Darvon products by examining specifications such as (a) uniformity 257 of drug content, (b) uniformity of weight, (c) decomposition of aspirin in compound products into acetic acid and salicylic acid, and (d) purity (i.e., presence of nonpropoxyphene chemicals generated by the chemical manufacturing process). The results of that study indicated that petitioner's Darvon products were equal or superior to the 1101 generic propoxyphene hydrochloride products. Two particular defects were found in the generic compound products. First, x-ray examination of generic products having a pellet formulation (i.e., containing an encased pellet of propoxyphene hydrochloride to prevent the interaction of propoxyphene hydrochloride and aspirin) showed that some of the lots of the generic products contained capsules that contained either no pellet or two pellets. Second, examination of generic products having an all-powder formulation (i.e., products in which the propoxyphene hydrochloride was mixed directly with the aspirin) showed greater disintegration of aspirin into acetic acid and free salicylic acid than in Darvon compound products.Three of the pharmaceutical firms that entered the U.S market in 1973 with generic propoxyphene products were Zenith Laboratories, Inc., 258 Rachelle Laboratories, Inc., and Smith Kline & French Laboratories. Each company sold both propoxyphene hydrochloride and a propoxyphene hydrochloride compound in 65 milligram strengths. We will discuss each company in turn below.B. Zenith Laboratories, Inc.Zenith Laboratories, Inc. (hereinafter Zenith) is a manufacturer of generic pharmaceuticals with facilities in northern New Jersey and the Virgin Islands. Its sales are divided evenly between private label manufacturing and sales under its own label, and are made both to large pharmaceutical companies and to drug distributors.Zenith purchases rather than produces the basic chemical substances used in its products. Zenith's activities, then, are limited to the pharmaceutical manufacturing activities of formulation, encapsulation or tableting, and packaging. During the early 1970s, it had approximately 190 employees, including 3 employees assigned to work full-time in obtaining FDA approval for its products. Zenith does not promote its products directly to physicians.Zenith's net sales for the years 1971, 1972, and 1973, respectively, were $ 9,436,000, $ 9,032,000, and $ 11,593,000. There is no evidence in the record indicating 259 what proportion of its 1973 net sales were attributable to sales of generic propoxyphene hydrochloride products.1102 C. Rachelle Laboratories, Inc.Rachelle Laboratories, Inc. (hereinafter Rachelle), is a subsidiary of International Rectifier Corp. located in Long Beach, California. Rachelle is largely a chemical company and produces basic substances as well as final pharmaceutical products. Rachelle produces products for sale not only to the human market, but to the veterinary market as well.Rachelle chemically manufactures most of the substances used in the manufacture of its final pharmaceutical products. In 1973, Rachelle produced the propoxyphene hydrochloride used in its plain propoxyphene hydrochloride capsules; 38 it purchased, however, finished propoxyphene hydrochloride compound-65 capsules from the Caribe Chemical Co., Inc., of the Virgin Islands.During 1973, Rachelle employed approximately 200 persons at its Long Beach facility. As of June 1973, 67 of those employees were involved in the chemical and pharmaceutical manufacture of products, 260 and 29 were involved in the sale and marketing of Rachelle's products.Rachelle's net sales were $ 5,944,000, $ 12,254,000, and $ 11,228,000 for 1971, 1972, and 1973, respectively. Rachelle's sales of propoxyphene hydrochloride products were approximately $ 50,000 in fiscal year ending June 30, 1973, and approximately $ 60,000 in fiscal year ending June 30, 1974.D. Smith Kline & French LaboratoriesSmith Kline & French Laboratories (hereinafter SKF) marketed a line of branded prescription pharmaceutical products on which patent protection had expired called the SK line. The SK line included a fairly wide range of antibiotics and mild tranquilizers as well as two propoxyphene hydrochloride products. SKF manufactured the plain propoxyphene hydrochloride product it marketed, but purchased its SK-65 Compound (a combination of propoxyphene hydrochloride and APC) from Milan Pharmaceuticals, Inc.1. Milan Pharmaceuticals, Inc.Milan Pharmaceuticals, Inc. (hereinafter Milan), of Morgantown, West Virginia, is a generic pharmaceutical manufacturing 1103 firm similar to Zenith and Rachelle. Milan purchases the basic chemical substances used in its products, and has no chemical manufacturing facilities. 261 Its sales, like those of Zenith, are made both under its own label and under those of the largest pharmaceutical houses. During the latter part of 1973, Milan employed approximately 235 persons, 4 of whom were involved in research and development and obtaining FDA approval for Milan's products.Milan's net sales for the years 1971, 1972, and 1973 were $ 4,253,000, $ 7,826,000, and $ 10,818,000, respectively. Of the 1973 net sales amount, approximately $ 1,200,000 were attributable to sales of propoxyphene hydrochloride compound.2. SK-65 CompoundThe SK-65 Compound manufactured for SKF by Milan contained an encased pellet of propoxyphene hydrochloride to prevent the propoxyphene hydrochloride from interacting with and decomposing the aspirin in that product. Because SKF did not have the capability of inserting the propoxyphene hydrochloride pellets into the capsules of SK-65 Compound, SKF decided to purchase SK-65 Compound from Milan, which had already developed that capability. In addition, Milan had obtained FDA approval to manufacture the SK-65 Compound, and, therefore, the use by SKF of Milan as the source of SK-65 Compound was the most expeditious way for SKF to enter the propoxyphene 262 hydrochloride market.Milan's basic price to SKF in 1973 for SK-65 Compound was $ 14.50 per 1,000 filled capsules. Milan also charged SKF $ 0.15 per bottle for packaging the SK-65 Compound capsules in bottles of 100 capsules and $ 0.3 for packaging the SK-65 Compound capsules in bottles of 500 capsules. Thus, Milan's price to SKF for a bottle of 100 SK-65 Compound capsules was $ 1.60, and Milan's price to SKF for a bottle of 500 SK-65 Compound capsules was $ 7.55.During 1973, SKF purchased 47,399,654 filled SK-65 Compound capsules from Milan at a total invoice cost of $ 742,865. Milan's sales to SKF of SK-65 Compound capsules in bottles of 100, bottles of 500, sample packages, and bulk during 1973 were as follows: 1104 Type of package1973 SalesBottle of 100 capsules$ 295,072Bottle of 500 capsules346,689Sample package of 4 capsules34,094Bulk67,010Total742,865SKF sold the SK-65 Compound products purchased from Milan to drug wholesalers in the United States. SKF's net trade price and price to wholesalers for bottles of 100 SK-65 Compound capsules were $ 3.75 and $ 3.09, respectively. SKF's net trade price and price to wholesalers for bottles of 500 SK-65 Compound capsules were $ 16.50 and 263 $ 13.61, respectively.SKF supplied to Milan at no charge the empty capsules, package inserts, labels, and bottle caps used by Milan in making SK-65 Compound for SKF. SKF's cost of providing those materials for Milan were $ 0.26 for a bottle of 500 SK-65 Compound capsules.During 1973, Lilly P.R. manufactured the empty capsules it used to make Darvon Compound-65 and purchased from suppliers the package inserts, labels, and bottle caps for Darvon Compound-65. 39264 During the period 1971 through 1973, petitioner sold billions of empty capsules to unrelated customers throughout the world. Petitioner's price per thousand for empty capsules of the type used by Lilly P.R. in manufacture of Darvon Compound-65 was about $ 1.60. During that period, Lilly P.R. lost, in the manufacturing process, approximately 3 percent of the empty capsules it used in the filling and finishing of Darvon Compound-65. Thus, the effective market price for empty capsules for Darvon Compound-65 was approximately $ 0.82 per bottle of 500 capsules. Lilly P.R.'s standard cost per bottle of 500 Darvon Compound-65 capsules for labels, package inserts, and bottle caps was approximately $ 0.04 in 1973.Milan's credit terms to SKF in 1973 relative to Milan's sales of SK-65 Compound to SKF were a 1-percent discount for payment within 10 days and net for payment in 30 days.SKF also purchased SK-65 Compound capsules from Milan for use as samples. Approximately 20 percent of the SK-65 Compound capsules used as samples by SKF in 1973 were 1105 packaged by Milan in packages of four capsules. Milan's price to SKF for such a sample package was $ 0.135 per package. The remaining SK-65 Compound capsules purchased by SKF from Milan for use as samples were purchased in bulk at the basic price of $ 14.50 per thousand capsules and packages by SKF.SKF loaned to Milan, at no charge, equipment used by Milan in 1973 to package SK-65 Compound capsules in sample packages. That equipment was excess old equipment owned by SKF which was not being used by it at the time the equipment was made available to Milan.Milan had its own quality control personnel who performed all required FDA checks on products it produced. SKF, however, performed complete quality control analysis on the first 265 several commercial batches of SK-65 Compound it purchased from Milan. After that time, SKF accepted Milan's quality control assay reports, but continued to perform a physical quality control check upon receipt of the SK-65 capsules. SKF also retained from each lot of SK-65 Compound capsules purchased from Milan a sampling of capsules for stability testing. In addition, during each of the production runs of SK-65 Compound at Milan, SKF had from 1 to 3 of its own quality control personnel at Milan's plant to observe the production process. SKF's quality control personnel were present at Milan's plant for the duration of each production run which, depending on the size of the run, was approximately 1 week.SKF paid the freight costs related to shipments of SK-65 Compound from Milan to SKF in 1973. SKF did not maintain any FDA required records for Milan; Milan maintained all the required records relative to its production of SK-65 Compound. SKF did not make any patent or manufacturing know-how relative to SK-65 Compound available to Milan. SKF did not perform any research and development, pilot plant testing, or process development testing for Milan.XIV. Respondent's Proposed AdjustmentsA. 266 Notice of DeficiencyIn his notice of deficiency dated March 26, 1976, respondent allocated gross income from Lilly P.R. to petitioner under section 482 in the amounts of $ 18,522,924, $ 17,820,986, and $ 10,717,187 for 1971, 1972, and 1973, respectively, with respect 1106 to Lilly P.R.'s sales of Darvon and Darvon-N products to petitioner in those years.The allocations of income in the notice of deficiency were based upon a multi-step method of determining Lilly P.R.'s gross income on sales of Darvon and Darvon-N products to petitioner. Under that method, Lilly P.R.'s gross income on sales to petitioner of Darvon and Darvon-N products was equal to the sum of the following amounts:(a) Lilly P.R.'s cost of goods sold;(b) Lilly P.R.'s location savings (i.e., the cost savings resulting from operating in Puerto Rico rather than in the continental United States);(c) a gross profit for the Mayaguez facility of Lilly P.R. determined by respondent; and(d) a gross profit for the Carolina facility of Lilly P.R. determined by respondent.The location savings of the Mayaguez and Carolina facilities of Lilly P.R. for the years 1971, 1972, and 1973 were as follows:197119721973Mayaguez$ 1,464,359$ 1,354,798$ 1,211,242Carolina3,263,9573,910,6442,602,491Total4,728,3165,265,4423,813,733267 In the notice of deficiency, respondent determined the gross profit for Lilly's P.R.'s Mayaguez facility by constructing prices for the bulk propoxyphene hydrochloride and propoxyphene napsylate transferred by the Mayaguez facility to Lilly P.R.'s Carolina facility. Respondent determined that those prices were $ 88, $ 86, and $ 77 per kilogram for 1971, 1972, and 1973, respectively. The gross profit of the Mayaguez facility as determined by respondent was the excess of those prices over Lilly P.R.'s cost of manufacturing propoxyphene hydrochloride and propoxyphene napsylate.In the notice of deficiency, respondent determined that the gross profit of the Carolina facility was 25 percent of the sum of (a) the Carolina facility's "cost" of acquiring the propoxyphene hydrochloride and propoxyphene napsylate from the Mayaguez facility at the transfer prices constructed by respondent, (b) the manufacturing cost of the Carolina facility (exclusive of the actual cost of propoxyphene hydrochloride 1107 and propoxyphene napsylate), and (c) the location savings attributable to the Carolina facility.B. Amendment to AnswerIn an amendment to answer filed April 14, 1981, respondent increased the section 482268 allocation of gross income from Lilly P.R. to petitioner with respect to Darvon and Darvon-N products by $ 23,952,413 for the period 1971 through 1973, as indicated by the following table:Sec. 482 allocationAmendmentNotice ofIncrease into answerdeficiencyallocation1971$ 26,620,387$ 18,522,924$ 8,097,463197226,314,91817,820,9868,493,932197318,078,20510,717,1877,361,018Total71,013,51047,061,09723,952,413The increase in section 482 allocations in the amendment to answer resulted from a new method of computing Lilly P.R.'s gross income from sales of Darvon and Darvon-N products to petitioner. In the amendment to answer, respondent asserted that such gross income should be limited to 130 percent of the sum of Lilly P.R.'s manufacturing costs and location savings. The notice of deficiency pricing method was asserted by respondent as an alternative position to the amendment to answer pricing method.OPINIONIntroductionThe issues before this Court involve respondent's reallocations of gross income from Lilly P.R. to petitioner for the taxable years 1971, 1972, and 1973.Petitioner is engaged in the manufacture and sale of pharmaceutical products. Petitioner invented and patented propoxyphene 269 hydrochloride (Darvon) during the early 1950s and propoxyphene napsylate (Darvon-N) during the early 1960s. Darvon was first introduced into the U.S. market in 1957, and was manufactured by petitioner in Indiana from 1957 through 1966. Darvon-N was not introduced into the U.S. market until 1971 and was never manufactured by petitioner.1108 During 1965, petitioner organized Lilly P.R. as a wholly owned Puerto Rican subsidiary. In December 1966, petitioner transferred "all right, title and interest in and to" the propoxyphene and napsylate patents to Lilly P.R., as well as the exclusive right to use petitioner's manufacturing know-how. The transaction qualified for nonrecognition under section 351 and, therefore, Lilly P.R. reported no gain or loss on the transaction in 1966. After the transfer in 1966 and throughout the years in issue, Lilly P.R. was the sole manufacturer of Darvon and Darvon-N; Lilly P.R. sold its products to petitioner, who in turn marketed the products throughout the United States.In the statutory notice of deficiency and in the amended answer, respondent, through adjustments in intercorporate pricing, reallocated the income attributable to the propoxyphene and napsylate 270 patents and related manufacturing know-how from Lilly P.R. to petitioner under the authority of section 482. Respondent's methods of determining the section 482 allocations in the notice of deficiency, the amended answer, and at trial treat Lilly P.R. as a contract manufacturer and do not take into account Lilly P.R.'s ownership of the manufacturing intangibles.The first issue we must decide is whether Lilly P.R. should be considered the owner of the propoxyphene and napsylate patents and manufacturing know-how for purposes of determining arm's-length prices to petitioner under section 482. We must then determine whether respondent's section 482 adjustments were arbitrary, capricious, or unreasonable. Finally, we must make a determination of arm's-length prices between petitioner and Lilly P.R.Issue 1. Ownership of Intangibles for Section 482 PurposesThe first issue for decision is whether, for purposes of determining arm's-length prices under section 482, 40271 the 1109 income attributable to the manufacturing intangibles should be allocated to petitioner or Lilly P.R.Petitioner contends that it transferred complete ownership of the propoxyphene and napsylate patents and manufacturing know-how to Lilly P.R., and that, therefore, the income from such patents and know-how belongs to Lilly P.R. Although respondent concedes that Lilly P.R. acquired legal title to the patents and know-how in 1966 in a valid section 351 transfer, 41 he maintains that for purposes of section 482, legal ownership of the intangibles can be disregarded and all income attributable to them reallocated from Lilly P.R. to petitioner. During all relevant years, Lilly P.R. was a qualifying section 931 possessions corporation and was exempt from U.S.272 tax on the income earned from its manufacture and sale of Darvon and Darvon-N products.A. Background of Relevant Provisions1. Tax Incentives for Companies Operating in Puerto Ricoa. Section 931Section 931, in effect during the years in issue, provided in relevant part:SEC. 931. INCOME FROM SOURCES WITHIN POSSESSIONS OF THE UNITED STATES.(a) General Rule. -- In the case of citizens of the United States or domestic corporations, gross income means only gross income from sources within the United States if the conditions of both paragraph (1) and paragraph (2) are satisfied: (1) 3-year period. -- If 80 percent or more of the gross income of such citizen or domestic corporation (computed without the benefit of this section) for the 3-year period immediately preceding the close of the taxable year (or for such part of such 273 period immediately preceding the close of such taxable year as may be applicable) was derived from sources within a possession of the United States; and(2) Trade or business. -- If -- (A) in the case of such corporation, 50 percent or more of its gross income (computed without the benefit of this section) for such period or such part thereof was derived from the active conduct of a trade or business within a possession of the United States.1110 Section 931 had its genesis 64 years ago in section 262 of the Revenue Act of 1921, ch. 136, 42 Stat. 271, which first exempted from Federal taxes the incomes of U.S. corporations operating in a possession. 42 Section 262(c) provided the requirements for qualification as a possessions corporation later set forth in section 931. The section was reenacted without any material change by section 251 of the Revenue Act of 1928, ch. 852, 45 Stat. 850, and section 931 of the Internal Revenue Code of 1954. It was not until enactment of the Tax Reform Act of 1976, that any material changes were made in the basic tax exemption for possessions corporations, and then Congress substituted an equally favorable tax credit mechanism. See section 936, Tax Reform 274 Act of 1976, Pub. L. 94-455, 90 Stat. 1643.The congressional intent for section 931 and its predecessors consistently has been the encouragement of American business investments in possessions of the United States. American companies operating in the possessions originally were subjected to double taxation by the imposition of both the Federal corporate income tax and the taxes levied by the possessions governments. Section II of the Tariff Act of 1913, ch. 16, 38 Stat. 166; Revenue Act of 1918, ch. 18, 40 Stat. 1058. Congress perceived that the tax burden so created placed American businesses at a competitive disadvantage when compared with their British and French counterparts, which were not subject to taxation on the profits earned abroad unless they were paid back to the home company. Congress consequently enacted section 931 and its predecessors to remove that competitive disadvantage and to encourage American business activity in the U.S. possessions. H. Rept. 275 350, 67th Cong., 1st Sess. 1 (1921), 1939-1 C.B. (Part 2) 168, 174.Generally, section 931 provided corporations an exclusion of possession source income if they met the 80-percent source test and 50-percent active trade or business test. Because of that exclusion, and because dividends received by a domestic corporation from its wholly owned possessions subsidiary were not eligible for the intercorporate dividends received deduction of section 246(a)(2)(B), possessions corporations amassed 1111 large amounts of income which were not repatriated to the United States. To encourage investment of possessions source earnings in the United States, in 1976 Congress enacted new section 936. That section eliminated the tax exemption for income from foreign investments outside the possessions and permitted the intercorporate dividends received deduction for dividends received from a wholly owned possessions subsidiary. Section 936 essentially transformed the exemption mechanism contained in section 931 to a credit system whereby the U.S. parent can elect a special tax credit to offset the U.S. tax on its wholly owned possessions subsidiary's source income. 43276 It is clear from the legislative record that Congress was aware of the highly favorable tax benefits afforded U.S. corporations operating in Puerto Rico. It is equally clear that Congress intended to retain and reaffirm such tax benefits, at least on the part of the United States, by its enactment of section 936. As the Senate Finance Committee and the House of Representatives Committee on Ways and Means stated, in virtually identical reports:The special exemption provided (under sec. 931) in conjunction with investment incentive programs established by possessions of the United States, especially the Commonwealth of Puerto Rico, have been used as an inducement to U.S. corporate investment in 277 active trades and businesses in Puerto Rico and the possessions. Under these investment programs little or no tax is paid to the possessions for a period as long as 10 to 15 years and no tax is paid to the United States as long as no dividends are paid to the parent corporation.Because no current U.S. tax is imposed on the earnings if they are not repatriated, the amount of income which accumulates over the years from these business activities can be substantial. The amounts which may be allowed to accumulate are often beyond what can be profitably invested within the possession where the business is conducted. As a result, corporations generally invest this income in other possessions or in foreign countries either directly or through possessions banks or other financial institutions. In this way possessions corporations not only avoid U.S. tax on their earnings from businesses conducted in a possession, but also avoid U.S. tax on the income obtained from reinvesting their business earnings abroad.1112 The committee after studying the problem concluded that it is inappropriate to disturb the existing relationship between the possessions investment incentives and the U.S. tax laws 278 because of the important role it is believed they play in keeping investment in the possessions competitive with investment in neighboring countries. The U.S. Government imposes upon the possessions various requirements, such as minimum wage requirements and requirements to use U.S. flagships in transporting goods between the United States and various possessions, which substantially increase the labor, transportation and other costs of establishing business operations in Puerto Rico. Thus, without significant local tax incentives that are not nullified by U.S. taxes, the possessions would find it quite difficult to attract investments by U.S. corporations.[S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 315, 315-316; H. Rept. 94-658 (1975), 1976-3 C.B. (Vol. 2) 945, 946-947. Emphasis added and fn. refs. omitted.] 44279 (The excerpt quoted is from the Senate report; the House report version differs by two words.) b. Puerto Rico's Operation BootstrapIn 1948, as part of its Operation Bootstrap, the Commonwealth of Puerto Rico matched the U.S. tax exemption for possessions corporations. Industrial Tax Exemption Act of 1948, P.R. Laws Ann. tit. 13, secs. 221-238 (1955). In addition to exempting corporations from Puerto Rican corporate income taxes, the legislation also provided exemptions from certain property taxes, excise taxes, and license fees, with a gradual phase-out of exemptions by 1962. The tax exemptions generally were available for a corporation manufacturing items not produced on a commercial scale in Puerto Rico prior to 1947.In 1954, the 1948 Act was reenacted with an amendment providing for an additional 10-year exemption for new businesses subsequently locating on the island. Industrial Incentive Act of 1954, P.R. Laws Ann. tit. 13, secs. 241-251 (1977). 280 Later, as the 1950s drew to a close and some of the original investors approached the end of their exemption periods, pressure mounted for further extensions of, and 1113 liberalizations in, the industrial incentives. The Industrial Incentive Act of 1963, P.R. Laws Ann. tit. 13, secs. 252-252j (1977), as subsequently enacted, provided completely new exemption grants for periods ranging from 10 to 25 years and retained virtually all the provisions of the 1954 Act.2. Nonrecognition Provision of Section 351Section 351 provides for the nonrecognition of gain or loss upon the transfer of property to a corporation if immediately after the transfer the corporation is controlled 45281 by the transferor. The transfer of property must be "solely in exchange for stock or securities" of the transferee corporation. The transfer of property to an existing controlled corporation will qualify the transaction for nonrecognition treatment even though the transferor did not receive any additional stock at the time of the transfer. 46Petitioner 282 transferred the propoxyphene and napsylate patents and manufacturing know-how to Lilly P.R., a wholly owned subsidiary. 47283 It is undisputed that petitioner's transfer of the patents and know-how to Lilly P.R. qualified for nonrecognition under section 351. Respondent not only has issued a private ruling letter (as set out in pp. 1029-1031 of our findings of fact) to petitioner in which he ruled that no gain or 1114 loss on the transfer would be recognized under section 351, 48 but has emphasized through counsel on brief that he does not challenge the validity of the section 351 transfer. Thus, petitioner recognized no gain or loss upon its transfer of patents and know-how to Lilly P.R. in 1966 and, after such transfer, Lilly P.R. was the legal owner of those patents and know-how.B. Interrelationship of Section 482 and Sections 351 and 9311. Introductiona. History and Purpose of Section 482Section 482 had its origin in Regulation 41, Articles 77 and 78 of the War Revenue Act of 1917, ch. 63, 40 Stat. 300, which gave the Commissioner the authority to require related corporations to file consolidated returns "Whenever necessary to more equitably determine the invested capital or taxable income." It reappeared in section 240(d) of the Revenue Act of 1921, ch. 136, 42 Stat. 260, as part 284 of the provisions liberalizing the consolidated return rules. 49 Section 240(d) permitted the Commissioner to consolidate the accounts of affiliated corporations "for the purpose of making an accurate distribution or apportionment of gains, profits, income, deductions, or capital between or among such related trades or business." Section 240(d) of the Revenue Act of 1921 was successively reenacted as section 240(d) of the Revenue Act of 1924, ch. 234, 43 Stat. 288, and as section 240(f) of the Revenue Act of 1926, ch. 27, 44 Stat. 46, both of which permitted taxpayers to request the Commissioner to consolidate the accounts of related businesses. Section 45 of the Revenue Act of 1928, ch. 852, 45 Stat. 806, gave the predecessor of section 482285 independent status by 1115 eliminating the taxpayer's power to invoke the section and emancipating it from the consolidated return provisions. The language in the new section 45 was essentially the same as that contained in the present section 482. The legislative history of the provision indicated that:Section 45 is based upon section 240(f) of the 1926 Act, broadened considerably in order to afford adequate protection to the Government made necessary by the elimination of the consolidated return provisions of the 1926 Act. The section of the new bill provides that the Commissioner may, in the case of two or more trades or businesses owned or controlled by the same interests, apportion, allocate, or distribute the income or deductions between or among them, as may be necessary in order to prevent evasion (by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of "milking"), and in order clearly to reflect their true tax liability. [H. Rept. 2, 70th Cong., 1st Sess. (1927), 1939-1 C.B. (Part 2) 395; see also S. Rept. 960, 70th Cong., 1st Sess. (1928), 1939-1 C.B. (Part 2) 426.]b. Scope of Respondent's AuthoritySection 482 gives 286 respondent broad authority to allocate between or among commonly controlled 50 corporations their respective gross incomes, deductions, credits, or allowances when necessary either to prevent the evasion of taxes or in order clearly to reflect the income of such corporations. 51 We emphasize that these are alternate bases for application of the section.A section 482 allocation based upon tax avoidance grounds is primarily intended to prevent the artificial shifting or milking of profits. 52 Thus, 287 respondent's application of section 482 has been upheld when the challenged transaction was arranged by the related parties without a valid business purpose and solely in order to avoid taxes. E.g., Asiatic Petroleum Co. v. Commissioner, 79 F.2d 234">79 F.2d 234 (2d Cir. 1935), affg. 31 B.T.A. 1152">31 B.T.A. 1152 (1935), 1116 cert. denied 296 U.S. 645">296 U.S. 645, rehearing denied 296 U.S. 664">296 U.S. 664 (1935); Northwestern National Bank of Minneapolis v. United States, an unreported case ( D. Minn. 1976, 38 AFTR 2d 76-1400, 76-1 USTC par. 9408), affd. 556 F.2d 889">556 F.2d 889 (8th Cir. 1977).Respondent also may compel a reallocation of income under section 482 where the incomes of related parties are not clearly reflected, even in the absence of tax avoidance motives. This aspect of the section is concerned with properly allocating income to the person who earns the income and the deduction to the person who, in substance, incurred the expenses and obtained the benefits of the 288 correlative deduction. Accordingly, the clear reflection of income doctrine has justified an allocation when the challenged transaction shifted income earned by one party to a related party ( Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182 (7th Cir. 1970), affg. in part and revg. and remanding in part an unreported District Court decision), or when it resulted in an artificial mismatching of a party's income and expenses. Rooney v. United States, 305 F.2d 681">305 F.2d 681 (9th Cir. 1962), affg. 189 F. Supp. 733">189 F. Supp. 733 (N.D. Cal. 1960); Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214">198 F.2d 214 (2d Cir. 1952), revg. and remanding on this issue 16 T.C. 882">16 T.C. 882 (1951), cert. denied 344 U.S. 874">344 U.S. 874 (1952).2. Income From Manufacturing Intangiblesa. Section 482 Allocations Involving Nonrecognition TransfersThe issue now before us is whether Lilly P.R. should be considered the owner of the propoxyphene and napsylate patents and manufacturing know-how for purposes of determining arm's-length prices to petitioner for Lilly P.R.'s Darvon and Darvon-N products. 53 Respondent concedes the validity of petitioner's section 351 transfer of the manufacturing intangibles to Lilly P.R. and that Lilly P.R. is the legal 289 owner of the intangibles. Respondent alleges, however, that he has the authority under section 482 to disregard the legal ownership 1117 of the intangibles and to reallocate the income attributable to the intangibles from Lilly P.R. back to petitioner in order to prevent the evasion of taxes or clearly to reflect petitioner's income. Petitioner agrees that respondent may use section 482 to reallocate income from property received in a section 351 transfer back to the transferor. Petitioner contends, however, that allocations ignoring nonrecognition transfers are upheld by the courts in only two narrow factual situations, discussed hereinafter, neither of which applies in this case. 290 Therefore, petitioner asserts that respondent has no authority to disregard completely petitioner's 1966 transfer of the manufacturing intangibles to Lilly P.R. by reallocating the income attributable to those intangibles to petitioner. For the reasons discussed below, we agree with petitioner.As we stated earlier, section 482 provides that respondent may make allocations between related parties when necessary either to prevent the evasion of taxes, or in order clearly to reflect their incomes. Moreover, section 1.482-1(d)(5), Income Tax Regs., specifically provides:Section 482 may, when necessary to prevent the avoidance of taxes or to clearly reflect income, be applied in circumstances described in sections of the Code (such as section 351) providing for nonrecognition of gain or loss. See, for example, National Securities Corporation v. Commissioner of Internal Revenue, 137 F. 2d 600 (3rd Cir. 1943), cert. denied 320 U.S. 794">320 U.S. 794 (1943).National Securities Corp. v. Commissioner, 137 F.2d 600">137 F.2d 600 (3d Cir. 1943), affg. 46 B.T.A. 562">46 B.T.A. 562 (1942), and its progeny delineate the situations in which courts have upheld section 482 allocations that, in effect, ignored nonrecognition transfers. 291 Those situations can be separated into two narrowly defined categories: (1) Cases in which property was transferred in a nonrecognition transaction and subsequently disposed of by the transferee, and in which the sole purpose of the transfer was to achieve tax consequences on the disposition of the property by the transferee that were more favorable than the tax consequences of a disposition by the transferor (see, e.g., National Securities Corp. v. Commissioner, supra; Southern Bancorporation v. Commissioner, 67 T.C. 1022">67 T.C. 1022 (1977); Northwestern National Bank of Minneapolis v. United States, an unreported case ( D. Minn. 1976, 38 AFTR 2d 76-1400, 76-1 USTC par. 1118 9408), affd. 556 F.2d 889">556 F.2d 889 (8th Cir. 1977)); 54292 and (2) cases in which the nonrecognition transfer of property resulted in an artificial separation of income from the expenses of earning the income. See, e.g., Rooney v. United States, 305 F.2d 681 (9th Cir. 1962); Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214">198 F.2d 214 (2d Cir. 1952). But see Heaton v. United States, 573 F. Supp. 12">573 F. Supp. 12 (E.D. Wash. 1983); Fanning v. United States, 568 F. Supp. 823">568 F. Supp. 823 (E.D. Wash. 1983). The leading cases in each category are discussed in detail below.(i) National Securities Corp. and Avoidance of TaxesThe leading case in the first category is National Securities Corp. v. Commissioner, supra. In that case, a parent corporation transferred shares of stock in an unrelated corporation, Standard Gas & Electric Co. (Standard), to the taxpayer, its wholly owned subsidiary, in exchange for additional shares of the taxpayer's stock. The transaction qualified as a nonrecognition exchange under the predecessor of section 351. 55 The parent's basis in the Standard stock was approximately $ 140,000, but the stock had only a market value of approximately $ 8,500 at the time of the transfer. At the end of the transfer year, the taxpayer sold the stock for $ 7,175 and reported on its return a loss of $ 133,202, the difference between the parent's basis in the stock (the taxpayer's carryover basis under section 362) and the amount realized by the taxpayer. The parent, having already realized a net capital loss for that year in excess of the amount deductible under the relevant revenue provision, could 293 not have derived any tax benefit from the loss on the sale if it had retained and then sold the Standard stock itself. Acting pursuant to section 482, the Commissioner disregarded the nonrecognition transfer of stock and allocated the entire loss on the sale from the taxpayer to the parent. 56 The taxpayer contended that the nonrecognition and basis provisions of sections 351 and 362, respectively, precluded the application of section 482 to the taxpayer. The Court of 1119 Appeals for the Third Circuit upheld the Commissioner's allocation from the taxpayer to the parent under section 482 of the deduction for the portion of the loss sustained before the transfer.The Court of Appeals based its holding in National Securities Corp. upon the clear reflection of income standard rather than the tax avoidance test of section 482. Factually, however, the case involved a tax avoidance situation in which a nonrecognition 294 transaction was used solely to shift to the taxpayer the tax consequences of a preconceived disposition of stock in order to obtain a tax benefit that could not be obtained by the parent. Because there was no valid business purpose for the transfer, we view National Securities Corp. and all members of the first category primarily as tax avoidance cases. See Southern Bancorporation v. Commissioner, 67 T.C. 1022">67 T.C. 1022, 1027 (1977).The facts of the case before us are readily distinguishable from those discussed above. Petitioner's transfer of the patents and manufacturing know-how to Lilly P.R. was motivated by bona fide business reasons, and Lilly P.R. did not thereafter dispose of the transferred assets. Petitioner in 1965 needed to expand its chemical and pharmaceutical manufacturing facilities in order to meet the projected 1975 U.S. requirements for its products. After considering several alternatives, petitioner decided to locate two such facilities in Puerto Rico. That decision allowed petitioner to take advantage of the congressionally sanctioned tax incentives, Puerto Rican tax exemptions, and lower labor costs available in Puerto Rico. In addition, petitioner was able to diversify 295 geographically its manufacturing facilities.Once petitioner determined that the products it would manufacture in Puerto Rico were Darvon and Darvon-N, it consulted with its tax counsel to ascertain the most desirable means of doing so. Petitioner was advised that it could minimize its Federal income taxes by transferring ownership of the patents and the manufacturing intangibles relating to the production of Darvon and Darvon-N to a subsidiary possessions corporation that qualified for the benefits of section 931. On the basis of that advice, petitioner organized Lilly P.R. to operate the manufacturing facilities and executed the Assignment of Patent and Related Technical Data.1120 It is well established that taking advantage of tax benefits made available by Congress does not constitute tax avoidance. In Barber-Green Americas, Inc. v. Commissioner, 35 T.C. 365">35 T.C. 365 (1960), this Court held that the organization of a subsidiary to take advantage of the Western Hemisphere Trade Corporation provisions of sections 921 and 922, and the organization of the business and sales procedures of the subsidiary to qualify for the benefits of sections 921 and 922, did not constitute tax avoidance under 296 the predecessor of section 269. See also Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182">435 F.2d 182 (7th Cir. 1970). Sections 921 and 922 provided a special deduction for corporations making sales in the Western Hemisphere. The purpose of the tax incentives provided in those sections is similar to the purpose of section 931, namely, to promote commerce and economic development in the targeted areas.What we stated in Barber-Greene is equally applicable here:When the Congress offered certain tax benefits as an inducement to United States corporations to engage in foreign trade, it was to be expected that some corporations would seek to avail themselves of these benefits. The creation of a subsidiary to carry on the business in the Western Hemisphere area of an existing domestic corporation does not constitute tax avoidance within the meaning of [the predecessor of section 269], * * * and there seems to be no good reason why the deliberate organizing of such a corporation's business and sales procedures to meet the other conditions specified by the legislation and thereby to qualify for the tax benefits offered should be regarded as tax avoidance. Otherwise the purpose of organizing 297 a subsidiary would be lost and the congressional objective would not be carried out.It has repeatedly been stated that taxpayers have the right so to arrange their affairs that their taxes shall be as low as possible, Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935); that one is not obliged to pursue a course of action giving rise to a greater tax liability if another is open which will give rise to a lesser liability, Fruit Belt Telephone Co., 22 B.T.A. 440">22 B.T.A. 440 (1931), * * and that what a taxpayer did, rather than what he might have done, determines his liability. Seminole Flavor Co., 4 T.C. 1215">4 T.C. 1215, 1230 (1945). * * [35 T.C. at 386.]See also Achiro v. Commissioner, 77 T.C. 881">77 T.C. 881 (1981); Rev. Rul. 76-363, 2 C.B. 90">1976-2 C.B. 90; Rev. Rul. 70-238, 1 C.B. 61">1970-1 C.B. 61.In enacting section 931, Congress intended to encourage American business investments in U.S. possessions. Responding to that congressional invitation, petitioner organized Lilly P.R. as a wholly owned Puerto Rican subsidiary qualifying for the tax benefits of section 931. Such action was motivated by 1121 valid business purposes and does not constitute tax avoidance. 57 Accordingly, National Securities Corp. v. Commissioner, supra, and the tax 298 avoidance standard of section 482 are inapplicable. ii. Central Cuba Sugar, Rooney, and Clear Reflection of IncomeCentral Cuba Sugar Co. v. Commissioner, 198 F.2d 214 (2d Cir. 1952), and Rooney v. United States, 305 F.2d 681">305 F.2d 681 (9th Cir. 1962), are typical of the second category of cases noted earlier, i.e., cases in which nonrecognition 299 transfers or property resulted in artificial separations of income from the expenses of earning that income. In each of those cases, the taxpayer transferred a planted crop, together with other assets, to a newly formed corporation in exchange for all the stock of the corporation. 58 The crop was harvested and the profit from the sale of the crop was reported as income by the new corporation. The taxpayer deducted the expenses incurred in growing the crop prior to its transfer and as a result, sustained a net operating loss which it sought to carry back to prior years. In each case, the Court of Appeals upheld the Commissioner's allocation of all the expenses of raising the crop from the taxpayer to the transferee corporation.In Central Cuba Sugar, the Court of Appeals for the Second Circuit rejected the taxpayer's argument that section 482300 was inapplicable in the face of the nonrecognition reorganization provisions. It observed that section 482 had its origin in the consolidated returns provisions, and that consolidation would have shown the income which accrued during the year for the business as a whole. It stated that allocation likewise should be available to dissolve the fiction that one entity was unprofitable, 1122 and that "to achieve 'the rough matching of expenses and income previously attained,' allocation of the expenses to the concern which is to profit by them is the alternative." 198 F.2d at 216; citations omitted. The Ninth Circuit Court of Appeals in Rooney followed suit, concluding that "section 482 * * * will control when it conflicts with section 351 * * * as long as the discretion of the Commissioner in reallocating is not abused." 305 F.2d at 686. Citing Central Cuba Sugar, the Court held that there was no abuse of discretion by the Commissioner.Both Central Cuba Sugar and Rooney dealt with bifurcations of a single taxable year. Both cases involved nonrecognition transfers of unharvested crops to new corporations, with the transferee corporations reporting the crop income and the transferors deducting 301 the crop growing expenses and, consequently, suffering net operating losses. 59302 Both cases also involved transfers which the Courts acknowledged were motivated by valid business reasons. 60 Also, in both it was the subsequent dispositions of the transferred crops by the successor corporations that triggered the application of section 482. In Central Cuba Sugar and Rooney the Courts focused on the timing of the transfers, which, coupled with the taxpayers' methods of accounting for growing crops, bifurcated the taxpayers' taxable years and artificially separated the expenses and the income attributable thereto. The Courts in both cases approved respondent's authority under section 482 to, in essence, ignore the nonrecognition provisions by treating the transferee corporations as having planted and incurred the expenses of growing the crops.Several of the factors mentioned above distinguish those cases from the one before us. In our case, petitioner's transfer of the intangibles in 1966 effected a change of ownership of those intangibles to Lilly P.R. Lilly P.R. did not sell or otherwise dispose of the intangibles in the year of the transfer, 1123 or in any other year, but held them and used them in the active conduct of its business of manufacturing and selling Darvon and Darvon-N products. 61303 It is the income from the conduct of that business in 1971, 1972, and 1973, not the income (or loss) realized upon the disposition of the transferred assets, that respondent is attempting to allocate from Lilly P.R. to petitioner.Respondent's reallocations conflict with a fundamental principle of Federal income tax law: that income from property is earned by the owner of the property. See Helvering v. Horst, 311 U.S. 112">311 U.S. 112 (1940); Blair v. Commissioner, 300 U.S. 5">300 U.S. 5 (1937). This principle is recognized by the regulations under section 482 at section 1.482-1(b)(1), Income Tax Regs. That section provides that "the purpose of section 482 is to place a controlled taxpayer on a parity with an uncontrolled taxpayer by determining * * * the true taxable income from the property and business of a controlled taxpayer." (Emphasis added.) Therefore, the income produced by Lilly P.R. attributable to its use of the transferred property cannot be allocated to petitioner under section 482 because it is income earned by Lilly P.R. from the use of its property in its business.Our conclusion is supported by Bank of America v. United States, an unreported case ( N.D. Cal. 1979, 44 AFTR 2d 79-5013, 79-1 USTC par. 9170). In that case, a wholly owned subsidiary transferred the assets of its foreign branches to its parent bank in consideration for the parent's assumption of the branches' liabilities 304 plus the payment of an additional amount of cash. The transaction qualified for nonrecognition treatment under section 311. The parent bank did not dispose of the branches but continued to operate them. The District Court for the Northern District of California rejected the Commissioner's attempt to allocate income from the parent to the subsidiary under section 482. The Court stated that:No * * distortion of income [is] produced by this transfer which is not sanctioned by section 311. The income from the branches goes to the [parent] instead of to [the subsidiary] but that is because the income producing capital assets were transferred. [44 AFTR 2d at 79-5106, 79-1 USTC par. 9170, at 86,253.]1124 Moreover, we note that nothing in National Securities Corp. v. Commissioner, supra, is to the contrary. In that case, the Commissioner conceded, and the Court concurred, that the subsidiary was entitled to deduct that portion of the loss on the sale of the transferred stock sustained after the section 351 transfer of that stock.Finally, Central Cuba Sugar and Rooney each involved the mismatching of income and expenses occurring within a single taxable year. The mismatching resulted 305 from the transfer of a crop midway through the taxable year. The expenses of growing the crop were paid by the transferor and the transferee had only to sell the crop to realize the income. Respondent argues that petitioner's transfer of the intangibles to Lilly P.R. under section 351 without reimbursement for the expenses incurred in connection with the research and development of Darvon and Darvon-N created a distortion of income. However, no mismatching of income and expenses, as occurred in Central Cuba Sugar and Rooney, resulted from petitioner's 1966 transfer of patents and know-how to Lilly P.R. The income in question was income earned by Lilly P.R., using the patents and know-how in its business during 1971, 1972, and 1973. The only expenses of petitioner even remotely related to that income were the expenditures petitioner incurred in developing the patents and know-how, largely in the 1950s. Those expenditures were incurred by petitioner not only long before the years in issue but also long before the 1966 transfer. Moreover, the net income earned by petitioner from the manufacture and sale of Darvon products during the years prior to the transfer, greatly exceeded 306 petitioner's research and development expenses related to Darvon and Darvon-N products during that period. 62307 Clearly, all expenses related to petitioner's research and development of the Darvon and 1125 Darvon-N intangibles were recovered by petitioner prior to the transfer of those intangibles.In any event, we believe the expenses giving rise to the development of the patents and know-how simply are too remote in time to be matched with the income earned by Lilly P.R. during the years in issue. 63 To attempt to match income and expenses at this point would cause a distortion of petitioner's income no less severe than that which respondent seeks to remedy by his application of section 482. Petitioner's transfer of intangibles to Lilly P.R. did not create a mismatching of income and expenses, and respondent's actions disregarding that transfer were improper.iii. Substance Over FormRespondent maintains that our conclusion would effectively foreclose his application of section 482 whenever a domestic parent transfers property to a subsidiary. Respondent argues that, although he is not attacking the validity of the section 351 transfer, he is authorized by section 482 to allocate the income from the transferred property back to petitioner. In essence, respondent 308 is making the ubiquitous "substance over form" argument: he acknowledges the valid "form" of the transaction but challenges the "substance" thereof because of the alleged income distortion resulting from the transfer. Quoting extensively from Gregory v. Helvering, 293 U.S. 465 (1935), and its progeny, respondent contends that the technical form of a transaction cannot control its true nature where that form does not accord with economic reality.We find that both the form and the substance of petitioner's transfer of assets to Lilly P.R. comported with economic reality. Petitioner transferred patents and know-how to its newly formed subsidiary, Lilly P.R., by its Assignment of Patents and Related Technical Data dated December 5, 1966. Such a transfer of intangibles to a wholly owned subsidiary is a common section 351 transaction. See sec. 1.351-1(a)(2), example (1), Income Tax Regs., relating to a section 351 transfer of a patent, which has been part of the regulations for over 50 years. See art. 1572(c), Regs. 65. As pointed out in Rev. Rul. 64-56, 1964-1 C.B. (Part 1) 133, the establishment of a 1126 new subsidiary to conduct manufacturing operations outside the United States typically 309 involves the transfer of manufacturing intangibles to the subsidiary.Petitioner's assignment transferred ownership of the patents and know-how in substance as well as in form. The assignment was ratified by the boards of directors of petitioner and Lilly P.R. on December 19, 1966. The assignment was recorded in the U.S. Patent Office on February 14, 1969. After the transfer of the patents and know-how on December 5, 1966, and during the years in issue, Lilly P.R. was the only manufacturer of Darvon and Darvon-N products in the United States and Puerto Rico and, therefore, was the only user of the patents and know-how in those locations. Moreover, after the 1966 transfer of the patents and know-how, Lilly P.R. initiated two patent infringement suits in its own name to protect the propoxyphene patent and bore the cost of prosecuting those suits. Under patent law, only the owner of a patent may sue for infringement of that patent. Waterman v. Mackenzie, 138 U.S. 252">138 U.S. 252 (1891).Additionally, respondent's argument, that petitioner, having originally developed the patents and know-how, is forever required to report the income from those intangibles, is without merit. Respondent ignores 310 the fact that petitioner, as developer and owner of the intangible property, was free to and did transfer the property to Lilly P.R. in 1966. Respondent's case actually is based upon his belief that because petitioner could have retained the ownership of the patents and know-how and realized all the income attributable thereto, petitioner's transfer of the ownership of the patents and know-how can be ignored for income tax purposes. That argument was rejected by this Court 40 years ago. In overturning a section 482 allocation in Seminole Flavor Co. v. Commissioner, 4 T.C. 1215">4 T.C. 1215, 1235 (1945), we stated:Actually, the principal force behind all of the Commissioner's argument is that the petitioner could as well have done all the things that the partnership did and reaped all of the earnings of the related enterprises. Since petitioner could have had the earnings, the Commissioner would make it so by exercising the authority conferred by [the predecessor of section 482]. The same type of argument was made in the Koppers case, supra, which rejected the argument in language equally apt to the present contention * *1127 "The answer to this argument is that petitioner did not do this. It 311 was free to and did use its funds for its own purposes. It was under no obligation to so arrange its affairs and those of its subsidiary as to result in a maximum tax burden. On the other hand, it had a clear right by such a real transaction to reduce that burden."[Emphasis added and citations omitted.]The above reasoning in Seminole Flavor has been consistently applied in later cases. See Hospital Corp. of America v. Commissioner, 81 T.C. 520">81 T.C. 520, 583 (1983); Polak's Frutal Works, Inc. v. Commissioner, 21 T.C. 953">21 T.C. 953, 976 (1954). Accordingly, we will not disregard petitioner's transfer of the intangibles to Lilly P.R. on the basis of substance over form.b. Arm's-Length ConsiderationNotwithstanding the fallacies of respondent's other arguments, 64313 he is authorized under section 482 to make allocations between petitioner and Lilly P.R. if necessary clearly to reflect their respective incomes. Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182">435 F.2d 182 (7th Cir. 1970). Respondent argues that petitioner's transfer of valuable income-producing intangibles under section 351 to Lilly P.R., without receiving arm's-length consideration as defined under section 1.482-2(d)(2), Income Tax Regs., 312 for such intangibles, created a distortion of income. On the other hand, petitioner contends that section 351 permits a tax-free transfer of the intangibles, and that any distortion which results was contemplated and authorized by Congress.Although we agree with petitioner that the purpose of section 351 is to facilitate the incorporation of businesses, 65314 we 1128 recognize that section 482 authorizes respondent to make allocations among related taxpayers clearly to reflect income even in the context of a nonrecognition provision. However, the mere existence of a section 351 transfer of property does not, per se, require a section 482 allocation by respondent. Accordingly, we must decide whether the prices Lilly P.R. charged petitioner for Darvon and Darvon-N products during 1971, 1972, and 1973 caused an unclear reflection of income. For the reasons set forth below, we believe they did. Respondent maintains that, because petitioner did not receive arm's-length consideration as defined in section 1.482-2(d)(2), Income Tax Regs., in exchange for its transfer of the propoxyphene and napsylate patents in 1966, he can totally disregard the transfer in making pricing allocations for the years in issue. In support of his argument, respondent relies on section 1.482-2(d), Income Tax Regs., which specifically addresses the transfer of intangible property to a related party for other than an arm's-length consideration. Section 1.482-2(d)(1)(i), Income Tax Regs., provides:(d) Transfer or use of intangible property. -- (1) In general. (i) Except as otherwise provided in subparagraph (4) of this paragraph, where intangible property or an interest therein is transferred, sold, assigned, loaned, or otherwise made available in any manner by one member of a group of controlled entities (referred to in this paragraph as the transferor) to another member of the group (referred to in this paragraph as the transferee) for other than an arm's length consideration, the district director may make appropriate 315 allocations to reflect an arm's length consideration for such property or its use. Subparagraph (2) of this paragraph provides rules for determining the form an amount of an appropriate allocation, subparagraph (3) of this paragraph provides a definition of "intangible property", and subparagraph (4) of this paragraph provides rules with respect to certain cost-sharing arrangements in connection with the development of intangible property. For purposes of this paragraph, an interest in intangible property may take the form of the right to use such property. [Emphasis added.]Section 1.482-2(d)(2)(i), Income Tax Regs., defines arm's-length consideration as royalties, lump-sum payments, or any other form, including reciprocal licensing agreements, consistent with the form adopted by unrelated parties. 66316 Although 1129 respondent may have utilized this regulation to impute a royalty or lump-sum payment from Lilly P.R. to petitioner, he chose not to do so. Instead, respondent argues that the regulation supports his disregarding completely the 1966 transfer in determining arm's-length prices during 1971, 1972, and 1973. With this we disagree. Respondent has no authority under section 1.482-2(d), Income Tax Regs., to disregard completely the 1966 transfer. We emphasize that respondent is not attempting to impose a royalty or lump-sum payment upon Lilly P.R. under this 317 regulation. Were he to do so, he most certainly would recognize the transfer and allow Lilly P.R. a return on the manufacturing intangibles after payment of the royalties or lump sum. Indeed, both parties agree that this is a pricing case and that, for purposes of determining arm's-length prices, section 1.482-2(e), Income Tax Regs., controls. Accordingly, we believe that respondent's use of section 1.482-2(d), Income Tax Regs., to disregard completely petitioner's transfer of intangibles is inappropriate. We do believe, however, that the lack of a royalty, lump-sum payment, or bona fide cost-sharing arrangement is a relevant factor to be considered in determining arm's-length prices between Lilly P.R. and petitioner during 1971, 1972, and 1973.Although we reject respondent's argument that the ownership of the intangibles should be disregarded in making pricing allocations, we agree with him that, during the years in issue, there was a distortion of petitioner's income warranting reallocations of income from Lilly P.R. to petitioner.The distortion of income in this case was caused primarily because petitioner's transfer of the intangibles to Lilly P.R., without receiving arm's-length 318 consideration as defined in the regulations under section 482, enabled it, through the mechanism of intercorporate pricing, to shift profits to Lilly P.R. 1130 Petitioner, a pharmaceutical company, competes in a research-intensive industry and spends a substantial amount of its annual budget on ongoing research and development. Such expenditures yield relatively few marketable products. Pharmaceutical companies, including petitioner, are dependent upon the profits derived from the few marketable products they invent to fund their current research and development functions. In the instant case, the prices petitioner paid Lilly P.R. for the Darvon and Darvon-N products did not enable petitioner to realize sufficient profit to fund a proportionate share of its ongoing research and development expenses. Had petitioner been dealing with an unrelated third party at arm's length, the fact that it did not receive arm's-length consideration for the transfer of the intangibles would have been reflected in lower prices from the transferee to petitioner, thus permitting petitioner to realize more profit. That this is true is illustrated by the testimony of respondent's expert accounting witness, 319 Dr. James Wheeler. Dr. Wheeler testified that, if petitioner had transferred to Lilly P.R. the rights to manufacture its nine most profitable products and had purchased those products from Lilly P.R. at prices consistent with the prices it paid for the Darvon and Darvon-N products, petitioner would have been operating at a loss.It is inconceivable that petitioner, negotiating at arm's length, would have transferred valuable income-producing intangibles without a royalty, lump-sum payment, or other agreement that would enable petitioner to continue its general research and development activities. In the absence of such an agreement, petitioner was able to structure its pricing so as to divert needed profits to Lilly P.R. Accordingly, we must conclude that the prices petitioner paid Lilly P.R. did cause a distortion of income which respondent may correct by making appropriate allocations under the authority of section 482. We must now determine whether respondent's allocations are arbitrary, capricious, or unreasonable.Issue 2. Respondent's Section 482 AdjustmentsSection 482 gives respondent authority to allocate income between or among related corporations when necessary to prevent 320 the evasion of taxes or clearly to reflect the income of such corporations. The purpose of section 482 is to place a 1131 controlled taxpayer on a tax parity with an uncontrolled taxpayer. See sec. 1.482-1(b)(1), Income Tax Regs.Respondent's determination as set forth in the notice of deficiency is presumptively correct, and the burden of disproving that determination lies with petitioner. Rule 142(a), 68Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933). The burden of proving the increases in deficiencies alleged in the amended answer, however, is on respondent. Rule 142(a).In addition to the general presumption of correctness that attaches to respondent's determination, respondent has broad discretion in his application of section 482 ( Spicer Theatre, Inc. v. Commissioner, 346 F.2d 704">346 F.2d 704, 706 (6th Cir. 1965), affg. 44 T.C. 198">44 T.C. 198 (1964)), so that his determination will be upheld unless petitioner proves it to be arbitrary, capricious, or unreasonable. 69 See, e.g., Phillip Bros. Chemicals, Inc. (N.Y.) v. Commissioner, 435 F.2d 53">435 F.2d 53, 57 (2d Cir. 1970), affg. Phillip Bros. Chemicals, Inc. (Md.) v. Commissioner, 52 T.C. 240 (1969); 321 Ach v. Commissioner, 42 T.C. 114">42 T.C. 114, 125-126 (1964), affd. 358 F.2d 342">358 F.2d 342 (6th Cir. 1966); Grenada Industries, Inc. v. Commissioner, 17 T.C. 231">17 T.C. 231, 255 (1951), affd. 202 F.2d 873">202 F.2d 873 (5th Cir. 1953); National Securities Corp. v. Commissioner, 46 B.T.A. 562">46 B.T.A. 562, 565 (1942), affd. 137 F.2d 600">137 F.2d 600 (3d Cir. 1943). Our decision as to whether or not respondent has exceeded or abused his discretion turns upon questions of fact. See, e.g., Ballentine Motor Co. v. Commissioner, 324 F.2d 796">324 F.2d 796 (4th Cir. 1963), affg. 39 T.C. 348">39 T.C. 348 (1962); American Terrazzo Strip Co. v. Commissioner, 56 T.C. 961">56 T.C. 961 (1971).Should petitioner prove respondent's determination to be arbitrary, capricious, or unreasonable, the general presumption of correctness no longer applies. See, e.g., Woodward Governor Co. v. Commissioner, 56">55 T.C. 56 (1970). Petitioner also may overcome the presumption by introducing sufficient evidence proving that the transactions in issue 322 satisfied the arm's-length standard of section 482. In the event that petitioner does overcome respondent's presumption of correctness and disproves the deficiencies set forth in the statutory notice, we must determine from the record before us the 1132 proper allocations, if any, of income between petitioner and Lilly P.R. See Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601">42 T.C. 601, 617 (1964): Ach v. Commissioner, supra.As we stated in Nat Harrison, "this Court may allocate income under the statute in a manner the evidence before us demonstrates to be correct and * * * respondent's allocation need not be approved or disapproved in toto." 42 T.C. at 617-618.Petitioner argues that, because respondent has espoused different section 482 determinations supported by totally disparate methodologies, respondent's determinations are arbitrary, capricious, and unreasonable. We disagree.In the notice of deficiency, respondent's determination was based upon a method which allowed Lilly P.R. its cost of goods sold, location savings, and a gross profit for each of the Mayaguez and Carolina manufacturing facilities. In his amended answer, respondent asserted increased deficiencies by eliminating 323 the intra-company profit on the transfer of chemicals from the Mayaguez to the Carolina facility and allowing Lilly P.R. a gross profit equal to 30 percent of manufacturing costs and location savings. At trial, respondent relied on his expert witness Dr. William S. Comanor who did not testify regarding the methods used in the notice of deficiency or amended answer. Instead, Dr. Comanor used two other methods for allocating income which involved averages of third-party prices and gross profits.There are often occasions when, in order to protect the revenue, respondent must make alternative determinations. Nat Harrison Associates, Inc. v. Commissioner, supra at 617. Moreover, as respondent's counsel argued at trial, to lock him into one exact methodology or calculation would require the Service to retain an expert at the time of mailing the deficiency notice, a requirement which would effectively preclude it from ever using outside experts. Accordingly, we do not think that because respondent made alternative determinations supported by differing methodologies, his actions were arbitrary, capricious, or unreasonable. See Nat Harrison Associates, Inc. v. Commissioner, supra.Thus, 324 the presumption of correctness would not be lost for that reason, alone.Although we do not take issue with respondent's conclusion that, during the years in issue, there was a distortion of income justifying some reallocation, we do disagree with 1133 respondent's determination of the amount of income to be allocated. In making the various allocations of income from Lilly P.R. to petitioner, respondent never permitted Lilly P.R. any income attributable to the manufacturing intangibles 70 which it owned and utilized in the manufacture of the Darvon and Darvon-N products. Because we have found Lilly P.R. is entitled to the income attributable to those intangibles, we must conclude that respondent's determination, which denied Lilly P.R. any income from the manufacturing intangibles, was unreasonable. Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182">435 F.2d 182, 187 (7th Cir. 1970); American Terrazzo Strip Co. v. Commissioner., 56 T.C. 961">56 T.C. 961, 973 (1971); P.P.G. Industries, Inc. v. Commissioner, 55 T.C. 928">55 T.C. 928, 993 (1970); Nat Harrison Associates, Inc. v. Commissioner, supra at 617-618; Seminole Flavor Co. v. Commissioner, 4 T.C. 1215">4 T.C. 1215, 1235 (1945). We must therefore make a determination of the 325 proper allocation of income from Lilly P.R. to petitioner, without the benefit of any presumptions, in a manner the evidence before us demonstrates to be correct. American Terrazzo Strip Co. v. Commissioner, supra;Nat Harrison Associates, Inc. v. Commissioner, supra;Ach v. Commissioner, supra at 126.Issue 3. Determination of Arm's-Length Prices Between Petitioner and Lilly P.R.We turn now to the third and final issue of this case: whether Lilly P.R.'s prices to petitioner for the Darvon and Darvon-N products sold by it during the years in question were prices at which those products would have been sold between unrelated parties dealing at 326 arm's length. We have found that Lilly P.R. is the owner of, and entitled to, the income from the manufacturing intangibles. Consequently, we must determine the applicable arm's-length prices from all the evidence submitted by the parties, and, if necessary, we may make our own best estimate as to the proper amounts under the principles of Cohan v. Commissioner, 39 F.2d 540">39 F.2d 540 (2d Cir. 1930), 1134 modifying 11 B.T.A. 743">11 B.T.A. 743 (1928). See Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601">42 T.C. 601 (1964); Ach v. Commissioner, 42 T.C. 114">42 T.C. 114 (1964).A. Section 482 Regulations1. 1971 and 1972 Taxable YearsSection 1.482-2(e)(1)(i), Income Tax Regs., provides that, when one controlled entity sells tangible property to another controlled entity at "other than an arm's length price," respondent may "make appropriate allocations between the seller and the buyer to reflect an arm's length price for such sale." An "arm's length price" for purposes of that section is defined as:the price that an unrelated party would have paid under the same circumstances for the property involved in the controlled sale. Since unrelated parties normally sell products at a profit, an arm's length price normally involves a 327 profit to the seller. [Sec. 1.482-2(e)(1)(i), Income Tax Regs.]The regulations set forth three detailed methods for determining an arm's-length price: the comparable uncontrolled price method, the resale price method, and the cost plus method. Sec. 1.482-1(e)(1)(ii), Income Tax Regs. A fourth method is provided by the following language in section 1.482-2(e)(1)(iii), Income Tax Regs.:Where the standards for applying one of the three methods of pricing * * are met, such method must, for the purposes of this paragraph, be utilized unless the taxpayer can establish that, considering all the facts and circumstances, some method of pricing other than those described * * * is more appropriate. Where none of the three methods of pricing * * * can reasonably be applied under the facts and circumstances as they exist in a particular case, some appropriate method of pricing other than those described * * , or variations on such methods, can be used. [Emphasis added.]Petitioner argues that the prices charged it by Lilly P.R. for the years 1971 and 1972 satisfy the resale price method or a variation of such method. Respondent, apart from his other arguments concerning his own pricing formulas 328 (which, as we already have held, erroneously failed to allocate any income 1135 attributable to the manufacturing intangibles to Lilly P.R.), 71329 argues that the 1971 and 1972 prices did not satisfy the resale price method because the appropriate markup was determined by reference to petitioner's own sales of other products. Respondent also alleges that petitioner's allocations of income and expenses between petitioner and Lilly P.R. with respect to Darvon and Darvon-N products were erroneous. For the reasons stated below, we agree with respondent. a. Pricing MethodsSection 1.482-2(e)(1)(ii), Income Tax Regs., establishes a priority for the application of the pricing methods listed above. The comparable uncontrolled price method is the most accurate of the methods, and is to be used whenever there are "comparable uncontrolled sales." Comparable uncontrolled sales are sales of the same or substantially identical property between uncontrolled buyers and sellers. Sec. 1.482-2(e)(2), Income Tax Regs. The resale price method is to be used if there are no comparable uncontrolled sales. Sec. 1.482-2(e)(1)(ii), Income Tax Regs. That method involves calculating an appropriate markup by which the resale price to an uncontrolled buyer is reduced to find the arm's-length 330 price for the controlled sale. Sec. 1.482-2(e)(3), Income Tax Regs.The cost plus method starts from the other end. Instead of reducing the sales price of the reseller (marketing company) by an appropriate markup, the cost plus method requires the determination of an appropriate gross profit, which is added to the seller's (manufacturer's) cost of producing such property. Sec. 1.482-2(a)(4), Income Tax Regs.If none of the above methods is viable under the facts of a particular case, a fourth "appropriate" method may be used. Sec 1.482-2(e)(1)(iii), Income Tax Regs.1136 i. Comparable Uncontrolled Price MethodDuring the years 1971 and 1972, there were no comparable uncontrolled sales of Darvon and Darvon-N products in the United States. Because of the existence of the propoxyphene and napsylate patents, no one other than Lilly P.R. could manufacture or sell Darvon or Darvon-N products in the United States. 72 Although the record does disclose that sales of propoxyphene in bulk form took place outside the United States in markets that were not covered by U.S. patent protection, those sales were not comparable uncontrolled sales because they occurred in a different, unprotected market. 331 Moreover, no sales were found of the final dosage form of the product at a comparable distribution level. During the years in issue, Darvon and Darvon-N products were among the 10 largest selling ethical pharmaceutical products in the United States. Darvon and Darvon-N products were prescribed for the relief of mild to moderate pain, and their principal competitors were combinations of codeine with either aspirin or acetaminophen. Those combinations were not substantially identical to Darvon and Darvon-N products. Therefore, no comparable uncontrolled sales of Darvon and Darvon-N products are available for 1971 and 1972.ii. Resale Price MethodThe next pricing method prescribed by the regulations under section 482 is the resale 332 price method. The regulations provide that the arm's-length price of a controlled sale determined using the resale price method is equal to "the applicable resale price * * * reduced by an appropriate mark-up" ( sec. 1.482-2(e)(3)(i), Income Tax Regs.), and adjusted "to reflect any material differences between the uncontrolled purchases and resales used as the basis for the calculation of the appropriate markup percentages and the resales of property involved in the controlled sale. The differences referred to * * * are those differences in functions or circumstances 1137 which have a definite and reasonably ascertainable effect on price." Sec. 1.482-2(e)(3)(ix), Income Tax Regs.The "'applicable resale price' is the price at which it is anticipated that property purchased in the controlled sale will be resold by the buyer in an uncontrolled sale. The 'applicable resale price' will generally be equal to either the price at which current resales of the same property are being made or the resale price of the particular item of property involved." Sec. 1.482-2(e)(3)(iv), Income Tax Regs. In this case, the applicable resale price is petitioner's sales price to its unrelated customers, i.e., 333 its wholesale distributors. The "appropriate markup" is the gross profit, expressed as a percentage of sales, "earned by the buyer (reseller) or another party on the resale of property which is both purchased and resold in an uncontrolled transaction, which resale is most similar to the applicable resale of the property involved in the controlled sale." Sec. 1.482-2(e)(3)(vi), Income Tax Regs.Prior to the publication of the regulations under section 482, petitioner adopted an approach similar to the resale price method by attempting to measure an appropriate margin to petitioner for the resale of Darvon and Darvon-N products and by calculating that margin as a percentage discount from petitioner's net wholesale prices. Petitioner contends that the discounts granted by Lilly P.R. to petitioner were comparable to discounts which would have prevailed had the parties been unrelated and dealing at arm's length. Petitioner thus asserts that the discounts constituted an appropriate markup within the meaning of the resale price method.In support of its position, petitioner submitted the testimony of three economic experts: Dr. Yale Brozen of the University of Chicago Graduate School of 334 Business, and Drs. William J. Baumol and Charles H. Berry of Princeton University. Respondent submitted the testimony of economic expert Dr. William S. Comanor of the University of Southern California at Santa Barbara. We found all these individuals qualified in the field of economics for the purposes of rendering expert opinions.Petitioner's economic experts were retained in this case to analyze the intercompany transfer pricing arrangement between petitioner and Lilly P.R. The experts testified individually, but they submitted a joint report stating their group 1138 analyses and conclusions. Unless otherwise indicated, we will refer to petitioner's economic experts, Drs. Brozen, Baumol, and Berry, in the collective.Petitioner's experts concluded that the transfer prices charged by Lilly P.R. for its Darvon and Darvon-N products during 1971 and 1972 were considerably less than the transfer prices that would have been charged between unrelated parties. 73335 Petitioner's experts also concluded that the transfer prices proposed by respondent were undefensibly low and completely unrelated to prices that would have been charged by parties dealing at arm's length.For 1971 and 1972, petitioner's experts were unable to locate any reasonably comparable uncontrolled transactions involving similar products to determine an arm's-length price. They thus concluded that an arm's-length price should be determined by reference to the profit generating assets and activities of each of the related companies. The assets and activities relative to Darvon and Darvon-N products considered by the experts were as follows:PetitionerLilly P.R.1.Market activity and1.Manufacturing activity andtangible assetstangible manufacturing assets2.Intangible assets2.Intangible assetsa.Petitioner's namea.Propoxyphene patent -- expiredat end of 1972b.Petitioner's marketingb.Napsylate patentorganizationc.Marketing know-howc.Process know-howd.Darvon and Darvon-Nd.Formula know-howtrademarksPetitioner's experts correctly viewed the ownership of the manufacturing intangibles as an important factor in determining an arm's-length 336 price. For the purposes of their analyses, the experts assumed that Lilly P.R. was the owner of the propoxyphene and napsylate patents during 1971 and 1972, and that petitioner was the owner of the Darvon and Darvon-N trademarks. Based on those assumptions, however, petitioner 1139 could not have sold propoxyphene products under the Darvon and Darvon-N trademarks in 1971 and 1972 unless it had purchased those products from Lilly P.R. If petitioner had been unable to use the Darvon and Darvon-N trademarks in 1971 and 1972, petitioner's economic experts concluded that the value of those trademarks would have fallen substantially. In other words, the experts concluded that the intangible value was attributable primarily to the propoxyphene and napsylate patents because the initial transfer of the patents to Lilly P.R. must have carried with it the right and the power to acquire all foreseeable propoxyphene profits.Viewed from another perspective, if Lilly P.R. had sold its propoxyphene products to another pharmaceutical company for distribution in the United States in 1971 and 1972, that other company could have established a new trademark for Lilly P.R.'s propoxyphene products in a market 337 environment protected by Lilly P.R.'s propoxyphene and napsylate patents from the competition of petitioner's Darvon and Darvon-N trademarks. Accordingly, in the opinion of the economic experts, the value of petitioner's Darvon and Darvon-N trademarks was minimal during the years 1971 and 1972, and the bulk of the profit contribution of intangibles related to propoxyphene products in 1971 and 1972 was attributable to the propoxyphene and napsylate patents and the other manufacturing intangibles owned by Lilly P.R.Because the experts believed the Darvon and Darvon-N trademarks had no especially significant independent value in 1971 and 1972, they estimated an arm's-length price to petitioner in those years on the basis of the profit contribution of petitioner's marketing activities and intangible marketing assets.Petitioner's economic experts concluded that the contribution of petitioner's intangible assets and activities related to the marketing of Darvon and Darvon-N products could best be estimated by reference to the price that petitioner would have been willing to pay Lilly P.R. for the right to market those products in the United States under the circumstances of this case. They 338 believed that in arm's-length negotiations with Lilly P.R., petitioner would have been willing to pay Lilly P.R. a price that produced a return on its resources devoted to marketing Darvon and Darvon-N products equal to what it 1140 could have earned by devoting those resources to the marketing of other products. To measure that return, the experts concluded that the opportunity cost to petitioner of marketing Darvon and Darvon-N products could be determined by looking at the profitability of the other products that petitioner could have promoted during the years 1971 and 1972 and, further, that the profitability of petitioner's nine leading products provided the best estimate of the maximum opportunity cost of marketing Darvon and Darvon-N products.Petitioner's nine leading products in 1972 were (1) Keflin Registered TM, (2) Keflex, (3) Ilosone, (4) Iletin Registered TM (including Dymelor Registered TM and Tes-Tape Registered TM, (5) Loridine Registered TM, (6) V-Cillin-K Registered TM, (7) Cordran Registered TM and Cordran-N Registered TM, (8)Mi-Cebrin Registered TM and Mi-Cebrin T Registered TM, and (9) Trinsicon Registered TM.Petitioner's economic experts examined the profitability 339 to petitioner of those products for the period 1964 through 1973. Because petitioner, with one exception, both manufactured and sold the nine leading products, 74 in order to determine the price at which the experts believed it would have been willing to market those products, a "purchase price" had to be established. The experts established that purchase price by treating petitioner's manufacturing cost as the price to petitioner's pharmaceutical marketing division.The economic experts' initial comparison of petitioner's nine leading products with Darvon and Darvon-N products indicated that the ratio of operating income to operating expense for Darvon and Darvon-N products was 151 percent, but that the ratio of operating income to operating expense for the nine leading products was 144 percent. Thus, the marketing of Darvon and Darvon-N products in 1971 and 1972 was about as profitable to petitioner as the marketing of the nine leading products during that same period. Petitioner's economic experts concluded that their analysis of the nine leading products 340 provided an appropriate evaluation of all the assets owned and activities performed by petitioner in connection with the marketing of Darvon and Darvon-N products. The nine leading products were promoted by the same detail force that promoted the Darvon and Darvon-N products; they were all sold under the "Eli Lilly and Company" trade name using 1141 petitioner's marketing organization and marketing know-how; and each of the nine leading products had its own distinctive trademark.The economic experts concluded that the comparison of operating income to operating expense, however, clearly overstated the profit attributable solely to the marketing activities devoted to the nine leading products. The operating income figures for the nine leading products included profits attributable to petitioner's capital investment, manufacturing know-how, and patent rights associated with those products. In the case of Darvon and Darvon-N products, however, the profits attributable to the manufacturing activities and the corresponding manufacturing intangibles belonged to Lilly P.R. Petitioner's experts made a conservative adjustment to the operating incomes of the nine leading products to take into 341 account the profits attributable to manufacturing costs and manufacturing intangibles: 30 percent of manufacturing costs and a 5-percent royalty for manufacturing intangibles. This resulted in a ratio of operating income to operating expense for the nine leading products of 99 percent.Considering the fact that the nine leading products were petitioner's most profitable products, it was the economic experts' view that it would be more realistic to attribute a profit of 100 percent of manufacturing costs for manufacturing activity and a royalty of 10 percent of net sales for manufacturing intangibles with the remaining profit being attributable to the marketing of the product. If those adjustments were made, the calculation of the nine leading products reduced the figure of operating income to operating expense still further to 15 percent.On the basis of that analysis, the economic experts concluded that Lilly P.R.'s transfer prices for Darvon and Darvon-N products in 1971 and 1972 were not only within the range of arm's-length prices but that petitioner earned significantly more profit from the marketing of those products in 1971 and 1972 than it could have earned by directing its 342 resources to its other leading products. Thus, the experts concluded that Lilly P.R.'s transfer prices for 1971 and 1972 were clearly lower than arm's-length prices for those years.Petitioner's economic experts tested the results of their analysis by using several other approaches to valuing the 1142 manufacturing intangibles owned by Lilly P.R. in 1971 and 1972. 75 Each of those approaches produced an estimation of the profit contribution of the manufacturing intangibles owned by Lilly P.R. ranging between 30 percent and 50 percent of petitioner's sales of Darvon and Darvon-N products in 1971 and 1972. Petitioner 343 asserts that the approach taken by its economic experts tracks the methodology laid down by the section 482 regulations' resale price method. Petitioner argues that, because no comparable uncontrolled sales existed, its experts determined that the next best approach to estimating an arm's-length price would be to determine the price (or absent a price, the margin) at which petitioner would be willing to market the products produced by Lilly P.R., and that that approach was the equivalent of a resale price approach focusing on the gross margin and net profit of the reseller.Petitioner argues that, by choosing petitioner's nine leading products for comparison with Darvon and Darvon-N, its experts followed the mandate of the regulations to focus on transactions, if possible, of the specific reseller involved in the controlled transaction (in this case, petitioner). See sec. 1.482-2(e)(3)(vii), Income Tax Regs. Petitioner argues further that, by focusing on those other products of petitioner, the experts were able to neutralize completely the significance of the marketing intangibles on the sale of the Darvon and Darvon-N products because petitioner sold all the nine leading products 344 using its Eli Lilly & Co. trade name, and promoted those products by its marketing force to the same customers through the same distribution channels. In addition, each of the nine leading products had its own distinctive trademark.On the other hand, respondent maintains that the approach taken by petitioner's economic experts does not satisfy the resale price method of section 1.482-2(e)(3), Income Tax Regs., because petitioner's nine leading products were not purchased by petitioner in uncontrolled sales. Moreover, because the 1143 regulations provide a listing of the methods to be used in pricing cases in strict order of their priority, respondent argues that the next method, the "cost plus" method, must be used before any variation on the resale price method can be utilized. Accordingly, respondent argues that petitioner's attempted use of the resale price method is in error in this case. Apart from that "initial obstacle," respondent also finds fault with the assumptions made by the experts regarding the constructed purchase prices for the nine leading products, and with the operating income to operating expense ratios as calculated from petitioner's statements and records. We 345 will address respondent's arguments in turn.Respondent correctly challenges the use of the resale price method based solely on evidence of internal transactions of the reseller. Section 1.482-2(e)(3), Income Tax Regs., determines the arm's-length price of property in a controlled sale by reducing the reseller's price of the property to an uncontrolled buyer by an "appropriate markup." Subdivision (vi) of that section clearly requires that the appropriate markup percentage be calculated using gross profit percentages earned by a reseller "on the resale of property which is both purchased and resold in an uncontrolled transaction." (Emphasis added.) The regulations state elsewhere their basic assumption that uncontrolled purchases and sales must be used under the resale price method. Sec. 1.482-2(e)(3)(vii), Income Tax Regs., states as follows:Whenever possible, markup percentages should be derived from uncontrolled purchases and resales of the buyer (reseller) involved in the controlled sale. * * * [Emphasis added.]Section 1.482-2(e)(3)(viii), Income Tax Regs., provides:In calculating the markup percentage earned on uncontrolled purchases and resales * * * the same elements which 346 enter into the computation of the sales price and the costs of goods sold of the property involved in the comparable uncontrolled purchases and resales should enter into such computation in the case of the property involved in the controlled purchases and resales. * * [Emphasis added.]And, finally, section 1.482-2(e)(3)(ix), Income Tax Regs., states:In determining an arm's length price appropriate adjustment must be made to reflect any material differences between the uncontrolled purchases 1144 and resales used as the basis for the calculation of the appropriate markup percentage and the resales of the property involved in the controlled sale. * * [Emphasis added.]We recognize that there simply were no similar uncontrolled purchases and resales in 1971 or 1972. 76348 Because of petitioner's failure to establish similar uncontrolled sales, the resale price method cannot be utilized to determine arm's-length prices. Subsequent case law confirms our literal reading of the regulation. In Lufkin Foundry & Machine Co. v. Commissioner, 468 F.2d 805 (5th Cir. 1972), revg. a Memorandum Opinion of this Court, 77 a machine manufacturing corporation sold its machinery to various wholly owned 347 subsidiaries for resale throughout the Western Hemisphere, exclusive of the United States. The prices it charged the subsidiaries were based on discounts from list prices, as well as on commissions on net invoice prices. The Commissioner, exercising his power under section 482, allocated to the parent 50 percent of the discounts given and 50 percent of the commissions paid to the subsidiaries. In this Court, the parent introduced evidence of the reasonableness of the discounts and commissions prepared by an independent certified public accountant using data from the parent's own internal marketing arrangements. We held that the evidence was sufficient to overcome the Commissioner's presumption of correctness and, because he had failed to introduce any evidence on his own behalf, that the Commissioner had abused his discretion in making the above allocations.Citing section 1.482-2(e), Income Tax Regs., the Court of Appeals for the Fifth Circuit reversed. In holding that evidence of the transactions of uncontrolled parties is necessary to determine an arm's-length price, the Court stated:1145 No amount of self-examination of the taxpayer's internal transactions alone could make it possible to know what prices or terms unrelated parties would have charged or demanded. We think it palpable that if the standard set by these unquestioned regulations is to be met evidence of transactions between uncontrolled corporations unrelated to Lufkin must be adduced in order to determine what charge would have been negotiated for 349 the performance of such marketing services. [468 F.2d at 808.]The method of determining arm's-length prices employed by petitioner's experts thus fails to satisfy the resale price method. Petitioner contends in the alternative that the methodology used by its economic experts was a permissible variation of the resale price method which was required by the particular facts of this case. Petitioner argues that, although the regulations under the resale price method call for the establishment of an appropriate markup using the actual purchases and resales of comparable property, there is no reason why this markup could not be arrived at by an analysis of the profit of products manufactured and sold, rather than of products purchased and sold. Furthermore, petitioner maintains that, although the regulations outline three methods valid in the order in which they are prescribed, the evidentiary rules for establishing any method should be applied flexibly by the Court citing United States Steel Corp. v. Commissioner, 617 F.2d 942">617 F.2d 942 (2d Cir. 1980), revg. two Memorandum Opinions of this Court. We do not agree.Unquestionably, there are problems with applying the regulations as they stand 350 today; 78 however, to approve the use of variations of the methods within their order merely would add to the problems and confusion surrounding intercompany pricing. In addition, adopting such an approach would render the delineation of each method, and its order of priority, meaningless. Moreover, neither the Commissioner nor the taxpayers would have an objective means of determining whether or not one of the three methods applied.iii. Cost Plus MethodBecause the facts of the case before us do not lend themselves 1146 to application of the resale price 351 method, the next method to be examined is the cost plus method described in section 1.482-2(e)(4), Income Tax Regs.The cost plus method, as previously described, is equal to the cost of producing the property plus an appropriate profit computed with reference to uncontrolled sales of similar property. It is this method that respondent urges upon us, and towards which his notice of deficiency, amendment to answer, and experts' testimony and reports are directed.Respondent's notice of deficiency and amendment to answer used a pricing formula allowing Lilly P.R. its manufacturing cost and location savings plus a manufacturing profit. 79 Respondent's calculations, however, do not allocate to Lilly P.R. any of the income associated with its manufacturing intangibles.Respondent's expert economic witness, Dr. William S. Comanor, examined the "functions" performed by petitioner and Lilly P.R. and attempted to determine an allowable level of profits based on those functions. Dr. Comanor used two separate 352 methods to determine what he believed to be acceptable profits for Lilly P.R. His first method observed certain third-party prices for the sale of propoxyphene products which occurred during 1973. Based on those observations, Dr. Comanor determined a weighted average for the market prices and then determined the percent differential between those prices and the ones charged by Lilly P.R. to petitioner. Based on that percent differential, he thus determined the amounts of profit reported by Lilly P.R. which were, in his opinion, in excess of the profits that would have been earned by it had the parties been unrelated.Dr. Comanor's second method compared Lilly P.R.'s reported gross profits with the gross profits earned by three unrelated pharmaceutical companies deemed comparable by Dr. Comanor. Dr. Comanor determined an average gross profit margin for all three companies for each of the years 1971, 1972, and 1973, and, based on those averages, he recalculated the amount of gross profits realized by Lilly P.R. as a result of its dealings with petitioner. 1147 Dr. Comanor's pricing methods do not provide Lilly P.R. with any income from the patents and manufacturing know-how, something 353 we have held necessary in this case. This Court is not bound by the testimony of an expert witness and must reject such testimony where the witness overlooked a significant factor in reaching his conclusion. See South Texas Rice Warehouse Co. v. Commissioner, 366 F.2d 890">366 F.2d 890, 898 (5th Cir. 1966), affd. 43 T.C. 540">43 T.C. 540 (1965). Moreover, after observing Dr. Comanor's demeanor on the witness stand, we must substantially discount his report and testimony. We therefore reject Dr. Comanor's pricing methods with respect to the 1971 and 1972 taxable years.The regulations under section 482 were promulgated for the purpose of providing specific guidelines and a degree of certainty to the realm of intercompany pricing. 31 Fed. Reg. 10394 (1966). Such purpose would be ill-served by our use of the cost plus method herein. There is no evidence in the record (other than petitioner's attempt in 1972 to value the napsylate patent) (see page 1080), concerning the value of the manufacturing intangibles. Petitioner's economic experts assigned a possible royalty value to the napsylate patent for 1973, but did not state how they arrived at their figure or what their qualifications for valuing a pharmaceutical 354 patent were. Respondent has not suggested any method whereby we could allocate income attributable to the intangibles to Lilly P.R. while using the cost plus method to determine arm's-length prices for the Darvon and Darvon-N products it sold. Our use of the cost plus method in such circumstances is unwarranted and we decline to use it. 80b. Profit Split ApproachWe have rejected the pricing methods and conclusions advocated by petitioner's and respondent's expert witnesses, and have found the use of all three pricing methods specified by the regulations under section 482 to be inappropriate. However, based upon the evidence before us, we must determine arm's-length prices for the Darvon and Darvon-N products purchased by petitioner from Lilly P.R. during 1971 and 1148 1972. American Terrazzo Strip Co. v. Commissioner, 56 T.C. 961">56 T.C. 961, 973 (1971); Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601">42 T.C. 601 (1964). Although petitioner has met its burden of proving that such arm's-length 355 prices would allow Lilly P.R. to earn the income attributable to the manufacturing intangibles, it has not proven what these arm's-length prices would be. Consequently, we must use our best judgment in determining arm's-length prices from the evidence submitted, bearing heavily against petitioner, "whose inexactitude is of [its] own making." Cohan v. Commissioner, 39 F.2d 540">39 F.2d 540, 544 (2d Cir. 1930); Ach v. Commissioner, 42 T.C. 114">42 T.C. 114, 126-127 (1964).The use of a pricing method other than the three methods previously discussed is contemplated by the regulations under section 482. The fourth method is contained in section 1.482-2(e)(1)(iii), Income Tax Regs. That section provides that:Where none of the three methods of pricing described in subdivision (ii) of this subparagraph can reasonably be applied under the facts and circumstances as they exist in a particular case, some appropriate method of pricing other than those described in subdivision (ii) of this subparagraph, or variations on such methods, can be used.This provision is clearly applicable to the facts of this case. We note that a study of more than 500 U.S. companies in 1970 and 1971 indicated that 36 percent of the section 482356 allocations made by Service field agents were based on some method other than the three described in the regulations. See Duerr, "Tax Allocations and International Business," Conference Board Report No. 555 (1972), portions reprinted in O'Connor & Russo, "A Study of Corporate Experience With Sec. 482," 3 Tax Adviser 526 (1972). Another study, made by the Service of its 1968 and 1969 audits involving transfer pricing, showed that agents used some other method 41 percent of the time. Treasury Department, "Summary Study of International Cases Involving Section 482 of the Internal Revenue Code (1973)," reprinted in 2 Rhoades, Income Taxation of Foreign Related Transactions 7-91 to 7-95 (1977). A third study, conducted by a private individual, was based on the experiences in 1977 of approximately 60 companies. The participants reported that, for intercompany exports audited since 1965, the Service used some other method 32 percent of the time; for those assessments that were settled, the figure rose to 35 percent. Burns, 1149 "How IRS Applies the Intercompany Pricing Rules of Section 482; A Corporate Survey," 52 J. Tax. 308 (1980).While the other methods mentioned by the companies consist 357 of everything from customs valuations to royalty agreements, the method most widely recognized by courts is the reasonable profit split approach. A leading case in this area is PPG Industries, Inc. v. Commissioner, 55 T.C. 928">55 T.C. 928 (1970). 81 In PPG, respondent allocated to the taxpayer a portion of the income of PPGI, its wholly owned foreign subsidiary, from sales of glass products. As an indication of the arm's-length nature of its sales to PPGI, the taxpayer introduced evidence of the reasonableness of the net profits earned on those sales. 82 This Court determined that "When the profit earned by both [the taxpayer] and PPGI on export sales is combined to give us a consolidated export sales figure * * * it appears PPGI is only receiving a fair percent of such consolidated profit." 55 T.C. at 997. The profit split was about 55 percent to the taxpayer and 45 percent to PPGI. We stated further:The relevance in sec. 482 cases of the division of profits realized on export sales is illustrated in Eli Lilly & Co. v. United States, 372 F.2d 990">372 F.2d 990 (Ct. Cl. 1967), where the court, in upholding the reallocation of profits between a domestic parent and its Western Hemisphere corporation subsidiary, 358 pointed out that prior to the reallocation the subsidiary received a share of total profits from Western Hemisphere sales ranging from 92.84 percent of 97.68 percent while the parent corporation's share of such profits ranged from 0.61 percent to 5.65 percent, whereas after the reallocation the subsidiary's share of the profits ranged from 62.07 percent to 74.56 percent while the parent corporation's share increased to a range of from 22.90 percent to 28.30 percent. (A second subsidiary was also involved in the reallocation of profits.) [55 T.C. at 997 n. 10.]This Court again approved a profit split in Lufkin Foundry & Machine Co. v. Commissioner, T.C. Memo. 1971-101, revd. 359 468 F.2d 805">468 F.2d 805 (5th Cir. 1972). There the taxpayer showed, through the analyses of a certified public accountant, that about 52 percent of the combined profit was income to Lufkin 1150 and 48 percent was income to its selling subsidiaries. Lufkin, however, introduced no evidence of uncontrolled transactions, and this Court relied solely upon the reasonable profit split analysis. 83 The Service decided to appeal the decision 84361 and the Court of Appeals for the Fifth Circuit reversed on the ground that "No quantum of evidence as to a taxpayer's internal transactions with its own subsidiaries, standing alone, [can] be sufficient to establish arm's-length dealing between them." 468 F.2d at 805. In its discussion of arm's-length pricing, however, the Court of Appeals stated briefly that the three pricing methods prescribed by the regulations under section 482 required evidence of the transactions of uncontrolled parties, then went on to say:[section 1.482-2(e)(1)(iii)] states that where the standards set out in the regulations indicate that one of the three methods is applicable, the taxpayer may avoid its application only by demonstrating that some other pricing method is clearly more appropriate. 360 Lufkin has not shown that each of the three methods is inapplicable, nor has it shown that a more appropriate method ought to be utilized. [468 F. 2d at 808.] From this language, we believe that the reversal of Lufkin is distinguishable. In the instant case, we are faced here with the task of approximating, as best we can, the arm's-length prices for Darvon and Darvon-N products in 1971 and 1972. The three preferred pricing methods detailed in the regulations are clearly inapplicable due to a lack of comparable or similar uncontrolled transactions. Petitioner's evidence amply demonstrates 1151 that some fourth method not only is more appropriate, but is inescapable.Petitioner's method of allocating income between itself and Lilly P.R. during 1972, although presented to us at trial and on brief as satisfying the arm's-length dealing test under the resale price method, was, in substance, based upon a profit split formula. By applying that formula to the amounts determined using petitioner's system 362 of allocating expenses, petitioner derived its discount from net wholesale prices to be applied to Lilly P.R.'s sales to petitioner.During 1972, petitioner's profit-split formula resulted in Lilly P.R. earning a manufacturing profit of 100 percent of its manufacturing costs (less operating expenses), plus its location savings from operating in Puerto Rico85363 and 60 percent of the combined net income attributable to the intangibles. Petitioner thereby earned a gross profit of 125 percent of its expenses related to the marketing of Darvon and Darvon-N products and the remaining 40 percent of the net income attributable to the intangible property. 86 While postponing for now the question of the appropriate intangible profit divisions, we note our acceptance of petitioner's use of a location savings. Respondent, in computing his allocations of income in both the notice of deficiency and the amended answer, allowed Lilly P.R. a location savings. Because petitioner has introduced no evidence showing that respondent's figures were erroneous, we will, accordingly, use those stated in the notice of deficiency. We also approve of the 100-percent manufacturing profit allowed Lilly P.R. Respondent, in his notice of deficiency, constructed prices at which the Mayaguez facility would transfer bulk propoxyphene hydrochloride and napsylate chemicals to the Carolina pharmaceutical manufacturing plant. The excess of those prices over Mayaguez's actual costs was allowed as manufacturing profit; Carolina received a manufacturing profit of 25 percent of its costs. Respondent's amended answer eliminated the intra-company profit and 1152 allowed Lilly P.R. only a manufacturing gross profit of 130 percent of the sum of Lilly P.R.'s manufacturing 364 costs and the location savings. Respondent has the burden of proof with respect to his amended answer and did not introduce any evidence to show the reasonableness of his method. Accordingly, our options are limited to petitioner's formula or respondent's notice of deficiency method. Based on our judgment that the results of the two are substantially equivalent, 87 and because respondent has focused his concern on the income from the intangibles, we will use petitioner's manufacturing profit of 100 percent. With respect to petitioner's marketing profit, we decline to use petitioner's profit split formula. Under that formula, petitioner would earn a marketing profit of 25 percent of its marketing expenses. Such a profit differs substantially from petitioner's 365 initial pricing policy established in 1965 by the second Puerto Rican project team, which recommended that petitioner earn profits equal to 90 to 100 percent of its marketing expenses based upon an analysis of the operating income to operating expense ratios of Marion Laboratories, Inc., and petitioner's foreign affiliates. See pp. 1024-1025 supra. Were we to apply the 25-percent figure to petitioner's 1971 and 1972 taxable years, petitioner's marketing profit for each year would be approximately $ 2,455,000 and $ 3,154,000 respectively. Such a profit in our judgment is unreasonably low considering petitioner's extensive marketing operations and net sales of Darvon and Darvon-N products in excess of $ 55 million and $ 73 million during 1971 and 1972. Consequently, we believe that petitioner should earn a marketing profit of 100 percent (of its marketing expenses) as originally recommended by its own project team. 88 As previously stated, petitioner's profit split formula was applied to the amounts determined on the 366 basis of allocations of expenses made by petitioner relative to its Darvon and Darvon-N operations. See Combined Income Statements for 1153 Darvon and Darvon-N Products at pages 1092-1093. Respondent alleges that certain of those allocations of expense items to income are erroneous and not in conformity with arm's-length dealings. We agree with respondent in principle but not as to specifics.i. Cost of Goods SoldThe first category of expenses is the cost of goods sold. In 1971, petitioner's cost of goods sold for Darvon and Darvon-N products did not include any expenses of petitioner's ticket issuance department. However, petitioner's cost of goods sold for 1972 and 1973 included an increasing percentage of the expenses of petitioner's ticket issuance department. 89 The ticket issuance department retained, copied, and sent to Lilly P.R. the manufacturing work tickets needed for its manufacture of chemical and pharmaceutical products. Petitioner determined that, based on the ratio of the number of manufacturing tickets for Darvon and Darvon-N products issued to Lilly P.R. for a year to the total number of manufacturing tickets issued during that year, 5 percent ($ 15,000) of the 367 total department expenses for 1972 and 7 percent ($ 22,000) of the total department expenses for 1973 should be charged to petitioner's cost of goods sold for Darvon and Darvon-N products for those respective years.Petitioner's Darvon and Darvon-N cost of goods sold for 1971 did not include any portion of the expenses of petitioner's finished stock planning department. As with the ticket issuance department expenses, some expenses of petitioner's finished stock planning department were included in petitioner's cost of goods sold for 1972 and 1973. Petitioner based its allocation for those years on the ratio of the number of persons handling Puerto Rican source products to the total number of persons in the finished stock planning department. The expenses charged to cost of goods sold for 1972 and 1973 were 12 percent ($ 51,000) and 14 percent ($ 63,000), 368 respectively, of the total expenses of the finished stock planning department for those years.1154 Section 1.482-2(b)(1), Income Tax Regs., provides that when one member of a group of controlled entities performs services for the benefit of another member without charge or for a charge which is less than arm's length, the District Director may make an appropriate allocation to reflect such an arm's-length charge. Section 1.482-2(b)(2)(i), Income Tax Regs., sets forth the "benefit test" relative to those services performed by one member of a controlled group for another. That section provides as follows:In general, allocations may be made if the service, at the time it was performed, related to the carrying on of an activity by another member or was intended to benefit another member, either in the member's overall operations or in its day-to-day activities * * In 1971, petitioner, through its ticket issuance and finished stock departments, provided Lilly P.R. with services for which it was not compensated. An adjustment must therefore be made to provide petitioner arm's-length compensation for those services. Exercising our best judgment, we allocate 3 percent of petitioner's 1971 369 ticket issuance department expenses ($ 285,000), or $ 8,550, and 10 percent of petitioner's 1971 finished stock planning department expenses ($ 438,000), or $ 43,800, from Lilly P.R. to petitioner. 90 Petitioner charged for 1972 expenses stated above to cost of goods sold and did not bill Lilly P.R. or seek reimbursement for them on the ground that they were "stewardship" expenses. We believe that petitioner's characterization of the ticket issuance and finished stock planning functions as stewardship activities is in error and caused petitioner's 1972 cost of goods sold to be inflated.Stewardship activities have been recognized both by the regulations and 370 in case law as an exception to the rule that services between controlled entities must be reimbursed. Those activities are not defined by the section 482 regulations. However, the regulations under section 861 are somewhat analogous, and contain a specific cross-reference to the section 1155 482 regulations. Section 1.861-8(e)(4), Income Tax Regs., provides as follows:If a corporation renders services for the benefit of a related corporation and the corporation charges the related corporation for such services * * , the deductions for expenses of the corporation attributable to the rendering of such services are considered definitely related to the amounts so charged and are to be allocated to such amounts. However, the regulations under section 482 (section 1.482-2(b)(2)(ii)) recognize a type of activity which is not considered to be for the benefit of a related corporation but is considered to constitute "stewardship" or "overseeing" functions undertaken for the corporation's own benefit as an investor in the related corporation, and therefore, a charge to the related corporation for such stewardship or overseeing functions is not provided for. Services undertaken by a corporation 371 of a stewardship or overseeing character generally represent a duplication of services which the related corporation has independently performed for itself. * * Section 1.482-2(b)(2)(ii), Income Tax Regs., referenced in the preceding regulation, provides:Allocations will generally not be made if the service is merely a duplication of the service which the related party has independently performed or is performing for itself. In this connection, the ability to independently perform the service (in terms of qualification and ability of personnel) shall be taken into account. * In a line of cases dealing with the deductibility of expenses claimed by one corporation when the expenses were incurred in connection with the activities of a related corporation, it has been held that amounts associated with day-to-day operations cannot be considered as stewardship expenses. See Austin Co. v. Commissioner, 71 T.C. 955">71 T.C. 955 (1979); Columbian Rope Co. v. Commissioner, 42 T.C. 800">42 T.C. 800 (1964). See also Feinschreiber, "Stewardship Expenses," 3 International Tax J. 344 (1977). In Austin Co., the issue concerned whether or not the taxpayer was entitled to a deduction under section 162 for reimbursing 372 a foreign subsidiary for foreign taxes it paid on salaries of loaned technical personnel. The taxpayer attempted to justify the deductibility of its payment of such taxes, claiming that it benefited by protecting its foreign investment and also by reducing its overhead burden of the salaried personnel. This Court responded to that claim as follows:Petitioner's argument that it loaned, on a full-time basis, supervisory and administrative personnel to safeguard its foreign investment simply does not 1156 withstand analysis * . No doubt this relationship enhanced the successful operation of Mexicanos which benefited petitioner as its owner, but this type of indirect and incidental benefit is not enough to justify petitioner's deduction. Columbian Rope Co. v. Commissioner, supra at 815-816. Petitioner simply cannot claim as its own expense, amounts paid for activities that were concerned with the day-to-day operation of the subsidiary's business. Young & Rubicam, Inc. v. United States, [187 Ct. Cl. 635">187 Ct. Cl. 635, 410 F.2d 1233">410 F.2d 1233 (1969)]supra at 1239. [71 T.C. at 967-968.]Petitioner herein cannot claim as its own expenses amounts attributable to the ticket issuance and finished stock planning 373 functions performed for Lilly P.R. The activities were not of an "overseeing" nature and were not carried out to benefit petitioner in its capacity as an investor in Lilly P.R. The ticket issuance and finished stock planning activities were necessary to and part of Lilly P.R.'s day-to-day manufacturing operations. As Dr. Frederic Lloyd, Vice President-Production, Operations Division of petitioner, testified with respect to the ticket issuance function, a "manufacturing ticket is the key to the whole technique of control of a manufacturing operation and the quality of the product that is produced" and "Some kind of a ticket kind of procedure is an FDA requirement." Dr. Lloyd described the function that produced those tickets as being "clerical" in nature. Moreover, the services performed by petitioner were not duplications of those independently performed by Lilly P.R. for itself. 91The ticket issuance and finished stock planning functions 374 were not stewardship functions. Accordingly, the amounts petitioner charged to its cost of goods sold for Darvon and Darvon-N products during 1972 (and 1973, though we discuss that year separately) for those functions must be reallocated from petitioner to Lilly P.R.ii. Operating ExpensesThe next category we consider is operating expenses, which includes the expenses of general administration, selling, merchandising, shipping, samples, and research and development. Respondent attacks the manner in which petitioner allocates those expenses, alleging that petitioner's method does not reflect the actual expenses borne by the revenue to which the 1157 allocations are made. Respondent finds particular fault with petitioner's allocations of general administrative and research and development costs. We will discuss each of these in turn.Petitioner's general administrative expenses were allocated on the basis of a percentage of the selling, merchandising, and shipping expenses which it determined were incurred relative to its marketing of Darvon and Darvon-N products. The percentage was determined by dividing the total general administrative expenses of petitioner's pharmaceutical division 375 by its (1) manufacturing costs less material costs; (2) total research and development expenses, and (3) selling, merchandising, and shipping expenses. Respondent presented the testimony of Dr. James Wheeler, an expert accounting witness, to prove that the percentage factor resulted in unreasonably low allocations of general administrative expenses to petitioner's Darvon and Darvon-N products. Dr. Wheeler based his opinion on the fact that, in an industry like the pharmaceutical one, general and administrative expenses are closely related to the direct costs of materials. Petitioner, however, excluded materials cost from the denominator of its ratio, and used instead only labor costs and overhead, overhead already being an allocated figure. Dr. Wheeler also testified that the use of the research and development figure in the denominator of the administrative expense factor caused some portion of the administrative expenses to be allocated away to research and development expenses, but none of petitioner's general research and development expenses were allocated to any of the product lines.Dr. Wheeler tested the allocations in question by comparing petitioner's and Lilly P.R.'s 376 rates of return on employed assets, rates of return on net sales, and percentages of operating expenses to sales. While we agree with the logic and correctness of Dr. Wheeler's conclusions regarding the allocation factor, we will not substitute his results for petitioner's inasmuch as his calculations ignore any manufacturing return of Lilly P.R. which might be attributable to its intangible assets. We will, however, adjust petitioner's allocation factors to include the materials costs in the cost of goods sold figures.Also, petitioner allowed Lilly P.R. the free use of its administrative manuals and paid the legal expenses connected with suits by persons claiming injuries caused by Darvon or 1158 Darvon-N products (see pp. 1072-1073). The costs to petitioner were included in petitioner's general and administrative expenses. Petitioner has allocated its general and administrative expenses as a percentage of its Darvon and Darvon-N marketing expenses, a method which we understand to include only those expenses allocable to the burden and overhead of petitioner's Darvon and Darvon-N selling, merchandising, and shipping activities. To capture the expense of the manuals, legal fees, 377 and all other nonmarketing general and administrative expenses, we must increase the allocation factor. Petitioner has introduced no evidence on this matter. Therefore, using our best judgment we have concluded that a 10-percent increase is appropriate. Accordingly, using petitioner's formula for allocation of general and administrative expenses, with modifications, 92 we have determined that petitioner's general and administrative expenses with respect to Darvon and Darvon-N products should be adjusted to $ 1,222,097 and $ 1,685,532 for 1971 and 1972, respectively. 93378 Thus, petitioner must include an additional $ 17,920 and $ 155,178 as general 1159 administrative expenses for the respective years 1971 and 1972. The next types of expenses included in petitioner's operating expenses are selling, merchandising, and shipping, i.e., petitioner's marketing expenses. Respondent does not seriously challenge the allocation methods of those expenses, nor can we find any error in such methods. Petitioner's expert accounting witness, Howard L. Shearon, testified at length and in great detail concerning petitioner's allocation methods. We found him to be an impressive witness who explained the methodologies used in connection with the ascertainment of the marketing expense items, carefully, and in a readily comprehensible manner. We agree that 379 those methodologies were reasonable, and make no allocations with respect thereto.We next consider research and development expenses. Up to this point we have dealt with what are considered by accountants to be strictly operating costs. Accounting methodology is concerned with associating, or matching, expenses with the appropriate time period as well as with the appropriate income. Operating expenses relate to the current operating period and are those costs currently chargeable against the principal revenue sources. While Lilly P.R.'s payments for the expenses of the support research and development activities 94380 carried out for it under the joint research agreement were currently chargeable against its sales income, research and development expenses ordinarily are not considered operating expenses, but are other current income deductions. 95 This is because, as petitioner's Controller, Richard A. Warne, testified, general research and development expenses do not apply to present operations or to any defined period, but apply only to future operations. During the years in issue, Lilly P.R. was charged by petitioner for certain research and development expenses under the terms of the joint research agreement. Those 1160 expenses were for research and development activities carried out by petitioner that petitioner determined related specifically to Darvon and Darvon-N products. Similarly, petitioner recorded and allocated to its other product lines the research and development expenses it determined related specifically to those product lines. No allocation, however, was made of the general 381 research and development expenses. 96 Those expenses were borne by petitioner's total revenues. We have carefully considered the testimony of both parties' expert accounting witnesses. Petitioner's witnesses maintained that, because the general research and development expenses did not relate to any specific time period or 382 pharmaceutical product, no allocation of those expenses to Darvon and Darvon-N products in 1971 and 1972 was necessary. Respondent and his experts believe that, given the research-intensive nature of the pharmaceutical business, no independent entity could fail to do otherwise. For the reasons discussed below, we agree with respondent.Research and development is the lifeblood of the pharmaceutical industry. Pharmaceutical companies rely for their long-range survival on the research and development of new chemical products as well as on the maintenance and upgrading of their existing patents. The time and cost of inventing and developing new drugs and testing them in order to receive FDA approval to market them is a complex, risky, 97 and expensive 98383 process. A pharmaceutical company must fund that process through the revenues of its successfully marketed products.In this case, petitioner invented and developed two highly successful products. Petitioner transferred the patents and 1161 know-how for those products to Lilly P.R. in a section 351 exchange. Petitioner did not receive royalties, a lump-sum payment, or other arm's-length consideration to take the place of the prospective revenues those patents would have produced. Petitioner thus deprived itself of the means to carry on a portion of its general research and development activities, or at least, was forced to fund those activities with income that would otherwise have gone elsewhere (e.g., shareholders' dividends, capital investments). As respondent's expert accounting witness, Dr. James Wheeler, testified, using petitioners' allocation methods, were petitioner to transfer the patents and know-how for its nine most profitable products to a related entity for manufacture and sale of those products to petitioner, petitioner would not receive sufficient income from the marketing of such products to sustain its operations.Dr. Wheeler stated, and we agree, that no independent company would market 384 a product for an amount insufficient to cover its own ongoing expenses. Petitioner's research and development has contributed greatly to its success in the pharmaceutical industry, and is not a function that we believe petitioner would discontinue under any circumstances. Accordingly, some allocation of research and development expenses must be made. We conclude that $ 7,054,856 and $ 7,844,778 should be included in petitioner's operating expenses for 1971 and 1972, respectively, to cover a proportionate share of its general research and development expenses. 99 Petitioner's remaining potential problem areas can be dealt with summarily. The technical assistance fees it billed to Lilly P.R. during the years in issue were determined according to the number of 385 hours reported by petitioner's employees 1162 multiplied by the technical assistance fee rates applicable to those employees, plus 5 percent of the hourly charge. The technical assistance fee rates were equal to the average hourly compensation costs, including benefits and employment taxes, for petitioner's employees. Petitioner also billed Lilly P.R. for traveling expenses and the standard charge for engineering services. The amounts billed represented all the technical assistance rendered to Lilly P.R. during 1971 and 1972, except for the ticket issuance and finished stock planning services mentioned previously. Accordingly, no allocation with respect to the technical assistance fees is warranted.During the years 1971 and 1972, Lilly P.R. purchased 20 percent and 19 percent, respectively, of its raw materials from petitioner. Lilly P.R. also purchased some of its equipment and machine parts through petitioner during those years. In the case of raw materials, petitioner charged Lilly P.R. at its cost for manufactured items and at its materials cost for items purchased by it. In the case of the equipment and machine parts, petitioner accumulated all costs with respect to its purchase 386 of an item under a job cost number; when the item was received by petitioner, it shipped the item to Lilly P.R. and invoiced Lilly P.R. for the total costs accumulated. We believe the amounts billed to Lilly P.R. were reasonable and represented all the costs associated with the supplying of the materials and equipment to Lilly P.R., except for the clerical costs of the actual billings themselves. Those costs, however, can be viewed as falling under the umbrella of general and administrative services, a portion of which has already been included in petitioner's operating costs relative to Darvon and Darvon-N products. We conclude no revision is necessary with respect to the clerical costs of the actual billings.The fees associated with the joint research agreement covered the research and development activities performed by petitioner for Lilly P.R. but not billed to Lilly P.R. under the technical assistance agreement. Under the joint research agreement, Lilly P.R. was invoiced for and paid the costs of Darvon and Darvon-N research and development activities performed by petitioner. Such activities were classified as support work, and consisted of the expenses attributed by Lilly 387 Research Laboratories' project accounting system to the research projects and clinical grants related to Darvon and 1163 Darvon-N products. Any activities not related directly to a specific product and thereby slipping outside of petitioner's project development system were billed to general research. Inasmuch as we already have revised petitioner's Darvon and Darvon-N expenses to include a portion of such general research and development expenses, no allocation is necessary here.iii. Applicable Profit Split PercentageWe turn now to the application of the profit split approach to the revised income and expense items of petitioner and Lilly P.R. 100388 Petitioner has stated at various times throughout the 1164 trial and on brief that Lilly P.R.'s prices to it were based upon and satisfied a profit split approach. To support its claim, petitioner introduced testimony pertaining to the relative value of patents and trademarks, as well as the testimony of its pharmaceutical industry expert witness regarding the profit level at which an unrelated company would be willing to market Darvon and Darvon-N products.389 Eugene L. Step, president of petitioner's pharmaceutical division and possessing an impressive background in the pharmaceutical industry, testified concerning the marketing efforts of petitioner. Mr. Step stated that he considered petitioner's marketing force to be the leader among the approximately 30 pharmaceutical manufacturers in the United States, but that petitioner's name, reputation, and sales force were no guarantees of promoting a successful product if the product could not "sell itself." Mr. Step stressed the quality of a product and the discerning nature of the health care professionals who prescribe that product as being the deciding factors in its success rather than a trademark. He testified that health care professionals knew a successful product such as Darvon by its generic name of propoxyphene hydrochloride, and that, had the Darvon trademark name been lost, the professionals would have been alerted to a new trademark by pharmacists and petitioner's marketing force and would have simply prescribed the product under its new 1165 name. Thus, the Darvon and Darvon-N trademarks had relatively less value as opposed to the patents, which gave Lilly P.R. the exclusive right 390 to manufacture propoxyphene products in the United States.This concept of the patent value exceeding the value of the trademark was reiterated by Dr. Baumol, one of petitioner's expert economic witnesses. Dr. Baumol was very familiar with the pharmaceutical industry, and became involved in this case in 1971. Dr. Baumol viewed the trademark for a product as having a negligible value so long as the patent for that product was in effect. He testified that any successful marketing operation, given the opportunity to market a high sales volume pharmaceutical product, could have created an identical demand for the sale of "Carvon," or whatever they chose to call it, with only minor expenditures for the establishment of the new trademark. We find the testimony of Mr. Step and Dr. Baumol very convincing in support of the proper profit split between the manufacturing and marketing intangibles.Petitioner also introduced the testimony of Lawrence C. Hoff, Executive Vice President, World Wide Pharmaceutical Operations, Upjohn Co. As a result of his employment with the Upjohn Co. and his involvement in industry associations, Mr. Hoff developed throughout a 30-year career an extensive knowledge 391 of the manufacturing and marketing of pharmaceutical products in the United States. Accordingly, Mr. Hoff was qualified as an expert witness on the U.S. pharmaceutical industry. Prior to trial, Mr. Hoff reviewed the sales history of Darvon and Darvon-N products for the years 1958 through 1973, the distribution agreement between petitioner and Lilly P.R., and also the combined income statements for Darvon and Darvon-N products set out in this opinion at pages 1092 and 1093.Mr. Hoff became familiar with propoxyphene products when petitioner introduced Darvon in the late 1950s. In his opinion, petitioner's Darvon and Darvon-N products filled a significant therapeutic need for a product providing relief from mild to moderate pain. During the 1950s, there was a large gap between the narcotics used to treat severe pain and the over-the-counter drugs such as aspirin used to treat mild pain. For that reason, Mr. Hoff believed petitioner's Darvon and Darvon-N products were well accepted by physicians and were important products in the pharmaceutical industry.1166 It was Mr. Hoff's opinion that a product line such as Darvon and Darvon-N would be of substantial value to any pharmaceutical company. 392 Petitioner's propoxyphene product line was well respected by health care professionals in the United States; propoxyphene products were used by health care professionals ranging from the rural general practitioner to the most experienced urban neurosurgeon. Moreover, the marketing of prescription pharmaceutical products is a sample-oriented business and, under the terms of the distribution agreement, Lilly P.R. provided petitioner with samples free in 1971 and 1972 and at manufacturing cost in 1973. Mr. Hoff believed that the ability to provide large numbers of samples of Darvon and Darvon-N products to a broad range of health care professionals, who respected and were interested in those products, would be extremely valuable to any pharmaceutical company because it would provide additional access to the offices of health care professionals. 101393 Mr. Hoff was also of the opinion that the promotion of Darvon and Darvon-N products by sales representatives would consume a minimal amount of time of those representatives, because the products were "doorknob detail" products, i.e., the promotion of the products was sample oriented and health care professionals already were interested in those products.Mr. Hoff believed that the distribution of Lilly P.R.'s propoxyphene products would provide a pharmaceutical company a substantial return on its marketing efforts at the transfer prices charged by Lilly P.R. during the years in issue. Mr. Hoff, however, based his belief upon the profits afforded petitioner according to the pro forma combined income statements for Darvon and Darvon-N products. Those statements, as we previously discussed, were incorrect in several respects concerning petitioner's allocation of expenses. Accordingly, our adjustment of those statements requires a correlative adjustment of petitioner's profits for 1971 and 1972.Mr. Hoff, as well as Mr. Step and Dr. Baumol, testified to the minimal value of the trademark while the patent protection remained in effect. The three agreed on the quality of 394 1167 petitioner's marketing force, but emphasized the value that a product line such as the Darvon and Darvon-N product lines would have for the marketing force promoting it, especially, as Messrs. Hoff and Step noted, in terms of increased access for its sales representatives to the offices of health care professionals. The three witnesses believed that the prices petitioner paid Lilly P.R. for its propoxyphene products were arm's-length prices based upon the profit petitioner received on their resale. Under the pricing formula petitioner used in determining Lilly P.R.'s prices, that profit was approximately 40 percent of the net intangible income.We concur with Mr. Hoff, Mr. Step, and Dr. Baumol that the propoxyphene patents had relatively greater value than the Darvon and Darvon-N trademarks. We note, however, that those witnesses did not give enough weight to goodwill and the value of the Lilly name. The witnesses also failed to consider the short life remaining on the propoxyphene patent in 1971 and 1972. We question their assumption that an unrelated marketing company would have paid the same prices as petitioner for the propoxyphene products, knowing it had at best 2 years 395 in which to develop the market recognition for its trademark before the patent expired. Mr. Hoff, Mr. Step, and Dr. Baumol agreed that, after the patent's expiration, the trademark was the intangible with the greater value.Petitioner has failed to prove what the arm's-length prices for Lilly P.R.'s products should be, and we must bear heavily against petitioner in our determination. Using our best judgment, we conclude that petitioner should receive 45 percent of the net intangible income as its income attributable to the marketing intangibles. Consequently, we allocate $ 11,317,000 and $ 12,547,000 from Lilly P.R. to petitioner for the years 1971 and 1972, respectively. 102396 1168 2. 1973 Taxable YearBecause of the expiration of the propoxyphene patent at the end of 1972 and the entry into the U.S. market of at least 24 pharmaceutical companies which sold propoxyphene hydrochloride products in 1973, petitioner contends that in 1973 the most appropriate method for ascertaining arms'-length prices for Lilly P.R.'s products is to look to the market prices for such products in uncontrolled sales. It is petitioner's position that Lilly P.R.'s prices satisfy the comparable uncontrolled price 1169 method of section 1.482-2(e)(2), Income Tax Regs.103 While respondent agrees that the comparable uncontrolled price method is available for 1973, he takes issue with petitioner's adjustments to third-party prices for propoxyphene hydrochloride products.a. Comparable Uncontrolled Price MethodUnder the comparable uncontrolled price method, "the arm's length price of a controlled sale is equal to the price paid in comparable uncontrolled sales, adjusted as provided in subsection (ii) of this subparagraph." Sec. 1.482-2(e)(2)(i), Income Tax Regs.397 Uncontrolled sales are defined as "sales in which the sellers and the buyers are not members of the same controlled group." Sec. 1.482-2(e)(2)(ii), Income Tax Regs. The section 482 regulations also determine the comparability of uncontrolled sales, as follows:Uncontrolled sales are considered comparable to controlled sales if the physical property and circumstances involved in the uncontrolled sales are identical to the physical property and circumstances involved in the controlled sales, or if such properties and circumstances are so nearly identical that any differences either have no effect on price, or such differences can be reflected by a reasonable number of adjustments to the price of uncontrolled sales. For this purpose, differences can be reflected by adjusting prices only where such differences have a definite and reasonably ascertainable effect on price. If the differences can be reflected by such adjustment, then the price of the uncontrolled sale as adjusted constitutes the comparable uncontrolled sale price. Some of the differences which may affect the price of property are differences in the quality of the product, terms of sale, intangible property associated with 398 the sale, time of sale, and the level of the market and the geographic market in which the sale takes place. Whether and to what extent differences in the various properties and circumstances affect price, and whether differences render sales noncomparable, depends upon the particular circumstances and property involved. [Sec. 1.482-2(e)(2)(ii), Income Tax Regs.]Thus, under the comparable uncontrolled price method of section 1.482-2(e)(2), Income Tax Regs., adjustments can be made to reflect differences between the controlled sale and the uncontrolled sale. The only guidance for those adjustments is contained in the regulations which state, in section 1.482-2(e)(2)(ii), Income Tax Regs., "differences can be reflected 1170 by adjusting prices only where such differences have a definite and reasonably ascertainable effect on price."During 1973, Lilly P.R. sold its Darvon and Darvon-N products to petitioner at prices equal to a 58-percent discount from petitioner's net wholesale prices for those products. The discount from net wholesale prices was increased from its previous 1972 level of 46 percent to reflect the expiration of the propoxyphene patent at the end of 1972.Throughout the 399 years in issue, Smith Kline & French Laboratories, Inc. (hereinafter SKF) marketed a line of branded prescription pharmaceutical products on which patent protection had expired called the SK line. In 1973, after the expiration of the propoxyphene patent, the SK line included two propoxyphene hydrochloride products: plain propoxyphene hydrochloride which was manufactured by SKF, and SK-65 Compound (propoxyphene hydrochloride with a combination of aspirin, phenacetin, and caffeine) which was manufactured for SKF by Milan Pharmaceuticals, Inc. (hereinafter Milan), of Morgantown, West Virginia. SK-65 Compound was competitive with petitioner's Darvon Compound-65 (PU 369).During 1973, SKF purchased 47,399,654 filled SK-65 Compound capsules from Milan at a total invoice cost of $ 742,865. Milan's price to SKF for a bottle of 500 SK-65 Compound capsules was $ 7.55. Milan and SKF are unrelated. Petitioner contends that, if the Milan prices to SKF are properly adjusted to reflect the differences between those sales and sales by Lilly P.R. to petitioner, the Milan prices to SKF fully support Lilly P.R.'s pricing for 1973. 104400 401 1171 i. Petitioner's Adjustments to Milan's PricesPetitioner's economic experts compared the $ 7.55 price SKF paid for its SK-65 Compound with the $ 12.17 price petitioner paid Lilly P.R. for its Darvon Compound-65. 105 The experts identified seven adjustments which they believed had to be made to the Milan price in order to make the transactions between Milan and SKF comparable to the sales by Lilly P.R. to petitioner.The first adjustment identified by petitioner's experts related to the raw materials furnished to Milan by SKF. SKF supplied to Milan at no charge the empty capsules, package inserts, labels, and bottle caps used by Milan to make SK-65 Compound for SKF. Lilly P.R. manufactured its 402 own empty capsules, but purchased from petitioner the package inserts, labels, and some bottle caps needed for its Darvon Compound-65. 106 Petitioner's experts concluded that Milan's price should be adjusted for this difference by adding the costs that Milan would have incurred if it had purchased those materials. The experts determined that that adjustment should be $ 0.85 per bottle, although petitioner introduced evidence at trial to show that the actual cost of those materials to Milan was $ 1.14 per bottle.The second factor which petitioner's economic experts identified for adjustment was the difference in credit terms provided by Milan versus those provided by Lilly P.R. Milan's credit terms to SKF were a 1-percent discount for payment in 10 days and net in 30 days. Lilly P.R.'s terms to petitioner were net in 180 days, and petitioner, as a practice, took the full 180 days to pay. Petitioner's experts valued the differences in those credit terms using the interest costs 403 that petitioner would have saved by receiving from Lilly P.R. what amounted to a 5-month interest-free loan of $ 12.17 (the 1973 transfer prices of a bottle of 500 Darvon Compound-65 capsules). That value was determined to be $ 0.40 at an interest rate of 8 percent.1172 The third significant difference identified by petitioner's experts between the Milan sales to SKF and the Lilly P.R. sales to petitioner was that Lilly P.R. provided a substantial quantity of samples to petitioner at cost during 1973. Milan charged SKF $ 14.50 per thousand bulk capsules used by SKF as samples, and $ 0.135 for a sample pack of four capsules. Petitioner's experts thus increased Milan's prices by $ 1.56 per bottle to reflect the additional value of providing samples on the terms and in the relative amount provided by Lilly P.R.The fourth adjustment described by petitioner's experts involved equipment loaned by SKF to Milan at no cost. The equipment was used by Milan in the packaging of SK-65 Compound capsules in packages of four capsules. Because Lilly P.R. owned all the equipment it used to manufacture Darvon products, petitioner's experts believed that Milan's price should be adjusted to reflect that 404 difference by adding to that price the rental value of the equipment loaned by SKF to Milan.The fifth item of adjustment related to the quality control operations for Milan's products carried out by SKF both at Milan's plant and at SKF's facilities. Lilly P.R. carried out its own quality control operations in Puerto Rico and reimbursed petitioner for certain sample tests performed by it in Indianapolis. Petitioner's experts determined that the cost of SKF's quality control activities should be added to the Milan price, but were unable to quantify this cost.The sixth difference identified by petitioner's experts was the difference in quality of the Milan product as opposed to that manufactured by Lilly P.R. The Darvon compound product manufactured by Lilly P.R. during the years 1971 through 1973 utilized the glutamic acid hydrochloride formulation to avoid both the misuse and odor problems associated with other formulations of those products. Lilly P.R. bore the cost of developing that formulation, which was a trade secret owned by Lilly P.R. In contrast, the SK-65 Compound sold by Milan to SKF contained a propoxyphene pellet and, therefore, was subject to misuse. Furthermore, 405 SK-65 Compound had a slightly greater variability of active ingredient per capsule than the Darvon Compound-65 produced by Lilly P.R.The final adjustment by petitioner's experts was made with respect to the continued existence of the napsylate patent. The 1173 $ 12.17 transfer price of Darvon Compound-65 in 1973 was computed by a formula 107 that spread the value of Lilly P.R.'s napsylate patent over all the Darvon and Darvon-N products produced by Lilly P.R. 108 Thus, the $ 12.17 price in part reflected the value of the napsylate patent. The experts concluded that either the Milan price or the Lilly P.R. price should be adjusted for that factor in order to make the Milan price comparable to that of Lilly P.R.On the basis of the foregoing, the adjustments to the Milan price made by petitioner's experts can 406 be summarized as follows:Milan price$ 7.55Adjustmentsa. Raw materials0.85b. Credit terms0.40c. Samples1.56d. Equipmente. Quality controlf. Quality differencesg. Darvon-N patentItems d -- g (estimate)n1 1.81Adjusted Milan price12.17Petitioner's experts concluded that, because the adjusted Milan price was roughly equivalent to the price petitioner paid Lilly P.R. for the same product, the prices petitioner paid Lilly P.R. during 1973 for Darvon Compound-65, as well as all the other prices petitioner paid Lilly P.R. during 1973 for Darvon and Darvon-N products, were arm's-length prices. Petitioner relies upon the conclusions of its expert witnesses to support its contention that Lilly P.R.'s 1973 prices satisfied the comparable uncontrolled sales method of section 1.482-2(e)(2), Income Tax Regs., and thus were arm's-length prices.ii. Respondent's Expert Economic EvidenceRespondent argues that petitioner's 1973 prices were not at 1174 arm's length based upon his review of comparable sales of generic propoxyphene hydrochloride products in 1973. Respondent's 407 evidence compares prices that Milan, Zenith Laboratories, Inc., Rachelle Laboratories, Inc., and Caribe Chemical Co., Inc., charged for manufacturing propoxyphene hydrochloride products. Respondent's approach to specific price evidence also differs from petitioner's by rejecting any add-ons to the prices uncontrolled manufacturing companies charged for the same products manufactured by Lilly P.R., and by encompassing a broader spectrum of propoxyphene products.Respondent's expert economic witness, Dr. William Comanor, utilized two methods to determine what he believed to be arm's-length prices for the years 1971 through 1973. Both methods involved comparing the activities of three unrelated pharmaceutical companies with those of Lilly P.R. While we already have discussed the inherent flaws in Dr. Comanor's report and testimony (i.e., no rate of return computed for intangible property), we will consider such evidence insofar as it relates to third-party prices of propoxyphene products.Dr. Comanor's first method observed third-party prices for propoxyphene hydrochloride products, using a weighted average of the prices to determine the percent differential between those prices and 408 the ones charged by Lilly P.R. His second method involved observations of the gross profit margins earned by three pharmaceutical companies, Milan, Rachelle Laboratories, Inc., and Zenith Laboratories, Inc. Dr. Comanor determined an average gross margin for all three companies and then compared such margins to those actually earned by Lilly P.R.Rachelle Laboratories, Inc. (hereinafter Rachelle), is a subsidiary of the International Rectifier Corp. and is located in Long Beach, California. In 1973, Rachelle had in its pharmaceutical line a plain propoxyphene hydrochloride product and a propoxyphene hydrochloride compound. The propoxyphene hydrochloride, sold in 65 mg. capsules, was produced by Rachelle; the propoxyphene hydrochloride compound-65 capsules were purchased as finished products from Caribe Chemical Co., Inc. (hereinafter Caribe), of the Virgin Islands.A large part of Dr. Comanor's information concerning the three pharmaceutical companies previously mentioned was 1175 obtained through interviews conducted by Dr. Comanor with company officials. The information pertaining to Rachelle and Caribe was provided at trial by Rachelle's president, Dr. Melvin Hochberg. 109 Dr. Hochberg 409 produced records and letters which showed that Caribe's 1973 prices for the propoxyphene hydrochloride compound-65 mg. in 500-capsule bottles was $ 6.50 per bottle.Rachelle employed approximately 200 persons in its Long Beach facility during 1973. Only 29 of those employees were involved in sales and marketing. Rachelle's net sales were $ 11,228,000 in 1973; its sales of propoxyphene hydrochloride products were approximately $ 50,000 in fiscal year ending June 30, 1973, and approximately $ 60,000 in fiscal year ending June 30, 1974.Zenith Laboratories, Inc. (hereinafter Zenith), is a manufacturer of generic pharmaceutical products with facilities in New Jersey and in the Virgin Islands. Zenith purchases rather than produces the basic chemical ingredients needed for its pharmaceutical manufacturing activities. During the early 1970's Zenith employed approximately 190 persons. Zenith does not promote its products directly to physicians. Zenith's net sales for 1973 were $ 11,593,000; there is no evidence in the record indicating what proportion of those sales were attributable to sales of generic propoxyphene 410 hydrochloride products.Smith Kline & French, or SKF, a leading pharmaceutical company, has already been discussed in pertinent part.Respondent argues that the information relative to the above companies, and Dr. Comanor's conclusions based thereon, clearly show that Lilly P.R's 1973 prices to petitioner were greater than arm's length. Although we agree with Dr. Comanor's ultimate conclusion, we disagree with his methods. Dr. Comanor's approach to pricing failed to take into account the presence of any intangibles held by Lilly P.R., specifically, in 1973, the glutamic acid hydrochloride formulation, and the napsylate patent. Respondent argues that Dr. Comanor purposely was told to evaluate the pricing relationship between petitioner and Lilly P.R., with no instructions given as to the ownership of intangibles, so as to achieve a fresh and untainted view of the situation, as opposed to petitioner's experts who 1176 from the start assumed the presence of intangibles. Such an argument is specious and completely ignores the ownership of the intangibles by Lilly P.R.Moreover, the pricing data relied upon by Dr. Comanor are not supported by evidence in the record. The data were derived from 411 interviews conducted by Dr. Comanor with company officials of Milan, Zenith, and Rachelle. The prices are not supported by a single document in the record in this case and constitute hearsay evidence. The data were also inconsistent with the actual sales data introduced by petitioner with respect to SKF's purchases from Milan. Finally, the record is completely devoid of any facts regarding the circumstances of the sales by the three companies that would allow comparability to be determined, other than with respect to SKF's purchases from Milan. Rachelle and Zenith employed far fewer persons than did petitioner and had substantially lower net sales. Rachelle in particular had sales of propoxyphene hydrochloride products of only $ 50,000 in fiscal year ending June 30, 1973, and $ 60,000 the next year, as opposed to petitioner's sales of Darvon and Darvon-N products in 1973 of approximately $ 70 million (see page 1093). Mr. Hochberg's testimony with respect to Rachelle thus does not support the use of its sales as comparables.Dr. Comanor, on direct examination, was responsive to the questions advanced by respondent's counsel; however, on cross-examination he refused to answer many 412 of the hypothetical questions asked by petitioner's attorneys, which questions, in the Court's opinion, were very reasonable under the circumstances. In short, the substance of his testimony fell apart on cross-examination. Accordingly, we have discounted much of Dr. Comanor's report and testimony.iii. Determination of Arm's-Length PriceWe turn now to petitioner's adjustments to Milan's price for SK-65 Compound. The underlying rationale of the increases made by petitioner's experts is that Milan enjoyed a more advantageous relationship with SKF than Lilly P.R. enjoyed with petitioner. In order to equalize the positions, and prices, of the two, petitioner's experts believed it was necessary to adjust the Milan price before comparing it to the Lilly P.R. price for similar products.1177 The first add-on identified by petitioner's experts relates to raw materials that SKF provided free to Milan but which Lilly P.R. purchased for itself. Petitioner's experts determined an add-on of $ 0.85, and petitioner introduced evidence showing that the actual cost to Milan was $ 1.14. Respondent takes issue with any add-on whatsoever. He argues that the amount of materials provided to Milan was not 413 great, 110 and that petitioner's experts merely speculated that the same materials would still have been provided free to Milan if it had produced the same volume of propoxyphene hydrochloride products as did Lilly P.R.Respondent also alleges that petitioner's experts failed to consider certain favorable circumstances that petitioner extended Lilly P.R. with respect to the same raw materials. Petitioner originally granted Lilly P.R. two licenses to U.S. patents, together with manufacturing know-how, so that Lilly P.R. could manufacture empty capsules. Petitioner provided packaging materials, bottles, and labels to Lilly P.R. at cost. In addition, petitioner designed and obtained all FDA approvals for labels and package inserts with respect to Lilly P.R.'s products. In contrast, the costs associated with Milan's obtaining FDA approval of its product, including the approval of labels and package inserts, were borne by Milan and not SKF.We believe some adjustment is necessary for the raw materials provided Milan by SKF. The amount of materials provided may not have been large by petitioner's standards, but it apparently represented 414 100 percent of Milan's needs, and Milan benefited therefrom accordingly. Respondent censures petitioner's experts for a "highly speculative" assumption that Milan would still receive free materials from SKF were Milan to produce the same volume of products as petitioner. However, in comparing the prices it is impossible to neutralize completely the effect caused by the differences in size and sales of Milan and Lilly P.R. Whether Milan's terms and prices would or would not differ depending on an increased volume, the fact remains that Milan did receive free materials. We too would be speculating if we refused to adjust Milan's price upwards for this difference based upon a notion that it is normal for small volume manufacturers to receive 1178 some raw materials free of charge from their purchasers. An adjustment is necessary, but not in the amount of $ 1.14, which was the actual cost of the materials provided Milan, or $ 0.85, the amount estimated by petitioner's experts. To reflect more accurately the cost of the materials at the volume of sales carried on by Lilly P.R., the adjustment should be Lilly P.R.'s own cost of purchasing the raw materials. During 1973, Lilly P.R. manufactured 415 the empty capsules it used to make Darvon Compound-65. During that time, petitioner manufactured and sold billions of empty capsules to unrelated customers throughout the world at a price of $ 1.60 per thousand capsules. Lilly P.R. lost approximately 3 percent of its capsules in the filling and finishing of Darvon Compound-65. Thus, the market price for Lilly P.R.'s empty capsules was approximately $ 0.82 per bottle of 500 capsules. Lilly P.R.'s standard cost per bottle of 500 Darvon Compound-65 capsules for labels, package inserts, and bottle caps was approximately $ 0.04 in 1973. Accordingly, Milan's price should be increased by $ 0.86.Respondent argues that the Milan price should be reduced to take into account the favorable conditions Lilly P.R. enjoyed over Milan, namely, the licenses to manufacture capsules, the packaging and other materials provided at cost, and petitioner's design of, and obtainment of, FDA approval for Lilly P.R.'s labels and package inserts. Respondent's argument with respect to empty capsules is without merit inasmuch as Lilly P.R. agreed under the license agreements to pay petitioner a royalty of 5 cents per 1,000 commercially acceptable empty capsules 416 manufactured by Lilly P.R. and covered by either of the two U.S. patents owned by petitioner. Respondent has neither argued nor introduced any evidence to prove that such license agreements were not at arm's length. Accordingly, Lilly P.R.'s manufacture of empty capsules is not cause for a downward adjustment to Milan's price. As for respondent's position that an adjustment is necessitated by petitioner's providing certain raw materials to Lilly P.R. at cost, we already have compensated for this factor by adjusting Milan's price upward to reflect Lilly P.R.'s own cost per 500-capsule bottles of labels, package inserts, and bottle caps.Respondent urges us to reduce Milan's price to reflect its costs associated with Milan's obtaining FDA approval of its product, labels, and package inserts. We addressed the question 1179 of Lilly P.R.'s reimbursing petitioner for research and development expenses, of which FDA work is a part, at an earlier time. We concluded that it is inappropriate to charge Lilly P.R. now for research and development activities carried on by petitioner in the past. Research and development activities performed by petitioner in 1973 with respect to Darvon and Darvon-N 417 products (i.e., support research) were charged to Lilly P.R. under the joint research agreement. Petitioner has not proven that those amounts included the costs associated with maintaining FDA approval for the products, storing samples, and with updating and securing approval for the labels, packaging, and package inserts for those products. However, because those costs would be included in petitioner's general research and development expenses, which we discuss at pages 1159-1161, and infra at pages 1185-1186, we make no adjustment at this time.Respondent next alleges that the adjustment made by petitioner's experts for the difference in credit terms was erroneous because petitioner and Lilly P.R. were related entities attempting to allow petitioner the tax-free use of Lilly P.R. funds in the United States. 111 We agree with petitioner's experts that such an adjustment is appropriate. Indeed, the terms of sale is one of the factors specifically mentioned in the section 482 regulations as a cause for adjustment of the comparable uncontrolled price. Sec. 1.482-2(e)(2)(ii), Income Tax Regs. Milan required payment from SKF of the net price in 30 days while Lilly P.R.'s terms were 418 net in 180 days. However, instead of an adjustment of $ 0.40, based upon the interest saved by petitioner upon a 5-month loan of $ 12.17 with interest at 8 percent, we conclude the adjustment should be calculated using an interest rate of 5 percent. See sec. 1.483-1(c)(2)(ii), Income Tax Regs. Such a calculation would yield a $ 0.25 adjustment, were we to work our way backwards from Lilly P.R.'s actual price as petitioner's experts did. Our task, however, is to work forward and adjust Milan's price of $ 7.55 to the price we believe Lilly P.R. would have charged to an unrelated pharmaceutical company. Using our best judgment, we conclude the adjustment for the difference in credit terms is $ 0.20.1180 The third item of adjustment deals with samples. Petitioner's experts adjusted Milan's price to reflect the value of the samples provided to petitioner at cost during 1973, as opposed to the normal bulk price SKF paid Milan for capsules it used as samples. Respondent argues that petitioner's experts erroneously adjusted for this difference, which was not based on an advantage SKF 419 received due to its terms of sale with Milan, but rather on Lilly P.R.'s relationship with petitioner. Respondent also argues that, because both SKF and petitioner packaged the majority of capsules used as samples, no difference exists and hence no adjustment is necessary. We agree with respondent that the add-on determined by petitioner's experts is incorrect. The add-on of $ 1.56 was calculated using petitioner's cost of purchasing samples at Lilly P.R.'s transfer price of $ 12.17 per 500-capsule bottles rather than at cost. In other words, petitioner's experts again are working backwards from Lilly P.R.'s transfer price in order to arrive at the components making up the differences between Lilly P.R.'s and Milan's prices. That approach is in error.If Milan were to sell bulk capsules for samples to SKF at its cost rather than at its normal trade prices, Milan indeed would realize less income for so doing. The difference in income, however, merely would be Milan's lost profit on the transactions. Consequently, an add-on in the amount of the profit lost is appropriate in the instant case. Milan's price for bulk capsules was $ 14.50 per thousand capsules. Lilly P.R.'s prices 420 to petitioner for bulk products were "consistent with its prices to Petitioner for products in trade packages." (Petitioner's requested finding of fact number 389, n. 12.) Petitioner's cost for purchasing the capsules it used as samples was $ 1,872,896. From the above information, one cannot definitely ascertain the correct adjustment, although we believe some adjustment is necessary. Because petitioner's inexactitude is of its own making, we must bear heavily against it in making our adjustment. Cohan v. Commissioner, 39 F.2d 540">39 F.2d 540, 544 (2d Cir. 1930). Keeping in mind that both petitioner and SKF performed most of their own sample packaging activity, for which, as respondent points out, no adjustment is necessary, we conclude that Milan's price should be adjusted upward by $ 0.50.1181 The final four differences identified by petitioner's experts were free equipment, quality control, quality difference, and the napsylate patent. Petitioner's experts were unable to quantify the values of these four factors, and so provided what they determined was a conservative adjustment of $ 1.81. The equipment was excess sample packaging equipment loaned by SKF to Milan free of charge during 1973. 421 Respondent correctly argues that no adjustment should be made to the purchase price paid by SKF for this alleged advantage of Milan because no evidence was presented as to the value of the equipment. Petitioner's witness, Mr. Brian McLarnon, was Director of Corporate Facilities for SKF at the time of trial and manager of the SK line during 1971, 1972, and the first half of 1973. Mr. McLarnon testified that the sample packaging equipment provided to Milan was excess equipment not being used by SKF at that time. He stated that the equipment was relatively old and that he did not know its original cost. In light of the fact that the only equipment loaned to Milan was old surplus equipment used only for the packaging of samples, and because there was no testimony or other evidence in the record of the value of that equipment, we believe an adjustment to Milan's price for SKF's provision of equipment is inappropriate.Petitioner's experts determined an add-on to Milan's price for the quality control activities performed by SKF. Because SKF had certain of its quality control personnel at Milan's facility during each of SKF's production runs of SK-65 Compound, the experts concluded that 422 Milan's relationship with SKF was more favorable than that of Lilly P.R.'s with petitioner. Respondent states, however, and we agree, that that analysis overlooks the fact that Milan was still required to employ and utilize its own quality control personnel. Milan's quality control personnel performed all required FDA checks on the SK-65 Compound produced. After the first several production runs of the compound, SKF accepted Milan's quality control assay reports. SKF did not maintain any FDA required records for Milan; Milan maintained all of the required records relative to its production of SK-65 Compound.We believe that SKF's quality control activities on behalf of Milan were duplicative at best and did not relieve Milan of any of the costs of providing its own quality control. Accordingly, 1182 petitioner's add-on for the difference in quality control is without merit.The sixth adjustment by petitioner's experts was made with respect to quality differences between the Darvon Compound-65 manufactured by Lilly P.R. and the SK-65 Compound manufactured by Milan. We believe petitioner's experts correctly determined that some add-on to Milan's price is necessary for these differences. 423 The Darvon Compound-65 manufactured by Lilly P.R. during 1973 utilized the glutamic acid hydrochloride formulation to avoid both the misuse and odor problems associated with other formulations of those products. Lilly P.R. developed and owned the know-how relative to the glutamic acid hydrochloride process. Lilly Research Laboratories in 1973 had begun evaluating generic propoxyphene hydrochloride formulations that were in direct competition with petitioner's Darvon 65 mg. and Darvon Compound-65. The quality of the generic products was compared with that of petitioner's Darvon products by examining specifications such as (a) uniformity of drug content, (b) uniformity of weight, (c) decomposition of aspirin in compound products into acetic acid and salicylic acid, and (d) purity, i.e., presence of nonpropoxyphene chemicals generated by the chemical manufacturing process.One of the products evaluated by Lilly Research Laboratories was the SK-65 Compound manufactured by Milan. Milan at that time utilized the encased propoxyphene hydrochloride pellet to prevent its interaction with the aspirin in the formulation. Lilly Research Laboratories identified two problems with that formulation. 424 First, the pellet easily was removed from the capsule and therefore was subject to misuse. Second, x-ray examination of the capsules showed a greater variability of active ingredient per capsule than in Darvon Compound-65, as some SK-65 Compound capsules contained either two pellets or no pellet at all.Petitioner has demonstrated to the Court's satisfaction that Darvon Compound-65 was a better product than SK-65 Compound. It has not, however, demonstrated what the adjustment to Milan's price should be for that difference. When petitioner was attempting to determine arm's-length prices for Lilly P.R.'s products for 1973, when the propoxyphene patent no longer would be in existence, petitioner valued the glutamic 1183 acid hydrochloride formula as providing Lilly P.R. a 3-percent royalty. Because the Darvon Compound products using that formula represented approximately 65 percent or $ 54 million of petitioner's 1973 estimated sales of Darvon and Darvon-N products of $ 70 million, petitioner estimated that approximately $ 2 million of income was attributable to the glutamic acid hydrochloride formula. See p. 1079. Bearing this in mind, and in light of all other pertinent facts, we conclude 425 that Milan's price should be increased by $ 0.21.The seventh and final adjustment involves the value of the unexpired napsylate patent owned by Lilly P.R. Because Lilly P.R. calculated its transfer prices on the basis of a standard discount from net wholesale price, the retained value of Lilly P.R.'s napsylate patent was spread across Lilly P.R.'s entire Darvon and Darvon-N product lines. Petitioner's experts thus believed that some adjustment to Milan's price was necessary to reflect the ownership of that valuable patent by Lilly P.R. Working backwards from Lilly P.R.'s transfer price of $ 12,17, and taking into consideration the increases previously determined, petitioner's experts arrived at a total figure of $ 1.81 for the last four adjustments. We are provided with no breakdown of that estimated, lump-sum amount, and petitioner has compounded our dilemma further by stating on brief that, because Milan's actual raw materials cost was proven at trial to be $ 1.14 rather than $ 0.85, the aggregate adjustment for the final four items need only be $ 1.52.As with the glutamic acid hydrochloride formula, petitioner considered the value of the napsylate patent when it was attempting 426 to set Lilly P.R.'s prices for 1973. See p. 1080. Petitioner at that time concluded that a reasonable royalty on the napsylate patent would be $ 1.5 to $ 3 million of the estimated $ 30 million attributable to intangibles under petitioner's method of allocations. On projected sales of $ 70 million, with sales of napsylate products projected to be approximately 20 percent of total sales, the napsylate royalty then was approximately 10 to 20 percent of total propoxyphene sales. Petitioner's expert, Dr. Brozen, testified that the napsylate patent royalty could go as high as 30 percent. Because Darvon-N sales in 1973 actually were approximately 25 percent of total sales, these figures represent possible royalties of 2.5, 5, and 7.5 percent of all propoxyphene sales. 1184 Petitioner argues that the 7.5 percent factor (multiplied against the net wholesale price for Darvon Compound-65 of $ 28.97) would yield an adjustment of $ 2.17, which alone was well in excess of the aggregate adjustments of $ 1.81 or $ 1.52 determined by its experts as being the add-on for all four of the final four differences. The smaller 2.5- and 5-percent factors stated above yield adjustments of $ 0.72 and $ 1.45, 427 respectively, when applied against petitioner's net wholesale price of $ 28.97.While petitioner's evidence as to the value of the napsylate patent was uncontroverted by respondent, and it is clear that some adjustment is necessary, we cannot accept the figures above. Dr. Brozen was one of petitioner's economic witnesses: he has not shown that he had the necessary expertise in the pharmaceutical industry to value the napsylate patent. Also, the figures are based upon petitioner's method of allocating expenses between it and Lilly P.R.Additionally, respondent argues that petitioner's experts failed to consider some important differences between the petitioner-Lilly P.R. and SFK-Milan sales relationships which would reduce the Milan price to SFK. During 1973, SFK's market for Milan's SK-65 Compound was in the range of $ 1 million, while petitioner's purchases of Lilly P.R.'s products were in excess of $ 30 million. Respondent contends that basic economics would provide for an adjustment to the prices where, as here, one of the parties was a large volume purchaser; and that petitioner's experts failed to take into account that an arm's-length purchaser paying $ 30 million for products 428 would demand a substantial quantity discount. Respondent also argues that Lilly P.R., as opposed to Milan, bore none of the risk associated with manufacturing propoxyphene hydrochloride compound. SKF made no guarantees in the event Milan could not manufacture the product economically or if SKF could not successfully market the product against petitioner and other competitions. On the other hand, respondent alleges that Lilly P.R. had a guaranteed market for its products, and that production levels were determined by petitioner and Lilly P.R. assumed no risk in manufacturing Darvon and Darvon-N products.We agree with respondent that the above factors must be taken into account when determining the adjustment for the 1185 napsylate patent. The levels of market were greatly different between Lilly P.R. and Milan, and such a difference clearly is contemplated by the section 482 regulations as being susceptible to evaluation and adjustment. Sec. 1.482-2(e)(2)(ii), Income Tax Regs. Although we would not characterize Lilly P.R.'s relationship with petitioner as being one in which Lilly P.R. had a guaranteed purchaser for its products, the fact remains that petitioner notified Lilly P.R. of 429 its anticipated product needs and Lilly P.R.'s production planning personnel then determined Lilly P.R.'s production schedules and output based upon that information. The likelihood of Lilly P.R. producing products for which it had no purchaser (petitioner) at the time, thus was highly remote.Finally, in our discussion of the years 1971 and 1972, we stated that petitioner improperly classified some expenses and failed entirely to include others (i.e., general research and development expenses) in its pro forma combined income statements for Darvon and Darvon-N products. Such treatment artificially inflated the income resulting from Lilly P.R.'s ownership of the manufacturing intangibles. Irrespective of the total lack of connection between sales dollars and dollars spent on research, in the "real world" a research-intensive company such as petitioner simply would not purchase for resale a product that did not allow a sufficient return to cover a proportionate share of its research expenses. In keeping with our earlier holding concerning petitioner's current general research and development expenses, some adjustment is necessary to reflect that portion of petitioner's general research 430 and development activities the cost of which is borne by Darvon and Darvon-N revenues.Respondent has proven that, in making our adjustment with respect to the value of Lilly P.R.'s napsylate patent, we must consider the additional factors of market level, risk, technical assistance, and research and development. However, he has offered no evidence or estimation of what the adjustment should be. That task is left to us. Using our best judgment, we conclude that Milan's price should be increased by $ 0.48.The following is a summary of the Court's adjustments to Milan's price for the reasons and in the amounts set out above. 1186 Milan price$ 7.55Adjustmentsa. Raw materials0.86b. Credit terms0.20c. Samples0.50d. Equipmente. Quality controlf. Quality difference0.21g. Napsylate patent, market level, risk, technical0.48assistance, and research and developmentAdjusted Milan price9.80The Milan price, as adjusted, yields an arm's-length price of $ 9.80 for Darvon Compound-65 in 500 capsule bottles. Petitioner's net wholesale price for such product was $ 28.97. Accordingly, Lilly P.R.'s prices for Darvon and Darvon-N products are adjusted to petitioner's net wholesale price less a discount of 431 66 percent. 112 In accordance with our earlier discussion and holding concerning the expenses of petitioner's ticket issuance and finished stock planning activities performed for Lilly P.R., we also allocate from Lilly P.R. to petitioner the amounts of $ 22,000 (ticket issuance) and $ 63,000 (finished stock planning) in 1973.B. Revenue Procedure 63-101. 1971 and 1972 Taxable YearsPetitioner argues in the alternative that its prices for 1971 and 1972 can be measured under section 4.03 and 4.04 of Rev. Proc. 63-10, 1 C.B. 490">1963-1 C.B. 490 (based upon Technical Information Release (T.I.R.) 441, dated January 11, 1963), and that under either of those subsections Lilly P.R.'s prices to petitioner satisfy the arm's-length standard. Respondent argues that Rev. Proc. 63-10 is not applicable to a situation where the mainland affiliate has transferred intangibles to its island affiliate without receiving in exchange adequate compensation.1187 Rev. Proc. 63-10 was issued prior to the promulgation of the 1968 section 482 regulations and set forth guidelines for the application 432 of section 482 in cases involving U.S. companies with Puerto Rican manufacturing affiliates. Rev. Proc. 63-10 still may be used in such cases if the result is more favorable to the taxpayer than that obtained under the section 482 regulations. Rev. Proc. 68-22, sec. 4, 1 C.B. 819">1968-1 C.B. 819, 821. Sections 4.03 and 4.04 of Rev. Proc. 63-10 provide in their entirety as follows:.03 All Income-Producing Intangibles Belong to the Island Affiliate.If all applicable intangibles are treated as belonging to the island affiliate, all of the income produced by the intangibles is allowed to the island affiliate. In this case, gross income of the island affiliate would be determined on the basis of a selling price equal to the highest price which a representative independent United States company comparable to the mainland affiliate would pay for the product involved. In principle, this price would approximate the final United States market price for the product less (a) the mainland affiliate's costs of distribution, (b) a reasonable margin of profit for distribution, and (c) all costs incident to transportation from the point of sale in Puerto Rico..04 Some Income-Producing Intangibles Belong to 433 the Island Affiliate.If some, but not all intangibles which are significant in a joint operation are treated as belonging to the island affiliate, it would be allowed a price, which assumed the ownership of no intangibles plus an amount representing an estimated payment by the mainland affiliate for those intangibles owned by the island affiliate. This amount would be based on evidence available regarding what an independent company would receive as royalties or fees or as an increased price in such circumstances.[1963-1 C.B. at 496-497.]Respondent argues that Rev. Proc. 63-10 applies only to cases in which the island affiliate itself has developed an intangible, or where it has purchased an intangible for arm's-length consideration. As support for his argument, respondent cites section 1 of the revenue procedure, which section provides in relevant part:The guidelines concern what may be considered as the standard type of allocation problem that has arisen in these cases. They do not deal with other problems that may be involved in particular cases, including those which may be present in cases involving the transfer of income producing intangibles from the United States to an affiliate 434 located in Puerto Rico. [1963-1 C.B. at 490; emphasis added.]1188 We believe that Rev. Proc. 63-10 is clear on its face and that it does apply to the situation at hand. Contrary to respondent's assertion, the quoted language does nothing more than restate the obvious -- that Rev. Proc. 63-10 does not provide guidelines for problems other than section 482 problems that could be involved in cases in which intangibles are transferred to Puerto Rican affiliates. The principle nonsection 482 problem involved in such cases is the determination of whether or not the intangibles in fact have been transferred.Our interpretation is supported by a realistic view of the legal and factual environment in which Rev. Proc. 63-10 applies. The tax incentives provided by the government of Puerto Rico generally apply only to income from manufacturing operations in Puerto Rico. A Puerto Rican affiliate can qualify for the tax incentives of section 931 only if it earns 80 percent or more of its gross income from sources within Puerto Rico and 50 percent or more of its gross income from the active conduct of a trade or business in Puerto Rico. To qualify for those tax incentives, taxpayers must conduct 435 their Puerto Rican operation according to certain well-defined patterns. Generally, mainland affiliates organize new wholly owned domestic subsidiaries to manufacture products in Puerto Rico, with the marketing and distribution functions retained and performed by the mainland affiliate. Moreover, except in unusual cases, any significant intangibles related to products manufactured by the Puerto Rican affiliate are first developed or acquired by the mainland affiliate.In this context, the only realistic cases in which the Puerto Rican affiliate can own significant intangibles are those in which the intangibles have been transferred to the Puerto Rican affiliate from its mainland affiliate. If sections 4.03 and 4.04 of Rev. Proc. 63-10 do not apply to intangibles transferred to Puerto Rican affiliates, it is difficult to conceive of a case in which they would apply. Our interpretation of the language quoted by respondent is buttressed by section 4 of Rev. Proc. 63-10, entitled "Application of Section 482 in Cases Involving Intangibles." Subsection 4.01 states as follows:Not infrequently, the return attributable to intangibles is substantial. Therefore, in cases where significant income-producing 436 intangibles are present the determination whether they belong to the island affiliate or the 1189 mainland affiliate is important in the proper application of section 482 of the Code.* * * It is a question to be decided under the facts and circumstances of a particular case (a) whether significant intangibles are present, and (b) if significant intangibles are present, whether they belong to the mainland or the island affiliate.[1 C.B. 496">1963-1 C.B. 496.]Furthermore, on January 15, 1963, 4 days after the issuance of T.I.R. 441, the Service issued Manual Supplement 42G-86, which provided instructions to Service personnel for applying the guidelines of T.I.R. 441. Section 4.02 of Manual Supplement 42G-86, entitled "Determination of the Party to Whom Intangibles Belong," provided as follows:It is a question to be decided under the facts and circumstances of a particular case (a) whether significant intangibles are present and (b) if significant intangibles are present, whether they belong to the mainland or to the island affiliate. * * As to other intangibles, such as patents, trademarks, trade names, etc., originally developed or owned by the mainland affiliate, an examination must be made to 437 determine whether there is evidence that they have been transferred to the island affiliate. Taxpayers may claim that there has been a sale at a fair market price or a tax-free transfer under section 351, with section 367 clearance if the island affiliate is a foreign corporation rather than a section 931 domestic corporation.Examination may show that there is in fact no substantial evidence that intangibles have been transferred or may show that the island affiliate has merely been permitted to use the mainland affiliate's intangibles as, for example, by manufacturing patented products and affixing to them the mainland affiliate's trademark. The lack of formal documents transferring the intangibles, continued use of the intangibles by the mainland affiliate in its own operations, and the retention by the mainland affiliate of protective and exploitative activities related to the intangibles, such as the conduct of infringement proceedings and supervision of licensing programs, would indicate that the intangibles have not, in substance, been transferred to the island affiliate and are still owned by the mainland affiliate.Manual Supplement 42G-166, which was issued on April 8, 1968, 438 was intended to supplement the provisions of Manual Supplement 42G-86. Section 5 of Manual Supplement 42G-166 provided that "the Service will continue to apply the 1190 guidelines of Manual Supplement 42G-86." Section 5.03(8) of Manual Supplement 42G-166 provided in pertinent part as follows:In final analysis, however, as Section 4.02 of Manual Supplement 42G-86 points out, "It is a question to be decided under the facts and circumstances of a particular case (a) whether significant [income-producing] intangibles are present and (b) if significant intangibles are present, whether they belong to the mainland or to the island affiliate."It thus is clear that Rev. Proc. 63-10 applies to the case in which the Puerto Rican subsidiary owns intangibles transferred to it by the U.S. parent. Petitioner argues that section 4.03 provides a resale-price method by which an arm's-length price can be determined. Without addressing any of petitioner's other contentions, we conclude that section 4.03 is not applicable to petitioner's case. Petitioner transferred to Lilly P.R. only the manufacturing intangibles; it retained and used the marketing intangibles associated with its sales of Darvon and 439 Darvon-N products. Petitioner has made no claim otherwise. The value of its marketing intangibles was not an insubstantial amount, and we held that petitioner earned 45 percent of the net income attributable to intangibles through its promotion and sales of the trademarked Darvon and Darvon-N product line.In short, because petitioner continued to own the marketing intangibles throughout the years in issue, Lilly P.R. did not own all of the income-producing intangibles as required by section 4.03 of Rev. Proc. 63-10. This result is contemplated in section 4.01, which provides as follows:It may be expected that as to certain intangibles no supportable contention could be made that they belong to the island affiliate. For example, if the mainland affiliate acts as the marketing and servicing organization for products produced by the island affiliate, any market position, consumer acceptance, or similar factors of good will attributable to the distribution and product servicing activities in the United States do not, as a matter of substance, belong to the island affiliate.Consequently, section 4.03 is unavailable for our purposes herein. Section 4.04, however, provides guidelines for 440 a case such as this, where "some, but not all intangibles which are significant in a joint operation are treated as belonging to the island affiliate." The guidelines are extremely brief and 1191 basically provide that the island affiliate is to receive a price for its products as if it owned no intangibles, plus an amount representing an estimated payment from the mainland affiliate for the use of the intangibles owned by the island affiliate. This method is similar to the cost plus method of the regulations under section 482. We previously rejected the use of that method for 1971 and 1972 due to the lack of evidence with respect to unrelated companies and estimated royalty values. On the facts of this case, we conclude the method provided by Rev. Proc. 63-10, sec. 4.04, would not result in either a more accurate or more favorable estimate of Lilly P.R.'s arm's-length prices than the profit split approach we used under the section 482 regulations. We thus decline to apply it.2. 1973 Taxable YearPetitioner argues in the alternative that Lilly P.R.'s prices satisfy the independent prices for similar products method under section 3.02(2) of Rev. Proc. 63-10, 1 C.B. 490">1963-1 C.B. 490, 493. That 441 section provides as follows:2. Independent Prices for Similar Products. -- The problem of applying section 482 of the Code is more difficult as a practical matter when directly applicable independent prices are not available. However, when a product manufactured in Puerto Rico and sold only to a mainland affiliate differs only slightly from other products bought and sold by independent firms, an arm's length price for the island affiliate may be determined by adjusting these independent prices to take account of such minor differences as are present.Rev. Proc. 63-10 thus provides for adjustments to the independent prices just as section 1.482-2(e)(2) of the regulations does. Accordingly, our adjustments, adjusted price, and discount from petitioner's net wholesale prices would be the same under Rev. Proc. 63-10.To reflect the foregoing,Decision will be entered under Rule 155. Footnotes1. These and the above deficiencies include amounts attributable to the issues severed from this case and consolidated with the case of petitioner in docket No. 19606-80.↩2. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue.↩3. Of the remaining 40 percent, 30 percent was attributable to the sale of agricultural products and 10 percent was attributable to the sale of cosmetics.↩4. Acetaminophen is sold separately over the counter under such trademarks as Tylenol Registered TM.↩5. When propoxyphene hydrochloride is mixed with aspirin (acetylsalicylic acid), the aspirin tends to deteriorate in the presence of moisture into its component parts: acetic acid, which smells like vinegar, and salicylic acid, which is a highly irritating substance.6. Subsequent to Dec. 5, 1966, petitioner manufactured 700 kilograms of propoxyphene hydrochloride pursuant to a license agreement with Lilly P.R., and obtained 2,607.2 kilograms of propoxyphene hydrochloride from recovery, rework, or cleanup of lots of propoxyphene hydrochloride manufactured by petitioner in 1966, prior to its assignment of the propoxyphene and napsylate patents to Lilly P.R.7. The term "developed" as we use it here includes, but is not limited to, the initiation, testing, and modification of the procedures involved.↩8. See pp. 1066-1068 for a definition and discussion of NDAs.↩9. The term "dry pharmaceutical products" refers to tablets and filled capsules which are taken orally as contrasted with other pharmaceutical products such as syringes, liquids, ointments, and injectable medications.↩10. The expenses and operating profits, as published, for the four export subsidiaries involved were adjusted by petitioner to better relate intercompany administrative fees to the appropriate sales income. The percentages stated above utilized the adjusted operating figures.↩11. As stated earlier, that plan involved (1) the commencement of pharmaceutical manufacturing operations in a leased facility; (2) the establishment of empty capsule manufacturing and pharmaceutical manufacturing in a permanent facility owned by Lilly P.R.; and (3) the establishment of chemical manufacturing on a permanent site, also to be owned by Lilly P.R.12. The Service and petitioner both use "Darvon" to include Darvon and Darvon-N products.↩13. Patent 3,065,261 is the napsylate patent, not the patent relating to Ultran Registered TM14. "Net wholesale price" refers to petitioner's price to drug wholesalers for a particular product. During the years 1965 through 1973, net wholesale prices were determined by discounting petitioner's "net trade prices," which were its suggested prices to retail pharmacies, by 17 percent.↩15. See also pp. 1074-1076.↩16. "Identi-dose" was petitioner's trademarked name for its individual dosage from packages of Darvon and Darvon-N products.↩17. Petitioner's projected product needs were updated on a monthly basis and, if sales were moving faster than anticipated, changes in product needs were communicated to Lilly P.R. by telephone.↩18. The Carolina facility also manufactured one small volume propoxyphene liquid product, Darvon-N Suspension.↩19. The master formula and manufacturing ticket for a product were often as long as 15 feet.↩20. The parties have stipulated the amounts of the expenses. We accept them as fact although the amounts do not total $ 65,551,000, as shown.↩21. The required application for new drugs other than antibiotics is called an NDA. The required application for an antibiotic drug is FDA Form 5 and contains essentially the same information as an NDA. For convenience, both NDAs and Forms 5 are referred to herein as NDAs.↩22. Lilly Research Laboratories also utilized a research project number (RP 1195) for studies of analgesics in general. Some information obtained from studies under RP 1195 was submitted as support for Darvon-N related NDAs during the years 1971 through 1973; however, the studies were not specifically related to propoxyphene products.↩23. NDA No. 16-827 covered Darvon-N capsules. Petitioner, however, decided not to market Darvon-N in capsule form.↩24. On Mar. 12, 1973, petitioner filed an NDA (No. 17-122) with the FDA covering Darvocet-N 100 (TA 1893). Darvocet-N 100 is the same product as Darvocet-N 50, except that it contains twice the amounts of propoxyphene napsylate and acetaminophen contained in Darvocet-N 50. The NDA was approved on Nov. 12, 1973, but petitioner did not market Darvocet-N 100 until 1974.25. All animal and human testing, as well as the preparation of all correspondence, associated with obtaining FDA approval of NDAs for Darvon and Darvon-N products was performed or contracted by Lilly Research Laboratories.↩26. The parties incorrectly stipulated this number as $ 897,065. We have found what we consider to be the correct total.↩27. The 50-, 100-, and 500-package sizes refer to bottles of 50, 100, and 500 capsules or tablets, respectively. The 25/30-package size was a package containing 25 packages of 30 capsules or tablets. The 20/50-package size was a package containing 20 packages of 50 capsules or tablets. The ID 10cc-package size for Darvon-N Suspension was an Identi-dose package of 100 individually labeled bottles each containing one dose.↩1. We have corrected the parties' erroneous stipulation of this package size as 20/30.↩28. The parties have stipulated these figures as being the discounts in effect during the years stated. We note, however, that the stipulated discounts often were in effect for only part of the respective years. For example, the discount for 1971 was 45 percent as of Jan. 1, 1971. That discount was reduced to 40 percent for Darvon products in March 1971, and for Darvon-N products in August 1971.↩1. These discounts also applied to Darvon-N products sold by Lilly P.R. to petitioner.↩29. During January and February 1971, the chargeback percentage was 15 percent.↩30. Petitioner's calculation, as we have deduced it from the record, was as follows:↩In millions of dollarsMinimumMaximumManufacturing know-how4.55Glutamic acid hydrochloride22Napsylate patent1.538.010Expressed as a percentage of $ 30attributable to intangibles26.6%33.3%Average of minimum and maximum29.9%31. RP 1638 (propoxyphene hydrochloride and acetaminophen), established for the purpose of developing the product Darvocet, appears to be an exception to this rule. Petitioner has failed to explain the disparity in treatment of Darvocet and other products. Also, no PD number was established for Darvon-N products until 1967, although propoxyphene napsylate was identified and the patent was approved in the early 1960's.↩32. Prior to 1970, the project accounting system did not charge clinical grants directly to research projects. For the years 1967 through 1969, petitioner reviewed the clinical grants records of Lilly Research Laboratories to determine which clinical grants properly were attributable to Darvon and Darvon-N products. Petitioner billed Lilly P.R. for the costs of the grants it so identified. From 1970 through 1973, all clinical grants determined by petitioner to be attributable specifically to Darvon and Darvon-N products were charged directly to such projects, and thus billed to Lilly P.R., in accordance with the project accounting system.33. See e.g., pp. 1072-1073 supra↩.34. If the employees traveled to Puerto Rico, however, their time as well as their travel expenses were billed to Lilly P.R.35. Those activities included the serving of petitioner's employees on Lilly P.R.'s board of directors, as all the employees so serving were above the level of assistant director.↩1. Includes sample expense of $ 1,872,896.↩36. See p. 1054 for the meaning of primary details.↩37. The record is silent as to what those accounts were in 1972. In 1973, the total pharmaceutical division selling expenses were reduced only by the expenses of the Dista sales force.↩38. Rachelle purchased propiophenone and began its chemical manufacture of propoxyphene hydrochloride at the equivalent of petitioner's step 2.↩39. Lilly P.R. purchased from petitioner all labels and literature, as well as some bottle caps, used in its packaging of Darvon and Darvon-N products.40. Sec. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.41. SEC. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.(a) General Rule. -- No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)↩) of the corporation.42. For an overview of the tax relationship between the United States and its possessions and territories, see Hoff, "U.S. Federal Tax Policy Towards the Territories: Past, Present and Future," 37 Tax L. Rev. 53">37 Tax L. Rev. 53↩ (1981).43. Sec. 936 allows the tax credit to domestic corporations operating in Puerto Rico and all possessions of the United States except the Virgin Islands. Sec. 931 was retained to provide the possessions source income exclusion to qualifying U.S. individual citizens. For sec. 931 purposes, however, "possession" does not include Puerto Rico, Guam, or the Virgin Islands. Sec. 931(c); sec. 1.931-1(a), Income Tax Regs.↩ The Puerto Rican-source income exclusion for qualifying U.S. individual citizens is now contained in sec. 933.44. On Sept. 3, 1982, Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Pub. L. 97-248, 96 Stat. 324. TEFRA contains new provisions dealing specifically with the issue before us involving the tax-free transfer of intangibles to a possessions corporation. However, no inference can be drawn from those provisions and the fact of their enactment can have no effect on our decision herein. See H. Rept. 97-760 (Conf.) (1982), 2 C.B. 600">1982-2 C.B. 600↩, 617 n. 1. Moreover, the provisions are effective, with two exceptions not relevant herein, only for taxable years beginning after Dec. 31, 1982.45. "Control" is defined by sec. 368(c) as being "the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." There is no question of control being present in the case as Lilly P.R. was at all times the wholly owned subsidiary of petitioner. We mention control merely as being one of the requirements for nonrecognition under sec. 351↩.46. Rev. Rul. 64-155, 1964-1 C.B. (Part 1) 138 provides, in pertinent part:"X, a domestic corporation, proposes to contribute appreciated property to Y, an existing wholly owned foreign subsidiary. Although X will not receive any additional Y shares, the transaction will be considered an exchange of property for stock described in section 351 of the Internal Revenue Code of 1954."Revenue rulings "have none of the force or effect of Treasury decisions" and do not commit the Service to a particular interpretation of the law. Helvering v. New York Trust Co., 292 U.S. 455 (1934). While a ruling is not controlling, however, it is not without weight and we will consider it as a statement of respondent's position on a given set of facts. Groves v. United States, 533 F.2d 1376">533 F.2d 1376 (5th Cir. 1976), affg. an unreported District Court opinion, cert. denied 429 U.S. 1000">429 U.S. 1000↩ (1976).47. Petitioner's transfer of patents and know-how was a "transfer of property." See, e.g., Hooker Chemicals & Plastic Corp. v. United States, 591 F.2d 652">591 F.2d 652 (Ct. Cl. 1979); DuPont de Nemours & Co. v. United States, 471 F.2d 1211 (Ct. Cl. 1973); Bell International Corp. v. United States, 381 F.2d 1004">381 F.2d 1004 (Ct. Cl. 1967); Rev. Rul. 71-564, 2 C.B. 179">1971-2 C.B. 179; Rev. Rul. 64-56, 1964-1 C.B. (Part I) 133. See also generally Beschell, Taxation of Patents, Trademarks, Copyrights & Know-How, par. 6.3, 6.3A, at 6-5 -- 6-14 (1974).48. A ruling may be modified or revoked by the Service, effective in rare cases even retroactively. Sec. 7805(b); sec. 601.201(1), Statement of Procedural Rules; Automobile Club of Michigan v. Commissioner, 353 U.S. 180">353 U.S. 180, 184 (1957). The record in this case clearly indicates that the representations of fact by petitioner upon which the Service's ruling to petitioner was based were accurate. The ruling issued to petitioner has not been revoked and thus is controlling. See Wisconsin Nipple & Fabricating Corp. v. Commissioner, 67 T.C. 490">67 T.C. 490, 497 (1976), affd. 581 F.2d 1235">581 F.2d 1235↩ (1978).49. Sec. 240 allowed affiliated corporations, which were previously required to file consolidated returns, to file separate returns. Corporations entitled to the benefits of sec. 262 (the predecessor of sec. 931), however, were treated as foreign corporations by sec. 240(d) and thus were prevented from filing consolidated returns. Sec. 1504 (b)(4), I.R.C. 1954↩, continues the possessions corporation proscription from filing consolidated returns.50. The term "controlled," as defined by sec. 1.482-1(a)(3), Income Tax Regs., has a much more expansive meaning than that used in secs. 351 and 368. See n. 44 supra. For the purposes of sec. 482↩, "'controlled' includes any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised." Lilly P.R. was at all times the wholly owned subsidiary of, and was controlled by, petitioner.51. See generally B Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders, par. 15.06, at 15-16 (4th ed. 1979); Eustice, "Tax Problems Arising From Transactions Between Affiliated or Controlled Corporations," 23 Tax L. Rev. 451">23 Tax L. Rev. 451, 460-462, 480-496↩ (1968).52. For purposes of sec. 482, the terms "tax evasion" and "tax avoidance" are interchangeable. See Asiatic Petroleum Co. v. Commissioner, 79 F. 2d 234, 236 (2d Cir. 1935); Foster v. Commissioner, 80 T.C. 34">80 T.C. 34, 158 (1983), affd. on this issue 756 F. 2d 1430↩ (9th Cir. 1985).53. Sec. 1.482-1(b)(1), Income Tax Regs., adopted in 1968, provides, in pertinent part:(b) Scope and purpose. (1) The purpose of section 482↩ is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true taxable income from the property and business of a controlled taxpayer. * * * The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.54. But see Ruddick Corp. v. United States, 226 Ct. Cl. 426">226 Ct. Cl. 426, 643 F.2d 747">643 F.2d 747 (1981), remanded 3 Cl. Ct. 61">3 Cl. Ct. 61 (1983), affd. 732 F.2d 168">732 F.2d 168↩ (Fed. Cir. 1984).55. To facilitate our discussion of the cases, we will hereafter refer to the sections involved solely by their current designations.↩56. At trial, the Commissioner conceded that the taxpayer was entitled to deduct the portion of loss sustained during the period in which it held the stock.↩57. Because of the lack of tax avoidance motives herein, petitioner states that Ruddick Corp v. United States, 226 Ct. Cl. 426">226 Ct. Cl. 426, 643 F.2d 747">643 F.2d 747 (1981), remanded 3 Cl. Ct. 61">3 Cl. Ct. 61 (1983), affd. 732 F.2d 168">732 F.2d 168 (Fed. Cir. 1984), is controlling. In that case, the Court of Claims held that, absent the taint of tax avoidance or tax evasion, the Commissioner is not authorized by sec. 482 to allocate income on the ground of clear reflection of income in a situation involving a specific nonrecognition provision. However, National Securities and subsequent law make it clear that a valid business purpose will not preclude the application of sec. 482 in such a situation when necessary clearly to reflect income. Secs. 1.482-1(c), 1.482-1(d)(5), Income Tax Regs.; Rooney v. United States, 305 F.2d 681">305 F.2d 681 (9th Cir. 1962); Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214">198 F.2d 214↩ (2d Cir. 1952).58. Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214 (2d Cir. 1952), revg. and remanding this issue 16 T.C. 882">16 T.C. 882 (1951), involved a tax-free reorganization under the predecessor of sec. 368(a)(1)(F); the taxpayers in Rooney v. United States, 305 F.2d 681">305 F.2d 681 (9th Cir. 1962), affg. 189 F. Supp. 733">189 F. Supp. 733 (N.D. Cal. 1960), transferred their crop under sec. 351↩.59. Contra Heaton v. United States, 573 F. Supp. 12">573 F. Supp. 12 (E.D. Wash. 1983); Fanning v. United States, 568 F. Supp. 823 (E.D. Wash. 1983). In each of those cases, the District Court held the Commissioner abused his discretion in allocating planting expenses claimed by individual farmers to their newly formed farm corporation because the farmers, unlike the taxpayers in Central Cuba Sugar and Rooney↩, did not generate a net operating loss.60. In Central Cuba Sugar↩, the taxpayer received from the Service an advance ruling under the predecessor of sec. 367 that the proposed transaction was "not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income taxes."61. The level of activity carried on by Lilly P.R. and the amount of its capital investment were set out in detail in our findings of fact. No purpose would be served by restating that information here.62. Petitioner's research and development expenses related to Darvon and Darvon-N products for the years 1951 through 1966 were $ 3,168,000 (see p. 1084). That figure, however, does not include the expenses during that period for propoxyphene-related clinical grants. Petitioner's best estimate of the amounts expended for those clinical grants during the years 1951 through 1957 is $ 200,000 per year, or $ 1,400,000 for the 7-year period. Petitioner estimates that its propoxyphene-related clinical grants for the years 1958 through 1966 averaged $ 1 million per year, or $ 9 million for the 9-year period. Petitioner's total propoxyphene-related research and development expenses, therefore, were approximately $ 13,568,000. Petitioner's net income before taxes on U.S. sales of Darvon products for the years 1958 through 1966 totaled $ 155,100,000. (See p. 1009.) (1966 sales of Darvon included some sales by Lilly P.R.)63. We do not imply that respondent's authority to invoke sec. 482 is limited to within a 1 year period. See G.U.R. Co. v. Commissioner, 117 F.2d 187">117 F.2d 187 (7th Cir. 1941), affg. 41 B.T.A. 223">41 B.T.A. 223↩ (1940).64. In addition to the arguments discussed above, respondent argues that petitioner's transfer of the intangibles should be ignored for sec. 482 purposes under Foglesong v. Commissioner, 621 F.2d 865">621 F.2d 865 (7th Cir. 1980), revg. and remanding a Memorandum Opinion of this Court, on remand, 77 T.C. 1102">77 T.C. 1102 (1981), revd. 691 F.2d 848">691 F.2d 848 (7th Cir. 1982). We, however, find Foglesong clearly distinguishable from the present case. In Foglesong the Seventh Circuit held that a sec. 482 allocation of income from a one-man personal service corporation to the shareholder-employer was improper because the taxpayer as employee could not be considered a separate trade or business. Respondent's determinations herein do not involve allocations of income and deductions from a personal service corporation to the sole shareholder-employer. Accordingly, Foglesong is not on point and does not control disposition of the issues in the present case. Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742, 757 (1970), affd. 445 F. 2d 985 (10th Cir. 1971); Arnwine v. Commissioner, 76 T.C. 532">76 T.C. 532, 544-545↩ (1981).65. See Portland Oil Co. v. Commissioner, 109 F.2d 479">109 F.2d 479, 488 (1st Cir. 1940), affg. 38 B.T.A. 757">38 B.T.A. 757 (1938):"It is the purpose of [the predecessor of section 351] to save the taxpayer from an immediate recognition of gain, or to intermit the claim of a loss, in certain transactions where the gain or loss may have accrued in a constitutional sense, but where in a popular economic sense there has been a mere change in form of ownership and the taxpayer is not really 'cashed in' on the theoretical gain or closed out of a losing venture."66. Sec. 1.482-2(d)(2)(i), Income Tax Regs., provides:(2) Arm's length consideration↩. (i) An arm's length consideration shall be in a form which is consistent with the form which would be adopted in transactions between unrelated parties under the same circumstances. To the extent appropriate, an arm's length consideration may take any one or more of the following forms: (a) royalties based on the transferee's output, sales, profits, or any other measure; (b) lump-sum payments; or (c) any other form, including reciprocal licensing rights, which might reasonably have been adopted by unrelated parties under the circumstances, provided that the parties can establish that such form was adopted pursuant to an arrangement which in fact existed between them. However, where the transferee pays nominal or no consideration for the property or interest therein and where the transferor has retained a substantial interest in the property, an allocation shall be presumed not to take the form of a lump-sum payment.68. All Rule references are to the Tax Court Rules of Practice and Procedure.↩69. The fact that some cases express the taxpayer's burden of proof in the conjunctive rather than the disjunctive is of no consequence as the terms used are synonymous. See Foster v. Commissioner, 80 T.C. 34">80 T.C. 34, 142 n. 59 (1983), affd. on this issue 756 F.2d 1430">756 F.2d 1430↩ (9th Cir. 1985).70. The income attributable to the manufacturing intangibles is, by definition (see our discussion at p. 1151), the excess of Lilly P.R.'s net operating profit over its manufacturing profit and location savings. Our determination that petitioner's intercorporate pricing structure caused a distortion of income, necessitates a downward adjustment in the prices petitioner paid Lilly P.R. for the Darvon and Darvon-N products. Such an adjustment results in a commensurate diminution of Lilly P.R.'s income attributable to the manufacturing intangibles.↩71. Respondent advocates a "functional analysis" of petitioner's and Lilly P.R.'s activities vis-a-vis general pharmaceutical companies' operations. Respondent separates the functions performed into (1) research and development, (2) manufacturing, and (3) marketing. He argues that petitioner did all of (1) and (3), and part of (2), but was never reimbursed fully for the services and materials provided to Lilly P.R. Respondent thus recomputes their "true taxable income" based upon the functions performed by each over a period of more than 25 years. Respondent's argument ignores the fact that income is earned not only through the performance of specified functions, but also through the use of tangible and intangible property in the performance of such functions. Thus, respondent has disregarded a fundamental principle of taxation that income from property is earned by the owner of the property. This principle is recognized in sec. 1.482-1(b), Income Tax Regs., which provides that the purpose of sec. 482↩ is to determine the "true taxable income from the property and business of a controlled taxpayer."72. A patent owner has three exclusive rights under a patent: the right to manufacture, use, and sell the patented product. 35 U.S.C. sec. 154. However, once the product is sold by the patent owner to a third-party purchaser, such as petitioner in this case, the purchaser acquires the right to resell the product. Duplan Corp. v. Deering Milliken, Inc., 444 F. Supp. 648">444 F. Supp. 648 (D.S.C. 1977), affd. in part, revd. in part on other grounds 594 F.2d 979">594 F.2d 979↩ (4th Cir. 1979).73. "Less than" an arm's-length price in this situation is beneficial to petitioner inasmuch as respondent argues that Lilly P.R.'s prices were greater than arm's-length prices and, therefore, allowed petitioner to transfer too much income to Lilly P.R. See Rev. Proc. 63-10, 1 C.B. 490">1963-1 C.B. 490↩, 491.74. The exception was the raw material ingredient of Cordran products, which petitioner purchased from an unrelated third party.↩75. Petitioner's economic experts utilized: (1) A comparison of Darvon and Darvon-N gross profits to gross profits of all other pharmaceutical products of petitioner; (2) a comparison of Darvon and Darvon-N operating income to operating income from all other pharmaceutical products of petitioner; and (3) an analysis of 1973 prices for generic propoxyphene products sold in the United States. A fourth method, analyzing propoxyphene market prices in various foreign markets where no patent protection exists, was used, but Dr. Brozen admitted that that test was almost meaningless.↩76. "Similar" in the context of the resale price method relates to the probable effect upon the markup percentage of any differences between the uncontrolled and controlled purchases and resales. Thus, close physical similarity of the property involved in the sales compared is not required under the resale price method since a lack of close physical similarity is not necessarily indicative of dissimilar markup percentages. Sec. 1.482-2(e)(3)(vi), Income Tax Regs.↩ Darvon and Darvon-N products were among the 10 largest selling ethical pharmaceutical products in the United States during 1971 and 1972; the other largest selling products on the market apparently were marketed by their manufacturing companies, as petitioner did with its other product lines, and were not resold for marketing and distribution by an independent company.77. T.C. Memo. 1971-101↩.78. The following list is but a sampling of the critical commentary regarding the pricing regulations: Eustice, "Tax Problems Arising From Transactions Between Affiliated or Controlled Corporations," 23 Tax L. Rev. 451">23 Tax L. Rev. 451 (1968); Fuller, "Problems in Applying the 482 Intercompany Pricing Regs. Accentuated by DuPont Case," 52 J. Tax. 10 (1980); Fuller, "Section 482 Revisited," 31 Tax L. Rev. 475">31 Tax L. Rev. 475 (1976); Jenks, "Treasury Regulations Under Section 482," 23 Tax Law. 279">23 Tax Law. 279 (1970); Simon, "Section 482 Allocations," 46 Taxes 254">46 Taxes 254 (1968); Webb, "DuPont and U.S. Steel Exacerbate Section 482 Intercompany Pricing Regulations," 10 J. Corp. Tax. 152 (1983)↩.79. The two methods differ in that the notice of deficiency also allows Lilly P.R. an intracompany profit on the transfer of chemicals from the Mayaguez facility to the Carolina facility.↩80. See sec. 1.482-2(e)(3)(iii), examples (1) & (2↩), Income Tax Regs., where the manufacturer's use of a patent made difficult the determination of an appropriate gross profit percentage under the cost plus method.81. See also Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182">435 F.2d 182, 185 (7th Cir. 1970), affg. in part an unreported District Court opinion; Woodward Governor Co. v. Commissioner, 55 T.C. 56">55 T.C. 56, 66 (1970); Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601">42 T.C. 601, 622 (1964); Eli Lilly & Co. v. United States, 372 F.2d 990">372 F.2d 990, 997↩ (Ct. Cl. 1967).82. The taxpayer also introduced sufficient evidence to satisfy the comparable uncontrolled price method. PPG Industries, Inc. v. Commissioner, 55 T.C. 928">55 T.C. 928, 993-995↩ (1970).83. The Court noted that, because the taxpayer did not have the benefit of the regulations under sec. 482↩ (adopted Apr. 15, 1968) for the tax years in issue (1961 and 1962), it did not attempt to consider the case within the confines of those regulations.84. The author states in Fuller, "Section 482 Revisited," 31 Tax L. Rev. 475">31 Tax L. Rev. 475, 513 (1976), with respect to this case, that the Service decided to prosecute an appeal in Lufkin apparently only after careful consideration was given to the profit split analysis of the opinion. As he explains in note 158:"The Service appealed the Tax Court's decision on October 20, 1971, but on November 9, 1971 the court granted the Service's motion to extend the time for transmission of the record to the Fifth Circuit to January 8, 1972 to give the Service time to determine whether the appeal should be further prosecuted. See Aland, Section 482: 1971 Version, 49 Taxes 815">49 Taxes 815, 826 (1971). The Treasury Department was working at that time on a revised approach to intercompany pricing and it was understood by some tax practitioners that 'the Treasury [was] devoting its most intensive efforts' to developing an income spliting approach. See Hammer, Morrione & Ryan, Concepts and Techniques in Determining the Reasonableness of Intercompany Pricing Between United States Corporations and Their Overseas Subsidiaries, 30 N.Y.U. Inst. 1407, 1437-1438 (1972)."85. The location savings portion of the formula represented the reduced cost of operating in Puerto Rico as compared to the United States and was attributable primarily to lower labor rates and Lilly P.R.'s exemptions from Puerto Rican property and other nonincome taxes.86. The combined net income attributable to the intangibles (e.g. patents, manufacturing know-how, trademarks, tradenames, reputation, and goodwill) was calculated as the combined net profit excluding Lilly P.R.'s manufacturing profit and location savings, and petitioner's marketing profit. Petitioner owned the marketing intangibles, and was entitled to the income attributable thereto.↩87. Lilly P.R.'s manufacturing profit for 1971 as computed using petitioner's formula would be $ 14,549,000 (100 percent of Lilly P.R.'s manufacturing costs less operating expenses -- $ 9,821,000 (see p. 1163 infra↩) plus Lilly P.R.'s location savings allowed by respondent -- $ 4,728,000); Lilly P.R.'s gross profit for 1971 per respondent's notice of deficiency was $ 13,671,275 (Mayaguez -- $ 7,732,538 plus Carolina -- $ 5,938,737).88. Generally, by increasing petitioner's marketing profits we are decreasing Lilly P.R.'s prices to petitioner for Darvon and Darvon-N products. See pp. 1078-1080 supra↩.89. Because of the amounts of expenses of the ticket issuance and finished stock planning departments included in petitioner's cost of goods sold of Darvon and Darvon-N products increased from 1972 to 1973, we will consider this aspect of 1973 for the purpose of determining the expenses properly chargeable to cost of goods sold in 1971.↩90. The amounts petitioner charged to cost of goods sold of Darvon and Darvon-N products for 1972 and 1973, respectively, were 5 percent and 7 percent of the total ticket issuance department expenses, and 12 percent and 14 percent of the finished stock planning department expenses. We believe that petitioner's methods of determining those charges are reasonable and appropriate. It follows that the allocations for 1971 should be 3 percent (ticket issuance) and 10 percent (stock planning) of the actual expenses of those departments.↩91. We have considered the fact that Lilly P.R. could have performed the ticket issuance function during the years in issue had it had the necessary copy machine, but find it of no importance. The day-to-day character of the function remains unchanged.↩92. Besides including material costs in petitioner's cost of goods sold and increasing the allocation factor by 10 percent, we are using only petitioner's pharmaceutical division research and development expenses, rather than the total research and development expenses used by petitioner.↩93. The amounts were calculated as follows (000's omitted):[(Total G & A) Because Milan's actual cost for raw materials was $ 1.14, petitionerstates that the aggregate adjustment for items d -- g need only be $ 1.52.1/(COGS n2 + R&D n3 + Mrktg.) n4 100%] X Mrktg. allocated to Darvon/Darvon-N n5 = Darvon/Darvon-N G&A1971[(31,740)/(135,365 + 40,393 + 69,963) 110%] X 8,601 = 1,222.0971972[(35,069)/(135,781 + 45,397 + 68,994) 110%] X 10,931 = 1,685.5321 General and administrative expenses of petitioner's pharmaceutical division, p. 1089.n2 Cost of goods sold of petitioner's pharmaceutical division, p. 1089.n3 Research and development expenses of petitioner's pharmaceutical division, p. 1063.n4 Selling, merchandising, and shipping expenses of petitioner's pharmaceutical division, p. 1089.n5 Selling, merchandising, and shipping expenses with respect to Darvon and Darvon-N products, pp. 1092-1093.↩94. As discussed in our findings of fact, petitioner's research and development activities were categorized according to the nature of the work involved. The three categories were (1) general, involving the search for new pharmaceutical products; (2) defined, involving development of a specific new product; and (3) continuing or support, involving the ongoing research for, e.g., improved formulations or delivery systems of established products. The expenses allocated to Darvon and Darvon-N during the years in issue were primarily for support activities.95. See R. Wixon, W. Kell & N. Bedford, Accountants' Handbook 2-49 -- 9-51 (5th ed. 1970); American Institute of Certified Public Accountants, Inc., 2 APB Accounting Principles, APB Opinion No. 9, at 6557, 6560-6561 (June 30, 1973).↩96. Although the parties stipulated that 60 percent of petitioner's research and development expenses related to general (not defined or support) research and development activities, petitioner's expert accounting witness, Howard L. Shearon, testified that 80 percent of petitioner's research and development expenses were not allocated to particular products or product lines. Because petitioner has not proven that all the expenses connected with its provision to Lilly P.R. of FDA-related services, including, but not limited to, the maintenance of Darvon and Darvon-N NDAs, the retention and storage of lot samples, and the allowance of the right to refer to petitioner's NDAs in subsequent and supplemental NDAs, were allocated to and reimbursed by Lilly P.R., we will use the 80-percent figure as the amount of petitioner's unallocated research and development expenses.↩97. Only 1 in 8,000 new synthesized compounds is finally marketed as a new drug. Only 1 in 10 new drugs for which INDs are filed ever receives final FDA approval for marketing.↩98. Joint Exhibit 73-BT, titled "Research and Development Intensity in Pharmaceutical Industry -- A Composite Profile of Six Major Companies," states that, for 1971, research and development expenses as a percentage of net income was 42.4 percent.99. The figures above were based upon the percentage of petitioner's sales of Darvon and Darvon-N products to petitioner's total pharmaceutical sales, and were calculated as follows:Darvon/Darvon-N sales (from pp. 1092-1093)/total sales (from p. 1089) X 80% pharm. R&D (from p. 1063) = Darvon and Darvon-N general R&D197173,861,799/338,321,035 X .80 (40,393,000) = 7,054,856197275,827,232/351,043,948 X .80 (45,397,000) = 7,844,778↩100. A summary of such items, and their places in the financial statements, are set forth below:1971Financial statementsWith adjustmentsLilly P.R. (from p. 1086)Lilly P.R.Net sales$ 55,573,774Net sales$ 55,573,774Cost of goods sold12,754,744Cost of goods sold12,754,744Gross profit42,819,030Gross profit$ 42,819,030Operating expenses2,881,214Operating expenses2,881,214Operating profit39,937,816Adjustments:Ticket issuance8,550Finished stockplanning43,8002,933,564Operating profit39,885,466Petitioner (from p. 1092)PetitionerNet sales$ 73,861,799Net sales$ 73,861,799Cost of goods sold47,059,792Cost of goods sold47,059,792Gross profit26,802,007Gross profit$ 26,802,007Operating expenses9,805,444Operating expenses9,805,444Operating profit16,996,563Adjustments:Generaladministration17,920Research &development7,054,85616,878,2209,923,787Other operatingincome:Ticket issuance8,550Finished stockplanning43,80052,350Operating profit9,976,137↩1972Financial statementsWith adjustmentsLilly P.R. (from p. 1086)Lilly P.R.Net sales$ 57,188,297Net sales$ 57,188,297 Cost of goods sold14,387,345Cost of goods sold14,387,345 Gross profit42,800,952Gross profit$ 42,800,952Operating expenses$ 3,085,136Operating expenses$ 3,085,136 Operating profit39,715,816Adjustments:Ticket issuance$ 15,000 Finished stockplanning51,000 $ 3,151,136Operating profit39,649,816Petitioner (from pp. 1092-1093)PetitionerNet sales$ 75,827,232Net sales$ 75,827,232Cost of goods sold46,686,723Cost of goods sold$ 46,686,723 Gross profit29,140,509Adjustments:Ticket issuance(15,000)Finished stockplanning(51,000)46,620,723Gross profit29,206,509Operating expenses12,461,454Operating expenses12,461,454 Operating profit16,679,055Adjustments:Generaladministration155,178 Research &development7,844,778 20,461,410Operating profit8,745,099101. Mr. Step agreed with this aspect of the marketing intangibles. While he was not sure whether good products create a good company, or vice versa, he was sure that a good product enhances the reputation of a company, and makes it easier for that company's sales representatives to get in to see a health care professional about the company's other products.102. The following figures are taken from the adjusted financial statements on pp. 1163 and 1164, and from the findings of fact at p. 1106. The allocated amounts are in addition to those allocated from Lilly P.R. to petitioner for ticket issuance and finished stock planning expenses, and are calculated as follows (000's omitted):↩1971Lilly P.R.'s operating profit$ 39,885Petitioner's operating profit9,976Combined operating profit49,861Less:Manufacturing profit -- 100% Lilly P.R.'s COGs less operatingexpenses$ 9,821Location savings (from notice ofdeficiency)4,728Marketing profit -- 100% petitioner'smarketing expenses9,823Total profit excludingintangibles$ 24,372Profit due to intangibles25,489Division of intangible profitManufacturing -- 55% Lilly P.R.$ 14,019Marketing -- 45% Petitioner11,470Lilly P.R.PetitionerAllocated profit$ 14,019 Allocated profit11,470Manufacturing profit9,821 Marketing profit9,823Location savings4,728 21,29328,568 Actual profit39,885 Actual profit9,976(11,317)11,3171972Lilly P.R.'s operating profit$ 39,650Petitioner's operating profit8,745Combined operating profit48,395Less: Manufacturing profit -- 100% Lilly P.R.'s COGs less operating expenses$ 11,236Location savings (from notice of5,265deficiency)Marketing profit -- 100% petitioner'smarketing expenses12,617Total profit excluding intangibles29,118Profit due to intangibles19,277Division of intangible profitManufacturing -- 55% Lilly P.R.$ 10,602Marketing -- 45% Petitioner8,675Lilly P.R.PetitionerAllocated profit$ 10,602 Allocated profit$ 8,675Manufacturing profit11,236 Marketing profit12,617Location savings5,265 21,29227,103 Actual profit39,650 Actual profit8,745(12,547)12,547103. As stated previously, that method, when available, is the preferred approach to arm's-length pricing. Sec. 1.482-2(e)(1)(ii), Income Tax Regs.↩104. Neither party places much emphasis on the determination of arm's-length prices for all of Lilly P.R.'s Darvon and Darvon-N products based upon the prices for plain propoxyphene hydrochloride and propoxyphene hydrochloride compound products marketed by SKF and others. The reason for this is contained in sec. 1.482-2(e)(1)(iv), Income Tax Regs.:"(iv) The methods of determining arm's length prices described in this section are stated in terms of their application to individual sales of property. However, because of the possibility that a taxpayer may make controlled sales of many different products, or many separate sales of the same product, it may be impractical to analyze every sale for the purposes of determining the arm's length price. It is therefore permissible to determine or verify arm's length prices by applying the appropriate methods of pricing to product lines or other groupings where it is impractical to ascertain an arm's length price for each product or sale." * * *Petitioner determined Lilly P.R.'s prices according to a standard discount from net wholesale prices, applied to both Darvon and Darvon-N products. If the prices charged petitioner by Lilly P.R. for its Darvon Compound-65 were arm's-length prices, it follows that the prices charged petitioner on Lilly P.R.'s other products likewise were arm's-length prices. This reasoning is particularly persuasive here, as Darvon Compound-65 accounted for 50.7 percent of petitioner's Darvon and Darvon-N sales in 1973. (See p. 1089.)105. Petitioner's net wholesale price for Darvon Compound-65 in 500-capsule bottles was $ 28.97 (see p. 1074). Petitioner's discount from net wholesale prices for 1973 was 58 percent (see p. 1075). Fifty-eight percent of $ 28.97 is $ 12.17.↩106. For materials manufactured by petitioner, Lilly P.R. paid petitioner its cost plus 100 percent; for materials purchased by petitioner, Lilly P.R. paid petitioner its cost (including packaging and handling).↩107. In recognition of the propoxyphene patent's expiration on Dec. 27, 1972, petitioner revised its pricing formula so that petitioner would receive 70 percent of the intangible income for its possession of the Darvon trademark and other marketing intangibles, and Lilly P.R. would receive the remaining 30 percent as income attributable to its manufacturing intangibles.↩108. See note 104.↩109. Dr. Comanor did not use the information with respect to Caribe in his reports.↩110. The total value of those raw materials was $ 39,435.↩111. Petitioner, in 1973, could not receive dividends from Lilly P.R. without substantial tax consequences.↩112. Computed as follows:↩Net wholesale price -( net wholesale price x discount) =Lilly P.R.'s transfer price28.97 - (28.97 x) = 9.8 x = .66	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622016/	Booker T. Brooks v. Commissioner.Brooks v. CommissionerDocket No. 43750.United States Tax CourtT.C. Memo 1954-80; 1954 Tax Ct. Memo LEXIS 165; 13 T.C.M. (CCH) 583; T.C.M. (RIA) 54200; June 29, 1954, Filed Booker T. Brooks, 650 Rhodes Avenue, Akron, Ohio, pro se. James A. Scott, Esq., for the respondent. OPPERMemorandum Findings of Fact and Opinion OPPER, Judge: Respondent determined deficiencies in income tax and penalties against petitioner as follows: PenaltiesYearIncome TaxSec. 294(d)Sec. 291(a)1945$2,380.11$595.0319461,680.46420.1019471,562.461948695.55173.891949691.65172.911950728.80$116.61182.20The questions presented166 are (1) whether respondent properly determined petitioner's gross income for the years 1945 to 1950, inclusive, by means of the "expenditures" method; (2) whether in computing petitioner's net income for 1948 and 1949, respondent properly limited the standard deduction to $500; (3) whether petitioner is liable for penalties under section 291(a) for the years 1945, 1946, 1948, 1949, and 1950; and (4) whether petitioner is liable for a penalty under section 294 (d) for the year 1950. Findings of Fact Petitioner, a resident of Akron, Ohio, filed an income tax return for the calendar year 1947 with the then collector of internal revenue for the eighteenth district of Ohio. This return stated that a return had been filed for the year 1946. Petitioner failed to file any returns for the years 1945, 1948, 1949, and 1950. During the taxable years petitioner owned or operated three business: the Rotary Bowling Alley, the Theatrical Grille, and the recreation room of the Cosmopolitan Political Club. He had no records or books from which a determination of his net income for any of the years involved could be made. Respondent resorted to the "expenditures" method in order to determine petitioner's167 taxable income for the years in question. Respondent secured from loan companies and banks in Akron records of many loans and loan repayments made by petitioner during the years in question. After subtracting the loans from the loan repayments in each year, respondent added estimated living expenses for petitioner and his family for each year. The following schedule shows the amount of gross income which respondent thus determined petitioner should have reported, the amount of gross income which petitioner did report in 1947, and the resultant understatement of gross income for each year: GrossUnder-IncomeGrossstatementPerIncomeof GrossYearnoticeReportedIncome1945$13,621.90$13,621.90194612,863.0312,863.03194712,449.01$5,431.807,017.21194810,377.8110,377.81194910,357.7010,357.70195010,302.0810,302.08Petitioner has eight children for whom he was allowed dependency exemptions for each of the years involved. Petitioner was married and was divorced not earlier than 1950. Respondent allowed him a standard deduction of $1,000 for 1950 but limited the standard deduction for 1948 and 1949168 to $500. The following schedule shows the net income determined by respondent for the years involved and the amount of net income which petitioner reported for 1947: NetIncome perNetNotice ofIncomeYearDeficiencyReported1945$13,121.90194612,363.03194711,949.01$4,931.8019489,877.8119499,857.7019509,302.08Respondent relied upon information from the Akron Police Department that petitioner was known to be engaged in questionable or illegal activities. Petitioner was never arrested for gambling. Respondent determined that petitioner spent $3,900 during each of the years 1945 to 1949, inclusive, and $4,300 during 1950 for the entertainment of himself and his family. Neither petitioner nor his wife drinks. Petitioner has not had a vacation in 15 years. Petitioner's only entertainment expense consisted of sending his children to the movies about once a week. His total entertainment expense for each year did not exceed $200. Respondent properly used the "expenditures" method in determining petitioner's income for the years involved. Petitioner received gross income for the years involved as determined by respondent except169 that the amount expended for annual entertainment expenditures did not $200exceed. Petitioner's failure to file returns for 1945, 1948, 1949, and 1950 was due to negligence and not to reasonable cause. Petitioner's failure to file a declaration of estimated tax for 1950 was due to negligence and not to reasonable cause. Opinion Making every possible allowance for the fact that petitioner appeared at the hearing without counsel, that respondent made no effort to cross-examine him, and that there was virtually no probative admissible evidence offered on respondent's behalf, there yet remains the presumption of correctness to which respondent's determination is entitled and which, in order to sustain petitioner, we must find to have been overcome by this record. In that respect the only categorical statement made by petitioner which, since it was made on the stand under oath and not in any way discredited, we accept, is that his entertainment expenses as determined by respondent were excessive. We have incorporated in our findings the figure which we think should be employed for that item. We cannot, however, find that petitioner has sustained his burden with respect to the170 other amounts of income attributed to him. Since no books and records or other evidence as to petitioner's income or expenditures were available, respondent resorted to an "expenditures" method in order to determine petitioner's gross income from the three businesses he owned or operated. Such method consisted of adding an estimate of annual living expenses for petitioner and his family to the excess of petitioner's loan repayments over new loans during each year. Petitioner does not contend that his expenditures came from accumulated funds on hand at the beginning of the period, and under such circumstances, the method adopted is not unreasonable. See Joseph Calafato, 42 B.T.A. 881">42 B.T.A. 881, affd. (C.A. 3) 124 Fed. (2d) 187; Halle v. Commissioner, (C.A. 2) 175 Fed. (2d) 500, certiorari denied 338 U.S. 949">338 U.S. 949. But in computing petitioner's net income for 1948 and 1949, respondent improperly limited petitioner's standard deduction under section 23(aa)(1)(A) 1 to $500. Respondent contends on brief that "it is reasonable to assume that if returns had been filed in those years, petitioner and his wife would have filed separate returns in view171 of their divorce in 1950." We think this assumption both unreasonable and unwarranted, particularly since respondent allowed a standard deduction of $1,000 for 1950, the year the divorce was supposed to have taken place. To avoid the penalties, petitioner must show that his failure to file any returns at all and his failure to file a declaration of estimated tax in 1950 were "due to reasonable cause and not due to willful neglect." Sections 291(a), 294(d), I.R.C. Petitioner, upon whom the burden rests, see West Side Tennis Club v. Commissioner, (C.A. 2) 111 Fed. (2d) 6, certiorari denied 311 U.S. 674">311 U.S. 674,172 contends that he followed the advice of an accountant in regard to his tax liability. Cf. Hatfried, Inc. v. Commissioner, (C.A. 3) 162 Fed. (2d) 628. For this to be a defense, however, it must be shown that "sufficient information was made available to the accountant to enable him to come to an intelligent conclusion," Tarbox Corporation, 6 T.C. 35">6 T.C. 35, 37, and that the accountant is "qualified to advise or represent the taxpayer in the premises." Rene R. Bouche, 18 T.C. 144">18 T.C. 144, 149. Petitioner admits on brief to the possibility of having annual income amounting to as much as $4,800. An income tax return obviously should have been filed. Section 51(a), I.R.C. The accountant was not produced as a witness. Possibly there was no accountant employed, or at any rate no direct communication between petitioner and the accountant on tax matters for any years except 1946 and 1947. If there was, we must assume that petitioner failed to supply him with all the information necessary for filing returns. In either event, the penalties, except for 1946, should be sustained. Tarbox Corporation, supra; Rene R. Bouche, supra.173 We have been unwilling, however, to find that petitioner failed to file a return for 1946 in view of the inconclusive character of the revenue agent's testimony and the existence of the statement on the 1947 return, which was introduced by respondent himself, that a return had been filed for the prior year. Decision will be entered under Rule 50. Footnotes1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. * * *(aa) Optional Standard Deductions for Individuals. - (1) Allowance. - In the case of an individual, at his election a standard deduction as follows: (A) Adjusted Gross Income $5,000 or More. - If his adjusted gross income is $5,000 or more, the standard deduction shall be $1,000 or an amount equal to 10 per centum of the adjusted gross income, whichever is the lesser, except that in the case of a separate return by a married individual, the standard deduction shall be $500.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622017/	Henry W. and Letty M. Meyer v. Commissioner.Meyer v. CommissionerDocket No. 74948.United States Tax CourtT.C. Memo 1959-94; 1959 Tax Ct. Memo LEXIS 155; 18 T.C.M. (CCH) 428; T.C.M. (RIA) 59094; May 12, 1959155 Held, petitioners have failed to prove error in respondent's determination that certain amounts received by petitioner as "per diem" or "incentive pay" are not properly deductible as travel expenses while away from home in connection with the performance by him of services as an employee or in the pursuit of a trade or business. Henry W. Meyer, pro se., 1311 Indian River Avenue, Titusville, Fla. Hugh G. Isley, Esq., for the respondent. FISHERMemorandum Findings of Fact and Opinion FISHER, Judge: Respondent determined deficiencies in petitioners' income taxes for the years 1953 and 1956 in the respective amounts of $468.04 and $564.58. The only issue before us is whether petitioners are entitled to a deduction from gross income for the alleged travel expenses of Henry W. Meyer while away from home in connection with the performance by him of services as an employee or in the pursuit of a trade or business. Findings of Fact Petitioners are husband and wife who presently reside in Indian River City, Florida. They filed joint returns for the taxable years 1953 and 1956 with the director of internal revenue at Los Angeles, California. In the latter part of 1951, Henry W. Meyer (hereinafter referred to as Meyer or petitioner) entered the employ of North American Aviation, Inc., as an aircraft mechanic. Petitioner was assigned by North American to Edwards Air Force Base, and prior to the end of 1951, he moved his157 family to Palmdale, California, which was approximately 35 miles from Edwards Air Force Base. Petitioner drove by auto to Edwards Air Force Base each day and returned to his home in Palmdale each night. Petitioner continued in the employ of North American until July 1953 when he went to work for the Northrup Aircraft Company. He spent a short period of time at the Northrup's home plant in Hawthorne, California, and was then assigned to Edwards Air Force Base. He never gave up his home in Palmdale between the time he worked for North American and the time he worked for Northrup. Petitioner remained in the employ of Northrup and continued to reside at Palmdale and commute daily to Edwards Air Force Base until November 1954, when he went to Florida. Petitioner lived in Florida for approximately 2 months. His wife became ill and petitioner returned to California where he entered the employ of the General Electric Company. By mid-1955, petitioner left General Electric and in July 1955 entered the employ of the Douglas Aircraft Company. From July 1955 until the latter part of 1957, petitioner was employed by Douglas Aircraft at Edwards Air Force Base. Throughout this period petitioner158 resided in Palmdale, California, and commuted daily to Edwards Air Force Base. In his income tax return for the year 1953, petitioner reported $5,853.39 as wages from North American Aviation and Northrup Aircraft. He further reported as "expenses reimbursed by North American and Northrup" the respective amounts of $2,054.00 and $117.60, which he explained in a statement attached to his return as follows: "Expenses for board and lodging incurred while working for North American Aviation. Away from Los Angeles main plant, at Edwards Air Force Base, and reimbursed by North American Aviation - $,2,054.00. "Expenses for board and lodging incurred while working for Northrup Aircraft, away from Hawthorne main plant, at Edwards Air Force Base and reimbursed by Northrup Aircraft - $117.60." In his Federal income tax return for the year 1956, petitioner reported amounts received from Douglas Aircraft Company as follows: Wages$10,016.08Less: Reimbursed expenses perDiem allowance2,485.00Adjusted gross income$ 7,531.08In the notice of deficiency, respondent explained his adjustments to petitioner's income for the years 1953 and 1956 by reference to a report159 of examination which was mailed to petitioners. In the aforesaid report, respondent explained his adjustments to petitioner's income for the years 1953 and 1956 as follows: "1953 "Information on file in this office indicates that you received compensation of $2,171.60 which you did not include in income reported on your return. The project on which you were working at the time such compensation was paid was considered to be indefinite and therefore, any expenses which you may have incurred would be personal and nondeductible for income tax purposes. "1956 "Information on file in this office indicates that you received compensation of $10,016.08 and that you claimed $2,485.00 as 'away from home expenses'. The project on which you were working at the time such compensation was paid was considered to be indefinite and therefore, any expenses which you incurred would be personal and nondeductible for income tax purposes." During the years 1953 and 1956, petitioner resided at Palmdale, California, and his principal post of duty was at Edwards Air Force Base. In so far as pertinent here, any expenses incurred by petitioner during the years in question were personal expenses160 and not deductible from gross income. Opinion In 1953, petitioner received certain amounts from his employers which were denoted as "per diem" or "incentive pay." These amounts were not reported on petitioner's income tax return, but petitioner attached an explanatory note to the return stating that he was claiming a deduction in the exact amount received. In 1956, petitioner received certain amounts from his employer which were denoted as "per diem payments." Petitioner included these amounts in gross income and claimed a deduction of the exact amount as "reimbursed expenses" for travel while away from home. 1Respondent included these amounts in petitioner's gross income but disallowed them as deductions, stating that they were personal and nondeductible. The burden of proving error in respondent's determination is, of course, on petitioner. We find that he has failed to carry his burden. The evidence establishes that petitioner resided at Palmdale, California. Petitioner moved, 161 with his family, to that city in the latter part of 1951 and continued to live there throughout 1952, 1953, and until November 1954. Petitioner did not remove his family from Palmdale upon his change of employment from North American to Northrup in 1953. 2 Petitioner and his family moved to Florida in November of 1954. They returned to Palmdale in February 1955 and remained there until October 1957. During the 2 years in issue, petitioner's residence was in Palmdale and his principal place of employment was Edwards Air Force Base. The most that petitioner has established is that he has incurred certain commuting expenses in traveling daily to and from his home to his place of employment at Edwards Air Force Base. Such commuting costs are not deductible. ; ,162 on appeal C.A. 9, February 24, 1958. Petitioner contends that the "per diem" received (which one employer, Northrup Aircraft, labelled "incentive pay") indicates that he was being reimbursed for travel expenses while away from home. We are satisfied that these payments were intended to take care of, or at least alleviate, to some extent, the higher cost of living in the Edwards Air Force Base area. The only expenditures relied upon by petitioner to support the claimed deduction represent personal expenditures, which, by statute, 3 are expressly prohibited from being deductible by a taxpayer. For example, petitioner testified that he had to travel 30 miles one way to work. He further testified that expenses were higher in Palmdale than in the Los Angeles area. He stated that medical care was poor and that he had to transport his child 120 miles one way to visit a pediatrician. It is evident that these expenses are personal and nondedutcible. Accordingly, on the basis of the record before us, we must hold that petitioner has failed to prove error in respondent's determination. Decision will be entered for respondent. 163 Footnotes1. The year 1953 is governed by the provisions of sections 22(n)(2) and 23(a)(1)(A) of the Code of 1939. The year 1956 is governed by sections 62(2)(b) and 162(a)(2) of the Code of 1954.↩2. Petitioner testified that upon his employment with Northrup, he was assigned for a "short while" to Hawthorne, California. However, he still maintained his residence at Palmdale. There is no evidence in the record to determine sufficiently whether or not the expenses of petitioner while in Hawthorne are properly deductible and, if so, in what amounts.↩3. Section 24(a)(1), 1939 Code, and section 262, 1954 Code.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622018/	Clifford R. Dammers and Robin A. Dammers, Petitioners v. Commissioner of Internal Revenue, RespondentDammers v. CommissionerDocket No. 7543-78United States Tax Court76 T.C. 835; 1981 U.S. Tax Ct. LEXIS 125; May 21, 1981, Filed 125 Decision will be entered under Rule 155. Petitioner was employed as an attorney in a law firm. In 1971, the law firm requested petitioner to transfer to its Paris office. As an inducement for petitioner to accept the transfer, the law firm agreed to pay for all expenses incurred in moving to Paris as well as for all moving expenses incurred in returning to this country. In 1973, the law firm requested petitioner to transfer to its London office, and reiterated its promise to pay for petitioner's expenses in returning to this country. In 1975, after 2 years in the Paris office and 2 years in the London office, petitioner moved back to the United States, and the law firm paid for the return moving expenses. Held, for the purposes of the foreign tax credit, the reimbursement for petitioner's move back to the United States is compensation for personal services performed without the United States. Clifford R. Dammers, pro se.Paulette Segal, for the respondent. Wilbur, Judge. WILBUR836 OPINIONRespondent determined a deficiency in petitioners' Federal income tax for the year 1975 in the amount of $ 1,025.98. This case was submitted fully stipulated under Rule 122. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Due to concessions by the petitioners, the remaining issue for our decision is whether $ 7,312.05 of reimbursed moving expenses is attributable to foreign source income or U.S. income.At the time of the filing of the petition in this case, petitioners resided in New York, N.Y. Because the facts pertaining to this dispute involve primarily Clifford Dammers, he will be referred to as petitioner.From August 1970 until January 1979, petitioner was employed as an attorney in the law firm of Cleary, Gottlieb, Steen & Hamilton (Cleary, Gottlieb). In 1971, petitioner was requested by Cleary, Gottlieb to transfer to its Paris, France, office. In order to induce petitioner to accept the transfer, Cleary, Gottlieb orally promised to reimburse him for all expenses incurred in moving him, his family, and 128 his household goods to France and also to reimburse him for moving expenses incurred in returning to the United States. In reliance on Cleary, Gottlieb's promise, petitioner agreed to transfer to its Paris, France, office. Petitioner and his family moved to France on August 30, 1971, and resided there until September 10, 1973.In 1973, Cleary, Gottlieb requested petitioner to move from its Paris, France, office to its London, England, office. At the time of the request, Cleary, Gottlieb promised to reimburse petitioner for the move to London and reiterated its promise to reimburse petitioner for the cost of moving him and his family back to the United States. Petitioner and his family moved from Paris to London on September 10, 1973, and resided there until June 20, 1975. On August 5, 1975, petitioner and his family returned to the United States to live. In 1975, Cleary, Gottlieb reimbursed petitioner for the move to the United States in the amount of $ 7,312.05.The parties are in agreement that the amount received by petitioner as reimbursement for moving expenses is includable 837 in petitioner's gross income under section 82. 1 The disagreement relates to whether 129 the reimbursement for moving expenses is attributable to services performed by petitioner outside the United States and thus is income from sources outside the United States, or whether the reimbursement is income from sources within the United States. Resolution of this issue affects the computation of the foreign tax credit allowed petitioner for the year 1975. 2130 Petitioner maintains that the reimbursed moving expenses must be considered income attributable to his services in a foreign country because his employer agreed to pay the moving expenses incurred in returning to the United States before and as an inducement for petitioner's transfer to the Paris office. On the other hand, respondent contends that the reimbursed expenses must be considered income from sources within the United States because petitioner continued to work for the same employer after his return and thus the reimbursement was attributable to petitioner's services within this country. We agree with petitioner that the reimbursement for moving expenses is income from sources outside the United States for the purposes of calculating the foreign tax credit.Section 861(a)(3) 3 provides that income from sources within 838 the United States includes compensation for labor or personal services performed in the United States. Section 862(a)(3) 4 provides that income from sources without the United States includes compensation for labor or personal services performed without the United States. Thus, the source of income, United States or foreign, is determined by the131 situs of the services rendered, not by the location of the payor, the residence of the taxpayer, the place of contracting, or the place of payment. .It is clear, given the facts of this case, that the reimbursement132 of petitioner's moving expenses is attributable to petitioner's employment in France, and is thus foreign source income. In 1971, petitioner's employer agreed to pay for the expenses of moving petitioner and his family back to the United States as an inducement for petitioner to accept a position in its foreign office. The agreement to reimburse petitioner was not made contingent upon petitioner's continued employment with Cleary, Gottlieb after his return to this country, but rather was given in consideration for petitioner's agreement to transfer to and work in the Paris office.Citing , respondent asks us to adopt the broad proposition that any time an employer reimburses an employee for moving expenses and the employee works for the employer after the move, the reimbursement is attributable to the future services performed after the move. We decline to adopt such a rule, and find nothing in , which would compel us to do so. In Hughes, the taxpayer was reimbursed for moving expenses he incurred when his employer transferred him from the United133 States to Spain. The issue was whether a portion of his expenses, otherwise deductible under section 217, must be disallowed because it was allocable to income earned from sources without the United States, exempt from tax under section 911(a). The Court found that the reimbursement received by petitioner was attributable to the gross income earned at the new place of 839 employment, and thus was income from sources outside the United States.Generally, as the Hughes case illustrates, when an employer reimburses an employee for expenses incurred in moving to a new location to work for him, the reimbursement is given in anticipation of the future work to be performed for the employer, and is thus attributable to services to be performed at the new location. In the case before us, however, the reimbursement was not tendered in anticipation of petitioner's future work in the New York office, but rather was in accordance with a prior agreement made by Cleary, Gottlieb that if petitioner transferred to its Paris office, it would pay for the moving expenses incurred when petitioner returned to this country. Indeed, it is clear from the record before us, and we do not understand134 respondent to contend otherwise, that petitioner would have been reimbursed by Cleary, Gottlieb regardless of whether he continued in their employment upon his return. Because the agreement to reimburse petitioner was made prior to and in consideration for the petitioner's transfer to the foreign office and was not contingent upon petitioner's continued employment upon his return, the reimbursement must be considered compensation for services performed without the United States, and thus income from sources without the United States. To reflect the foregoing,Decision will be entered under Rule 155. Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended and in effect during the taxable year in issue, unless otherwise indicated.Sec. 82 provides as follows:SEC. 82. REIMBURSEMENT FOR EXPENSES OF MOVING.There shall be included in gross income (as compensation for services) any amount received or accrued, directly or indirectly, by an individual as a payment for or reimbursement of expenses of moving from one residence to another residence which is attributable to employment or self-employment.↩2. Under sec. 901, a taxpayer is allowed a credit against his U.S. income tax liability for income taxes paid during the taxable year to any foreign country. The foreign tax credit is limited, however, by sec. 904 which provides that the total amount of the credit may not exceed that proportion of the U.S. tax which taxable income from sources without the United States bears to the taxpayer's entire taxable income for the same taxable year. Thus, if the reimbursement for moving expenses is considered to be income earned from sources without the United States, the numerator of the fraction which is applied against the U.S. tax liability under sec. 904 is increased, resulting in a larger credit to offset petitioner's tax liability.↩3. Sec. 861(a)(3) provides in relevant part as follows:SEC. 861. INCOME FROM SOURCES WITHIN THE UNITED STATES.(a) Gross Income From Sources Within United States. -- The following items of gross income shall be treated as income from sources within the United States: * * * (3) Personal services. -- Compensation for labor or personal services performed in the United States * ↩4. Sec. 862(a)(3) provides as follows:SEC. 862. INCOME FROM SOURCES WITHOUT THE UNITED STATES.(a) Gross Income From Sources Without United States. -- The following items of gross income shall be treated as income from sources without the United States: * * *(3) compensation for labor or personal services performed without the United States.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622019/	CYRUS H. MCCORMICK, HAROLD F. MCCORMICK, STANLEY MCCORMICK, TRUSTEES SOMETIMES KNOWN AS CHICAGO STOCK EXCHANGE BUILDING TRUSTEES, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.McCormick v. CommissionerDocket No. 44139.United States Board of Tax Appeals26 B.T.A. 1172; 1932 BTA LEXIS 1182; October 11, 1932, Promulgated 1182 Held, that the trust involed was not an association taxable as a corporation. Edward Clifford, Esq., and A. E. James, Esq., for the petitioners. H. D. Thomas, Esq., for the respondent. VAN FOSSAN 1172 This proceeding is for the redetermination of deficiencies in income taxes for the years 1924, 1925 and 1926 in the sum of $17,616.75 for 1924, $11,794.42 for 1925, and $19,208.20 for 1926. The petitioner alleged as grounds of error: (1) That the respondent held that the income from the Chicago Stock Exchange Building and other income incidental thereto for the years 1924, 1925 and 1926 was taxable to the petitioners as an association and not as the individual beneficiaries of a certain purported trust, or (2) That the respondent held that income for the years in question was taxable against the petitioners as an association and not to the petitioners as the individual owners, as joint tenants or as tenants in common, of premises conveyed by a certain trust deed. FINDINGS OF FACT. The petitioners are the persons named as trustees under a certain trust agreement dated April 7, 1900. Prior to the date of the execution of this1183 instrument the petitioners had acquired all the capital stock of the Chicago Stock Exchange Building Company, which had constructed the building at 30 North LaSalle Street in the city of 1173 Chicago. They had bought in fee a portion of the land on which that building was situated and had purchased a long-term lease of the remainder of such land. On April 7, 1900, the three petitioners, as individuals, caused the building situated at 30 North LaSalle Street, together with the portion of the land owned by them and the lease referred to, to be conveyed to themselves as trustees by a deed of trust executed on that day. This deed of trust provides, among other things, that upon its execution and delivery the trustees, namely, Cyrus H. McCormick, Harold F. McCormick and Stanley McCormick, should cause to be issued to themselves, respectively, receipts reciting that they were entitled to the benefit of their respective contributions to the funds and property held by the trustees under the deed, which contributions were in respect to each of them one-third of the value of the property described in the deed. The deed further provided the manner in which the transfer of the receipts1184 to other persons might be accomplished through a transfer agent named in the trust deed. The third, fourth and fifth paragraphs of the trust deed are as follows: Third: All moneys received by the Trustees, from whatever source, shall be used and expended by them as follows: (1) In such ways and for such objects as shall, in their judgment, be reasonably necessary or proper for the improvement, protection or conservation of the above described real estate and of the other funds and property of the Trust hereby created, at any time in the possession or control of the Trustees (which real estate, funds and property are hereinafter called the "Trust Estate"), or as shall seem to the Trustees, in the exercise of their discretion, to be calculated to enhance the value of the Trust Estate; (2) In establishing and maintaining (if the Trustees shall, in their discretion, determine so to do) a contingent fund, or a sinking fund, or both, the amount of such fund or funds from time to time to be determined by the Trustees in their discretion; any such fund may be established and may be distributed one or more times or not at all, according to the Trustees' discretion; (3) Moneys belonging1185 to the Trust Estate, in The trustees' opinion not required for either purpose above enumerated, may (at such times as the Trustees shall determine) be divided among the holders of the Receipts issued in accordance with the foregoing provisions of this Deed, in proportion to their respective holdings of Receipts: provided, that any moneys belonging to the Trust Estate and awaiting permanent investment or disposal, may be temporarily put out at interest or invested, converted and re-converted in interest-bearing or dividend-paying securities, by the Trustees. The title to all moneys and other property acquired by the Trustees as such shall be taken and held by them as Trustees under this Deed and as joint tenants and not as tenants in common. Fourth: Subject only to the provisions of this Deed, the Trustees shall have as full and absolute control over and right to dispose of the Trust Estate and every part thereof as if they were the absolute beneficial owners thereof; including 1174 (among other things) the power and right to invest and re-invest; to convert and re-convert, to sell for cash or on credit, at public or private sale; to encumber for the purpose of securing1186 the payment of money; to lease for a term or terms within or beyond the possible life of the Trust hereby created; to exchange, release, partition, grant and acquire easements; to improve, repair and rebuild. The Trustees may borrow money for the purpose of improving, repairing or rebuilding real estate belonging to the Trust Estate or for any other purpose which the Trustees may regard as beneficial to the Trust Estate. The Trustees shall also have such other powers and rights (with respect to the control, management and disposition of the Trust Estate) as are possessed and enjoyed by the absolute owners of similar property, including the power to execute and deliver all instruments and to do all acts necessary or proper to give effect to any other powers by this Deed conferred upon them. But anything in this Deed contained to the contrary notwithstanding, the Trustees shall not at any time within fifteen (15) years after the date hereof have power to dispose of the above described real estate or any part thereof, nor to borrow any money, nor to do any act or execute and deliver any instrument (except leases for ten (10) years or less) which shall have the effect of encumbering1187 or charging with any lien or claim the real estate above described or any part thereof, without in each case first obtaining the consent in writing of the holders or at least three-quarters (in amount) of the Receipts at the time outstanding, issued in accordance with the preceding provisions of this Deed; which consent shall be expressed and evidenced only in the manner hereinafter provided; and every person whosoever shall be chargeable with notice of any shall be bound by this provision of this Deed from and after the recording hereof in the Office of the Recorder of Deeds of Cook County, Illinois. In no event, however, shall any person lending or otherwise paying any money or transferring any property other than money to the Trustees be responsible for the proper application of such money or property. Fifth: The beneficiaries of the Trust hereby created (whose rights shall at all times be subject to the terms and provisions of this Deed) shall have no right of possession, management or control of the Trust Estate, save only so far as is expressly provided in this Deed; no widow, widower, heir or devisee of any beneficiary shall have any right of dower or right to homestead1188 or right of inheritance or any other real property right, statutory or otherwise, in any real estate belonging to the Trust Estate. The beneficiaries hereunder shall always have a right of account against the Trustees. But the property interests of the beneficiaries under this Deed are confined to such personal property, being income and profits and proceeds of sale of the Trust Estate, as shall, under the provisions of this Deed, be subject to division from time to time among the Receipt-holders hereunder. Otherwise, the rights and remedies of the beneficiaries shall be exclusively against or through the Trustees. The relation between the Trustees and the beneficiaries established by this Deed and intended so to be established, is the relation which exists between active Trustee and cestui que trust, and is no other relation; the relation between the Trustees (as among themselves) established by this Deed and intended so to be established, is the relation which exists between co-Trustees and joint-tenants of the legal title to property held in active trust, and is no other relation; the relation between the beneficiaries (as among themselves) established by this Deed and1189 intended so to be established, is the relation between the co-owners of the realized net income and profits and proceeds of sale (when set apart for distribution) of an estate held in active trust, and is no other 1175 relation. The Trustees shall be the representatives of the beneficiaries in such a sense that in no suit affecting or relating to the Trust Estate to which the Trustees are parties (except suits between the beneficiaries themselves), shall the beneficiaries or any of them be necessary or proper parties by reason of their interest under this Deed, and in the Trust hereby created. The trust deed further provides that, in the event of a vacancy occurring among the trustees, the remaining trustees or trustee shall continue to discharge the duties and exercise the powers conferred by the deed and appoint a successor or successors to the retiring trustee or trustees. Under the provisions of the deed three-fourths in interest of the receipt holders at any time may remove any trustee or trustees and appoint a successor or successors or fill any vacancy which the acting trustee or trustees might have filled, and, in the event that the trustees should refuse to act1190 or in the case of a simultaneous vacancy of all three trusteeships, were authorized to fill vacancies or appoint three new trustees. The immediate reason for the execution of the trust deed was the desire of the three McCormicks to create a security which could be used as collateral in raising funds to loan to the McCormick Harvester Machine Company, which needed money for improvements. The McCormicks wished to avoid the publicity attendant upon a loan secured by a recorded mortgage covering any of their realty. Upon the execution of the trust deed the three McCormicks borrowed approximately $1,000,000 from the Scottish Provident Institution of Edinburgh, Scotland, giving the lender their promissory note for that amount and causing receipts covering the beneficial interest under the trust deed to which they were each, respectively, entitled, to be issued to the lender as collateral to the note. This loan was renewed once, but in 1912 was entirely paid off out of the personal funds of the three McCormicks and not out of the income of the trust property. Upon payment of the note the beneficial interest receipts issued to the Scottish Provident Institution as collateral were canceled1191 and new receipts declaring beneficial interest were issued to the McCormicks in accordance with the terms of the trust deed. Thereafter none of these receipts were transferred by them or by either of them. The entire management of the Chicago Stock Exchange Building at all times material to this proceeding was under the direction of one Judson F. Stone, whose principal business consisted in managing and representing the McCormick interests, ordinarily known as the McCormick Estates, in Chicago and elsewhere. In that capacity and as an individual Stone was an officer and director of numerous corporations. As representative of the McCormick interests and as agent of the so-called McCormick Estates, Stone was in full charge of an office in which, under the name of the McCormick Estates, are 1176 pooled substantially all of the affairs of the various individuals who are heirs of Cyrus H. McCormick, Sr. In that capacity Stone held powers of attorney from the various interested individuals to act for them, respectively, in all matters as fully as they might act in their individual capacity. The office managed by Stone was located in the Chicago Stock Exchange Building and1192 in all the years in question and prior thereto had custody of all securities which the various members of the McCormick family owned. It managed all of their real estate and collected all dividends and all bond interest belonging to them. It also had possession of all their title papers and other evidence of property, and all books of account connected with such interests were kept by the office force. Under the direction of Stone all of the income-tax returns of all of the said individuals were prepared, and after they were signed by him were filed. The real estate managed by the office directed by Stone consisted of from 25 to 30 parcels. The office made all leases connected with these parcels, made necessary repairs and alterations, bought the supplies connected therewith, engaged all the help necessary to the operation of the properties, compromised claims and paid all bills. The Chicago Stock Exchange Building was managed by Stone in exactly the same manner as all of the other property owned by the McCormicks individually was managed. The building had from 200 to 300 tenants during the years in question and its gross income amounted to more than $400,000 in each of1193 such years. The net income was distributed by Stone to the three McCormicks at irregular intervals. At times it was accumulated by him in considerable amounts to be used for purposes of improvement of the Stock Exchange Building. A separate bank account was kept for the Stock Exchange Building. During the period in question it was the policy of the members of the McCormick family to hold real estate in the individual name of the owners. During these years the trustees had no formal meetings and no minutes of the operations of the trust or of meetings of the trustees were made. No official communications were ever sent by Stone to the trustees as such. The trust, as such, had no employees and paid no bills or accounts. In general the business of the property covered by the trust deed was managed by the office of which Stone was the head, without reference to the three McCormicks. In matters of large policy, however, Stone consulted them individually, though never as trustees. Prior to 1912 Stanley McCormick, one of the trustees and a holder of a beneficial receipt, became incompetent to manage his business 1177 affairs. He was not, however, judicially adjudged1194 incompetent until the year 1929. The trustees filed fiduciary returns for each of the taxable years in question under the name of "Chicago Exchange Building Trustees, Cyrus H. McCormick, Harold F. McCormick and Stanley McCormick, Trustees." The net income shown on the respective returns was reported in equal amounts by the three McCormicks in their individual returns for the respective years. The respondent determined that the petitioners were an association, taxable as a corporation, thus creating the deficiencies in question. OPINION. VAN FOSSAN: The question here presented is whether or not petitioning taxpayers constituted an association, taxable as a corporation. In considering this question we must look to the form and purpose of the organization structure and the actual functioning of the organization during the taxable years. An association is an unchartered organization employing the characteristics, form and procedure of a corporation in the prosecution of a business enterprise. Here we find a trust charged with the management of a commercial office building. The creating deed denominated three trustees and gave them almost unlimited powers. In actual1195 fact, however, the three trustees had nothing more to do with the management of the building than had they been strangers to the matter. They never met as trustees. No minutes were kept by them or on their behalf. They had no separate books and records as trustees; no communications were ever sent or exchanged officially among themselves; they had no employees as trustees and to all practical ends completely ignored the trust relationship. The property involved was one of some thirty similar properties owned by or on behalf of the several heirs of Cyrus H. McCormick, Sr., collectively known as the McCormick Estates. These properties were all managed by one office, directed by one Judson F. Stone. Stone held an unlimited power of attorney from the various heirs and dealt with the properties as fully as though individually owned by him. The heirs were seldom consulted and then only on matters of important policies. As funds became available for distribution they were placed to the credit of the respective heirs. The property covered by the trust here involved was managed by Stone precisely as all other properties constituting the McCormick Estates - no distinction whatever1196 being made in any respect because of the trust. No salary was paid to Stone or any of his office force by the trust, as such. 1178 In this state of facts we see no resemblance to corporate operation. The trust was merely a shadow without substance and vitality. Respondent erred in holding the trust to be an association, taxable as a corporation. Reviewed by the Board. Decision will be entered for the petitioners.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622021/	Harlin H. and Ella Lucas v. Commissioner.Lucas v. CommissionerDocket No. 1178-65.United States Tax CourtT.C. Memo 1966-253; 1966 Tax Ct. Memo LEXIS 31; 25 T.C.M. (CCH) 1312; T.C.M. (RIA) 66253; November 22, 1966Harlin H. Lucas, pro se, Box 43, Harlowton, Mont. Walter John Howard, Jr., for the respondent. DAWSONMemorandum Opinion DAWSON, Judge: Respondent determined a deficiency in the income tax of petitioners for the year 1962 in the amount of $103.36. Respondent has conceded on brief that petitioners are entitled to a deduction of $164 as a medical expense for automobile transportation during 1962, thus leaving for our decision the single issue as to whether or not the costs of meals and lodging for outpatient medical care in Seattle are deductible as medical expenses under section 213, Internal Revenue Code of 1954. Most of the facts were stipulated by the parties and are so found. Harlin H. Lucas (hereinafter called petitioner) and Ella Lucas are husband and wife residing in Harlowton, 32 Montana. They filed their joint Federal income tax return for the year 1962 with the district director of internal revenue at Helena, Montana. Throughout 1962 the petitioner was an employee of the Chicago, Milwaukee, St. Paul and Pacific Railroad at Harlowton. He has suffered from rather severe malignancies of exposed facial areas for several years. During 1962 it was necessary for the petitioner to make five trips by automobile and train from Montana to Seattle, Washington, for outpatient medical care by radiologists and plastic surgeons. While in Seattle he stayed with his sister who resides there. In his income tax return for 1962 the petitioner itemized medical expenses totaling $1,008.40 and claimed a medical deduction of $865.28 after applying the 3 percent of income adjustment. The amount of $600 (computed at the rate of $8 per day for 75 days) was claimed for meals and lodging while traveling away from home for medical care. In his notice of deficiency respondent determined that the petitioner was not entitled to deduct the costs of meals and lodging claimed for outpatient medical care. Petitioner contends that he should be allowed the deduction and that to deny it to him33 would be unfair and discriminatory. Respondent counters with the contention that such costs are not allowable as part of the claimed medical expense deduction because they were not incurred as part of a hospital bill. Section 213(e)(1), Internal Revenue Code of 1954, defines "medical care" as follows: (e) Definitions. - For purposes of this section - (1) The term "medical care" means amounts paid - (A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body (including amounts paid for accident or health insurance), or (B) for transportation primarily for and essential to medical care referred to in subparagraph (A). The intent of Congress in enacting this provision of the statute is expressed in the House and Senate Committee Reports in the following manner: Subsection (e) defines medical care to mean amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of diseases or for the purpose of affecting any structure or function of the body (including amounts paid for accident or health insurance), or for transportation primarily for and essential34 to medical care. The deduction permitted for "transportation primarily for and essential to medical care" clarifies existing law in that it specifically excludes deduction of any meals and lodging while away from home receiving medical treatment. * * H. Rept. 1337, 83d Cong., 2d Sess. A60(1954); S. Rept. 1622, 83d Cong., 2d Sess. 219-220 (1954). Sections 1.213-1(e)(iv) and (v), Income Tax Regulations, carry out the legislative intent by providing: (iv) Expenses paid for transportation primarily for and essential to the rendition of the medical care are expenses paid for medical care. However, an amount allowable as a deduction for "transportation primarily for and essential to medical care" shall not include the cost of any meals and lodging while away from home receiving medical treatment. (v) The cost of in-patient hospital care (including the cost of meals and lodging therein) is an expenditure for medical care. As respondent points out, the predecessor statute, section 23(x) of the Internal Revenue Code of 1939, had been construed by this Court as allowing all meals and lodging as a part of the medical expense deduction. See L. Keever Stringham, 12 T.C. 580">12 T.C. 580 (1949)*35 affirmed per curiam, 183 F. 2d 579 (C.A. 6, 1950). But in Commissioner v. Bilder, 369 U.S. 499">369 U.S. 499 (1962), the Supreme Court of the United States held that Congress by the enactment of section 213 of the 1954 Code specifically excluded the deductibility of meals and lodging as medical expenses unless incurred as a part of a hospital bill. See also Max Carasso, 34 T.C. 1139">34 T.C. 1139 (1960), affd. 292 F.2d 367">292 F.2d 367 (C.A. 2, 1961), certiorari denied 369 U.S. 874">369 U.S. 874; Martin J. Lichterman, 37 T.C. 586">37 T.C. 586 (1961); and Leo R. Cohn, 38 T.C. 387">38 T.C. 387, 391 (1962). Petitioner impressed us with his sincere belief that the law should permit him to deduct the expenses in question. However, notwithstanding the personal compassion we have for petitioner under these circumstances, we are compelled to follow the statute as explained by Congress and the Supreme Court. Accordingly, we hold that the claimed costs of meals and lodging incurred by petitioner while in Seattle during 1962 for outpatient medical care are not deductible as medical expenses. Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622022/	David N. Bodley, Petitioner v. Commissioner of Internal Revenue, RespondentBodley v. CommissionerDocket No. 5993-70SCUnited States Tax Court56 T.C. 1357; 1971 U.S. Tax Ct. LEXIS 54; September 23, 1971, Filed 54 Decision will be entered under Rule 50. Held, the expenses incurred in 1968 by petitioner, a schoolteacher, in attending law school are not deductible under sec. 162(a), I.R.C. 1954, or the amplifying regulations, sec. 1.162-5(a) and (b), Income Tax Regs.David N. Bodley, pro se.Bobby S. Tyler, for the respondent. Featherston, Judge. FEATHERSTON1357 Respondent determined a deficiency in petitioner's Federal income tax for 1968 in the amount55 of $ 559.98. Concessions having been made, the only issue for decision is whether the expenses incurred by petitioner during 1968 in attending law school, while employed as a schoolteacher, are deductible as ordinary and necessary business expenses under section 162(a). 1FINDINGS OF FACTDavid N. Bodley (hereinafter referred to as petitioner) was a legal resident of Cincinnati, Ohio, at the time his petition was filed. He filed his Federal income tax return for 1968 with the district director of internal revenue, Cincinnati, Ohio.Petitioner was graduated from the University of Cincinnati in June 1966 with a bachelor's degree in vocational education in the field of electronics. He obtained a teaching certificate reflecting that he was 1358 qualified to teach vocational classes in any school in Ohio for a period of 4 years from September 1, 1966, with the authorized subject or56 field specified as "Electronic Tech." In September 1966, he accepted employment on a contract basis with the Board of Education, Cincinnati Public Schools, as a teacher of electronics at Courter Technical High School (hereinafter Courter Tech). He continued to teach there until November 20, 1969.In addition to teaching courses in the physical and mechanical-technical skills of the electronics industry, petitioner counseled his students concerning their business relationships with employers, employment contracts and negotiations, employment interviewing procedures, and personal problems.In September 1966, petitioner enrolled as a night law student at Salmon P. Chase College of Law (hereinafter Chase Law) in Cincinnati. His course of study led to a juris doctor degree. Petitioner carried a full credit course each semester from the time he enrolled in law school until he was graduated in June 1970.On November 7, 1966, petitioner filed, with the Supreme Court of Ohio, an application for registration as a law student. In response to a question on the application requesting a paragraph concerning "your reasons for desiring to be an attorney at law," petitioner replied: "My reasons57 for enrolling in law school are many, but may be summarized by a desire to become a better person, and professional ambition to be a judge in the court system of Ohio."During the spring, summer, and fall semesters of 1968 petitioner took the following courses: Procedure I, Property II, Business Associations II, Federal Taxation I, Patent Law, Insurance, Negotiable Instruments, Wills, and Evidence.At no time was petitioner required by the Board of Education, Cincinnati Public Schools, to obtain a juris doctor degree. However, the degree was classified as a doctoral degree for the purposes of the teacher salary schedule, and the credit hours which he earned in law school entitled him to salary increases.In November 1969, petitioner, because of a general dissatisfaction with his teaching situation at Courter Tech, terminated his employment with the Board of Education, Cincinnati Public Schools, and accepted a position as constable for the Hamilton County, Ohio, Court of Common Pleas. His duties as constable included performing legal research, attending court sessions, and performing such services as were required by the presiding judge.Petitioner has not taught school since resigning58 from Courter Tech. In July 1970, he took the Ohio State bar examination but did not pass. On March 2, 3, and 4, 1971, he again took the Ohio State bar examination, but had not been advised of the results as of the date of the trial of this case.1359 In his Federal income tax return for 1968, petitioner deducted claimed education expenses in the amount of $ 1,112. In this connection, the stipulation of facts recites:The educational expenses of $ 1,112.00 which were claimed as a deduction on the petitioner's Federal income tax return for the taxable year 1968 were incurred by reason of the petitioner taking law courses at the Salmon P. Chase College of Law, Cincinnati, Ohio. The petitioner has submitted a signed statement attached hereto as Exhibit 2 which reveals that the petitioner expended $ 1,196.00 for tuition, fees, books and supplies in 1968 in connection with his legal education, instead of the $ 1,112.00 amount claimed on his 1968 return; however, the petitioner was only able to present substantiating data in the amount of $ 903.19.In his notice of deficiency, respondent disallowed the education expense deduction in its entirety.OPINIONWe are again presented 59 with the question of whether an individual's expenditures incurred in attending law school are deductible. We have previously pointed out that the Code does not deal specifically with the deductibility of educational expenses; however, section 162(a) provides generally that "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business," and section 262 denies deductions for "personal" expenses. Because of the absence of a specific statutory provision on the subject, the regulations synthesizing sections 162(a) and 262 in relation to educational expenses take on added significance. Burke W. Bradley, Jr., 54 T.C. 216">54 T.C. 216 (1970). 260 These regulations 3 lay down the general rule that educational expenses 1360 are deductible if the education maintains or improves skills required by the individual in his employment or other trade or business or meets the express requirements of his employer. Sec. 1.162-5(a), Income Tax Regs. However, this general rule applies only if the expenditures do not fall within specified nondeductible categories. The category with which we are here concerned is "expenditures made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business." Sec. 1.162-5(b)(3)(i), Income Tax Regs. Such outlays are nondeductible "personal expenditures or constitute an inseparable aggregate of personal and capital expenditures." Sec. 1.162-5(b)(1), Income Tax Regs.61 The standards laid down by these regulations are objective ones. Under those standards, if a taxpayer is pursuing a course of educational study which will qualify him for a new trade or business, his expenditures therefor are not deductible even though his studies are required by his employer and he does not intend to enter the new field of endeavor. An example in the regulations deals specifically with a situation where a taxpayer's employer requires him to obtain a law degree and the taxpayer intends to continue practicing his nonlegal profession. It specifies that, in these circumstances, "the expenditures made by * * * [the taxpayer] in attending law school are not deductible since this course of study qualifies him for a new trade or business." Sec. 1.162-5(b)(3)(ii), ex. (2), Income Tax Regs.The facts in petitioner's case fall squarely within the provisions of these regulations. The education which he was pursuing was part of a program designed to qualify him for a new profession. His situation is not unlike that in Jeffry L. Weiler, 54 T.C. 398">54 T.C. 398 (1970), where an Internal Revenue agent's claim to a deduction for law school expenses was denied62 even though he disavowed an intention to enter the legal profession. The Court stated (p. 402):While it is true, that petitioner may never leave the IRS, or may rejoin a public accounting firm, or even become a tax attorney, he nevertheless is qualifying himself as a lawyer, a trade or business separate and distinct from that in which he is now engaged and his educational expenses are nondeductible. * See also Ronald F. Weiszmann, 52 T.C. 1106">52 T.C. 1106 (1969), affirmed per curiam 443 F. 2d 29 (C.A. 9, 1971); Burke W. Bradley, Jr., supra.Petitioner's main contention is that he undertook the study of law in order to increase his salary as a teacher and did not intend at that time to leave the teaching profession. In support of this argument he has shown that, under the salary schedule issued by Courter Tech, he became entitled to salary increases upon the completion of specified numbers of credit hours of graduate study and that a juris doctor degree 1361 would have qualified him for the maximum salary schedule. The salary increases are evidently allowed by Courter Tech on the theory 63 that graduate study improves a teacher's skills. Yet the regulations, as pointed out above, specify that educational expenditures which qualify an individual for a new trade or business are not deductible even though "the education may maintain or improve skills required * * in his employment," sec. 1.162-5(b)(1), Income Tax Regs. See also sec. 1.162-5(c)(1) and (2), Income Tax Regs. Indeed, under the regulations, such expenditures are not deductible even if they are incurred for education which is expressly required by an employer. Secs. 1.162-5(b)(1) and 1.162-5(b)(3)(ii), ex. (2), Income Tax Regs.Petitioner challenges the validity of these regulations on the ground that they arbitrarily deny the deductibility of expenses which he incurred to increase his earning power. To support this argument he relies, of course, on section 162(a) which allows a deduction for expenses paid or incurred in "carrying on any trade or business." However, expenses incurred in the pursuit of education designed to qualify an individual to enter a new trade or business are not deductible; because, in the words of the regulation, they are "personal expenditures" or "an inseparable aggregate of personal64 and capital expenditures" -- nondeductible under either section 262 or 263 or both. See Welch v. Helvering, 290 U.S. 111">290 U.S. 111, 115 (1933). Even if an individual taking a course which both qualifies him for a new profession and improves his skills and earning power in his current field of endeavor does not intend to enter the new profession, his purpose and intention may change. He may later decide to enter the new profession. Indeed, in the instant case, petitioner ceased teaching even before he finished his law school study. Factual situations may arise where petitioner's argument would have more weight. However, since petitioner's law school work obviously had substantial long-term utility apart from its assistance in obtaining a larger teaching salary, we cannot say that denial of the claimed deductions in accordance with the objective standards of the regulations involves an arbitrary application of sections 162(a) and 262. We have previously sustained these provisions of the regulations as a valid exercise of rule-making power. Ronald F. Weiszmann, supra at 1111-1112; Jeffry L. Weiler, supra at 402.65 We adhere to that conclusion. Commissioner v. South Texas Co., 333 U.S. 496">333 U.S. 496, 501 (1948).Even if, in testing the deductibility of petitioner's expenditures, we should look to his primary purpose in attending law school, we are not satisfied that he has met that test. His application for admission to law school, referred to in our Findings, discloses an ambition -- to be a judge in the court system of Ohio -- which presupposes entry into the 1362 legal profession. He frankly admitted in the course of his testimony that he had not ruled out the practice of law as a career. Furthermore, his study of law had only the remotest connection with the field of electronics, in which he was then teaching. Carroll v. Commissioner, 418 F. 2d 91 (C.A. 7, 1969), affirming 51 T.C. 213">51 T.C. 213 (1968). Finally, he demonstrated the tentativeness of his commitment to the teaching profession by leaving it even before he completed his work toward a law degree. Taking into account these and other facts of record, we are not convinced that petitioner's primary purpose in attending law school was to promote66 his advancement in the teaching profession. See, e.g., N. Kent Baker, 51 T.C. 243">51 T.C. 243 (1968); Sandt v. Commissioner, 303 F. 2d 111 (C.A. 3, 1962), affirming a Memorandum Opinion of this Court; Condit v. Commissioner, 329 F. 2d 153 (C.A. 6, 1964), affirming a Memorandum Opinion of this Court.Finally, petitioner urges, in the alternative, that he should be allowed to treat his law school expenses as capital expenditures and amortize them over a 5-year period. There is no legal or factual support for this contention. See, e.g., Nathaniel A. Denman, 48 T.C. 439">48 T.C. 439 (1967), acq. 1 C.B. 2">1968-1 C.B. 2. It must be rejected.To reflect the concessions of the parties,Decision will be entered under Rule 50. Footnotes1. All section references are to the Internal Revenue Code of 1954, as in effect during the year in issue, unless otherwise noted.↩2. Since the tax year here in question is 1968, the current regulations issued in 1967 rather than the 1958 version are applicable, and petitioner is not entitled to the election accorded taxpayers for the years immediately prior to 1968. See, e.g., Burke W. Bradley, Jr., 54 T.C. 216">54 T.C. 216 (1970), and Ronald F. Weiszmann, 52 T.C. 1106">52 T.C. 1106 (1969), affirmed per curiam 443 F. 2d 29↩ (C.A. 9, 1971).3. Income Tax Regs.:Sec. 1.162-5 Expenses for education.(a) General rule. -- Expenditures made by an individual for education * * * which are not expenditures of a type described in paragraph (b)(2) or (3) of this section are deductible as ordinary and necessary business expenses (even though the education may lead to a degree) if the education --(1) Maintains or improves skills required by the individual in his employment or other trade or business, * * ** * * (b) Nondeductible educational expenditures -- (1) In general. Educational expenditures described in subparagraphs (2) and (3) of this paragraph are personal expenditures or constitute an inseparable aggregate of personal and capital expenditures and, therefore, are not deductible as ordinary and necessary business expenses even though the education may maintain or improve skills required by the individual in his employment or other trade or business * ** * * (3) Qualification for new trade or business↩. (i) The second category of nondeductible educational expenses within the scope of subparagraph (1) of this paragraph are expenditures made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business. * *	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622023/	JOHN E. MATHEWS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Mathews v. CommissionerDocket No. 9583.United States Board of Tax Appeals8 B.T.A. 209; 1927 BTA LEXIS 2930; September 22, 1927, Promulgated 2930 The petitioner was during the year 1923 county attorney of Duval County, Florida, and received as compensation for his services $200 per month. Held, upon the evidence, that he was during 1923 an employee of the Board of County Commissioners of Duval County, Florida, within the meaning of section 1211 of the Revenue Act of 1926. John E. Mathews, Esq., pro se. Joseph B. Harlacher, Esq., for the respondent. SMITH209 This is a proceeding for the redetermination of deficiency in income tax for the year 1923 in the amount of $1,073.53. The petitioner contends that the Commissioner erroneously included in his taxable income for the year 1923, $2,400 received as compensation for services rendered as county attorney of Duval County, Florida, during the taxable year. The allegations of error stated in the petition are as follows: a. The Commissioner has erroneously concluded that the taxpayer was employed by the Board of County Commissioners under the authority of section 1475 of Revised General Statutes of Florida. This section authorizes the employment of an attorney, not under the control or direction of the Board of County Commissioners2931 and for the specific purpose of prosecuting crimes in and before the county judges court. This section has no relation whatever to the employment of the taxpayer as shown in and by the record. b. The Commissioner erroneously failed to recognize the common law, and general law, which authorizes governmental subdivisions to adopt an attorney at law as an instrumentality for the proper performance of governmental functions. c. The Commissioner overlooked the fact that the Board of County Commissioners is the administrative board of a governmental subdivision of the State of Florida, with its duties and powers set forth in sections 1475 to 1577. Attention is called to the section 1475 of Revised General Statutes of Florida and particularly the 3rd and 10th paragraphs of said section. Attention is also called to all sections in the Revised General Statutes of Florida, from 1475 to and including section 1773. d. The Commissioner erroneously decided that governmental Bureaus and Boards have the authority to make rules and regulations in direct conflict with the constitution of the UnitedStates. e. The Commissioner erroneously decided that the services of the petitioner2932 were occasional and temporary and are not continuous. f. The Commissioner erroneously decided that the Board of County Commissioners failed to reserve to itself the authority to control the manner of performance of the taxpayer's duties. g. The Commissioner erroneously decided that the petitioner was not a regular employee of Duval County. 210 h. The Commissioner erroneously decided that the taxpayer was not a part of the regular force of Duval County. i. The Commissioner overlooked the fact that under the United States Constitution, the Government of the United States has not the constitutional right, power or authority to assess or collect taxes against any instrumentality adopted by Duval County for the proper performance of its governmental functions. FINDINGS OF FACT. The petitioner is an attorney at law residing in Jacksonville, Fla. On January 2, 1923, he was elected attorney of Duval County by the Board of County Commissioners of said county for the term of two years. Notice of such election was conveyed to the petitioner by the following letter: JANUARY 3, 1923. Mr. JOHN E. MATHEWS, Attorney at Law, Bisbee Building, Jacksonville,2933 Florida.DEAR SIR: I beg to advise that on the 2nd day inst., the Board of County Commissioners of Duval County, Florida, designated you as the county attorney. You will be expected to attend to all of the legal matters for Duval County and you will receive as your compensation the sum of $200.00 per month for attending all meetings of the Board of County Commissioners and giving advice concerning all routine matters coming before the board, and for defending or prosecuting law suits in which the county is a party or interested, or attending to all legal matters in connection with bond issues, you will receive the usual compensation allowed in this jurisdiction. This appointment is for a period of two years unless sooner modified by mutual agreement. Please advise me of your acceptance. Yours very truly, (Signed) R. H. CARSWELL, Chairman of the Board of County Commissioners.The petitioner accepted the appointment according to the terms set forth in the above letter and entered immediately upon his duties. He took no oath of office and did not sign any contract of employment. The duties of the attorney are to furnish legal advice to the Board of County Commissioners, 2934 draw deeds and contracts, orders, resolutions, and defend the county in any action brought against it and to do its general legal work. He is expected to give advice to the Board upon all legal matters. He is also expected to attend all meetings of the Board of County Commissioners. During the year 1923 the Board of County Commissioners held regular meetings twice a month and held many special meetings, so that the average number held during the year was approximately two per week. The petitioner attended all such meetings. During the year 1923 the county issued $3,000,000 in bonds and in addition expended $1,500,000, which was raised by general taxation. The petitioner had a large amount of work to do in connection with the 211 bond issue and in giving advice and doing the legal work connected with the laying out of many county roads. In addition he was forced to work evenings and Sundays in connection with the legal work of the county. The Board of County Commissioners is the administrative head of Duval County under the governmental system of the State of Florida. The powers and duties of Commissioners of the several counties of the state are defined in sections2935 1475 to 1620 of the Revised Statutes of Florida. Section 1475 gives the Board of County Commissioners authority - Third - To represent the county in the prosecution and defense of all legal causes. * * Tenth - To issue bonds in their respective counties for the purpose of erecting a courthouse, jail, to build or construct roads and to fund the present outstanding indebtedness, and to prescribe the rate of interest thereon: Provided, That no bonds shall be issued except the same shall be ordered by a majority of the registered voters in the respective counties. Prior to the year 1923 the petitioner had been actively engaged in the practice of law and during the year 1923 continued this practice. He maintained a separate law office but did not allow his private practice to interfere with his duties which he owed to the county. He was always at the beck and call of the County Commissioners. The legal matters were referred to him and he was instructed to draw legal papers for the use of the county. The Commissioners did not instruct him how he should perform his legal work. They had no special control over the hours he was employed engaged in practice. He was carried2936 on the pay roll of the County Commissioners and received his salary monthly. OPINION. SMITH: The question presented by this proceeding is whether the income received by the petitioner as compensation for legal services rendered the Board of County Commissioners of Duval County, Florida, during the year 1923, is exempt from taxation by the United States: Section 1211 of the Revenue Act of 1926 provides: Any taxes imposed by the Revenue Act of 1924 or prior revenue Acts upon any individual in respect of amounts received by him as compensation for personal services as an officer or employee of any State or political subdivision thereof (except to the extent that such compensation is paid by the United States Government directly or indirectly), shall, subject to the statutory period of limitations properly applicable thereto, be abated, credited, or refunded. No contention is made that the petitioner was an officer of Duval County and the record does not disclose that he was such an officer. 212 The statutes of the State of Florida do not provide for a county attorney in addition to the prosecuting attorney (which the petitioner was not), and he took no oath of office. 2937 The only real question before us is whether the petitioner was an employee of the State of Florida or of a political subdivision thereof within the meaning of section 1211 of the Revenue Act of 1926. A situation similar to the instant case was before the United States Supreme Court in the case of . The question there was as to whether certain consulting engineers engaged to advise States and subdivisions with reference to water and sewerage projects not required to take any oath or forego other employment as officers or employees of the State or subdivision within the meaning of section 201(a) of the Revenue Act of 1917, which contains a provision for exemption from tax as follows: This title shall apply to all trades or businesses of whatever description, whether continuously carried on or not, except - (a) In the case of officers and employees under the United States, or any State, Territory, or the District of Columbia, or any local subdivision thereof, the compensation or fees received by them as such officers or employees. The court held that in the circumstances of the case the petitioners were not officers2938 of any State. The court then stated: Nor do the facts stated in the bill of exceptions establish that the plaintiffs were "employees" within the meaning of the statute. So far as appears, they were in the position of independent contractors. The record does not reveal to what extent, if at all, their services were subject to the direction or control of the public boards or officers engaging them. In each instance the performance of their contract involved the use of judgment and discretion on their part and they were required to use their best professional skill to bring about the desired result. This permitted to them liberty of action which excludes the idea that control or right of control by the employer which characterizes the relation of employer and employee and differentiates the employee or servant from the independent contractor. ; . And see 2939 ; . The facts in this case are substantially different from those which obtained in the case of Here the petitioner was employed for a definite period at a definite monthly salary. He was required to attend all meetings of the Board of County Commissioners; to give legal advice concerning all routine matters coming before the Board; to attend to all legal matters in connection with bond issues; and in general to do the legal work of the Board. He was under the direction of the Board during the entire taxable period and practically all of his energies during the 213 year 1923 were devoted to the Board. We do not understand it to be the ruling of the Supreme Court that the relationship of employer and employee obtains only where the relationship of master and servant obtains and then only whenever the employer retains the right to direct the manner in which the business shall be done as well as the results to be accomplished, in other words, not only*2940 what shall be done, but how it shall be done. See . If this were so a physician who might be employed by a railroad company to devote his entire activities to the company could not be an employee of the company because clearly in such a case the employer would not expect to tell the physician how his work should be done. A skilled laborer is no less an employee because he uses his skill in the performance of his work. The term "employee" should not in our opinion be restricted only to menials. The petitioner was in our opinion an employee of the Board of County Commissioners of Duval County, Florida, during the year 1923, within the meaning of section 1211 of the Revenue Act of 1926. Cf. ; ; . Reviewed by the Board. Judgment will be entered for the petitioner on 15 days' notice, under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622024/	ROBERT J. MILES and LILA I. MILES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentMiles v. CommissionerDocket No. 15930-79United States Tax CourtT.C. Memo 1983-206; 1983 Tax Ct. Memo LEXIS 580; 45 T.C.M. (CCH) 1333; T.C.M. (RIA) 83206; April 13, 1983. Dante M. Scaccia, for petitioners. Jerome F. Warner, for respondent. COHENMEMORANDUM FINDINGS OF FACT AND OPINION COHEN, Judge: Respondent determined a deficiency of $1,021 in petitioners' tax for 1976. After concessions, the issue for decision is whether petitioners' chicken farming was an "activity not engaged in for profit" within the meaning of section 183.1Trial was held in this case on May 26, 1981, before the Honorable Sheldon V. Ekman, who died before entering a decision. Petitioners' Motion for New Trial was granted on September 16, 1982, and the581 parties partially retried this matter on December 7, 1982. At that time, the parties agreed to stipulate to the record made in the prior proceeding, supplementing it with any additional evidence admitted at the new trial. FINDINGS OF FACT Petitioners Robert J. Miles and Lila I. Miles were married during 1976 and timely filed a joint Federal income tax return for 1976 with the Internal Revenue Service Center in Andover, Massachusetts. Petitioners resided in Sauquoit, New York, during the year in issue and at the time of the filing of the petition herein. Hereinafter Robert J. Miles will be referred to as "petitioner." Petitioner is a licensed professional engineer in the State of New York. He has been employed full time as an electrical engineer by General Electric Company since 1958 and was so employed in 1976. He has a Bachelor of Science in Electrical Engineering from Massachusetts Institute of Technology, a Master of Science in Electrical Engineering from Syracuse University, and has almost completed the requirements for a Master's in Business Administration at Rensselaer Polytechnic Institute. Lila I. Miles was a housewife during the year in issue; she and petitioner582 have five children, who, in 1976, ranged from approximately 8 to 17 years of age. In 1971, petitioner bought a farm located about 3 to 4 miles from his home. The farm consisted of 45 acres of land (of which 35 to 40 were tillable), a barn, and a storage house. Petitioner subsequently bought a farmhouse situated on land adjacent to the farm and moved his family into it before beginning his farming activities.In the fall of 1975, petitioner began a chicken farming venture. Petitioner did not study chicken farming methods, consult experts, or make any independent investigation prior to beginning his venture. He bought mature chickens from a farmer located in another community. These chickens were generally nonproductive, however, and many died during the winter, although petitioner and his family tried to take care of them. Petitioner did not realize that the hen house had to be heated to induce the chickens to lay eggs. In addition, the chickens were raised under the "open range" concept, which allowed the chickens to roam freely. As a result, if any eggs were produced petitioner either could not find them or could not guarantee their freshness for sale. Petitioner then decided583 to buy and raise chicks, not realizing that chickens must be at least 8 months old before they become productive. After learning that the chicks were not going to be productive, petitioner, with his wife's prodding, decided to get out of chicken farming. After 1976, he attempted to enter the berry farming business, but it was also unprofitable due to a combination of unforeseen natural occurrences and petitioner's ignorance of berry farming. In 1979, petitioner began a hydroponic tomato venture, which had not been profitable as of the time of the second trial. Petitioner did not maintain a separate checking account with respect to his chicken farming activity. He did not maintain separate books for the venture. His receipts were kept in manila folders. In 1974, he applied for and received a certificate for transacting business under an assumed name from the State of New York. Petitioner reported wages of $26,342.70 for 1976. On Schedule F, Form 1040, petitioner reported no farm income and various farm expenses totaling $3,918.24. This deduction was disallowed by respondent, who advised petitioner that the "farm expenses * * [were not] ordinary and necessary expenses for584 the production of income, and you have not verified the expenses * * [that] have been disallowed." At trial, petitioner produced receipts documenting the expenditures, and respondent conceded the issue of substantiation. On brief, respondent conceded that $228.28 claimed as taxes paid was properly deducted. OPINION Respondent contends that petitioner's activities with respect to his farm were activities "not engaged in for profit" within the meaning of section 183(a). Section 183 proides in part that if an individual's activity is "not engaged in for profit" only those deductions allowable regardless of a profit objective (such as interest or taxes) may be taken. The disputed deductions are allowable only if petitioner had an actual and honest profit objective in investing in the farming activities. Dreicer v. Commissioner,78 T.C. 642">78 T.C. 642 (1982), on appeal (D.C. Cir., June 1, 1982). The taxpayer's expectation of profit need not be a reasonable one, but the taxpayer must enter into the activity, or continue it, with a profit objective. Sec. 1.183-2(a), Income Tax Regs.; Allen v. Commissioner,72 T.C. 28">72 T.C. 28, 33 (1979). The determination of585 whether the requisite objective exists is to be resolved on the basis of all the facts and circumstances. Dunn v. Commissioner,70 T.C. 715">70 T.C. 715, 720 (1978), affd. 615 F.2d 578">615 F.2d 578 (2d Cir. 1980). The burden of proof is on petitioner, Golanty v. Commissioner,72 T.C. 411">72 T.C. 411 (1979), affd. in an unpublished opinion 647 F.2d 170">647 F.2d 170 (9th Cir. 1981), with greater weight given to objective facts than to petitioner's mere statement of intent. Sec. 1.183-2(a), Income Tax Regs.; Engdahl v. Commissioner,72 T.C. 659">72 T.C. 659, 666 (1979). The regulations provide a list of factors relevant in determining whether a taxpayer has the requisite profit objective. No one factor is conclusive, and we do not reach our decision herein by merely counting the factors that support each party's position. Sec. 1.183-2(b), Income Tax Regs.; Dunn v. Commissioner,supra at 720. These factors are: (1) The manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity586 may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, that are earned; (8) the financial status of the taxpayer; and (9) any elements of personal pleasure or recreation. Sec. 1.183-2(b)(1) through (9). The factors that are meaingfully applied to the facts of this case are discussed below. The manner in which petitioner carried on his chicken farming activity does not support his claim of a profit objective. Petitioner's chosen method of chicken farming, the "open range" concept, seems guaranteed to prevent the realization of profits. It simply was impossible for petitioner to market eggs while allowing his chickens to roam about freely. Petitioner did not attempt to maintain any records that would help him determine whether his expenses could ultimately be recouped. He testified that he had additional related expenses that he did not bother to claim. Thus, petitioner's manner of conducting his farming activity does not reflect a bona fide profit objective and undermines his statements to the contrary. 587 Dunn v. Commissioner,supra at 720; Jasionowski v. Commissioner,66 T.C. 312">66 T.C. 312, 322 (1976). The obvious lack of expertise of the taxpayer or his advisors, is also supportive of respondent's position and adverse to petitioner's. Although petitioner testified that he spent some time during his youth employed on a chicken farm, he did not present any evidence that he did anything more than the most menial of tasks. In addition, petitioner's own testimony, as well as the chain of events leading to his decision to abandon chicken farming, reveals that petitioner knew very little about it. Petitioner made no effort to learn about chicken farming prior to incurring the expenses in question, nor did he consult experts or advisors who may have been able to prevent some of petitioner's losses. After one disaster, petitioner still failed to consult others although his own experience with chicken farming was quite limited. As a result, petitioner made another unfortunate and costly mistake in buying chicks. These facts indicate a lack of profit objective. See Golanty v. Commissioner,supra at 432. Petitioner was employed full588 time as an electrical engineer while he was engaged in his chicken farming venture. He did not take leave from that job to attend to the farm or gradually phase out his engineering duties to spend more time farming. 2 Although this is not a prerequisite for a finding of a profit objective, petitioner's failure to demonstrate that either he or his family devoted substantial amounts of time or energy to discerning the problems with the chickens or learning how to remedy the problems encountered suggests a lack of a profit objective. Petitioner testified at great length about other "business" ventures he has undertaken, both prior and subsequent to the chicken farming activity. These include marketing snowmobiles (prior), growing raspberries (subsequent), and growing hydroponic tomatoes (subsequent). Both the snowmobile and raspberry ventures met with the same initial enthusiasm, lack of success, and abandonment as the chicken farming venture. Although the tomato activity may ultimately be successful, it had not yet become so by the second trial, which was held approximately 3 years after the589 activity was initiated. Petitioner's lack of success in carrying on other similar or dissimilar activities tends to negate his claim that he held the required profit objective in 1976. Neither of the next two factors provided in the regulations, the petitioner's history of income or losses with respect to the activity and the amount of occasional profits, if any, that are earned by the activity, support petitioner's argument that he entertained a profit objective.There was no evidence that petitioner's losses were unavoidable, or that others engaged in the activity for profit often incur similar losses. Petitioner has a history of only losses and this loss pattern tends to negate the required profit objective. Petitioner did not have a significant amount of gross income in 1976; nor did he realize inordinately large amounts of tax savings attributable to his farm losses, although the amount was not insignificant. Unfortunately for petitioner, this is but one factor slightly in his favor and it does not overcome the weight of the factors supporting respondent's position. The farm did not have facilities on it that would make recreation and not profits the more plausible reason590 for being there, but petitioner and his family made their home there, which strengthens the inference that the activities served a personal purpose. In summary, when the facts of this case are examined in the light of the factors provided in the regulations, 3 we conclude that petitioner did not have an actual and honest profit objective with respect to his chicken farming activity. Because of concessions by respondent, Decision will be entered under Rule 155.Footnotes1. Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954, as amended and in effect during the year in issue.↩2. Compare, e.g., Daugherty v. Commissioner,T.C. Memo. 1983-188↩.3. The one factor not discussed, the expectation that assets used in the activity may appreciate in value, was not addressed by the parties and presumably is not relevant herein.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622025/	Courtney F. Smith, Jr., and Imogene S. Smith, Petitioners v. Commissioner of Internal Revenue, RespondentSmith v. CommissionerDocket No. 14059-81United States Tax Court80 T.C. 1165; 1983 U.S. Tax Ct. LEXIS 67; 80 T.C. No. 64; June 28, 1983, Filed 67 Decision will be entered under Rule 155. Petitioner-husband, who was self-employed, deducted certain business travel expenses on a per diem basis. Held: Away-from-home travel expenses of a self-employed individual are subject to the substantiation requirements of sec. 274(d), I.R.C. 1954. 1 Petitioner-husband's claimed per diem expenses are not deductible because they have not been substantiated. Certain related business mileage is deductible because the requirements of sec. 274(d) have been met.Taylor W. O'Hearn, for the petitioners.H. Karl Zeswitz, Jr., for the respondent. Goffe, Judge. GOFFE1166 The Commissioner determined deficiencies in petitioners' Federal income tax in the amount of $ 5,020.50 for the taxable year 1977 and $ 5,318.70 for the taxable year 1978. After concessions, the issues for decision are whether petitioners may deduct (1) certain itemized deductions, (2) a per diem amount for away-from-home business travel, and (3) away-from-home business mileage.FINDINGS OF FACTSome of the facts in this case have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference.The petitioners are husband and wife and filed joint Federal income tax returns for the taxable 69 years 1977 and 1978 with the Internal Revenue Service Center, Austin, Tex. At the time they filed their petition in this case, they resided in Shreveport, La. References to petitioner in the singular will refer to petitioner-husband, Courtney F. Smith, Jr.Petitioner Courtney Smith was self-employed as the community relations director (national field man) for the Liberty Lobby during the taxable years 1977 and 1978. He traveled extensively in this capacity, principally to lecture throughout the country. His business-related automobile travel for the taxable years 1977 and 1978 was as follows:SCHEDULE OF BUSINESS AUTOMOBILE TRAVEL -- 1977FromToDate of meetingShreveport, LAPasadena, CAJan. 28-30 Pasadena, CASan Diego, CAFeb. 5 San Diego, CAPhoenix, AZMar. 18-19 Phoenix, AZOklahoma City, OKApr. 1-2 Oklahoma City, OKEvansville, INApr. 27-30 Evansville, INDallas, TXMay 2 Dallas, TXSt. Louis, MOMay 13-14 St. Louis, MOShreveport, LAShreveport, LaCincinnati, OHMay 26 Cincinnati, OHMemphis, TNJune 2 Memphis, TNHouston, TXJune 7 Houston, TXNashville, TNJune 14 Nashville, TNBirmingham, ALJune 16 Birmingham, ALStockton, CAJune 28 Stockton, CALos Gatos, CAJune 30 Los Gatos, CASacramento, CAJuly 5 Sacramento, CAPortland, ORJuly 7 Portland, ORMeridian, IDJuly 12 Meridian, IDReno, NVJuly 14 Reno, NVAtlanta, GAJuly 28 Atlanta, GAMarietta, GAJuly 29 Marietta, GACharlotte, NCAug. 2 Charlotte, NCGreensboro, NCAug. 4 Greensboro, NCMemphis, TNAug. 5-6 Memphis, TNSan Antonio, TXAug. 16 San Antonio, TXAustin, TXAug. 18 Austin, TXEuless, TXAug. 19 Euless, TXTyler, TXAug. 23 Tyler, TXIndianapolis, INAug. 30 Indianapolis, INShreveport, LAShreveport, LAPhoenix, AZSept. 20-22Phoenix, AZSan Bernardino, CASept. 26San Bernardino, CABakersfield, CASept. 27Bakersfield, CAOakland, CASept. 29Oakland, CAShreveport, LAShreveport, LASt. Petersburg, FLOct. 11 St. Petersburg, FLTampa, FLOct. 13 Tampa, FLOrlando, FLOct. 17 Orlando, FLJacksonville, FLOct. 18 Jacksonville, FLShreveport, LAShreveport, LABaltimore, MDNov. 10 Baltimore, MDNew York, NYNov. 18-20 New York, NYBaton Rouge, LADec. 5 Baton Rouge, LANew Orleans, LADec. 6 New Orleans, LADenver, CODec. 9-10 Denver, CONorth Miami, FLDec. 12 North Miami, FLWest Palm Beach, FLDec. 13 West Palm Beach, FLMobile, ALDec. 15 Mobile, ALShreveport, LAShreveport, LALittle Rock, ARJan. 5 Little Rock, ARTulsa, OKJan. 9 Tulsa, OKOklahoma City, OKJan. 10 Oklahoma City, OKDallas, TXJan. 12 Dallas, TXShreveport, LAShreveport, LAPasadena, CAJan. 26-29, 31 Pasadena, CAGlendale, CAFeb. 2 Glendale, CASanta Barbara, CAFeb. 6 Santa Barbara, CAHollywood, CAFeb. 7 Hollywood, CACulver City, CAFeb. 9 Culver City, CATorrance, CAFeb. 13 Torrance, CaLong Beach, CAFeb. 14 Long Beach, CAWest Covina, CAFeb. 16 West Covina, CASanta Ana, CAFeb. 20 Santa Ana, CASan Diego, CAFeb. 21, 23 San Diego, CaShreveport, LAShreveport, LAJackson, MSMar. 3-4 Jackson, MSShreveport, LAShreveport, LAHouston, TXMar. 11-12 Houston, TXShreveport, LAShreveport, LALittle Rock, ARMar. 21 Little Rock, ARShreveport, LAShreveport, LANew Orleans, LAApr. 20 New Orleans, LABaton Rouge, LAApr. 21 Baton Rouge, LANew Orleans, LAApr. 22 New Orleans, LAShreveport, LAShreveport, LALouisville, KYMay 1 Louisville, KYDayton, OHMay 2 Dayton, OHKalamazoo, MIMay 4 Kalamazoo, MICleveland, OHMay 8-9 Cleveland, OHYoungstown, OHMay 11 Youngstown, OHPittsburgh, PHMay 15 Pittsburgh, PACanton, OHMay 16 Canton, OHAkron, OHMay 16 Akron, OHCharleston, WVMay 18 Charleston, WVColumbus, OHMay 22 Columbus, OHSpringfield, OHMay 23 Springfield, OHShreveport, LAShreveport, LAElkhart, INJune 6 Elkhart, INSouth Bend, INJune 7 South Bend, INFt. Wayne, INJune 8 Ft. Wayne, INPerrysburg, OHJune 9 Perrysburg, OHDetroit, MIJune 12-13 Detroit, MILansing, MIJune 15 Lansing, MIBay City, MIJune 16 Bay City, MIGreen Bay, WIJune 19 Green Bay, WIMilwaukee, WIJune 20 Milwaukee, WIMenomonee Falls, WIJune 22 Menomonee Falls, WIGurnee, ILJune 26 Gurnee, ILAurora, ILJune 27 Aurora, ILShreveport, LAShreveport, LADallas, TXJuly 1 Dallas, TXShreveport, LAShreveport, LADallas, TXJuly 8 Dallas, TXShreveport, LAShreveport, LAJoplin, MOJuly 13 Joplin, MOKansas City, MOJuly 14 Kansas City, MOOmaha, NEJuly 17 Omaha, NEDes Moines, IAJuly 18 Des Moines, IAMinneapolis, MNJuly 20 Minneapolis, MNSt. Paul, MNJuly 24 St. Paul, MNMadison, WIJuly 25 Madison, WIDavenport, IAJuly 27 Davenport, IAPeoria, ILJuly 31 Peoria, ILBridgeton, MOAug. 1 Bridgeton, MOShreveport, LAShreveport, LAAustin, TXAug. 11 Austin, TXAmarillo, TXAug. 14 Amarillo, TXAlbuquerque, NMAug. 15 Albuquerque, NMDenver, COAug. 17 Denver, COSalt Lake City, UTAug. 21 Salt Lake City, UTPocatello, IDAug. 22 Pocatello, IDBillings, MTAug. 24 Billings, MTSpokane, WAAug. 28 Spokane, WASeattle, WAAug. 29 Seattle, WABellingham, WAAug. 31 Bellingham, WAWilsonville, ORSept. 5Wilsonville, ORSan Francisco, CASept. 7San Francisco, CALos Angeles, CASept. 19Los Angeles, CASanta Barbara, CASept. 21Santa Barbara, CAEl Paso, TXSept. 23El Paso, TXShreveport, LAShreveport, LAWashington, DCOct. 10-13 Washington, DCCharleston, SCOct. 17 Charleston, SCFt. Wayne, INOct. 19 Ft. Wayne, INShreveport, LAShreveport, LAMetaire, LAOct. 31 Metaire, LANew Orleans, LANov. 2-5 New Orleans, LAHouston, TXNov. 6 Houston, TXCorpus Christi, TXNov. 7 Corpus Christi, TXHarlinger, TXNov. 9 Harlinger, TXBig Spring, TXNov. 13 Big Spring, TXFt. Worth, TXNov. 14 Ft. Worth, TXDallas, TXNov. 16 Dallas, TXShreveport, LAShreveport, LAJackson, MSDec. 4 Jackson, MSColumbus, GADec. 5 Columbus, GAJacksonville, FLDec. 7 Jacksonville, FLDaytona Beach, FLDec. 8 Daytona, Beach, FLFt. Lauderdale, FLDec. 11 Ft. Lauderdale, FLMiami, FLDec. 12 Miami, FLFort Myers, FLDec. 14 Fort Myers, FLSt. Petersburg, FLDec. 15 St. Petersburg, FLShreveport, LA70 1170 Petitioners paid $ 1,718.23 in 1977 and $ 2,119.94 in 1978 as interest to Associates Financial Services of America, Inc.The petitioners claimed certain excess itemized deductions and certain Schedule C business or professional deductions on their Federal income tax returns for the taxable years 1977 and 1978. These Schedule C business expenses included travel away-from-home expenses computed on a per diem basis and certain business mileage. The Commissioner disallowed portions of all of these claimed deductions, including all of petitioner's claimed away-from-home travel and mileage expenses.OPINIONPetitioner was self-employed as the community relations director for the Liberty Lobby. In this capacity, he traveled and lectured extensively.The first issue concerns itemized deductions in excess of the amount allowed by the Commissioner in his statutory notice of deficiency. The respondent has conceded that certain of these amounts are deductible. Petitioners, who have the burden of proof ( Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933)), have presented this Court no affirmative evidence concerning these deductions except as to certain interest71 expense payments which we have set forth above. Accordingly, we find the amounts determined by the Commissioner's notice, as adjusted by the interest expense payments and the concessions of respondent, to be correct.1171 The second issue concerns petitioner Courtney Smith's away-from-home 2 travel expenses, other than mileage. Petitioner, relying upon a publication of the Internal Revenue Service, the 1976 Instructions for Form 1040, claims a per diem deduction of $ 44 per day for travel away from home. Respondent maintains that petitioners may not rely upon the IRS publication and, in any event, have not substantiated these claimed deductions as required by section 274(d).Informal publications of the Internal Revenue Service, such as the one relied upon by the petitioners, are not authoritative sources 72 of law. Zimmerman v. Commissioner, 71 T.C. 367">71 T.C. 367, 371 (1978), affd. without published opinion 614 F.2d 1294">614 F.2d 1294 (2d Cir. 1979). Even if these instructions were authoritative, they clearly speak to the allowance of a per diem to an employee, which petitioner Courtney Smith is not.Section 274(d) requires that taxpayers substantiate away-from-home traveling expenses as a prerequisite for claiming such expenses as deductions. Section 274 provides in pertinent part as follows:SEC. 274. DISALLOWANCE OF CERTAIN ENTERTAINMENT, ETC., EXPENSES.(d) Substantiation Required -- No deduction shall be allowed -- (1) under section 162 or 212 for any traveling expense (including meals and lodging while away from home),* * * unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating his own statement (A) the amount of such expense * * (B) the time and place of the travel, entertainment * * * (C) the business purpose of the expense * * This statute clearly provides that a taxpayer who seeks to deduct travel expenses must prove by his records or by his corroborated testimony the amount he spent, 73 when he spent it, where he spent it, and how the expenditures related to his business. Thus, section 274(d) sets forth elements that a taxpayer must prove and the kind of proof needed to establish those elements. Regulations have been promulgated to explain further the elements and the standards of proof. See secs. 1.274-5(b)(2) and 1.274-5(c), Income Tax Regs.Congress has 1172 chosen to impose a rigorous test of deductibility in the area of travel expenses. Each of the foregoing elements must be proved for each separate expenditure. General vague proof, whether offered by testimony or documentary evidence, will not suffice. See Dowell v. United States, 522 F.2d 708 (5th Cir. 1975), vacating 370 F. Supp. 69">370 F. Supp. 69 (N.D. Tex. 1974). In contrast to the per diem for employees authorized by section 1.274-5(f)(2), Income Tax Regs., independent contractors fall under the general substantiation rules of section 1.274-5, Income Tax Regs., except as to certain reimbursement provided for in section 1.274-5(g), Income Tax Regs. The petitioners have not offered this Court any evidence which might meet the substantiation74 requirements of section 274(d). The petitioners have failed to meet their burden of proof. We hold for respondent on this issue.The remaining issue concerns business auto mileage of petitioner Courtney Smith. Unlike general travel expenses, the Commissioner allows business mileage at a standard rate both to employees and self-employed individuals. 3 Respondent, however, contends that away-from-home business mileage is subject to the same section 274(d) substantiation requirements as other away-from-home travel expenses and that the petitioners have failed to meet these requirements as to their claimed deductions.We agree with respondent that section 274(d) applies to away-from-home business mileage. It speaks in very general terms to "any traveling expense." As set forth above, section 274(d) requires substantiation of the amount, time and75 place, and business purpose of travel expenses. The substantiation requirements for away-from-home business mileage are relatively easy to meet, however, because of the nature of the expense. The amount of mileage can be substantiated by any reasonable means, such as the use of a contemporaneous log of business travel or, in the instant case, by proving that a taxpayer traveled between certain cities and then by referring to an authoritative automobile map to determine the amount of mileage.1173 The amount of the expense for away-from-home business mileage can be determined on the basis of a mileage allowance. The Commissioner is authorized to establish mileage allowances that will be deemed to satisfy the substantiation requirements as to amount. Sec. 1.274-5(f)(3), Income Tax Regs. The Commissioner has established specific mileage allowances in Rev. Proc. 74-23, 2 C.B. 476">1974-2 C.B. 476, as modified by Rev. Proc. 77-40, 2 C.B. 574">1977-2 C.B. 574, as an optional method of substantiating business mileage. The current standard mileage rate is set forth in Rev. Proc. 82-61, 2 C.B. 849">1982-2 C.B. 849.76 The time and place of the expense could be adequately substantiated by a contemporaneous log of business mileage or by otherwise establishing a taxpayer's business travel. The business purpose of the travel may be established by specific evidence or by the surrounding facts and circumstances. Section 1.274-5(c)(2)(ii)(b), Income Tax Regs., provides:(b) Substantiation of business purpose. In order to constitute an adequate record of business purpose within the meaning of section 274(d) and this subparagraph, a written statement of business purpose generally is required. However, the degree of substantiation necessary to establish business purpose will vary depending upon the facts and circumstances of each case. Where the business purpose of an expenditure is evident from the surrounding facts and circumstances, a written explanation of such business purpose will not be required. For example, in the case of a salesman calling on customers on an established sales route, a written explanation of the business purpose of such travel ordinarily will not be required. Similarly, in the case of a business meal described in section 274(e)(1), if the business purpose of such77 meal is evident from the business relationship to the taxpayer of the persons entertained and other surrounding circumstances, a written explanation of such business purpose will not be required.In the present case, petitioner Courtney Smith has presented this Court announcement letters for the various meetings at which he lectured as well as newspaper clippings, all of which show the dates and places of the meetings at which he lectured. For the taxable year 1978, he also presented the Court with a personal calendar that showed the dates and places of his 1978 lectures. He testified that, except for one trip to Hawaii and one trip to Washington, D.C., he traveled to all of these meetings in a mobile home. His testimony was uncontroverted and we believe him. Although respondent's attorney initially objected to some of the above-mentioned exhibits as hearsay, he stated at trial that he had no objection 1174 to admitting the exhibits to establish that Courtney Smith was at these places. The Court received these exhibits with this understanding.After carefully reviewing the record, we find that the petitioners have adequately substantiated petitioner-husband's away-from-home78 business mileage. He has established the time and place of his expenses by showing that he traveled by automobile to his various lecture sites and back home. Petitioner's business mileage consisted of traveling the circuit of cities at which he lectured, which we have set forth above. The amount of his business mileage deduction will be determined under a Rule 155 computation in which the parties will determine the mileage that this travel represents and then determine a deductible amount based upon the mileage allowances permitted by the Commissioner. 4 The business purpose of this travel is established by the very nature of the travel, from town to town on an endless lecture circuit. 5Decision will be entered under Rule 155. Footnotes1. All section references are to the Internal Revenue Code of 1954 as amended.↩2. Petitioner maintained his legal residence in Shreveport, La., and respondent does not contend that this is not his "tax home." Kroll v. Commissioner, 49 T.C. 557">49 T.C. 557↩ (1968).3. Rev. Proc. 74-23, 2 C.B. 476">1974-2 C.B. 476, as modified by Rev. Proc. 77-40, 2 C.B. 574">1977-2 C.B. 574↩.4. References to Rules refer to the Tax Court Rules of Practice and Procedure.↩5. Sherman v. Commissioner, T.C. Memo. 1982-582↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622026/	Sam A. Haigh v. Commissioner.Haigh v. CommissionerDocket No. 3523.United States Tax Court1945 Tax Ct. Memo LEXIS 165; 4 T.C.M. (CCH) 613; T.C.M. (RIA) 45204; June 11, 1945165 Where a Massachusetts Trust for tax purposes is an association taxable as a corporation, held, the criteria to be employed in determining the value of the Trust shares are those provided for in the official Regulations for determining the value of shares of stock in a corporation; held, further, the separate identity of the Trust will not be disregarded, and the gift of shares of stock in the Trust will not be treated as the gift of a part of the assets of the Trust in kind. Value of the trust shares is determined under Regulations 108, section 86.19, relating to the gift tax. Mark E. Lefever, Esq., 1507 Packard Bldg., Philadelphia, Pa., for the petitioner. William H. Best, Jr., Esq., for the respondent. BLACK Memorandum Findings of Fact and Opinion This proceeding involves the determination by the respondent against petitioner of a deficiency in gift tax for the calendar year 1940 of $6,285.89. In a statement attached to the deficiency notice is this explanation: The deficiency results from the following adjustments: Schedule AReturnedDetermined1st Item29 shares of stock ofSam Haigh Trust, 30Winthrop Road, Win-throp, Mass. given toClarence Haigh, 4945Monument Rd. Phila-delphia, Pa.43,500.00117,087.66166 The determined value of $4,038.54 per share for the Trust shares of the Sam Haigh Trust is based on a careful consideration of all relevant factors affecting fair market value, primary weight being accorded the adjusted book value wherein the underlying securities were valued at market. By appropriate assignments of error petitioner contests the above adjustment and prays that this Court determine that instead of a deficiency petitioner has overpaid his gift tax for the year 1940 and is entitled to a refund for that year and that such refund is not barred by the statute of limitations. Petitioner contends that instead of the valuation of $1,500 per share of the stock of the Sam Haigh Trust which he returned in his Gift Tax Return, the said stock had a fair market value on the date of gift, June 12, 1940, of $1,015.52 per share. The respondent contends that his determination of $4,038.54 per share should be upheld. Findings of Fact Petitioner is an individual and resides at 125 Sargent Street, Winthrop, Massachusetts. On March 13, 1941, he filed a United States Gift Tax Return for the calendar year 1940 with the collector of internal revenue at Boston, Massachusetts. In Schedule167 A of this return he reported a gift of 29 shares of stock of the Sam Haigh Trust to his son Clarence Haigh, made on June 12, 1940, and as having a value at date of gift of $43,500 or a per share value of $1,500. The total tax payable as computed on the return was $606.88, which amount petitioner paid. The petition herein was filed on November 29, 1943. The Sam Haigh Trust, herein sometimes referred to as the "Trust," is a Massachusetts Trust which has 100 shares of outstanding capital stock. It was organized on or about January 1, 1923. Prior to the gift in question petitioner owned 80 shares and Clarence Haigh 20 shares. Immediately after the gift petitioner owned 51 shares and Clarence Haigh 49 shares. The principal business of the Trust was the operation, maintenance, leasing and sale of approximately 25 residential properties, all but three of which were located in Winthrop, Massachusetts. Most of these properties were single homes which had been converted into two or more family dwellings. The Trust regularly employed two men, William Remby, the manager, and Henry Hoffman, the maintenance man. There were also other employees from time to time. The rents received from the168 operation of the residential properties formed the major proportion of the gross income of the Trust. The only other income received by the Trust was dividends from stocks and interest from bonds owned by the Trust. The capital stock of the Trust never had an open market at any time during the period of its existence. There were never any sales of this stock on the open market. On the date of the gift, the Trust had assets and liabilities with book values, as follows: Cash$ 4,929.81Stocks & Bonds109,610.19Mortgage (Somerset Mills)17,860.45Real Estate237,999.32Account Receivable60.21Total Assets$370,459.98Total Liabilities21,545.04Book value of total shares$348,914.94Book value of one share$ 3,489.15The above book values represented cost in the case of securities and cost less accrued depreciation in the case of the real estate. Except for cash and the account receivable, the above book values of the assets did not represent the fair market value thereof on the date of the gift. The real estate consisted of 32 separate parcels. The parties have stipulated that the fair market value of the stocks and bonds owned by the Trust169 on June 12, 1940 was $164,475, less commissions of $536, and less taxes of $117.65, or a net value of $163,821.35. In addition to this amount interest of $763.93 had accrued on the bonds. On June 12, 1940, the mortgage on Somerset Mills was overdue and interest payments were then several thousand dollars in default. The Trust sold the mortgage and the overdue interest in September, 1944 for $9,000. The business of this concern was better in 1944 than it was in 1940. The fair market value of the mortgage and overdue interest on the date of the gift in question was $9,000. The town of Winthrop is a suburb of Boston. In 1940 it had a population of 15,000 to 16,000 people. It is closely built. The houses are single, double or row, and of frame construction. The average lot is 50 by 100 feet. In 1940 the Winthrop real estate market was depressed. At that time the banks had not unloaded a large amount of foreclosed real estate which had accumulated since the closing of the banks early in the National depression. The people of Winthrop were largely salaried employees and wage workers. The rental market in that locality in 1940 was fair with an average amount of vacancy. The tax assessment170 system which existed in the town of Winthrop was inaugurated in the early twenties by one Frank W. Tucker. At that time there was a considerable amount of new building being done and building costs were high. All new buildings were assessed at practically 100 percent of their estimated cost. Tucker likewise increased the assessed value of all the property in Winthrop. There were practically no reduction in assessment values until the community changed the board of assessors in 1941. The 1940 assessments were practically on the same level with the 1920 assessments and in many cases went considerably beyond the fair market value of the assessed property. In 1940, three properties were sold in Winthrop for $8,000, $4,500, and $4,500, which had an assessed value in that year of $15,500, $8,500, and $5,600, respectively. On September 25, 1942, Eugene P. Whittier appraised 28 of the 32 pieces of real estate owned by the Trust as of June 12, 1940. This was done at the request of petitioner's counsel. Whittier has been in the real estate business for about 46 years, 30 of which have been in Winthrop. He has never met petitioner or been employed by either him or the Trust, except for this171 one appraisal. He valued the 28 pieces of real estate as of June 12, 1940 at a total fair market value of $135,000. The four properties not considered in this appraisal were Sargent Street Beach, a lot at 275 Court Road in Winthrop, a lot in Miami, and a lot in New Hampshire. Whittier thought the market values in 1940 in Winthrop were generally about 42 percent lower than the assessed values. The assessed value in 1940 of the 28 pieces appraised by Whittier was $254,675. Whittier's appraisal of $135,000 was about 47 percent lower than the assessed value of $254,675. In November 1944, William H. Emerson appraised 30 of the 32 pieces of real estate owned by the Trust as of June 12, 1940. This was done at the request of respondent's counsel. Emerson is engaged in the real estate and insurance business. He was born and raised in Winthrop and 60 percent of his business is transacted there. He valued the 28 pieces of real estate, which had been appraised by Whittier, as of June 12, 1940 at a total of $257,300. He valued the Sargent Street Beach at $500 and the lot at 275 Court Road at $4,000. The two properties not considered in Emerson's appraisal were the lot in Miami and the lot in172 New Hampshire. The market value of property in Winthrop in 1944 was between 20 and 33 percent higher than in 1940. A brief description of the 32 pieces of real estate owned by the Trust on June 12, 1940, the values testified to by both Whittier and Emerson, the assessed values, any additional valuation factors applicable to the particular property not referred to above, together with our ultimate finding of fair market value as of the date of gift follows immediately: (1) 101-103 Banks Street. This is a two-family frame dwelling with a two-car garage and sun parlors with each apartment. The foundation is cement block. It has two separate steam heaters. The house is about 20 years old and is built on filled land. The location is poor. It was assessed at $8,000 in 1940 and $6,800 in 1941. A property somewhat near this property, namely, 19 Wilshire Street, was sold in 1944 for $8,000. The Wilshire property was in a much better location than the Banks Street property. The two are not comparable properties. Whittier and Emerson appraised the fair market value of the Banks Street property as of June 12, 1940 at $4,100 and $8,000, respectively. We find it was $5,000. (2) 62 Beacon173 St. and 57 Moore St. This was a single frame dwelling which was converted into a two-family house of three and five rooms, respectively. On entrance was on Beacon Street and the other on Moore Street. It is about 50 years old. It is located in a very much depressed area. It was assessed at $3,900 in 1940 and $3,700 in 1941. On or about June 12, 1944, the Trust entered into an agreement to sell this property and three other properties (63-65 Beacon St.; 5-7 Faun Bar Avenue; and 252 River Road) to the same person. The purchaser's attorney raised serious title objections to all the properties, except the 252 River Road property, and as a result thereof the agreement to sell the three properties objected to was not executed. The title objection made in connection with the instant property was the fact that apparently there was a blanket mortgage outstanding on this property of $100,000 made back in the nineteen twenties. The Trust has not abandoned this property but is trying to find some way to clear its title. Whittier appraised the fair market value of this property as of June 12, 1940 at $3,200 on the assumption that the Trust had a good marketable title thereto. Emerson's value was174 $4,400. We find the fair market value as of the basic date to be $2,000. (3) 63-65 Beacon Street. This is a duplex frame dwelling house consisting of 14 rooms. It has two steam heaters, old flooring and concrete foundation. The house is 45 or 50 years old. It has an unobstructed view of the ocean, but is in a poor locality with practically no yard area. On or about June 12, 1944, the Trust agreed to sell this property for $3,500, but due to a defective title the sale was not consummated. It and 5-7 Faun Bar Avenue were assessed together at $11,100 in 1940 and $9,900 in 1941. Whittier and Emerson appraised the instant property as of the basic date as having a fair market value of $2,500 and $5,500, respectively. Whittier's appraisal was on the assumption that the Trust had a good marketable title to the property. We find the fair market value of the property on the basic date to be $2,000. (4) 165 Court Road. This is a two-family house with a two-car garage under the house. Its location is very good and sets back 80 feet from the street on a brick foundation. It was originally erected as a single dwelling and the conversion into a two-family house of five and seven rooms was poorly175 done. It has a private bathing beach and the beach is equipped with a wooden bulkhead. The house is about 20 years old and has been through two fires, one of which was a serious fire, and on the basic date the house had not been thoroughly repaired. In 1944, a much better property located at 111 Court Road sold for $10,500. The instant property was assessed at $9,950 in 1940 and $9,700 in 1941. Whittier and Emerson appraised the property as of the basic date at $5,600 and $10,000, respectively. We find the fair market value to be $7,500. (5) 205 Court Road. This is a single house, frame dwelling, eight rooms, all improvements, including oil heat. There is no garage but there is a sun room in the rear of the house overlooking the harbor. The house is relatively new and is in a good location. In September, 1940, the property at No. 12 Bartlett Parkway sold for $9,500. The house on the Bartlett property is comparable with the instant house but the location of the Bartlett property is slightly better. The instant property was assessed at $8,200 in 1940 and 1941. Whittier and Emerson appraised the property as of the basic date at $6,000 and $8,700, respectively. We find the fair market176 value to be $7,500. (6) 215 Court Road. This is a relatively new frame two-apartment house with a built-in two-car garage. It is in a good location. The house has a tile bath, fireplaces, and is of the best construction. It has six and seven rooms, respectively, and sun rooms. It has riparian rights to the channel and a private bathing beach. It was assessed at $11,350 in 1940 and $10,850 in 1941, and was sold by the Trust on May 18, 1944 for $10,500. It was appraised by Whittier and Emerson as of the basic date, June 12, 1940, at $7,300 and $12,000, respectively. We find the fair market value on the basic date to be the amount of $8,750. (7) and (8) 281 Court Road and 283-285 Court Road. These two properties will be considered together. The house at 281 Court Road is an old, inexpensive, single, frame house which has been improved and is in an excellent location. Whittier valued it at $5,600 as of the basic date. The other house is a good conversion from a single to two-apartment house. Whittier valued it at $7,200 as of the basic date. Emerson valued them together at $27,000. The two properties were assessed as one unit at $26,550 in 1940 and $25,050 in 1941. We find the fair177 market value of the two properties as of June 12, 1940 to be $15,400. (9) 30 Emerson Road. This is a two-family frame dwelling consisting of five rooms for each family, exclusive of sun rooms. It stands on a poured concrete foundation and is in a good location. The house is relatively new and was built by a speculator. It has a two-car garage built under the house. It was assessed at $9,800 in 1940 and $8,650 in 1941. Whittier and Emerson appraised this property as of the basic date at $6,200 and $10,000, respectively. We find its fair market value as of the basic date to be $7,000. (10) 5-7 Faun Bar Avenue. This property adjoins the property at 63-65 Beacon Street and is almost a duplicate of the latter, with the exception that the instant property has hot air heat whereas the former property has steam heat. On or about June 12, 1944, the Trust agreed to sell this property for $3,500, but due to a defective title the sale was not consummated. It and 63-65 Beacon Street were assessed together at $11,100 in 1940 and $9,900 in 1941. Whittier and Emerson appraised the instant property as of the basic date at $2,500 and $5,000, respectively. Whittier's appraisal was on the assumption178 that the Trust had a good marketable title to the property. We find the fair market value of the property on the basic date to be the same as the 63-65 Beacon Street property, namely, $2,000. (11) 10 Grovers Avenue. This is a two-family frame dwelling with a poured concrete foundation. The house sets on a very steep grade and was built about 20 years ago. It is close to the beach and has an excellent view of the ocean. The Trust sold the property on November 18, 1943 for $7,500. It was assessed at $10,250 in 1940 and $8,100 in 1941. It was appraised by Whittier and Emerson as of the basic date at $5,400 and $10,500, respectively. We find its fair market value as of the basic date to be $6,250. (12) 164 Hermon Street. This is a small, inexpensive, single type bungalow in a poor location. It was sold by the Trust on June 10, 1944 for $2,000. It was assessed at $1,600 in 1940 and 1941. It was appraised by Whittier and Emerson as of the basic date at $1,800 and $2,000, respectively. We find its fair market value as of the basic date to be $1,800. (13) 20 Lewis Avenue. This is a two-family frame dwelling consisting of six and seven rooms, respectively, and two steam heaters. It179 is about 18 years old. The location is good. The foundation is concrete block. There are no garages. The lot is 50 by 70 feet. In 1944 the Trust agreed to sell this property for $7,500, but due to a defective title the sale was not consummated. The attorney for the purchaser discovered a possible mortgage against the property of $10,500, and until this matter is cleared up the Trust will not be able to convey a good title to the property. This situation existed on the basic date. The assessed value of the property was $10,000 in 1940 and $8,500 in 1941. Whittier and Emerson appraised the property as of the basic date at $5,800 and $10,000, respectively. We find the fair market value as of the basic date to be $4,000. (14) 51-53 Lowell Road. This is a two-family frame dwelling consisting of five and six rooms, respectively, and sun parlors. It has a two-car garage under the house and two steam heaters. The location is good. The foundation is poured concrete and the side walls are wooden shingles. It was assessed at $10,050 in 1940 and $8,900 in 1941. Whittier and Emerson appraised the property as of June 12, 1940 at $5,700 and $10,000, respectively. We find its fair market value180 as of the basic date to be $6,500. (15) 61-63 Lowell Road. This is a two-family frame dwelling consisting of five and six rooms, respectively, and sun parlors. It has fireplaces and a two-car garage built under the house. This property adjoins the property at 51-53 Lowell Road. The house on the instant property is a better house than the one on 51-53 Lowel Road. The instant house has an architectural design which gives it the resemblance of a single house. The location is good and the house is relatively new. It was assessed at $10,300 in 1940 and $9,550 in 1941. Whittier and Emerson appraised the property as of the basic date at $6,500 and $10,000, respectively. We find its fair market value as of the basic date to be $7,000. (16) 239 Pleasant Street. This is a large rambling house, single frame with a separate two-car garage. On the basic date it was in need of considerable repair. It is corner property. It has been used professionally by a dentist for 20 years. The foundation is of Quincy granite and the lot is 40 by 70 feet. Late in the fall of 1941 the adjoining property at 233 Pleasant Street sold for $5,300. It was also in need of considerable repair. The house on the property181 that was sold had been converted into a two-family apartment. The instant property was assessed at $7,200 in 1940 and $7,150 in 1941. Whittier and Emerson appraised the instant property as of the basic date at $4,500 and $7,500, respectively. We find its fair market value as of the basic date to be $5,000. (17) 252 River Road. This is an old single frame house that has been poorly converted into a two-family apartment. The lot is shallow being 70 by 60 feet. In 1939, a house at 183 River Road, which was a one family dwelling and badly in need of repair, sold for $5,000. The Trust sold the instant property on November 1, 1944 for $5,000. The instant property was assessed at $7,800 in 1940 and $7,300 in 1941. Whittier and Emerson appraised the instant property as of the basic date at $4,000 and $7,500, respectively. We find its fair market value as of the basic date to be $4,200. (18) 120 Sargent Street. Originally this was a very good single house. It was the Delano property. It occupies a very large and excellent lot with a frontage of 120 feet on Sargent Street and 80 feet on Johnson Avenue. It was expensively converted into a very nice two-family apartment with a two-car garage. 182 It has all such improvements as oil heat, fireplace, tile baths, copper conductor pipes, fencing and landscape gardening. It was assessed at $20,000 in 1940 and $16,800 in 1941. Whittier and Emerson appraised it as of the basic date at $10,000 and $22,000, respectively. We find its fair market value as of the basic date to be $15,000. (19) 75 Temple Avenue. This is a two-family apartment poorly converted from a single house. The location is fair. There is a cheap metal garage on the property. In the spring of 1940 a much better house at 138 Highland Avenue sold for $9,000. The Trust sold the instant property on October 11, 1944 for $6,000. The instant property was assessed at $6,950 in 1940 and $6,500 in 1941. Whittier and Emerson appraised the instant property as of the basic date at $4,000 and $7,000, respectively. We find its fair market value as of the basic date to be $4,900. (20) 120 Shore Drive. This is a two-family, frame, corner dwelling, with five and six rooms, respectively, steam heat with oil, and is about 14 years old. It overlooks the ocean and rents well in the summer. The Trust sold the property on August 10, 1944 for $8,000. It was assessed at $9,850 in 1940183 and $9,000 in 1941. Whittier and Emerson appraised the property as of the basic date at $5,400 and $10,000, respectively. We find its fair market value as of the basic date to be $6,700. (21) 55 Wave Way Avenue. This is a fourfamily frame dwelling with wood shingle side walls. The foundation is poured concrete. There are four hot water heaters. The lot is 50 by 100 feet. It has two five-room apartments and two three-room apartments. It is 45 or 50 years old and is in a poor location. It sold in 1922 for $5,000. It was assessed at $13,150 in 1940 and $9,250 in 1941. Whittier and Emerson appraised the property as of the basic date at $3,500 and $11,000, respectively. We find its fair market value as of the basic date to be $6,000. (22) 125 Sargent Street. This is petitioner's personal residence. He rents it from the Trust. It is a corner property and is in an excellent location. It has a commanding view of the entire harbor. It consists of 10 rooms, two baths, and an extra lavatory. It is wood frame with stucco on the outer walls of the second and third floors. It has a slate roof. It has a sunken four-car garage. The house has the very latest of modern equipment. The land is well184 landscaped, with trees, rock garden, driveways and footpaths. The house is between 40 and 50 years old. The property was assessed at $24,050 in 1940 and $19,350 in 1941. Whittier and Emerson appraised the property as of the basic date at $9,000 and $25,000, respectively. We find its fair market value as of the basic date to be $14,000. (23) Lot 71 Court Road. This is 7,000 square feet of vacant land. It is in a good location but has a bad, steep grade. It was assessed at $2,250 in 1940 and $1,600 in 1941. Whittier and Emerson appraised this lot as of the basic date at $1,300 and $3,000, respectively. We find its fair market value as of the basic date to be $1,400. (24) Lot 73 Court Road. This is 6,300 square feet of vacant land and is a slightly better lot than the one at 71 Court Road. It was assessed at $2,200 in 1940 and 1941. Whittier and Emerson appraised it at $1,500 and $2,800, respectively. We find its fair market value as of the basic date to be $1,500. (25) Lots 12-15 Bellevue Avenue. This property consists of 4 lots of a total area of 30,406 square feet of good, level and. Whittier valued them at $800 each or $3,200. Emerson thought the plot could be divided into185 five lots and marketed for $1,300 each. In 1940, there was a small shop on this property which Emerson appraised at $400. It has since been torn down. This property was assessed at $6,800 in 1940 and $6,000 in 1941. We find the fair market value of this property as of the basic date to be $5,200. (26) Dorchester. This property is located at 61 Lithgow Street, Dorchester, Massachusetts. It is a relatively new three-apartment house and is what is generally known around Boston as a "three-decker." It has a detached three-car concrete block garage. Each apartment contains a separate steam heater, white sinks, standard bath, and hard pine floors. The foundation is granite stone. The roof is a flat top and gravel. There are three rear porches. The location is very accessible to transportation, schools, playgrounds and a large shopping district. It was assessed at $11,500 in 1940 and $9,800 in 1941. Whittier and Emerson appraised this property as of the basic date at $5,500 and $9,500, respectively. We find its fair market value as of the basic date to be $7,500. (27) Stoneham. This property is located at 594 Main Street, Stoneham, Massachusetts. It is a single frame dwelling and garage186 in a good location, except that it is on a heavily traveled highway. It fronts about 150 feet on Main Street and 230 feet on Wilson Road. It was assessed at $7,875 in 1940 and 1941. Whittier and Emerson appraised it as of the basic date at $4,500 and $8,000, respectively. We find the fair market value of this property as of the basic date to be $6,000. (28) Melrose. This property is located at 11 Warren Street, Melrose, Massachusetts. It is an old single frame dwelling in a fairly good location with no garage. It has seven rooms, hard pine floors, white sinks, hot water heat, granite foundation, wood clapboard side walls, asbestos shingle roof and a front porch. It was assessed at $4,000 in 1940 and 1941. Whittier and Emerson appraised it as of the basic date at $3,200 and $4,000, respectively. We find its fair market value as of the basic date to be $3,200. (29) Sargent Street Beach. This is a little strip of land with a 35 foot frontage on the end of Sargent Street. It lies between 120 and 125 Sargent Street. It was assessed at $300 in 1940 and 1941. This was not included in Whittier's appraisal but at the hearing he did not think it had any value. Emerson thought it had a187 value of $500 to the owners of 120 and 125 Sargent Street. We find its fair market value as of the basic date to be $175. (30) Lot 275 Court Road. This is a vacant lot 60 feet by 80 feet next door to 281 Court Road. It is a very desirable lot. It was assessed at $3,600 in 1940 and 1941. Whittier and Emerson appraised the lot as of the basic date at $2,000 and $4,000, respectively. Whittier's appraisal was made at the hearing. This lot was not included in Whittier's 1942 appraisal. We find the fair market value of the lot as of the basic date to be $2,800. (31) Miami Lot. This was a lot in Miami owned by the Trust on the basic date and its fair market value at that time was $50. (32) New Hampshire Lot. This was a lot in New Hampshire owned by the Trust on the basic date and its fair market value at that time was $275. The total fair value of the above 32 pieces of real estate owned by the Trust on June 12, 1940 was the amount of $166,600. The standard brokerage commission for the sale of real estate in Winthrop in 1940 was 5 percent of the gross sales price, which on $165,600 would be the amount of $8,330. The Trust filed corporation income and excess profits tax returns188 for the years 1935 to 1940, inclusive, and reported a taxable net income or loss thereon, as follows: 1935 Net income$ 3,909.361936 Net income8,934.701937 Loss4,587.111938 Loss7,301.821939 Loss7,746.121940 Loss44,436.38For the years 1935 and 1936, the Commissioner determined deficiencies and the Trust filed a petition with the United States Board of Tax Appeals (now the Tax Court). The parties stipulated that proceeding on the basis of a net income for 1935 of $2,390.76 and $25,500 for 1936. After making adjustments to the above stipulated taxable net income for 1935 and 1936 and the above reported losses for 1937 to 1940, inclusive, for items of nontaxable income and unallowable deductions, the actual commercial net income or loss for each of the years is as follows: 1935 Net income$11,116.731936 Net income3,555.591937 Loss4,743,581938 Loss7,150.321939 Loss37,200.051940 Loss62,549.98The large loss for 1940 was due partly to a salary of $30,000 paid to Clarence Haigh during the year as Treasurer of the Trust and partly to a charge against income for that year of $18,113.60 for legal fees and costs of189 prior years. The Trust declared and paid a dividend of $50 per share or $5,000 during the year 1936. No dividends were declared or paid by the Trust for the years 1937 to 1940, inclusive, or for the year 1935. A fair charge against the total assets for the expense of liquidating the Trust would be $10,000. The net worth of one share of stock of the Trust on the date of the gift, based upon the fair market value of the assets of the Trust less its liabilities on that date was $3,236.30, computed as follows: Cash$ 4,929.81Stocks & Bonds163,821.35Interest Receivable on bonds763.93Mortgage (Somerset Mills)9,000.00Real Estate (32 items)166,600.00Account Receivable60.21Total fair market value ofassets$345,175.30Less total liabilities21,545.04Net worth of total shares$323,630.26Net worth of one share$ 3,236.30To liquidate the real estate assets of the Trust would have required three years; commissions for selling real estate would have been $8,330. Other expenses would have been $10,000 for the three years required for liquidation. The fair market value of the 29 shares in the Sam A. Haigh Trust which petitioner gave his son, 190 Clarence Haigh, on June 12, 1940, was $79,750 or $2,750 per share. Opinion BLACK, Judge: This is a gift tax case. On June 12, 1940, petitioner gave his son 29 shares of stock of the Sam Haigh Trust. Section 1005 of the Internal Revenue Code provides that "If the gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift." Our sole question is to determine the value of the 29 shares at the date of the gift. This is primarily a question of fact "But the question of what criterion should be employed for determining the 'value' of the gifts is a question of law." Powers v. Commissioner, 312 U.S. 259">312 U.S. 259. See also Weber v. Rasquin, 101 Fed. (2d) 62; Forbes v. Hassett, 124 Fed. (2d) 925; Helvering v. Maytag, 125 Fed. (2d) 55; and Commissioner v. McCann, 146 Fed. (2d) 385. The Trust is a Massachusetts trust and for tax purposes is treated as a corporation. It filed its returns as a corporation for the years 1935 to 1940, inclusive. It had 100 shares of capital stock outstanding. Prior to the gift in question petitioner owned 80 shares and his son Clarence191 owned 20 shares. The stock of the Trust was not traded on the open market. There was no evidence of any sales of the stock at any time. Neither was there any evidence of any offers to buy or sell. Regulations 108 relating to the Gift Tax under the Internal Revenue Code provides in part, as follows: SEC. 86.19 Valuation of Property. - (a) General. - The statute provides that if the gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift. The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell. The value of a particular kind of property is not to be determined by a forced sale price. Such value is to be determined by ascertaining as a basis the fair market value at the time of the gift of each unit of the property. For example, in the case of shares of stock or bonds, such unit of property is a share of a bond. All relevant facts and elements of value as of the time of the gift should be considered. * * * (c) Stocks and bonds. - The value at the date of the gift in the case of stocks and bonds, 192 within the meaning of the statute, is the fair market value per share or bond on such date. * * * * If actual sales or bona fide bid and asked prices are not available, then * * the value is to be arrived at * * * in the case of shares of stock, upon the basis of the company's net worth, earning power, dividend-paying capacity, and all other relevant factors having a bearing upon the value of the stock. Complete financial and other data upon which the donor bases his valuation should be submitted with the return. The respondent did not follow these regulations in arriving at the value of $4,038.54 stated in his deficiency notice. 1 He determined his value on the basis of the actual book value set out in our findings of $348,914.94, except that he changed the book value of the stocks and bonds from $109,610.19 to approximately $164,446. 2 In his brief he contends that Regulations 108 do not contain any provision for a valuation method to be applied to a personal family holding trust such as is now being considered and that "The situation here is exactly the same as if there were no trust and the donor had the title to the property in his individual name and had transferred193 part of it by gift to his son, in which even the fair market value of the assets transferred would be the value of the gift to be reported on the gift tax return." We do not agree with this contention. For tax purposes a Massachusetts trust such as we have here is treated as an ordinary domestic corporation and we know of no reason why its shares of stock should not be valued in the same manner as the shares of stock in an ordinary domestic corporation where the stock is closely held. Under the respondent's contention we would have to ignore the separate identity of the Sam Haigh Trust. This we are not authorized to do. It was organized on or about January 1, 1923, and has been in business ever since then and we know of no reason for ignoring its separate identity at this time. It is evidence that the Commissioner has treated it as a corporation for income tax purposes and no one is contending it should be treated otherwise in that respect. 194 If we were to base our valuation of each share in the Trust on the basis alone of the fair market value of the underlying assets of the Trust on the date of the gift, we would find a fair market value of $3,236.30 for each share. If we should base the valuation alone on the liquidating value of the assets our finding would be $3,053 per share and this value would have to be discounted because of the fact that three years would be required to liquidate the assets of the Trust. If we were to use earnings and dividends for the five years prior to the gift as the sole criterion of value, we could find very little value for each share of the Trust on the basic date because only one dividend had been paid during these five years, and income had been realized in only two of them and losses in the other three. (The last three years prior to the date of gift.) But giving effect to all the elements of value prescribed in the Commissioner's regulations, namely, "upon the basis of the company's net worth, earning power, dividend-paying capacity, and all other relevant factors having a bearing upon the value of the stock," we have arrived at a value of $2,750 per share on the date of the195 gift. Cf. Weber v. Rasquin, supra; Forbes v. Hassett, supra. In arriving at this value we have kept in mind that this Trust is not in liquidation. Petitioner has asked us to fix a value on the basis of the liquidating value of the assets, discounted by the number of years it would take to liquidate the assets and still further to discount the value so reached because of the lack of earning power of the Trust during the last three years prior to the date of the gift. Under petitioner's formula, starting out with his contention that the asset value per share as of June 12, 1940, was $2,769.40, we would arrive at a value of $1,015.52 per shares. The formula as used in his brief is as follows: Asset value per share as ofJune 12, 1940$2,769.40Same discounted at 40%1,662.00Less 4 years' loss at $161.62 pershare per year, or $646.481,015.52We reject petitioner's computation because it is not supported by the evidence or the regulations. The evidence was to the effect that the Trust is not in liquidation but is in active business as it had been for many years. The evidence is also to the effect that in two or three years after196 the date of the gift, the real estate market very considerably improved and the rentals from such property also substantially improved. Petitioner's own witness testified that by the year 1944 the real estate market had improved to where it was the best it had been since 1929. While, of course, the valuation of the shares here to consider must be made as of the date of the gift, this improvement in the real estate market and the rental value of the property is illustrative of the fact that business enterprises have their ups and downs, some good years and some bad ones. The Sam Haigh Trust had been in the real estate business for many years, it also might well be expected to have its good years and its bad ones and the valuation of its shares should not be exclusively based on its showing in three unprofitable years just prior to the date of gift. We feel convinced from the evidence that each of the 29 shares of the Trust which petitioner gave his son on June 12, 1940, had a fair market value of at least $2,750 per share. This valuation should be used in a recomputation under Rule 50. Decision will be entered under Rule 50. Footnotes1. The respondent determined that the value of the 29 shares on the date of gift was $117,087.66. This amount divided by 29 equals $4,037.51 instead of $4,038.54. ↩2. By substituting $164,446 for $109,610.19, the respondent's determination of $4,037.51 per share may be shown as follows: ↩Cash$ 4,929.81Stocks & Bonds164,446.00Mortgage (Somerset Mills)17,860.45Real Estate237,999.32Account Receivable60.21Total assets$425,295.79Less total liabilities21,545.04Value of total shares$403,750.75Value of one share$ 4,037.51	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622028/	Leon R. Meyer, Petitioner, v. Commissioner of Internal Revenue, Respondent; 1 Lucile H. Meyer, Petitioner, v. Commissioner of Internal Revenue, Respondent 1Meyer v. CommissionerDocket Nos. 4779-62, 4780-62United States Tax Court46 T.C. 65; 1966 U.S. Tax Ct. LEXIS 114; April 21, 1966, Filed 114 Decisions will be entered under Rule 50. In 1946 petitioners, Leon and Lucile, husband and wife, who were coowners of a partnership caused the organization of a corporation, Jewelry, to which they transferred the partnership assets in exchange for the assumption of the partnership liabilities and the issuance to them in equal amounts of Jewelry's capital stock (designated as class A stock) and notes totaling in par and face value the net value of the partnership assets so transferred. In 1947 the notes were capitalized by the issuance to Leon and Lucile of class B stock of Jewelry which had at that time voting rights and some preference over class A stock. In 1956 Jewelry had financial difficulties and in a bankruptcy proceeding a composition with creditors was arranged under chapter XI of the Bankruptcy Act, whereby approximately $ 189,000 of its debts were discharged. Some 3 days before the entry of the order effecting this discharge and in contemplation thereof, Jewelry caused an appraisal of its assets to be made. It credited an amount purporting to be equivalent to the amount of its forgiven debts (less certain adjustments) to an account designated "Contributed capital" on 115 its balance sheet and included in certain expense items on its income statement amounts totaling the amount of the write-downs of its assets to fair market value resulting from the appraisal thereof. As part of the arrangement under chapter XI, Leon was required to contribute $ 25,000 to Jewelry, a part of which ($ 15,000) he borrowed from a bank on his personal notes secured by stock in Thiokol Corp. owned by him. Jewelry was required to borrow and did borrow from the same bank $ 100,000 on its note of which Leon and substantial friends of his were guarantors. In 1958 all distinctions between the class A and class B stock of Jewelry were obliterated by appropriate corporate action. In the latter part of that year a plan was evolved by Leon and Lucile and their advisors for Leon to contribute some of this Thiokol stock to Jewelry, for Jewelry to sell the stock which had tremendously increased in value and from the proceeds to pay the $ 50,000 balance on its note to the bank, for Jewelry to distribute the balance of the proceeds to Lucile, for Lucile in return therefore to surrender her stock in Jewelry for redemption, and for Lucile to pay Leon's $ 15,000 note to the bank from 116 such distribution. Accordingly, in the early part of 1959 Leon duly endorsed and transferred to Jewelry and Jewelry accepted 700 shares of his Thiokol stock, and Jewelry authorized the sale of the 700 shares by its broker. The management of the sale was left to Leon. Sales of 638 shares of this stock were made by Jewelry in the early part of April 1959, and certificates for these shares were eventually transferred on the stock record books of Thiokol from the name of Leon to the names of those purchasing the stock from Jewelry. On May 4, 1959, the brokers at Leon's request had the certificate for the remaining 62 shares still in Leon's name changed to three certificates; one for 32 shares in Leon's name and two for 15 shares in the names of his son and spouse and daughter and spouse, respectively. After Leon had donated the 700 shares of Thiokol stock to Jewelry and shortly before the sales of the 638 shares by Jewelry, Thiokol voted a 3 for 1 split of its stock, the new stock to be issued to the stockholders of record of Thiokol as of April 20, 1959, when Leon was still the stockholder of record of the 700 shares. The new Thiokol stock distributable on account of the 638 shares 117 sold by Jewelry were delivered in due course to the purchasers thereof, while the new stock (124 shares) distributable on account of the 62 shares not sold by Jewelry were received by Leon on April 30, 1959, and were retained by him. The distributions by Jewelry to Lucile (of the excess of the proceeds from its sales of the 638 shares of Thiokol stock over the amount required for the payment of its bank note) in the total amount of $ 31,328 were charged to an account receivable on its books under Lucile's name. Immediately after the receipt of the distributions Lucile made the payments therefrom contemplated by the plan. In the latter part of 1959 (after June 30, but before December 31) Lucile surrendered all of her stock in Jewelry for redemption at its par value of $ 29,000, which amount was credited to her account by Jewelry as of December 31. The balance of $ 2,328 contained in her account owing to Jewelry was never paid. No interest was charged thereon and no security therefor was asked or given. At the time of the distribution, Lucile served as a salaried officer of Jewelry. She continued to serve in this capacity through the year ended June 30, 1962. Respondent determined 118 deficiencies against Leon on the grounds that the capital gains realized on sales of the Thiokol stock were taxable to him, that the distributions to Lucile were taxable to him, and that the 62 shares of Thiokol stock constituted a distribution to Leon from Jewelry, and in the case of Lucile, on the ground that the distributions from Jewelry received by her constituted income taxable to her. At the trial respondent conceded that Jewelry sold the Thiokol stock, and gains therefrom were not taxable to Leon. Held:1. Respondent's notices of deficiency were valid and presumptively correct in spite of inconsistencies and confession of error as to one ground.2. Earnings and profits of Jewelry increased by amount of its debts forgiven in bankruptcy proceeding in excess of amount available for reduction of basis of its assets; and such amounts and Jewelry's earnings and profits are determined.3. Under various provisions of sections 301, 302, 316, and 318, I.R.C. 1954, distributions by Jewelry to Lucile were equivalent to dividends and taxable as such to Lucile.4. Sixty-two shares of Thiokol stock issued to Leon and his donees pursuant to his instructions of May 4, 1959, and 124 shares of Thiokol 119 stock received by him on April 30, 1959, as a split of such stock held in his name on books of Thiokol and retained by him constituted dividend distributions to Leon from Jewelry and value of such stock determined as of such dates. Joseph A. Hoskins and Philip J. Erbacher, for the petitioners.Merrill R. Talpers, for the respondent. Kern, Judge. KERN67 Respondent originally determined a deficiency in the income tax liability of petitioner Leon R. Meyer (hereinafter sometimes referred to as Leon) for the year 1959 in the sum of $ 40,101.55 and a deficiency in the income tax liability of petitioner Lucile H. Meyer (hereinafter sometimes referred to as Lucile) for the year 1959 in the sum of $ 17,402.09.The statement attached to the notice of deficiency addressed to Leon indicated the increase of his taxable income as disclosed in his return by the addition thereto of the following items: (1) Capital gains totaling $ 39,766.39, realized from the sale of 638 shares of Thiokol stock made in the name of Meyer Jewelry Co., a corporation of which most of the stock was owned by Leon and Lucile (sometimes hereinafter referred to as Jewelry) and to which the Thiokol stock had been transferred 120 by Leon shortly before its sale as a contribution to Jewelry's capital; (2) an alleged distribution to Leon from Jewelry on April 13, 1959, of $ 7,920.50, representing the value on that date of 62 shares of Thiokol stock originally included in the Thiokol stock contributed by Leon to Jewelry but which was eventually reissued in the names of and delivered to Leon and/or his nominees; and (3) the 68 alleged "payments to [Leon], or on [his] behalf," of $ 31,328.17 by Jewelry, representing payments made by Jewelry to Lucile, the wife of Leon and a principal stockholder of Jewelry, a large part of which payments were used by her shortly after their receipt by her to make payments to Leon or in satisfaction of Leon's obligations. Because of these increases in Leon's taxable income respondent disallowed a deduction claimed by Leon as a medical expense.The statement attached to the notice of deficiency addressed to Lucile indicated the increase of her taxable income as disclosed in her return by the addition thereto of the payments made to her by Jewelry in the total amount of $ 31,328.17.These cases were consolidated for hearing and opinion.At the trial herein respondent conceded error in 121 adding to Leon's taxable income the capital gains derived from the sale of the 638 shares of Thiokol stock made by Meyer Jewelry Co. At the close of the hearing respondent moved for leave to amend his answer to conform to the proof by allegations to the effect that the Thiokol stock alleged to have been received by Leon from Jewelry was received by him on April 30, 1959, and May 4, 1959, in the amounts of 124 and 62 shares, respectively, and the total value of such stock on these dates was $ 10,013. A written amendment to the answer was later filed by respondent to this effect with the leave of the Court.FINDINGS OF FACTPetitioner Leon R. Meyer is a resident of Johnson County, Kans., whose separate income tax return for the calendar year 1959 was filed with the district director of internal revenue at Kansas City, Mo.Petitioner Lucile H. Meyer is a resident of Johnson County, Kans., whose separate income tax return for the calendar year 1959 was filed with the district director of internal revenue at Kansas City, Mo.Meyer Jewelry Co. was incorporated in the State of Missouri on July 29, 1946. The authorized capital stock of Jewelry at the date of its incorporation was: 1,250 class 122 A shares -- $ 100 par value, and 1,250 class B shares -- $ 100 par value. As of the date of incorporation, both classes of shares authorized by the articles of incorporation of Jewelry had equal rights and preferences, with the exception that the class A shares had voting rights and class B shares were nonvoting. However, changes could be made as to voting rights and preferences by the passage of "Special By-Laws."Jewelry commenced business with a capital of $ 500 received from the cash payment for five initially subscribed class A shares. Leon paid in $ 200 for two shares; Lucile paid in $ 200 for two shares; and one Sol Silberman paid in $ 100 for one share.The one share of class A $ 100 par value stock acquired by Sol Silberman was held as nominee, one-half share for Leon and one-half share 69 for Lucile. The cost basis attributable to Leon and Lucile individually of each of said one-half share is one-half of $ 100 or $ 50. Lucile's one-half share was eventually transferred to Jack Becker on December 24, 1958.Prior to the incorporation of Jewelry, a partnership had conducted a jewelry business known as Meyer Jewelry Co. The partners were Leon R. Meyer and Lucile H. Meyer, each 123 having a 50-percent interest.On August 1, 1946, a special combined meeting of stockholders and directors of Jewelry was held at which a plan of reorganization of Meyer Jewelry Co., the partnership, was discussed. The plan involved the dissolution of the partnership as of the close of business July 31, 1946, the transfer to the newly formed corporation by the partners of all of the assets (except cash of $ 2,743.13), subject to the liabilities, both as shown on the closing partnership statement, the transfer and assignment of a lease, and the issuance and delivery to Leon of 297 1/2 shares of the class A stock of the corporation and the same number of shares of such stock to Lucile. In addition, there were to be issued and delivered to each of the former partners negotiable promissory notes in the aggregate face amount of $ 25,000, payable in 10 years from date with interest at 4 percent, payable semiannually.Pursuant to an agreement entered into on the same date between Leon and Lucile as parties of the first part and Jewelry as party of the second part the following steps were taken: Leon and Lucile transferred all of the partnership assets (except cash of $ 2,743.13) subject to 124 liabilities, both as shown on the closing partnership statement, to the corporation, and the corporation assumed all of the liabilities, issued to Leon 297 1/2 shares of its class A stock with a par value of $ 100 and to Lucile 297 1/2 shares of the same class A stock, and issued to each, negotiable promissory notes in the aggregate face amount of $ 25,000, payable in 10 years from date thereof with interest at 4 percent, payable semiannually. The five notes of Leon's photostatic copies of which were admitted in evidence, all bear the notation on the reverse side: "Interest to and including Sept. 30, 1947/Received/Leon R. Meyer/Pay to order of/Meyer Jewelry Co./Leon R. Meyer/Cancelled 9/30/47/ Meyer Jewelry Co./ By ." The five notes of Lucile, photostatic copies of which were also admitted in evidence, bear the notation on the reverse side: "Cancelled 9/30/47/ By Leon R. Meyer, Pres./Meyer Jewelry Co."The partners' closing investment in the partnership as of July 31, 1946, was:Leon R. Meyer$ 56,121.57Lucile H. Meyer56,121.56112,243.1370 The assets of the partnership transferred to the corporation totaled $ 315,899.22 ($ 318,642.35 - $ 2,743.13) and the liabilities assumed by the 125 corporation totaled $ 206,399.22. From the closing partnership investment account and assets, $ 2,743.13 was retained by the partners prior to transfer of assets and property to the corporation. The assets transferred were carried at their cost to the partnership on its books as reflected in the balance sheet of the partnership attached to the minutes of the corporation dated August 1, 1946, and in the agreement entered into by Leon, Lucile, and the corporation dated August 1, 1946.The combined cost basis of class A $ 100 par value stock and notes issued to Leon and Lucile, at the incorporation of Jewelry and upon acquisition of the net assets received by the Meyers in dissolution of the partnership, was as follows:Leon R. Meyer300 shares -- class A -- $ 100 par value stock$ 30,000$ 25,000 aggregate face value 10-year negotiable notes,4-percent interest25,00055,000Lucile H. Meyer300 shares -- class A -- $ 100 par value stock$ 30,000$ 25,000 aggregate face value 10-year negotiable notes,4-percent interest25,00055,000 On September 30, 1947, a combined meeting of stockholders and directors of Jewelry was held. At the meeting the officers of the corporation were authorized to issue 126 250 class B shares to Leon and 250 class B shares to Lucile in exchange for their notes of the corporation, exclusive of unpaid interest, subject to the provisions of the special bylaws of the corporation adopted at the same meeting. These special bylaws provided for a priority of dividends to the class B shares of $ 6 per share in respect of each fiscal year, and made the class B shares subject to redemption at any time at the par value thereof, on compliance with the restrictions and limitations of the laws of Missouri. Moreover, the right to vote was granted to the class B shares. The purpose of this exchange was to improve the balance sheet of the corporation for credit purposes by the capitalization of what appeared on its balance sheet as a $ 50,000 liability to Leon and Lucile.Pursuant to these minutes, 250 shares of class B ($ 100 par value) stock were issued to Leon and the same number of shares of the same stock to Lucile in exchange for the notes described above being $ 25,000 of notes payable to each. No dividends were ever paid by Jewelry on any of its capital stock during the period 1946 through 1958.71 On May 31, 1956, an involuntary bankruptcy petition was filed in 127 the U.S. District Court for the Western District of Missouri at Kansas City, Mo., against the Meyer Jewelry Co. Thereafter, Jewelry filed an answer denying that it was insolvent. On June 18, 1956, Jewelry filed a debtor's petition stating that it was unable to pay its debts as they mature, proposing an arrangement with its unsecured creditors, and praying for a proceeding in accordance with chapter XI of the Bankruptcy Act (11 U.S.C. sec. 721). The proposed arrangement called for the payment of all administrative expenses and priority claims such as taxes in cash by Jewelry. 2 The proposal divided the unsecured creditors into the following three classes: (1) Claims which were incurred prior to April 17, 1956, were to be paid to the extent of 30 percent; (2) claims for merchandise incurred subsequent to April 17, 1956, were to be paid in full; and (3) an obligation in the amount of $ 7,500 to the Jewelers Board of Trade in connection with negotiations with creditors was to be paid in full.As part of the proposed arrangement, Jewelry had negotiated a $ 100,000 loan from Commerce Trust Co., Kansas City, Mo., 128 such loan to be guaranteed individually by Leon and partially guaranteed by certain friends of Leon. In addition, Leon agreed to contribute to the corporation $ 25,000 cash as additional working capital.Among provisions included in the terms of the loan by Commerce Trust Co. to Jewelry were the following: Leon was to put not less than $ 25,000 into Jewelry as working capital; Leon was to guarantee payment of the note to Commerce Trust Co.; Leon and Lucile were to pledge as surety for the guaranty of Leon all issued and outstanding capital stock of Jewelry, except such part thereof, not to exceed 25 percent, as might be distributed to key employees of Jewelry, including Richard Burstein and Louis S. Meyer; and the corporation was to deliver to Commerce Trust Co. the written guaranty of six individuals in Kansas City, Mo., designated by name.The loan by Commerce Trust Co. was to bear interest at 5 percent, payable quarterly, and was to be evidenced by a 90-day note, renewable not to exceed 19 extensions, provided the corporation was operating on a satisfactory basis. A payment of $ 10,000 was to be made on this note at the end of the second quarter, and thereafter $ 5,000 per quarter 129 was to be paid thereon. The loan of $ 100,000 to Jewelry was completed, and Lucile consented to the pledge of her shares of stock in Jewelry.In order to raise the $ 25,000 required to be contributed as working capital, Leon obtained $ 10,000 by cashing in a certain life insurance policy, under which Lucile was beneficiary, and borrowed an additional $ 15,000 from Commerce Trust Co. secured by 798 shares of 72 stock of Thiokol Corp. (now Thiokol Chemical Corp.), sometimes hereinafter referred to as Thiokol. At that time the 798 shares of Thiokol stock thus pledged had a fair market value of approximately $ 30,000. Subsequently, as hereinafter noted, the value of this stock greatly increased in value and the number of shares held in pledge increased by reason of stock dividends, stock splits, and the exercise of rights to purchase by Leon.In June of 1956, Leon paid to Jewelry the sum of $ 25,000, as required by the proposed arrangement, in exchange for which there was issued to him under date of July 3, 1956, a certificate for 250 shares of class B stock of the corporation.On July 3, 1956, the court confirmed the arrangement proposed by Jewelry and accepted by a majority in number 130 of each class of affected creditors. The order confirming the arrangement recited the fact that Jewelry had paid into the bankruptcy court the sum of $ 103,953.54.On July 10, 17, and 19, 1956, the court entered its orders of distribution reflecting the amount of the claims against Jewelry incurred prior to April 17, 1956, and the amounts to be distributed to these creditors in full and final discharge of these claims.According to the distribution orders of the court, Jewelry had incurred unsecured claims prior to April 17, 1956, in the total amount of $ 271,121.71, of which the creditors were paid 30 percent thereof or $ 81,336.29 3 pursuant to the terms of the confirmed arrangement. The difference between the total amount of the unsecured claims incurred prior to April 17, 1956, and the amounts paid to these creditors in full and final discharge of these claims was $ 189,785.42.The order of the court also required the payment in full of the $ 7,500 obligation to the Jewelers Board of Trade and the payment of $ 12,672.92, in full 131 satisfaction of unsecured debts incurred subsequent to April 17, 1956.In anticipation of the bankruptcy proceeding, Jewelry's accountant credited an account designated "Contributed capital" on the balance sheet in the amount of $ 178,211.16. This figure purports to represent the total amount of debts discharged, less the $ 7,500 payment to the Jewelers Board of Trade and certain estimated tax and administrative expenses. 4 Jewelry's accountant also arranged for the write-down of the inventory 73 and certain other assets 5 of Jewelry in the amount of $ 64,000. The inventory reduction was first noted in the journal as debits of $ 64,000 to "Cost of sales" and corresponding credits in the same amount to "Inventory." The accounts and notes receivable adjusting journal entries 132 were as follows:Insurance claim pending$ 4,795.79Bad debt reserve7,219.17Bad debt expense10,886.84Accounts receivable$ 18,956.75Notes receivable3,945.05The net reduction in accounts and notes receivable as reflected by these journal entries is $ 10,886.84. 6133 The reductions were then reflected in the amounts at which these assets were carried on the balance sheet of Jewelry. These entries were executed 3 days prior to and in anticipation of the bankruptcy order and reflected the reappraisal of the assets in question to their respective fair market values.The income statement of Jewelry for the year ended June 30, 1956, which was submitted in evidence, contains the following items taken as expenses: "Bad debts $ 18,106.01," "Discounts allowed $ 7,486.99," "Taxes $ 6,910.15," and "Miscellaneous $ 8,678.58." Across the face of the income statement is the penciled notation "65,000 Invtry writeoff." 7The earned surplus of Meyer Jewelry Co. on June 30, 1955, as shown on its Federal income tax return, was $ 21,970.23. Taxable income or loss, as reflected on its Federal income tax returns, for the succeeding years was as follows:Loss for year ended June 30, 1956($ 132,582.37)Loss for year ended June 30, 1957(16,147.89)Loss for year ended June 30, 1958(69,941.20)Taxable income for year ended June 30, 1959,including reported taxable gain of $ 81,228.17 on saleof 638 shares of Thiokol Chemical Corp. stock66,007.10 Taxable income for year ended June 30, 19602,492.13 74 134 The Federal income tax returns filed by Jewelry for the years ended June 30, 1955, through June 30, 1960, indicate that Jewelry made the following charitable contributions which were not taken as deductions because of the 5-percent limitation of section 170(b)(2) of the 1954 Code:Year endedJune 30Contributions1955$ 1,090.881956780.001957452.501958587.031959425.001960375.00The loss for the year ended June 30, 1956, includes the $ 64,000 write-down in inventory which was reflected on its books by debits in that amount to "Cost of sales" and corresponding credits to "Inventory." This $ 64,000 write-down in inventory was reflected in the "Cost of Sales" entry on the income statement of Jewelry for the year ended June 30, 1956. Although the net reduction of accounts and notes receivable by the journal entries was $ 10,886.84 (see fn. 6, supra), the income statement of Jewelry for the year ended June 30, 1956, contains an item of $ 18,106.01 opposite the account "Expenses: Bad debts." 8On September 22, 1958, by action of the 135 stockholders and directors of Jewelry, the special bylaws were amended so that all preferences, qualifications, limitations, restrictions, and all special or relative rights of class A and class B shares of the corporation became identical and as if all the class A and class B shares were of the same and identical class.On December 24, 1958, Lucile transferred by gift class A shares of Jewelry to the individuals listed below, all of whom were employees of Jewelry as follows: Jack Becker -- 50 shares class A, $ 100 par value; Richard C. Burstein -- 50 shares class A, $ 100 par value; Louis S. Meyer -- 30 shares class A, $ 100 par value. Louis S. Meyer and Richard C. Burstein are respectively the son and son-in-law of Leon and Lucile; Jack Becker is unrelated to the Meyers. Included in the transfer to Jack Becker on December 24, 1958, was the one-half share originally held as nominee for Lucile by Sol Silberman.On February 13, 1959, Lucile transferred by gift the following shares of class A stock of Jewelry to the same individuals: Jack Becker -- 50 shares class A, $ 100 par value; Richard C. Burstein -- 50 shares class A, $ 100 par value; Louis S. Meyer -- 30 shares class A, $ 100 136 par value. Included in the transfer to Jack Becker on February 75 13, 1959, were the two shares issued to Lucile on July 30, 1946, for cash at the original incorporation.The holdings of class A and class B stock of the corporation on April 1, 1959, were as follows:Class A Stock $ 100 Par ValueNumberParof sharesvalueLeon R. Meyer300$ 30,000Lucile H. Meyer404,000Jack Becker10010,000Richard C. Burstein10010,000Louis S. Meyer606,000Total outstanding60060,000Class B Stock $ 100 Par Value(Identical with class A stock as of Sept. 22, 1958)Leon R. Meyer50050,000Lucile H. Meyer25025,000Total outstanding75075,000Total stock1,350135,000 Prior to April 1, 1959, and beginning in the latter part of 1958, a plan was evolved to eliminate the bank indebtedness of Jewelry to Commerce Trust Co. This liability was still outstanding due to the loan of $ 100,000 by Commerce Trust Co. made in June of 1956. This loan enabled the chapter XI bankruptcy arrangement to be carried out. The plan also envisioned the elimination of the capital investment of Lucile in Jewelry by means of a distribution to her of cash and the surrender and cancellation of the stock certificates of Jewelry owned and held by her. The 137 price to be paid to Lucile in redemption of her stock was not agreed upon at this time, but it was assumed that she would be paid either the book value ($ 37,337.50) or par value ($ 29,000) of the shares. The feasibility of this plan was predicated on the increase in value of the Thiokol stock of Leon held by Commerce Trust Co. as collateral securing Leon's note for $ 15,000 and the availability of such stock or a considerable part of it to Leon and, through him, to Jewelry.Pursuant to the plan to eliminate the indebtedness of Jewelry to Commerce Trust Co. which then amounted to $ 50,000 and to provide funds with which the company could make a distribution of cash to Lucile, Leon on or before April 1, 1959, contributed to Jewelry as a capital contribution 700 shares of the 1,848 shares of Thiokol stock which at that time was held as collateral by Commerce Trust Co.76 to secure the note executed by Leon for $ 15,000. The 1,848 shares of Thiokol then held as collateral by the bank represented the 798 shares originally pledged by Leon as proliferated by stock dividends, stock splits, and the exercise by him of rights to purchase additional shares. During the period 1956 to 1959 this 138 stock had tremendously increased in value.On April 1, 1959, the board of directors of Jewelry adopted a resolution to the effect that it was the "owner of 700 shares of the capital stock of Thiokol" identified by 13 certificate numbers; authorized the president or treasurer of the corporation to sell the shares of stock or any part of them; authorized Commerce Trust Co. or any broker selected by Commerce Trust Co. to handle the sale of said shares on behalf of the corporation; and authorized Commerce Trust Co. to receive the remittance or remittances issued in the name of the corporation and to deposit such remittance or remittances to the account of the corporation in the Commerce Trust Co. Leon was president and a director of Jewelry.On April 2, 1959, Commerce Trust Co. delivered, as shown by its receipt, certificates representing 700 shares of Thiokol stock to Stern Bros. & Co., Kansas City, Mo., brokers, with endorsements from Leon to Jewelry and stock powers to Stern Bros. & Co. attached to the certificates executed by Jewelry with all endorsements guaranteed by the bank, the instructions of the bank to Stern Bros. & 139 Co., written by one of its assistant cashiers, being in part:We understand Mr. Meyer has instructed you in regard to selling this stock. We also understand that it is to be sold sometime this month.As funds are received, check should be made payable to the Meyer Jewelry Company and delivered to the Commerce Trust Company, attention the writer or Harry Wuerth.On April 2, 1959, Stern Bros. & Co. issued a letter of instruction to the United States Corporation, Stock Transfer Department, Jersey City, N.J., requesting that 13 certificates of Thiokol stock aggregating in total 700 shares (which were enclosed in the letter) be reissued in its name in seven 100-share certificates. Stern Bros. & Co. received from the transfer agent six certificates for 100 shares each, certificate number 3671 for 38 shares and certificate number 3672 for 62 shares of Thiokol stock. These eight certificates were transferred on the books of Thiokol Chemical Corp. to the name of Stern Bros. & Co. on April 27, 1959.On various dates from April 6, 1959, through April 13, 1959, Stern Bros. & Co. effected sale of 638 shares of stock of Thiokol on the New York Stock Exchange for the account of Jewelry. The dates and 140 77 prices, net after commissions and charges, at which the shares were sold were:DateNumber ofTrade priceNet proceedsshares1959Apr. 6100131$ 13,038.14Apr. 710012712,638.71Do100126 7/812,626.22Do100127 1/412,663.68Apr. 810012812,738.57Apr. 9100128 3/412,813.45Apr. 1338127 3/44,809.40The sales of the 638 shares of Thiokol stock by Stern Bros. & Co. were made at Leon's request.The income tax return of Jewelry for the year ended June 30, 1959, indicates that the basis of the 638 shares of Thiokol stock sold during that period for $ 81,328.17 was $ 100.On or about April 15, 1959, Commerce Trust Co. received from Stern Bros. & Co. its check payable to the order of Jewelry in the amount of $ 76,518.77, representing the proceeds of the sale of 600 shares of Thiokol stock. Upon receipt of this check the treasurer of Jewelry endorsed the check on behalf of Jewelry and the same was deposited to the account of Jewelry in the bank on April 15, 1959.On or about May 1, 1959, Commerce Trust Co. received a second check from Stern Bros. & Co., payable to the order of Jewelry in the amount of $ 4,809.40, representing the proceeds of the sale of 38 shares of Thiokol stock. This check was similarly endorsed 141 on behalf of Jewelry by its treasurer and deposited to the account of Jewelry in the Commerce Trust Co.On May 4, 1959, Stern Bros. & Co. transmitted by letter to the United States Corporation, Stock Transfer Department, Jersey City, N.J., certificate 3672 for 62 shares of stock of Thiokol. This was the same certificate 3672 for 62 shares received from United States Corporation in response to the letter dated April 2, 1959, from Stern Bros. & Co. to United States Corporation. Pursuant to said letter of instruction dated May 4, 1959, from Stern Bros. & Co., which was written at Leon's request, 30 of these 62 shares were transferred on the records of the transfer agent on May 7, 1959, to the following individuals: Louis S. Meyer (the son of petitioners) and Mrs. Betty Lee Meyer, J/T/R/S (15 shares); Richard C. Burstein and Mrs. Suzanne Burstein (the daughter of petitioners), J/T/R/S (15 shares); and 32 of these 62 shares were reissued in the name of Leon Meyer.Shares of Thiokol stock were split in April of 1959, when two additional shares were issued for each share outstanding in order to 78 accomplish a 3 for 1 split. The split was effective as of record date April 20, 1959, and the 142 distribution of the additional shares was on April 30, 1959. The stock sold "Ex-dividend" on May 1, 1959. The sales of 638 shares of Thiokol stock effected on various dates from April 6 to April 13, 1959, carried with the shares sold the additional shares produced by the stock split so that Leon as the record owner was required to deliver the additional shares resulting from the split to the purchasers in the trades effected by Stern Bros. & Co. Leon retained the 124 shares distributed to him pursuant to the split on April 30, 1959, as the record owner of the 62 shares which had not been sold. The books of Jewelry contain no account receivable from Leon on account of his receipt of the 62 or the 124 shares of Thiokol stock, and no payment has ever been made by him to Jewelry on account thereof.The parties have stipulated that the high and low bids for Thiokol stock on April 20, April 27, May 4, and May 7, 1959, were as follows:HighLowApr. 20$ 149.75$ 146.00Apr. 27162.00154.50May 4 1143 53.7559.75May 7 169.87 1/262.00The sale of the 638 shares of stock of Thiokol executed by Stern Bros. & Co., brokers, on various dates from April 6, 1959, through April 13, 1959, was for the account of Jewelry, a corporation, and represented sales by and on behalf of Jewelry and not the sales of property owned by Leon.On April 15, 1959, Jewelry used the sum of $ 50,000 from the proceeds ($ 76,518.77) of the sale of 600 shares of stock of Thiokol to satisfy the balance of $ 50,000 remaining on the $ 100,000 note evidencing the loan of June 1956 by Commerce Trust Co. to Jewelry.On April 18, 1959, Jewelry issued its check drawn on its account at Commerce Trust Co. to the order of Lucile in the amount of $ 26,518.77. The amount of this check represented the difference between $ 76,518.77 paid to Jewelry, being the proceeds of the sale of 600 shares of Thiokol stock, and the $ 50,000 paid by Jewelry in satisfaction of its obligation to Commerce Trust Co. On May 1, 1959, Lucile received a second check from Jewelry in the amount of $ 4,809.40. This check equaled the proceeds from the sale of 38 shares 144 of Thiokol stock for the account of Jewelry. The sum of these two payments is $ 31,328.17. Jewelry made debit entries on an account receivable in 79 its books entitled "Mrs. Lucile Meyer" in the amounts and at the time of these payments. Prior to these entries this account reflected small debits never in excess of $ 75 with balances due never in excess of $ 311. No interest was charged on this receivable, no note was ever given for any indebtedness shown thereon, and no formal security was given for the repayment of any balance.No formal restrictions were imposed on Lucile with regard to her use of the money received by her from Jewelry. It was the intention of all of the parties concerned that these payments or a part of them would ultimately constitute a distribution to Lucile in redemption of all of her stock in Jewelry at a price later to be decided upon representing either the par value or book value of such stock. Lucile delivered her stock for redemption to the general counsel of Jewelry who kept its stock records in the late summer or early fall of 1959. Sometime between June 30 and December 31, 1959, the parties agreed that the price to be paid to Lucile in redemption of 145 her stock should be its par value, $ 29,000, rather than its book value, which according to Jewelry's income tax return for the year ended June 30, 1959, was $ 37,337.50.On December 31, 1959, an entry was made on the books of the corporation, crediting the ledger account receivable designated "Mrs. Lucile Meyer" with the sum of $ 29,000 and debiting or reducing capital stock accounts in the total amount of $ 29,000, the individual entries being debits to an account labeled "Capital Stock -- Common 'A' -- $ 4,000.00" (40 shares) and "Capital Stock -- Common 'B' -- $ 25,000.00" (250 shares). The difference of $ 2,328.17 between the total of the two payments to Lucile from the proceeds of the sales of the Thiokol stock ($ 31,328.17) and the $ 29,000 credited to her account in connection with the redemption of her stock continued to be carried in her account with Jewelry as a receivable, this ledger account showing a debit balance of not less than $ 2,472.89 as of December 31, 1959, and not more than $ 2,623.86, the latter figure representing the balance as of May 25, 1961, the date of the last entry therein. Amounts recorded as debits to this account were not represented by notes from 146 Lucile, did not require any interest to be paid by her, were not payable at a fixed maturity date, were not secured by any of Lucile's assets, and, so far as the record discloses, were never paid.Two factors contributing to the delay in the submission by Lucile of the 40 shares of class A stock and 250 shares of class B stock for redemption and cancellation were the absence of Lucile on a foreign trip, hereinafter referred to in greater detail, and the summer vacation of counsel for the company, who acted as keeper of the stock records.80 After the redemption, the stock ownership of the Meyer Jewelry Co. was as follows:Number ofPercentage ofshares 1ownershipLeon R. Meyer80075.47 Jack Becker1009.435Richard C. Burstein1009.435Louis S. Meyer605.66 Total1,060100.00 The original and remaining cost basis of Lucile in the 40 shares of class A $ 100 par value stock and 250 shares of class B $ 100 par value stock of Jewelry was $ 29,000. No distributions had ever been made 147 by the corporation in the form of a return of capital.At the Community State Bank, Kansas City, Mo., petitioners maintained two joint bank accounts. One account was entitled "Leon Meyer or Lucile Meyer," referred to in these findings as joint bank account A. The other account was entitled "Lucile Meyer or Leon Meyer," referred to in these findings as joint bank account B. Bank statements and canceled checks on joint bank account A were sent to Leon. Bank statements and canceled checks on joint bank account B were sent to Lucile.On April 20, 1959, Lucile deposited the $ 26,518.77 check of Jewelry dated April 18, 1959, payable to her, in joint bank account B. Lucile drew a check on joint bank account B, dated April 18, 1959, payable to Commerce Trust Co. in the amount of $ 15,000. This check was utilized on April 20, 1959, to pay the note executed by Leon to the Commerce Trust Co. in the amount of $ 15,000, which was then secured by 1,148 shares of Thiokol stock and which had been secured by 1,848 shares of such stock prior to the execution (with the consent of the bank) of the plan already detailed in our findings, which plan was predicated on the withdrawal by Leon of 700 of these 148 shares, his contribution of these shares to Jewelry and its sale thereof.Lucile drew a check upon joint bank account B, dated April 19, 1959, payable to the Community State Bank in the amount of $ 8,000. This check was utilized on April 20, 1959, to pay three notes executed by both Leon and Lucile in the total amount of $ 8,000.Lucile drew a check upon joint bank account B, dated April 18, 1959, in the amount of $ 3,000 to the order of Leon. On April 20, 1959, this check was deposited to joint bank account A.On May 4, 1959, Lucile deposited in joint bank account B the check for $ 4,809.40 of Jewelry received by her on May 1, 1959.81 On May 1, 1959, Lucile drew a check dated May 1, 1959, upon joint bank account B in the amount of $ 4,000 to the order of Leon. On May 4, 1959, this check was deposited to joint bank account A.Prior to 1959, the customary family practice was that Lucile would advance to Leon the estimated expenses of vacation trips taken by them. After the trip, Leon would return to Lucile any of the advanced funds which were not spent.In the early part of 1959 the health of Leon had not been good. He had severe hypertension and also had undergone a cataract operation. 149 Following this operation a trip to Sarasota, Fla., had been taken by the Meyers. The trip was paid for by Lucile. Following the trip to Florida the doctor recommended that Leon take a long vacation. Later in 1959, Leon and Lucile were invited by friends of many years standing to join them on a trip to Europe. Leon objected to taking such a trip, but Lucile strongly advanced an opposite view. The outcome of the family discussion was that both Leon and Lucile went to Europe.The checks drawn by Lucile upon joint bank account B to the order of Leon for $ 3,000, dated April 18, 1959, and $ 4,000, dated May 4, 1959, and deposited in joint bank account A were transferred and used for the purposes of financing the trip to Europe by Leon and Lucile.Of the checks totaling $ 7,000, described above, the approximate sum of $ 6,000 was used for the purpose of the trip to Europe. The amount not spent was returned to Lucile. No formal requirements were imposed upon Lucile to use any part of the moneys received by her from Jewelry to finance the trip to Europe.Neither Leon nor Lucile have ever filed with respondent the agreement prescribed in section 302(c)(2)(A)(iii) of the 1954 Code and specifically 150 described in section 1.302-4(a), Income Tax Regs.At the time of the distribution to Lucile here involved and throughout the fiscal years of Jewelry ended June 30, 1959, 1960, 1961, and 1962, Lucile received the sum of $ 7,500 a year as vice president of Jewelry, devoting part of her time to the business in each of those years.OPINIONWith regard to the payments made by Jewelry to Lucile in the total amount of $ 31,328.17, respondent argues with great vigor that they constituted distributions of dividends to her which were includable as such in her taxable income. In the alternative and with much less vigor, respondent argues that they constituted similar income of Leon since these payments to Lucile were either used by her immediately after their receipt for the satisfaction of Leon's obligations or were paid over to Leon.82 With regard to the 186 shares of Thiokol stock which were finally issued in the names of and delivered to Leon and to his donees (his son and daughter-in-law and his daughter and son-in-law), respondent argues that they constituted dividends distributed to Leon by Jewelry and as such were taxable to him at their fair market value at the date of issuance.Petitioners 151 in their voluminous briefs have advanced many arguments with regard to both procedural and substantive questions. As to some of the procedural questions, these arguments repeat with elaboration the arguments of counsel at or shortly after the trial herein and have been decided by Judge Fisher. As to the others, petitioners particularly press their contentions that respondent's determinations of deficiency herein have been in some way vitiated or deprived of their presumption of correctness because (1) respondent's determination that Leon in reality owned and sold the 638 shares of Thiokol stock and derived capital gains thereby, rather than Jewelry (as to which respondent conceded error at the trial) was inconsistent with his determination in Leon's case that the distribution by Jewelry of a part of the proceeds to him constituted taxable income and with his determination in Lucile's case that it constituted income taxable to her and (2) respondent's determination in Leon's case that the distribution by Jewelry of $ 31,328.17 was made to him or for his benefit was inconsistent with his determination in Lucile's case that the same distribution was made by Jewelry to her and should 152 be added to her taxable income. Petitioners argue not only that these inconsistencies cause the respondent's determination to lose the presumption of correctness normally attaching to determinations of deficiency but also that these inconsistencies indicate such arbitrariness and capriciousness on the part of respondent as to render them invalid. We disagree. Respondent may take inconsistent positions for the purpose of protecting the revenue without causing his determinations to lose their presumptive correctness. See Revell, Inc. v. Riddell, 273 F. 2d 649. In the instant cases the facts as disclosed by the record indicate such ambiguity with reference to the crucial transactions as to cause us to reject petitioners' contention that respondent's inconsistent determinations, made for the purpose of protecting the revenue, were arbitrary and capricious. The ambiguous character of the transactions is such as frequently exists in cases involving a small corporation controlled by a cohesive family group with informal and often incomplete corporate records. In the instant cases it appears to us that the respondent in order to protect the revenue acted reasonably and in good faith, 153 rather than arbitrarily, in making his determinations of deficiency. See Nat Harrison Associates, Inc., 42 T.C. 601">42 T.C. 601, 617. Here, as in that case "counsel for respondent made it clear that the determinations 83 were in the alternative and that respondent did not contend that the [income items] should be taxed more than once." We conclude that since respondent's inconsistent determinations were made reasonably and in good faith for the purpose of protecting the revenue and were intended to be in the alternative, they have not lost their presumptive correctness by reason of their inconsistency. Petitioners' reliance upon Revell, Inc. v. Riddell, supra, is misplaced. See Sanford Reffett, 39 T.C. 869">39 T.C. 869, 875.The fact that respondent has conceded error with regard to one of his grounds for deficiency, as stated in the deficiency notice addressed to Leon, does not affect the validity of the other grounds in view of our opinion that the ground abandoned by respondent though conceded to be erroneous was not arbitrary or unreasonable in the light of the facts available to respondent. See Hoffman v. Commissioner, 298 F. 2d 784, 788; Clark v. Commissioner, 266 F. 2d 698, 706, 707.We turn now to 154 a consideration of the substantive issues presented.The first one to be considered is whether respondent erred in his determination that the payments of $ 31,328.17 made by Jewelry to Lucile constituted taxable income of Lucile.Respondent first contends that they constituted dividend distributions made to Lucile by Jewelry in the fiscal year of Jewelry ended June 30, 1959, during which Jewelry had current net earnings in the approximate amount of $ 66,000 and cannot be considered as having been made in redemption of her stock in Jewelry, which redemption was accomplished much later in the calendar year 1959 and in Jewelry's fiscal year 1960 when its income was only in the amount of $ 2,500. Respondent further contends that in the event we find that the payments were made to Lucile as a step in the ultimate redemption of her stock in Jewelry's fiscal year 1960, they were nevertheless equivalent to the distribution of a dividend and that Jewelry's accumulated earnings and profits in its fiscal year 1960 were in excess of such payments.Petitioners contend that these payments were made to Lucile as a step in the ultimate redemption of her stock in Jewelry's fiscal year 1960; that the 155 distributions to Lucile were not equivalent to the distribution of a dividend; that in any event Jewelry had no accumulated earnings and profits in that year and its income available for the payment of dividends was not in excess of $ 2,500; and that to the extent of $ 25,000, these payments should be considered as the payment to Lucile on account of the notes of Jewelry for which 250 shares of its class B stock were exchanged in 1947 and with regard to which her basis was $ 25,000.If respondent be correct in his contention that the distributions to Lucile in April and May of 1959 did not constitute a step in the redemption 84 of her stock and that the surrender and redemption of her stock which occurred in December 1959 was only conceived and executed at this much later time for the sole purpose of effecting a tax advantage, then there would be little question but that the distributions would be taxable as dividends to Lucile in their full amount under section 316(a) of the Internal Revenue Code of 1954. 9156 However, after a careful consideration of the record herein, we have concluded that in spite of the considerable lapse in time between the payments to Lucile by Jewelry and the surrender and redemption of her stock, they were parts of one planned transaction, and the payments to her constituted a step in the redemption of her stock which was accomplished in Jewelry's fiscal year 1960. See American Bantam Car Co., 11 T.C. 397">11 T.C. 397, 406-407, 157 affd. 177 F. 2d 513. In reaching this conclusion we have particularly relied on the following: (a) The surrender and redemption of the stock did follow within the same calendar year the payments to Lucile; (b) the categorical testimony of Leon, Lucile, and the attorney for them and for Jewelry who kept the stock records of Jewelry was to the effect that Leon, Lucile, and Jewelry intended the payments to Lucile to be steps in the redemption of Lucile's stock at the time they were made, which testimony is questioned by respondent principally on account of the lapse of time between the payments and the surrender and redemption of the stock; and (c) our belief that this lapse of time is a fact which loses its significance against the background of informality which characterized the conduct of Jewelry's corporate affairs vis-a-vis its controlling stockholders, Leon and Lucile, an informality which, as we have already commented in a context unfavorable to a contention of petitioners, is not unusual in situations where a relatively small corporation is owned and controlled by a small cohesive family group.We have chosen to characterize the distribution to Lucile as having occurred in Jewelry's 158 fiscal year ended June 30, 1960, because we believe that at the time the payments were made to her, they constituted bona fide accounts receivable of Jewelry. These accounts were to be paid upon the redemption of Lucile's stock when the price per share was agreed upon. At the time the payments were made to Lucile, the parties 85 anticipated that the redemption of her stock would take place several months later, a fact which convinces us that the open account receivable was subject to an informal obligation on her part to redeem her stock in return for the pro tanto satisfaction of this account, when the price for such redemption was fixed and the company counsel was available to oversee the transaction. We believe that this informal understanding coupled with the short length of time during which the receivable was carried (at most 6 or 7 months) establishes the bona fides of Lucile's obligation to Jewelry until and to the extent the ultimate redemption price was fixed at $ 29,000. Because it was contemplated that the price for the stock would be either the par value ($ 29,000) or the book value ($ 37,337.50), we believe that the account receivable maintained its bona fides as to 159 the full amount of the distribution to Lucile ($ 31,328.17) until the redemption price was fixed several months later. We reach this conclusion despite the failure of the parties to draft notes and impose interest on these advances. In view of the above, we therefore hold that any possible dividend distribution occurred at the time Lucile's stock was redeemed in payment of her account, i.e., during Jewelry's fiscal year ended June 30, 1960.This conclusion forces us to the consideration of other questions, most of which are difficult and one of which has been described in some opinions by even more forceful adjectives. See Thomas G. Lewis, 35 T.C. 71">35 T.C. 71, 76; Wilson v. United States, 154 F. Supp. 341">154 F. Supp. 341, 342, affd. 257 F. 2d 534; United States v. Fewell, 255 F.2d 496">255 F. 2d 496, 499.The first of these is a general question which involves subsidiary questions. It is whether the redemption of Lucile's stock by Jewelry was essentially equivalent to the payment of a dividend. If it was not, then the payments would be considered as "a distribution in * * full payment in exchange for the stock." See sec. 302(a) and (b)( 1), I.R.C. 1954. 10160 We are compelled to consider the application of section 302(b)(1) because sections 302(b)(2), 11162 302(b)(3), 12 and 302(b)(4) 13 are inapplicable. The inapplicability of section 302(b)(4) is obvious. Sections 302(b)(2) and 302(b)(3) are inapplicable because of the 86 provisions of section 302(c)(1) 14163 which make section 318(a) 15164 165 166 applicable "in determining the ownership of stock for purposes of * * [sec. 302]." The exception provided in section 302(c)(2)(A) 16167 does not apply here since immediately after the distribution to Lucile, here in question, she was and continued to be for at least 2 years, a salaried officer of Jewelry. In this connection it should also be noted that Lucile did not file, and so far as the record here discloses has never filed, the agreement 161 called for by section 302(c)(2)(A) (iii). Cf. Georgie S. Cary, 41 T.C. 214">41 T.C. 214.87 The reason for our conclusion with regard to the inapplicability of sections 302(b)(2) and 302(b)(3), as read in the light of section 88 318(a)(1), is readily apparent upon examination of the stock ownership of Jewelry prior and subsequent to the redemption. On April 168 1, 1959 (prior to the redemption), the stock ownership of Jewelry was as follows:Number ofPercentageshares 1of ownershipLeon R. Meyer80059.26Lucile H. Meyer29021.48Jack Becker1007.41Richard C. Burstein1007.41Louis S. Meyer604.44Total1,350100.00After the redemption, the stock ownership of Jewelry was as follows:Number ofPercentageshares 1of ownershipLeon R. Meyer80075.47 Jack Becker1009.435Richard C. Burstein1009.435Louis S. Meyer605.66 Total1,060100.00 Applying the rule of section 318(a)(1), ownership of Leon's (her husband) and Louis' (her son) stock in Jewelry is attributed to Lucile. Consequently, her percentage of ownership before and after the redemption was 85.18 and 81.13 percent, respectively. This percentage shift is not large enough to constitute a "substantially disproportionate redemption" under section 302(b)(2), the minimum of which must be 20 percent. Moreover, it is clear that there has not been a complete "termination of [Lucile's] interest" 169 in Jewelry within the meaning of section 302(b)(3) and the statutory framework pertinent thereto.Turning, then, to a consideration of section 302(b)(1) and a resolution of the question whether the distribution to Lucile was or was not "essentially equivalent to a dividend," it is appropriate to consider certain criteria which the courts have determined to be pertinent to this question. In Thomas Kerr, 38 T.C. 723">38 T.C. 723, affd. 326 F. 2d 225, certiorari denied 377 U.S. 963">377 U.S. 963, we discussed these criteria as follows (pp. 729-730):It is recognized in the case law and in the regulations that the question whether a distribution is essentially equivalent to a dividend depends on the facts and circumstances of each case. Earle v. Woodlaw, 245 F. 2d 119 (C.A. 9, 1957), certiorari denied 354 U.S. 942">354 U.S. 942 (1957); Standard Linen Service, Inc., 33 T.C. 1 (1959); sec. 1.302-2(b), Income Tax Regs. Although the cases on this 89 point have failed to lay down a sole decisive test, Flanagan v. Commissioner, 116 F. 2d 937, 939 (C.A.D.C. 1940), affirming a Memorandum Opinion of this Court, they have established certain judicial criteria which have proven useful in determining the net effect of the distribution which, 170 in actuality, is the fundamental question. Flanagan v. Commissioner, supra;Genevra Heman, 32 T.C. 479">32 T.C. 479 (1959), affd. 283 F. 2d 227 (C.A. 8, 1960); Ferro v. Commissioner, 242 F. 2d 838 (C.A. 3, 1957), affirming a Memorandum Opinion of this Court; and John A. Decker, 32 T.C. 326">32 T.C. 326, 330 (1959), affirmed per curiam 286 F. 2d 427 (C.A. 6, 1960).Among these criteria are: Did the corporation adopt any plan of contraction of its business activities; did the transaction actually result in a contraction of the corporation business; did the initiative for the corporate distribution come from the corporation or the shareholders; was the proportionate ownership of stock by the shareholders changed; what were the amounts, frequency, and significance of dividends in the past; was there a sufficient accumulation of earned surplus to cover distribution or was it partly from capital; and was there a bona fide corporate business purpose for the distribution? Flanagan v. Commissioner, supra;Earle v. Woodlaw, supra; and Genevra Heman, supra. It is to be noted that while these criteria materialized for the most part in cases construing section 115(g) of the Internal Revenue Code of 1939, Congress has 171 expressed a desire that they be made applicable to cases arising under section 302(b)(1) as well. S. Rept. No. 1622, to accompany H.R. 8300 (Pub. L. 591), 83d Cong., 2d sess., pp. 233, 234 (1954).In the instant case Jewelry did not have any plan to contract its business, the transaction did not result in any contraction of its business, the initiative for the corporate distribution did not come from the corporation but came from the stockholders, there had been no dividends in the past, and there was no bona fide corporate business purpose for the distribution.In considering as a criterion in the application of section 302(b)(1) the question of whether the transaction resulted in a change in the proportionate ownership of stock by the shareholders or, as it is referred to in Estate of Arthur H. Squier, 35 T.C. 950">35 T.C. 950, 956, "a substantial dislocation of relative stockholdings in the corporation," we must give effect to the constructive ownership rules of section 318(a). Thomas G. Lewis, supra. By so doing, it appears that Lucile's proportionate stock ownership was 85.18 percent before the distribution and redemption and 81.13 percent thereafter. In our opinion, this decrease did not 172 constitute "a substantial dislocation of relative stockholdings" in Jewelry. Moreover, in this case there is no suggestion of a change in control or of any "sharp cleavage" between the members of the Meyer family, which might tend to diminish the significance of the attribution rules of section 318(a)(1) as a factor in the consideration of whether a redemption is "not essentially equivalent to a dividend" under section 302(b)(1). Cf. Estate of Arthur H. Squier, supra.To the contrary, an examination of the record herein discloses an almost touching picture of family affection, trust, and cooperation.90 Thus, all of the criteria available for our guidance on this subject 17173 (with the exception of the availability of earnings and profits of Jewelry from which dividends could be paid, a matter hereinafter to be discussed) point to a conclusion that the payments made by Jewelry to Lucile as steps in the redemption of her stock were essentially equivalent to a dividend, and we so hold subject to our resolution of several troublesome problems pertaining to the availability of earnings and profits from which a dividend distribution could be made.The net effect of the transaction (see Flanagan v. Helvering, 116 F.2d 937">116 F.2d 937) was the distribution to Lucile by a corporation controlled by her and her husband, Leon, of a considerable part of the proceeds realized by the corporation from the sale of securities contributed by Leon (after they had greatly appreciated in market value since he purchased them) to the corporation which at that time was entitled to a large operating loss carryover, without any substantial dislocation of the relative stockholdings or of any diminution in the control over the corporation by the closely knit Meyer family, and without a "significant modification of shareholder interests." 18We now turn to a consideration of the question whether there was "a sufficient accumulation of earned surplus to cover [the] distribution."Because we have concluded that the distributions to Lucile were made in Jewelry's fiscal year ended June 30, 1960, as a part of the redemption of her stock in that fiscal year, we must consider whether there were sufficient earnings 174 and profits available at that time to support respondent's determination that these distributions were dividends.In this connection the principal question is what effect the cancellation of indebtedness of Jewelry under a chapter XI arrangement under the Bankruptcy Act confirmed on July 3, 1956, had on its earnings and profits account.Petitioners argue that the effects of the chapter XI proceeding which canceled indebtedness in the amount of $ 189,785.42 were to produce a zero balance in the earnings and profits account of Jewelry and create a "Contributed capital" account in the amount of $ 179,746.36, 19 on the ground that the cancellation of indebtedness pursuant to the chapter XI bankruptcy did not result in any increase in the earnings and profits account, but rather that such cancellation should produce a credit in the above-mentioned amount to "Contributed capital." Respondent argues that because the cancellation of indebtedness had the effect of freeing certain assets from the encumbrance of liabilities, 91 this fact must be reflected in the earnings and profits account of Jewelry. His position, as summarized on brief, is as follows:Since the earnings and profits 175 account was decreased when the debts were incurred, the entries made at the time of the deduction should be corrected by restoring to earnings and profits the amount of debts forgiven in the arrangement proceeding in order to reflect the correct accumulated earnings and profits of the corporation.The resolution of this problem is crucial to a characterization of the distributions received by Lucile, because if we follow petitioners' contentions with respect to the cancellation of indebtedness issue, there would have been earnings and profits available to Jewelry in the fiscal year ended June 30, 1960, only to the extent of its current earnings of that year in the amount of $ 2,117.13.Petitioners' argument proceeds along the following lines: that both the relevant sections of the Bankruptcy Act 20177 and respondent's own regulations 21178 provide that no income shall be realized in connection with a cancellation of indebtedness pursuant to a bankruptcy proceeding. Petitioners maintain that the proper treatment of such cancellation would be either to create a "Contributed capital" account in such amount or to set off the deficit existing prior to the chapter XI proceeding and carry the excess 176 in a capital surplus account.92 Petitioners contend that two items, the $ 7,500 payment to the Jewelers Board of Trade and an alleged $ 2,539.06 payment for estimated tax and administrative expenses, should 179 be deducted from the total amount of debts discharged, $ 189,785.42. Petitioners therefore argue that $ 179,746.36 is the correct amount to be reflected on the corporate balance sheet. Respondent, on the other hand, questions the propriety of these deductions and urges that the $ 189,785.42 figure be used. 22180 However, it appears to us unnecessary to decide this question since it will be seen from our resolution of the issue as to whether there were sufficient earnings and profits to support the $ 31,328.17 distribution to Lucile, that even if we were to reduce the cancellation of indebtedness figure by the total amount of the deductions herein at issue, $ 10,039.06, the result would be the same. The precise question which we face is whether the cancellation of corporate indebtedness pursuant to a chapter XI proceeding may, in whole or in part, be considered as generating earnings and profits. While the Bankruptcy Act (11 U.S.C. secs. 795, 796) and section 1.61-12(b), Income Tax Regs., provide that such cancellation is exempt from the Federal corporate income tax, despite the provisions of section 61(a)(12), they are silent with regard to the effect of such a transaction upon the "earnings and profits" of the debtor corporation.However, both 11 U.S.C. sec. 796, and section 1.61-12(b)(2), Income Tax Regs., deal with adjustment of basis, the latter containing a reference to the regulations under section 1016. The pertinent regulation under this section is section 1.1016-7, Income Tax Regs., 181 23182 183 184 185 186 93 dealing with certain required adjustments to basis "in the case of a cancellation or reduction of indebtedness in any proceeding under chapters X, XI, or XII of the Bankruptcy Act." This regulation establishes a priority system for the reduction of the bases of assets of a bankrupt, in the total amount of any indebtedness which is canceled or reduced in the bankruptcy proceeding. However, both the bankruptcy statute and the regulation further provide that no asset's basis shall be reduced below its fair market value as of the date of entry of the order confirming the plan of bankruptcy.94 Exhibits submitted by the petitioners and oral testimony establish the fact that on June 30, 1956, 3 days prior to the formal approval of the bankruptcy arrangement, the inventory and fixed assets were written down in the amount of $ 64,000, and the accounts and notes receivable were similarly adjusted downward in the net amount of $ 10,886.84 to reflect the fair market value of these assets. Although 187 this write-down in the total amount of $ 74,886.84 was executed 3 days prior to the formal entry of the bankruptcy order, we believe that it was done in anticipation of that order, and may be considered by us as fixing the fair market value of the assets of Jewelry as of the time of the forgiveness of its indebtedness pursuant to the bankruptcy proceedings at their book value, minus the total amount of such write-downs.It is significant that the regulations provide for such a reduction of basis, for the effect of such a rule is to defer recognition of any gain realized upon the cancellation of indebtedness until the property with the reduced basis is sold or otherwise disposed of. Bangor and Aroostook Railroad Co., 16 T.C. 578">16 T.C. 578, 582-586, affd. 193 F.2d 827">193 F. 2d 827. Although the Bangor case dealt with section 22(b)(9) of the 1939 Code (the predecessor of sec. 108 of the 1954 Code), we feel that the relationship it describes between the concepts of "basis" and "earnings and profits" is a fundamental one. See also Kentucky Farm & Cattle Co., 30 T.C. 1355">30 T.C. 1355, 1367. Because section 1.1016-7(a), Income Tax Regs., speaks of "required" reductions in basis, we conclude that the gain occasioned by cancellation 188 of a bankrupt's indebtedness to the extent that it reduces the basis of the debtor's assets is not permanently relieved of taxation, but the time for such taxation is merely postponed to a subsequent transaction in which the resulting gain or 95 loss is recognized for income tax purposes. It is at the time of the subsequent transaction that the resulting gain or loss, if any, will affect the earnings and profits of the debtor corporation.In view of this postponement in the recognition of gain, we choose to follow the reasoning in the Bangor opinion with respect to the effect of a forgiveness of indebtedness to the extent it affects the basis of the debtor's assets upon earnings and profits of the debtor in the year of the forgiveness. In that case, the Court held that although section 115(1) of the 1939 Code 24191 192 193 was not literally applicable to a discharge of corporate indebtedness to be accompanied by a corresponding decrease in the basis of corporate assets, it "gave expression to a concept of 'earnings and profits' that was already widely recognized and which inheres in the meaning of those words." Bangor and Aroostook Railroad Co., supra at 584. On pages 585 and 586 of our opinion 189 in that case we made the following statements which are helpful in our consideration of the case before us:The present case must be distinguished from situations where fully realized income which is exempt from tax, such as interest on state bonds, is included in earnings and profits. See Treasury Regulations 111, section 29.115-3. Although the general introductory language of section 22(b) of the Code characterizes the various types of income in the subdivisions to follow as "exempt," the fact is that, under the specific provisions of section 22(b)(9), the income from discharge of indebtedness escapes taxation only by reason of the option in 96 section 22(b)(9), and the effect of exercise of the option is not a complete withdrawal or insulation of the profit from tax. Unlike other exclusions from income provided for by section 22(b), the profit from discharge of indebtedness is excluded only in the condition that it be applied in reduction of the basis of property held by the petitioner. Sections 22(b)(9), 113(b)(3), Internal Revenue Code. In reality, by providing for an adjustment altering the basis of property which petitioner would otherwise be entitled to use. Congress did 190 not relieve the profit of tax but only postponed the time for levying the tax. [n5] Instead of collecting a tax on the profit when received, Congress merely deferred recognition of the profit and collection of the tax until the time at which the property with the reduced basis was sold or otherwise disposed of. [n6] See Commissioner v. Jacobson, 336 U.S. 28">336 U.S. 28, 44-46.This method of treating the profit is comparable to the treatment accorded nontaxable exchanges governed by the so-called reorganization provisions in section 112 of the Code, where recognition is similarly postponed. In both situations, the earnings and profits are affected, not at the time of the original unrecognized transaction, but at the time that the gains or losses are actually taken into account in computing taxable income. True, the result with respect to section 112 transactions, dealing with sales and exchanges, is specifically called for by section 115(1), [n7] but, as we have seen, section 115(1) was merely declaratory of existing law in this regard, and the same result is required by a proper interpretation of the term "earnings and profits." [Footnotes omitted.] Respondent calls our attention to section 1.312-6(b), Income Tax Regs. This provision states:Among the items entering into the computation of corporate earnings and profits for a particular period are all income exempted by statute, income not taxable by the Federal Government under the Constitution, as well as all items includible in gross income under section 61 or corresponding provisions of prior revenue acts. Gains and losses within the purview of section 1002 or corresponding provisions of prior revenue acts are brought into the earnings and profits at the time and to the extent such gains and losses are recognized under that section. Interest on State bonds and certain other obligations, although not taxable when received by a corporation, is taxable to the same extent as other dividends when distributed to shareholders in the form of dividends.Respondent contends that petitioners' position is squarely opposed to the above regulation. Although income from discharge of indebtedness is included in the definition of gross income by section 61(a)(12) of the 1954 Code, 25 it is our opinion that it is not realized 194 at the time of the discharge by virtue of the relevant provisions of the Bankruptcy Act because of and only to the extent of its use in the reduction of the basis of the debtor's assets, and further, that to the extent it was not so used, it is fully realized income even though exempt from tax, such as interest on State bonds and proceeds from life insurance, which 97 are included in earnings and profits. Bangor and Aroostook Railroad Co., supra at 585. To the extent of such use the discharge of indebtedness, although reducing the liabilities of the debtor corporation, simultaneously reduces the basis of its assets in an equal amount, and therefore has no net effect on its balance sheet. We are therefore convinced that section 1.312-6(b), Income Tax Regs., is not applicable in the instant case to that part of the discharge of the indebtedness which can be used in the reduction of the basis of the debtor's assets and hold that to the extent that the basis of a bankrupt's assets can be reduced by reason of a cancellation of indebtedness under section 1.1016-7, Income Tax Regs., any such cancellation of indebtedness made pursuant to a bankruptcy proceeding should not, to the extent indicated, 195 increase earnings and profits.However, in the instant case the book value of Jewelry's assets was written down in the amount of $ 74,886.84 to reflect a fair market value of the total assets, at or about the time of the cancellation, in the total amount of $ 325,400.04, while the total cancellation of indebtedness was $ 189,785.42. No further reduction of basis is allowable under 11 U.S.C. sec. 796, and section 1.1016-7, Income Tax Regs., because the record indicates that the $ 325,400.04 figure represented the fair market value of Jewelry's assets as of the time of the chapter XI proceeding. While the Internal Revenue Code, respondent's regulations, and the Bankruptcy Act 26 make no specific provision as to the proper treatment of the excess of discharged indebtedness over the amount of allowable basis reduction, we feel that in light of the general provision of section 61(a)(12) and the reasoning of the Court in Bangor and Aroostook Railroad Co., supra, 196 such excess is realized income merely exempt from corporate taxation. Therefore, we conclude that this excess must be included in the earnings and profits account. As such the rule as stated in section 1.312-6(b), Income Tax Regs., would apply to this excess amount.We cannot accept petitioners' argument that the amount of discharged indebtedness or any part thereof be placed in a "Contributed capital" account. Since the creditors whose debts were discharged were not shareholders of Jewelry and had no intention of making any investment in Jewelry, it appears obvious to us that the discharge of the 98 debts owing to them cannot be considered as "Contributed capital." See sec. 1.61-12(a), Income Tax Regs.27197 Petitioners' exhibits indicate the fact that on Jewelry's income statement for the fiscal year ended June 30, 1956, the $ 64,000 inventory write-down was carried into the "Cost of Sales" account. Moreover, a total amount of $ 18,106.01 was noted in the income statement under "Expenses: Bad debts." With regard to this latter item, we have already found that this figure represents the two debits of $ 10,886.84 and $ 7,219.17 to "Bad debt expense" and "Bad debt reserve," respectively. Our explanation of the nature of the 1956 198 debit to the bad debt reserve in the amount of $ 7,219.17 contained in our findings, footnote 6, supra, concluded that such an item cannot represent an asset write-down. It is obvious that such a reduction in a bad debt reserve cannot constitute a bad debt expense, since such a reserve represents estimates of uncollectible accounts and not actual accounts shown to be uncollectible. If anything, a reduction in a bad debt reserve would indicate that certain accounts believed to be uncollectible proved collectible in the amount of the reduction. We therefore find that the expenses for the year ended June 30, 1956, were overstated in the amount of $ 7,219.17, and our computations reflect this holding.The remaining question for our consideration with regard to the earnings and profits of Jewelry is whether the $ 64,000 inventory write-down and the $ 10,886.84 ($ 18,106.01 - $ 7,219.17) accounts or notes receivable write-down to fair market value made pursuant to the chapter XI arrangement can still be regarded as expenses (as petitioners contend) for the year ended June 30, 1956, in view of our holding that such write-downs must be reflected in the appropriate assets and liabilities accounts. 199 While these write-downs might be regarded as expenses from an accounting standpoint, our resolution of the problem prevents these write-downs from entering into the profit and loss computations for this year, for to do so in combination with our holding that they must serve to reduce the amount of discharged liabilities which would otherwise have been included in earnings and profits would give them double effect on such earnings and profits. The reason for this is apparent upon comparison of petitioners' contentions with respect to the balance sheet effects of the bankruptcy and our own.Petitioners argue that the proper balance sheet treatment of these events is to create an account designated "Contributed capital" in the 99 total approximate amount of the discharged debts and reduce the "Liabilities" account by the same amount. Since this operation merely involves a change of classification on the right side of the balance sheet, both the left and right sides thereon would still be "in balance." However, petitioners have reduced the figures at which various assets were carried on the left side of the balance sheet by $ 74,886.84, the total amounts of the alleged write-down of the 200 assets to their fair market values. In order to compensate for this reduction on the "assets" side of the balance sheet, petitioners have regarded these write-downs as expenses for the year ended June 30, 1956. By designating these write-downs as expenses, petitioners have increased the loss for the year ended June 30, 1956, and consequently have decreased the earnings and profits account.Our resolution of this issue has rejected the creation of a "Contributed capital" account in the amount of the discharged debts. We have held that the excess of the amount of discharged debts over the allowable basis reductions should be placed in the earnings and profits account. We have therefore effected the following operations upon the balance sheet: A reduction on the left (assets) side by the amount of allowable basis write-downs, a reduction on the right side (the liability account) by the amount of the discharged debts, and an increase on the right side of the earnings and profits account in the amount by which the discharged debts exceed the allowable basis reductions. These three steps leave the accounts "in balance." While this conclusion has the result of decreasing the amounts of 201 "expenses" and loss for the year ended June 30, 1956, as used by petitioners in their computations on brief by $ 74,886.84 with a consequent decrease in the deficit of Jewelry's earnings and profits in the same amount, it has no material effect 28 on the computations which, in our opinion, are properly to be made on the basic premise, as stated above, of including in earnings and profits that part of the discharged indebtedness not used in a reduction of the bases of the debtor's assets. 29202 We therefore conclude that the net loss and the deficit as reported for this year were overstated in the amount of $ 82,106.01 ($ 74,886.84 +$ 7,219.17). Since Jewelry's income statement indicates that the deficit 100 as of June 30, 1956, was ($ 111,392.14), 30 the adjustment as outlined above would result in a deficit figure of ($ 29,286.13) for the earnings and profits account as of June 30, 1956. As we have stated, we hold that the excess of discharged indebtedness over total allowable basis deductions should increase earnings and profits. This excess is computed as follows:$ 189,785.42Discharged indebtedness74,886.84Allowable basis deductions114,898.58Since the prebankruptcy deficit does survive the chapter XI proceeding, El Pomar Investment Co. v. United States, 210 F. Supp. 333">210 F. Supp. 333, 203 affd. 330 F.2d 872">330 F. 2d 872, and is not canceled as petitioner contends, 31 a computation of the earnings and profits of Jewelry up to the time of the distribution to Lucile would be as follows:Deficit as of June 30, 1956($ 29,286.13)Amount of discharge of indebtedness income includablein earnings and profits as of July 3, 1956114,898.58 Loss from operations, fiscal year ending June 30, 1957(16,147.89)Loss from operations, fiscal year ending June 30, 1958(69,941.20)Gain from operations, fiscal year ending June 30, 1959165,997.38 Nondeductible contributions (June 30, 1957 - June 30,1959)(1,464.53)64,056.21 Less: Disallowed excess of charitable deductionsabove 5 percent of taxable income, fiscal yearending June 30 -- 21957$ 452.501958587.031959425.001,464.53Earnings and profits as of July 1, 195962,591.68 Because Jewelry's income tax return indicates that there was income during the fiscal year ended June 30, 1960, in the 204 amount of $ 2,492.13, and disallowed charitable contributions in the amount of $ 375 due to the 5-percent rule, it is apparent that there were more than sufficient earnings and profits of Jewelry in that year to cover the $ 31,328.17 distribution to Lucile. Hence, we reiterate our holding that such distribution 101 was a dividend within the meaning of section 316(a) of the Internal Revenue Code of 1954. The record indicates that the difference of $ 2,328.17 between the total of the payments to Lucile ($ 31,328.17) and the $ 29,000 credited to her account in connection with the redemption of her stock continued to be carried in her account with Jewelry as a receivable. This ledger account showed a debit balance of not less than $ 2,472.89 as of December 31, 1959, and not more than $ 2,623.86, the latter figure representing the balance as of May 25, 1961, the date of the last entry therein.As we have noted in our findings, supra, these amounts were not represented by notes, did not bear any interest in favor of Jewelry, 205 were not payable at any fixed maturity date, and were not secured in any manner by any of Lucile's assets once the redemption price for her stock was fixed at its par value, $ 29,000. Lucile has never repaid to Jewelry the balance of $ 2,328.17, and petitioners have made no attempt to contend that the $ 2,328.17 was a bona fide debt of Lucile's to the corporation. In the light of all the above-mentioned factors, we conclude that the entire amount received by Lucile ($ 31,328.17) is taxable to her as a dividend. Atlanta Biltmore Hotel Corp. v. Commissioner, 349 F. 2d 677, affirming a Memorandum Opinion of this Court; Jacob M. Kaplan, 43 T.C. 580">43 T.C. 580, 595.Petitioners further argue that in any event the redemption of Lucile's stock is not essentially equivalent to a dividend to the extent of $ 25,000 under the terms of section 302(b)(1). Petitioners base this contention on the theory that $ 25,000 of the $ 31,328.17, which Lucile received from Jewelry, represented no more than the ultimate repayment of the $ 25,000 liability to Lucile which the corporation incurred in 1946 in the form of five 10-year notes of $ 5,000 each. These notes were issued to Lucile as part of the consideration 206 paid to her at the time the partnership known as Meyer Jewelry Co. assumed corporate form. In support of this argument, petitioners call our attention to Keefe v. Cote, 213 F. 2d 651, and Estate of Henry A. Golwynne, 26 T.C. 1209">26 T.C. 1209.Petitioners attempt to bring the instant situation within the rule of the above cases on the ground that the $ 50,000 of liabilities which Jewelry incurred to Leon and Lucile in 1946 were capitalized into 500 shares of class B stock in 1947 only to improve the balance sheet of the corporation so as to obtain a more favorable credit rating. They argue that the liability was still regarded as remaining outstanding and as such, $ 25,000 of the total amount paid to Lucile during the year 1959 represented repayment of this debt.We neither agree with petitioners' analysis of the transaction nor do we believe that either of the two cases supports petitioners' position.102 The notes were converted into 500 shares of class B stock in 1947, a year after the corporation was organized. The $ 100 par class B stock carried with it the right to vote and a $ 6 per share noncumulative dividend preference. It could have been redeemed "at the option of the Board of Directors 207 at any time at the par value thereof." In spite of this recital in the amendment to the articles of incorporation, there is nothing in the record which would suggest that this $ 50,000 "investment" was ever treated in any manner other than that of ordinary equity capital.While the interest may have been paid on the five notes totaling $ 25,000 due Leon up until their conversion into class B stock, there is no similar indication that any interest was ever paid to Lucile. 32 No amounts were ever repaid either on the notes or in redemption of the class B stock throughout the period 1946 through 1958. Moreover, there is no evidence that any preference dividends were paid on the class B shares during the period 1947 through 1958. On September 22, 1958, all of the class A and class B stockholders of Jewelry voted to remove the alleged preferences which attached to the class B shares and to make the class A and B shares "of the same and identical class." After maintenance of the separate class B stock for 11 years without any corporate action tending to recognize the $ 50,000 "investment," either as a debt or as preferred stock, the class B shares were rendered indistinguishable from the 208 ordinary common stock of Jewelry.Given the complete failure of Jewelry to adhere to the terms of the notes or to the 250 class B shares held by Lucile by making any payments thereon for such a long period of time, the failure of Lucile to make any demands for such payments, the absence of any agreement, either explicit or implicit, that the class B shares would be redeemed when Jewelry was financially able to do so, the fact that Lucile was a 50-percent stockholder in Jewelry and participated in its management during the period 1946 to 1959, the ultimate obliteration of the class B distinction in the capital structure of the corporation, the fact that the distributions to Lucile were treated by all of the 209 parties as in redemption of all of Lucile's stock without reference to any part of such stock taken by her 11 years prior thereto in exchange for her notes, and the testimony of Lucile and Leon concerning the motives prompting the distributions to Lucile which made no reference to the repayment of any debt but which as we construe it was to the effect that the distributions to Lucile in redemption of her 103 stock were made for the purpose of enabling Lucile to withdraw her capital investment therefrom, we are convinced that all of Lucile's stock represented an ordinary equity investment at the time it was redeemed. See Montclair, Inc. v. Commissioner, 38">318 F. 2d 38, 40, affirming a Memorandum Opinion of this Court, and Wilbur Security Co., 31 T.C. 938">31 T.C. 938, 948, affd. 279 F.2d 657">279 F. 2d 657.In view of our conclusion, petitioners' citation of Keefe v. Cote, and Estate of Henry A. Golwynne, both supra, is inapposite. Although each of those cases held that the stock redemption under scrutiny was not essentially equivalent to a dividend, each dealt with a situation wherein a bona fide corporate indebtedness, incurred in the operation of a corporate business, was temporarily capitalized into stock for 210 the purpose of improving the credit position of the corporation. In both of these cases, there was an understanding that the corporation would redeem the shares as soon as it could do so conveniently, and pursuant to such understanding redemptions were made at such times, in such amounts and manner as to indicate clearly that they constituted in reality, although indirectly, repayments of the original debts.In view of the above, we reject petitioners' contention that the distributions in redemption of Lucile's common stock which occurred in late 1959 or any part thereof, should be considered as constituting, either directly or indirectly, the repayment of a $ 25,000 debt owing to her from Jewelry.Respondent determined that on April 13, 1959, Leon received a taxable distribution of $ 7,920.50 from Meyer Jewelry Co., consisting of 62 shares of Thiokol stock having a value of $ 127.75 per share, which he failed to report as income. At the conclusion of the trial, respondent submitted a motion for leave to file an amended answer. Such motion was subsequently granted. In his amended answer, respondent asserted that Leon received a taxable distribution from Jewelry in the amount of 211 $ 10,013, representing the fair market value of 124 shares of Thiokol received on April 30, 1959, at a fair market value of $ 52.375 per share, and 62 shares of Thiokol received on May 4, 1959, at a fair market value of $ 56.75 per share.Petitioners' primary contention with respect to this issue is that Leon contributed only 638 presplit shares of his Thiokol stock to Jewelry's capital and retained title to 62 shares. Consequently, it is urged by petitioners that Leon did not receive a distribution of 62 shares of Thiokol stock on April 13, 1959. In response to respondent's amended answer, petitioners argue that for the same reason Leon did not receive distributions of 124 and 62 shares of Thiokol stock on April 30 and May 4, 1959, respectively.Petitioners, on brief, concede that "The record indicates that Leon on or after May 4, 1959 received 32 [split] shares out of 62 shares of 104 Thiokol held by Stern Brothers & Co.," having a fair market value of no more than $ 53.75 per share, the lowest selling price for that date. However, petitioners argue that respondent, having pleaded new matter, has not sustained his burden of proving either that the receipt of the stock in question constituted 212 more than a return to Leon of his own property or that the shares had a value greater than $ 53.75 per share as of the date of delivery.With respect to petitioners' assertion that respondent has pleaded new matter and must bear the burden of proof, we are convinced that notwithstanding the question as to which party bears the burden of proof as to this issue, the record clearly supports respondent's assertions that all 700 of the presplit shares of Thiokol were given to Meyer Jewelry Co. by Leon on or about April 1, 1959, as a capital contribution, including the 62 shares which were not sold on behalf of Jewelry. Whether the stock was transferred to Jewelry depends upon all the attendant facts and circumstances, including the intent of the parties. Tabery v. Commissioner, 354 F. 2d 422, 426, affirming a Memorandum Opinion of this Court; Thal v. Commissioner, 142 F. 2d 874; Bank of America National Trust & Savings Assn., 15 T.C. 544">15 T.C. 544, affd. 193 F.2d 178">193 F. 2d 178. Initially, we note that the petition herein signed and verified by Leon specifically alleges that Leon made a capital contribution of 700 shares of Thiokol stock to Meyer Jewelry Co. on April 1, 1959. Nowhere in the petition is there 213 any reference to Leon's alleged intent to restrict his capital contribution as to the number of shares of Thiokol stock "up to 700" necessary to effect certain alleged purposes.The record shows that the 700 presplit shares of Thiokol were identified by 13 certificates issued in the name of Leon R. Meyer. At the time of contribution these certificates had been endorsed by Leon to Jewelry. The minutes of Jewelry's board of directors meeting dated April 1, 1959 (at which Leon acted as chairman), state that the stock certificates representing the 700 shares were endorsed by Leon to Jewelry; that Jewelry is the "owner of 700 shares of the capital stock of Thiokol"; the stock powers attached to the 13 certificates were all executed by Jewelry before delivery to Stern Bros. & Co., brokers; and the instructions to the broker were that all checks representing proceeds of sale of the 700 shares should be made payable to Jewelry.The record also shows that from the period April 6 through April 13, 1959, 638 of these shares were sold by a broker, Stern Bros. & Co., on behalf of Meyer Jewelry Co. In order to facilitate this sale and to transfer the shares into a street name, the broker, on April 214 2, 1959, issued a request to the stock transfer agent of Thiokol Chemical Corp. to reissue the 700 shares in the name "Stern Brothers & Company." The shares were actually transferred on the books of Thiokol Chemical Corp. on April 27, 1959. In the meantime, a stock dividend 105 had been declared by Thiokol providing for two additional shares to be issued for each share presently held, in order to effect a 3 for 1 split of the stock. The stock record date for determining the proper parties entitled to this dividend was April 20, 1959. The payment date for the stock dividend was April 30, 1959. Therefore, on April 20, 1959, according to the stock record books of the Thiokol Chemical Corp., the proper party to receive the stock dividend was Leon Meyer. The stock dividend on the 638 shares which had been sold during the period April 6 through April 13, 1959, although received by Leon Meyer, had to be returned to Stern Bros. & Co. for transfer to the respective purchasers of the 638 shares. Leon did receive, however, on April 30, 1959, the stock dividend of 124 additional shares on the 62 shares which had not been sold by Meyer Jewelry Co. The original 62 shares (now one-third of the 215 value existing prior to the split) were first received by Stern Bros. in a street name. Of this amount, 30 shares were reissued in accordance with Leon's request to Stern Bros. & Co. on May 4, 1959, to various members of his family, and 32 shares were reissued to himself. Pursuant to this instruction of Leon, these transfers were noted on the records of the stock transfer agent on May 7, 1959.Although Meyer Jewelry Co. did not physically receive any of the 124 shares resulting from the split of the original 62 shares, this factor alone is not determinative if the intention of the parties is otherwise. Helvering v. Kaufman, 136 F. 2d 356, affirming 46 B.T.A. 924">46 B.T.A. 924. Moreover, Jewelry's failure to recognize a receivable is not conclusive of the matter. Doyle v. Mitchell Bros. Co., 247 U.S. 179">247 U.S. 179, 187; Commissioner v. North Jersey T. Ins. Co., 79 F.2d 492">79 F. 2d 492. Since ownership of the original 62 shares had been transferred to Meyer Jewelry Co. prior to the stock split, it is clear that Jewelry, not Leon, was entitled to retain the 62 shares and receive the 124 additional shares. By permitting Leon to receive, retain, and redistribute in part these 186 shares, Jewelry, in effect, made a distribution 216 thereof to him. We hold that this distribution is taxable as a dividend in the light of our earnings and profits computations, supra.On April 20, 1959, the effective record date of the stock split, Leon was still the record owner on the books of Thiokol of the 62 shares to be split. It is petitioners' position that the 124 additional shares produced by the split came directly to Leon and not via a distribution from Jewelry. We find no merit in this argument since the record shows that on April 20, 1959, Leon was not only the record holder, per Thiokol's books of the 62 unsold shares but was also the record holder of the other 638 shares already sold by Jewelry's broker. The sale of 638 shares of Thiokol sold from April 6 to April 13, 1959, carried with the shares sold the additional shares produced by the stock 106 split so that the record owner was required to deliver the additional shares resulting from the split to the purchaser in the transaction effected by Stern Bros. & Co. for the account of Jewelry. We believe that this situation is equally applicable to the 62 remaining presplit shares. They had been owned for nearly 3 weeks by Meyer Jewelry Co. If they had been sold in 217 the interim, the purchaser would have been entitled to the 124 shares arising from the split. In our opinion, Meyer Jewelry Co. was acting in its own behalf, and not as an agent of Leon, with respect to the 700 shares. Leon's interest in the 700 shares, including the 62 shares unsold, arose solely from Thiokol's delay in performing a ministerial, bookkeeping act. Leon's position was tantamount to that of a nominee. Hence, he had no legal or equitable right to retain any of the 1,400 split shares received by virtue of that position. When Leon, apparently acting in his official capacity as president and controlling stockholder of Jewelry, chose to retain the 124 and 62 split shares, he received in substance a distribution of such property from his corporation.Respondent's amended answer alleges a fair market value of the 124 Thiokol shares, which Leon received on April 30, 1959, in the amount of $ 52.375 per share. The parties stipulated orally that the split Thiokol stock sold on the New York Stock Exchange on April 30, 1959, at a high of $ 53.875 per share and a low of $ 51 per share. With respect to the 62 presplit shares of Thiokol, petitioners admit that Leon received 32 of 218 these shares on or about May 4, 1959, and that the fair market value thereof was the lowest selling price obtained on the New York Stock Exchange for the split Thiokol stock on the latter date. On that date, the parties have likewise stipulated that Thiokol stock sold on the exchange at a low of $ 53.75 per share and at a high of $ 59.75.Notwithstanding the question as to which party should assume the burden of proof with respect to the fair market value of the Thiokol stock on the two distribution dates, we find that the record supports respondent's determinations. Where stock is listed and freely marketed in substantial amounts on a recognized exchange, the mean price between the two extreme trading prices on a given date is regarded as the fair market value for that date. Batterman v. Commissioner, 142 F. 2d 448, affirming a Memorandum Opinion of this Court. The fair market value alleged by the respondent with respect to the 124 shares received by Leon on April 30, 1959, was slightly below the midpoint between the high and low selling prices for that date, while the fair market value alleged by respondent for the 62 shares received by Leon on May 4, 1959, was the precise midpoint 219 between the high and low selling prices for that date. In the light of the foregoing, and upon the entire record, we sustain respondent's 107 determination that Leon received a taxable distribution from Jewelry in the amount of $ 10,013, representing the fair market value of 124 and 62 shares of Thiokol stock received on April 30 and May 4, 1959, respectively.In our computations of the earnings and profits of Jewelry, we have subtracted $ 9.72 in order to recognize the effects of the above distribution to Leon. Section 312(a)(3) of the 1954 Code 33 provides that when a corporation distributes property with respect to its stock, its earnings and profits shall be decreased by the adjusted basis of the property. Since Leon contributed the 700 shares of the Thiokol stock to Jewelry's capital, Jewelry's basis in the Thiokol stock would be equivalent to Leon's. See sec. 362(a)(2), 1954 Code. 34 The record indicates that Jewelry's basis in the 638 shares sold in the year ended June 30, 1959, was $ 100. Using these figures, Leon's (and therefore Jewelry's) basis in the 62 shares (plus the additional 124 shares received in the stock split) 35 would be $ 9.72. We have therefore made that deduction 220 from Jewelry's earnings and profits for the year ended June 30, 1959, in our computations.Decisions will be entered under Rule 50. Footnotes1. These cases were heard by Judge Morton P. Fisher and briefs were duly filed. Judge Fisher died on Feb. 11, 1965. These cases, not having been disposed of, were reassigned to Judge John W. Kern on Mar. 2, 1965, and notice was given to the parties that any request for rehearing or reargument might be presented to him within 30 days. No such requests have been received.↩2. According to the proposed arrangement, the tax claims amounted to $ 4,967.12.↩3. Although 30 percent of $ 271,121.71 is $ 81,336.51, the court orders employed the figure as indicated. Nothing in the record explains this discrepancy.↩4. Although this figure was used on Jewelry's balance sheet as of June 30, 1956, petitioners' computations on brief result in the figure $ 179,746.36 ($ 189,785.42 - ($ 7,500+$ 2,539.06)). There is nothing in the record to explain this discrepancy. While these computations include the reduction of $ 2,539.06 for "Tax and Administrative expenses -- Est.," there is nothing in the record to support this latter figure.↩5. Described in the journal of Jewelry as "materials," "mountings," and "shop" with respective write-downs of $ 50,000, $ 8,000, and $ 6,000.↩6. We believe the net reduction in the accounts and notes receivable to be $ 10,886.84. The debit to "Insurance claim pending" is an increase in an asset account and the companion credits indicate that the insurance claim was reclassified by taking it out of accounts or notes receivable. The debit to "Bad debt reserve" normally indicates a reduction in a liability account set up to estimate uncollectible accounts receivable. As such, this entry is not a write-down in an asset account arising out of an expense or a forgiveness of indebtedness. The corresponding credit might well indicate that certain amounts estimated uncollectible proved collectible in part. While we would not go so far as to attribute income to Jewelry because of this entry, we find no justification for treating the $ 7,219.17 debit as an asset write-down.7. Despite this notation, the journal entries indicate total write-downs of $ 64,000. See fn. No. 5, supra↩. Nothing in the record explains this discrepancy.8. It appears that the $ 18,106.01 figure is the sum of the following two debits in the journal: $ 10,886.84 to "Bad debt expense" and $ 7,219.17 to "Bad debt reserve."↩1. After 3 for 1 split the parties have also stipulated that on Apr. 30, 1959, "the old stock of Thiokol Chemical Corp., prior to split, was selling at a low of $ 153.75 and a high of $ 161.50, and the split stock was selling at a low of $ 51 per share and a high of $ 53.87 1/2 per share."1. Includes ownership in both class A and class B shares which are deemed to be of the same and identical class as a result of an amendment of the special bylaws of the corporation at the stockholder meeting of Sept. 22, 1958.↩9. SEC. 316. DIVIDEND DEFINED.(a) General Rule. -- For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders -- (1) out of its earnings and profits accumulated after February 28, 1913, or(2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.↩Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection.10. SEC. 302. DISTRIBUTIONS IN REDEMPTION OF STOCK.(a) General Rule. -- If a corporation redeems its stock (within the meaning of section 317(b)), and if paragraph (1), (2), (3), or (4) of subsection (b) applies, such redemption shall be treated as a distribution in part or full payment in exchange for the stock.(b) Redemptions Treated as Exchanges. -- (1) Redemptions not equivalent to dividends. -- Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend.↩11. Sec. 302(b)(2). Substantially disproportionate redemption of stock. -- (A) In General. -- Subsection (a) shall apply if the distribution is substantially disproportionate with respect to the shareholder.(B) Limitation. -- This paragraph shall not apply unless immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote.(C) Definitions. -- For purposes of this paragraph, the distribution is substantially disproportionate if -- (i) the ratio which the voting stock of the corporation owned by the shareholder immediately after the redemption bears to all of the voting stock of the corporation at such time,is less than 80 percent of -- (ii) the ratio which the voting stock of the corporation owned by the shareholder immediately before the redemption bears to all of the voting stock of the corporation at such time.For purposes of this paragraph, no distribution shall be treated as substantially disproportionate unless the shareholder's ownership of the common stock of the corporation (whether voting or nonvoting) after and before redemption also meets the 80 percent requirement of the preceding sentence. For purposes of the preceding sentence, if there is more than one class of common stock, the determinations shall be made by reference to fair market value.(D) Series of Redemptions. -- This paragraph shall not apply to any redemption made pursuant to a plan the purpose or effect of which is a series of redemptions resulting in a distribution which (in the aggregate) is not substantially disproportionate with respect to the shareholder.↩12. SEC. 302. DISTRIBUTIONS IN REDEMPTION OF STOCK.(b) Redemptions Treated as Exchanges. --* * * * (3) Termination of shareholder's interest. -- Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder.↩13. Sec. 302(b)(4). Stock issued by railroad corporations in certain reorganizations. -- Subsection (a) shall apply if the redemption is of stock issued by a railroad corporation (as defined in section 77(m) of the Bankruptcy Act, as amended) pursuant to a plan of reorganization under section 77 of the Bankruptcy Act.↩14. Sec. 302(c). Constructive Ownership of Stock. --(1) In general. -- Except as provided in paragraph (2) of this subsection, section 318(a) shall apply in determining the ownership of stock for purposes of this section.15. SEC. 318. CONSTRUCTIVE OWNERSHIP OF STOCK.(a) General Rule. -- For purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable -- (1) Members of family. -- (A) In general. -- An individual shall be considered as owning the stock owned, directly or indirectly, by or for --(i) his spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and(ii) his children, grandchildren, and parents.(B) Effect of adoption. -- For purposes of subparagraph (A)(ii), a legally adopted child of an individual shall be treated as a child of such individual by blood.(2) Partnerships, estates, trusts, and corporations. -- (A) Partnerships and estates. -- Stock owned, directly or indirectly, by or for a partnership or estate shall be considered as being owned proportionately by its partners or beneficiaries. Stock owned, directly or indirectly, by or for a partner or a beneficiary of an estate shall be considered as being owned by the partnership or estate.(B) Trusts. -- Stock owned, directly or indirectly by or for a trust shall be considered as being owned by its beneficiaries in proportion to the actuarial interest of such beneficiaries in such trust. Stock owned, directly or indirectly, by or for a beneficiary of a trust shall be considered as being owned by the trust, unless such beneficiary's interest in the trust is a remote contingent interest. For purposes of the preceding sentence, a contingent interest of a beneficiary in a trust shall be considered remote, if, under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest, computed actuarially, is 5 percent or less of the value of the trust property. Stock owned, directly or indirectly, by or for any portion of a trust of which a person is considered the owner under subpart E of part I of subchapter J (relating to grantors and others treated as substantial owners) shall be considered as being owned by such person; and such trust shall be treated as owning the stock owned, directly or indirectly, by or for that person. This subparagraph shall not apply with respect to any employees' trust described in section 401(a) which is exempt from tax under section 501(a).(C) Corporations. -- If 50 percent or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, then --(i) such person shall be considered as owning the stock owned, directly or indirectly, by or for that corporation, in that proportion which the value of the stock which such person so owns bears to the value of all the stock in such corporation; and(ii) such corporation shall be considered as owning the stock owned, directly or indirectly, by or for that person.(3) Options. -- If any person has an option to acquire stock, such stock shall be considered as owned by such person. For purposes of this paragraph, an option to acquire such an option, and each one of a series of such options, shall be considered as an option to acquire such stock.(4) Constructive ownership as actual ownership. -- (A) In general. -- Except as provided in subparagraph (B), stock constructively owned by a person by reason of the application of paragraph (1), (2), or (3) shall, for purposes of applying paragraph (1), (2), or (3), be treated as actually owned by such person.(B) Members of family. -- Stock constructively owned by an individual by reason of the application of paragraph (1) shall not be treated as owned by him for purposes of again applying paragraph (1) in order to make another the constructive owner of such stock.(C) Option rule in lieu of family rule. -- For purposes of this paragraph, if stock may be considered as owned by an individual under paragraph (1) or (3), it shall be considered as owned by him under paragraph (3).↩16. SEC. 302. DISTRIBUTIONS IN REDEMPTION OF STOCK.(c) Constructive Ownership of Stock. --* * * * (2) For determining termination of interest. -- (A) In the case of a distribution described in subsection (b)(3), section 318(a)(1) shall not apply if --(i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor,(ii) the distributee does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, and(iii) the distributee, at such time and in such manner as the Secretary or his delegate by regulations prescribes, files an agreement to notify the Secretary or his delegate of any acquisition described in clause (ii) and to retain such records as may be necessary for the application of this paragraph.If the distributee acquires such an interest in the corporation (other than by bequest or inheritance) within 10 years from the date of the distribution, then the periods of limitation provided in sections 6501 and 6502 on the making of an assessment and the collection by levy or a proceeding in court shall, with respect to any deficiency (including interest and additions to the tax) resulting from such acquisition, include one year immediately following the date on which the distributee (in accordance with regulations prescribed by the Secretary or his delegate) notifies the Secretary or his delegate of such acquisition; and such assessment and collection may be made notwithstanding any provision of law or rule of law which otherwise would prevent such assessment and collection.↩1. Includes ownership in both class A and class B shares which are deemed to be of the same and identical class as a result of an amendment of the special bylaws of the corporation at the stockholder meeting of Sept. 22, 1958.↩17. Including the three deemed pertinent in J. Milton Sorem, 40 T.C. 206">40 T.C. 206, 220(Judge Dawson dissenting), revd. 334 F. 2d 275↩.18. See Moore, "Dividend Equivalency -- Taxation of Dividends in Redemption of Stock," 19 Tax L. Rev. 249">19 Tax L. Rev. 249, 252↩.19. See fn. 4, supra↩.20. 11 U.S.C. sec. 795. Taxes; income or profit from modification of indebtedness.Except as provided in section 796 of this title, no income or profit, taxable under any law of the United States or of any State now in force or which may hereafter by enacted, shall, in respect to the adjustment of the indebtedness of a debtor in a proceeding under this chapter, be deemed to have accrued to or to have been realized by a debtor or a corporation organized or made use of for effectuating an arrangement under this chapter by reason of a modification in or cancellation in whole or in part of any such indebtedness in a proceeding under this chapter: Provided, however, That if it shall be made to appear that the arrangement had for one of its principal purposes the evasion of any income tax, the exemption provided by this section shall be disallowed. * * ** * * Sec. 796. Same; income tax; property basis adjustment.In determining the basis of property for any purposes of any law of the United States or of a State imposing a tax upon income, the basis of the debtor's property (other than money) or of such property (other than money) as is transferred to any person required to use the debtor's basis in whole or in part shall be decreased by an amount equal to the amount by which the indebtedness of the debtor, not including accrued interest unpaid and not resulting in a tax benefit on any income-tax return, has been canceled or reduced in a proceeding under this chapter, but the basis of any particular property shall not be decreased to an amount less than the fair market value of such property as of the date of entry of the order confirming the arrangement. Any determination of value in a proceeding under this chapter shall not be deemed a determination of fair market value for the purposes of this section. The Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury, shall prescribe such regulations as he may deem necessary in order to reflect such decrease in basis for Federal income-tax purposes and otherwise carry into effect the purposes of this section. * 21. Sec. 1.61-12 Income from discharge of indebtedness.(b) Proceedings Under Bankruptcy Act. (1) Income is not realized by a taxpayer by virtue of the discharge, under section 14 of the Bankruptcy Act (11 U.S.C. 32), of his indebtedness as the result of an adjudication in bankruptcy or by virtue of an agreement among his creditors not consummated under any provision of the Bankruptcy Act, if immediately thereafter the taxpayer's liabilities exceed the value of his assets. Furthermore, unless one of the principal purposes of seeking a confirmation under the Bankruptcy Act is the avoidance of income tax, income is not realized by a taxpayer in the case of a cancellation or reduction of his indebtedness under --(i) A plan of corporate reorganization confirmed under Chapter X of the Bankruptcy Act (11 U.S.C., ch. 10);(ii) An "arrangement" or a "real property arrangement" confirmed under Chapter XI or XII, respectively, of the Bankruptcy Act (11 U.S.C., ch. 11, 12); or(iii) A "wage earner's plan" confirmed under Chapter XIII of the Bankruptcy Act (11 U.S.C., ch. 13).(2) For adjustment of basis of certain property in the case of cancellation or reduction of indebtedness resulting from a proceeding under the Bankruptcy Act, see the regulations under section 1016.↩22. While the record supports the petitioner with respect to the fact of the $ 7,500 payment, there is no indication that the tax and administrative expenses in connection with the chapter XI proceeding were in the amount of $ 2,539.06. Even if we were to assume that both payments were in fact made, it is extremely doubtful whether there is justification for deducting them from the amount of the debts discharged and considering such deductions in any computations we might make with regard to the earnings and profits of Jewelry. The income statement for the year ended June 30, 1956, contains expense entries for "Taxes" and "Miscellaneous" in the respective amounts of $ 6,910.15 and $ 8,678.58. If, as we believe, petitioners have the burden of proof on this issue, they have not borne the burden of proving that these items were not reflected in the corporate income statement as of June 30, 1956.23. Sec. 1.1016-7 Adjusted basis; cancellation of indebtedness under Bankruptcy Act.(a) In addition to the adjustments provided in section 1016, further adjustment is required in the case of a cancellation or reduction of indebtedness in any proceeding under chapters X, XI, or XII of the Bankruptcy Act (11 U.S.C. ch. 10, 11, and 12) and corresponding provisions of prior law. For exceptions to the above rule see sections 372, 373, 374, and 1018. Furthermore, no such further adjustment will be made in the case of a "wage earner" as that term is defined in section 606(8) of the Bankruptcy Act (11 U.S.C. 1006(8)). The further adjustments required by this section shall be made in the following manner and order:(1) In the case of indebtedness incurred to purchase specific property (other than inventory or notes or accounts receivable whether or not a lien is placed against such property securing the payment of all or part of such indebtedness, which indebtedness shall have been canceled or reduced in any such proceeding, the cost or other basis of such property shall be decreased (but not below its fair market value) by the amount by which the indebtedness so incurred with respect to such property shall have been canceled or reduced;(2) In the case of specific property (other than inventory or notes or accounts receivable) against which, at the time of the cancellation or reduction of the indebtedness, there is a lien (other than a lien securing indebtedness incurred to purchase such property) the cost or other basis of such property shall be decreased (but not below its fair market value) by the amount by which the indebtedness secured by such lien shall have been canceled or reduced;(3) Any excess of the total amount by which the indebtedness shall have been so canceled or reduced in such proceeding over the sum of the adjustments made under subparagraphs (1) and (2) of this paragraph shall next be applied to reduce the cost or other basis of the property of the debtor (other than inventory and notes and accounts receivable, but including property covered by such subparagraphs) as follows: the cost or other basis of each unit of property shall be decreased (but not below its fair market value) in an amount equal to such proportion of such excess as the adjusted basis (after adjustment under subparagraphs (1) and (2) of this paragraph) of each such unit of property bears to the sum of the adjusted bases (after adjustment under such subparagraphs) of all the property of the debtor other than inventory and notes and accounts receivable;(4) Any excess of the total amount by which such indebtedness shall have been so canceled or reduced over the sum of the adjustments made under subparagraphs (1), (2), and (3), of this paragraph shall next be applied to reduce the cost or other basis of any units of property covered by such subparagraphs which have a remaining basis (after adjustment under such subparagraphs) greater than their fair market value, as follows: the cost or other basis of each such unit of property shall be decreased (but not below its fair market value) in an amount equal to such proportion of such excess as the remaining basis of each such unit bears to the sum of the remaining bases of such units. The process shall be repeated until the cost or other basis of each unit of the property covered by subparagraphs (1), (2), and (3) of this paragraph is reduced to its fair market value or the amount by which the indebtedness shall have been canceled or reduced is exhausted, taking into account in the successive steps only those units of property having, after the preceding adjustment, a remaining basis greater than their fair market value; and(5) Any excess of the total amount by which the indebtedness shall have been so canceled or reduced over the sum of the adjustments made under subparagraphs (1), (2), (3), and (4) of this paragraph shall next be applied to reduce the cost or other basis of inventory and notes and accounts receivable as follows: the cost or other basis of inventory or notes or accounts receivable, as the case may be, shall be decreased (but not below its fair market value) in an amount equal to such proportion of such excess as the adjusted basis of inventory, notes receivable or accounts receivable, as the case may be, bears to the sum of the adjusted bases of such inventory and notes and accounts receivable. The process shall be repeated until the adjusted bases of inventory, notes receivable, and accounts receivable are reduced to their fair market value or the amount by which the indebtedness shall have been canceled or reduced is exhausted, taking into account in the successive steps only those units of property having, after the preceding adjustment, a remaining basis greater than their fair market value.(b) For the purposes of this section:(1) Basis shall be determined as of the dates of entry of the order confirming the plan, composition, or arrangement under which such indebtedness shall have been canceled or reduced;(2) Except where the context otherwise requires, property means all of the debtor's property, other than money;(3) No adjustment shall be made by virtue of the cancellation or reduction of any accrued interest unpaid which shall not have resulted in a tax benefit in any income tax return;(4) The phrase "indebtedness incurred to purchase" includes (i) indebtedness for money borrowed and applied in the purchase of property and (ii) an existing indebtedness secured by a lien against the property which the debtor, as purchaser of such property, has assumed to pay; and(5) The term "fair market value" has reference to such value as of the date of entry of the order confirming the plan, composition, or arrangement under which such indebtedness shall have been canceled or reduced.(c) Any determination of value in a proceeding under the Bankruptcy Act (11 U.S.C. 1 et seq.), shall not constitute a determination of fair market value for the purpose of this section.(d) The basis of any of the debtor's property which shall have been transferred to a person required to use the debtor's basis in whole or in part shall be determined in accordance with the provisions of this section.↩24. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(1) Effect on Earnings and Profits of Gain or Loss and of Receipt of Tax-Free Distributions. -- The gain or loss realized from the sale or other disposition (after February 28, 1913) of property by a corporation -- (1) for the purpose of the computation of earnings and profits of the corporation, shall be determined, except as provided in paragraph (2), by using as the adjusted basis the adjusted basis (under the law applicable to the year in which the sale or other disposition was made) for determining gain, except that no regard shall be had to the value of the property as of March 1, 1913; but(2) for the purpose of the computation of earnings and profits of the corporation for any period beginning after February 28, 1913, shall be determined by using as the adjusted basis the adjusted basis (under the law applicable to the year in which the sale or other disposition was made) for determining gain.Gain or loss so realized shall increase or decrease the earnings and profits to, but not beyond, the extent to which such a realized gain or loss was recognized in computing net income under the law applicable to the year in which such sale or disposition was made. Where in determining the adjusted basis used in computing such realized gain or loss the adjustment to the basis differs from the adjustment proper for the purpose of determining earnings or profits, then the latter adjustment shall be used in determining the increase or decrease above provided. For the purposes of this subsection, a loss with respect to which a deduction is disallowed under section 118, or a corresponding provision of a prior income tax law, shall not be deemed to be recognized. Where a corporation receives (after February 28, 1913) a distribution from a second corporation which (under the law applicable to the year in which the distribution was made) was not a taxable dividend to the shareholders of the second corporation, the amount of such distribution shall not increase the earnings and profits of the first corporation in the following cases: (1) No such increase shall be made in respect of the part of such distribution which (under such law) is directly applied in reduction of the basis of the stock in respect of which the distribution was made.(2) No such increase shall be made if (under such law) the distribution causes the basis of the stock in respect of which the distribution was made to be allocated between such stock and the property received.25. SEC. 61. GROSS INCOME DEFINED.(a) General Definition. -- Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: * * * (12) Income from discharge of indebtedness;↩26. The legislative history of the pertinent sections of the Bankruptcy Act indicates that the intention of Congress was to provide exemption from taxation of the income received in such a situation, conditioned on an equivalent basis reduction which would result in the realization of income from a later sale or exchange of such assets if they were sold or exchanged at a price in excess of their reduced basis. See S. Rept. No. 1916, 75th Cong., 3d Sess., p. 39.↩27. Sec. 1.61-12 Income from discharge of indebtedness.(a) In general↩. The discharge of indebtedness, in whole or in part, may result in the realization of income. If, for example, an individual performs services for a creditor, who in consideration thereof cancels the debt, the debtor realizes income in the amount of the debt as compensation for his services. A taxpayer may realize income by the payment or purchase of his obligations at less than their face value. In general, if a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation to the extent of the principal of the debt.28. This is not the case with regard to the $ 7,219.17, which we found to be an improperly taken expense. Since it is neither an expense nor a reduction of the basis of assets, we have subtracted this amount from the expenses for the year ended June 30, 1956. This subtraction has the effect of increasing both income for the year ended June 30, 1956, and existing earnings and profits as of that date.↩29. Whether the $ 74,886.84 is employed as a basis reduction and offsets the amount of discharged debts otherwise includable in earnings and profits ($ 189,785.42 - $ 74,886.84), or whether it is regarded as an expense for the fiscal year ended June 30, 1956, thereby increasing the deficit in earnings and profits as of June 30, 1956, with no offset effected upon the total amount of discharged debts includable in earnings and profits (-$ 74,886.84 +$ 189,785.42), the effect upon the computation of the earnings and profits is exactly the same.30. This figure includes subtractions for charitable contributions of $ 1,090.88 and $ 780 made in the years ended June 30, 1955, and June 30, 1956, and disallowed because of the 5-percent-limitation rule of sec. 170(b)(2).↩31. Cf. Dunning v. United States, 353 F. 2d 940, affirming 232 F. Supp. 915">232 F. Supp. 915↩, where all the old capital stock was wiped out pursuant to a sec. 77B bankruptcy proceeding.1. After reduction of $ 9.72 for dividend distribution to Leon. See our discussion, infra↩.2. Excess charitable contributions not deducted in computing taxable income because of the 5-percent ceiling should reduce earnings and profits. See sec. 1.312-7(b)(1), Income Tax Regs.↩32. The five notes of Leon's, photostatic copies of which were admitted in evidence, all bear the notation on the reverse side: "Interest to and including Sept. 30, 1947/ Received/ Leon R. Meyer/ Pay to order of/ Meyer Jewelry Co./ Leon R. Meyer/ Canceled 9/30/47/ Meyer Jewelry Co./ By ↩." The five notes of Lucile, photostatic copies of which were also admitted in evidence, merely bear the notation on the reverse side: "Canceled 9/30/47/ By Leon R. Meyer, Pres./Meyer Jewelry Co."33. SEC. 312. EFFECT ON EARNINGS AND PROFITS.(a) General Rule. -- Except as otherwise provided in this section, on the distribution of property by a corporation with respect to its stock, the earnings and profits of the corporation (to the extent thereof) shall be decreased by the sum of --* * * * (3) the adjusted basis of the other property, so distributed.↩34. SEC. 362. BASIS TO CORPORATIONS.(a) Property Acquired by Issuance of Stock or as Paid-in Surplus. -- If property was acquired on or after June 22, 1954, by a corporation --* * * * (2) as paid-in surplus or as a contribution to capital, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.↩35. See sec. 305(a) and 307(a), 1954 Code. When the stock dividend is not includable in gross income, an allocation of basis takes place.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622029/	EUGENE LECOURS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentLecours v. CommissionerDocket No. 42637-84.United States Tax CourtT.C. Memo 1988-260; 1988 Tax Ct. Memo LEXIS 286; 55 T.C.M. (CCH) 1078; T.C.M. (RIA) 88260; June 20, 1988; As amended June 28, 1988 Eugene Lecours, pro se. [Text Deleted by Court Emendation] 287 Monica E. Koch, for the respondent.WHALENMEMORANDUM FINDINGS OF FACT AND OPINION WHALEN, Judge: Respondent determined the following deficiencies in, and additions to, petitioner's Federal income tax for 1982: AdditionsSectionSectionSectionSectionTax6651(a)(1) 16653(a)(1)6653(a)(2)6654$ 6,818.00$ 1,043.95$ 340.9050% of interest$ 341.68due on underpaymentof $ 6,818.00The issues are: (1) whether wages received by petitioner during 1982 are includible in his gross income under section 61; (2) whether the additions to tax, set forth above, have been properly imposed; and (3) whether damages under section 6673 should be awarded. At the outset, a brief note about the procedural posture of the case is appropriate. On November 30, 1987, petitioner filed a Motion for Summary Judgment Pursuant To Rule 121 in which he argued that his wages are not subject to288 income tax on the theory that he has a "God-Given and constitutionally-Guaranteed RIGHT" to exist and to sustain himself and that the exercise of such right cannot lawfully be subject to income tax. The motion was heard before the Court on December 7, 1987, and was denied. At that time, the Court explained to petitioner that its denial of the motion did not dispose of his case, and the Court scheduled trial of the case for later that afternoon. Petitioner stated that it would be impossible for him to conduct the trial that day due to the distance over which he would have to bring his evidence. He did not request a continuance, and he acknowledged that he had previously been given notice setting the case for trial on December 7, 1987. In fact, the notice was dated July 2, 1987. Accordingly, trial was held later that day and both petitioner and respondent's counsel appeared and made arguments. FINDINGS OF FACT During 1982, petitioner received wages from Warner Brothers, Inc. ("Warner Brothers") in the amount of $ 26,375.81. He was employed by Warner Brothers to repair heavy equipment. Petitioner filed a Form 1040, Individual Income Tax Return, with respondent for 1982. On289 such form, he listed his name, address, social security number, occupation, and filing status. Petitioner's name and address appear on the form as, "Rev. Eugene J. LeCours O-S-M, c/o Finance Director, Order of St. Matthew, 2090 Merrick Ave., Merrick, New York 11566." His occupation is listed as "Agent of Religious Order." Petitioner signed and dated the form. The date appearing on the form is April 8, 1983, but it does not appear from the record when the return was actually filed. On line 7 of the Form 1040, "Wages, salaries, tips, etc.," petitioner entered the total amount of wages, $ 26,375.81, which he had received from Warner Brothers during 1982, as reflected on the Form W-2 for 1982 which Warner Brothers had sent to him. Petitioner attached the Form W-2 to his return. On line 25 of the Form 1040, under "Adjustments to Income," petitioner struck through the words printed on the form and typed the words, "Wages nontaxable by reason of taxpayer being agent of Religious Order," and he entered $ 26,375.81 as the amount of the adjustment. Petitioner thus reported zero adjusted gross income on line 32, and zero tax due on line 38. Petitioner then entered the total income tax290 withholding from his wages, $ 2,642.22, on line 60. He altered line 64 to read "Excess FICA and RRTA tax withheld Vow of Poverty," by partially striking over the words printed on the form, and he entered $ 1,767.18 as the amount of such excess. Petitioner claimed refund of the resulting "amount overpaid," $ 4,409.40. OPINIONIssue 1: Taxability of Wage IncomeAt trial, petitioner abandoned the theory suggested in his petition that, as an "ordained minister and a member of a religious Order," his wages are not subject to Federal income tax. Petitioner relied solely on his contention that wages do not constitute income under decisions of the Supreme Court interpreting the 16th Amendment and other provisions of the United States Constitution, and hence that the wages he received in 1982 from Warner Brothers are not subject to Federal income tax. We have consistently rejected similar frivolous arguments in the past and do so once again here. E.g., Rowlee v. Commissioner,80 T.C. 1111">80 T.C. 1111 (1983). We find that the wages paid to petitioner in 1982 are includible in his gross income for such year and are subject to Federal income tax. Section 61(a)(1); Commissioner v. Glenshaw Glass Company,348 U.S. 426">348 U.S. 426 (1955);291 Eisner v. Macomber,252 U.S. 189">252 U.S. 189 (1920); Grimes v. Commissioner,82 T.C. 235">82 T.C. 235 (1984), affd. per curiam 806 F.2d 1451">806 F.2d 1451 (9th Cir. 1986). Thus, we sustain respondent's determination of a tax deficiency in the amount of $ 6,818.00.Issue 2: Additions to TaxRespondent determined the additions to petitioner's 1982 Federal income tax set out above. Petitioner, of course, bears the burden of proving that respondent's determination of each such addition to tax is erroneous. Rule 142(a); Welch v. Helvering,290 U.S. 111">290 U.S. 111 (1933); Grimes v. Commissioner, supra.Petitioner presented no evidence to rebut such determinations at trial. They must, accordingly, be sustained and we hereby do so. In the case of the additions determined by respondent under sections 6653(a)(1), 6653(a)(2) and 6654f, there is nothing in the record to suggest that respondent's determinations are incorrect. In the case of the addition determined by respondent under section 6651(a)(1) for failure to file a timely return, the record contains the document filed by petitioner for the year 1982 described above. However, petitioner introduced292 no evidence or testimony to suggest, contrary to respondent' determination, that such document constitutes a "return" for purposes of section 6651(a)(1). See Beard v. Commissioner,82 T.C. 766">82 T.C. 766, 777 (1984), affd. per curiam 793 F.2d 139">793 F.2d 139 (6th Cir. 1986). For example, there is no evidence here to show that there was "an honest and reasonable attempt to satisfy the requirements of the tax law," one of the four requirements for determining whether a document constitutes a "return" in determining the applicability of the addition to tax under section 6651(a)(1). Beard v. Commissioner, supra at 777.Issue 3: DamagesRespondent has moved for the imposition of damages on petitioner under section 6673. Under such provision, damages in an amount not in excess of $ 5,000.00 shall be awarded "whenever it appears to the Tax Court that proceedings before it have been instituted or maintained by the taxpayer primarily for delay [or] that the taxpayer's position in such proceeding is frivolous or groundless * * ." Petitioner's 1982 income tax return asserts that he realized no taxable income during the year because he was an "agent of Religious293 Order" and had taken a "Vow of Poverty." The same position is set out in his petition. In passing, we note that the petition appears to be a form petition to which petitioner simply added his name, address and certain other information before filing. Petitioner failed to respond to the request for admissions which respondent served on him on March 27, 1989, more than eight months prior to trial, and he refused to enter into a stipulation of facts with respondent. Petitioner was notified of the trial setting of his case by notice dated July 2, 1987, five months beforehand, but at trial, he presented no evidence to support his theory and, in fact, abandoned it and took the position that wages do not constitute income. Further, in a letter to respondent's counsel dated April 24, 1987, petitioner stated that "[I]t was a mistake on my part to petition the Tax Court and I apologize for wasting your time and the courts [sic] time." Petitioner's course of conduct convinces us that he instituted and maintained this action primarily for purposes of delay. Further, his claims are frivolous and groundless. Accordingly, we award damages to the United States in the amount of $ 1,500.00. *294 To reflect the foregoing, Decision will be entered for respondent.Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue, and all rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated. ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622032/	JOSEPH WARGANZ and ELISA WARGANZ, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentWarganz v. CommissionerDocket Nos. 14252-79, 8218-80.United States Tax CourtT.C. Memo 1981-403; 1981 Tax Ct. Memo LEXIS 340; 42 T.C.M. (CCH) 568; T.C.M. (RIA) 81403; August 5, 1981. Joseph Warganz, pro se. Steven I. Klein, for the respondent. DAWSONMEMORANDUM FINDINGS OF FACT AND OPINION DAWSON, Judge: This case was assigned to and heard by Special Trial Judge Fred R. Tansill pursuant to the provisions of section 7456(c) of the Internal Revenue Code1 and Rules 180 and 181, Tax Court Rules of Practice and Procedure.2 The Court agrees with and adopts his opinion which is set forth below. OPINION OF THE SPECIAL TRIAL JUDGE TANSILL, Special Trial Judge: Respondent determined deficiencies343 in petitioners' federal income taxes for 1976 (docket No. 8218-80) and 1977 (docket No. 14252-74) in the amounts of $ 3,464.92 and $ 512, respectively, and a $ 252.51 addition to tax under section 6653(a) for 1976. Due to various concessions by both parties at the hearing and on brief, including respondent's decision not to pursue the addition to tax, the remaining issues for decision are: (1) whether $ 7,833 received by petitioner Joseph Warganz while on sabbatical leave from his employer, County College of Morris, is includable in gross income for 1976 or excludable as a fellowship grant under section 117; (2) whether under section 274(d) petitioners have substantiated employee business expenses in excess of the $ 4,090.22 allowed by respondent in his notice of deficiency for 1976; (3) whether petitioners earned taxable income from the lease of their personal residence in 1976; (4) whether under section 38 petitioners are entitled to an investment tax credit for the purchase of a dictation machine in 1976; and (5) whether under section 280A petitioners are entitled to deduct the cost of maintaining an office in their home. FINDINGS OF FACT Some of the facts have been stipulated344 and those facts are so found. Petitioners filed joint federal income tax returns for 1976 and 1977 with the Internal Revenue Service. At the time the petition herein was filed, petitioners resided at Boonton, New Jersey. Since September 1, 1968, and continuing to the present time, petitioner Joseph Warganz (hereinafter "petitioner") has been employed as a professor of philosophy with the County College of Morris ("CCM") in New Jersey. During 1974 he applied for sabbatical leave for the 1975-1976 academic school year. On June 20, 1975 petitioner was notified by the president of CCM that he was awarded sabbatical leave for the Spring Semester, February 1 through June 30, 1976, with compensation in the amount of $ 7,833. The notification further advised petitioner to make arrangements with the business office concerning appropriate salary payments during his period of leave. Sabbatical leave was a fringe benefit pursuant to a collective bargaining agreement ("agreement") between CCM and the Faculty Association of the County College of Morris, Inc. To be considered for sabbatical leave pursuant to the agreement, petitioner had to submit an application containing a detailed345 prospectus of his intended activity, including purpose, objective and plans, and had to describe explicitly how the proposed activity would increase his value to the college. According to the agreement, the purpose and use of sabbatical leave was as follows: Sabbatical leaves are awarded by the Board of Trustees to selected members of the full-time teaching faculty to foster their creative activities related to their teaching disciplines, which will increase their professional effectiveness and usefulness to the College. Acceptable pursuits include * * intellectual activities or travel clearly relevant to and designed to enhance the recipient's value to the College. Eligibility for sabbatical leave was limited to faculty members who had completed six consecutive years of full-time active service with CCM. Upon acceptance of a sabbatical leave award, a recipient was required to signify, as did petitioner, his obligation to remain in the service of CCM for a period of not less than two consecutive years following expiration of the leave. Petitioner's employment benefits continued to accrue during his sabbatical leave. On his 1976 return, petitioner excluded the $ 7,833 from346 his gross income contending that it was excludable as a fellowship grant. Respondent, in his notice of deficiency, included the $ 7,833 in petitioner's gross income maintaining that it constituted compensation. In accordance with the terms of his sabbatical leave application, petitioner, accompanied by his wife and son, traveled to the Philippines to study the last writings of the Spanish philosopher, Francisco Marin-Sola, which were collected in the archives of the University of Santo Tomas in Manila. Before arriving in the Philippines, however, petitioner and his family flew from New York City to New Zealand, where they stayed for four weeks and then flew from New Zealand to Australia where they stayed for another week. While in New Zealand and Australia, petitioner casually inquired at six universities about future employment opportunities for him after he fulfilled his two-year post-sabbatical leave commitment with CCM. In addition, he spoke to professors at the various universities about instituting an exchange professorship with CCM. Petitioner and his family arrived in Manila, Philippines on February 19, 1976. For four months they stayed at the home of petitioner's347 in-laws whom they had visited many times in past years. To help defray household expenses during their visit, petitioner contributed money to his in-laws. During those four months, petitioner commuted to the University of Santo Tomas where he studied the writings of Marin-Sola. Petitioner's in-laws' home was not conducive to his work habits, so for the last two months of their stay in the Philippines, petitioner and his family rented the home of a vacationing executive. In addition, he hired the executive's secretary to do his typing. Petitioner's wife cannot type. The writings of Marin-Sola were in Spanish. Petitioner, fluent in Latin but not conversant in Spanish, quickly learned to translate the Spanish writings due to his Latin education. His wife, though fluent in Spanish, only incidentally assisted petitioner in translating the writings. Petitioner and his family left the Philippines on August 9, 1976 to return to the United States. Petitioner Kept no diaries, records or documents which would substantiate specific employee business expenses incurred during his sabbatical leave. The only evidence of his expenses consisted of copies of checks payable to cash and348 credit transfer slips which he submitted to respondent during audit. On his 1976 return, petitioner deducted the following employee business expenses in connection with his sabbatical leave: Airplane fares$ 4,787.97Meals and lodging6,645.46Dictating machine230.86Shots38.00Total$ 11,702.29These figures include expenses incurred on behalf of petitioner's wife and son. The parties stipulate that airplane fares amounted to $ 1,914.84 each for petitioner and his wife and $ 959.09 for his son. In his notice of deficiency for taxable year 1976 respondent allowed only $ 4,090.22 of the claimed employee business expenses consisting of the following: Airplane fare for petitionerJoseph Warganz$ 1,914.84One-third (1/3) of total cashoutlay verified of $ 5,719.551,906.52Dictating machine230.86Shots38.00Total$ 4,090.22Petitioner claims that in addition to the $ 7,612 of disallowed employee business expenses, he is entitled to a further deduction of $ 3,685.54 as employee business expenses incurred in connection with his sabbatical leave. While petitioner and his family were away on sabbatical leave, petitioner rented349 the family residence in Booton, New Jersey to a Mr. Walker for approximately 8 months. Petitioner received total rental income in the amount of $ 2,975 but did not report any of it on his 1976 return. Respondent concedes that petitioner is entitled to an itemized deduction for his real estate taxes and mortgage interest paid during the year in connection with the Boonton residence. Petitioner did not deduct any expenses incurred in connection with the rental of the Boonton residence and submitted no evidence as to what they might have been. In 1976, petitioner purchased a dictation machine for $ 230.86 which he deducted in full on his 1976 return and respondent allowed as an employee business expense. Petitioner now claims he is simultaneously allowed an investment tax credit of $ 23.09 in 1976 for the purchase of the dictation machine. In 1977, petitioner constructed an office in the basement of his home in which he performed many professorial responsibilities, conducted his real estate investments and wrote an introductory textbook on philosophy (another aspect of his sabbatical leave application). CCM provided petitioner with an office on campus which he admits is his350 principal place of business with respect to his employment as a professor. Petitioner earned no income in 1977 from writing his textbook which he finished in January of 1978. At present, the book has not been published. On his 1977 return, petitioner claimed miscellaneous deductions in the amount of $ 1,909.54 which included deductions of $ 942.89 for home office expenses, $ 627 for typist services, and $ 15.43 for depreciation on a rug used in his home office. In his notice of deficiency pertaining to 1977, respondent disallowed $ 1,585.32 of petitioner's miscellaneous deduction consisting of the home office expense, typist service and rug depreciation mentioned above. Respondent now concedes petitioner is entitled to deduct $ 627 for typist services. OPINION Section 117(a) provides for the exclusion from gross income of amounts received "as a fellowship grant," subject to the limitations contained in section 117(b) (none of which is in issue here). According to section 1.117-4(c), Income Tax Regs., section 117 does not permit the exclusion of payments351 which represent compensation for past, present, or future services. However, if the primary purpose of the grant is to further the education and training of the recipient, then the amount can qualify as a fellowship grant. Section 1.117-4(c)(2), Income Tax Regs. In Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, 751 (1969), the Supreme Court upheld the validity of this regulation, comporting as it does with the "ordinary understanding of 'scholarship' and 'fellowships' as relatively disinterested, 'no-strings' educational grants, with no requirement of any substantial quidproquo from the recipients." The primary purpose of the County College of Morris in paying the funds to petitioner determines whether he received a fellowship grant. Bailey v. Commissioner, 60 T.C. 447">60 T.C. 447, 451 (1973). It is clear to us that the County College of Morris was not motivated by disinterested generosity in making the sabbatical leave payments to petitioner. CCM expected to receive benefit from the tasks pursued by petitioner during his sabbatical leave. Factors considered in reviewing his application included whether the proposed activities352 would increase petitioner's "professional effectiveness and usefulness to the College" and whether they were relevant to and designed to enhance the recipient's value to the College. Given this, it is reasonable to conclude that if no benefit to CCM had been evident from petitioner's application for sabbatical leave, it would not have been granted. It is equally clear that petitioner earned his sabbatical leave. Sabbatical leave was a negotiated fringe benefit for faculty at CCM. A faculty member was required to have been employed at CCM for no less than six consecutive years before becoming eligible to take sabbatical leave. Further, the faculty member was obligated to return to CCM for at least two years after the sabbatical leave. Thus, we conclude that petitioner was granted sabbatical leave in recognition of his past services and in consideration of his commitment to perform future services. See Turem v. Commissioner, 54 T.C. 1494">54 T.C. 1494, 1506-1507 (1970). In determining the allowable amount of petitioner's claimed employee business expense deduction, respondent disallowed the portion of expenses incurred on behalf of petitioner's wife and son during their travel353 in New Zealand, Australia and the Philippines maintaining that no bona fide business purpose existed for their presence on the trip. We agree. Section 162 allows a taxpayer to deduct travel, meal and lodging expenses incurred while away from home in pursuit of a trade or business. However, with regard to such expenses incurred by family members who accompany a taxpayer on a business trip, section 1.162-2(c), Income Tax Regs., provides: Where a taxpayer's wife accompanies him on a business trip, expenses attributable to her travel are not deductible unless it can be adequately shown that the wife's presence on the trip has a bona fide business purpose. The wife's performance of some incidental service does not cause her expenses to qualify as deductible business expenses. The record lacks any evidence of a bona fide business purpose with regards to the presence of either petitioner's wife or son during petitioner's trip to New Zealand, Australia and the Philippines. Their presence was purely the result of a personal choice and, consequently, their expenses354 are nondeductible. Guglielmetti v. Commissioner, 35 T.C. 668 (1961). 3Inasmuch as the parties stipulate that petitioner's airplane fare was $ 1,914.84 (which respondent properly allowed as an employee business expense deduction in addition to the cost of a dictation machine and shots), the only employee business expense remaining in dispute is the deductible amount of petitioner's meal and lodging expense. Respondent determined that the meal and lodging expenses attributable solely to petitioner amounted to $ 1,906.52. Before a taxpayer is entitled to a deduction for meal and lodging expenses that qualify as ordinary and necessary business expenses under section 162, he must satisfy the substantiation requirements of section 274(d). Section 274(d) provides that no business expense deduction is allowable for traveling expenses (including meals355 and lodging while away from home) "unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating his own statement (A) the amount of such expense or other item, (B) the time and place of the travel * * , [and] (C) the business purpose of the expense or other item * " Petitioner did not introduce into evidence any records which might indicate that he is entitled to the meal and lodging expenses claimed. Rather, he relies on statements made by respondent's agent and an informal Internal Revenue Service publication which he claims permits him to deduct a standard allowance of $ 44/day without need of records. Deductions are a matter of legislative grace. A taxpayer seeking a deduction must be able to show that he comes within the express provisions of the statute. New Colonial Ice Co. v. Helvering, 292 U.S. 435">292 U.S. 435, 440 (1934). It has become axiomatic that neither respondent nor this Court is bound by erroneous advice given taxpayers by respondent's agents. Dixon v. United States, 381 U.S. 68">381 U.S. 68, 73 (1965). Furthermore, 356 whether or not petitioner correctly interpreted the Internal Revenue Service publication, it is clear that he may not rely on an informal publication to support a deduction where the tax statute denies it. Johnson v. Commissioner, 620 F.2d 153">620 F.2d 153 (7th Cir. 1980), affirming a Memorandum Opinion of this Court. In short, we must follow the statutes, regulations, and case law in determining whether a deduction is allowable. In the instant case, petitioner has failed to introduce adequate records required under section 274(d) to substantiate his meal and lodging expenses. Accordingly, we sustain respondent's determination as to petitioner's employee business expense deduction. Petitioner did not report the income he received in 1976 from renting the family residence while he and his family were away on sabbatical leave. He half-heartedly explained that had he properly reported the rental income from his Boonton residence, it would have been offset by deductons he would have claimed, e.g., depreciation, and therefore he thought it was not necessary to report the income. We find this reasoning appalling from a taxpayer who is well familiar with the proper reporting of357 rental income from rental property he owns. The income is fully taxable and petitioner is required to report it on his return against which appropriate deductions may be taken. Absent the itemized deductions taken by petitioner, and allowed by respondent, with respect to real estate taxes and mortgage interest, petitioner presented no evidence of other expenses incurred in connection with the rental of the Boonton residence. Accordingly, the rental income must be reported in full. To be entitled under section 38 to an investment tax credit on the purchase of his dictating machine, petitioner must show that the machine falls within the definition of section 38 property. Section 48(a)(1) defines section 38 property as including tangible personal property with respect to which depreciation is allowable. Section 1.48-1(b), Income Tax Regs., provides that a deduction for depreciation is allowable if the property is of a character subject to the allowance for depreciation under section 167 and the basis (or cost) of the property is recovered through a method of depreciation.358 However, a deduction for depreciation is not "allowable" if the cost is recovered through deduction of the full cost in one taxable year Section 1.48-1(b)(3), Income Tax Regs.; Coca-Cola Bottling Co. of Baltimore v. United States, 487 F. 2d 528 (Ct. Cl. 1973). In the instant case, petitioner fully expensed the dictating machine by deducting its full cost on his 1976 return. By so doing, the basis of the machine was reduced to zero, rendering the machine undepreciable, and therefore it does not simultaneously qualify as section 38 property entitled to an investment tax credit. Section 280A allows a taxpayer to deduct expenses attributable to a portion of his dwelling unit which is used exclusively and on a regular basis as a taxapyer's principal place of business. Section 280A(c)(5) limits the deduction so as not to exceed the gross income derived from such use. In view of these requirements, we coclude that none of the activities undertaken by petitioner in his home office will support a home office expense deduction. First, petitioner's real359 estate investment activity cannot support the deduction because it has not been shown that such activity amounted to a trade or business, a necessary element under section 280A(c)(1)(A). Curphey v. Commissioner, 766">73 T.C. 766 (1980), on appeal (9th Cir. Nov. 24, 1980). Second, insofar as section 280A(c)(5) limits a home office expense deduction from exceeding the gross income derived from the use of the home office, petitioner cannot base his deduction on his book writing activity which earned him no income in 1977. Lastly, petitioner readily admits his office on CCM's campus was his principal place of business with respect to his employment as a professor. Therefore, by his own admission, the use of his home office with respect to his professorial activities does not meet the requirements of section 280A. The fact that it is maintained for the convenience of CCM is irrelevant if the threshhold requirement that it be his principal place of employment is not met. Finally, for petitioner's sake, we note that the appropriate and helpful test raised by petitioner was the old test applied before the enactment of section 280A. See section 162(a); Peiss v. Commissioner, 40 T.C. 78">40 T.C. 78, 83-84 (1963).360 Inasmuch as petitioner is not entitled to a deduction for home office expenses, he cannot deduct depreciation of the rug used in the home office. Decisions will be entered under Rule 155. Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated. ↩2. Pursuant to the order of assignment, on the authority of the "otherwise provided" language of Rule 182, Tax Court Rules of Practice and Procedure↩, the post-trial procedures set forth in that rule are not applicable to this case.3. See Herder v. Commissioner, T.C. Memo. 1979-323↩ (where the travel expenses of a taxpayer's children who accompanied him on a business trip were disallowed for lack of a bona fide business purpose".	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622033/	LLOYD PATTERSON and CHARLENE PATTERSON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentPatterson v. CommissionerDocket No. 697-72.United States Tax CourtT.C. Memo 1973-39; 1973 Tax Ct. Memo LEXIS 245; 32 T.C.M. (CCH) 181; T.C.M. (RIA) 73039; February 15, 1973, Filed Charles H. Creason, for the petitioners. David R. Brennan, W. Durrell Nielsen and C. Garold Sims, for the respondent. DAWSONMEMORANDUM FINDINGS OF FACT AND OPINION DAWSON, Judge: Respondent determined a deficiency of $5,167.14 in petitioners' Federal income tax for the year 1969. 2 Concessions having been made by the parties, the only issue remaining for our decision is whether the petitioners constructively received in 1969 an $18,000 payment actually received from J. R. Simplot Company on January 5, 1970. FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. Lloyd and Charlene Patterson (hereinafter called petitioners) are husband and wife who resided in Paul, Idaho, when they filed their petition in this proceeding. Their joint Federal income246 tax return for the year 1969 was filed with the Western Service Center at Ogden, Utah. During 1969 Lloyd Patterson was a farmer. On June 17, 1969, he entered into a potato growing agreement and a modification agreement with J. R. Simplot Company. In the fall of 1969 the potato crop, which was governed by the terms of the potato growing agreement, was harvested and stored in petitioners' storage facilities. Petitioners received moneys under the provisions of the potato growing agreement as follows: DateAmount11-7-69$ 1,500.001-5-7018,000.003-6-704,867.94Total$24,367.94 3 The petitioners reported the amounts received as income in the year of receipt. The amounts paid include payments under section III, 2(i), providing payment for the storage of potatoes in petitioners' facilities. The potatoes harvested under the potato growing agreement were delivered to J. R. Simplot Company on the following dates: DatePounds DeliveredPrice2-19-703,061.0$ 6,105.282-20-706,756.212,821.972-21-702,917.45,440.69Total12,734.6$24,367.94On such dates, the potatoes were inspected by the Federal-State247 inspection service pursuant to section IV of the potato growing agreement. On January 3, 1970, Rex Rasmussen, field manager of J. R. Simplot Company inspected and measured the potatoes held in storage by petitioners. The company approved the payment of $18,000 to petitioner Lloyd Patterson on that date. If petitioner had requested Rasmussen to make the inspection and estimate in late 1969, Rasmussen would have done so, and the payment would have been made by the company in 1969. On January 5, 1970, the day petitioner Lloyd Patterson received the $18,000 payment from J. R. Simplot Company, he insured the potatoes through SAFECO Insurance Company. The insurance policy contained a loss payable clause in favor of J. R. Simplot Company. 4 The term "delivered" means the time when the potatoes were physically removed from petitioners' storage facility to the facilities of J. R. Simplot Company. J. R. Simplot Company agreed to compensate petitioners for the use of their land and for services in growing the potato crop. It had title to and ownership of the potato crop. It could enter on the land and take care, control and management of the potato crop if the petitioners did248 not use proper care. J. R. Simplot Company filed an appropriate security agreement to perfect its interest in the potato crop. It inspected the crop as it was growing in the fields of the petitioners. Petitioners had the risk of loss for damage to the potato crop until insured. Petitioners were entitled to additional compensation for storing the potatoes from the date of harvest until the date of delivery to J. R. Simplot Company. After deducting the cost of services, seed, materials and cash advances made by J. R. Simplot Company, the petitioners were entitled to one-half of the proceeds of the potato crop at the time of harvest, one-fourth at petitioners' option on December 31, 1969, or January 5, 1970, and the balance by March 15, 1970, or when the potatoes were delivered, whichever was later. Petitioners' potato crop was harvested in late September or early October of 1969. 5 J. R. Simplot was capable of making payments to petitioners under their agreement in December 1969. All petitioners needed to do to receive payment was to request inspection and payment in December 1969. Petitioners were entitled to three-fourths of the potato crop proceeds on or249 by December 31, 1969. In his notice of deficiency dated November 30, 1971, the respondent determined that the petitioners constructively received gross income of $18,000 in the year 1969. ULTIMATE FINDINGS The $18,000 payment was available to petitioners without any substantial restriction on or by December 31, 1969. They alone controlled the date of the $18,000 payment and it was through their own volition that the payment was deferred from December 31, 1969, to January 5, 1970. Therefore, the amount of $18,000 was constructively received by petitioners in the taxable year 1969. OPINION It is settled law that income which is subject to a taxpayer's unfettered command and which he is free to enjoy at his own option is taxed to him as his income whether he sees fit to enjoy it or not. See Corliss v. Bowers, 281 U.S. 376">281 U.S. 376 (1930); Loose v. United States, 74 F.2d 147">74 F.2d 147, 150 (C.A. 8, 1934); and Ralph Romine, 25 T.C. 859">25 T.C. 859 (1956). The doctrine of constructive receipt is applied where a cash basis 6 taxpayer is presently entitled to money which250 is made immediately available to him and his failure to receive it in cash is due entirely to his own volition. The test of taxability is not the actual receipt of income but the present right to receive it. Irish v. Commissioner, 129 F.2d 468">129 F.2d 468 (C.A. 3, 1942), affirming 43 B.T.A. 864">43 B.T.A. 864 (1941). In other words, "a taxpayer may not deliberately turn his back upon income and thus select the year for which he will report it." Hamilton National Bank of Chattanooga, Administrator, 29 B.T.A. 63">29 B.T.A. 63, 67 (1933); Cecil Q. Adams, 20 B.T.A. 243">20 B.T.A. 243 (1930), affirmed 54 F.2d 228">54 F.2d 228 (C.A. 1, 1931). Section 1.451-2, Income Tax Regs., provides that income not actually reduced to possession is constructively received and includable in gross income when it is credited, set apart or otherwise made available to the taxpayer. Income available and subject to the demand of the taxpayer is treated as received by him at the time it becomes available regardless of the time of actual receipt. Ralph Romine, supra.251 The potato growing agreement executed by petitioners and the J. R. Simplot Company provided in section III that Simplot would compensate petitioners for the use of their land and for their services for growing a potato crop. The final amount was to be determined after the potatoes were harvested and graded. Title to and ownership of the potato crop was in Simplot, and Simplot could 7 enter on the land and take active care, control and management of the crop if the petitioners did not use proper care. Simplot further filed an appropriate security agreement to perfect its interest in the crop. However, the risk of loss for damage to the potatoes was on petitioners until a significant advance was made by Simplot, at which time the potatoes were then insured with a loss payable clause in favor of Simplot. Under section VII of the modification agreement the petitioners were entitled to, after deducting the cost of services, seed, materials and cash advances made by Simplot, one-half of the proceeds of the potato crop at time of harvest, one-fourth at petitioners' option on December 31, 1969, or January 5, 1970, and the balance by March 15, 1970, or when the potatoes were delivered. 252 Thus, petitioners were entitled to three-fourths of the proceeds on or by December 31, 1969. As we see it, there was no substantial restriction or limitation on the receipt of the $18,000 in late 1969.Under the agreement with Simplot the petitioners needed only to request payment. Mr. Rasmussen, an employee of Simplot, would then inspect the potatoes in storage and estimate payment. He had over 23 years experience and he determined that the potatoes were in excellent condition. In addition, when the payment was made, the potatoes were insured with a loss payable clause in favor or Simplot. The Simplot employee 8 would estimate the payment so that it would not exceed three-fourths of the total proceeds. Hence the risk of loss to petitioners was minimal, if any, and the only restriction on the receipt of the $18,000 was that they request it. It is true that a possibility existed that, if the potatoes went bad before delivery to Simplot, petitioners would have to reimburse it for part of the advance. However, the law is clear that income must be determined as of the close of the253 taxable year without regard to subsequent events. Penn v. Robertson, 115 F.2d 167">115 F.2d 167 (C.A. 4, 1940). Income for a cash basis taxpayer is accountable in the year of receipt or in the year it could have been received, and if the taxpayer is required to restore it in a subsequent year, he is entitled to claim a deduction for the repayment in the year the repayment is made. North American Oil Consolidated v. Burnet, 286 U.S. 417">286 U.S. 417 (1932); Anderson v. Bowers, 170 F.2d 676">170 F.2d 676 (C.A. 4, 1948). The main thrust of petitioners' position is that they did not have an unqualified right to receive income in 1969 in the form of advancements. They rely principally on two cases, namely, Wilfred Weathers, 12 T.C.M. (CCH) 314">12 T.C.M. 314 (1953), and Lloyd S. Elder, 9 T.C.M. (CCH) 59">9 T.C.M. 59 (1950). We think both of these are distinguishable on their facts. In each the constructive receipt doctrine was held to be inappropriate because one of the prongs of proof necessary to sustain its application was absent. For the raiments of this doctrine to fit, two 9 determinations, 254 both factual, are necessary. First, there must be an obligation to pay an amount inuring in favor of the taxpayer. Second, the taxpayer must have a concomitant right to demand payment. Richards' Estate v. Commissioner, 150 F.2d 837">150 F.2d 837 (C.A. 2, 1945). The Weathers case misses the gravamen of respondent's position in the instant case. There the Court was confronted with a different issue. It was not concerned, as it is here, with whether an advance, capable of being requested by the taxpayer, constituted the constructive receipt of income. Instead, it was faced with determining the efficacy of an oral agreement which modified the terms of an erstwhile contract. Having once decided that the oral contract was binding, we concluded that the taxpayers' buyer was not obligated to pay and the taxpayers did not have a right to demand payment in the year in question.Therefore, the constructive receipt doctrine was held to be inapplicable. Furthermore, unlike the circumstances in Weathers, the petitioners' contract in this case did not specify that payment was to be made in a subsequent year. On the contrary, the petitioners had an absolute right to one-half of the amount255 of the sale at the time of harvest and one-fourth on either December 31, 1969, or January 5, 1970 - the date of demand of the latter payment being reserved to, and entirely within the volitional control of the petitioners. In Weathers the oral modification created an obligation in the buyer and a right in the seller in a subsequent 10 tax year; here, by contrast, the contract provided that J. R. Simplot Company, the buyer, was obligated to pay, and the petitioners had a right to demand payment of three-fourths of the selling price in the year 1969. In the Elder case neither requirement of the constructive receipt doctrine was satisfied - (1) the taxpayer's employer denied any obligation to pay the taxpayer until a final settlement was reached and (2) the speculative nature of the taxpayer's commissions made any settlement impossible. The taxpayer had no rightful demand to any commissions in advance. Here there was a specific provision in the modification agreement which guaranteed a partial settlement in 1969. Moreover, Rex Rasmussen's testimony supports the conclusion that the petitioners had a right, exercisable under the contract, which insured payment in 1969 of three-fourths*256 of a determinable amount. All that was required was the petitioners' communication of a request for payment which triggered an inspection and estimate and then a payment. The contract unequivocally provided for these settlements and, if the potatoes were satisfactory, which they in fact were, Simplot was under an obligation to pay the petitioners pursuant to its terms. Accordingly, we hold that the petitioners constructively received the $18,000 payment in 1969 and they must include that amount in their gross income for that year. Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622034/	Jerry S. Turem, Petitioner v. Commissioner of Internal Revenue, RespondentTurem v. CommissionerDocket No. 944-67United States Tax Court54 T.C. 1494; 1970 U.S. Tax Ct. LEXIS 94; July 16, 1970, Filed 94 Decision will be entered for the respondent. Petitioner, an employee of the Department of Public Welfare of the City and County of San Francisco, received "maintenance payments" from the California State Department of Social Welfare during 1963 and 1964 while on educational leave and studying at the University of California's school of social welfare. Held, such payments are not excludable from petitioner's gross income as scholarships or fellowship grants. Sec. 117(a), I.R.C. 1954; sec. 1.117-4(c), Income Tax Regs.Jerry S. Turem, pro se.Harry M. Asch, for the respondent. Raum, Judge. RAUM95 1494 OPINIONThe Commissioner determined deficiencies in the income tax of Jerry S. and Jeanne L. Turem for the calendar years 1963 and 1964 in the amounts of $ 596.04 and $ 324.43, respectively. The only question for decision is whether amounts received by petitioner, Jerry S. Turem, during 1963 and 1964 are excludable from gross income as scholarships or fellowship grants under section 117, I.R.C. 1954. The facts have been stipulated.Petitioner, Jerry S. Turem, and his wife, Jeanne L. Turem, filed joint Federal income tax returns for the calendar years 1963 and 1964 with the district director of internal revenue, San Francisco, Calif. The taxpayers have subsequently been divorced. The petitioner resided in Madison, Wis., when the petition in this case was filed.Between September of 1953 and February of 1957, petitioner attended undergraduate college first at the University of North Carolina and subsequently at the University of Connecticut, majoring in psychology at each school. From February of 1960 until June of 1961, he attended San Francisco96 State College where he majored in liberal arts ("creative writing") and received an A.B. degree.In October of 1961, petitioner took a job with the Department of Public Welfare of the City and County of San Francisco (the county 1495 department) as a social worker with temporary status, and in July of 1962, he achieved permanent employee status, with the title and duties of a senior social service worker.At that time Federal, State, and local governments were jointly involved in the funding and administration of social welfare programs in the State of California. The Federal Government provided a substantial portion of the funding for such programs, but delegated to California's State and local governments the responsibility for administering the funded programs. Under titles I, IV, X, XIV, and XVI of the Federal Social Security Act (42 U.S.C. sec. 301 et seq. (1964)), State governments were required to satisfy the applicable Federal requirements in order to qualify for the Federal funds available for various public-assistance programs. One such requirement was that the State submit for the approval of the Secretary of the Department97 of Health, Education, and Welfare (HEW) a "state plan" which met the applicable Federal requirements. See 42 U.S.C. secs. 301, 302, 601, 602, 705, 1201, 1202, 1351, 1352, 1381, 1382 (1964). Ordinarily, under its plan, a State could either directly administer the program in question and disburse public-assistance payments itself or delegate such functions to local government organizations which remained subject to its supervision. The State of California chose the latter plan.The CaliforniaWelfare and Institutions Code (Welfare Code) 1 declared the provision of social services to be "a matter of statewide concern." Accordingly, the California State Department of Social Welfare (CSDSW) was charged with the responsibility for supervising the provision of public assistance throughout the State and ensuring compliance with the applicable Federal and State regulations:§ 10600. Supervisory agency. It is hereby declared that provision for public social services in this code is a matter of statewide concern. The department is hereby designated as the single state agency with full power to supervise every phase of the administration of the public98 social services for which grants-in-aid are received from the United States government or made by the state in order to secure full compliance with the applicable provisions of state and federal laws. * * § 10603. Advice and supervision. The department shall advise public officers regarding the administration of public social services by public agencies throughout the state, and shall supervise the administration of state aid to all persons receiving or eligible to receive state aid. * § 10604. Administration of funds; conditions; standards. In administering any funds appropriated or made available to the department for disbursement through the counties for welfare purposes, the department shall:1496 (a) Require as a condition for receiving such grants-in-aid, that the county shall bear that proportion of the total expense of furnishing aid, as is fixed by the law relating to such aid.(b) Establish regulations, not in conflict with the law fixing statewide standards for the administration of all state or federally aided public social service programs, defining and controlling the conditions under which aid may be granted or refused. All regulations established99 by the department shall be binding upon the boards of supervisors and the county department. * * § 10613. Agent of federal government. The functions of the department may include the administration and the supervision of the administration of public social services within this state as an agent of the federal government, and acting as a service agency for the federal government in the field of social service and welfare.California county governments ultimately received Federal and State funds and disbursed them, along with county funds, in the form of public-assistance payments (Cal. Welf. & Inst'ns Code sec. 10800):§ 10800. Administration as county function; establishment of county department. The administration of public social services in100 each of the several counties of the state is hereby declared to be a county function and responsibility and therefore rests upon the boards of supervisors in the respective counties pursuant to the applicable laws, and in the case of public social services for which federal or state funds are provided, subject to the regulations of the department.For the purpose of providing for and carrying out this function and responsibility, the board of supervisors of each county, or other agency as may be otherwise provided by county charter, shall establish a county department, unless otherwise provided by the county charter. Except as provided herein, the county department shall be the county agency for the administration of public social services and for the promotion of public understanding of the public social services provided under this code and the problems with which they deal.As a result, county departments served the applicants for and recipients of public assistance in California, but they remained subject to substantial bodies of Federal and State regulations regarding such matters as personnel standards, hearings, reports, records, and qualifications for aid. The relationship101 between State and Federal regulations and county responsibility is exemplified by the statutory provision governing personnel standards (Cal. Stats. 1963, ch. 1916, sec. 40, pp. 3927-3928, repealed id. 1969, ch. 1283, sec. 6, p. 2514):Standards. For the purposes of the administration of state or federally supported public social services, the director [of CSDSW] shall, by regulation, establish and maintain personnel standards on a merit basis (including therein standards of qualifications, competency, education, experience, tenure and compensation) necessary for proper and efficient administration, and to assure state conformity with applicable federal requirements.In the exercise of his functions under this section, the director shall exercise no authority with respect to the selection, tenure of office and compensation of any individual employed in accordance with such standards.1497 Nothing in this section shall prevent any county from establishing its own merit system and determining thereunder the personnel standards to be applicable to its employees, but as to employees engaged in administering state and federally supported public social services, such county systems102 and standards shall be subject to approval and review by the department.A "state" plan under titles I, IV, X, XIV, and XVI of the Social Security Act was required to "provide such methods of administration * * as are found by the Secretary [of HEW] to be necessary for the proper and efficient administration of the plan." 42 U.S.C. secs. 302(a)(5), 602(a)(5), 1202(a)(5), 1352(a)(5), and 1382(a)(5) (1964). In connection with these provisions, the Social Security Act authorized Federal funding of 75 percent of expenditures made for "the training of personnel employed or preparing for employment by the State agency or by the local agency administering the plan in the political subdivision." See 42 U.S.C. secs. 303(a)(4)(A)(iv), 603(a)(3)(A)(iv), 1203(a)(3)(A)(iv), 1353(a)(3)(A)(iv), and 1382(a)(4)(A)(iv) (1964). HEW's "Handbook of Public Assistance Administration," dated October 16, 1963, stated (sec. 3250):3250. Opportunities for Technical and Professional EducationOpportunities for technical and professional education contribute to proper and efficient administration by increasing the number of adequately103 trained personnel to fill specified agency positions. Provision for educational leave is based on the premise that certain classes of positions require technical or professional education to insure the knowledge and skill necessary for public assistance administration and that such education should ordinarily be at the graduate level. The State agency must determine the positions that require professional or technical training in accordance with agency program objectives. If staff with the required qualifications are not available through the normal recruitment and selection devices, the agency will make available, to selected personnel within the agency or to personnel specifically recruited and appointed for training purposes, the opportunity to obtain the professional or technical training needed for assignment in such positions upon completion of the educational experience. Persons with employment status in the agency are more likely to be willing and able to fulfill their obligation upon completion of training. However, should personnel of superior capacity with employment status in the agency not be available, then persons selected to prepare for employment may be awarded104 training grants to obtain the training necessary to qualify them for such positions.With regard to selection and compensation of the employees involved in educational programs, the HEW handbook stated (sec. 3251):3251. Plans for Selection of Staff for Educational GrantsAn adequate payment for salary and educational expenses for employees, adequate training grants for persons preparing for employment, and a plan for systematic and objective evaluation of candidates are essential to assure the selection of persons with greatest potentiality for contributing to improvement of the agency's services following the period of study.In March of 1962, petitioner applied to the California State Department of Social Welfare (CSDSW) for an educational stipend for 1498 study in social work at the University of California's Berkeley campus.Section 10907 of the Welfare Code authorized the board of supervisors of any county to --provide educational leaves to employees under such conditions as may be prescribed in an agreement or plan entered into by this state with the federal government.Section 10900 of the Welfare Code and the federally approved State Child Welfare and Public105 Assistance Staff Development Plan authorized CSDSW to grant stipends for education in social work to county welfare department employees and persons preparing for such employment. The Welfare Code declared the purpose of such grants to be (sec. 10900):to promote welfare personnel training in every county in this state, which will provide the quality and quantity of trained personnel required to eliminate or reduce the circumstances or conditions which impede or prevent an individual or a family from making progress toward proper social adjustment, self-support, and self-direction.The CSDSW Manual, sec. SD-540.10 (Aug. 1, 1962), stated that the stipend program was "designed to supplement county administered educational leave programs" and that its purpose was "to enable the state to administer the public welfare programs more effectively":The SDSW graduate stipend program is basically designed to supplement county administered educational leave programs as provided for under W&IC Section 300. 2 Under this section, county welfare departments may grant educational leaves with pay to their permanent employees to attend an institution of learning for the purpose of improving 106 their skills, knowledge, and techniques in the administration of social welfare programs which will benefit the departments as follows:.1 To develop the professional and technical skills of employees to achieve proper and efficient administration of the public social services programs in the State of California..2 To add to the reservoir of professionally trained employees required to staff the expanding public social services and programs..3 To provide incentive and motivation in the form of financial help to experienced employees engaged in the administration of public welfare programs who have shown ability and aptitude to profit from professional education, and to attract and prepare other eligible persons, for professional employment in the administration of the public assistance and child welfare programs. Since completion of the professional social work curriculum requires two years, it is to the advantage of the agency and the employee that upon satisfactory completion of the first year of graduate education, the employee be granted another educational leave to enable him to qualify for a second year State Department of Social Welfare stipend.1499 The manual also107 set forth the criteria and method of selection (sec. SD-540.50):.3 Criteria for Selection -- The selection of applicants will be made by the SDSW in cooperation with the county welfare departments, and the graduate schools of social work. Consideration will be given to:.31 The professional staff needs of county welfare departments in the administration of public social service programs. (Each year the SDSW will publish a list of counties in which students (noncounty employees) may secure employment to fulfill their employment commitment under the education stipend plan.)According to the manual, the stipends for graduate education were granted to both permanent county welfare department employees and "persons preparing for employment" who were college graduates, who were admitted to a first- or second-year program in an accredited graduate school of social work, and who resided in California. The manual (sec. SD-540.30.1) further stated that employees on educational leave were required to "sign a legally binding agreement to return to the agency granting such leave and accept employment in a professional capacity in the administration of the public welfare programs." 3108 On his application form for the stipend, petitioner signed a statement declaring that he was familiar with the conditions under which stipends were granted and that if he were awarded a stipend, he would sign an agreement with CSDSW assenting to those conditions. The application form asked petitioner to describe the kind of public-assistance work he was interested in upon completion of his studies. Petitioner's response was, "I would be interested in working in a public welfare agency in one of the categorical aid programs." The application also asked whether 109 petitioner had been granted educational leave by a county welfare department or whether he had applied or was planning to apply for such leave. Petitioner answered that he was planning to apply for educational leave. Petitioner's application was successful, and he was awarded a $ 3,293 stipend for study in social work at the University of California.Pursuant to the statement he signed in his application for the stipend, petitioner subsequently executed a form document, "Public Assistance Educational Stipend Agreement." The agreement was also 1500 executed by the Director of Public Welfare for the County of San Francisco and by a CSDSW official, and provided as follows:PUBLIC ASSISTANCE EDUCATIONAL STIPEND AGREEMENT1. This contract is made between Jerry Turem hereinafter called the Student, the State Department of Social Welfare, hereinafter called the State, and San Francisco Public Welfare Department, hereinafter called the County, as part of a Public Assistance Educational Stipend program with the purpose of increasing the number of adequately trained staff available for work in the administration of public assistance programs in this State.2. The source of funds for 110 providing these stipends are State-Federal administrative matching funds under Title I, IV, X, XIV, of the Social Security Act and sections 300 et seq. of the Welfare and Institutions Code. This agreement is made subject to all laws and regulations applicable to said funds.3. This stipend is for attendance at University of California for the period beginning September 1962 and ending June 1963 to pursue a course of study in Social Work.4. This stipend is for $ 2,970 which includes maintenance and allowance for dependents (plus an amount for the employee's and County's share of retirement as determined by the appropriate Retirement Board). This will be paid to the Student by the County in monthly increments in accordance with the attached stipend award notice.5. An expense allowance of $ 323 is also made to include tuition, fees, transportation, books, supplies, and field work travel expenses. This amount will be advanced to the Student by the County in increments in accordance with the attached stipend award notice.6. The Student agrees to use his best efforts to maintain a satisfactory performance while attending school pursuant to this agreement. The State may terminate a111 stipend after 30-days' notice if in the judgment of the State the Student's performance is unsatisfactory, or if the school determines for any reason that the Student should leave school. During such a 30-day period stipend funds will be paid; however, no expense allowance will be paid.7. The stipend and expense allowance will terminate immediately if the Student leaves school of his own volition.8. The Student is an employee of the County on educational assignment and agrees to continue in employment with the County in a public assistance program upon completion of training, for a period of one calendar year for each academic year of such educational assignment.9. The student agrees to repay all amounts received pursuant to this agreement:a. If the Student leaves school of his own volition.b. If the Student fails to return immediately to employment as specified above on completion of the stipend course, or within such additional time as may be mutually granted by the County and State.10. If the Student leaves employment with the County without approval of the State before completion of the agreed term of employment, he agrees to reimburse the County that portion of the total112 of the stipend award and expense allowance which is proportional to the uncompleted term of his employment commitment.1501 State of California,Department of Social WelfareBy: R. JamesTitleDateStudent: Jerry TuremSignature4214 California, S.F.Address8/11/62DateCounty of: San FranciscoBy: [Illegible signature]Director of Public WelfareTitleAugust 23, 1962DateBefore beginning his graduate studies, petitioner was earning a gross salary of $ 493 per month as a senior social worker.Petitioner attended the University of California at Berkeley (Berkeley) from September 1962 until June 1963. During that time he participated in the first half of a 2-year master's degree program in the school of social welfare. In early 1963 petitioner applied for a second educational stipend to complete the master's program. On his application form, he signed his name below the following statement:I understand my commitment to accept employment in a professional capacity and to remain in such employment for one calendar year for each academic year for which the educational award is granted (Employees on educational leave113 from a county welfare department agree to return to the agency granting such leave: persons not currently employed by a county agree to accept employment either with the State Department of Social Welfare, or in one of the county welfare departments designated by the State Department of Social Welfare.)The remainder of the completed form was substantially the same as petitioner's first application. His application was successful, and he was awarded a $ 3,586.50 stipend (nearly $ 300 larger than the previous year's stipend). Petitioner again executed a "Stipend Agreement," substantially identical to the form he had signed a year earlier.In total, petitioner studied at Berkeley for two 9-month periods, September 1962 to June 1963, and September 1963 to June 1964, and at the end of the second academic year, he received a master's degree in social welfare. While studying at Berkeley, petitioner maintained his status as an employee of the county department and was granted educational leave for each of the 9-month academic years. 4 However, with 1502 the exception of the requirement that petitioner maintain satisfactory progress toward a master's degree in social welfare 114 in an accredited educational institution, neither CSDSW nor the county department explicitly exercised control over his curriculum or research.The gross payments made to petitioner with respect to his 2 years of school were as follows:September 1962 -- June 1963Maintenance:$ 330 per month for 9 months$ 2,970.00Expenses323.00tuition and fees$ 173.00books and supplies50.00fieldwork travel100.00Total3,293.00September 1963 -- June 1964Maintenance:$ 360 per month for 9 month3,240.00Expenses346.50tuition and fees196.50books and supplies50.00fieldwork travel100.00Total3,586.50The portions of the stipends allocated to "expenses" were paid by CSDSW and mailed to the petitioner in care of the University115 of California. The maintenance payments were made monthly by the county department and were mailed to the petitioner at his home address to arrive at his customary payday. All such payments made by the county department were reimbursed by CSDSW. Social security taxes, Federal withholding taxes, and retirement benefit and health insurance payments were deducted from the monthly maintenance payments, and for each of the years 1963 and 1964, the county department prepared withholding tax statements which included the entire amount of the maintenance payments.In addition to the gross monthly maintenance payments described above, the county department made expenditures for certain employee benefits, such as retirement, old age, and survivors and dependents insurance, workmen's compensation, and health insurance. These expenditures by the county department were reimbursed by CSDSW. When the value of the employee benefits is added to the gross monthly maintenance payments, the monthly payments made on petitioner's behalf averaged approximately $ 369 for the first academic year and $ 407 for the second.The educational stipends paid to petitioner were financed from funds appropriated116 for local staff development to the extent of 75 percent by the Federal Government and 25 percent by the State of 1503 California. The size of the maintenance payments was determined on the basis of a policy decision to make educational stipends available to the largest number of people with the funds available, and among the factors taken into account in establishing the size of the payments were the size of similar grants made by other Government agencies and the cost of living. The parties have stipulated that "For the academic years 1963-1964 through 1968-1969, there were 1,261 graduate education stipends for study in social welfare granted to county welfare department employees and 388 of such stipends to nonemployees." The maintenance payments made to social welfare employees were larger than those made to nonemployees in the hope that the employees would thereby be induced to contribute their greater experience beyond the time period required by their stipend agreements. For similar reasons, larger amounts were paid to supervisory personnel than to nonsupervisory personnel.During his educational leave, petitioner retained his civil service classification as a senior117 social worker, his accrued sick leave and vacation leave, and his accrued seniority rights. Moreover, during the 2 academic years, petitioner continued to accrue seniority rights (which were applicable to such personnel actions as layoffs, promotions, and salary adjustments) and retirement benefits (consisting of payment by CSDSW into existing county retirement plans of both the county's share and the employee's share of the required monthly amount of benefits). If ill during his education leave, petitioner was entitled to receive the full amount of the educational stipend, and that right was considered the equivalent of and in lieu of the sick leave time which employees were ordinarily granted. School vacations were considered equivalent to and in lieu of the vacation time which employees customarily enjoyed. However, during the summer vacation which separated his 2 school years at Berkeley, petitioner was employed by the County Department as a child welfare worker at the normal salary for that position of $ 644 per month.Pursuant to the educational stipend agreements, petitioner continued his employment with the county department upon completion of his graduate education. 118 From July of 1964 through April of 1965, he was employed as a child welfare supervisor at a monthly salary of $ 710. A master's degree in social welfare was required in order to hold that position. From April of 1965 through November of that year he held the position of a senior management assistant, with a salary of $ 745 per month, and thereafter, until October of 1966, petitioner was employed as a data processing coordinator at $ 813 per month. Funds for the salaries paid to all employees in social service and child welfare 1504 positions came from Federal, State, and local sources, while funds for the salaries paid to senior management assistants and data processing coordinators came from Federal and local sources.Employees of the county department were within the jurisdiction of the San Francisco Civil Service Commission and were governed by a retirement plan limited in its coverage to employees of the City and County of San Francisco. The San Francisco Civil Service Commission and the retirement plan were completely autonomous of counterpart State systems governing State employees, including those of CSDSW.In October of 1966, petitioner terminated his employment with119 the county department.Petitioner filed joint returns for the taxable years 1963 and 1964 and excluded the monthly maintenance payments 5 from his gross income for each year. In his notice of deficiency the Commissioner determined that the payments were not excludable.Section 117(a)6 excludes from gross income any amount received "as a scholarship at an educational institution" or "as a fellowship grant." However, regulations section 1.117-4(c)7121 provides that payments representing "compensation for past, present, or future employment services" and payments made "to, or on behalf of, an individual to enable him to pursue studies or research primarily for the benefit of the grantor" are not to be considered scholarships or fellowship grants for the purpose of the exclusion authorized by section 117. These regulations have recently been upheld by the Supreme Court in Bingler v. Johnson, 394 U.S. 741">394 U.S. 741.120 The Court stated (394 U.S. at 757-758):1505 The thrust of the provision dealing with compensation [sec. 1.117-4(c)] is that bargained-for payments, given only as a "quo" in return for the quid of services rendered -- whether past, present, or future -- should not be excludable from income as "scholarship" funds. * The regulations are thus designed, at least in part, to distinguish relatively disinterested payments made primarily for the purpose of furthering the education of the recipient from payments made primarily to reward or induce the recipient's performance of services for the benefit of the payor. Cf. Elmer L. Reese, Jr., 45 T.C. 407">45 T.C. 407, 411, affirmed 373 F. 2d 742 (C.A. 4).The Commissioner contends that the payments here in issue were both "compensation for * * employment services" and payments made to enable petitioner "to pursue studies * * * primarily for the benefit of the grantor" and that therefore the payments are not excludable 122 from petitioner's gross income. We agree.HEW was the source of 75 percent of the maintenance payments and CSDSW was the source of the remainder. Each agency made its contribution in order to upgrade the quality of social services in California. Recipients were either county welfare department employees or persons preparing for such employment, and the payments were designed to enable them to be trained so that they could perform their duties in the future more effectively. As an applicant, petitioner was required to state the nature of the public-assistance work in which he was interested, and when accepted, petitioner was required to promise to continue in employment with a county public welfare department upon completion of his studies for a period of 1 calendar year for each academic year of study. Although petitioner's selection of courses was not formally subject to the review of any government agency, he was required to pursue studies in social work in an accredited graduate school and to maintain a satisfactory academic record there. Furthermore, since his stipends were granted on a yearly basis, his studies were subject to some supervision by virtue of the fact that 123 at the time he applied for a second stipend, his record could have been reevaluated. Thus, it would seem that the maintenance payments were awarded in such manner as to ensure that they would benefit CSDSW and the county department. Cf. John E. MacDonald, Jr., 52 T.C. 386">52 T.C. 386, 392-393.However, petitioner takes the position that the stipends cannot be considered compensation or payments made primarily for the benefit of the grantor because he has never been an employee of the grantor, CSDSW. 8 The argument is without merit. Social services in 1506 California were provided as the result of a cooperative effort by Federal, State, and county governments. Each government had an interest in providing social services, and they joined in a cooperative effort to provide them. The Federal Government offered substantial funds for use in social welfare programs to States complying with its requirements. The State of California accepted Federal funds, provided funds of its own, and assumed a supervisory role in the provision of social services throughout the State. California's county governments, however, were primarily responsible for the dispensation124 of social services to those in need.The educational stipend program was a result of this joint effort. The funds, provided by Federal and State sources, were designed to supplement and enhance the educational leave programs administered by the counties and thereby improve the quality of social services in the State. While a State agency, CSDSW, selected the recipients of the stipends, it did so with the advice of the counties employing the applicants and with each applicant's assurance that he had or would apply to his county welfare department for educational leave. The joint nature of the stipend grants is further reflected by the fact that each "Stipend Agreement" 125 signed by petitioner was also signed by representatives of both the State and the county. It is therefore clear to us that in providing social services and in granting petitioner's educational stipends, the State and the county were engaged in a joint enterprise, and that for the purposes of regulations section 1.117-4(c), they may both be viewed as employers of the petitioner and the grantors of his stipends.The petitioner contends, however, that since the results of his education ultimately benefited the citizenry of the State, the stipends may not be considered compensation or payments made primarily for the benefit of the grantor. We disagree. The fruits of the labor of many employees are ultimately enjoyed by the public. The fact that the State and county made no economic profit as the result of petitioner's studies does not support either the conclusion that the maintenance payments should not be considered compensation or the conclusion that the payments were not made primarily for the benefit of the grantor. 9 "Benefit" in the case of a governmental agency may mean 1507 something in addition to or different from monetary gain; it may and properly should include126 that which may be helpful in the carrying on of relevant governmental operations. CSDSW and the county department were jointly engaged in the enterprise of providing social services. They made the maintenance payments to petitioner and others in order to advance that enterprise by increasing the number of adequately trained staff available for public-assistance work. Their objective was furthered as the result of petitioner's studies. 10127 CSDSW and the county department thus made payments to petitioner in order to induce him to engage in activity beneficial to them in the conduct of their governmental functions. The payments were therefore clearly in the nature of compensation, the "quo" in the "quid pro quo" exchange to which regulations section 1.117-4(c) is addressed. See Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, 757.It is also significant that during the years in issue petitioner continued to be treated as an employee. He retained his status as a county employee. The county mailed the maintenance payments at such times as they would arrive at petitioner's home on his customary payday, and it continued to deduct Federal withholding taxes from his monthly checks. The petitioner continued to participate in social security, retirement, and insurance programs and to accrue seniority rights, sick leave time, and vacation time. Although petitioner's salary fell from $ 493 per month to $ 320 per month during the first academic year and to $ 360 per month during the second year, his education did qualify him for a position paying $ 710 per month after his studies were completed, and during the summer between his 2 years of study, he was employed by the county at the rate of $ 644 per month.The facts of this case are strikingly similar to 128 those in Marjorie E. Haley, 54 T.C. 642">54 T.C. 642. There the taxpayer, an employee of the Jackson County Public Welfare Commission in the State of Oregon, received educational leave grants from the Oregon State Public Welfare Commission to study at the University of Washington, School of Social Work. We held the grants not excludable from the taxpayer's gross income, and although the taxpayer's employment relationship to the State of Oregon in Haley was apparently more proximate than was 1508 the petitioner's relationship to the State of California in this case, we think that the two cases should be treated identically. We conclude that the maintenance payments are not excludable from petitioner's income. See also Stewart v. United States, 363 F. 2d 355 (C.A. 6), and Ussery v. United States, 296 F. 2d 582 (C.A. 5), which were both cited with approval in Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, 756 fn. 30. 11129 Petitioner relies primarily on Aileene Evans, 34 T.C. 720">34 T.C. 720, acq. 1 C.B. 4">1965-1 C.B. 4, withdrawn and nonacq, substituted 1970-1 C.B. XVII. The facts of that case are distinguishable from those presented herein since there the taxpayer had not been employed by the grantor prior to the time when the payments in issue were made. In any event, the precedential value of that opinion must be considered not only in the light of the Supreme Court's subsequent opinion in Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, see, e.g., id. at 756 fn. 30, but also against the background of such later cases as Ussery, Stewart, Haley, and Reese.Decision will be entered for the respondent. Footnotes1. References to the Welfare Code are to the current code section numbers, but the statutory language cited is substantially identical to that in effect after July 24, 1963. See Cal. Stats. 1963, ch. 1916, pp. 3918-3930; id., 1961, ch. 1780, sec. 1↩, pp. 3792-3793.2. Sec. 300 is identical to current Welfare Code sec. 10907.↩3. The manual also declared (sec. SD-540.30):.3 Persons in preparation for employment in the public assistance or child welfare program will be required, prior to completion of their education to take a written Merit System examination, and accept employment in the appropriate public assistance or child welfare program in a professional capacity with the SDSW or in a county welfare department.↩4. From June through September of 1963, while on summer vacation between his 2 years of study, petitioner was employed by the county department as a child welfare worker at the regular salary for that position of $ 644 per month.↩5. The petitioner did not claim the "expenses" portion of the stipends as exclusions, and those payments are not here in issue.↩6. SEC. 117. SCHOLARSHIPS AND FELLOWSHIP GRANTS.(a) General Rule. -- In the case of an individual, gross income does not include -- (1) any amount received -- (A) as a scholarship at an educational institution (as defined in section 151(e)(4)), or(B) as a fellowship grant,including the value of contributed services and accommodations; * ↩7. Sec. 1.117-4 Items not considered as scholarships or fellowship grants.The following payments or allowances shall not be considered to be amounts received as a scholarship or a fellowship grant for the purpose of section 117: * * *(c) Amounts paid as compensation for services or primarily for the benefit of the grantor. (1) Except as provided in paragraph (a) of § 1.117-2, any amount paid or allowed to, or on behalf of, an individual to enable him to pursue studies or research, if such amount represents either compensation for past, present, or future employment services or represents payment for services which are subject to the direction or supervision of the grantor.(2) Any amount paid or allowed to, or on behalf of, an individual to enable him to pursue studies or research primarily for the benefit of the grantor.↩8. Petitioner does not contend that by virtue of the fact that it supplied the State with 75 percent of the funds for the payments here in issue, the Federal Government should be considered the grantor. See Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, 743 fn. 4; Marjorie E. Haley, 54 T.C. 642↩.9. In Bingler v. Johnson, 394 U.S. 741">394 U.S. 741, 758 fn. 32, the Supreme Court noted that:"n32 We accept the suggestion in the Government's brief that the second paragraph of Treas. Reg. § 1.117-4(c) -- which excepts from the definition of 'scholarship' any payments that are paid to an individual 'to enable him to pursue studies or research primarily for the benefit of the grantor' -- is merely an adjunct to the initial "compensation" provision: "'By this paragraph, the Treasury has supplemented the first in order to impose tax on bargained-for arrangements that do not create an employer-employee relation, as, for example, in the case of an independent contractor. But the general idea is the same: "scholarship" or "fellowship" does not include arrangements where the recipient receives money and in return provides a quid pro quo.' Brief for Petitioner 22."Thus, the fact that the general public may have derived substantial benefits from the educational stipends is not inconsistent with a finding that the payments were made "primarily for the benefit of the grantor." The last-quoted phrase is designed to distinguish relatively disinterested payments made primarily for the purpose of furthering the education of the recipient from payments made as compensation for services performed for the benefit of the grantor and thus has no bearing on what use is ultimately made of the recipient's services. Cf. Elmer L. Reese, Jr., 45 T.C. 407">45 T.C. 407 at 411↩.10. We note in particular that as a result of his education, petitioner was able to accept a position for which he would not have qualified had he not earned a master's degree.11. Stewart and Ussery held that educational leave grants made to employees of the Mississippi and Tennessee Department of Public Welfare were not excludable under sec. 117↩. We think a different result is not called for here simply because the State of California chose to organize its public assistance programs and qualify for Federal funds by delegating many administrative functions to county governments.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622036/	FIRST NATIONAL BANK OF CHAMPLAIN, N.Y., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.First Nat'l Bank v. CommissionerDocket No. 39782.United States Board of Tax Appeals21 B.T.A. 415; 1930 BTA LEXIS 1849; November 24, 1930, Promulgated 1849 Under a plan of reorganization, holders of bonds in a corporation, a party to reorganization, were entitled to exchange such bonds for preferred stock in another corporation, a party to the reorganization, and the right to purchase sufficient additional preferred stock at less than market value to bring the face value of stock received on exchange and on exercise of the right up to the face value of bonds exchanged. Held that no loss resulted on exchange of bonds and exercise of the right by paying additional amount. R. H. Crook, Esq., for the petitioner. W. F. Gibbs, Esq., for the respondent. MATTHEWS 416 This proceeding is for the redetermination of a deficiency in income tax for the calendar year 1925, asserted by the respondent in the amount of $656.20. The only issue arises from the disallowance by the respondent of a deduction claimed as a loss upon the exchange of bonds for stock. All of the facts were stipulated and the case was submitted on the pleadings and agreed stipulation. FINDINGS OF FACT. The petitioner is a corporation existing under and by virtue of the National Bank Act, with offices at Champlain, N.Y.The1850 petitioner in the year 1921 puchased 10 $1,000 Riordon Pulp & Paper Co., Ltd., 10-year, 6 per cent gold bonds at a cost of $9,575. On or about November 21, 1921, a protective committee for holders of the 10-year 6 per cent gold bonds of the Riordon Pulp & Paper Co., Ltd., was formed and the petitioner deposited its bonds with this committee. The protective committee consummated a plan of reorganization dated March 2, 1925, a copy of which was admitted in evidence under the stipulation. Pursuant to the terms of this plan of reorganization, the petitioner, on June 5, 1925, delivered title to its 10 Riordon Pulp & Paper Co., Ltd., 6 per cent gold bonds and, having made a payment of $4,975, received 100 shares of 7 per cent preferred stock of the International Paper Co. The cost to the petitioner of the 100 shares of International Paper Co. 7 per cent preferred stock received as a result of this transaction, was $14,550, as follows: Cost of 10 $1,000 Riordon Pulp & Paper Co., Ltd., 6 per cent gold bonds$9,575Cash paid on exercising rights to purchase 70 shares of International Paper Co. 7 per cent preferred stock4,97514,550The market value of the1851 100 shares of International Paper Co. 7 per cent preferred stock acquired by the petitioner in this transaction on June 5, 1925, the date of exchange, was $90.50 per share, or $9,050. Under the plan approved by the 6 per cent bondholders' committee, and under a corresponding plan which was adopted by the committee constituted under deposit agreement dated September 8, 1921 (as amended March 31, 1924) representing holders of the 8 per cent first mortgage and refunding gold bonds of Riordon Co., Ltd. (hereinafter referred to as the 8 per cent bondholders' committee), it was proposed that all the properties formerly owned by the Riordon Co., Ltd. (which was the successor of the Riordon Pulp & Paper Co., Ltd.), with certain other related properties, be sold to the Canadian 417 International Paper Ltd., a newly formed Canadian company (which would take title directly or through a subsidiary), and that all the capital stock of that company be acquired by the International Paper Co., a New York corporation, engaged in the manufacture of newsprint and other kinds of paper, the development of water power, and sale of hydroelectric power, and other related industries. The depositors1852 of the 6 per cent bonds who participated in the plan were to receive, in exchange for their interest in the properties involved, 7 per cent cumulative preferred stock of the International Paper Co., in the amounts and subject to the conditions specified below. At the foreclosure and liquidation sale of the assets of the Riordon Co., Ltd., in Montreal on September 8, 1924, all the properties of that company were purchased either by the 6 per cent bondholders' committee or by the 8 per cent bondholders' committee. In general, each committee purchased the properties on which its bonds had priority over the other issue. The property purchased by the 6 per cent bondholders' committee at the Riordon Co. sale, however, was subject to a large amount of indebtedness which was provided for in the reorganization, as more fully specified below. The properties to be transferred by the two bondholders' committees were to be paid for by the Canadian company in part by the delivery to the committees or their respective depositors of securities of the International Paper Co., and in part by the payment in cash of several millions of indebtedness outstanding against the properties. To provide1853 for these requirements and also for additional working capital, the International Paper Co. was to authorize an issue of 6 per cent sinking fund mortgage gold bonds and an issue of new 7 per cent preferred stock. In connection with its acquisition of the securities of the Canadian company, the International Paper Co. was also to issue an additional $5,000,000 par value of common stock. The new bonds were to bew secured by direct pledge of all the capital stock of the Canadian company, which was to own, either directly or through its own subsidiaries, the Canadian properties of the Riordon Co. acquired from the two committees, and certain other Canadian properties then held by a subsidiary of the International Paper Co. They were also to be secured by a mortgage and pledge, junior to the lien of the present first and refunding mortgage bonds of the International Paper Co., of all the pulp and paper mills directly owned by the International Paper Co. at the time of the execution of the mortgage and of the stock of certain of its American subsidiaries. 418 About $6,900,000 of the new bonds were to be acquired by the Canadian company and delivered in part payment for the1854 properties of the 8 per cent bondholders' committee, and it was expected that about $15,500,000 would be sold for cash to provide for the cash payments to be made by the Canadian company in connection with the acquisition of the properties of the two committees and for other corporate purposes of the International Paper Co. The new 7 per cent preferred stock was to rank in priority to the existing 6 per cent preferred stock of the International Paper Co., but the holders of the 6 per cent stock were given the privilege of exchanging their holdings for the new 7 per cent preferred, share for share, on payment of $10 per share. It was to be of $100 par value, entitled to 7 per cent cumulative dividends, and to par and accrued dividends in liquidation in preference over the existing 6 per cent preferred and the common stock, and redeemable at 115 and accrued dividends, and was to have full voting power equally with the other two classes of stock. Dividends were to be payable quarterly on January, April, July, and October 15th. The properties of the 6 per cent bondholders' committee were subject to a variety of charges and obligations, aggregating over $6,000,000. Based on figures1855 of November 30, 1924, the classification and approximate amounts of these liabilities were as follows: 1. Mortgage indebtedness:First Mortgage Debentures of the Riordon Pulp & Paper Company, Ltd., (after payment of sinking fund arrears)$1,562,900.00Less Cash and investments in hands of Trustee64,809.961,498,090.04Small real estate mortgages86,000.00$1,584,090.042. Rentals and title retention claims37,330.003. Sinking fund arrears on First Mortgage Debentures265,900.004. Advances by Royal Trust Company, Trustee, guaranteed by Committee, to pay interest on First Mortgage Debentures, with interest on such advances, and accrued interest on Debentures to November 30407,831.425. Miscellaneous secured claims53,144.296. Obligations of Committee for indebtedness incurred to discharge various prior claims against the properties and to pay for properties purchased, for interest and otherfinancing charges, and for expenses of Committee1,579,836.057. Current operating loans, secured against inventories and receivables1,895,037.098. Miscellaneous current accounts and accruals282,342.176,105,511.061856 419 The properties were to be transferred subject to the indebtedness included in items 1 and 2 of the above summary, and the miscellaneous current accounts and accruals were to be assumed by the Canadian company. The other items, aggregating (as of November 30, 1924) about $4,200,000 had to be provided for in cash. Of this amount, the committee was required to furnish, as one of the conditions of its agreement with the Canadian company, somewhat less than $2,000,000, and the balance was to be paid by the purchasing company. In consideration of the transfer of the properties, and of the delivery to the Canadian company of all the 6 per cent general mortgage bonds of the Riordon Pulp & Paper Co., Ltd., held by the committee in behalf of depositors participating in the plan of reorganization, the Canadian company was to (a) transfer to the committee or on its order 10 shares of the new 7 per cent preferred stock of the International Paper Co. for each $1,000 bond so delivered (and in the same proportion for $500 bonds) subject to the committee's providing $500 in cash for each 10 shares so transferred, to be applied in reduction of the obligations against the properties; 1857 and (b) pay or assume the entire remaining indebtedness against the properties. Each depositor was entitled, on complying with the conditions of the plan, to receive, for each $1,000 bond represented by his certificate of deposit, new 7 per cent preferred stock of the International Paper Co. as follows: SharesWithout any cash payment3On Payment of $500 in cash an additional7Total10The $500 in cash was payable in installments, 50 per cent on or before May 15, 1925, and 50 per cent on or before July 15, 1925. Interest at 6 per cent per annum to July 15 was to be allowed on the first installment and credited against the final payment. Of the 10 shares to be received on account of each $1,000 bond participating, 3 shares were to be delivered on or about May 20, 1925, and were to be entitled to dividends accruing from April 15, and the remaining 7 shares were to be delivered on or about July 20, 1925, and were to be entitled to dividends accruing from July 15. The procedure for participation in the plan was that upon receipt of notice from the committee that the warrants hereinafter mentioned were ready for delivery, each depositor would be entitled1858 to present his certificate of deposit to the State Street Trust Co., of Boston, depositary, or its agent, the Royal Trust Co. in Montreal, on or before May 15, 1925, and to have stamped thereon a statement of 420 his right to receive on or about May 20, 1925, on surrender of such certificate of deposit, 3 shares of the new 7 per cent preferred stock of the International Paper Co. (if, as and when received by the depositary from the Canadian company) for each $1,000 bond represented by such certificate of deposit. There was also to be issued to each depositor so presenting his certificate of deposit a negotiable warrant entitling the holder thereof to receive on or about July 20, 1925, (if, as and when received by the depositary) seven additional shares of said stock for each $1,000 bond represented by the certificate of deposit against which such warrant was issued, on payment to the depositary, for each seven shares, of $500 in cash (in United States funds) in the installments and on the dates specified above, and subject to credit for interest on the first installment as above stated. Depositors who did not present their certificates of deposit to be stamped within the1859 time above specified were, nevertheless, to be entitled, on later surrender of their certificates of deposit, to receive three shares of stock for each $1,000 bond, entitled to dividends accruing from the last previous dividend payment date, but were to forfeit all rights in respect to the other seven shares. Holders of the above described warrants who failed to make the first installment payment when due were to forfeit all rights under such warrants. OPINION. MATTHEWS: This case arises under the Revenue Act of 1926. The respondent contends that under section 203(b)2, no gain or loss is recognized on the exchange of bonds for preferred stock. The petitioner contends that the provisions of the act applicable to the situation are sections 202(c), 202(d), and 203(b)1. The provisions relied on by petitioner and respondent, and other pertinent portions of sections 202 and 203, read as follows: SEC. 202. (a) Except as hereinafter provided in this section, the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis provided in subdivision (a) or (b) of section 204, and the loss shall be the excess of such basis1860 over the amount realized. * * (c) The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. (d) In the case of a sale or exchange, the extent to which the gain or loss determined under this section shall be recognized for the purposes of this title, shall be determined under the provisions of section 203. * * * SEC. 203. (a) Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 202, shall be recognized, except as hereinafter provided in this section. 421 (b) (1) No gain or loss shall be recognized if property held for productive use in trade or business or for investment (not including stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest) is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment, or if common stock in a corporation is exchanged solely for common stock in the1861 same corporation, or if preferred stock in a corporation is exchanged solely for preferred stock in the same corporation. (2) No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. * * * (f) If an exchange would be within the provisions of paragraph (1), (2), (3), of (4) of subdivision (b) if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized. * * * (h) As used in this section and sections 201 and 204 - (1) The term "reorganization" means (A) a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or substantially all the properties of another corporation), or (B) a transfer by a1862 corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred, or (C) a recapitalization, or (D) a mere change in identity, form, or place of organization, however effected. (2) The term "a party to a reorganization" includes a corporation resulting from a reorganization and includes both corporations in the case of an acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation. * * If subdivision (b)(1) of section 203 stood alone, there would seem to be no question that it would control in this case and that the exception therein contained with respect to stocks, bonds, notes, etc., an exception upon which petitioner relies, would take the present case out of the category in which no gain or loss shall be recognized and allow the computation of gain or loss in accordance with section 202. But paragraph 2 of section 203(b) and the subsequent subdivisions of section 203, are intended to cover exchanges in1863 the various cases of corporate reorganization which may arise, and they must, therefore, be considered, inasmuch as the plan is referred to in the stipulation as a plan of reorganization, and in the plan itself, the transaction is referred to as a reorganization. It must be determined, however, whether as a matter of law what was accomplished was a reorganization within the meaning of section 422 203(h)(1), and if so, whether the Riordon Pulp & Paper Co. and the International Paper Co. are parties to a reorganization within the meaning of section 203(b)(2), and whether the exchange is one in which the loss can not be recognized. The plan, which is set forth in our findings of fact, provides in effect for the acquisition by the International Paper Co. of all the properties formerly owned by the Riordon Pulp & Paper Co. and its successor, the Riordon Co., held by the two bondholders' committees, in exchange for its 7 per cent preferred stock and 6 per cent bonds, title to the properties to be taken and held in the name of a Canadian corporation, which was organized for that purpose, all of whose stock was to be owned by the International Paper Co. This is the acquisition1864 by one corporation of all of the properties of another corporation, and comes squarely within the language used in section 203(h) 1: "The term 'reorganization' means (A) a merger or consolidation (including the acquisition by one corporation of * * substantially all the properties of another corporation) * * ." We are not advised as to the date or manner in which the Riordon Co., Ltd., became the successor of the Riordon Pulp & Paper Co., Ltd. We do not think this is material, however, as the plan discloses that all the property which secured the 6 per cent gold bonds of the Riordon Pulp & Paper Co., Ltd., as well as the first mortgage debentures of the Riordon Pulp & Paper Co., Ltd., was purchased by the 6 per cent bondholders' committee at the foreclosure and liquidation sale of the assets of the Riordon Co., Ltd. We conclude, therefore, that the Riordon Co., Ltd., had, at the time it became successor of the Riordon Pulp & Paper Co., Ltd., acquired all the properties of the Riordon Pulp & Paper Co., Ltd., and assumed the bonds which were secured on such properties, and that it was not able to meet either its own obligations on the 8 per cent first mortgage and refunding gold1865 bonds of the Riordon Co., Ltd., or the obligations on the bonds of the Riordon Pulp & Paper Co., Ltd., which it had assumed. Each bondholders' committee, therefore, purchased the properties on which its bonds had priority over the other issue, and thus the 6 per cent bondholders' committee acquired the property formerly owned by the Riordon Pulp & Paper Co., Ltd. Under the plan adopted by the 6 per cent bondholders' committee, securities of the Riordon Pulp & Paper Co., Ltd., and the properties formerly owned by that company are dealt with, while under the plan adopted by the 8 per cent bondholders' committee, the securities of the Riordon Co., Ltd., and the property of that company which secured such bonds are dealt with. Both plans form a part of the general reorganization plan, but we are concerned with the plan adopted by the 6 per cent bondholders of the Riordon Pulp & Paper Co., Ltd. 423 We do not think that the intervention of the Canadian corporation to hold title to the properties is material, but even if we considered that there were two simultaneous transactions, the acquisition of the properties of the Riordon Pulp & Paper Co. by the Canadian corporation, 1866 and the acquisition of all the stock of the Canadian corporation by the International Paper Co., it would still be a reorganization, because both transactions fall within (A), which also includes cases where one corporation acquires all the stock of another corporation. This then was a reorganization within the meaning of the statute. We have next to determine whether the Riordon Pulp & Paper Co., whose bonds were exchanged, and the International Paper Co. whose preferred stock was received in exchange, are parties to the reorganization. The term "a party to a reorganization" is defined in section 203(h)(2). We are of the opinion that the Riordon Pulp & Paper Co. whose bonds petitioner exchanged, is a party to the reorganization. Any other interpretation would stultify the statute. The fact that the properties of the company had been sold under foreclosure before the plan became effective, does not alter the fundamental fact that it is being reorganized and that its assets and liabilities and its security-holders are being dealt with under the reorganization plan. In this case, the bondholders, upon foreclosure, had become the owners of all the assets of the corporation, 1867 subject to the remaining liabilities, and there was no equity left in the stockholders. The bondholders, therefore, were the only ones who could enter into a plan of reorganization of the corporation. It will be observed tat paragraph (2) of subdivision (h) of section 203, does not, like paragraph (1), which defines the term "reorganization," employ the word "means," but says that the term "a party to the reorganization includes," thereby merely extending the definition to certain other corporations than the one reorganized. The Canadian corporation is a corporation "resulting from a reorganization" and comes specifically within the terms of the statute. Both the Canadian corporation and the International Paper Co., whose securities were issued in exchange, fall within the second half of the definition which provides that the term "includes both corporations in the case of the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation," since here the International Paper Co. acquired all of the capital stock of the Canadian corporation. The Riordon1868 Pulp & Paper Co. and the International Paper Co. are, therefore, corporations which are parties to a reorganization. 424 Does the statute prohibit the recognition of loss in this case? It is not an uncommon practice, in corporate reorganizations, to give in exchange securities in the new corporation, different in nature and interest rate from those held in the old corporation. The language of the statute is sufficiently broad to cover an exchange of bonds in a corporation, a party to a reorganization, solely for stock in another corporation, a party to the reorganization, in pursuance of the plan of reorganization. Section 203(b) 2. The only question that need detain us, therefore, is whether loss is to be recognized upon an exchange where additional cash is furnished by the old securityholders in order to receive stock or securities equal in face value to securities exchanged. Under the instant plan, the old bondholder, in order to realize by the exchange an amount of new stock equal in face value to that of his old bonds, was required to pay in cash an amount equal to 50 per cent of the face value of his old bonds. Such provisions are common in corporate reorganization1869 plans, since the new corporation usually finds it necessary to provide new money to carry out the plan, but they more ordinarily affect participating stockholders than bondholders. Tracy on Corporate Receiverships, Foreclosues & Reorganizations (1929). Here the stockholders of the old corporation had no equity in the properties and did not participate in the plan. The petitione, as a dpositor, could have surrendered its bonds without any cash payment, but if it had done so, it would have received only three shares of stock having an aggregate face value of only $300 for each $1,000 bond, while by paying $500 in cash additional, it could obtain ten shares of stock of an aggregate face value of $1,000. The right to obtain seven additional shares of stock by paying in $500 in cash, was one reserved to bondholders of the old corporation, who participated in the plan. This right was evidenced by a negotiable warrant issued to each depositor upon presenting his certificate of deposit, entitling the holder thereof to receive on or about July 20, 1925, seven additional shares of preferred stock for each $1,000 bond represented by the certificate of deposit against which such warrant was*1870 issued, on payment to the depositary of $500 in cash for each seven shares. The warrant evidencing such right is property. What each bondholder received upon the exchange of his bonds, therefore, was stock and property. Under the provisions of subdivision (f) of section 203, no loss is to be recognized in such a case. Cf. ; affirmed in . Reviewed by the Board. Judgment will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622037/	Gunderson Bros. Engineering Corp., Petitioner, v. Commissioner of Internal Revenue, RespondentGunderson Bros. Engineering Corp. v. CommissionerDocket No. 19672United States Tax Court16 T.C. 118; 1951 U.S. Tax Ct. LEXIS 309; January 18, 1951, Promulgated 309 Decision will be entered under Rule 50. 1. Where the taxpayer on the accrual basis intentionally claimed an unallowable deduction on its state and Federal tax returns and did not accrue the added tax which would otherwise have been due on its books and did not admit its liability therefor until some years later, held, that the added tax and interest resulting from the subsequent elimination of the deduction was accruable and deductible only in the taxable year in which the taxpayer finally recognized and admitted its liability for such tax and interest.2. Where the taxpayer under a contract with the Government supplied a part of the materials and equipment and all of the labor involved in the construction of certain Naval vessels but held no title to the materials and equipment it purchased or those supplied by the Government, or to the vessels at any stage of completion, held, that petitioner's interest in the vessels, materials, and equipment was not the equivalent of title to or the ownership of finished goods, partially finished goods, or raw materials and, therefore, did not constitute property includible in its inventory within the meaning of the Commissioner's 310 regulations, and petitioner may not by means of a so-called inventory adjustment anticipate a loss it expects to realize in a following taxable year based on the estimated cost of completing certain contracts with the Government. Carl E. Davidson, Esq., and Burton M. Smith, C. P. A., for the petitioner.John H. Pigg, Esq., for the respondent. Arundell, Judge. ARUNDELL119 The respondent has determined deficiencies in declared value excess-profits tax and excess profits tax for the taxable years ended May 31, 1944 and 1945, in the following amounts:Declared valueYear endedexcess-profitsExcess profits5-31-44$ 15,144.92$ 182,309.485-31-45263,828.80Three issues are presented:(1) Whether the petitioner was entitled to a deduction for the taxable year ended May 31, 1944, in the amount311 of $ 26,040.49 representing Oregon state excise taxes.(2) Whether the petitioner is entitled to a deduction for the taxable year ended May 31, 1945, in the amount of $ 8,901.89, representing interest on Federal income and excess profits tax deficiencies determined by the Commissioner for the taxable year ended May 31, 1944.(3) Whether the petitioner understated its closing inventory for the taxable year ended May 31, 1945, in the amount of $ 332,418.77 as determined by the respondent.The parties have settled by stipulation various other issues raised in the pleadings relating to the amount of petitioner's invested capital for the taxable years 1944 and 1945 and its allowance for depreciation in the taxable year 1945 and have agreed that effect may be given thereto in proceedings under Rule 50.FINDINGS OF FACT.Petitioner is an Oregon corporation organized on June 1, 1942, with its office and principal place of business located in Portland, Oregon. At all times material to the issues herein petitioner was engaged in the business of manufacturing life rafts, cargo lighters, landing craft, and other such vessels. Its books are maintained and its tax returns filed on the accrual312 basis. Petitioner's Federal tax 120 returns for the taxable years involved herein were filed with the collector of internal revenue for the district of Oregon.On or about September 1, 1944, petitioner filed its Oregon corporation excise tax return for the taxable year ended May 31, 1944, upon which it claimed a deduction, inter alia, in the amount of $ 253,774.13 which it described as "Post-war reconversion expense deemed applicable to current year's operations although not expended -- credited to reserve." Petitioner's return showed a "Net Tax Payable" in the amount of $ 20,965.01. Deductions in the amount of $ 253,774.13 and $ 20,965.01 representing the petitioner's post-war reconversion reserve and its Oregon excise tax liability, respectively, were claimed by the petitioner in its Federal income and declared value excess-profits tax returns for the taxable year ended May 31, 1944.On October 16, 1945, petitioner entered into a final agreement with the Navy Price Adjustment Board in respect to its renegotiable profits for the fiscal year ended May 31, 1944. In determining the amount of petitioner's renegotiable profits, the deduction representing the post-war reconversion313 reserve of $ 253,774.13 was disallowed as an item of expense, and the petitioner was allowed a credit against the profits to be eliminated in the amount of $ 15,040, which figure was determined as being petitioner's Oregon corporate excise tax liability for the taxable year ended May 31, 1944, after the elimination of the excessive profits to be refunded under the renegotiation agreement.On or about November 30, 1946, petitioner filed an amended Oregon corporation excise tax return for the taxable year ended May 31, 1944, in which the deduction of $ 253,774.13 for post-war reconversion reserve was eliminated and which disclosed an excise tax liability in the amount of $ 26,040.49.Petitioner made no accrual on its books during or as of the close of the taxable year ended May 31, 1944, on account of its state excise taxes for that year.In determining the deficiencies in declared value excess-profits tax and excess profits tax for the taxable year ended May 31, 1944, respondent allowed $ 15,040 of the $ 20,965.01 claimed by petitioner as a deduction for state excise taxes in that year, and disallowed the post-war reconversion reserve item of $ 253,774.13 in full.There was no accrual314 on the petitioner's books during, or as of the close of, the taxable year ended May 31, 1945, on account of interest in respect of the deficiencies in declared value excess-profits tax and excess profits tax determined by the Commissioner for the taxable year ended May 31, 1944.Petitioner's Federal and state tax returns for the taxable years in question were prepared by a certified public accountant who advised the petitioner's officers that the $ 253,774.13 claimed as a deduction for 121 post-war reconversion reserve was not properly deductible. Petitioner's officers, understanding that the amount was not deductible under existing legislation, claimed the deduction in the hope that legislation would be passed to validate it.On or about September 25, 1944, the petitioner entered into a fixed price contract, hereinafter referred to as Contract 1847, with the Government for the construction of five 65-foot steel harbor tugs at a contract price for each vessel of $ 79,746, amounting to a total contract price of $ 398,730.In respect to payments on the contract price of each vessel, the contract provided in part as follows:Article 10. Payments. -- (a) The Government shall make315 payments on account of the contract price of each vessel as follows: Twenty-five percent (25%) of the contract price when all steel plating for the vessel is received at the plant of the Contractor.Twenty-five percent (25%) of the contract price when the vessel is framed and ninety percent (90%) plated.Twenty percent (20%) of the contract price when the main propulsion machinery is installed and the vessel is launched.Ten percent (10%) of the contract price when the vessel is substantially ready for trials.Such payments may, if the Supervisor so directs, be based upon the contract price as adjusted from time to time as the result of change orders under Article 3.* * * (d) On final acceptance of each vessel, payment of the balance then owing on account of such vessel shall be made to the Contractor.The contract required petitioner to furnish all materials other than those furnished by the Government, necessary for the construction of the tugs, and all labor, including that necessary to the installation of Government furnished materials.The contract provided that "The Contractor shall not, unless otherwise directed in writing by the Department, carry, or incur the expense316 of any insurance against any form of loss of or damage to the vessels or to the materials or equipment therefor to which the Government has acquired title or which have been furnished by the Government for installation by the Contractor." The contract further provided that "Title to the Government-Furnished Material shall remain in the Government."Under the general provisions of Contract 1847, it was provided that:Article 3. Liens and titles. -- * * (c) Title to each vessel under construction shall be in the Government and title to all materials and equipment acquired for any of the vessels shall vest in the Government upon delivery thereof to the plant of the Contractor or other place of storage selected by the Contractor, whichever of said events shall first occur: Provided, that the Supervisor may by written direction require that title shall vest in the Government upon delivery of such materials and equipment 122 to the carrier for transportation to the plant of the Contractor or other place of storage selected by the Contractor. * * * Upon completion of each vessel, all such materials and equipment which have not been included therein and which are no longer required317 therefor, except materials and equipment which were furnished by the Government, shall become the property of the Contractor.The contract also provided that under certain specified conditions it could be suspended or terminated by the Government. It was further provided that neither the contract "nor any interest herein nor any claim arising hereunder" could be assigned by the petitioner, except that "claims for moneys due or to become due to the Contractor from the Government arising out of this contract may be assigned to any bank, trust company, or other financing institution, including any Federal agency authorized to make loans."On or about October 2, 1944, petitioner entered into another fixed price contract, hereinafter referred to as Contract 1964, under which the petitioner contracted to construct ten 500-ton non-self-propelled steel covered cargo lighters at a price of $ 40,675 for each vessel, or a total contract price of $ 406,750. The provisions of Contract 1964 were in all material respects the same as those incorporated in Contract 1847 and which have been set out above.At the close of its taxable year ended May 31, 1945, petitioner was engaged in the construction318 but had not completed the five tugs covered by Contract 1847 and as of that date had expended in connection therewith $ 122,086.89 for materials and $ 74,800.55 for labor. Two of the tugs were completed and the contract was cancelled as to the other three during the following taxable year ended May 31, 1946.At the close of its taxable year ended May 31, 1945, petitioner was engaged in the construction of seven of the ten lighters covered by Contract 1964, the other three lighters having been completed and delivered prior to that date. As of May 31, 1945, petitioner had expended in connection with all ten lighters $ 179,378.46 for materials and $ 158,719.16 for labor. These amounts were allocated by the petitioner between the three lighters completed prior to May 31, 1945, and the seven lighters in the process of completion as follows:Description of itemsAll ten lightersMaterials$ 179,378.46Labor158,719.16Total$ 338,097.62Three lightersSeven lighterscompleted in yearstill under constructionDescription of itemsended 5-31-45on 5-31-45Materials$ 59,093.54$ 120,284.92Labor101,615.7557,103.41Total$ 160,709.29$ 177,388.33319 Petitioner reported "gross sales" for the taxable year ended May 31, 1945, in the amount of $ 5,601,224.31, which sum included $ 122,025 representing the contract price of the three lighters completed and delivered during that year. Petitioner deducted as the "cost of goods sold" the sum of $ 5,075,398.37 consisting of the following items: 123 Materials used$ 2,596,082.70Direct labor1,864,469.68Manufacturing expense (including indirect labor andother shop and administrative overhead charges)614,845.99$ 5,075,398.37Included in the "materials used" and "direct labor" items set out above were the amounts of $ 59,093.54 and $ 101,615.75 allocated by petitioner to the three lighters completed and delivered in the taxable year. In determining the deficiency in excess profits tax for the taxable year ended May 31, 1945, respondent made no adjustment in respect to the receipts and expenditures reported by the petitioner on account of the three lighters completed and delivered in that year.Of the seven lighters under construction as of May 31, 1945, five were completed during the taxable year ended May 31, 1946, during which year Contract 1964 was cancelled320 as to the remaining two lighters.Petitioner on its return for the taxable year ended May 31, 1945, reported closing inventories in the amount of $ 1,060,289.05, representing "work in progress" and consisting of the following items:ItemsAmountsMaterials$ 890,873.85Direct labor121,146.99Supplies11,000.00Prepaid expense37,268.21Total$ 1,060,289.05Petitioner included in the foregoing "materials" and "direct labor" the sum of $ 41,857 rather than $ 196,887.44, representing the $ 122,086.89 and $ 74,800.55 actually expended by the petitioner during the taxable year for materials and labor, respectively, in connection with Contract 1847. The sum of $ 41,857 was computed by petitioner as the "market value" of the "work in progress" on the five tugs covered by Contract 1847 as of the close of the taxable year in the following manner:Total contract price (Contract 1847)$ 398,730Less: estimated normal profit39,873Market value of costs on completed contract358,857Estimated costs to complete:Labor (direct)$ 180,000Materials29,000Overhead (60% of labor)108,000317,000Market value of inventory at May 31, 1945$ 41,857321 No part of the sums of $ 120,284.92 and $ 57,103.41 expended by petitioner during the taxable year ended May 31, 1945, for materials and labor, respectively, in connection with the seven lighters covered by Contract 1964, which were uncompleted by the end of the taxable 124 year, was included by the petitioner in the "materials" and "direct labor" items as set out above. The petitioner's determination of a market value of zero for "work in progress" in respect to Contract 1964 resulted from the following computation:Estimated cost to complete contract:Labor$ 180,000Materials17,600Overhead (60% of labor)108,000Estimated costs to complete the seven lighters still underconstruction on May 31, 1945305,600Less contract price of seven lighters284,725Estimated loss$ 20,875The net effect of petitioner's valuation of its "work in progress" on Contracts 1847 and 1964 as of May 31, 1945, at a "market value" of $ 41,857 and zero, respectively, rather than at actual cost was to write off against the petitioner's income for the fiscal year ended May 31, 1945, its estimate of unrealized and anticipated losses on such contracts in the total amount322 of $ 332,418.77.Petitioner on its books charged the costs of materials and direct labor separately to each Government contract but did not maintain separate accounts of costs incurred in connection with the construction of each vessel. However, in determining its income from Government contracts, petitioner accrued on its books in the year of completion and delivery the profit or loss realized upon each vessel and computed such profit or loss on the basis of the portion of the total contract price and total contract costs allocable to each unit when completed. The costs allocated to each vessel upon completion did not include "overhead charges" which were charged to expense and deducted in the year paid or incurred.Petitioner either received or became entitled to receive during the taxable year ended May 31, 1945, payments aggregating $ 119,619, on account of the five tugs which were under construction at the close of that taxable year, and under Contract 1964 payments aggregating $ 58,492.50 on account of the seven lighters which were under construction at the close of that taxable year. These amounts, aggregating $ 178,111.50, were credited on petitioner's books to an account323 captioned "Customer Deposits" and were not included in the gross income of $ 5,601,224.31 as reported on the petitioner's return for the taxable year ended May 31, 1945, but were reported as deferred income.Petitioner on its returns for the taxable years ended May 31, 1943, and 1944 reported as closing inventories the amounts of $ 847,229.24 and $ 813,092.16, respectively, representing "work in progress," consisting 125 of expenditures for materials and direct labor in connection with the construction of certain Naval vessels which had not been completed at the close of the taxable years. The amounts of $ 847,229.24 and $ 813,092.16 represented the actual cost of the materials used and the direct labor employed and none of the materials or labor represented by such expenditures could have been purchased or replaced by petitioner at the close of such taxable years for less than the actual cost.Except as to Contracts 1847 and 1964, all the items or amounts included in petitioner's reported closing inventories figure of $ 1,060,289.05 for the taxable year ended May 31, 1945, represented the actual cost of the materials used and the direct labor employed in connection with vessels324 under construction by petitioner on May 31, 1945. None of the materials or labor represented by such expenditures could have been purchased or replaced by petitioner on May 31, 1945, for less than the actual cost. The same is true as to the expenditures made by the petitioner during the taxable year for materials and direct labor on account of the five tugs and seven lighters still under construction on that date.On petitioner's return for its first taxable year ended May 31, 1943, Question 12, "State whether the inventories at the beginning and end of the taxable year were valued at cost, or cost or market, whichever is lower" was answered: "Cost or market whichever is lower."In his determination of the involved excess profits tax deficiency for the taxable year ended May 31, 1945, the respondent increased the net income as reported on petitioner's return for that year by the amount of $ 332,418.77, and in explanation of such adjustment the deficiency notice stated:It has been determined that the costs of your work in progress relating to Contracts No. 1847 and No. 1964 as of May 31, 1945, were $ 196,887.44 and $ 177,388.33, respectively, that the market value of such work in325 progress was not less than cost, and that your writedown of $ 155,030.44 with respect to Contract No. 1847, and complete write-off of $ 177,388.33 with respect to Contract No. 1964 should be restored to net income. Accordingly, the net income reported by you in your corporation return for the year ended May 31, 1945, has been increased in the amount of $ 332,418.77.OPINION.The sole issue in regard to the petitioner's tax liability for the fiscal year ended May 31, 1944, concerns the amount petitioner may properly accrue and deduct for Oregon corporation excise taxes in that year. Respondent concedes that the petitioner is entitled to deduct the sum of $ 20,965.01 which represents the tax originally reported by the petitioner in its state tax return and the amount claimed by the petitioner as a deduction in its Federal tax returns 126 for that year. Petitioner, on the other hand, contends that it is entitled to accrue and deduct the amount of $ 26,040.49 representing the total tax as disclosed in an amended state tax return which it filed on or about November 30, 1946.Petitioner concedes that the additional state excise tax of $ 5,075.48 results from the elimination of 326 the deduction for "Post-war Reconversion Expense" in the amount of $ 253,774.13 claimed in its Oregon corporation excise tax return as originally filed, and agrees with the respondent that the issue herein is governed by the so-called "contested tax" rule. See Dixie Pine Products Co. v. Commissioner, 320 U.S. 516">320 U.S. 516; Security Flour Mills Co. v. Commissioner, 321 U.S. 281">321 U.S. 281. The parties differ as to whether petitioner's claim of the deduction for post-war reconversion expense on its Oregon excise tax return, in the face of advice to it that this item was not properly deductible, constituted a "contest" of its liability for the additional tax which would otherwise have been due.The right to accrue a liability for tax comes with the occurrence of all the events which fix the amount of the tax and determine the liability of the taxpayer to pay it. United States v. Anderson, 269 U.S. 422">269 U.S. 422; see G. C. M. No. 25298, 1947-2 C. B. 39. In cases involving taxpayers who contest the imposition of a tax by court action, it has been consistently held that 327 the right to accrue such expense must be postponed until such time as the taxpayer's liability for the tax and the amount thereof has been finally determined. Dixie Pine Products Co. v. Commissioner, supra;Security Flour Mills Co. v. Commissioner, supra.However, it is not necessary that a taxpayer institute legal proceedings in order to "contest" his liability for a tax. In Great Island Holding Corp., 5 T. C. 150, 160, we stated that:We do not agree with petitioner's contention that the "contested tax" rule is applicable only in cases where the dispute has been carried to the courts. In our view, it is sufficient if the taxpayer does not accrue the items on its books and denies its liability therefor.The petitioner herein did not accrue the tax in question on its books, nor can it fairly take the position that it did not deny its liability for any additional tax when it claimed the benefit of the deduction for post-war reconversion expense. The additional tax which petitioner now seeks to accrue and deduct in the fiscal year 1944 was not the result of innocent error or oversight328 on the part of the petitioner but was the direct result of its deliberate and affirmative claim to a deduction in the amount of $ 253,774.13. The petitioner, with clarity and in all apparent sincerity, claimed the deduction on its state tax return, which had the practical effect of denying tax liability in any greater amount than reported. It is of no moment now to learn that petitioner's officers had been forewarned as to the unlawfulness of the deduction 127 or that they were unwilling to press the claim should it be disallowed, for these facts were in no manner reflected on the returns. The important considerations are that the deduction and the resulting lower tax were in fact claimed and that at no time prior to the filing of its amended return on November 30, 1946, did the petitioner in any manner recognize or concede its liability for taxes in any greater amount than originally reported and paid.Therefore, it is our opinion that the petitioner is not entitled to accrue and deduct in computing its net taxable income for the fiscal year ended May 31, 1944, the additional tax in the amount of $ 5,075.48 which it admitted as owing for the first time on its amended return329 filed in 1946.The parties state that our decision on the first issue is determinative of the second issue relating to petitioner's claim that it is entitled to a deduction for the fiscal year ended May 31, 1945, in the amount of $ 8,901.89 representing interest on deficiencies in Federal income and excess profits tax for the fiscal year ended May 31, 1944, arising out of the respondent's disallowance of the same deduction of $ 253,774.13 for post-war reconversion expense which petitioner claimed on its Federal tax returns for the latter year. We agree. It is clear the petitioner did not accrue this interest expense on its books during the fiscal year ended May 31, 1945, and there is no evidence that it had at any time in that year recognized or conceded its liability for the deficiencies in tax and the interest which were ultimately determined by the respondent in respect to the petitioner's tax liability for the fiscal year ended May 31, 1944. For the reasons we have discussed above, we are of the opinion that petitioner is not entitled to accrue and deduct interest expense of $ 8,901.89 in the fiscal year ended May 31, 1945. Lehigh Valley Railroad Co., 12 T.C. 977">12 T. C. 977, 1000.330 The principal issue herein relates to the correctness of the petitioner's reported closing inventory for the fiscal year ended May 31, 1945. Petitioner purported to value its closing inventory at cost or market, whichever was lower, and reported a closing inventory of $ 1,060,289.05 as of May 31, 1945, including therein "Work in Progress" on the uncompleted vessels covered by Contracts 1847 and 1964 at a "market" value of $ 41,857 and zero, respectively, whereas the actual cost of the materials and labor expended by the petitioner on such contracts totaled $ 196,887.44 and $ 177,388.33, respectively, as of May 31, 1945.In the notice of deficiency respondent held that the market value of such "Work in Progress" was not less than the actual cost of the materials and labor expended, and accordingly increased the petitioner's closing inventory and thereby its net income by the amount of $ 332,418.77.128 The statute directly grants to the Commissioner the responsibility and the authority for determining the need and the methods to be followed for the taxpayer's use of inventories in determining income for Federal tax purposes. Section 22 (c), Internal Revenue Code. Pursuant 331 to this authority, the Commissioner, in Regulations 111, section 29.22 (c)-1, has held that inventories are necessary in every business where the production, purchase, or sale of merchandise is an income-producing factor and that such inventories shall include finished goods, partially finished goods, and raw materials and supplies which have been acquired for sale or which will physicallly become a part of merchandise intended for sale.However, the Commissioner's regulations provide that "Merchandise shall be included in the inventory only if title thereto is vested in the taxpayer." There is nothing novel about the Commissioner's requirement that a taxpayer hold title to the merchandise he seeks to inventory as this position is generally supported by the recognized authorities on accounting. See Accountant's Handbook, Second Edition, page 451, and Third Edition, pages 551-552, 558; Principles of Accounting, Third Edition, by H. A. Finney, ch. 15, page 250; Mertens, Law of Federal Income Taxation, Vol. 2, ch. 16, section 16.26, page 544, and cases cited therein.By the express terms of Contracts 1847 and 1964, petitioner had no title to the materials supplied by the Government for332 use in the construction of the harbor tugs and lighters, and for that matter during the process of construction had no title in the materials or equipment it acquired for installation in the vessels. Under these circumstances it was appropriate that the contracts provided that the petitioner was prohibited from insuring the vessels, or any of the materials or equipment used in the construction thereof. Moreover, the contract was nonassignable by the petitioner. Thus, it is clear that the petitioner held no title or interest in the vessels, materials or equipment as such, nor did it possess any product which it could sell in its own right at any stage of completion.In our opinion, the interest of petitioner in the vessels and the materials and equipment consisted of nothing more than a contractual right to receive a fixed fee for carrying out the construction of the vessels in the manner specified in the contracts. The petitioner's contractual interest was not the equivalent of title to and ownership of finished goods, partially finished goods, or raw materials, and in our opinion for that reason did not constitute property of a nature includible in inventories as contemplated333 by the Commissioner in his Regulations, and the accounting authorities in their discussions of accepted inventory practices.Moreover, it was not until the petitioner concluded that it would probably incur losses upon completion of Contracts 1847 and 1964 in 129 the following taxable year that it undertook to anticipate such losses by inventorying its "work and progress" under the contracts at a "market" figure which was $ 332,418.77 less than the actual costs.Petitioner entered into both contracts shortly after the beginning of the fiscal year ended May 31, 1945, and during that year completed three of the ten lighters covered by Contract 1964. In its Federal tax returns, petitioner for that year included in its gross income $ 122,025 representing the contract price of the three completed lighters, and in its costs the sum of $ 160,709.29 representing the actual cost of materials and labor expended in the construction of the three lighters completed and delivered during that year. Under the terms of the contract, petitioner was entitled to receive partial payments aggregating $ 119,619 and $ 58,492.50 on account of the five tugs and the seven lighters, respectively, which334 were not completed during the fiscal year ended May 31, 1945. However, these partial payments were not included by petitioner in its gross income for that year but were recorded as "customer deposits" on petitioner's books and treated as deferred income on its tax returns.It may well be that had the petitioner chosen to report its income from these contracts on the so-called percentage of completion basis and had discovered that the costs incurred in connection with the contracts were running ahead of receipts, it could have accrued and deducted the loss reflected thereby as of the close of its taxable year. However, petitioner did not choose to employ the percentage of completion basis. Instead, it appears from the petitioner's method of handling the income and costs attributable to the three lighters completed in the fiscal year 1944 and the testimony of its accountant that petitioner elected to defer its income and costs until the various units covered by the contracts were completed and delivered, at which time it would take into income the contract price of the completed unit and include in its costs the portion of the total contract costs allocable to the completed unit. 335 The sole purpose of petitioner's including the materials and labor supplied under Contracts 1847 and 1964 in its closing inventory for the fiscal year 1945 at a nominal "market" value rather than cost was to record during the fiscal year ending May 31, 1945, the loss it expected to incur on the contracts in the following taxable year. Recognition of the device employed by the petitioner would be clearly violative of the long established rule that the revenue laws only permit the deduction of realized losses and not anticipated losses. Weiss v. Wiener, 279 U.S. 333">279 U.S. 333; Lucas v. American Code Co., 280 U.S. 445">280 U.S. 445. This rule applies with equal effect to those taxpayers properly employing inventories. Ewing Thomas Converting Co. v. McCaughn, 43 Fed. (2d) 503, certiorari denied, 282 U.S. 897">282 U.S. 897; Adams-Roth Baking Co., 8 B. T. A. 458; Higginbotham-Bailey-Logan Co., 8 B. T. A. 566.130 Therefore, we conclude that the Commissioner did not err in determining that there should be restored to the petitioner's336 income for the fiscal year ended May 31, 1945, the sum of $ 332,418.77, representing the petitioner's write-off in that year of unrealized losses which it expected to incur in connection with Contracts 1847 and 1964 in the following taxable year. Various adjustments which the parties have agreed to will be given effect under Rule 50.Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622038/	Robert S. Groetzinger and Beverly L. Groetzinger, Petitioners v. Commissioner of Internal Revenue, RespondentGroetzinger v. CommissionerDocket No. 562-82United States Tax Court87 T.C. 533; 1986 U.S. Tax Ct. LEXIS 57; 87 T.C. No. 29; August 26, 1986, Filed 57 An appropriate order will be issued and decision will be entered under Rule 155. Ps, husband and wife, were employed abroad under a joint employment contract, which provided a stock option for petitioner-husband alone. Held: Ps, who were free to structure the provisions of their joint employment contract as they wished, and who abided by the contract as they made it, must accept the tax consequences of their structural choice. Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134">417 U.S. 134, 149 (1974). Therefore, Ps may not allocate any of the gain from petitioner-husband's 1978 disposition of the stock to petitioner-wife for the purpose of computing her foreign earned income exclusion under sec. 911, I.R.C. 1954. Held, further, Ps may attribute petitioner-husband's stock option proceeds to their 1977 gross income under the attribution rule of sec. 911(c)(2) for the limited purpose of computing the foreign earned income exclusion for 1977 under sec. 911(a)(1) and (c)(1)(B). Robert S. Groetzinger, pro se.Mark S. Priver, for the respondent. Nims, Judge. NIMS534 OPINIONRespondent determined deficiencies of $ 297 and $ 28,276.23 in petitioners' joint Federal income tax for 1977 and 1978, respectively. After concessions, two issues remain: (1) Whether petitioners, husband and wife, may disavow the form of the stock option provision within their employment contract so as to allocate the stock option proceeds between themselves for purposes of computing their section 911 foreign earned income exclusions; 1 and (2) whether petitioners may attribute any income from the 1978 disposition of the employee stock option to 1977 by virtue of the attribution rule of section 911(c)(2) (now section 911(b)(2)(B)).61 This case has been submitted fully stipulated. The evidence consists of a stipulation of facts with attached exhibits which is incorporated herein by this reference.Robert S. Groetzinger and Beverly Groetzinger (hereinafter referred to as petitioners, collectively, or Robert and Beverly, individually) were married and residents of Fribourg, Switzerland, at the time the petition was filed in this case, and were bona fide residents of a foreign country at all times during the taxable years in issue, 1977 and 535 1978. Petitioners were employees of American Telecommunications Corp. (ATC), a California corporation, during the tax years in question pursuant to a written, joint employment contract between petitioners and ATC. The parties executed the agreement on November 1, 1976. The terms of the agreement are set forth in an 8-paragraph instrument.Paragraph 1 of the instrument 2 essentially provides for the employment of Robert and Beverly with American Telecommunications S.A. (ATSA), a subsidiary of ATC in Fribourg, Switzerland. Paragraph 1 also specifies the employment title and salary of Robert and Beverly. Robert was to be employed as President of ATSA at a annual salary62 of $ 16,000 and Beverly as an administrative secretary at an annual salary of $ 8,000.Paragraph 2 sets forth the terms of the employee stock option. 3 This paragraph refers to "R.S. GROETZINGER" as the optionee. The paragraph describes the contingencies, the 536 quantities of shares, and the dates upon which Robert could exercise the option. Paragraph 2 makes no explicit or implicit reference to Beverly.63 Paragraphs 3 through 8 set forth further incidents of employment. 4 In each instance, these remaining paragraphs refer to petitioners collectively. Paragraph 8 provides in conclusion that the agreement as written would be construed and performance determined under California law and could not be amended except by an instrument executed by all of the parties.64 On January 19, 1977, the board of directors of ATC formally granted to Robert a stock option on ATC stock pursuant to paragraph 2 of the employment contract.Petitioners filed a joint individual income tax return for the calendar year 1977. On this return they reported gross income of $ 39,486.83. For purposes of the foreign earned income exclusion, Robert reported $ 20,009.60 and Beverly reported $ 10,004.80 of foreign earned income.During 1978 Robert exercised his option on 10,000 shares of ATC stock. 5 On December 1, 1978, ATC transferred the 10,000 shares to Robert, who paid $ 40,000 for the lot. Robert sold the 10,000 ATC shares within the month for the sum of $ 235,000. This sum was deposited in petitioners' 537 joint bank account on December 11, 1978. The gain amounted to $ 195,000.Petitioners filed a65 joint individual income tax return for the calendar year 1978. On this return they reported gross income of $ 146,850. Robert reported $ 125,594 in foreign earned income, which consisted of $ 97,500, or half of the gain, from the disposition of the employee stock option and $ 28,094 in salary. Beverly reported $ 10,747 in foreign earned income, which consisted of her ATSA salary alone. Under section 911, Robert and Beverly excluded $ 15,000 and $ 10,747, respectively, of their foreign earned income. On Form 3921 of petitioners' 1978 return, they described the option exercised as a restricted stock option within the meaning of section 424(b) and Robert as the person to whom the optionor ATC transferred the stock. Petitioners consistently described in their returns Robert's occupation as businessman and Beverly's as corporate secretary.In 1979 and 1980, petitioners filed two amendments to their 1977 tax return and one amendment to their 1978 return. Essentially, petitioners' amendments to their 1977 and 1978 tax returns reallocated the gain from the 1978 disposition of ATC stock first, between petitioners' taxable years 1977 and 1978 and second, between Robert and Beverly for66 1978 for purposes of computing their foreign earned income exclusions.Issue 1The first issue for decision is whether the proceeds from the stock option, which ATC explicitly granted to Robert, are divisible between Robert and Beverly for purposes of the foreign earned income exclusion provided in section 911. The resolution of this issue turns on whether petitioners may disavow the form of the employment contract pursuant to which the stock option was granted on the theory that the instrument did not represent the substance of the agreement.Section 911, 6 for the tax years in issue, permits an individual citizen of the United States who establishes 538 either bona fide residency in a foreign country or physical presence in such country for 17 months during a consecutive 18-month period to exclude certain earned income from foreign sources during the qualifying period. For 1978, 539 qualified taxpayers could elect to exclude a maximum of $ 15,000 for a complete tax year of foreign residence. When qualifying taxpayers are husband and wife, and both reside abroad and earn income abroad, separate ceilings apply to their earnings attributable to the services of each, 67 even though the income is community income. Sec. 911(c)(3).68 On brief, petitioners argue that for 1978, Beverly is entitled to the maximum exclusion under section 911(c)(1). The argument is predicated on their assertion that although in form the gain from the ATC stock disposition is allocable to Robert, alone, in substance the gain is allocable to both Beverly and Robert. Thus, under such allocation, Beverly's foreign earned income is sufficiently high to allow for the maximum exclusion.In arguing substance over form, petitioners address the economic reality of the employment agreement and the intention of the parties to the agreement. Petitioners contend that in economic reality the sales-related contingencies regarding the rights to exercise the stock option were achieved only by the services of both Beverly and Robert. According to petitioners on brief, "[Robert] would never have received his share of the proceeds without her participation." (Emphasis of petitioners.) They assert that the deposit of the proceeds in their joint bank account is objective evidence that in economic reality both received the income. Petitioners also contend that the parties to the agreement intended the stock option to apply to both Robert and 69 Beverly. Petitioners explain that "the stock option was issued only in the name of [Robert] solely for reasons of administrative facility and simplicity."On brief, respondent makes two arguments against any allocation of gains to Beverly. 7 First, he contends that "it would defy reason" to believe the parties intended anything other than the form in which the agreement was cast because its terms are "so clearly and unmistakably described." Second, respondent argues that the stock option involved herein constitutes a section 424 restricted stock option, and to permit the transfer of ATC shares to anyone 540 other than Robert would contradict the restrictive nature and purpose of section 424.We agree with respondent's determination, although with regard to his first contention we would be reluctant to bind petitioners to the form of their agreement solely on the70 ground that the form is clearly described. See Helvering v. F. & R. Lazarus & Co., 308 U.S. 252">308 U.S. 252 (1939); Landa v. Commissioner, 206 F.2d 431">206 F.2d 431, 432 (D.C. Cir. 1953), revg. a Memorandum Opinion of this Court; Ciaio v. Commissioner, 47 T.C. 447">47 T.C. 447, 457 (1967). Before proceeding with our reasons for deciding this issue for respondent, we pause to observe that respondent's second contention is clearly erroneous because the stock option involved herein cannot constitute a section 424 stock option by definition. According to sections 424(b) and 424(c)(3), a statutory "restricted stock option" must be granted before 1964, or later if pursuant to a binding contract made before 1964 or a written plan adopted and approved before 1964. By contrast, ATC granted Robert the stock option involved herein on January 19, 1977, pursuant to a November 1976, employment contract.The Commissioner's determinations, however, are presumptively correct, and petitioners bear the burden of disproving his adjustments. Rule 142(a). In cases such as the one sub judice, where the taxpayer seeks to avoid the form of his own71 agreement, a higher level of proof, known as the "strong proof standard," often is required in order for him to carry his burden. See Coleman v. Commissioner, 87 T.C. 178">87 T.C. 178 (1986); Major v. Commissioner, 76 T.C. 239">76 T.C. 239, 247 (1981); Lucas v. Commissioner, 58 T.C. 1022">58 T.C. 1022, 1032 (1972). 8 We find it unnecessary to determine whether this higher standard of proof is applicable to this case, for after a careful survey of the facts before us we are convinced that the petitioner has failed to disprove by a preponderance of evidence the Commissioner's determinations.72 541 Under the doctrine of substance over form, the objective economic realities, rather than the particular form in which the agreement was cast, govern the tax consequences of the agreement. Frank Lyon Co. v. United States, 435 U.S. 561">435 U.S. 561, 573 (1978); Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935). Under certain circumstances, a taxpayer may be entitled to argue substance over form in a transaction ( Helvering v. F. & R. Lazarus & Co., supra;Ciaio v. Commissioner, supra at 457), although petitioner must provide objective evidence that the substance of the transaction was in accord with the position argued by petitioner rather than the form set forth by all the relevant documents. Gulf Oil Co v. Commissioner, 86 T.C. 937">86 T.C. 937 (1986); Yamamoto v. Commissioner, 73 T.C. 946">73 T.C. 946, 954 (1980), affd. without published opinion 672 F.2d 924">672 F.2d 924 (9th Cir. 1982). Moreover, it is axiomatic that:while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must73 accept the tax consequences of his choice, whether contemplated or not, * * * and may not enjoy the benefit of some other route he might have chosen to follow but did not. * * * [Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134">417 U.S. 134, 149 (1974). 9We are convinced that the rule of National Alfalfa accurately addresses the situation presented herein. ATC and petitioners were free to structure the employment agreement, including the stock option provision, to their tax advantage. The record clearly establishes, and the petitioners do not dispute, that the employment agreement in form provided that ATC would grant the incentive stock option to Robert, alone. Under paragraph 2 of the agreement, the parties explicitly provided that Robert, rather than both Robert and Beverly, would be entitled to the stock option. The omission of Beverly's name in paragraph 2 is particularly obvious74 in the context of each of the remaining paragraphs, which refer to petitioners, collectively. In addition, the parties stressed in paragraph 8 of their instrument that the instrument represented the final embodiment of the agreement. In ascertaining the deliberateness of this form we look to the acts of the parties and the documentation surrounding the agreement unless we are given evidence to the contrary. Yamamoto v. Commissioner, supra at 954. The 542 objective acts and documentation indicate the parties subsequently abided by the agreement as they made it. Both petitioners and respondent agree that ATC formally granted the option to Robert alone pursuant to the agreement and that Robert himself exercised this option. In addition, petitioners document in their 1978 return that ATC transferred the shares to Robert in his name, alone.The petitioners understandingly elected to structure the stock option in the form of compensation for Robert, alone, and abided by the agreement as they made it. Following the principle of National Alfalfa, we find that petitioners must accept the tax consequences of their structural choice.We reject petitioners' 75 argument that the substance of the agreement, including the economic realities and underlying intent, differs from its form. In applying the substance-over-form doctrine we are concerned with the intentions at the time of the agreement and economic realities as then perceived by the participants. We are not called upon to restructure the transaction with the benefit of hindsight, for the nature of the stock option depends upon the agreement when entered into, and not upon subsequent action or inaction by the parties. See Yamamoto v. Commissioner, supra at 954; Barrett v. Commissioner, 58 T.C. 284">58 T.C. 284, 289 (1972). 10 As such, we are not concerned with petitioners' hindsight perspective of the agreement's potential tax benefits as well as their contention that Beverly's services helped ATSA achieve various sales quotas upon which Robert's exercise powers were contingent, or with such subsequent actions as the deposit of the proceeds from petitioners' sale of ATC stock into their joint account.76 By focusing on the substance of the agreement at the time the parties made it, we are convinced that the form of the stock option was imbued with economic reality. In making this factual determination, we look to the nature of this compensatory provision vis-a-vis the nature of services which each petitioner as employee performed. ATC structured the stock option essentially as a sales incentive. That is, Robert's exercise of the option was contingent upon ATSA's achievement of various sales goals as well as Robert's continuity of employment. In light of Robert's 543 status as president of ATSA and self-description as "Businessman," we reasonably assume that Robert had a direct impact on ATSA's volume of sales. Petitioners provide no objective evidence that Beverly, in her capacity as administrative secretary, had more than an indirect effect on ATSA's sales volume or that her position was by nature sales-oriented. We are concerned not with Beverly's title as "Administrative Secretary," but rather with her role as perceived by the parties to the agreement when executed. The surrounding facts, including petitioners' documentation on various returns, suggest her role was77 purely that of secretary and assistant. In consideration of the sales-oriented nature of the incentive stock option, we find it plausible that the form of the incentive stock option, applicable to Robert, alone, was imbued with economic reality.In petitioners' remaining contention as to the substance of the agreement, they argue that the parties to the agreement actually intended to allocate the stock option between Robert and Beverly. We find this argument unconvincing for two reasons. First, their argument is self-defeating. Petitioners explained that the stock option was structured as it was because the parties to the agreement intended to employ an administratively convenient form. Faced with competing intentions and the choice of tax benefits versus administrative simplicity, petitioners opted for simplicity, and they must accept the tax consequences. It is this type of deliberate choice of one form over another to which the Court in National Alfalfa speaks.Second, petitioners present no objective evidence that the parties to the contract specifically intended when the instrument was executed to allocate the stock option between Robert and Beverly. When an agreement78 in form is objectively void of any apportionment of the consideration which taxpayer is to receive, taxpayer's unilateral self-serving apportionment of the consideration is not binding upon the Commissioner. Accord Winn-Dixie Montgomery, Inc. v. United States, 444 F.2d 677">444 F.2d 677, 682 (5th Cir. 1971) (involving purchaser's unilateral allocation of goodwill to amortizable assets); Blackstone Realty Co. v. Commissioner, 398 F.2d 991">398 F.2d 991, 997 (5th Cir. 1968), affg. a Memorandum 544 Opinion of this Court (involving seller's unilateral valuation of certain component parts of sale). Petitioners present no objective evidence that the parties to the agreement intended to allocate quantitatively part of the option to Beverly, rather than merely to benefit her in a community property sense by compensating her spouse. Therefore, we reject petitioners' argument that their unilateral, self-serving allocation in their amended 1978 return of the stock option proceeds between Robert and Beverly is binding upon the Commissioner.We hold that the substance of the stock option provision within the employment contract coincided with its form. 79 Consequently, we agree with respondent that Robert, alone, is entitled to report the gain from the disposition of the stock option as earned income for purposes of computing the section 911 exclusion.Issue 2The second issue for decision is whether petitioners may attribute any gain from the 1978 disposition of the employee stock option to 1977 under the attribution rule of section 911(c)(2) (now section 911(b)(2)(B)).On brief, petitioners argue that the proceeds from the sale of the ATC shares "must be equally divided over the years 1977 and 1978 for income tax purposes." According to petitioners, section 911(c)(2) permits their attribution of the proceeds from the stock option to the years in which Robert earned the right to exercise the option. Petitioners assert they earned those rights by their performance of services over the 2-year period of 1977-78, and are entitled to report the proceeds as such.Respondent argues that petitioners must report the gain entirely in 1978. He relies on the application of the disqualifying disposition provisions of section 421(b)11 and 545 section 1.421-8(b)(1), Income Tax Regs., which require recognition of gain in the year of80 disposition. Respondent contends that Robert's exercise of the stock option and disposition of the ATC shares prior to the end of the 2-year holding period constituted a disqualifying disposition of a restricted stock option. As such, he contends petitioners must report the entire gain in the year of the disposition, i.e., 1978. Respondent concludes that this "mandate" as to the time for reporting the gain precludes petitioners from any attribution of gain to the year in which it was earned within the authority of section 911(c)(2).81 Respondent attempts to buttress his argument by tracing the legislative history of the attribution rule. 12 According to respondent, Congress intended the attribution rule of section 911(c)(2) to apply to such income items as salaries and profit-related bonuses paid after the closing of the taxable year. By contrast, respondent asserts most forms of deferred compensation are ineligible for the foreign earned income exclusion by virtue of section 911(c)(4) (now section 911(b)(1)(B)(iv)).We reject respondent's arguments; however, we find that petitioners have satisfied their burden of proof only in part. Respondent's argument that petitioners must report income from a disqualifying disposition of a section 424 restricted stock option in the year of disposition serves no purpose in this case, 82 for section 424 is inapplicable here by virtue of the dates on which ATC proposed and granted the option. 13 See secs. 424(b), 424(c)(3). Moreover, respondent's references to the legislative history of sections 911(c)(2) and 911(c)(4) carry little weight with regard to whether petitioners may attribute part of the gain to the taxable year 1977. Respondent shows no trace of congressional intent to preclude the application of section 911(c)(2) to such foreign earned income as exists here. Although section 911(c)(4) may preclude "most deferred compensation" from the 546 exclusion, that provision is inapplicable to the earned income in this case. Section 911(c)(4) explicitly precludes "[amounts] received after the close of the taxable year following the taxable year in which the services to which the amounts are attributable are performed." Robert received the stock option proceeds involved herein, by contrast, within the taxable year after the services were performed.83 Nevertheless, section 911(c)(2) does not necessarily permit taxpayers to exclude all of their foreign earned income attributable to the year in which the underlying services were performed. This is a consequence of the limitations on the amount of exclusion provided in section 911(c)(1). The attribution rule in effect puts a cash basis taxpayer on the accrual method of accounting exclusively for the purpose of calculating the section 911 exclusion, and does not affect the time of reporting foreign earned income that is includable in gross income. Section 911(c)(2) provides, "For purposes of [computing the amount excludable under section 911], amounts received shall be considered received in the taxable year in which the services to which the amounts are attributable are performed." (Emphasis supplied.) Section 1.911-2(d)(1), Income Tax Regs., T.D. 6665, 2 C.B. 27">1963-2 C.B. 27, applicable to the tax years in issue, dispels any possible vagueness as to the limited applicability of section 911(c)(2). Section 1.911-2(d)(1), Income Tax Regs., in relevant part provides:(1) Attribution to year in which services are performed. (i) For purposes84 of applying paragraphs (a)(4) and (b)(2) of this section, amounts received * * * by an individual shall be considered received in his taxable year in which the services to which the amounts are attributable are performed by such individual.(ii) The rule of subdivision (i) of this subparagraph applies only to determine the total amounts attributable to any one year for the purpose of determining the amount of the exclusion under paragraph (a)(4) or (b)(2) of this section and does not affect the time of reporting of any amounts which are includible in the individual's gross income. [Emphasis supplied.]See Cook v. United States, 220 Ct. Cl. 76">220 Ct. Cl. 76, 599 F.2d 400">599 F.2d 400, 408 (1979). Needless to say, under section 911 petitioners may not attribute to 1977 any of the gain from the sale of ATC stock for purposes other than applying it against Robert's 547 $ 25,000 exclusion for 1977, regardless of when Robert performed the underlying services.Having determined in issue 1 that the gain from the 1978 sale of ATC stock constitutes foreign earned income of Robert, alone, we find the real issue is whether petitioners may attribute any of the85 gain to 1977 for purposes of recomputing Robert's 1977 foreign earned income exclusion. Resolution of this issue turns on whether any amount of the gain is attributable to Robert's services performed in 1977 and, if so, whether any of such gain is excludable from 1977 gross income within the applicable section 911 dollar limitations.We accept petitioners' contention that half of the $ 195,000 gain from the sale of ATC stock is attributable to services performed in 1977. Petitioners claim that the rights to exercise the stock option on the 10,000 shares of ATC stock were earned from services performed during 1977 and 1978. According to petitioners, half of the gain resulting from the sale of ATC shares is therefore attributable to services performed in 1977. Respondent did not dispute this assertion, and we conclude that respondent concedes this point.From this part of the gain attributable to Robert's performance of services in 1977, we determine that $ 4,990.40 is excludable within the section 911 ceiling applicable to Robert for 1977. We compute this figure as follows. For tax years beginning in 1977, individuals who were bona fide residents of a foreign country for an uninterrupted86 period of 3 consecutive years were entitled to a maximum annual exclusion of $ 25,000. Sec. 911(c)(1)(B). In petitioners' amended 1977 return, they indicate, and respondent does not dispute, that Robert was such a bona fide resident. According to petitioners' 1977 tax return, Robert's foreign earned income, excluding the stock option proceeds attributable to 1977 services, amounted to $ 20,009.60. Petitioners are therefore entitled to attribute $ 4,990.40 of the gain from the 1978 sale of ATC stock to the taxable year 1977 for purposes of computing Robert's section 911 exclusion. To the extent such holding results in an overpayment for 1977, petitioners will be deemed to have amended their petition to request such overpayment. Petitioners may 548 not attribute any of the balance of the gain to 1977 for purposes of the section 911 exclusion.As a final matter, we must deal with petitioners' motions for dismissal, filed July 15, 1985, and for the award of fees and costs, filed July 15, 1985. Petitioners based their motion for dismissal on events occurring entirely at the administrative level. In rejecting this motion, we remind petitioners, as we informed them during the87 hearing, that trials in the Tax Court are de novo. We must determine petitioners' tax liability based on the merits of the case and not on any previous record developed at the administrative level. Greenberg's Express, Inc. v. Commissioner, 62 T.C. 324">62 T.C. 324, 327-328 (1974).We also reject petitioners' motion for award of fees and costs pursuant to section 7430, which provides that reasonable litigation costs may be awarded to the prevailing party. Petitioners' motion, filed on the date of the hearing rather than after the service of the written opinion, does not comply with the provisions of Rule 231(a)(2) and is therefore denied.To reflect the foregoing, as well as concessions,An appropriate order will be issued and decision will be entered under Rule 155. Footnotes1. Unless otherwise indicated, all section references are to sections of the Internal Revenue Code of 1954 in effect during the years in issue. All Rule references are to the Tax Court Rules of Practice and Procedure.↩2. Par. 1 of the employment contract provides in relevant part:"Mr. R.S. GROETZINGER will be employed as President of ATC's subsidiary company in FribourgSwitzerland, AMERICAN TELECOMMUNICATIONS S.A. ('ATSA') at a salary of $ 16,000 per year. BEVERLY L. GROETZINGER, his wife, will be employed as administrative secretary of ATSA at a salary of $ 8,000 per year. During the period of employment of Mr. GROETZINGER by ATSA, MANAGEMENT AND FINANCE S.A., of FribourgSwitzerland ('MAFSA') will be paid a consulting fee of $ 6,000 per year. * "↩3. Par. 2 of the employment contract provides:"Subject to ATC Board of Directors' approval and further subject to and contingent upon the validity and operability under applicable laws and regulations, it is intended that Mr. R.S. GROETZINGER will receive a stock option in two parts."A. 8,000 shares of a normal ATC stock option based on a plan to be initially presented at the next ATC board meeting. This plan will allow R.S. GROETZINGER to exercise 20% of the shares during each year of his employment for five years at the market price prevailing at the time the option is initially granted by the ATC board."B. Up to 10,000 additional shares on terms similar to the normal ATC stock option will be made available at market price at the date of the initial grant by the ATC board on the following basis if Mr. GROETZINGER is then still employed by ATSA: If on May 1, 1979, the cumulative sales of ATSA will have been $ 4,576,981 or more, Mr. GROETZINGER will be able to exercise an option for 687 shares. If on May 1, 1980, the cumulative sales of ATSA will have been $ 9,607,448 or more, Mr. GROETZINGER will be able to exercise an option for 1,226 additional shares. If, for any reason, the 687 shares scheduled for the previous year were not exercised, he may then also exercise those shares. If on May 1, 1981, the cumulative sales of ATSA will have been $ 18,578,929 or more, Mr. GROETZINGER will be able then to exercise an option for 2,187 additional shares. In addition, he may exercise his option for the shares which he would have been eligible for at May 1, 1979, and May 1, 1980, if he did not exercise those options at that time. If on May 1, 1982, the cumulative sales of ATSA will have been $ 34,578,929 or more, Mr. GROETZINGER will be able to exercise an option for 3,900 additional shares. In addition, he may then exercise his option for the shares which he would have been eligible for during the three previous years. Also in addition, on May 1, 1982, if the cumulative sales are greater than that figure ($ 34,578,929), he may exercise an option for one additional share for each $ 4,322.37 of sales over that total to a maximum of 2,000 additional shares."↩4. Pars. 3 through 8 of the employment contract provide in relevant part:3. Mr. and Mrs. GROETZINGER will be immediately eligible for health insurance under ATC's normal Blue Cross plan. * 4. The employees have agreed to move their residence from London to Switzerland as soon as practicable and to there establish ATC's principal European operating headquarters. * 5. Special Overseas Benefit -- Commencing in 1978 and each year thereafter in which both Mr. and Mrs. GROETZINGER are employed by ATSA, ATC agrees to reimburse them for the cost of economy airfare from Europe to the U.S.A. for the purpose of annual home leave. * 6(a) Unless sooner terminated for cause by either party, or except as provided in (b) below, this agreement will be effective for three (3) years commencing on November 1, 1976.(b) Either party may terminate this Agreement at any time upon one (1) year's written notice. It is expressly agreed by R. S. GROETZINGER and by B. L. GROETZINGER that they have accepted this provision for termination by ATC on one year's notice * 7. It is contemplated and agreed to by the parties that this Agreement may be assigned by ATC to ATSA at some time in the future, at ATC's option.8. MiscellaneousA. This Agreement will be construed and performance determined in accordance with the laws of the State of California, U.S.A.B. This Agreement constitutes the entire agreement related to the employment of R.S. GROETZINGER and B.L. GROETZINGER by ATC and/or by ATSA and shall not be varied, amended or supplemented except by an instrument in writing executed by all the parties * ↩5. The record does not reveal how Robert in 1978 could exercise the option on 10,000 shares of ATC stock within the terms of the stock option plan as provided in par. 2 of the employment contract.↩6. For 1977 sec. 911 provided in relevant part:SEC. 911(a). General Rule. -- The following items shall not be included in gross income and shall be exempt from taxation under this subtitle: (1) Bona fide resident of foreign country. -- In the case of an individual citizen of the United States who establishes to the satisfaction of the Secretary that he has been a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year, amounts received from sources without the United States (except amounts paid by the United States or any agency thereof) which constitute earned income attributable to services performed during such uninterrupted period. The amount excluded under this paragraph for any taxable year shall be computed by applying the special rules contained in subsection (c).(2) Presence in foreign country for 17 months. -- In the case of an individual citizen of the United States who during any period of 18 consecutive months is present in a foreign country or countries during at least 510 full days in such period, amounts received from sources without the United States (except amounts paid by the United States or any agency thereof) which constitute earned income attributable to services performed during such 18-month period. The amount excluded under this paragraph for any taxable year shall be computed by applying the special rules contained in subsection (c). * * (b) Definition of Earned Income. -- For purposes of this section, the term "earned income" means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered. * (c) Special Rules. -- For purposes of computing the amount excludable under subsection (a), the following rules shall apply: (1) Limitations on amount of exclusion. -- The amount excluded from the gross income of an individual under subsection (a) for any taxable year shall not exceed an amount which shall be computed on a daily basis at an annual rate of -- (A) except as provided in subparagraph (B), $ 20,000 in the case of an individual who qualifies under subsection (a), or(B) $ 25,000 in the case of an individual who qualifies under subsection (a)(1), but only with respect to that portion of such taxable year occurring after such individual has been a bona fide resident of a foreign country or countries for an uninterrupted period of 3 consecutive years.(2) Attribution to year in which services are performed. -- For purposes of applying paragraph (1), amounts received shall be considered received in the taxable year in which the services to which the amounts are attributable are performed.(3) Treatment of community income. -- In applying paragraph (1) with respect to amounts received for services performed by a husband or wife which are community income under community property laws applicable to such income, the aggregate amount excludable under subsection (a) from the gross income of such husband and wife shall equal the amount which would be excludable if such amounts did not constitute such community income.Congress revised much of sec. 911 for tax years beginning in 1978 under the Tax Treatment Extension Act of 1977, Pub. L. 95-615, sec. 202, 92 Stat. 3098 (act). Under the act's transition rule, however, taxpayers could elect for 1978 to apply sec. 911 as it existed for 1977, subject to a $ 15,000 limitation. Pub. L. 95-615, sec. 209, 92 Stat. 3109.Congress initially enacted the $ 15,000 limitation under sec. 911(c)(1)↩ effective for tax years beginning in 1976. Tax Reform Act of 1976, Pub. L. 94-455, sec. 1011(a), 90 Stat. 1610. Under subsequent amendments, however, Congress postponed the effective date of the $ 15,000 limitation until tax years beginning in 1978. See Tax Reduction and Simplification Act of 1977, Pub. L. 95-30, sec. 302, 91 Stat. 152; Tax Treatment Extension Act of 1977, Pub. L. 95-615, sec. 4(a), 92 Stat. 3097.7. Respondent does not dispute that the entire gain from the disposition of ATC stock constitutes "earned income" within the meaning of sec. 911(b)↩.8. Most of the "strong proof standard" cases involve potentially conflicting claims among taxpayers, including disputes over partial allocations of sale prices to covenants not to compete. See Major v. Commissioner, 76 T.C. 239">76 T.C. 239, 246 (1981); Lazisky v. Commissioner, 72 T.C. 495">72 T.C. 495, 500-502 (1979), affd. sub nom. Magnolia Surf, Inc. v. Commissioner, 636 F.2d 11 (1st Cir. 1980). But see Coleman v. Commissioner, 87 T.C. 178">87 T.C. 178 (1986); Mittleman v. Commissioner, 56 T.C. 171">56 T.C. 171, 175 (1971), affd. per curiam 464 F.2d 1393">464 F.2d 1393↩ (3d Cir. 1972).9. See Treister v. Commissioner, T.C. Memo. 1986-53↩.10. See also Import Specialties, Inc. v. Commissioner, T.C. Memo. 1982-41↩.11. Sec. 421(b) provides in pertinent part:SEC. 421(b)↩. Effect of Disqualifying Disposition. -- If the transfer of a share of stock to an individual pursuant to his exercise of an option would otherwise meet the requirements of section * * 424(a) except that there is a failure to meet any of the holding period requirements of section * * * 424(a)(1), then any increase in the income of such individual or deduction from the income of his employer corporation for the taxable year in which such exercise occurred attributable to such disposition, shall be treated as an increase in income or a deduction from income in the taxable year of such individual or of such employer corporation in which such disposition occured.12. Respondent cites S. Rept. 1881, 87th Cong., 2d Sess. 74, 77 (1962), 3 C.B. 707">1962-3 C.B. 707, 783; H. Rept. 1447, 87th Cong., 2d Sess. 54, 56 (1962), 3 C.B. 405">1962-3 C.B. 405↩, 459-460.13. We remind respondent of his ruling that income from the disqualifying disposition of a statutory employee stock option may constitute excludable foreign earned income under sec. 911. Rev. Rul. 69-118, 1 C.B. 135">1969-1 C.B. 135. According to the ruling, the special rules of sec. 911(c), including the attribution of earned income to the period during which the services were performed, govern the reporting of this foreign earned income. Rev. Rul 69-118, supra, 1969-1 C.B. at 136↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622041/	HAROLD L. CARTER, DECEASED, AND CAROLYN R. CARTER, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentCarter v. CommissionerDocket No. 32161-88United States Tax CourtT.C. Memo 1989-639; 1989 Tax Ct. Memo LEXIS 639; 58 T.C.M. (CCH) 818; T.C.M. (RIA) 89639; November 30, 1989Leonard Thomas Bradt, for petitioners. Carole L. Meisler and Richard Goldman, for the respondent. FAYMEMORANDUM FINDINGS OF FACT AND OPINION FAY, Judge: This case was assigned to Special Trial640 Judge D. Irvin Couvillion pursuant to the provisions of section 7443A(b) of the Internal Revenue Code of 1986 and Rule 180 et seq. 1 The Court agrees with and adopts the opinion of the Special Trial Judge, which is set forth below. OPINION OF THE SPECIAL TRIAL JUDGE COUVILLION, Special Trial Judge: This case is before the Court on cross motions to dismiss for lack of jurisdiction. Respondent's motion is based on the contention that the petition was not filed timely. Petitioners' motion is based on the contention that the notice of deficiency was not mailed to their last known address. FINDINGS OF FACT At the time the petition was filed, the legal residence of petitioners was Miami, Florida. Respondent determined a deficiency of $ 8,954 in petitioners' 1983 Federal income tax and additions to tax of $ 447.70 under section 6653(a)(1), 50 percent of the interest due on that portion of the deficiency attributable to641 negligence or intentional disregard of rules or regulations under section 6653(a)(2), and $ 2,238.50 under section 6661. Respondent issued the notice of deficiency, by certified mail, on February 27, 1987. It was addressed to petitioners at "3430 N W 19th St., Miami, FL 33125." The petition was filed with this Court on December 15, 1988, 658 days after the notice of deficiency was mailed. At the time the petition was filed, Harold L. Carter was deceased, and the petition was filed by Carolyn R. Carter (petitioner). Respondent offered United States Postal Service (USPS) Form 3877, Application for Registration or Certification, as evidence of proper mailing of the notice of deficiency. The address to which the notice of deficiency was sent was the same address which appeared on petitioners' 1985 Federal income tax return as well as on their 1983 return. Petitioners' 1985 return was the last return filed by them prior to issuance of the notice of deficiency. In September 1986, five months prior to mailing of the notice of deficiency, petitioner moved from 3430 N.W. 19th Street to 1450 N.W. 36th Avenue in Miami. Approximately three months later, in December 1986, petitioner moved642 to 3564 Crystal Court in Miami, also prior to mailing of the notice of deficiency. Each time petitioner moved, she submitted to the USPS a change of address card ordering all mail addressed to her at her previous addresses to be forwarded to her new address. Petitioner testified she did not experience any difficulty with these orders being complied with, except with regard to the notice of deficiency. Petitioner did not notify respondent of any change of address from 3430 N.W. 19th Street. The notice of deficiency was returned to respondent undelivered on March 16, 1987, 17 days after it had been mailed, with the following handwritten notation on the envelope: "FWD TO 3564 CRYSTAL CT 33133." Both petitioner and respondent deny that either they or any agent acting on their behalf inscribed the forwarding notation on the envelope. Neither party established who inscribed this forwarding notation. After receiving the undelivered notice, respondent made no attempt to mail any other notice to petitioner and did not forward the undelivered notice to the forwarding address indicated. The returned envelope bears no USPS notations with regard to attempted deliveries. Petitioner, for the643 first time, received a copy of the notice of deficiency upon request in 1988 and filed the petition within 90 days of her receipt of the notice. Respondent alleges that the period in which a petition could have been filed with this Court expired on May 28, 1987, 90 days after February 27, 1987, and, accordingly, moved to dismiss for lack of jurisdiction. Petitioner filed an objection to respondent's motion and filed a cross motion to dismiss for lack of jurisdiction. Petitioner alleges (1) respondent failed to mail the notice of deficiency to petitioner's last known address, (2) respondent failed to use due diligence in ascertaining petitioner's correct address in light of the forwarding address written on the returned envelope, and (3) diversion of the notice by the USPS resulted in an invalid notice. OPINION A valid notice of deficiency and a timely-filed petition are prerequisites to commencing an action for the redetermination of a deficiency in this Court. Sections 6212 and 6213; e.g., Pyo v. Commissioner, 83 T.C. 626">83 T.C. 626, 632 (1984). When the notice of deficiency is addressed to a person within the United States, a petition is timely only if filed within644 90 days after the notice of deficiency is mailed. Section 6213(a). The petition here was filed December 15, 1988, 658 days after the notice of deficiency was mailed. If the notice of deficiency was properly issued, respondent's motion must be granted because the petition was clearly filed late. Respondent is authorized to send a notice of deficiency to a taxpayer if it is determined that there is a deficiency in tax. Section 6212(a). If the notice is "mailed" to the taxpayer's "last known address" by certified or registered mail, respondent has complied with the mailing requirement of section 6212(a) and the 90-day period during which a petition may be filed begins to run. Section 6212(a) and (b). On February 27, 1987, the date the notice of deficiency was mailed, petitioner's actual address was 3564 Crystal Court. The notice of deficiency was addressed to 3430 N.W. 19th Street, petitioner's correct former address. It is respondent's knowledge of petitioner's address, however, rather than what may in fact be petitioner's current address which is the relevant inquiry. Brown v. Commissioner, 78 T.C. 215">78 T.C. 215, 218-219 (1982); Alta Sierra Vista, Inc. v. Commissioner, 62 T.C. 367">62 T.C. 367, 374 (1974).645 "A taxpayer's last known address is that address which appears on the taxpayer's most recently filed return, unless respondent has been given clear and concise notification of a different address." Abeles v. Commissioner, 91 T.C. 1019">91 T.C. 1019, 1035 (1988). Petitioner's most recently filed return was her 1985 Federal income tax return. The address which appeared on that return was 3430 N.W. 19th Street, the address to which the notice was mailed. Petitioner concedes she did not notify respondent of any change in her address. Further, there is no evidence to suggest that, at the time the notice was mailed, petitioner's last address known to respondent was other than 3430 N.W. 19th Street. Petitioner argues that respondent failed to use due diligence to ascertain petitioner's last known address in light of the undelivered notice returned to respondent with a forwarding address indicated. Once respondent becomes aware of a change in address, reasonable care and diligence must be exercised in ascertaining and mailing the notice of deficiency to the correct address. Frieling v. Commissioner, 81 T.C. 42">81 T.C. 42, 49 (1983). However, such an obligation arises only if646 respondent becomes aware of an address change prior to mailing the notice of deficiency; events subsequent to the mailing have no effect on respondent's knowledge at the time of mailing. Monge v. Commissioner, 93 T.C. 22">93 T.C. 22, 33 (1989). Petitioner's reliance on McPartlin v. Commissioner, 653 F.2d 1185">653 F.2d 1185 (7th Cir. 1981), revg. and remanding an order of this Court, is misplaced. In McPartlin, the communications between the taxpayer and respondent in which respondent was advised of the taxpayer's new address occurred two to three years prior to mailing the notice of deficiency. The case of Mulder v. Commissioner, 855 F.2d 208">855 F.2d 208 (5th Cir. 1988), revg. and remanding T.C. Memo. 1987-363, also relied on by petitioner, is similarly distinguished. Both McPartlin and Mulder support the proposition that due diligence must be exercised in ascertaining the correct address where there is evidence of a new address prior to mailing the notice of deficiency. The focus is on what respondent knew at the time the notice of deficiency was issued and whether, in light of all the surrounding facts and circumstances, the address647 used was that which respondent reasonably believed was the address where the taxpayer wanted the notice to be sent. Pyo v. Commissioner, supra at 633; Brown v. Commissioner, supra at 218-219. Relying on Estate of McKaig v. Commissioner, 51 T.C. 331">51 T.C. 331 (1968), petitioner contends that the USPS improperly diverted the notice of deficiency and, because of such diversion, the notice was invalid. This Court has expressed reservations as to whether the holding for Estate of McKaig has withstood the test of time. Evans v. Commissioner, T.C. Memo 1989-569">T.C. Memo. 1989-569. Nevertheless, petitioner has not shown that the notice of deficiency was diverted by the USPS in this case. The envelope in which the notice of deficiency was mailed was stipulated into evidence by the parties. An inspection of the envelope shows clearly that, on the right side of the address window, a yellow sticker had been affixed to the envelope, and a major portion of this sticker had been removed, except for a small piece of the lower right-hand corner. No evidence was adduced by petitioner with respect to the sticker or its removal. If the USPS diverted*648 the notice, as petitioner contends, the Court would have been interested in considering evidence as to how the notice was handled, whether a forwarding sticker had been affixed to the envelope containing the notice, who removed the sticker and why, and, if the removed sticker was a forwarding sticker, whether the forwarding address thereon was correct. The mere fact that the notice was returned to respondent undelivered, in and of itself, does not establish diversion. Without any evidence, this Court is unable to find that the USPS improperly diverted the notice of deficiency. The evidence presented to the Court, as noted, points to compliance by the USPS with petitioner's forwarding instructions. The Court finds, therefore, that the notice of deficiency was mailed to petitioner's last known address. The petition was not timely filed and, accordingly, respondent's motion to dismiss for lack of jurisdiction is granted. Petitioner's motion is denied. An appropriate order will be entered. Footnotes1. Unless otherwise indicated, all further section references are to the Internal Revenue Code of 1954, as amended and in effect for the year at issue. All Rule references are to the Tax Court Rules of Practice and Procedure.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622042/	JERRY J. BEZNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentBezner v. CommissionerDocket No. 27044-82.United States Tax CourtT.C. Memo 1985-87; 1985 Tax Ct. Memo LEXIS 545; 49 T.C.M. (CCH) 835; T.C.M. (RIA) 85087; February 26, 1985. 545 Held: Wages and compensation received by petitioner as an employee are includable in his gross income and are subject to the payment of Federal income tax thereon. Jerry J. Bezner, pro se. David G. Hendricks, for the respondent. CLAPPMEMORANDUM FINDINGS OF FACT AND OPINION CLAPP, Judge: Respondent determined a deficiency of $1,902.91 in petitioner's 1980 Federal income tax. The parties have stipulated that the only issue for decision is whether wages and compensation received by petitioner as an employee are subject to Federal income tax. It is further stipulated that should the issue be decided against petitioner, the deficiency in his 1980 Federal income tax is to be $1,190.09. FINDINGS OF FACT Many of the facts, including the contingent determination of deficiency, are stipulated. The stipulation and attached exhibits are incorporated herein by this reference. Petitioner Jerry J. Bezner was a resident of Union City, Oklahoma, at the time of filing the petition. The original petition challenged respondent's disallowance of claimed deductions for certain medical expenses and charitable contributions. Petitioner at trial was granted546 leave to file an amended petition wherein he alleges that wages and compensation paid to him by his employer are not income within the contemplation of the Sixteenth Amendment to the U.S. Constitution or the Internal Revenue Code of 1954. The dispute regarding the claimed deductions has been resolved by stipulation of the parties. OPINION Petitioner asserts that the wages and compensation paid him by his employer are not subject to the Federal income tax because they do not constitute income. We do not agree. It is well settled that wages are income. Rowlee v. Commissioner,80 T.C. 1111">80 T.C. 1111, 1119-1122 (1983), and cases cited therein. As to this issue, we find for respondent. An appropriate decision will be entered.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622044/	Vernon W. McPherson and Carolyn M. McPherson v. Commissioner.McPherson v. CommissionerDocket No. 79784.United States Tax CourtT.C. Memo 1962-106; 1962 Tax Ct. Memo LEXIS 203; 21 T.C.M. (CCH) 583; T.C.M. (RIA) 62106; May 1, 1962Richard W. Case, Esq., 300 St. Paul Place, Baltimore, Md., and George Edward Thomsen, Esq., for the petitioners. William L. Kinzer, Esq., for the respondent. MULRONEY Memorandum Findings of Fact and Opinion MULRONEY, Judge: The respondent determined a deficiency in petitioners' income tax for the year 1954 in the amount of $32,407.92. The main issue is whether the gain realized by petitioners upon dissolution of their corporation is to be considered as gain from the sale or exchange of property which is not a capital asset, as provided in section 341, Internal Revenue Code of 1954. 1 Another issue is presented involving the correct amount of gain petitioners realized upon the dissolution204 of the corporation. Findings of Fact Some of the facts have been stipulated and they are found accordingly. Petitioners are husband and wife and they reside in Baltimore, Maryland. They filed their joint income tax return for the taxable year 1954 with the district director of internal revenue at Baltimore, Maryland. Vernon W. McPherson has been in the real estate business since 1939. The business consisted of selling all kinds of houses and occasionally he sold new houses for builders. In 1953 he decided to go into the building business and in about June of that year he negotiated for the purchase of a 62-acre tract of land located on the west side of York Road near Towson, Baltimore County, Maryland. As the result of these negotiations McPherson, on October 10, 1953, signed a contract to purchase the above described tract of land containing approximately 62 acres for the sum of $86,279.20, or approximately $1,400 per acre. A preliminary statement should be made with respect to acreage areas. There is confusion in the record because of the use of fractions, or such terms as "approximately" 205 or "more-or-less" - sometimes the entire area is referred to as 62 1/2 acres by one party and 62 acres by the other. Other parts of this area, which, as will be seen later, must receive separate mention, are given different acreage areas (differing by as much as 1 to 2 acres) by the parties. We do not understand that any issue depends on exact acreage so we will omit fractions and qualifying phrases and use the acreage figures that seem to identify parcels. Prior to McPherson signing the contract to purchase the above property he had engaged the services of Bernard Willemain, who was a Site Planner, for the principal purpose of ascertaining how many lots could be made out of the tract so that he would know about how much he could pay for the tract. Willemain made up a lot plan and he recommended that an engineering firm, Whitman, Requardt and Associates, be engaged to prepare a topographic map of the entire tract, principally to see how many of the proposed lots would or could be served with existing sewer lines. It was based upon reports received from Willemain and Whitman, Requardt and Associates that McPherson entered into the contract to purchase the 62-acre tract and at the206 time of the execution of the contract he made a down payment of $8,500. On October 26, 1953, McPherson caused the formation of two corporations. One was The Carolyn Company, in which he was issued 90 percent of the stock and his wife was issued 10 percent of the stock for a total of $8,000 cash. The other was Carolyn Homes, Inc., in which he, his wife, and Robert L. Purdy were each issued one-third of the stock. On March 23, 1954 settlement was made for the 62-acre tract by deed to The Carolyn Company and a purchase money mortgage signed by Carolyn Company and guaranteed by Vernon W. McPherson in the amount of $56,000. The mortgage only covered 47 acres in the northern part of the 62-acre tract. On March 30, 1954, The Carolyn Company deeded the 15 acres not encumbered by the mortgage to Carolyn Homes, Inc. McPherson's plan for the development of the tract was to have Carolyn Homes, Inc. begin its development first on its 15-acre tract by building houses on the lots which were to be laid out on a final plat to be recorded with Baltimore County and thereafter have Carolyn Company start its development. Since Purdy was a one-third owner of Carolyn Homes, Inc., separate financing207 would be required. Pursuant to this plan carolyn Homes, Inc., in order to obtain working capital, on March 30, 1954, borrowed $24,960 on a mortgage on its 15 acres, which yielded a net of $23,285.94. The working capital was inadequate due to erroneous estimates of costs and overhead expenses and failure to take into consideration advancements necessary for cost of installing utilities. After construction had started on the first lots in the 15-acre tract McPherson learned utilities costing in the neighborhood of $40,000 would be required and that Baltimore County would not allow the installation of the utilities and payment at the time of sale of the completed houses; that payment had to be deposited with the county before beginning the work of installing the utilities. Construction mortgages covering certain lots which financed the buildings on the lots would not be available to finance the prepayment of utility costs. McPherson was without quick assets on which he could borrow the sum needed to continue Carolyn Homes, Inc. development. In May or early June 1954 the decision was made to raise the needed money by dissolving Carolyn Company and put the 47 acres back in the names208 of McPherson and his wife and sell a part of the 47 acres to raise the needed money. Some time in early June, McPherson was offered $2,000 an acre by The Edmondale Building Company for 37 acres of the 47-acre tract, which offer was refused. On July 6, 1954 the directors of Carolyn Company voted to dissolve the corporation. In July of 1954 McPherson again entered into negotiations with a broker representing The Edmondale Building Company. This company was developing a tract of land lying to the west of the 62-acre tract called Orchard Hills. The Edmondale Building Company was anxious to secure a portion of The Carolyn Company's tract lying adjacent to its Orchard Hills development. Some 20 acres of the land which had been in its Orchard Hills development had been taken for school purposes. The Carolyn Company's land would give the Orchard Hills development an access to York Road, which was a more valuable vehicle access than the one it had to the west of its Orchard Hills development. As the result of further negotiations, McPherson entered into a contract on July 29, 1954 wherein he agreed to sell The Edmondale Building Company 37 acres of the 47 acres The Carolyn Company owned209 for the sum of $113,965.62, or approximately $3,125 per acre. On September 3, 1954 the articles of dissolution of The Carolyn Company were received by the State Tax Commission of Maryland. On September 22, 1954, the 47-acre tract was deeded by The Carolyn Company to the two stockholders, Vernon W. McPherson and Carolyn M. McPherson. On November 23, 1954 settlement was made between the petitioners and The Edmondale Building Company and the 37 acres were conveyed by petitioners to The Edmondale Building Company for the full amount of $113,965.62. On their joint individual income tax return for the taxable year 1954, petitioners reported the amount of $77,550 as a long-term capital gain realized upon the exchange of their stock in dissolution of The Carolyn Company. The reported gain was computed as follows: Gross Sales Price (Net Equity in AssetsDistributed)$85,550Less Cost Basis8,000Gain$77,550In his notice of deficiency the respondent determined the fair market value of petitioners' net equity in the assets received upon liquidation of The Carolyn Company was $95,250 instead of $85,550, as reported. Accordingly, respondent determined the gain realized210 upon liquidation of The Carolyn Company was $87,250 instead of $77,550, as reported. Respondent also determined that The Carolyn Company was a collapsible corporation, as defined in section 341(b) and therefore the gain was taxable as ordinary income. The Carolyn Company was not formed or availed of principally for the construction of property, with a view to a distribution to petitioners, prior to the realization by The Carolyn Company of a substantial part of the net income to be derived from the property. Opinion The first issue is whether the gain upon the distribution of Carolyn Company's assets to its two stockholders is taxable to them as ordinary income, as determined by respondent, or as capital gain, as reported by petitioners. The parties admit the issue will be determined by deciding whether Carolyn Company was a "collapsible corporation", as defined in section 341(b), Internal Revenue Code of 1954. 2211 Respondent's position is that the requisite view: that Carolyn was formed or availed of with a view to a distribution to stockholders by liquidation before realization of a substantial part of its income to be derived from its property, existed at the time the company was formed or the land purchased, or thereafter the requisite view existed during construction. We think it was established that at the time Carolyn Company was formed and the land acquired, the incorporators entertained no thought of its liquidation prior to its realization of a substantial part of income from the property acquired. The corporation was formed and the property acquired for the purpose of subdividing the land into lots, building houses thereon, and selling them to the public. Nothing in the record would indicate that at the time the company was formed and the land acquired McPherson contemplated an early liquidation prior to the company realizing the potential income that prompted him to form the company and cause it to buy the property. The purchase price was based upon surveys as to the number of building lots that the tract contained and everything indicates that at the time the company was formed212 and the land obtained, the intent of McPherson, who dictated the policy of the corporation, was to have it enter the building business on the land it acquired. McPherson testified that the intent to liquidate first came when he was pressed for funds to carry on building activities that had been started by Carolyn Homes, Inc. on its property. Other evidence corroborates his testimony. We hold the requisite view did not exist at the time The Carolyn Company was formed and the land acquired. Carolyn Company was, as indicated above, and, to use the words of the statute, "formed * * principally for * * * construction." (Sec. 341 (b)(1)). Respondent admits that if the requisite view did not exist at the time the corporation was formed and its land asset acquired, it would have to exist "during construction" in order to make Carolyn Company a collapsible corporation within the statutory definition. See also section 1.341-2(a)(3), Income Tax Regs. Thus we have here a corporation that was formed for construction but it could not be availed of for construction with a view to a distribution to its stockholders by early liquidation if no construction occurred before213 liquidation. We hold no construction in fact ever occurred prior to liquidation. At the time the corporation was liquidated its land asset was in the same condition as when it was purchased. It was a tract of rural realty covered by second growth timber and nothing was physically done to the land during the life of Carolyn Company. Respondent argues construction within the meaning of the statute occurred by virtue of preliminary steps with respect to surveys and platting the area. The most that the record shows in this regard is that McPherson, before he executed the contract to buy the 62 acres in October of 1953, hired Willemain to make a plat layout to show him what he could expect to do with the land and give him an idea of how much he could pay for it. Willemain, who was not an engineer, recommended hiring Whitman, Requardt and Associates, who made a topography survey, which showed approximately how many lots would be serviced by present sewer lines. McPherson testified he paid Willemain $600 and Whitman, Requardt and Associates $3,000 for the plat layout and survey. The two items appear as preincorporation expenses on the books of Carolyn Company as of March 23, 1954, the214 date Carolyn Company acquired the 62 acres. A survey map, prepared by Whitman, Requardt and Associates, and bearing date "November 27, 1953 Revised February 24, 1954" was introduced in evidence. Witnesses refer to this as a "tentative plat." It shows the entire area of 62 acres but it is not a plat in the sense of portraying accurate lots, and dedicated highways. There was some testimony that the map of Whitman, Requardt and Associates or one like it was filed with Baltimore County, but witnesses testified the filing of such a map, called a tentative plat, would give the landowner no right to improve and develop the property; that nothing short of a recorded plat showing lot and road layouts would or could be approved for construction and development. Witnesses for petitioner testified the filing of this tentative plat was required by the county authorities. We find nothing in the Maryland statutes to that effect. However, it is clear that the map of Whitman, Requardt and Associates would not qualify for recording as a plat under Art. 17, § 60, Annotated Code of Maryland. 3 There was testimony that a final plat was recorded for the 15 acres titled to Carolyn Homes, Inc. but petitioners' 215 evidence is that no final plat was ever recorded for the 47 acres by Carolyn Company. One was filed later by Edmondale (who made no use of the tentative plat filed by petitioner) on the 36 acres it purchased. We do not believe the filing of this tentative plat can be called a step in construction. Respondent relies upon J. D. Abbott, 28 T.C. 795">28 T.C. 795, affirmed 258 F. 2d 537. The case is readily distinguishable. There the corporation had, prior to liquidation, actually subdivided the property, dedicated streets, secured approval of the municipality of its plans, constructed streets, installed utilities, and secured financing through FHA commitments. We held such activities constituted "construction" in the statutory sense. Here none of the things, which were held to be part of construction in216 the Abbott case, were done prior to liquidation. We conclude on the record presented that construction had not commenced on the property by Carolyn Company prior to its dissolution. This means that the requisite view did not exist; that Carolyn Company was not availed of for construction with the view to liquidation prior to the realization of a substantial part of its income; and that Carolyn Company was not a collapsible corporation within the statutory definition. In view of the above, we do not reach the argument presented by petitioner that the tract of land in issue was not a section 341 asset because The Carolyn Company did not intend to sell the land, but only intended to sell the houses that it would construct thereon and retain the entire interest in the land. 4There seems to be an issue remaining with respect to the amount of gain petitioners realized upon the liquidation of Carolyn Company, though petitioners make no argument on brief that respondent's determination that the gain was $87,250 was incorrect. Respondent's determination is based217 upon stipulated figures of $8,000 paid by petitioners for their stock for which they received land subject to a mortgage on which there was then due $55,100 which they assumed. There is a dispute as to the fair market value of the 47 acres at the time of liquidation. Respondent used a fair market value of $150,350 (approximately $3,100 an acre for 48.5 acres) value for the land, making the gain $87,250. Petitioner requested a finding of fact that "the fair market value of the land contracted for to any developer other than Edmondale was $2,000.00 per acre." The witness who handled the Edmondale purchase gave that as his expert opinion. Petitioner introduced no evidence of the fair market value of the land at the time of dissolution. Respondent's valuation is supported by the sale to Edmondale at about the time of the dissolution at $3,125 an acre. There is evidence that Edmondale might pay a premium for the land but respondent is entitled to the judgment on this issue because of petitioners' complete failure to sustain their burden. We hold for respondent on the issue that petitioners realized a gain of $87,250 upon the liquidation distribution, which, because of our holding that218 Carolyn Company was not a collapsible corporation, was reportable as capital gain. Decision will be entered under Rule 50. Footnotes1. All statutory references are to the Internal Revenue Code of 1954, as amended.↩2. SEC. 341. COLLAPSIBLE CORPORATIONS. * * (b) Definitions. - (1) Collapsible Corporation. - For purposes of this section, the term "collapsible corporation" means a corporation formed or availed of principally for the manufacture, construction, or production of property, for the purchase of property which (in the hands of the corporation) is property described in paragraph (3), or for the holding of stock in a corporation so formed or availed of, with a view to - (A) the sale or exchange of stock by its shareholders (whether in liquidation or otherwise), or a distribution to its shareholders, before the realization by the corporation manufacturing, constructing, producing, or purchasing the property of a substantial part of the taxable income to be derived from such property, and (B) the realization by such shareholders of gain attributable to such property. (2) Production or Purchase of Property. - For purposes of paragraph (1), a corporation shall be deemed to have manufactured, constructed, produced, or purchased property, if - (A) it engaged in the manufacture, construction, or production of such property to any extent. (B) it holds property having a basis determined, in whole or in part, by reference to the cost of such property in the hands of a person who manufactured, constructed, produced, or purchased the property, or (C) it holds property having a basis determined, in whole or in part, by reference to the cost of property manufactured, constructed, produced, or purchased by the corporation. * ↩3. The requirements prescribed by the cited statute are many, starting with the requirement: "[such] plats must be drawn accurately to scale * *" and ending with the requirement that it contain the owner's certificate that statutory requirements have been complied with. We refrain from setting forth the long statute since neither party bases any argument thereon.↩4. This involves the Maryland ground rent system, which is explained in Welsh Homes, Inc., 32 T.C. 239">32 T.C. 239↩.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622045/	Title and Trust Company, Petitioner, v. Commissioner of Internal Revenue, RespondentTitle & Trust Co. v. CommissionerDocket No. 21593United States Tax Court15 T.C. 510; 1950 U.S. Tax Ct. LEXIS 64; October 16, 1950, Promulgated 64 Decision will be entered under Rule 50. Complying with the directive of the Oregon Insurance Commissioner issued pursuant to Oregon statutes, petitioner segregated from its 1945 premium income an amount equal to 3 per cent of its total premiums received on title insurance policies issued during the calendar years 1942, 1943, 1944 and 1945. This amount was deemed by the directive to constitute unearned premiums and was set up on petitioner's books as a reserve as of December 31, 1945. The directive further required petitioner to add to the reserve monthly thereafter an amount equal to 3 per cent of its premium income. At the end of 180 months from January 1, 1942, such portion of the reserve as had been maintained for more than 180 months was to be released for general corporate purposes. Held, petitioner properly excluded as "unearned premiums" from its 1945 premium income the amount of the reserve set up as of December 31, 1945. Early v. Lawyers Title Insurance Corp., 132 Fed. (2d) 42, followed. Clarence D. Phillips, Esq., for the petitioner.John H. Pigg, Esq., for the respondent. Arundell, Judge. ARUNDELL511 Respondent has determined a deficiency in petitioner's excess profits 65 tax for the calendar year 1945 in the amount of $ 36,377.35.The only adjustment set forth in the deficiency notice which is disputed is respondent's determination that the entire title insurance premiums reported by the petitioner were earned and that petitioner improperly deducted therefrom "unearned premiums" in the amount of $ 46,889.63.The proceeding has been submitted upon the pleadings and a stipulation of facts. The stipulated facts are summarized below in material part.FINDINGS OF FACT.Petitioner is a corporation legally qualified by the State of Oregon to carry on the business of insuring titles to real estate, and has its principal place of business in Portland, Oregon. During the taxable year 1945, over 75 per cent of its gross income was derived from its title insurance business in connection with which it issued exclusively perpetual title insurance policies.Petitioner files its returns and keeps its books on the accrual basis. Its income and excess profits tax returns for the calendar year 1945 were filed with the collector of internal revenue for the district of Oregon. Respondent mailed the deficiency notice involved in this proceeding to petitioner on November 66 2, 1948.On December 26, 1945, petitioner received from the Insurance Commissioner of the State of Oregon the following directive:Pursuant to Section 101-136, O. C. L. A., * an examination of your Company was made as of September 30, 1945 by a duly authorized examiner of this Department. Enclosed herewith is a copy of the examination report.On page 23 of said report attention is called to the advisability of making adequate reserve provision for unearned premiums. Study has been given by the Department towards the formulation of a reasonable, adequate, and sound rule for the determination of such a reserve. Consideration was given to the trend of your experience, premium volume, and size and types of risks underwritten. In order to make broader comparison with the requirements and procedures followed in other states as regards such reserves, the statutes of the various states were analyzed. As a consequence, in accordance with the provisions of 512 Section 101-137, O. C. L. A. the following rule has been promulgated as applicable to your Company.1. The Title and Trust Company shall establish, segregate and maintain an unearned premium 67 or reinsurance reserve as hereafter provided, which shall at all times and for all purposes be deemed and shall constitute unearned portions of the premiums and shall be charged as a reserve liability of your corporation in your statements; such reserve shall be cumulative and shall be established and shall consist of the following: (a) As at December 31, 1945 or within a period of three years thereafter an amount equal to 3% of the total gross fees and premiums received or to be received on account of policies issued during the four calendar years -- 1942, 1943, 1944 and 1945; and(b) Monthly at the close of each month beginning January, 1946, 3% of the total gross fees and premiums received or to be received on account of policies written during the preceding calendar month;(c) After the expiration of 180 months from January 1, 1942, that portion of the unearned premium or reinsurance reserve established more than 180 months prior shall be released and shall no longer constitute part of the unearned premium or reinsurance reserve and may be used for any corporate purposes.2. As at December 31, 1945, the Title and Trust Company may charge against and reduce thereby the "Title Loss 68 Reserve" carried in the amount of $ 50,000.00 the total of losses paid during the four calendar years 1942, 1943, 1944, and 1945 on account of title policies issued; and monthly thereafter all such losses paid during the preceding calendar month may be similarly charged against this reserve. Provided, however, that the amount of said reserve shall never be less than an amount at least equal to the aggregate estimated amount due or to become due on account of all unpaid losses and claims upon title insurance policies of which the company has received notice nor less than the aggregate of title losses incurred during the preceding 36 months. After the expiration of 180 months from January 1, 1942, the balance in this reserve account, in excess of the aforementioned estimated amounts for claims due or accrued or 36 months aggregate losses, may be released and be available for any corporate use or purpose.3. Commencing January 1, 1946 the Title and Trust Company shall not issue a policy of title insurance for a single transaction, the face amount of which shall exceed an amount which is five times the capital and surplus of your Company; but nothing herein shall prevent the Title and 69 Trust Company from assuming the risk on a single policy jointly with another title insurance company or companies in excess of five times the Title and Trust Company's capital and surplus, provided that the total amount of such insurance shall not exceed five times the total combined capital and surplus of all such companies liable under such insurance; and provided that each such company shall not assume more than its proportionate share of the total amount at risk in accordance with the above defined maximum retention limit.If at any date subsequent hereto, upon review or examination as provided in the Oregon Insurance Laws, it is determined that the reserves and procedures established by the rules as promulgated above are inadequate for the safety and welfare of the policyholders and not in the best interests of the company operations, said rules will be modified as necessary; furthermore should any statute hereafter be adopted by the State of Oregon bearing on this subject, then any sections of these rules inconsistent or in conflict with said statute or statutes shall be automatically voided.513 In compliance with the above directive, petitioner set up on its books on December 70 31, 1945, an account captioned "Unearned Premiums" with a credit to that account in the amount of $ 46,889.63 and a corresponding debit to "Undivided Profits." The figure of $ 46,889.63 was determined in accordance with the above directive of the Insurance Commissioner as follows:1942 Premium $ 238,305.093%$ 7,149.151943 Premium $ 330,204.133%9,906.121944 Premium $ 433,552.983%13,006.591945 Premium $ 560,926.283%16,827.77Total$ 46,889.63The losses paid by petitioner during each of the calendar years 1942, 1943, 1944, and 1945 on account of title insurance policies previously issued by it were charged on its books in each of the above years to the "Undivided Profits" account and were claimed as deductions on its income tax returns for those years in the following amounts:YearAmount1942$ 2,157.5219431,126.9719442,267.7719457,394.39Other than as indicated by the losses paid by petitioner in the above years, there were no estimated unpaid losses or claims upon title insurance policies of which petitioner had notice during those years. Among the items of liabilities shown on petitioner's balance sheets as at the beginning and close of the calendar year ended December 31, 1945, were the 71 following:BeginningCloseReserve for Title Insurance Losses$ 50,000.00$ 50,000.00Reserve for Unearned Premiums46,889.63The above described "Reserve for Title Insurance Losses" balance sheet item was carried on petitioner's books in an account captioned "Reserve for Contingencies" and represented a surplus reserve, no part of which has been claimed as a deduction on any income tax return filed by petitioner. This "Reserve for Contingencies" account was set up on petitioner's books on July 26, 1934, by a credit to that account in the amount of $ 500 with continuing monthly credits of like amounts until December 1935, and thereafter like monthly credits of $ 1,000 until May 31, 1939, when the credit balance of the account equalled $ 50,000. In each instance the corresponding debit entry was to "Contingent Losses," the annually accumulated debit balances of this account being charged to "Surplus."Of the securities owned by petitioner and listed among the assets shown on its balance sheet as at December 31, 1945, securities of a 514 value of $ 100,000 were, on that date, on deposit with the Treasurer of the State of Oregon as a "Guarantee Fund" as required by the insurance laws of the State 72 of Oregon.In its income and declared value excess profits tax return for the year 1945, petitioner reported a gross income of $ 601,664.97 consisting of the following items:Title insurance premiums (home and branch offices)$ 560,926.28Less: "Unearned Premiums"46,889.63$ 514,036.65Abstract premiums (home and branch offices)26,426.70Commissions (trust, escrow and general)29,991.76Interest13,132.36Rents17,312.50Dividends765.00Total gross income reported$ 601,664.97This amount, as offset by items of $ 375 and $ 9,523.16, representing nontaxable interest and net long term capital gain, respectively, neither of which items is here in controversy, resulted in net income of $ 203,935.77 reported in petitioner's return. In the determination of the deficiency, respondent disallowed as an exclusion or deduction from petitioner's gross income the amount of $ 46,889.63 reported on the return as "Unearned Premiums" with the following explanation:In a schedule attached to your income and declared value excess profits tax return for the year 1945 you reported title insurance premiums in the total amount of $ 560,926.28. You reported that $ 46,889.63 of such total premiums constituted "unearned premiums" 73 and credited that sum to a "reserve for unearned premiums." The sum of $ 46,889.63 was not included in net income reported.The Bureau holds that title insurance premiums received in the total amount of $ 560,926.28 during the year 1945 were earned in that year. Net income reported has, therefore, been increased by the sum of $ 46,889.63.OPINION.The only question here is whether petitioner properly excluded the amount designated as "unearned premiums" from its title insurance premium income. This depends upon whether the $ 46,889.63 so excluded constituted unearned premiums within the meaning of section 204 (b) (1) (4) and ( 5) of the Internal Revenue Code. 174 515 In Early v. Lawyers Title Insurance Corp., 132 Fed. (2d) 42, Judge Parker, speaking for the Fourth Circuit, declared that such portions of title insurance premiums as were 75 given for a specified period the status of unearned premiums by either law or contract should likewise be treated tax-wise as unearned premiums under section 204 (b), supra. It was subsequently held by the Second Circuit that a state statute did not impart to title insurance premiums the status of being "unearned" where it was impossible to determine whether the portions of the premiums required by the statute to be set aside as a reserve would ever be released and become "free assets" of the company. City Title Insurance Co. v. Commissioner, 152 Fed. (2d) 859.Deductibility of the statutorily prescribed reserves out of title insurance premium income thus turns on whether the local statute calls for a mere insolvency reserve of indefinite duration or whether the required reserve is established by segregating a portion of the premium income for a specified period when the risk of loss is presumably greatest. In the latter instance, the reserve becomes taxable income to the company when it is released for general corporate purposes at the expiration of the prescribed period. Commissioner v. Dallas Title & Guaranty Co., 119 Fed. (2d) 211.Respondent does not question the authority 76 of Early v. Lawyers Title Insurance Corp., supra, (see I. T. 3798, 1946-1 C. B. 127) but argues it is not applicable because the reserve here in question was set up under a directive of the Oregon Insurance Commissioner instead of under the direct mandate of an Oregon statute.The Insurance Code of Oregon embodied in Title 101 of Oregon Compiled Laws Annotated (O. C. L. A.) gives the Insurance Commissioner under section 101-105, O. C. L. A., 278 authority to issue such department rulings, instructions and orders as he deems necessary to 516 secure the enforcement of the Insurance Code. Concerning insurance reserves, section 101-137, O. C. L. A., provides as follows:§ 101-137. Examination: Reserve: Liability: (Formulating or adopting rules). In ascertaining the condition of an insurance company under the provisions of this act, or in any examination made by the insurance commissioner, his deputy, or examiner, he shall allow as assets only such investments, cash and accounts as are authorized by the laws of this state at the date of the examination, or under the existing laws of the state or country under which such company is organized and which investment he may approve or reject, but 77 unpaid premiums on policies written within three months shall be admitted as available resources. In ascertaining his [sic] liabilities, unless otherwise provided in this act, there shall be charged the capital stock, all outstanding claims, a sum equal to the total unearned premiums on the policies in force computed on a pro rata basis, and such an amount as may be found necessary as a reserve to provide for the future payment of deferred and undetermined claims for losses and promised benefits. In determining the amount of such reserve or unearned premium liability, the insurance commissioner, his deputy or examiner may formulate such rules as he may deem proper and consistent with law or he may adopt such rules as are used in other states or approved by the national convention of insurance commissioners. Acting pursuant to section 101-137, O. C. L. A., supra, the Oregon Insurance Commissioner directed the petitioner "to segregate and maintain an unearned premium or reinsurance reserve as hereafter provided, which shall at all times and for all purposes be deemed and shall constitute unearned portions of the premiums * ." The reserves were required to be 3 per cent of total premiums received on policies issued during 1942, 1943, 1944, and 1945 and 3 per cent of monthly premiums received thereafter. After 180 months, such portion of the reserve as had been established for more than 180 months would be released for general corporate purposes.From our reading of the Oregon statutes and the directive issued to petitioner by the Oregon Insurance Commissioner, we perceive nothing to indicate that the Insurance Commissioner exceeded the bounds of his statutory authority to make rules concerning reserves. It should be apparent that 79 a valid exercise of the discretion entrusted to the Insurance Commissioner by the Oregon statutes should have equal weight and effect as the statutes themselves. Maryland Casualty Co. v. United States, 251 U.S. 342">251 U.S. 342. See also Fidelity & Deposit Co. of Marylandv.United States, (D. C., Md., May 19, 1949), affd., 177 Fed. (2d) 805, rehearing denied, 178 Fed. (2d) 753.Respondent urges in the alternative that so much of the $ 46,889.63 as is attributable to premium income received in the years 1942, 1943, and 1944 cannot properly be excluded from petitioner's premium income in the taxable year 1945. Allowance of such an exclusion, asserts respondent, would distort petitioner's 1945 income. We cannot agree. Petitioner was required by the directive of the Insurance Commissioner to set aside in the reserve a sum equal to 3 per cent of its 517 premiums received on policies written during 1945 and the 3 preceding years. Although measured in part by premium income in the 3 years prior to 1945, the reserve was taken from 1945 income and thus made unavailable to the company for general corporate use the funds so restricted. The amount of the reserve was, therefore, properly excluded from "earned 80 premiums" in 1945 when for the first time the State of Oregon required the establishment of this reserve. A like question faced the Circuit Court in Early v. Lawyers Title Insurance Corp., supra, p. 46, where it was held that deduction of the portion of the reserve attributable to title insurance contracts issued prior to the effective date of the state statute there involved did not distort the insurance company's income in the taxable year. We are in accord with the result reached by the Circuit Court.We conclude that respondent erred in his determination that petitioner cannot exclude from its 1945 premium income the amount required to be segregated as unearned premiums by the Oregon Insurance Commissioner pursuant to Oregon law.Because of an uncontested adjustment,Decision will be entered under Rule 50. Footnotes. Oregon Compiled Laws Annotated. (Explanation ours.)↩1. SEC. 204. INSURANCE COMPANIES OTHER THAN LIFE OR MUTUAL. * * (b) Definition of Income, Etc. -- In the case of an insurance company subject to the tax imposed by this section -- (1) Gross income. -- "Gross income" means the sum of (A) the combined gross amount earned during the taxable year, from investment income and from underwriting income as provided in this subsection, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners, and (B) gain during the taxable year from the sale or other disposition of property, and (C) all other items constituting gross income under section 22; except that in the case of a mutual fire insurance company described in paragraph (1) of subsection (a) of this section, the amount of single deposit premiums paid to such company shall not be included in gross income; * * (4) Underwriting income. -- "Underwriting income" means the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred;(5) Premiums earned. -- "Premiums earned on insurance contracts during the taxable year" means an amount computed as follows:From the amount of gross premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance. To the result so obtained add unearned premiums on outstanding business at the end of the preceding taxable year and deduct unearned premiums on outstanding business at the end of the taxable year. * ** * * ↩2. § 101-105. General powers and duties of commissioner. (1) The insurance commissioner shall have and exercise the power to enforce all the laws of the state relating to insurance, and it shall be his duty to enforce all the provisions of such laws for the public good. He shall issue such department rulings, instructions and orders as he may deem necessary to secure the enforcement of the provisions of this act, but nothing contained in this act shall be construed to prevent any company or persons affected by any order or action of the insurance commissioner from testing the validity of same in any court of competent jurisdiction. * * *↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622047/	FRANK T. HEFFELFINGER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Heffelfinger v. CommissionerDocket Nos. 41145, 44852, 53881, 63407, 69694, 73479.United States Board of Tax Appeals32 B.T.A. 1232; 1935 BTA LEXIS 833; August 20, 1935, Promulgated 833 1. Section 219(h), Revenue Acts of 1924 and 1926, and section 167, Revenue Act of 1928, providing for the inclusion in the computation of the net income of the grantor of a trust of any part of the income of the trust which is or may be applied to the payment of premiums upon policies of insurance on the life of the grantor, make no distinction either between endowment policies and other kinds of policies, or between that part of a particular premium which equals the cost of protection and the excess paid over that amount, which excess may represent an investment. 2. Where the grantor of two trusts did not include any amount in computing his net income to represent the amounts of trust income applicable to the payment of premiums on policies of insurance on his life, and all of the income of the two trusts was reported upon a separate fiduciary return because he honestly believed that was the proper way to report it, a penalty for intentional disregard of the rules and regulations will not be imposed. James B. Templeton, Esq., for the petitioner. E. L. Corbin, Esq., for the respondent. MURDOCK 1233 OPINION. MURDOCK: The deficiencies834 determined by the Commissioner and the appropriate docket numbers are shown in the following table: Docket No.YearDeficiency411451924$6,595.50Do19253,777.17Do19263,704.934485219272,915.05538811928$3,220.146340719293,209.556969419303,005.077347919312,704.85The cases were consolidated for hearing and a stipulation was filed which settled some of the original issues and set forth the facts upon which others were to be decided. The petitioner has stated that the issues raised by him have been settled except for the question of "whether or not any part of the income of a trust created by the petitioner on December 30, 1922 is taxable to the petitioner." Since all of the facts relating to that issue have been stipulated, no findings of fact are necessary in that connection. The petitioner, an individual residing in Minneapolis, Minnesota, created an irrevocable trust on December 30, 1922, and transferred to it 1,700 shares of the preferred stock of a domestic corporation. A bank was named trustee. The income from the trust was to be used to pay the annual premiums on a 10-year endowment policy of insurance on835 the life of the petitioner. His daughter was the beneficiary of the trust and of the policy of insurance. The income of the trust in excess of the premiums and expesnses was to be accumulated and added to the corpus of the trust. The petitioner reserved to himself no rights under the trust or under the policy of insurance. The following table shows the annual income received and the premiums and expenses paid by the trust: YearDividendsInterestTotal incomeTrustee feesNet incomePremiums paid1924$10,200$76.43$10,276.43$170.0010,106.43$9,882.0019257,650103.007,753.00204.007,549.009,753.00192612,750100.5512,850.55255.0012,595.559,535.00192710,200102.7310,302.73204.0010,098.739,393.00192810,20086.2010,286.20210.2210,075.989,245.00192910,20050.8910,250.89216.0410,034.858,641.20193010,200101.4610,301.46217.2010,084.268,930.00193110,200213.0810,413.08222.4710,190.618,760.00The Commissioner, in computing the deficiencies for 1924, 1925, 1926, 1927, and 1931, included in the petitioner's income the premiums paid on the insurance policy. 836 He included the net income of the trust in the petitioner's income for 1928, 1929, and 1930. 1234 Section 219(h) of the Revenue Act of 1924 provides in part as follows: * * * where any part of the income of a trust is or may be applied to the payment of premiums upon policies of insurance on the life of the grantor * * * such part of the income of the trust shall be included in computing the net income of the grantor. Section 219(h) of the Revenue Act of 1926 and section 167 of the Revenue Act of 1928 contain substantially similar provisions. Clearly the Commissioner erred as to 1928, 1929, and 1930 in including in the petitioner's income more than the part of the income of the trust applicable to the payment of the premiums on the policy. But the part of the income of the trust for each year applicable to the payment of the premium for that year upon the policy of insurance on the life of the grantor must be included in computing the net income of the grantor. Although the policy was an endowment policy, it was nevertheless a policy of insurance upon the life of the grantor. 837 ; ; ; ; ; ; Cooley - Briefs on the Law of Insurance, vol. 1, p. 19. The statute makes no distinction between endowment policies and other kinds of policies, such as ordinary life policies. Nor does it make any distinction between that part of a particular premium which equals the cost of protection and the excess paid over that amount, which excess may represent an investment. The annual premium on a "straight life" policy contains similar elements (), yet the Supereme Court in a case similar to this one held that such premiums were properly included in the income of the grantor. . The Court there held the statutory provision constitutional as applied to such premiums. This case does not present an exception requiring a special rule. The Commissioner by amended answers makes claim for838 penalties under section 275(a) of the Revenue Acts of 1924 and 1926 and section 293(a) of the Revenue Act of 1928, which provide that "if any part of any deficiency is due to * * * intentional disregard of rules and regulations but without intent to defraud, 5 per centum of the total amount of the deficiency (in addition to such deficiency) shall be assessed, collected, and paid * * ." He filed no brief. The burden of proof was upon him. The stipulated facts show that the petitioner did not include any amount in computing his net income to represent the amounts of trust income of two trusts applicable to the payment of premiums on policies of insurance on his life. All of the income of the two trusts was reported upon a separate fiduciary return. It was so reported because the petitioner 1235 honestly believed that was the proper way to report it. His view was apparently shared by members of the Circuit Court of Appeals for the Eighth Circuit and by four members of the Supreme Court of the United States. See , and *839 An explanation was given of why the income was not reported by the petitioner. We find as a fact from the entire record that no part of any deficiency was due to intentional disregard of the rules and regulations. The respondent's claim of a penalty is denied. Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622048/	WILLIAM J. LEVITT AND SIMONE H. LEVITT, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentLevitt v. CommissionerDocket No. 1684-87United States Tax CourtT.C. Memo 1993-294; 1993 Tax Ct. Memo LEXIS 297; 66 T.C.M. (CCH) 40; July 8, 1993, Filed 297 For Simone H. Levitt, petitioner: Robert S. Fink and Bryan C. Skarlatos. For respondent: Iris K. Rothman. FAYFAYMEMORANDUM OPINION FAY, Judge: This case was assigned to Special Trial Judge D. Irvin Couvillion pursuant to section 7443A(b)(4) 1 and Rules 180, 181, and 183. The Court agrees with and adopts the opinion of the Special Trial Judge which is set forth below. OPINION OF THE SPECIAL TRIAL JUDGE COUVILLION, Special Trial Judge: The matter before the Court is a motion by petitioner Simone H. Levitt (Mrs. Levitt) for leave to file a motion to vacate a decision of this Court which was entered on February 6, 1990. In the notice of deficiency, respondent determined deficiencies in Federal income taxes and an addition to tax against petitioners as follows: Addition to TaxYearDeficiencySec. 6653(a) 1973$ 3,309,557.00$ 165,477.8519752,355,478.00-- 19764,251,077.61-- 298 A decision was entered pursuant to a written stipulation of settlement which was filed and made part of the record of this case. In the decision, petitioners were decreed liable for deficiencies in Federal income taxes of $ 2,355,478 and $ 4,122,608.73, respectively, for 1975 and 1976; an overpayment in tax for 1973 in the amount of $ 312.08; and no addition to tax under section 6653(a) for 1973. The motion by Mrs. Levitt for leave to file the motion to vacate the decision was filed well in excess of 90 days after the decision was entered. 2299 The issues to be decided here are: (1) Whether the decision should be vacated on the ground that this Court lacked jurisdiction over Mrs. Levitt, and (2) if this Court had jurisdiction over Mrs. Levitt, whether the decision should be vacated on the ground that it resulted from a "fraud on the Court". The issue of this Court's jurisdiction over Mrs. Levitt was considered in another case involving the years 1977 through 1981. In that case, prior to entry of a decision, on motion by Mrs. Levitt, this Court held it had no jurisdiction over Mrs. Levitt because she had not filed a petition with this Court, nor had she timely ratified the petition filed by her husband, William J. Levitt (Mr. Levitt). Levitt v. Commissioner, 97 T.C. 437 (1991) (Levitt I). Mrs. Levitt's motion to vacate here raises a similar jurisdictional question for the years 1973, 1975, and 1976. Some of the facts were stipulated. Those facts, with the annexed exhibits, are made part hereof by reference. At the time the petition was filed, Mr. and Mrs. Levitt were residents of the State of New York. At the time Mrs. Levitt's motion was filed, both she and Mr. Levitt continued to 300 be residents of the State of New York. Petitioners were married in 1969. Both had been married previously. Mr. Levitt was an established, successful real estate developer at the time of their marriage. He established his business after World War II and gained national acclaim for developing affordable housing in towns and communities, some of which were named after him as "Levittown". Mrs. Levitt had been involved in the operation of art galleries but did not engage in such business after she married Mr. Levitt. Throughout their marriage, Mrs. Levitt was not involved in Mr. Levitt's business. She devoted most of her time as a social hostess and was in charge of operating their household, known as "La Collene". The household operation itself was a sizeable operation, consisting of a staff of some 20 persons, including a butler and a chef. Mr. and Mrs. Levitt have never separated or divorced and were living together at the time the motion in this case was heard. In recent years, Mr. Levitt has sustained significant financial reverses, and these reverses have strained the marital relationship between him and Mrs. Levitt. During her previous marriage, Mrs. Levitt filed separate301 Federal income tax returns. In 1989 and 1990, while married to Mr. Levitt, Mrs. Levitt filed separate returns, reporting income from her own investments in those years. Joint individual income tax returns (Forms 1040) in the names of William J. and Simone Levitt were filed for taxable years 1973, 1975, 1976, 1977, 1978, 1979, 1980, and 1981. Mr. Levitt signed his own name and Mrs. Levitt's name to the returns. Except for the 1973 return, which is in dispute, Mrs. Levitt did not sign these returns, nor did she have knowledge of the returns when they were filed. Mrs. Levitt was not aware that Mr. Levitt had filed any joint income tax returns until May 1987, when she learned that one joint return might have been filed for an unspecified prior year. At that time, she questioned Mr. Levitt about the filing of a joint return and was told that he had only shown her as a dependent on the return, and that she should not be concerned about it. During and subsequent to the audit of the returns for 1973, 1975, and 1976, Mr. Levitt signed his own and Mrs. Levitt's name to eight waivers or consents to extend the statute of limitations on assessment. Mrs. Levitt did not sign these waivers302 or consents and had no knowledge of their execution. On October 23, 1986, respondent mailed the notice of deficiency upon which this case is based. The notice was addressed to Mr. and Mrs. Levitt at Mr. Levitt's office address and determined the deficiencies in Federal income taxes and an addition to tax for 1973, 1975, and 1976 in the amounts shown above. Mr. Levitt received the notice of deficiency. Mrs. Levitt did not receive it. Mr. Levitt contacted a law firm and arranged for a petition to be drafted for filing with this Court. Mr. Levitt signed his own name and Mrs. Levitt's name to the petition and filed it on January 20, 1987. Mrs. Levitt did not sign the petition, nor did she have knowledge of the petition. The attorneys who drafted the petition likewise did not sign the petition. The parties agreed, as noted earlier, that the petition in this case was not signed by Mrs. Levitt, but her name was signed by Mr. Levitt. Respondent contends that Mr. Levitt was authorized to sign for Mrs. Levitt, and, if he did not have such authority, Mrs. Levitt nevertheless ratified the petition. Respondent's ratification argument is based upon several documents which were entered303 into evidence and bear the purported signatures of Mrs. Levitt. Mrs. Levitt vigorously denied that the signatures on these documents were hers. These documents have been identified by the parties as the "disputed documents" and consist of the following: (1) A joint motion for continuance of this case dated March 7, 1988 (two signed copies); (2) an undated stipulation of settlement (two signed copies), which was filed with the Court on March 7, 1988; (3) petitioners' response to respondent's request for production of documents dated January 20, 1988; (4) the certificate of service which accompanied petitioners' response to the request for production of documents, also dated January 20, 1988; and (5) the 1973 joint Federal income tax return for Mr. and Mrs. Levitt. The stipulated decision, entered on February 6, 1990, was based upon the stipulation of settlement filed earlier on March 7, 1988 (one of the disputed documents). The second page of the stipulated decision of February 6, 1990, bears the purported signatures of petitioners along with "Respondent's Computation for Entry of Decision", dated February 1, 1990, which also is accompanied by a second page bearing the purported304 signatures of petitioners. Mrs. Levitt did not sign these documents. Mr. Levitt signed her name. Mrs. Levitt did not learn of the decision until December 1990, after she was advised that an assessment had been made against her. Mrs. Levitt contends that this Court lacked jurisdiction to enter a decision binding upon her because she did not file or authorize the filing of a petition on her behalf and did not ratify the petition filed by Mr. Levitt. Mrs. Levitt further contends, in the alternative, that the decision should be vacated because it was the result of a fraud on the Court by Mr. Levitt. Sections 7481 and 7483 provide that a decision of this Court becomes final, in the absence of a timely filed notice of appeal, 90 days from the date the decision is entered. As a general rule, this Court is without jurisdiction to vacate a decision after the decision becomes final. However, this Court has jurisdiction to vacate a decision that has become final where the Court lacked jurisdiction when the decision was entered. Billingsley v. Commissioner, 868 F.2d 1081">868 F.2d 1081, 1084-1085 (9th Cir. 1989); Abeles v. Commissioner, 90 T.C. 103">90 T.C. 103, 105 (1988).305 This Court also has jurisdiction to vacate a decision that was entered as a result of fraud on the Court. Billingsley v. Commissioner, supra at 1085; Toscano v. Commissioner, 441 F.2d 930">441 F.2d 930, 933 (9th Cir. 1971). Since the decision in this case became final, in the absence of an appeal, upon the expiration of the time allowed for filing a notice of appeal, petitioner must establish that this Court lacked jurisdiction to enter the decision or that a fraud on the Court exists. Senate Realty Corp. v. Commissioner, 511 F.2d 929">511 F.2d 929, 931 (2d Cir. 1975), affg. an Order of this Court; Kenner v. Commissioner, 387 F.2d 689">387 F.2d 689, 690-691 (7th Cir. 1968), affg. an Order of this Court; Brannon's of Shawnee, Inc. v. Commissioner, 69 T.C. 999">69 T.C. 999, 1001-1002 (1978). The burden of proof is on the party filing the motion to vacate. See Brannon's of Shawnee, Inc. v. Commissioner, supra at 1002. Where a joint notice of deficiency is issued and only one spouse signs the petition, the nonsigning spouse must ratify the petition306 and must intend to become a party to the case for this Court to have jurisdiction over the nonsigning spouse. Levitt v. Commissioner, 97 T.C. 437">97 T.C. 437, 441 (1991); Abeles v. Commissioner, supra at 108; Brooks v. Commissioner, 63 T.C. 709">63 T.C. 709, 716 (1975); see also Rule 60(a)(1). Absent ratification and the intent to become a party to the case by a nonsigning spouse, this Court lacks jurisdiction over the nonsigning spouse who, "never having petitioned the Court in this case, is not a party to this case". Abeles v. Commissioner, supra at 109. The parties agree that Mrs. Levitt did not sign the petition. Mr. Levitt signed his wife's name to the petition, as well as his own. He did not inform Mrs. Levitt that he had received a notice of deficiency or that he had filed the petition. Mrs. Levitt first argues that respondent is collaterally estopped from contending that Mr. Levitt was authorized to sign the petition on her behalf because of the Court's decision in Levitt I. Collateral estoppel is a judicial tool designed to avoid repetitious litigation of legal307 issues involving the same party or his privy and to put the limited resource of judicial time to its best economic use. Collateral estoppel applies where the matter raised in the second suit is identical in all respects with that decided in the first proceeding, and where the controlling facts and applicable legal rules remain unchanged. Jaggard v. Commissioner, 76 T.C. 222">76 T.C. 222, 223 (1981) (citing Commissioner v. Sunnen, 333 U.S. 591">333 U.S. 591, 599-600 (1948)). In Coors v. Commissioner, 60 T.C. 368">60 T.C. 368, 390 (1973), affd. 519 F.2d 1280">519 F.2d 1280 (10th Cir. 1975), this Court stated: "That portion of the doctrine of res judicata barring later litigation of that which could have been raised in the former proceeding must be viewed in the light of the principle set forth in Burnet v. Sanford & Brooks Co., 282 U.S. 359">282 U.S. 359 (1931), that each taxable year is separate and distinct." In Commissioner v. Sunnen, 333 U.S. 591">333 U.S. 591, 597-599 (1948), the Supreme Court held that each tax year gives rise to a different cause of action, thus confirming the308 rule that taxation is based upon annual accounting periods. In Commissioner v. Sunnen, supra at 599-600, the Court pointed out that the doctrine of collateral estoppel "must be confined to situations where the matter raised in the second suit is identical in all respects with that decided in the first proceeding". The Court further stated that "if the relevant facts in the two cases are separable, even though they be similar or identical, collateral estoppel does not govern the legal issues which recur in the second case". Id. at 601 (fn. ref. omitted). This case involves different tax years from those which were involved in Levitt I. The facts in the two cases are separable even though they may be similar. Moreover, at least one factual issue in this case is totally different from that which was at issue in Levitt I. In this case, respondent contends Mr. Levitt was authorized to file a petition in this Court on behalf of Mrs. Levitt, whereas, in Levitt I, respondent contended that Mrs. Levitt "did not file a petition or ratify the petition that Mr. Levitt filed". Levitt v. Commissioner, 97 T.C. at 440.309 Respondent, therefore, in Levitt I, contended that Mr. Levitt was not authorized to file a petition on behalf of Mrs. Levitt, whereas, in this case, respondent contends Mr. Levitt had such authority. The issue differs; consequently, respondent is not collaterally estopped from contending Mr. Levitt had the authority to file the petition in this case on behalf of Mrs. Levitt. There is no evidence that Mrs. Levitt directly authorized Mr. Levitt to file the petition in this case on her behalf. Respondent contends that Mr. Levitt had implied authority to file the petition on Mrs. Levitt's behalf because he was responsible for all their business, financial, and tax matters, which included the authority to file petitions in this Court. This included authority to sign Mrs. Levitt's name on checks drawn on a bank account in Mrs. Levitt's name which was maintained for operation of their extensive household. In addition, almost for their entire marriage, Mr. Levitt filed Federal joint income tax returns, and, over this period of time, Mrs. Levitt either knew or should have known that these returns were being filed in her name, even though she did not sign the returns. Mrs. Levitt contends310 she had no knowledge that any Federal income tax returns had been filed in her name over the years or that any returns for her were even necessary because she earned no income and owned no income-producing properties during those years which would have necessitated the filing of Federal income tax returns either jointly or separately. Mrs. Levitt, however, stipulated and admitted in her testimony to being record owner of several publicly traded stocks, as well as the owner of interest-bearing savings accounts. She knew that such assets produced income which had to be reported for Federal income tax purposes. The Court rejects her contention that, because Mr. Levitt never gave her the stock certificates and never remitted to her the dividends and interest, she was absolved from filing Federal income tax returns. Moreover, Mrs. Levitt suffers with a serious credibility problem. While she claimed she owned no income-producing assets during any years prior to 1989, on the 1989 and 1990 Federal income tax returns which she filed as married, filing separately, she reported interest and dividend income of $ 47,051 and $ 75,458, respectively, for these 2 years. When questioned as to311 how she suddenly acquired assets producing revenues in these amounts, she testified she had sold a ring for $ 250,000 or $ 300,000 and sold stocks which "were my stock, and I had the certificates". Since she used most of the proceeds from the sale of the ring to pay her attorneys, it is apparent to the Court that Mrs. Levitt owned substantial assets in her name prior to 1989 which produced the interest and dividend income reported on her 1989 and 1990 income tax returns. Therefore, Mrs. Levitt's testimony that she owned no income-producing properties during the years 1973 through 1988 is simply not credible or reliable. Another more serious credibility problem arises over inconsistent positions Mrs. Levitt has taken over the years with respect to stock in a corporation known as International Community Corporation (ICC), which either she and/or Mr. Levitt owns. During 1987, a consent judgment approximating $ 11 million was agreed to and entered against Mr. Levitt in favor of the State of New York acting on behalf of The Levitt Foundation, a charitable organization which had been organized by Mr. Levitt. The State of New York had asserted claims for self-dealing, fraud, and conversion312 against a number of defendants, including Mr. and Mrs. Levitt, who were directors of The Levitt Foundation, and ICC, contending that ICC had been used as a conduit to take money out of The Levitt Foundation for the benefit of Mr. and Mrs. Levitt. After the consent judgment was entered, Mrs. Levitt's deposition was taken in that proceeding to determine whether she owned any assets, including stock in ICC, which could be held subject to the consent judgment against Mr. Levitt. Mrs. Levitt, in that deposition, denied ownership of any interest in ICC and, based on her testimony, was released from liability as a transferee. However, in Mrs. Levitt's subsequent testimony at the hearing before this Court in Levitt I, Mrs. Levitt took the position that she owned 50 percent of the stock in ICC and, at the hearing in this case, Mrs. Levitt admitted filing a suit in New York State court claiming ownership of all the stock in ICC. When questioned about the inconsistency of her positions on the ICC stock in this Court with the testimony in the earlier deposition by the State of New York, Mrs. Levitt testified: I was not under oath. I was just asked a question and Mr. Shaw, who was my313 counsel at the time, gave to me an impression that I should not say it's mine [the ICC stock] because then the Attorney General would * * go after me for the money [the consent judgment]. I don't know what was going on between them. I had begin to lost trust on my husband. [sic] I didn't want to be the villain that was going to put him into his trouble.It is obvious to the Court that Mrs. Levitt's position with respect to the ICC stock has shifted to suit whatever crisis is at hand. Mrs. Levitt effectively discredited herself as a witness in this case. However, despite this conclusion, the Court is not willing to conclude that all of these facts, even if they occurred as contended by respondent, vested Mr. Levitt with the authority to file a petition in this Court on behalf of Mrs. Levitt. While the facts recited above may well have vested implied authority in Mr. Levitt to file Federal income tax returns on behalf of Mrs. Levitt, the nexus between that authority and the authority to file a petition on her behalf in this Court is simply not there. The fact remains that Mrs. Levitt did not know the petition in this case had been filed. In Abeles v. Commissioner, 90 T.C. at 108 n.8,314 this Court noted that, even if the husband had implied authority for all financial and tax matters involving the husband and the wife, the action of the husband in filing a petition in this Court on behalf of the wife, in the absence of ratification by the wife, is insufficient to confer jurisdiction by this Court over the wife. Therefore, the Court here rejects respondent's contention that, because Mr. Levitt was responsible for all tax and financial matters of himself and Mrs. Levitt, and because of Mrs. Levitt's contrary and inconsistent positions with regard to certain properties, he had the implied authority to file the petition in this case on behalf of Mrs. Levitt. The Court next addresses the question whether Mrs. Levitt ratified the petition. Respondent contends Mrs. Levitt ratified the petition, either by affirmative acts or by failing to disavow Mr. Levitt's actions taken on her behalf. To show affirmative acts of ratification, respondent relies on various documents (the disputed documents) submitted into evidence which bear the purported signatures of Mrs. Levitt. Both Mr. and Mrs. Levitt disputed the signature of Mrs. Levitt on the disputed documents. The parties315 each introduced an expert witness with respect to the authenticity of the signatures on the disputed documents. Respondent's expert witness, Charles Eggleston, examined the disputed documents and compared them to acknowledged examples of Mrs. Levitt's signature from years prior to and after the dates the disputed documents were signed. In his expert report, Mr. Eggleston concluded that it is "highly probable" that Mrs. Levitt signed two copies of the joint motion for continuance, two copies of the stipulation of settlement, and "probable" that she signed petitioners' response to respondent's request for production with the accompanying certificate of service and the 1973 tax return. Mr. Eggleston explained that, as used in his report, "highly probable" means that the evidence was very persuasive but fell just short of that necessary for certainty, and that "probable" was one step below "highly probable" in terms of weight of the evidence. Mr. Eggleston acknowledged consistent differences between the signatures on the disputed documents with the acknowledged or undisputed examples of Mrs. Levitt's signature. He reconciled these differences by comparing the signatures on the disputed316 documents with the signatures of Mrs. Levitt on a series of checks purportedly signed by Mrs. Levitt on a bank account in her name, which was maintained for purposes of paying the Levitts' household expenses. At the time Mr. Eggleston compared the signatures on these checks with the signatures on the disputed documents, Mr. Eggleston believed that the signatures on these checks were the unquestioned and acknowledged signatures of Mrs. Levitt. Because the signatures on the checks were consistent with those on the disputed documents, Mr. Eggleston concluded it was "highly probable" that most of the disputed documents had been signed by Mrs. Levitt. Later, Mr. Eggleston was informed that the signatures on the checks were not the acknowledged signatures of Mrs. Levitt but were disputed by her. He reviewed the signatures again and concluded that Mrs. Levitt had "definitely" signed those disputed documents in which he earlier concluded it was "highly probable" that they had been signed by her. Mr. Eggleston admitted that there were differences between the signatures on the checks and the signatures on the disputed documents with the signatures on other documents which were acknowledged317 to be those of Mrs. Levitt. These differences are clearly evident even to one who is not trained in handwriting analysis. While Mr. Eggleston was satisfied that these differences were not material to his conclusion, the Court is not satisfied that these differences were properly explained and reconciled by him. In the Court's view, there are significant differences between the signatures of Mrs. Levitt on the disputed documents with those signatures submitted to the Court which were the acknowledged signature of Mrs. Levitt. The Court, accordingly, does not accept Mr. Eggleston's conclusion. Charles Hamilton, Mrs. Levitt's expert, also examined the disputed documents, comparing the signatures thereon to the same examples of Mrs. Levitt's acknowledged signature which Mr. Eggleston had examined. Mr. Hamilton concluded that the signatures on the disputed documents were definitely not Mrs. Levitt's handwriting. Mr. Hamilton noted the same differences between the acknowledged signatures and the disputed ones which Mr. Eggleston had observed. While Mr. Eggleston was of the opinion that these differences, for unexplained reasons, were not material, Mr. Hamilton was of the opinion318 that these differences were material and irreconcilable. Mr. Hamilton was of the further opinion that Mrs. Levitt did not sign the checks which Mr. Eggleston had earlier assumed bore the acknowledged signatures of Mrs. Levitt. The testimony of Mr. Levitt and Mrs. Levitt, along with Mrs. Levitt's expert witness, satisfies the Court that Mrs. Levitt did not sign the checks which were submitted into evidence and which were examined by the two experts. The signatures on these checks are not the same as the signatures on the disputed documents. On this record, the Court accepts the opinion of Mr. Hamilton and concludes that Mrs. Levitt did not sign the disputed documents. Moreover, even if Mrs. Levitt did in fact sign the disputed documents, all of these documents, except the 1973 income tax return, were filed with the Court well in excess of 90 days after the notice of deficiency was issued. If these documents were signed by her and can be considered as a ratification of the petition by her, the ratification would not be timely because, under Rule 41(a), "No amendment [to the petition] shall be allowed after expiration of the time for filing the petition * * which would involve319 conferring jurisdiction on the Court over a matter which otherwise would not come within its jurisdiction under the petition as then on file." Levitt v. Commissioner, 97 T.C. at 442-443. 3 The signing of the 1973 income tax return by Mrs. Levitt, long before the notice of deficiency was issued, cannot be construed by any stretch of the imagination as authority for the filing of a petition in this Court by Mr. Levitt on behalf of Mrs. Levitt. The Court concludes, therefore, that Mrs. Levitt did not ratify the petition. 320 Having concluded that Mrs. Levitt neither authorized the petition nor subsequently ratified it, the Court lacked jurisdiction over her when the February 6, 1990 decision was entered. Accordingly, it is not necessary to consider Mrs. Levitt's other argument, that the decision was the result of fraud upon the Court. "[A] judgment entered without jurisdiction is void and 'is a legal nullity and a court considering a motion to vacate has no discretion in determining whether it should be set aside'." Brannon's of Shawnee, Inc. v. Commissioner, 69 T.C. 999">69 T.C. 999, 1001 (1978) (citing Jordon v. Gilligan, 500 F.2d 701">500 F.2d 701, 704 (6th Cir. 1974)). Since the Court lacked jurisdiction over Mrs. Levitt at the time the February 6, 1990 decision was entered, the decision, insofar as it relates to Mrs. Levitt, is a legal nullity. Accordingly, the Court will grant the motion for leave to file, file the motion to vacate, and vacate the February 6, 1990, decision insofar as it relates to Mrs. Levitt. In this opinion, the Court holds that there was no jurisdiction over Mrs. Levitt because she never petitioned this Court (by signing the petition 321 or authorizing anyone to sign on her behalf) and never ratified the petition filed by Mr. Levitt. This Court acquired jurisdiction over Mrs. Levitt only for the purposes of determining whether this Court had jurisdiction over her at the time the decision was entered. The Court concludes there was no jurisdiction over her at that time. This Court did not acquire general jurisdiction over Mrs. Levitt because she never filed either a petition, an amended petition, or ratified the petition purportedly filed in her name. Accordingly, this Court has no jurisdiction to make findings with respect to certain ancillary allegations by Mrs. Levitt in her motion for leave to file and her motion to vacate (1) that related to the filing of income tax returns and consents to extend the periods of limitations for 1973, 1975, and 1976; (2) that the notice of deficiency with respect to her is invalid; and (3) that she is an innocent spouse under section 6013(e). See Abeles v. Commissioner, 90 T.C. 103">90 T.C. 103, 109 (1988). Indeed, as noted by this Court in Levitt v. Commissioner, 97 T.C. 437">97 T.C. 437, 443 (1991): Here, however, our obligation is to322 find facts that are necessary to determine whether Mrs. Levitt is a party to this case. Inasmuch as we have concluded that Mrs. Levitt is not a party to this case, any additional or unnecessary findings would have no binding effect in this or any subsequent proceeding. If we were to resolve the disputed inference concerning Mr. Levitt's authority against Mrs. Levitt, she would be free to contend that we were without jurisdiction to make such findings.This Court, therefore, makes no findings or conclusions with respect to Mrs. Levitt's ancillary allegations. To reflect the foregoing, An appropriate order will be issued.Footnotes1. All section references are to the Internal Revenue Code as amended. All Rule references are to the Tax Court Rules of Practice and Procedure.↩2. Under the circumstances herein, the motion for leave to file the motion to vacate is a prerequisite to filing a motion to vacate. The motion to vacate was lodged with the Court concurrently with the filing of the motion for leave. Respondent did not object to the motion for leave to file but objected to the motion to vacate. In deciding whether to grant or deny motions for leave, this Court may consider the merits of the underlying motion to vacate to determine whether further proceedings are appropriate. Brannon's of Shawnee, Inc. v. Commissioner, 69 T.C. 999">69 T.C. 999↩ (1978). Accordingly, the Court here considers the merits of Mrs. Levitt's motion to vacate.3. The Court dismisses respondent's contention that the ratification, even after 90 days from issuance of the notice of deficiency, relates back to the date the petition was filed. In order for a ratification to relate back to the date the original petition was filed, there must be clear evidence that the party filing the initial petition had the authority to file the petition on behalf of the taxpayer and the taxpayer intended to petition the Court at that time. See Brooks v. Commissioner, 63 T.C. 709">63 T.C. 709, 713 (1975); Kraasch v. Commissioner, 70 T.C. 623">70 T.C. 623, 628↩ (1978). Here, the Court finds that Mrs. Levitt never intended to file a petition in this Court; therefore, the purported ratification by the disputed documents would not relate back to the date the petition was filed.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622050/	Ward Kremer v. Commissioner.Kremer v. CommissionerDocket No. 3871.United States Tax Court1944 Tax Ct. Memo LEXIS 6; 3 T.C.M. (CCH) 1322; T.C.M. (RIA) 44405; December 22, 19446 The determination in Ward Kremer, Docket No. 105838, dated April 20, 1942, that Kremer was not an employee of the City of Asbury Park, New Jersey, and that the compensation received by him from that city in 1936 was not exempt from taxation, is not res judicata of this proceeding. Petitioner received compensation from the City of Asbury Park, during the taxable years 1937 and 1938, for services rendered by him as special counsel, refunding counsel, and refunding agent. Held, petitioner was not an employee of the city and the compensation paid him by the city is subject to taxation. Ward Kremer, pro se, 601 Bangs Ave., Asbury Park, N.J., and Hyman Besser, C.P.A., for the petitioner. Robert S. Garnett, Esq., for the respondent. ARUNDELLMemorandum Findings of Fact and Opinion This proceeding involves a deficiency in income tax for the years and in the amounts as follows: Taxable YearIncome Tax1937$ 1,549.49193814,663.84Two questions are presented: (1) Whether petitioner is estopped by the judgment in the case of Ward Kremer, Docket No. 105838, entered April 20, 1942, from asserting in the instant proceeding that the Commissioner erred 7 in including as part of his taxable income for the taxable years 1937 and 1938, compensation received by him from the City of Asbury Park, New Jersey, and (2) whether petitioner was an employee of the City of Asbury Park in 1937 and 1938. At the hearing respondent conceded that petitioner sustained a capital loss in 1938, due to the worthlessness of certain stock owned by him. This concession will be given effect under Rule 50. Finds of Fact Petitioner is a resident of Asbury Park, New Jersey, where he has been engaged in the practice of law since 1914. He filed his income tax returns for the taxable years 1937 and 1938 with the Collector of Internal Revenue for the first district of New Jersey. In 1935 the City of Asbury Park, hereinafter referred to as the city, experienced financial difficulties and was placed under the jurisdiction of the New Jersey Municipal Finance Commission. The city was in default on its outstanding bonds and was involved in difficult litigation in trying to straighten out its financial affairs. In 1935 petitioner had been retained as special counsel to perform certain legal work for the city. Petitioner's work was mainly connected with the formulation8 of a refunding plan and securing the necessary approvals. He also drew contracts and represented the city in certain litigation, other than that involving its bonded indebtedness, and represented the city on some administrative matters. Petitioner received no fixed salary, but was paid the value of his services as agreed upon by the parties. A refunding plan was approved on July 31, 1937, by the New Jersey Supreme Court. The plan had been submitted to the Court early in 1936, and petitioner had represented the city before the Court. In the latter part of 1936 or early in 1937, after a conference with the city officials, petitioner was appointed refunding agent. At that time petitioner advised the city officials that he did not feel any salary could be paid him that would compensate him adequately for the work he was expected to do. He was advised to go ahead with the work and the city would pay what was right in accordance with the work done. Petitioner had no written contract with the city. During the taxable years 1937 and 1938, petitioner's efforts in behalf of the city were principally directed toward the accomplishment of the refunding plan and placing it in operation. There9 were many conflicts among various bondholders' committees, the Municipal Finance Commission, and the city authorities with regard to the plan. He worked to bring about agreement among the various groups. Though the refunding plan had been approved by the New Jersey Supreme Court, it was necessary that 85 per cent in amount of the bondholders agree to the plan before it could be declared operative. Petitioner rendered other services to the city during the same period. He handled legal matters relating to the sale of property acquired by the city on foreclosure of tax title liens, contracts connected with the leasing of city property, and litigated certain cases in which the city was a party. In his work for the city the petitioner used his own judgment, discretion and his best professional skill to obtain the desired results. The refunding plan was declared operative in June 1938. Thereafter petitioner's duties as refunding agent continued. Petitioner worked in close cooperation with the mayor, city manager, and the city council. He reported to the mayor as to the progress of his work and he conferred frequently with the mayor or city manager as to the cases or problems upon which10 he was working. Petitioner received general instructions from them concerning the course of his work. He devoted a substantial part of his time to the work of the city. No fixed salary was ever agreed upon, but petitioner was paid fees for the work performed. Petitioner submitted vouchers, generally on a quarterly basis, to the city. The vouchers reflected the work done and the fees asked by him. After necessary approvals, the vouchers were paid. He submitted vouchers for expenses incurred by him in handling the city's work and they were paid by the city. Petitioner took no oath of office, nor were his duties prescribed by law. There was no fixed term for petitioner's services to the city, but he was engaged at the pleasure of the governing body. He had no regular hours of employment, and he was not furnished an office, supplies, or assistants by the city. Petitioner did not furnish any bond to the city in connection with the work he performed. The firm of M. M. Freeman & Company, a bond house in Philadelphia, Pennsylvania, was the refunding agent for the city prior to the time the work was turned over to petitioner. The City of Asbury Park employed a regular city attorney, appointed11 pursuant to statute. This position was not held by petitioner, but was held by a different person. In 1937 the city paid the petitioner $23,764.85, and in 1938 the city paid him the total sum of $69,482.93. Of the 1938 payment, approximately $12,000 represented reimbursement for expenses paid by petitioner while representing the city, $25,000 was for services as refunding counsel and $15,000 for services as refunding agent. The fees for refunding services paid to petitioner were approved by the Municipal Finance Commission of New Jersey, and were for services rendered in 1937 and 1938. Petitioner maintained a private law office and he always had one or two younger lawyers to whom he assigned work. During 1937 petitioner received $17,501.97 from clients other than the city, and in 1938 he received $15,172.22 from other clients. Some part of these fees was for services rendered to clients in prior years. The petitioner in the instant case is the same individual that petitioned the United States Board of Tax Appeals for redetermination of his tax liability for the year 1936, in the case of Ward Kremer, Docket No. 105838. In that case the petitioner alleged error on the part of12 the Commissioner in including as part of his taxable income in 1936, $21,500 received by him in that year for services rendered as special counsel to the City of Asbury Park, New Jersey, (Pet. Docket No. 105838). In its Memorandum Findings of Fact and Opinion entered in the case of this petitioner for the year 1936, Docket No. 105838, on April 20, 1942, the Board stated the sole issue was whether the $21,500 received by the petitioner from the City of Asbury Park was constitutionally exempt from Federal income tax, the petitioner contending that the said amount was received as compensation for services rendered by him as an employee of a political subdivision of the State of New Jersey. In its opinion in that case the Board said: "Under the facts we think petitioner must be regarded not as an officer or employee of the city, but an independent contractor. The claimed immunity from tax must therefore be, and it is denied. * " The Board's decision was entered on April 20, 1942, and on November 15, 1943, an order was entered by the United States Circuit Court of Appeals for the Third Circuit docketing and dismissing the petition for review filed by the petitioner, for failure of13 petitioner to prosecute. Opinion ARUNDELL, Judge: The issue upon its merits concerns the correctness of the respondent's action in refusing to exempt from Federal income taxation the compensation received by the petitioner from the City of Asbury Park, New Jersey, during the years 1937 and 1938. Respondent interposed the plea of res judicata and contends that the petitioner is estopped to assert error in the instant proceeding by reason of the judgment entered on April 20, 1942, in the case of Ward Kremer v. Commissioner, Docket No. 105838. In the former case, Docket No. 105838, involving the taxable year 1936, we held that petitioner was not an officer or employee of the City of Asbury Park, in 1936, but an independent contractor and we denied his claimed immunity from Federal income taxation. The instant proceedings involve the taxable years 1937 and 1938, whereas, the earlier case involve the taxable year 1936, hence, we are concerned with a different cause of action. Tait v. Western Maryland Ry. Co., 289 U.S. 620">289 U.S. 620, 77 L. Ed. 1405">77 L. Ed. 1405, 53 S. Ct. 706">53 S. Ct. 706. In such circumstances the earlier judgment is conclusive only as to the facts, rights, questions, or issues adjudicated 14 in the earlier case which are again the facts, rights, questions, or issues presented for adjudication in the second case. Cromwell v. County of Sac, 94 U.S. 351">94 U.S. 351, 352, 24 L. Ed. 195">24 L. Ed. 195; Southern Pacific Railroad Co. v. United States, 168 U.S. 1">168 U.S. 1, 48, 42 L. Ed. 355">42 L. Ed. 355, 18 S. Ct. 18">18 S. Ct. 18; Charles P. Leininger, 29 B.T.A. 874">29 B.T.A. 874. The applicable statutes and the parties are the same as in the prior proceeding. While some aspects of the facts and issues before us bear a close resemblance to those that were before us in the earlier case, nevertheless, the instant proceeding is not only concerned with the receipt of income by petitioner for services rendered to the city as special counsel, but also for services as refunding agent and refunding counsel. In the circumstances, we think the petitioner is not estopped by the former judgment, which determined only his relationship with the city as special counsel in 1936. Turning to the merits of the instant case, the question before us is whether petitioner was an employee of the city during the taxable years 1937 and 1938, so that the compensation which he received would be exempt from income tax. 115 We are not persuaded by petitioner's argument or by the cases cited and relied upon by him. Petitioner was not employed by the city pursuant to any statutory authority, his duties were not prescribed by law, the rate at which he was to be compensated was not fixed prior to actual payment, and when paid, it was on the basis of vouchers reflecting the work performed and the value of the services set by petitioner, and agreed to by the proper city officials. Petitioner took no oath of office, he had no regular hours of employment, nor was he furnished office quarters, or equipment by the city. Petitioner has placed great emphasis upon the control exercised over his work by the mayor, city manager, and the city council. We agree that control by an employer is a major factor in determining whether the relationship is that of employee-employer, but we are unable to find that petitioner was sufficiently under the direction and control of the city officials as to denote that relationship. It may be, as he urges, that he reported frequently or regularly to the mayor as to the progress of his work; that he discussed city problems with him and obtained instructions concerning the work he was16 doing for the city; but, we think such control is no more than is exercised by an intelligent client. In his work for the city the petitioner used his own judgment, discretion, and his best professional skill to obtain results. The liberty of action which he enjoyed while performing services for the city, excludes the degree of control which denotes the employer-employee relation. The compensation paid to petitioner by the city amounted to $23,764.85 in 1937, and $69,482.93, including approximately $12,000 reimbursement for expenses in 1938. The whole relationship between petitioner and the City of Asbury Park bespeaks that of lawyer and client, rather than an employee-employer relationship. Petitioner was simply a lawyer retained by the city. As special counsel or refunding counsel for the city, he was not an agency through which the sovereign power of the state was being immediately and directly exercised so as to confer immunity as to the compensation received by him for the services he rendered. Petitioner asserts that of the compensation received from the city in 1938, some $15,000 was for services rendered by him as refunding agent and that in such capacity he was an employee17 of the city. The city's refunding plan was declared operative in June 1938. Petitioner took no oath, he furnished no bond, nor was he provided with an office by the city. It does not appear exactly what his duties or responsibilities were. The fact that the city council passed a resolution appointing petitioner refunding agent, does not per se signify that he became a city employee. The refunding agent prior to the petitioner was the firm of M. M. Freeman & Company, a bond house in Philadelphia, Pennsylvania. We are not persuaded that the compensation received by him as refunding agent should be treated differently from the other sums paid him by the City of Asbury Park. It is settled doctrine that one of a class subject to taxation claiming the benefit of an exemption, whether under law or regulations, or arising out of the want of power to tax, must bring himself exactly within the exemption he claims. Register v. Commissioner, 69 F.2d 607">69 F.2d 607, and cases cited thereunder. Petitioner has failed to establish his claimed immunity. It follows that the determination of the Commissioner must be sustained. Decision will be entered under Rule 50. *18 Footnotes1. Regulations 94, Article 116-2, as amended by T.D. 4787↩, and Regulations 101, Article 116-2.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622051/	HBE Corporation, Petitioner v. Commissioner of Internal Revenue, RespondentHBE Corp. v. CommissionerDocket No. 31278-84United States Tax Court89 T.C. 87; 1987 U.S. Tax Ct. LEXIS 99; 89 T.C. No. 10; July 13, 1987July 13, 1987, Filed 99 Decision will be entered for the respondent. During the 1980 taxable year, P, a corporation, realized and reported a net capital gain of $ 9,600,701 on its corporate return, which was part of its total taxable income of $ 10,035,963. P also had available tax credits totaling $ 2,186,855. P chose to calculate the amount of its item of tax preference for capital gain under the alternative formula found in sec. 1.57-1(i)(2)(i), Income Tax Regs., rather than by the statutory formula found in sec. 57(a)(9)(B), I.R.C. 1954, based on its belief that application of the alternative formula would result in a determination of a lower amount of tax preference item than would otherwise be calculated by utilizing the statutory formula. P takes the position that tax credits should be considered in applying the alternative formula, so as to reduce the amount of the item of tax preference for capital gain. R disagrees. Held, tax credits are not to be considered in applying the alternative formula. Robert W. Hoffman, for the petitioner.Steven W. LaBounty, for the respondent. Gerber, Judge. GERBER88 OPINIONRespondent determined a deficiency of $ 392,481 in petitioner's100 Federal income tax for the taxable year ended December 31, 1980. The issue for our consideration involves the computation of the "minimum tax." More specifically we are asked to redetermine whether petitioner may use income tax credits to reduce the amount of tax preference determined under the alternative formula (found in section 1.57-1(i)(2)(i), Income Tax Regs.) for computing a corporate capital gain item of tax preference under section 57(a)(9)(B). 1This case was submitted fully stipulated under Rule 122, and the stipulation of facts is incorporated by this reference. Petitioner is a Delaware corporation which had its principal place of business in St. Louis, Missouri, at the time its petition was filed. A timely 1980 consolidated Federal corporate income tax return was filed with the Internal Revenue Service101 Center, Kansas City, Missouri.Petitioner, for the 1980 taxable year, realized and reported on Schedule D of its corporate return (Form 1120) $ 9,600,701 of net capital gain. Total taxable income of $ 10,035,963 was reported for the 1980 taxable year. Without application of section 1201(a), petitioner's tax, as computed under section 11 (on its taxable income of $ 10,035,963) would have been $ 4,597,293, as follows: 89 17 percent of $ 25,000$ 4,25020 percent of $ 25,0005,00030 percent of $ 25,0007,50040 percent of $ 25,00010,00046 percent of $ 9,935,9634,570,543Total4,597,293However, by using the alternative capital gain tax computation under section 1201(a), 2 petitioner's income tax for the 1980 taxable year (before considering credits) was $ 2,869,167, computed at Part IV of Schedule D (Form 1120), as follows:Taxable income$ 10,035,963Net capital gain9,600,701Difference435,262Partial tax on income of $ 435,2623 180,97128 percent of net capital gain of 9,600,7012,688,196Alternative tax (sum of partial tax and 28% of net capitalgain)2,869,167Petitioner further reduced its reported income tax liability of $ 2,869,167102 by tax credits totaling $ 2,186,855, including an investment credit of $ 2,021,999 4 and a jobs credit of 90 $ 164,856. After applying these credits, petitioner's tax liability stood at $ 682,312, a figure which respondent does not herein dispute.103 Petitioner was also subject in 1980 to the minimum tax imposed under section 56(a) for items of tax preference defined in section 57. Section 56(a) provides that as a general rule --In addition to the other taxes imposed by this chapter, there is hereby imposed for each taxable year, with respect to the income of every corporation, a tax equal to 15 percent of the amount by which the sum of the104 items of tax preference exceeds the greater of -- (1) $ 10,000 or(2) the regular tax deduction for the taxable year (as determined under subsection (c)).[Emphasis added.]Petitioner's only item of tax preference during 1980 was its net capital gain of $ 9,600,701. Section 57(a)(9)(B), provides in relevant part, that --In the case of a corporation having a net capital gain for the taxable year, [the amount of the item of tax preference is] equal to the product obtained by multiplying the net capital gain by a fraction the numerator of which is the highest rate of tax specified in section 11(b), minus the alternative tax rate under section 1201(a), for the taxable year, and the denominator of which is the highest rate of tax specified in section 11(b) for the taxable year. * * [Emphasis added.]Respondent's regulations mirror the statutory language and provide --that in the case of corporations there is to be included as an item of tax preference with respect to a corporation's net section 1201 gain an amount equal to the product obtained by multiplying the excess of the net long-term capital gain over the net short-term capital loss by a fraction. 105 The numerator of this fraction is the sum of the normal tax rate and the surtax rate 5 under section 11 minus the alternative tax rate 91 under section 1201(a) for the taxable year, and the denominator of the fraction is the sum of the normal tax rate and the surtax rate under section 11 for the taxable year. * * * [Sec. 1.57-1(i)(2)(i), Income Tax Regs.]However, these regulations also provide that --In certain cases the amount of the net section 1201 gain which results in preferential treatment will be less than the amount determined by application of the statutory formula. Therefore, in lieu of the statutory formula, the capital gains item of tax preference for corporations may in all cases be determined by dividing --(a) The amount of tax which would have been imposed under section 11 if section 1201(a) did not apply minus --(b) The amount of the taxes actually imposed by the sum of the normal tax rate plus the surtax rate under section 11. * * [Sec. 1.57-1(i)(2)(i), Income Tax Regs. Emphasis added.]106 Petitioner claims to have calculated its item of tax preference for capital gain pursuant to the alternative formula found in section 1.57-1(i)(2)(i), Income Tax Regs., rather than by the statutory formula found in section 57(a)(9)(B). Petitioner computed its item of tax preference for capital gain in the following manner:Sec. 11 corporate tax on taxable income of$ 10,035,963$ 4,597,293 Less:Investment tax credit(6107 3,225,605)Jobs credit(164,856)Sec. 11 corporate tax after credits$ 1,206,832Sec. 1201(a) alternative tax2,869,167 Less:Investment tax credit(7 $ 2,021,999)Jobs credit(164,856)Sec. 1201(a) alternative tax after credits$ 682,312Difference$ 524,520Divided by .46.46 Tax preference for capital gain$ 1,140,26192 Accordingly, petitioner determined on Form 4626, attached to its corporate return for 1980, that it was liable for the minimum tax on tax preference items in the amount of $ 68,692, computed as follows:Tax preference items$ 1,140,261 Less regular tax deduction(682,312)Difference$ 457,949 Tax rate15% Minimum tax$ 68,692 Respondent, however, determined in the statutory notice of deficiency issued to petitioner that for the 1980 taxable year petitioner's item of tax preference for capital gain, as computed under the alternative formula found in section 1.57-1(i)(2)(i), Income Tax Regs., was $ 3,756,796, not $ 1,140,261, and that petitioner's minimum tax for items of tax preference was $ 461,173, 8 not the $ 68,892 listed on its corporate return. 9 Respondent arrived at a higher figure in determining the item108 of tax preference for capital gain 93 because, in contrast to petitioner, he did not reduce the "amount of tax" determined under sections 11 and 1201(a) by tax credits in making his computation. As a result, respondent's computed "difference" between the regular tax as determined under section 11 and the alternative tax as determined under section 1201(a), without factoring in tax credits, was $ 1,728,126, while petitioner's calculations, which did take into consideration these credits, showed a difference of only $ 524,520 (see page 92 supra). The following table demonstrates the difference in the parties' methodology:Petitioner'sRespondent'smethod 10methodSec. 11 corporate tax on taxableincome of $ 10,035,963$ 4,597,293 $ 4,597,293Less:Investment tax credit(3,225,605)Jobs credit(164,856)Sec. 11 corporate tax after credits1,206,832 Sec. 1201(a) alternative tax2,869,167 2,869,167Less:Investment tax credit(2,021,999)Jobs credit(164,856)Sec. 1201(a) alternative tax after credits682,312 Difference$ 524,520 $ 1,728,126Divided by .46.46 .46 Tax preference for capital gain$ 1,140,261 $ 3,756,796109 As illustrated by the above discussion, it is respondent's position that the alternative formula as set out in section 1.57-1(i)(2)(i), Income Tax Regs., for computing, under section 57(a)(9)(B), the item of tax preference for capital gain, should not, and does not, take into consideration tax credits available to110 the corporation for the taxable year. Petitioner, on the other hand, contends that under the alternative formula these credits should be taken into account in arriving at the amount of the tax preference item for capital gain.Conceptually, we recognize that the "minimum tax" was a somewhat indirect legislative attempt to remedy the actual lack of progressivity in our tax system. See S. Rept. 94 91-522 (1969), 3 C.B. 423">1969-3 C.B. 423, 495. Certain tax benefits were identified as "tax preferences." The statutory scheme requires identification and computation of the total amount of these preferences, followed by the imposition of a minimum tax on the amount so determined. This minimum tax component is then added to the ordinary amount of tax computed under the other sections of chapter 1 of the Internal Revenue Code (Code), to arrive at a taxpayer's gross tax liability. In effect, the minimum tax is like a surtax attributable to tax preferences, to be computed totally apart, and as an addition to a taxpayer's ordinary tax liability. The issue presented herein, in its most simplified form, is essentially whether a taxpayer may double count its tax credits, 111 by not only applying them as payments against its computed tax liability, but by also applying these same credits to reduce the amount owed on its minimum tax component as well. 11112 At first glance, the regulatory language could be read to support petitioner's position. As noted supra at page 91, the regulation, in describing the numerator of the alternative formula, simply makes reference to the difference between "The amount of tax which would have been imposed under section 11 if section 1201(a) did not apply" and "The amount of the taxes actually imposed," sec. 1.57-1(i)(2)(i), Income Tax Regs. (Emphasis added.) Thus, by looking at the regulation solely on its face, one could arguably interpret this language to mean the difference between the amount of tax(es) to be imposed under sections 11 and 1201(a) after application of allowable credits, i.e., a corporate taxpayer's bottom line tax liability in each 95 instance. However, when read in light of the unambiguous language of section 57(a)(9)(B), the legislative history which led to that section's adoption and the specific inequities, as detailed in the regulation's examples, which apparently caused respondent to promulgate the alternative formula found in section 1.57-1(i)(2)(i), Income Tax Regs., it becomes clear that such a view is not in harmony with the overall statutory scheme, 113 and that the only correct interpretation is the one put forth by respondent.Section 57, and its companion provisions sections 56 and 58, embody the so-called minimum tax on items of tax preference and were introduced into the Code by the Tax Reform Act of 1969, Pub. L. 91-172, 83 Stat. 487. Congress recognized a need for the implementation of such a tax because --Under [the] present law, many individuals and corporations do not pay tax on a substantial part of their economic income as a result of the receipt of various kinds of tax-exempt income or special deductions. * * Both individuals and corporations, for example, now pay the equivalent of the regular income tax on only part of their long-term capital gains. * [S. Rept. 91-522 (1969), 3 C.B. 423">1969-3 C.B. 423, 495.] The Senate Finance Committee report continues by explaining that -- The present treatment which permits individuals and corporations to escape tax on certain portions of their economic income results in an unfair distribution of the tax burden. This treatment results in large variations in the tax burdens placed on taxpayers who receive different kinds of income. * * [S. Rept. 114 91-522 (1969), 3 C.B. 423">1969-3 C.B. 423, 495.] As a result, section [ILLEGIBLE TEXT], the corporate minimum tax provision (see page 90 supra), was added to the Code to impose an additional tax on specific items of tax preference, as defined under section 57, so as "to reduce the advantages derived from these preferences and to make sure that those receiving such preferences also pay a share of the tax burden." S. Rept. 91-522 (1969), 3 C.B. 423">1969-3 C.B. 423, 495.Not unexpectedly, Congress targeted as an item of tax preference the benefit received by a corporate taxpayer by paying, under section 1201(a), a lower rate of tax on its 96 capital gain income than it would otherwise pay under section 11, and thus the statutory formula of section 57(a)(9)(B) was enacted. The formula is described in the Senate Finance Committee report, as follows:In the case of corporations, the tax preference is the excess of the net long-term capital gain over the net short-term capital loss, multiplied by a ratio in which the denominator is the regular corporate rate (48 percent) and the numerator is the regular rate minus the rate applicable to capital115 gains in the case of corporations (28 3/4 percent in 1970 and 30 percent thereafter). In other words, the corporate capital gains are included among the tax preferences in the ratio of the difference between their special rate and the general corporate tax rate to the general corporate tax rate. Thus, after 1970 3/8 of a corporation's net long-term capital gain will be treated as a tax preference (48% - 30% / 48%). [S. Rept. 91-522 (1969), 3 C.B. 423">1969-3 C.B. 423, 497. Emphasis added.]It appears that, with respect to section 57(a)(9)(B), Congress intended to apply the minimum tax only on what it considered to be the capital gain preference, i.e., reduction of taxes, realized by a corporate taxpayer with respect to its capital gain income due to the difference in the regular and capital gain tax rates. Thus, the statutory formula found in section 57(a)(9)(B) makes no allowance for tax credits, for they have no bearing on the amount of benefit or preference a corporate taxpayer receives by utilizing the lower tax rate found in section 1201(a).We reject petitioner's interpretation of respondent's regulation. To accept petitioner's view would116 require us to consider tax credits in applying the alternative formula which would lead to a result seemingly inconsistent with the statutory language and clearly inconsistent with congressional intent. On the other hand, by adopting respondent's interpretation --The ambiguity in the regulations can be eliminated and the regulations can be upheld by following the congressional intent underlying the statute. Where there is an interpretation of an ambiguous regulation which is reasonable and consistent with the statute, that interpretation is to be preferred. [United Telecommunications, Inc. v. Commissioner, 589 F.2d 1383">589 F.2d 1383, 1390 (10th Cir. 1978), affg. 67 T.C. 760">67 T.C. 760 (1977).]To do otherwise, would confer a benefit on petitioner and other similarly situated taxpayers, which was not congressionally intended.97 Moreover, a closer look at the regulation itself, focusing especially on the specific examples found therein, reveals that respondent did not intend to change the scope of the statute or reduce the amount of minimum tax a corporation was to pay on the actual benefit it received from computing its tax for capital117 gain under section 1201(a). To the contrary, it is readily apparent that respondent's sole motivation in providing an alternative to the statutory formula was to insure that corporate taxpayers were not unfairly taxed on an item of tax preference where the full benefit of the preference was not received due to circumstances not contemplated by Congress at the time section 57(a)(9)(B) was enacted. 12The regulation states that the alternative formula was made available only because "In certain118 cases the amount of the net section 1201 gain which results in preferential treatment will be less than the amount determined by application of the statutory formula." Sec. 1.57-1(i)(2)(i), Income Tax Regs. (Emphasis added.) As a guide to explaining the types of inequities to be remedied by the promulgation of this formula, the regulation details specifically in its examples two situations in which a corporate taxpayer does not fully benefit from the rate differential between section 11 and section 1201(a), and thus is unfairly burdened by the imposition of a minimum tax based solely on the existence of such a differential. 13120 While we recognize that use of the 98 alternative formula, by its terms, is applicable generally and not limited to only these two sets of circumstances, we think the regulatory language, especially when read in light of these examples, clearly reflects that respondent never intended that application of the alternative formula was to result in a reduction of a corporate taxpayer's preference amount (from what it would otherwise have been if computed under application of the statutory formula) in a situation, such as petitioner's, in which a corporation119 had in fact benefited from preferential treatment with respect to the full amount of its 1201(a) gain. Respondent sought only to provide a method by which all corporations would be equitably taxed, not to confer yet additional tax benefits on corporations; 14 a result which would not comport with the conceptual underpinnings of section 57(a)(9)(B) and the minimum tax.To reflect the foregoing,Decision will be entered for the respondent. Footnotes1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect during the year in issue, and all Rule references are to the Rules of Practice and Procedure of this Court.↩2. Sec. 1201(a) provides as follows:SEC. 1201(a). Corporations. -- If for any taxable year a corporation has a net capital gain, then, in lieu of the tax imposed by sections 11, 511, 821(a) or (c) and 831(a), there is hereby imposed a tax (if such tax is less than the tax imposed by such sections) which shall consist of the sum of -- (1) a tax computed on the taxable income reduced by the amount of the net capital gain, at the rates and in the manner as if this subsection had not been enacted, plus(2) a tax of 28 percent of the net capital gain.↩3. The partial tax on income of $ 435,262 was computed according to the rate schedule found in sec. 11, as follows:↩17 percent of $ 25,000$ 4,25020 percent of $ 25,0005,00030 percent of $ 25,0007,50040 percent of $ 25,00010,00046 percent of $ 335,262154,221Total180,9714. The investment credit of $ 2,021,999 included a regular investment credit of $ 2,015,917 and a business energy investment credit of $ 6,082, computed as follows:↩Tentative regular investment credit$ 6,165,867Regular investment credit limitation ($ 25,000 plus 70% ofincome tax over $ 25,000)figured on an income tax of $ 2,869,1672,015,917Allowed regular investment credit2,015,917Business energy investment credit6,082Business energy investment credit limitation (income tax lessallowed regular investment credit) figured on an incometax of $ 2,869,167853,250Allowed business energy investment credit6,082Total allowed regular and business energy investment credit2,021,9995. Under sec. 301(a) of the Revenue Act of 1978, Pub. L. 95-600, 92 Stat. 2763, 2820 (the 1978 Act), the normal tax and surtax rates under sec. 11 were repealed by Congress, and replaced by a five-step graduated rate structure on corporate taxable income, applicable to tax years beginning after Dec. 31, 1978. Accordingly, under sec. 301(b)(2) of the 1978 Act, the words "the highest rate of tax specified in section 11(b)" were to be inserted in place of the phrase "the sum of the normal tax rate and the surtax rate under section 11" in each place such phrase appeared in sec. 57(a)(9)(B). However, since sec. 1.57-1(i)(2)(i) of respondent's regulations were adopted prior to the 1978 Act, and have not since been amended, the regulation continues to make reference to "the normal tax rate and the surtax rate." Nonetheless, it is understood, and the parties do not argue otherwise, that sec. 1.57-1(i)(2)(i), Income Tax Regs.↩, is to be read as if in every place that the phrase "the sum of the normal tax rate and the surtax rate under section 11" now appears, the words "the highest rate of tax specified in section 11(b)," should be inserted instead. During the year in issue this rate was 46 percent.6. In determining its item of tax preference for capital gain, petitioner reduced its income tax liability computed under sec. 11 by an investment credit of $ 3,225,605 figured on an income tax liability of $ 4,597,293 as follows:Tentative regular investment credit$ 6,165,867Regular investment credit limitation ($ 25,000 plus 70% ofincome tax over $ 25,000)figured on an income tax of $ 4,597,2933,225,605Allowed regular investment credit3,225,605Business energy investment credit limitation (income tax lessallowed regular investment credit) figured on an income taxof $ 4,597,2931,371,688Business energy investment creditPetitioner has provided no explanation of why, in computing its investment credit figured on an income tax liability of $ 4,597,293, it did not include the business energy investment credit of $ 6,082 shown on its Form 3468 attached to its 1980 corporate income tax return. (See note 4 supra.)1 0Allowed business energy investment credit0Total allowed regular and business energy investment credit3,225,6057. In determining its item of tax preference for capital gain, petitioner reduced its income tax liability computed under sec. 1201(a) by an investment tax credit of $ 2,021,999 figured on an income tax liability of $ 2,869,167 as shown in note 4 supra↩.8. Respondent computed petitioner's minimum tax as follows:↩Sec. 11 corporate tax$ 3,756,796Less regular tax deduction682,312Difference$ 3,074,484Tax rate15% Minimum tax$ 461,1739. We note that if petitioner had chosen to calculate its item of tax preference for capital gain under the statutory formula found in sec. 57(a)(9)(B) (see pages - supra), the amount of its preference would have been the same $ 3,756,796 as determined by respondent under the alternative formula, computed as follows:Highest sec. 11 tax rate - Sec. 1201(a) alternative tax rate/Highest sec. 11 tax rate x Net capital gain = .46 - .28/.46 x $ 9,600,701 = $ 3,756,796↩10. See page 92 supra↩.11. Although afforded only limited probative significance, we note that the overall structure and symmetry of various Code sections would favor respondent's position and interpretation of the statutes in question. Sec. 11 provides for a tax computed upon taxable income. Similarly, sec. 56, in imposing the minimum tax add-on component, provides for the computation of a tax on tax preference items, in excess of specified amounts, which is "In addition to the other taxes imposed by this chapter." In turn, sec. 38, for example, provides for a "credit against the tax imposed" under other sections of ch. 1 (i.e., in the context of this case, secs. 11 and 56). In other words, both secs. 11 and 56 pertain to the imposition and computation of a tax upon corporations, whereas sec. 38 permits a reduction or, if you will, a means of payment of the tax. Accordingly, given the computational context of secs. 11 and 56, it would appear that in each of these sections reference is being made only to the computation of the gross amount of tax, without considering the means of payment or credits. Instead, consideration of such payments and credits has been left to other sections of the Code, to be applied as one-time offsets against a corporation's gross tax computation in arriving at a corporation's bottom line tax liability.↩12. Respondent's intent was discussed by John S. Nolan, Deputy Assistant Secretary for Tax Policy of the Treasury, in a speech given at the University of Pennsylvania Annual Tax Conference in 1970, in which he stated that respondent's "principal concern" in writing the regulations covering the minimum tax provisions as enacted by the Tax Reform Act of 1969, was to "devise rules to deal with situations where no tax benefit is actually derived from tax preference items." 33 J. Tax. 370, 372↩ (1970).13. The two situations discussed in the regulation's examples deal with (1) the effect of offsetting operating losses, and (2) the fact that the corporate surtax rate exemption, which in prior years operated to lower the maximum corporate rate and thus reduce the preference differential, was not factored into the statutory formula. As summarized by Mr. Nolan in the speech he gave at the University of Pennsylvania Annual Tax Conference, (see note 12, supra) --"A similar problem [i.e., a situation in which it is inappropriate to apply the minimum tax because a specified item of tax preference generates no tax savings for that year] results from the statutory formula for determining the amount of the capital gains preference for corporations. The statutory formula is based on a comparison between the regular corporate income tax rate and the alternative corporate capital gains rate. In cases where a corporation has operated [sic] losses but nevertheless uses the alternative tax computation for capital gains, the statutory formula overstates the tax benefit derived by the corporation from treating the income as capital gain rather than ordinary income. A similar problem exists with respect to the surtax exemption; the statutory formula is based on a 48-percent rate without giving effect to the 22-percent rate. The Regulations will provide a modified formula which may be used by the taxpayer to determine the actual dollar amount of tax preference which would result in the tax savings obtained by the taxpayer from using the alternative capital gain tax rate. [33 J. Tax. 372↩ (1970).]"14. To avoid any possible inference to the contrary, we reemphasize that during the year in issue petitioner utilized the full amount of its $ 2,186,855 in tax credits as a one-time "payment" to reduce its gross tax liability.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622052/	Estate of John J. Toeller, Franklin Mayo, Administrator With Will Annexed, Petitioner, v. Commissioner of Internal Revenue, RespondentToeller v. CommissionerDocket No. 6890United States Tax Court6 T.C. 832; 1946 U.S. Tax Ct. LEXIS 218; April 26, 1946, Promulgated 218 Decision will be entered under Rule 50. Decedent established a trust which provided that one-third of the income should be payable to his estranged wife and the remaining income, after the payment of small annual sums to his children, should be payable to him. Upon his death the corpus was to be divided among his wife (if then living) and his children, or, if dead, to their descendants. The trust instrument provided that "should misfortune or sickness cause the expenses of Trustor to increase so that in the judgment of the Trustee the net income so payable to Trustor is not sufficient to meet the living expenses of Trustor, then * * Trustee is authorized to pay * * * such portions of the principal * * * as may be necessary under the circumstances. Said Trustee is given the sole right to determine when payments from the principal sum shall be made and the amount of said payments." It further provided that "All discretions conferred upon the trustee * * * shall, unless specifically limited, be absolute and uncontrolled * * ." Held:(1) The corpus of the trust is includible in the gross estate of decedent, following Blunt v. Kelly, 131 Fed. (2d) 632.219 (2) Under the facts, the amount paid to a charitable organization pursuant to compromise of a will contest proceeding is deductible from the gross estate of decedent.(3) Under the facts, certain expenses of the trustee of the trust established by decedent are not deductible from decedent's gross estate. Charles R. Sprowl, Esq., and Cassius M. Doty, Esq., for the petitioner.Harold H. Hart, Esq., for the respondent. Kern, Judge. KERN 832 The Commissioner, on October 13, 1944, determined a deficiency in Federal estate taxes due from the estate of John J. Toeller, deceased, in the amount of $ 26,206.98, as a result of including in the gross estate the value of the corpus of a trust created by the decedent in 1930, and of disallowing deductions claimed on account of a charitable bequest and certain expense items.A substantial part of the facts is stipulated. We find them to be as stipulated, and set out herein those facts taken from the stipulation and from the oral evidence which are necessary to an understanding of the questions before us.John J. Toeller, a resident of Chicago, Illinois, died there on May 10, 1942, shortly before his 65th birthday. His last will and testament was duly admitted to probate in the Probate Court of Cook County, Illinois, on August 6, 1942; and on the same date Franklin Mayo was duly appointed 221 and confirmed as administrator with will annexed of the estate of John J. Toeller.833 On August 5, 1943, the administrator filed with the collector of internal revenue for the first district of Illinois a Federal estate tax return, in which the assets of the estate were valued at $ 7,666.50 as of the date of decedent's death. This return listed also, as deductions claimed, the amount of $ 374.67 for funeral expenses; executor's commission of $ 300, and attorneys' fees of $ 1,100; administration expenses totaling $ 223; and child's award to the minor daughter of decedent in the amount of $ 500, all of which totaled $ 2,497.67. The entire estate, after payment of the expenses of administration and funeral expenses, was shown to be payable to "The Society of The Divine Word," an Illinois charitable institution located at Techny, Illinois, and a deduction on account thereof in the amount of $ 5,168.83 was claimed. The return showed no net estate subject to Federal estate tax.On February 13, 1930, the decedent created a trust, naming Continental Illinois Bank & Trust Co. as trustee and transferring to it property which was valued, at the date of decedent's death in 1942, at $ 222 155,073.58, subject to certain accrued taxes then amounting to $ 3,350.82.The trust instrument provided that the net income of the trust was distributable as follows: To Myrtle Toeller, wife of the grantor, who was living separately from him, one-third of the net income during her lifetime, with certain qualifications; to Virginia Toeller, daughter of the grantor, $ 500 per year for a period of not more than two years from the date of the trust instrument, while she remained unmarried and living at the home of her mother; to John J. Toeller, Jr., son of the grantor, $ 500 per year during his minority, and thereafter in the discretion of the trustee while he continued his education, but not beyond the age of twenty-seven; to Shirley Ann Toeller, daughter of the grantor, $ 500 per year during her minority; and to the grantor all the remainder of the income, if any. It was further provided that upon the death of the grantor, and after payment of funeral expenses and debts, except those represented by notes secured by real estate, the trustee should divide and distribute the corpus one-third to Myrtle Toeller, if living, and two-thirds (or all, if Myrtle Toeller were not then living) 223 to be divided into as many parts as there might then be living children and deceased children leaving descendants, one such share to be distributed to each living child of grantor and Myrtle Toeller, and one share to the descendants of each deceased child, per stirpes. Provision was made for the share of any child to be applied, if needed, for the education and support of such child until he reached the age of thirty, when his share would be distributable. The trust was, in no event, to continue more than twenty-one years after the death of the survivor of Myrtle Toeller and her three children, and no beneficiary was to be allowed to anticipate any payment. The trustee was directed to pay out of the corpus 834 any estate, inheritance, or other succession taxes which might be levied in connection with any gift under the indenture.Virginia Toeller was born June 23, 1911; Shirley Ann Toeller was born June 23, 1925, and John J. Toeller, Jr., died December 25, 1931, never having been married and leaving no descendants.Myrtle Toeller executed an instrument, which was attached to the trust indenture, in which she acknowledged that she had read and understood the provisions224 of the trust instrument; that she was satisfied with it and would execute and deliver any further written instruments necessary to carry out its terms; and that the trust provisions would be accepted by her in full satisfaction of any and all of her claims to support, alimony, or separate maintenance, and all claims, right, title, and interest whatsoever, whether vested or inchoate, consummate or contingent, and however existing, including claims for dower, widow's award, and homestead.The trust agreement contained the following provisions:Eleventh E: * * Should misfortune or sickness cause the expenses of Trustor to increase so that in the judgment of the Trustee the net income so payable to Trustor is not sufficient to meet the living expenses of Trustor, then, and in such event said Trustee is authorized to pay in addition to the income from said Trust Estate such portions of the principal of said Trust Estate as may be necessary under the circumstances. Said Trustee is given the sole right to determine when payments from the principal sum shall be made and the amounts of said payments.Twelfth: Upon the death of the Trustor, and after payment of all funeral expenses and debts225 of Trustor, except such as may be represented by notes which are a lien on real estate, Trustee shall divide and distribute said Trust Estate as follows: * * Seventeenth: All discretions conferred upon the Trustee by this instrument shall, unless specifically limited, be absolute and uncontrolled and their exercise conclusive on all persons in this trust or Trust Estate.Myrtle Toeller, from whom the decedent was divorced on January 12, 1937, and Virginia and Shirley Ann, daughters of the decedent and Myrtle Toeller, survived the decedent. The son, John J. Toeller, Jr., died in 1931, unmarried and without descendants.In his last will and testament, executed on November 8, 1938, decedent stated that he had made provision for his wife by virtue of the trust dated February 13, 1930, which had been accepted by her in satisfaction of her claim to alimony, support, and maintenance, and of her claims to testator's property, including dower and homestead interests, and that she should take nothing under the will, it being his intention that the provisions of the trust should be taken in lieu of any gift, devise, or bequest under the will, or of any interest in any of his property. 226 The will further stated that his daughters had also been provided for, and that they should take nothing under the will, 835 but that the provisions of the trust should be taken to be in lieu of any gift, devise, or bequest under the will, or any other interest in his property. Decedent also stated in his will that he had made provision in the trust for the payment of his funeral expenses and all his debts except such as might be represented by notes secured by real estate, and for payment of estate, inheritance, or other succession taxes levied in connection with the transfers in trust. The will left all of decedent's estate, after payment of his debts represented by notes secured by real estate, to the Society of the Divine Word, a charitable organization. The value of the assets passing to the administrator with will annexed, not including any of the assets of the trust estate, as of the date of the decedent's death, was $ 7,731.50.On August 21, 1943, Shirley Ann Toeller, decedent's daughter, filed a complaint to contest the will, and on March 31, 1944, a compromise agreement was entered into whereby one-half of the net estate was to go to the Society of the Divine Word227 and one-half to Shirley Ann Toeller and Virginia Toeller Miller. It was further agreed that all Federal estate and Illinois inheritance taxes, if any, arising out of the share of the Society of the Divine Word should be paid by the society, while those arising out of the shares of the two daughters should be paid by them. The value of the assets having increased after decedent's death, the society received $ 6,516.60 and each of the two daughters received $ 3,258.30.On December 18, 1942, the trustee of the trust filed a complaint in Chancery in the Circuit Court of Cook County, seeking construction of certain provisions in the instrument of trust, particularly the first sentence of section 12, providing for distribution of the trust assets as therein set forth: "Upon the death of the Trustor, and after payment of all funeral expenses and debts of Trustor, except such as may be represented by notes which are a lien on real estate * * ." The suit also sought directions of the court with respect to termination of the trust and distribution of the assets. Myrtle Toeller, Virginia Toeller Miller and Howard Austin Miller, her husband, and Harry Booth Miller, III, their infant son, 228 Shirley Ann Toeller, Franklin Mayo, as administrator with will annexed of the estate of John J. Toeller, and the Society of the Divine Word were made defendants, and all filed answers. The court entered a decree finding that the words "and after payment of all funeral expenses and debts of Trustor, except such as may be represented by notes which are a lien on real estate" should be disregarded, rejected, and held for nought, and further ordered the trust terminated as to Myrtle Toeller and Virginia Toeller Miller, but continued as to Shirley Ann Toeller until she became 30 years old.From May 13, 1930, to May 10, 1942, the date of the decedent's death, the trust income was distributed annually by the trustee to and for the 836 benefit of decedent, his wife, and their children. The payments for John J. Toeller, Jr., were discontinued at the time of his death in 1931. The payments to Virginia Toeller were discontinued in 1932, when she married. Payments to decedent ranged from the lowest of $ 1,299.96 in 1935 to the highest of $ 3,949.96 in 1937.After the death of the decedent the trustee paid out of the trust corpus to itself, as trustee's fees, a total sum of $ 2,724.70, 229 and paid expenses arising out of the action for construction of the trust, including court costs, guardian ad litem fees, and attorneys' fees, totaling $ 1,906.44, and state inheritance taxes on the interests of decedent's daughters, in the amount of $ 984.90.OPINION.The first question to be resolved is whether the transfers to the trust involved in this proceeding were intended to take effect in possession or enjoyment at or after the trustor's death, within the meaning of section 811 (c) of the Internal Revenue Code, as respondent contends.Because it was executed prior to the passage of the Joint Resolution of Congress of March 3, 1931, this trust enjoys the protection of the rule announced in Reinecke v. Northern Trust Co., 278 U.S. 339">278 U.S. 339; May v. Heiner, 281 U.S. 238">281 U.S. 238; McCormick v. Burnet, 283 U.S. 784">283 U.S. 784; and Hassett v. Welch, 303 U.S. 303">303 U.S. 303. We may not, therefore, consider the reservation of a life interest in the trust income by the trustor in this connection. Estate of Edward E. Bradley, 1 T. C. 518; Proctor v. Commissioner, 140 Fed. (2d) 87.230 The provision of the trust instrument (par. 11-E), upon which respondent chiefly relies, has been set forth in our findings.It is the respondent's position that this provision has the effect of reserving in the trustor during his life an enforceable right to have the corpus invaded for his benefit, within the rule applied in Blunt v. Kelly, 131 Fed. (2d) 632; Estate of Margaret P. Gallois, 4 T.C. 840">4 T. C. 840; affirmed on another ground, 152 Fed. (2d) 81; Chase National Bank v. Higgins, 38 Fed. Supp. 858; Estate of Ida Rosenwasser, 5 T. C. 1043; and Malcolm D. Champlin, Administrator, 6 T.C. 280">6 T. C. 280.Petitioner, however, argues that the power to invade the corpus was conferred on the trustee, to be exercised in its sole, absolute, and uncontrolled discretion, and did not constitute a retention by the trustor of any right. Petitioner cites and relies on Commissioner v. Irving Trust Co., 147 Fed. (2d) 946.A comparison of Blunt v. Kelly with Commissioner v. Irving Trust Co., supra,231 brings into relief the critical distinction upon which the determination of this issue depends.837 In Blunt v. Kelly, supra, the trust instrument provided: "Should, in their opinion the necessity arise, the Trustees are hereby empowered to use such portion of the principal of the trust fund as may seem proper for the support, care or benefit of the party of the first part."No such invasion of the principal was ever sought or made.The court said:In the present case, however, the trust deed specified the circumstances under which the settlor would be entitled to receive the principal during her lifetime, namely, should the necessity arise, in the opinion of the trustees, to use the principal for her support, care and benefit. It is true that under this provision the trustees, one of whom held an adverse interest, were required to form an opinion as to the existence of any such necessity, but in so doing the trustees were not making a free and uncontrolled decision. They were of course bound to form their opinion on the existence of any such necessity in good faith and were subject to the control of the equity courts if they failed to do232 so. Read v. Patterson, 44 N. J. Eq. 211, 14 A. 490">14 A. 490, 6 Am. St. Rep. 877">6 Am. St. Rep. 877; Restatement of the Law of Trusts, § 187. Under these circumstances, the lower court properly held that the transfer of the securities by the trust deed was one which did not take effect in possession or enjoyment until the death of the settlor, since, until then, it might have become necessary under the terms of the trust to apply the principal to her support, care or benefit.In Commissioner v. Irving Trust Co., supra, cited by petitioner, the trust instrument contained the following provision:The trustee may from time to time in its absolute discretion, and as often as it deems advisable to pay over, transfer, convey, assign and deliver to the Settlor all or any part of the principal of the said trust fund, at all times retaining, however, a sufficient Principal fund to provide the income to be paid to Bertha L. Beugler as aforesaid, and upon such payment or transfer, all obligation of the Trustee in reference to that part of the principal so paid over shall forthwith cease.The court distinguished Bankers Trust Co. v. Higgins, 136 Fed. (2d) 477,233 and Blunt v. Kelly, supra, on the ground that, under the trust instruments involved there, the settlor had a right to require payments to be made out of the trust funds in order to meet his financial needs because of other circumstances set forth in the trust instruments and independent of the mere will of the trustee. It concluded that: * * In a case where the return of any part of the corpus to the settlor will depend solely upon the discretion of the trustee, the true test as to its inclusion * * * is whether the trustee is free to exercise his untrammelled discretion or whether the exercise of his discretion is governed by some external standard which a court may apply in compelling compliance with the conditions of the trust instrument. If the former, the corpus is not subject to taxation as a part of the settlor's estate. In the case at bar, the discretion of the trustee was absolute and no court could compel its exercise.Petitioner contends that the discretion vested in the trustee in the instant case is free and untrammeled, absolute and uncontrolled, and that we should therefore be governed by Commissioner v. Irving Trust Co., supra.234 His contention in this regard is based on the language 838 of the provision of subparagraph E of paragraph 11, already quoted and considered, that "Said Trustee is given the sole right to determine when payments from the principal sum shall be made, and the amounts of said payments," and the further language toward the end of the entire instrument, in paragraph 17, which states that:All discretions conferred upon the Trustee by this instrument shall, unless specifically limited, be absolute and uncontrolled and their exercise conclusive on all persons in this trust or Trust Estate.However, the use of such words as "absolute" and "uncontrolled" or "sole discretion" does not mean that the discretion conferred in the trustee is unlimited, where external standards are provided in the trust instrument for the guidance of the trustee in the exercise of his discretion. These words may enlarge the limits of the trustee's discretion, but the provision of external standards by the trustor indicates unmistakably that limits still exist. See Scott on Trusts, vol. 2, sec. 187, in which it is said:* * * The extent of the discretion may be enlarged by the use of qualifying adjectives 235 or phrases, such as "absolute" or "uncontrolled". Even the use of such terms, however, does not give him unlimited discretion. A good deal depends upon whether there is any standard by which the trustee's conduct can be judged. Thus, if he is directed to pay as much of the income and principal as is necessary for the support of a beneficiary, he can be compelled to pay at least the minimum amount which in the opinion of a reasonable man would be necessary. If, on the other hand, he is to pay a part of the principal to a beneficiary entitled to the income, if in his discretion he should deem it wise, the trustee's decision would normally be final * .With regard to paragraph 17, it seems to us that the specification in paragraph 11 of the circumstances under which invasion of the corpus by the trustee is authorized constitutes the external standards to which we have already referred, and, as such, it delimits the absolute discretion of the trustee. Had the trustor intended to confer, in this respect, absolute and uncontrolled discretion, the provisions setting up the external standards would have been quite unnecessary and meaningless. The trustee is vested with discretion 236 in the performance of many of its duties, and paragraph 17 is not without its importance with respect to them. But we do not believe it was intended to apply to paragraph 11, subparagraph E, where specific limitations are expressly set forth. Therefore, we conclude that the trustor retained the right, under the circumstances provided in paragraph 17, to the payment to him of the trust corpus and that this right was independent of the will of the trustee.The application of the "true test" suggested by the court in Commissioner v. Irving Trust Co., supra, to the facts in this case effectively demonstrates the existence here of that distinction upon which the courts have consistently relied in the solution of these questions. The trust instrument involved here provided the external standards 839 which are so important as to be virtually decisive of the issue. We therefore follow the decisions in Blunt v. Kelly, supra, and Estate of Ida Rosenwasser, supra, and conclude that the trust corpus is includible in the gross estate for estate tax purposes.Petitioner next urges that, 237 if any part of the trust estate is held includible in the grantor's taxable gross estate, the value of the interest reserved in the trustor, as of the date of his death, was much less than the statutory exemption granted under the Federal estate tax laws, so that no tax ever became due or payable.The theory which gives rise to this contention is that any right which he might have to compel invasion of the corpus for his benefit would be limited to a right to so much of the corpus as would be necessary, in addition to his share of the income, to meet the trustor's living expenses in the event of misfortune and sickness. Petitioner argues that the trustor's life expectancy at the time of his death was approximately 9 1/2 years, and that had he lived at least $ 5,000 per year could have been paid out of the corpus without reaching the amount of the statutory exemption, and he concludes that no court, in the exercise of reasonable judgment, could or would in any event have ordered the use of so great an amount for the trustor's benefit. With that conclusion we are unable to agree. The term "sickness or misfortune" used in the trust instrument is so broad in scope as to cover any conceivable238 form of calamity, physical, mental, or even economic, to which humanity is subject. It is not beyond the realm of possibility that the trustor's needs might approach or exceed the magnitude suggested by petitioner, or that a court would decide that his care, in that event, would be of greater importance than the ultimate inheritance of his former wife and children, of whom only one was still a minor in the later years of the trustor's life. The exigencies of life are such that the probabilities in this regard can not be accurately measured. The important point is that the possibility was present, by reason of the language employed by the trustor, and no limit was imposed on the extent to which the corpus could be so applied, beyond the setting up of the standards which should invoke the application. Assuming the need should arise, as there set forth, and continued to exist for a period of years, the entire corpus would have been available to whatever extent it was needed. In this important respect are the facts here distinguishable from those which existed in Bankers Trust Co. v. Higgins, supra, upon which the petitioner relies, where the trust239 provided for the use of the corpus to make up the difference between the actual income of the trust and $ 60,000 per year. The court there held that it was possible to determine with reasonable accuracy, in the light of past experience, the amount of the corpus which might be subject to that use, and that 840 only that amount should be included in the gross taxable estate of the trustor.We are of the opinion that the language of the trust instrument before us justifies the action of the respondent in including the entire corpus in the trust estate. See Malcolm D. Champlin, Administrator, supra.It is, in view of this holding, unnecessary to decide whether the entire corpus is includible in the gross estate also by reason of the existence of a possibility of reverter by operation of law, or to discuss in greater detail the evidence contained in the trust instrument which respondent cites as further supporting his theory that the trust was intended as a substitute for testamentary distribution.Section 812 (d) of the Internal Revenue Code provides for a deduction from the value of the gross estate in the "amount of all bequests, legacies, devises, 240 or transfers * * * to or for the use of * * * any corporation organized and operated exclusively for religious, charitable, scientific, literary or educational purposes," etc. It is stipulated that the Society of the Divine Word is an organization which fulfills the requirements of the statute.Respondent did not allow any deduction for the value of the bequest to charity, on the ground, stated in the explanation attached to the notice of deficiency, that it was impossible to ascertain the amount of the bequest. The bequest was residual in character, and the amount was therefore not specified in the will. Respondent based his action on the fact that the will was being contested. The record discloses that the action contesting the will had, in fact, been finally settled by compromise approximately six months prior to October 13, 1944, the date of the notice of deficiency. By the terms of the compromise agreement, the charity had waived its right to one-half of the residuary estate, which was valued at $ 5,168.83 as of the date of decedent's death. Petitioner now claims a deduction for only half of that amount, in accordance with section 81.44 of Regulations 105, which states 241 that:If as the result of a controversy involving a charitable bequest or devise, the charitable organization assigns or surrenders a part thereof pursuant to a compromise agreement in settlement of such controversy, the amount so assigned or surrendered is not deductible as a bequest or devise to such charitable organization.In view of the undisputed fact that the only two factors essential to a computation of the amount of the bequest had long since been established, i. e., the value of the residuary estate at decedent's death and the terms of the settlement determining the share to be paid the charitable beneficiary, we are of the opinion that respondent erred in failing to allow the proper deduction for this item.841 With respect to petitioner's contention relating to the expenditures made by the trustee out of the trust corpus after the death of the decedent, consisting of trustee's fees, attorneys' fees arising out of an action brought by the trustee for construction of the trust, guardian ad litem fees made necessary by the same action, and inheritance taxes paid to the State of Illinois, we are of the opinion that none of these constitutes an allowable deduction*242 for expenses of administration under the statute and the regulations. Sec. 812 (b)2, I. R. C.; Regulations 105, arts. 32-35; Frederick E. Baldwin, 44 B. T. A. 900; Frederick R. Shepherd, 39 B. T. A. 38; Regulations 105, sec. 81.37.Decision will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622056/	ROBERT F. AND RAMONA J. SAUNDERS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentSaunders v. CommissionerDocket No. 16232-88United States Tax CourtT.C. Memo 1992-361; 1992 Tax Ct. Memo LEXIS 383; 63 T.C.M. (CCH) 3180; June 24, 1992, Filed 383 Decision will be entered under Rule 155. Arthur H. Davis, for petitioners. Michael L. Boman, for respondent. WHALENWHALENMEMORANDUM FINDINGS OF FACT AND OPINION WHALEN, Judge: Respondent determined the following deficiencies in and additions to petitioners' Federal income tax: Additions to TaxYearDeficiencySec. 6653(a)(1)Sec. 6653(a)(2)Sec. 666150% of interest on:1983$ 35,803.40$ 1,790.00$ 35,803.00 $ 8,951.00198432,222.511,611.0032,222.51 8,056.0019856,654.00333.006,654.00 1,664.00All section references are to the Internal Revenue Code, as amended. After concessions, the sole issue for decision is whether petitioners substantiated deductions for Mrs. Saunders' interior design businesses in excess of the amounts allowed by respondent, $ 1,908.37 in 1983 and $ 4,838.69 in 1984. FINDINGS OF FACT Some of the facts have been stipulated and the Stipulation of Facts filed is incorporated herein. Petitioners are husband and wife. They have been married for more than 32 years and have three children. At the time they filed their petition in this case, they resided at Goddard, Kansas. During the years384 in issue, the couple had at least two sources of income. First, Mr. Saunders received wages from Boeing Military Airplane Company. He was employed by Boeing as a power plant engineer. Petitioners' joint income tax returns for the years in issue report Mr. Saunders' wages from Boeing in the amount of $ 28,790.52 in 1983, $ 34,008.56 in 1984, and $ 34,008.56 in 1985. Second, Mrs. Saunders realized income from interior design businesses which she operated under the names Special Request and Country Connections. None of petitioners' returns for the years in issue report any income from Mrs. Saunders' interior design businesses and none of the returns claim deductions for expenses paid by the businesses. In 1979, Mrs. Saunders' business was known as Joyce-Ann Interiors. By 1980, the business was known as Interiors Unlimited and was operated as a proprietorship. In December of 1981, Mrs. Saunders transferred Interiors Unlimited to a corporation, Special Request, Inc. Petitioners filed no corporate return for Special Request, Inc. for any period ending after November 30, 1982, and they allowed the corporation to forfeit its charter on June 15, 1984, for failure to file the company's385 1983 annual report. The parties agree that during the taxable years at issue, 1983, 1984, and 1985, Special Request was operated by Mrs. Saunders as a sole proprietorship. By 1983, Special Request shared a three room store on Main Street in Goddard, Kansas with a "recycled clothing" business, Daddy's Mony, operated by Mrs. Saunders' daughter-in-law, Ms. Marsha Saunders. The two businesses also shared a single bank account at the Garden Plains State Bank. In June or July of 1983, Mrs. Saunders began another interior design business known as Country Connections. That business was operated as a sole proprietorship until it was incorporated as Country Connections, Inc. For tax purposes, petitioners treated Country Connections, Inc., as having commenced at the end of June, 1984, but its Articles of Incorporation were filed on August 27, 1984. The corporation filed a Federal income tax return for the period ending July 31, 1985. It maintained its own bank account which was not included in respondent's bank deposits analysis of petitioners' income. For approximately 6 months, Country Connections, Inc., leased a store in Wichita, Kansas. At the end of that period, Mrs. Saunders 386 moved the business into her home. Country Connections, Inc., failed to file its 1985 annual report and it forfeited its charter in 1986. Respondent's agents were not provided with adequate records from which they could compute the income and expenses of Mrs. Saunders' interior design businesses. Accordingly, respondent computed petitioners' income for each of the years at issue using the bank deposits method of proof. Under that method, respondent determined that petitioners had realized unreported income of $ 85,103.14 in 1983, $ 81,103.91 in 1984, and $ 13,323.30 in 1985. The principal adjustment which respondent made in the notice of deficiency issued to petitioners was to increase their taxable income by the above amounts of unreported income. Respondent also determined that petitioners were entitled to deduct business expenses attributable to Mrs. Saunders' businesses in the amount of $ 1,908.37 in 1983 and $ 4,838.69 in 1984. In their petition, petitioners took issue with respondent's use of the bank deposits method of proof, and they claimed business expenses of $ 41,754.03 in 1983 and $ 28,004.50 in 1984. We note that respondent made eight other adjustments to petitioners' 387 returns in the notice of deficiency, but petitioners failed to place any of those adjustments at issue in the petition. Similarly, petitioners failed to take issue with any of those adjustments in their trial memorandum, in the statements of their attorney before trial or in their post-trial brief. At trial, respondent's revised computation of petitioners' unreported business income was introduced into evidence as a joint exhibit attached to the Stipulation of Facts. That computation shows that petitioners realized unreported income of $ 44,399.50 in 1983, $ 40,132.65 in 1984, and $ 5,165.62 in 1985, rather than the amounts set out in the notice of deficiency. OPINION In their post-trial brief, petitioners concede that respondent had correctly determined the unreported income realized by petitioners during each of the years in issue. Their post-trial brief states, "no disputes remain with respect to the income of the taxpayers for the years in question." We understand that statement to mean that petitioners accept respondent's revised computation of petitioners' unreported business income which was introduced as a joint exhibit at trial. According to petitioners' post-trial388 brief, the only question at issue is "what, if any, expenses should be allowed by the Court." As mentioned above, respondent determined, in the notice of deficiency, that petitioners were entitled to deduct additional business expenses in the amount of $ 1,908.37 in 1983 and $ 4,838.69 in 1984. Respondent determined no additional business expenses for 1985. In their petition, petitioners asserted: The Commissioner improperly disallowed business expenses incurred by Ramona J. Saunders in the amounts of $ 41,754.03 for 1983, and $ 28,004.50 for 1984.The above assertion is not accurate. Actually, petitioners failed to claim any expenses from Mrs. Saunders' interior design businesses as deductions on any of the returns at issue. In any event, petitioners have the burden of substantiating the additional business deductions to which they claim to be entitled. Rule 142(a), Tax Court Rules of Practice and Procedure (hereinafter all references to "Rule" are to the Tax Court Rules of Practice and Procedure). Petitioners failed to substantiate any additional deductions for Mrs. Saunders' interior design businesses. As their post-trial brief states, "no testimony or evidence389 was taken by the Court regarding taxpayers' expenses." We would add that petitioners failed to seek the introduction of any such testimony or evidence. At trial, petitioners called Mrs. Saunders as their only witness, and she testified, at length, about petitioners' numerous bank accounts and their income during the years in issue. However, she presented no testimony concerning expenses incurred in her interior design businesses. Accordingly, petitioners put no evidence in the record to substantiate business expenses in excess of those determined by respondent in the notice of deficiency. At the close of the trial, the Court noted that respondent's agents had agreed to meet with petitioners for the purpose of reviewing documentary evidence of additional business expenses. Respondent's agents agreed to meet with petitioners as an accommodation to the Court. In order to give the parties an opportunity to meet and, possibly, to settle this case, the Court refrained from ordering the parties to file post-trial briefs, and it set the case for report several months later. Unfortunately, the post-trial discussions between the parties were not fruitful. Petitioners now attach copies390 of a variety of documents to their post-trial brief, such as checks, invoices, and leases, in an effort to substantiate additional business deductions. None of the documents was introduced into evidence at trial. Petitioners argue as follows: The taxpayers respectfully submit that the additional expenses, disallowed by the respondent, are responsible and necessary expenses. The Court should order counsel for respondent review [sic] the additional expenses to determine whether such expenses are properly documented. In the alternative, the Court should allow such expenses and direct that Respondent recompute its deficiencies with respect to all tax years.In view of the fact that none of the documents attached to petitioner's brief was introduced at trial, none of them forms a part of the record of this case and we shall consider none of them at this point. E.g., Kwong v. Commissioner, 65 T.C. 959">65 T.C. 959, 967 n.11 (1976); West 80th Street Garage Co., Inc. v. Commissioner, 12 B.T.A. 798">12 B.T.A. 798, 800 (1928); Jacobs v. Commissioner, T.C. Memo. 1977-1. Moreover, the statements in petitioners' brief concerning the expenses incurred391 by petitioners are not evidence. Rule 143(b); Bialo v. Commissioner, 88 T.C. 1132">88 T.C. 1132, 1140 (1987); Reiff v. Commissioner, 77 T.C. 1169">77 T.C. 1169, 1175 (1981). For the above reasons, we hereby sustain respondent's determination that petitioners are entitled to deduct additional business expenses in the amount of $ 1,908.37 in 1983 and $ 4,838.69 in 1984. We hold that petitioners failed to prove any business deductions in excess of those amounts. We are constrained to make a final comment concerning this case. At the time the case was first called for trial, petitioners had not filed a trial memorandum as had been ordered by the Court in its Standing Pre-Trial Order. They had also failed to cooperate with respondent's attorney in preparing a trial stipulation, as required by Rule 91 and the Standing Pre-Trial Order. Through their attorney, petitioners asked the Court to continue the trial on the ground that their accountant was not available to testify on their behalf as an expert witness. Respondent objected to that motion and it was denied by the Court for a number of reasons, including the fact that petitioners had failed to file an expert witness392 report as required by Rule 143(f). Nevertheless, the Court, in effect, granted a continuance of 3 days for the purpose of giving the parties additional time to complete their pretrial preparation, including the preparation of a trial stipulation. When the case was again called for trial, petitioners' attorney renewed his motion for continuation on the ground that petitioners had assembled "documentary evidence concerning the expenses that related to (Mrs. Saunders') business" but that respondent had not had an opportunity to review that information and "there's quite a bit of work that still needs to done." Respondent's attorney objected to petitioners' motion for continuance. Ultimately, petitioners withdrew their motion for continuance and elected to proceed. To reflect concessions by respondent, Decision will be entered under Rule 155.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622058/	John D. Moss, Jr., and Diane C. Moss, Petitioners v. Commissioner of Internal Revenue, RespondentMoss v. CommissionerDocket No. 9975-80United States Tax Court80 T.C. 1073; 1983 U.S. Tax Ct. LEXIS 73; 80 T.C. No. 57; May 25, 1983, Filed 73 Decision will be entered under Rule 155. Petitioner, a partner of a law firm specializing in litigation, met with his colleagues each day at noon to discuss firm business, e.g., case assignments, scheduling, settlements. The lunches were paid for by the partnership. Respondent disallowed petitioner's distributive share of these expenses. Held, luncheon costs incurred at these meetings are nondeductible personal expenses. Sec. 262, I.R.C. 1954. Eugene L. Mahoney and Arnold A. Silvestri, for the petitioners.Tom P. Quinn, for the respondent. Wilbur, Judge. Sterrett, J., concurring. Tannenwald, Fay, Goffe, Whitaker, Korner, Shields, Hamblen, and Cohen, JJ., agree with this concurring opinion. WILBUR1073 75 Respondent determined a deficiency in petitioner's Federal income tax for the taxable year 1976 of $ 1,125 and for 1977 of $ 1,351. After concessions by the respondent, the sole issue for our decision is whether petitioner 1074 is entitled to deduct his share of the partnership's expenses representing daily business luncheon meetings.FINDINGS OF FACTSome of the facts have been stipulated and those facts are so found. The stipulation of facts and the attached exhibits are incorporated by this reference.The petitioners are husband and wife who resided in Chicago, Ill., when they timely filed the 1976 and 1977 Federal income tax returns in question. Petitioner Diane C. Moss is a party to this proceeding solely because she filed a joint return with her husband, petitioner John Moss.Petitioner, an attorney, was a partner in the law firm Parrillo, Bresler, Weiss & Moss in 1976 and 1977. The firm filed a partnership return for each of the years in question. It took a deduction each year for "meetings and conferences." Petitioner has claimed his share of the firm's expense on his individual return.Parrillo, Bresler, Weiss & Moss was a firm of six or seven lawyers who specialized76 in insurance defense work. Their case load was extremely heavy. Most of the lawyers spent the better part of each day participating in or preparing for depositions and trials throughout the greater Chicago area. Judges often held hearings on short notice, thus making it necessary for the firm to assign cases and plan schedules at the last minute.Robert Parrillo, the senior partner, was responsible for all cases involving the firm's major client, the Safeway Insurance Co.1 His partners and associates handled the details of these cases, but no final settlements were made without his approval.The firm had an unwritten policy of meeting every day during the noon recess at the Cafe Angelo, a small, quiet restaurant conveniently located near the courts and the office. Over lunch, the lawyers would decide who would attend various sessions; 2 discuss issues77 and problems that had come 1075 up in the morning; answer questions and advise each other on how to handle certain pending matters; update Mr. Parrillo on settlement negotiations; and, naturally, engage in a certain amount of social banter. Attorneys attended whenever possible for as long as possible; sometimes they ate, at other times they merely joined in the discussions.The law firm paid for the meals eaten during the noontime meetings. In 1976, the total bill was $ 7,113.85; 378 in 1977, they spent $ 7,967.85. The bill from the Cafe Angelo represents the bulk of the firm's "meeting and conference" expense. 4The noon hour was the most convenient and practical time for the firm to have its daily meeting. 5 The courts were almost always in recess at this time, so most attorneys could attend. The more experienced members of the firm were available to advise and educate the fledgling litigators. Parrillo was there to discuss and approve settlements. The Cafe Angelo provided a good location, efficient service, reasonable prices, and a place where judges could locate the attorneys.79 In its statutory notice of deficiency, respondent disallowed petitioner's distributive share of the Cafe Angelo expense, along with other items upon which the parties have reached an agreement.OPINIONPetitioner is a partner in a Chicago law firm that met every business day in 1976 and 1977 at the Cafe Angelo for lunch. Current litigation problems, scheduling, assignments, and settlement of cases were discussed at that time. The firm paid for the meals of those lawyers who ate during the firm 1076 meetings. The issue for decision is whether petitioner may deduct his share of those expenses in calculating his taxable income.Petitioner contends that the luncheon meeting expenses are deductible under section 162680 as ordinary and necessary business expenses. In the alternative, he claims that they qualify for deduction under section 1.162-5, Income Tax Regs., as outlays for education. Respondent, conversely, claims that the lunches are a personal and therefore nondeductible expense. We agree with respondent. 7The broad purpose of the Internal Revenue Code is to tax all accessions to wealth, "from whatever source derived." Sec. 61(a). The goal81 being to tax income, business expenses reduce taxable income. Sec. 162. Funds spent on personal consumption, on the other hand, are not deductible. Sec. 262. The boundary line dividing personal expenses from business expenses, often obscurely marked, has been a fertile field of battle. The taxpayer bears the burden in these skirmishes. Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933); Rule 142(a), Tax Court Rules of Practice and Procedure. In close contests, it is essential to bear in mind that the provisions of section 262 take priority over section 162. Sharon v. Commissioner, 66 T.C. 515">66 T.C. 515, 522-523 (1976), affd. per curiam 591 F.2d 1273">591 F.2d 1273 (9th Cir. 1978).The expense in question is close to that evanescent line dividing personal and business expenses. From the perspective of the partnership, the lunches were a cost incurred in earning their income. The lawyers needed to coordinate assignments and scheduling of their case load, and the noon hour was a 1077 logical, convenient time at which to do so. They considered the meeting to be part of their working day, not as an hour of reprieve from82 business affairs. The individuals did not feel free to make alternate plans, or to eat elsewhere. For this firm, petitioner argues, the meeting was both ordinary and necessary.The Commissioner focuses not on the circumstances bringing the partnership together each day, but rather on the fact that the individuals were eating lunch while they were together. Rather than to section 162, he looks to section 262, and the regulations which specifically categorize meals as personal expenses. 8Sec. 1.262-5, Income Tax Regs. The respondent, in essence, argues that while the meeting may have been ordinary and necessary to the business, the outlay was for meals, a personal item.The dual nature of the business lunch has long been a difficult problem for legislators and courts alike. The traditional83 view of the courts has been that if a personal living expense is to qualify under section 162, the taxpayer must demonstrate that it was "different from or in excess of that which would have been made for the taxpayer's personal purposes." Sutter v. Commissioner, 21 T.C. 170">21 T.C. 170, 173 (1953). 984 Following the Sutter formula, numerous taxpayers have attempted to deduct the cost of meals eaten under unusual or 1078 constraining circumstances. The claims have been denied almost invariably. See, e.g., Fife v. Commissioner, 73 T.C. 621">73 T.C. 621 (1980) (attorney may not deduct cost of meals eaten in restaurants due to late client meetings); Ma-Tran Corp. v. Commissioner, 70 T.C. 158">70 T.C. 158 (1978) (corporation may not deduct cost of officer's locally consumed meals absent travel or compliance with section 274); Drill v. Commissioner, 8 T.C. 902">8 T.C. 902 (1947) (construction worker cannot deduct cost of dinners on nights he worked overtime). 10 Daily meals are an inherently personal expense, and a taxpayer bears a heavy burden in proving they are routinely deductible.85 Petitioner relies on Wells v. Commissioner, 626 F.2d 868">626 F.2d 868 (9th Cir. 1980), affg. without published opinion T.C. Memo. 1977-419, in support of his position. 11 In Wells, we denied a deduction claimed by a public defender for the cost of occasional lunch meetings with his staff. The Court noted, however, that in a law firm, "an occasional luncheon meeting with the staff to discuss the operation of the firm would be regarded as an 'ordinary and necessary expense.'" We note, first, that this statement is dictum in a memorandum opinion, and thus not controlling. Second, that case referred to occasional lunches, a far cry from the daily sustenance involved in the case at bar. Even assuming that Wells is of any assistance to petitioner, we need not decide where the line between these two cases should be drawn, for we are convinced that outlays for meals consumed 5 days per week, 52 weeks per year would in any event fall on the nondeductible side of it.86 The only recent cases where deductions were allowed for meals taken on a regular basis were Sibla v. Commissioner, 611 F.2d 1260 (9th Cir. 1980), affg. 68 T.C. 422">68 T.C. 422 (1977), and Cooper v. Commissioner, 67 T.C. 870">67 T.C. 870 (1977). Those cases involved Los Angeles firemen who were required to contribute to a meal fund for each day they were on duty, regardless of 1079 whether they ate or even were present at the fire station. This Court allowed them to deduct the expense under section 162; a concurring opinion would have allowed the expense by analogy to section 119. Cooper v. Commissioner, supra at 874-876. On appeal, the Ninth Circuit approved of both theories, stating that because the taxpayer's situation was both unusual and unique, the expense was business rather than personal. 1287 The decision by the Ninth Circuit implies that similar considerations are involved in determining whether a meal is a business expense under section 162 and whether the value of a meal supplied by an employer should be included in gross income under section 61. Section 119 provides a limited exception to section 61 by allowing an employee to exclude such amounts if the meal is furnished on the business premises for the convenience of the employer. The cases decided under section 119 have focused on the degree to which the employee's actions are restricted by his employer's demands. Sibla v. Commissioner, supra at 1265; Commissioner v. Kowalski, 434 U.S. 77">434 U.S. 77 (1977). Language referring to compliance with the demands of one's employer can also be found in section 162 cases decided by this Court. See, e.g., Moscini v. Commissioner, T.C. Memo. 1977-245 ("restrictions on the manner in which petitioner could take his meals while on duty were not so significant that they transformed an essentially personal expense into a business expense"); cf. Hirschel v. Commissioner, T.C. Memo. 1981-189.88 Petitioner relies on this notion of restriction in contending that the cost of the lunches, like the cost of the firehouse mess in Sibla and Cooper, should be deductible. He argues that the attorneys "considered the luncheon meetings as a part of their regular work day," and that the firm incurred the expense "solely for the benefit of its practice and not for the personal convenience of its attorneys."1080 Petitioner has not explained, however, how this "restriction" is any different than that imposed on an attorney who must spend his lunch hour boning up on the Rules of Civil Procedure in preparation for trial or reading an evidence book to clarify a point that may arise during an afternoon session. In all these cases, the lawyer spends an extra hour at work. The mere fact that this time is given over the noon hour does not convert the cost of daily meals into a business expense to be shared by the Government.In Sibla and Cooper, on the other hand, the firemen were required by law to contribute to the communal meals; the petitioner in Cooper was threatened with dismissal when he refused to pay for days when he was on duty but not at the station. The89 involuntary nature of the payment, and the taxpayer's limited ability to eat the meal for which he was paying combined to create a unique circumstance which justified allowance of the deduction. No such unique situation is presented here. On the contrary, petitioner is much like employees in all fields who find it necessary to devote their lunch hour to work-related activities.In agreeing with the Commissioner on this point, we are well aware that business needs dictated the choice of the noon hour for the daily meeting. In a very real sense, these meetings contributed to the success of the partnership. But other costs contributing to the success of one's employment are treated as personal expenses. Commuting is obviously essential to one's continued employment, yet those expenses are not deductible as business expenses. Sec. 1.262-1, Income Tax Regs. As this Court stated in Amend v. Commissioner, 55 T.C. 320">55 T.C. 320, 325, 326 (1970):the common thread which seems to bind the cases together is the notion that some expenses are so inherently personal that they simply cannot qualify for section 162 treatment irrespective of the role played by such expenditures90 in the overall scheme of the taxpayers' trade or business. * * "A businessman's suit, a saleslady's dress, the accountant's glasses are necessary for their business but the necessity does not overcome the personal nature of these items and make them a deductible business expense. * * " [Quoting Bakewell v. Commissioner, 23 T.C. 803">23 T.C. 803, 805 (1955); fn. ref. omitted.]In the instant case, we are convinced that petitioner and his partners and associates discussed business at lunch, that the meeting was a part of their working day, and that this time 1081 was the most convenient time at which to meet. We are also convinced that the partnership benefited from the exchange of information and ideas that occurred.But this does not make his lunch deductible any more than riding to work together each morning to discuss partnership affairs would make his share of the commuting costs deductible. If only the four partners attended the luncheons, petitioner's share of the expenses (assuming they were coequal partners) would have corresponded to his share of the luncheons. This is not an occasion for the general taxpayer to share in the cost of his daily91 sustenance. Indeed, if petitioner is correct, only the unimaginative would dine at their own expense. 13Petitioner argues, in the alternative, that the cost of the meals may be deducted under sec. 1.162-5(a), Income Tax Regs., as an educational expense. Certainly the trading of information and ideas was beneficial to younger and older attorneys alike, and in that sense the lunches were educational. However, we find no cases supporting a deduction for informal training of the type that occurred here. Nor do we think Congress intended every occasion upon which information was imparted to qualify for deduction under section 1.162-5(a), Income Tax Regs. Again, combining nourishment with enlightenment does not make the nourishment deductible.Decision will be entered under Rule 155. STERRETTSterrett, J.,92 concurring: I concur in the result in this particular case, but I want to make it clear that I do not view this opinion as disallowing the cost of meals in all instances where only partners, co-workers, etc., are involved. We have here findings that the partners met at lunch because it was 1082 "convenient" and "convenient" 5 days a week, 52 weeks a year. Footnotes1. Petitioner's partner Robert Parrillo testified at trial that about 85 to 90 percent of the law firm's income and legal work came from the Safeway Insurance Co.↩2. Petitioner introduced into evidence several examples of the firm's "Daily Call Sheet."This master list, prepared by the docket secretary, showed the case name, court number, "call" (or what item was pending), location, and time of all matters scheduled. At lunch, the attorneys would decide who would handle what matters and so note on the call sheet.↩3. The statutory notice of deficiency and other work papers of the respondent show the expense as $ 7,103.85, although the stipulation of facts list it as $ 7,113.85. This latter figure appears to be the correct sum of the monthly bills from Cafe Angelo, and we will accept it as such.↩4. The partnership return shows a 1976 meeting and conference expense of $ 7,894, of which $ 7,113.85 was spent at the Cafe Angelo. In 1977, the figures were $ 8,670 and $ 7,967.85, respectively.↩5. At trial, respondent suggested several other times at which the partners and associates could conceivably have met. While we agree that it would have been possible to meet at 7 a.m. or 6 p.m., we believe Mr. Parrillo's testimony that such meetings would have been less well attended and less effective.↩6. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue.↩7. Respondent has directed virtually all of his fire to his argument under sec. 162↩. Nevertheless, he also suggests that the deduction should be denied as petitioner has not provided adequate substantiation as required by sec. 274(d). The parties stipulated the daily "guest checks" establishing the date, place, and amount spent at the lunches; they also stipulated the corresponding checks by which each of the bills was paid. Additionally, copies of the "daily call sheets" were stipulated; there is no dispute that these call sheets introduced in evidence were a significant item discussed at the luncheons. The lawyers in the firm (with the exception of a rare guest) were the only ones eating. Respondent's sec. 274 arguments seem to reflect a decision to leave no arrow remaining in his quiver. While we have doubts that his argument has validity on the facts before us, our decision on the first issue makes it unnecessary to decide whether he is wide of the mark.8. Sec. 1.262-1. Personal, living and family expenses.(b) * * (5) * * * Except as permitted under section 162, 212, or 217↩ the costs of the taxpayer's meals not incurred in traveling away from home are personal expenses.9. A similar balance governs the tension between secs. 213 and 262. Satisfaction of nutritional needs is presumptively personal, yet when medical conditions require specially prepared foods we have allowed a deduction for the additional costs because "the sole benefit received for the added expenses was the relief from medical infirmities." Randolph v. Commissioner, 67 T.C. 481">67 T.C. 481, 488 (1976); Cohn v. Commissioner, 38 T.C. 387">38 T.C. 387 (1962); cf. Taylor v. Commissioner, T.C. Memo. 1982-114 (no sec. 213 deduction because "there is no showing * * * that the substitute foods * * * were more expensive than the other foods").The present circumstances do not require an exploration of the dimensions of our opinion in Sutter v. Commissioner, 21 T.C. 170">21 T.C. 170 (1953). We note, however, that in the case of business meals, Sutter permits a deduction where the expense is "different from or↩ in excess of" the personal expenditure the taxpayer would otherwise have made. This language is in the disjunctive. Business meals have received extensive congressional consideration through the years. Accordingly, Congress is presumed to be aware of the administrative practice permitting the entire expense of a business meal to be deducted without fragmentation. In essence, where a proper business purpose and relationship are established, the expenses are presumed to be different from one the taxpayer would normally have made.10. See also Hirschel v. Commissioner, T.C. Memo 1981-189">T.C. Memo. 1981-189, affd. without published opinion 685 F.2d 424">685 F.2d 424 (2d Cir. 1982) (taxpayer-student may not deduct cost of meals on nights when class meets after work); Moscini v. Commissioner, T.C. Memo. 1977-245 (policeman may not deduct restaurant meals eaten while on duty even though police regulations forbid him to leave city limits); Antos v. Commissioner, 570 F.2d 350">570 F.2d 350 (9th Cir. 1978), affg. without published opinion T.C. Memo. 1976-89↩ (taxpayer CPA may not deduct cost of meals eaten while working late in his own office).11. Cf. Lennon v. Commissioner, T.C. Memo. 1978-176↩.12. Two cases decided after Sibla v. Commissioner, 611 F.2d 1260">611 F.2d 1260 (9th Cir. 1980), affg. 68 T.C. 422">68 T.C. 422 (1977), and Cooper v. Commissioner, 67 T.C. 870">67 T.C. 870 (1977), have effectively confined that holding to its facts. In Duggan v. Commissioner, 77 T.C. 911">77 T.C. 911 (1981), a Minnesota fireman was denied a deduction for contributions to the firehouse mess. The Court found that, unlike Sibla and Cooper, Duggan was not required to participate in the common mess, nor was he forced to pay for meals he did not eat. Also, the mess was organized by the employees rather than the employer. And, in Banks v. Commissioner, T.C. Memo. 1981-490↩, this Court again denied the deduction, stating that "the single fact that the meal was required to be eaten at the fire station did not convert the cost of such into a business expense."13. We note that where the costs attributable to non-partner employees are specified, these costs may be deductible to the partners and compensation to the employees. That is not an issue on this record.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622059/	THE TEXAS LAND & MORTGAGE COMPANY, LTD., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Texas Land & Mortg. Co. v. CommissionerDocket No. 67521.United States Board of Tax Appeals30 B.T.A. 861; 1934 BTA LEXIS 1252; June 7, 1934, Promulgated 1252 In determining the ratable part of the expenses, losses, and other deductions of a foreign corporation which can not definitely be allocated to some item or class of gross income for the purpose of computing the net income from sources within the United States, held that the gross income from all sources is not to be reduced by the amount of total losses from the sale of securities and that the gross income from sources within the United States is not to be reduced by the amount of losses from the sale of securities in the United States. W. M. Smith, Esq., for the petitioner. C. A. Ray, Esq., for the respondent. TRAMMELL 861 OPINION. TRAMMELL: This proceeding is for the redetermination of deficiencies in income tax of $250.66 and $984.19 for the fiscal years ended March 31, 1930, and March 31, 1931, respectively. The only matter in controversy is whether in determining the petitioner's taxable income for each of the years in question the respondent 862 correctly determined the proportion of petitioner's expenses, losses, and other deductions which could not definitely be allocated to some item or class of gross income for the1253 respective years. All other issues were conceded by the respondent. The proceeding was submitted upon a stipulation of facts and certain documentary evidence. The petitioner is a foreign corporation, with its principal office in London, England, and its domestic office in Dallas, Texas. Most of its income is derived from interest on mortgage loans, while only a minor part arises from dividends, interest on bank deposits and corporation bonds, rents, and dealings in securities. For the fiscal year ended March 31, 1930, the petitioner's gross income from all sources was $391,981.91, its gross income from sources within the United States was $320,102.36, its total losses on sales of securities was $28,802.99, and its losses on sales of securities made in the United States was $2,203.27. The amount of its expenses, losses, or other deductions which could not definitely be allocated to some item or class of gross income was $170,469.28. In determining the deficiency for the fiscal year ended March 31, 1930, the respondent determined that $139,205.38, or 81.66 percent of the $170,469.28 representing expenses, losses, or other deductions not definitely allocable to some item1254 or class of gross income, was the ratable part of the latter amount to be allowed as a deduction from gross income from sources within the United States. The percentage of 81.66 used by the respondent represents the proportion that the gross income from sources within the United States, $320,102.36, without deduction for losses of $2,203.27 on the sales of securities in the United States, bears to the gross income from all sources, $391,981.91, without deduction for total losses on the sales of securities of $28,802.99. For the fiscal year ended March 31, 1931, the petitioner's gross income from all sources was $345,097.89, its gross income from sources within the United States was $282,632.68, its total losses on the sale of securities was $52,775.15 and its losses on the sale of securities in the United States was $8,238.26. The amount of its expenses, losses, or other deductions which could not definitely be allocated to some item or class of gross income was $167,265.97. In determining the deficiency for the fiscal year ended March 31, 1931, the respondent determined that $136,990.83, or 81.90 percent of the $167,265.97 representing expenses, losses, or other deductions1255 not definitely allocable to some item or class of gross income, was the ratable part of the latter amount to be allowed as a deduction from gross income from sources within the United States. The percentage of 81.90 used by the respondent represents the proportion that the gross income from sources within the United States, 863 $282,632.68, without deduction for losses of $8,238.26 on the sale of securities in the United States, bears to the gross income from all sources, $345,097.89, without deduction for total losses on the sale of securities of $52,775.15. With respect to the fiscal year 1930 the petitioner asks that we determine that the proper deduction from gross income from sources within the United States on account of expenses, losses, or other deductions which could not definitely be allocated to some item or class of gross income was $149,215.79, or 87.53 percent of the unallocable deductions of $170,469.28, instead of $139,205.38 as determined by the respondent. With respect to the fiscal year 1931 the petitioner asks that we determine the corresponding deduction for that year to be $157,012.57, or 93.87 percent of the unallocable deductions of $167,265.97, 1256 instead of $136,990.83 as determined by the respondent. The petitioner's requests are based upon the contention that in determining the ratable part of expenses, losses, or other deductions to be allowed the gross income from all sources should be reduced by the total amount of the losses on all sales of securities and the gross income from sources within the United States should be reduced by the losses on the sales of securities in the United States. The respondent denies that this should be done and contends that his determination should be sustained. The Revenue Act of 1928 provides as follows: SEC. 22. GROSS INCOME. (a) General definition. - "Gross income" includes gains, profits and income derived from * * * businesses, commerce, or sales or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. SEC. 21. NET INCOME. "Net income" means the gross income computed under section 22, less the deductions allowed by section1257 23. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * (f) Losses by corporations. - In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise. SEC. 231. GROSS INCOME. (a) General Rule. - In the case of a foreign corporation gross income includes only the gross income from sources within the United States. SEC. 232. DEDUCTIONS. In the case of a foreign corporation the deductions shall be allowed only in and to the extent that they are connected with income from sources within the 864 United States; and the proper apportionment and allocation of the deductions with respect to sources within and without the United States shall be determined as provided in section 119, under rules and regulations prescribed by the Commissioner with the approval of the Secretary. Section 119, after stating in subsection (a) what items shall be treated as income from sources within the United States, provides: (b) Net income from sources in United States. - From the items of gross income specified in subsection (a) of this section there1258 shall be deducted the expenses, losses and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as net income from sources within the United States. The same section, after stating in subsection (c) what items are to be treated as income from sources without the United States, further provides as follows: (d) Net income from sources without United States. - From the items of gross income specified in subsection (c) of this section there shall be deducted the expenses, losses and other deductions properly apportioned or allocated thereto, and a ratable part of any expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be treated in full as income from sources without the United States. (e) Income from sources partly within and partly without United States. - Items of gross income, expenses, losses and deductions, other than those specified in subsections (a) and (c) of this section, shall1259 be allocated or apportioned to sources within or without the United States, under rules and regulations prescribed by the Commissioner with the approval of the Secretary. * * Article 680 of Regulations 74, relating to the Revenue Act of 1928, provides as follows: ART. 680. Apportionment of deductions. - From the items specified in articles 671-676 as being derived specifically from sources within the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any other expenses, losses, or deductions which can not definitely be allocated to some item or class of gross income. The remainder shall be included in full as net income from sources within the United States. The ratable part is based upon the ratio of gross income from sources within the United States to the total gross income. The question here presented for determination is whether losses on the sale of securities constitute a reduction in gross income or a deduction from gross income. In other words, in determining gross income under the statutory definition, are losses on the sale of securities in a business in1260 which such sales are only incidental to its main business deductible from gross income in determining the amount of gross income, or are they only deductible from gross income in determining net income? If the first of these alternatives is correct 865 the petitioner must prevail; otherwise, the action of the respondent must be sustained. Our consideration of the question will be based on the assumption, as is indicated by the stipulation of the parties, that the losses from the sale of securities for the respective years, which the petitioner seeks to have applied in reduction of gross income for such years, represent the net result of all dealings in securities and not the amount of losses from transactions resulting in losses as distinguished from transactions in which gains were realized. In our opinion the above quoted provisions of the statute clearly indicate that the losses in controversy are not to be used as a reduction in determining gross income. Section 22(a) states what items are to be included in gross income but contains no provision with respect to the application of losses to such items in order to determine the amount thereof. Section 21 provides that1261 net income shall be the gross income computed under section 22 less the deductions allowed by section 23. The last section provides with respect to the computation of the net income of corporations that there shall be allowed as a deduction losses sustained during the taxable year and not compensated for by insurance or otherwise. These sections of the act show that losses are items to be considered in computing net income and not gross income. If losses were properly allowable as offsets or reductions in computing gross income they could, under sections 22 and 23 of the act, be allowed again as a deduction in determining net income, therefore resulting in their allowance twice, which is something that was not intended by the statute. Sections 231, 232, and 119, relating more specifically to the income, gross and net, of foreign corporations, follow the same general plan set out in sections 21, 22, and 23. The foregoing sections of the act do not furnish, nor are we able to find elsewhere in the act, authorization for the method here sought by the petitioner. Consequently its contention is denied. In providing in article 680 of Regulations 74 that from the items of income1262 derived specifically from sources within the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any other expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income, and that the remainder shall be included in full as net income from sources within the United States, we think the respondent has given a fair and reasonable construction to the pertinent portions of the statute. We also think that the provision that the ratable part of any expenses, losses, or deductions which can not definitely be allocated to some item or class of gross income is to be based upon the ratio of gross income 866 from sources within the United States to the total gross income from all sources is likewise a fair and reasonable construction. The pertinent provisions of the act relating to the apportionment of deductions in determining net income from sources within and without the United States first appeared in section 217 of the Revenue Act of 1921 and have been reenacted in substantially the same language in all subsequent acts. The above mentioned1263 provisions of article 680 of Regulations 74 as to the apportionment of deductions for the purpose of determining net income from sources within the United States first appeared in article 325 of Regulations 62 under the Act of 1921. They have appeared in practically identical language in the later regulations promulgated under all the subsequent acts. Under these circumstances we think they are entitled to be considered as having legislative adoption and any doubt as to their correctness as having been eliminated by legislative action. See ; ; ; . Since we perceive no error in the respondent's determination with respect to the question in controversy, his action is sustained. Reviewed by the Board. Judgment will be entered under Rule 50.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622061/	George Arconti v. Commissioner.Arconti v. CommissionerDocket No. 685-68.United States Tax CourtT.C. Memo 1970-215; 1970 Tax Ct. Memo LEXIS 142; 29 T.C.M. (CCH) 945; T.C.M. (RIA) 70215; July 28, 1970, Filed 142 Held: That the evidence is not clear and convincing that any part of any of the deficiencies here involved is due to fraud and additions to tax under sec. 6653(b), I.R.C. 1954, are not to be applied. J. William Martin. Sylvan H. Sack, 2404 St. Paul, Baltimore, Md., and Marvin Joseph Garbis, 1731 Munsey Bldg., Baltimore, Md., for the petitioner. Charles F. T. Carroll for the respondent. QUEALYMemorandum Findings of Fact and Opinion QUEALY, Judge: Respondent determined deficiencies in petitioner's income tax and additions thereto under section 6653(b)1 as follows: YearDeficienciesAdditions to theTax Sec. 6653(b)1961$16,797.70$8,398.851962$17,429.67$8,714.841963$14,007.46$7,003.73143 The only issue presented for decision is whether the petitioner is liable for the additions to tax for fraud under section 6653 (b) for any of the taxable years 1961, 1962 and 1963. All other issues appearing in the notice of deficiency have been previously settled and the resulting tax was assessed and paid prior to the issuance of the notice of deficiency. Findings of Fact The petitioner, George Arconti, is an individual who, at the time of the filing of the petition herein, resided in Lutherville, Maryland. During the years 1961, 1962 and 1963, petitioner was an officer and employee of several corporations, namely, Bart Arconti & Sons, Inc., The G and L Construction Co., and Atlas Tile and Terrazzo, Inc. These corporations, of which petitioner was one of two principal officers, had annual sales of approximately $2 million during the years in question. As an officer of The G and L Construction Co., petitioner executed corporate income tax returns on behalf of the corporations. The income tax returns of the three above-named corporations, covering the years144 in issue (1961-1963), were audited by the internal revenue service. They were found 946 to be accurate, subject only to technical adjustments on fully disclosed items, i.e., the treatment of a widow payment, the amount of reasonable compensation for officers, and a question of automobile expenses. No suggestion of fraud or concealment was found or is alleged by the respondent in connection with the corporate returns. During the years at issue, petitioner received remuneration for his services to the above-named corporations in the following amounts: 1961SalaryTax Withheld andPaid OverBart Arconti & Sons, Inc$42,633.29$7,673.99The G & L Construction Co8,833.301,434.00(Excess F.I.C.A.)144.00Total$51,466.59$9,251.991962Bart Arconti & Sons, Inc$28,500.00$5,130.00The G & L Construction Co22,466.703,887.10Atlas Tile & Terrazzo, Inc1,500.00270.00(Excess F.I.C.A.)196.88Total$52,466.70$9,483.981963Bart Arconti & Sons, Inc$34,000.00$6,120.00The G & L Construction Co10,399.921,872.00Atlas Tile & Terrazzo, Inc1,500.00270.00(Excess F.I.C.A.)228.39Total$45,899.92$8,490.39145 Petitioner also received additional income in small amounts from interest dividends and interest in the years 1962 and 1963, and as directors' fees of a construction work trust fund in each of the years at issue. For the years 1961, 1962 and 1963, each one of the above-named corporations properly prepared and submitted to the internal revenue service (and to petitioner) W-2 forms disclosing the amount of petitioner's salary. Petitioner was fully aware of the submission of the W-2 forms. He did not make any attempt to prevent the corporations from filing timely and correct W-2 forms. He also did not make any attempt to prevent withholding by these corporations. During the years in question, the following amounts of petitioner's salary were withheld: AmountsFinally DeterminedYearWithheldTax Liability1961$ 9,251.99$16,797.7019629,483.9817,429.671963 8,490.3914,007.46Total$27,226.36$48,234.83Petitioner failed to file timely income tax returns for the years 1961, 1962 and 1963. The petitioner subsequently filed delinquent returns for these years on April 16, 1965. Subject only to minor technical adjustments, these returns were146 accepted as filed as follows: YearTax Per ReturnTax AfterAdjustment1961$16,375.31$16,7 97.701962$17,097.38$17,429.671963$13,121.78$14,007.46In two earlier years, petitioner had filed delinquent Federal income tax returns. He filed his 1957 return on May 7, 1959 (13 months late) and his 1959 return on February 27, 1961 (10 months late). On each occasion, he was assessed and paid the late filing fee. Petitioner's Maryland State income tax returns for the years in question were also filed late, at about the same time the petitioner filed his delinquent Federal income tax returns. Each of the State returns disclosed an overpayment of income taxes by virtue of withholding thus entitling petitioner to a refund. The refund was received for one of the years. On two of them, the refunds were not granted by the State of Maryland because the returns were filed after the expiration of the period allowed for the filing of refund claims. The petitioner's failure to file timely Federal income tax returns for the years 1961, 1962 and 1963 first became known to the internal revenue service in May of 1964 during the course of an audit of the returns147 of the corporations which employed the petitioner. The years involved in the 947 audit were 1959, 1961 and 1962. This audit was conducted by internal revenue agent James Foot (hereinafter the "agent") at the office of Paul Wooden (hereinafter "Wooden"), a certified public accountant who represented the corporations. At this time, petitioner's 1963 tax return, due April 15, 1964, was only a few weeks overdue. During the course of this audit, the agent asked Wooden to obtain for him copies of the returns of the principal officers of the corporations, and among them the returns of the petitioner for the years 1962 and 1963. The agent's request for these returns, together with his request for other documents, was presented by Richard Williams (hereinafter "Williams"), an accountant on the staff of Paul Wooden, to Bart Arconti, Jr. with a request that the marterial be collected to be picked up when ready. In response to this request, petitioner prepared his 1962 and 1963 tax returns because he had not previously done so. He then gave them to Williams for transmission to Wooden to give to the agent. He did not prepare his 1961 return at this time because he believed that he had filed148 a return for that year. Wooden received these returns from Williams and gave them to the agent in response to his request for copies of the returns for those years. The petitioner did not inform Wooden or the agent that he had not filed returns for the years 1961, 1962 and 1963. The petitioner also did not represent to anyone that he had in fact submitted his returns for 1961, 1962 and 1963 or that the documents he submitted were copies of the returns for those years. Thereafter, the agent requested the original returns through regular internal revenue service procedures and subsequently determined that no returns had been filed. On June 26, 1964 the agent had a conference with the petitioner at the local internal revenue service office. During the course of the conference, petitioner admitted he had not filed his returns for 1962 and 1963. Petitioner also expressed his uncertainty as to whether or not he had filed his 1961 return. At no time during the conference did he deny his failure to file his returns for 1962 and 1963. At the conference, petitioner showed the agent copies of his 1962 and 1963 returns and requested information as to what he should do with them. Petitioner149 also had a check with him in the amount of the additional tax due as shown on the returns. The agent told petitioner to take the tax returns and the check and deposit them with the cashier's office. The petitioner did not file his returns for 1961, 1962 or 1963 at that time. After the conference on June 26, 1964, the petitioner's failure to file returns was the subject of a criminal investigation. Petitioner cooperated with the investigating agents, giving them all the information they requested. On March 1, 1965 petitioner voluntarily went to the office of the intelligence division of the internal revenue service in Baltimore, Maryland, for a formal interview concerning his case. At that interview, petitioner was advised by revenue agent William E. Owens, the group supervisor, that payment of the tax due could affect the issue of willfulness in a subsequent criminal proceeding. Within 6 weeks after the interview, petitioner filed his returns for 1961, 1962 and 1963 and paid the taxes in the amounts shown due on those returns. During a period beginning prior to the June 26, 1964 conference and ending with a March 1, 1965 interview with the intelligence division of the internal150 revenue service, the petitioner believed that he was already being considered for criminal prosecution for his failure to file returns. Subsequently, the petitioner was indicted under section 7203 for his failure to file his Federal income tax returns for 1961, 1962 and 1963. Petitioner pleaded guilty to having willfully failed to file his 1962 income tax return. At the same time, the charges were dropped with respect to the years 1961 and 1963. No part of any underpayment of tax by the petitioner for the taxable years 1961, 1962 and 1963 was due to fraud within the meaning of section 6653(b). Opinion The only issue for decision is whether there was fraud within the meaning of section 6653(b)2 for any of the taxable years 1961, 1962 and 1963. 948The burden of proving fraud under section 6653(b)151 is placed upon the respondent by section 7454. 3 Fraud is never presumed but must be shown by clear and convincing evidence. Archer v. Commissioner, 227 F. 2d 270 (C.A. 5, 1955), affirming a Memorandum Opinion of this Court; Bryan v. Commissioner, 209 F. 2d 822 (C.A. 5, 1954), affirming a Memorandum Opinion of this Court; and Frank Imburgia, 22 T.C. 1002">22 T.C. 1002 (1954). The addition to tax for fraud under section 6653(b) may be imposed when there has been a willful attempt to evade taxes by means of a willful failure to file returns, as well as by means of intentionally filing false returns, and such willful attempt to evade taxes may be found from any conduct calculated to conceal or mislead. Stoltzfus v. United States, 398 F. 2d 1002 (C.A. 3, 1968), affirming 264 F. Supp. 824">264 F. Supp. 824 (E.C. Pa. 1967); Cirillo v. Commissioner, 314 F. 2d 478152 (C.A. 3, 1963), affirming on this issue a Memorandum Opinion of this Court; Powell v. Granquist, 252 F. 2d 56 (C.A. 9, 1958); Charles F. Bennett, 30 T.C. 114">30 T.C. 114 (1958); and Fred N. Acker, 26 T.C. 107">26 T.C. 107 (1956). A willful failure to file does not in and of itself, and without more, establish liability for a fraud penalty. Cirillo v. Commissioner, supra; Jones v. Commissioner, 259 F. 2d 300 (C.A. 5, 1958). However, such failure may be considered in connection with all other facts in deciding whether any underpayment of tax is due to fraud. Stoltzfus v. United States, supra; and Cirillo v. Commissioner, supra. Upon consideration of the record as a whole, and from a careful study of petitioner's testimony at the trial, we conclude that the government has not shown clear and convincing evidence of fraud. Petitioner was one of two principal officers of the three corporations from which he received almost the entire amount of his income for the years 1961, 1962 and 1963. No suggestion of concealment or fraud with respect to the income of the corporation or the amounts going to the petitioner was153 found or alleged in connection with the corporate returns. Despite his position of importance and control within the corporations, petitioner did not attempt to prevent the corporations from filing timely and correct W-2 forms, which reported all of the income petitioner received from the various corporations during the years in question. The petitioner also caused the corporations to withhold the full amount of his compensation, and in each of the years in question, the withholding amounted to over 50 percent of his total tax liability. These acts are inconsistent with a fraudulent intent. As to the taxable year 1961, we have found that petitioner believed that he had filed a return for that year. This finding is reinforced by petitioner's conduct at the June 26, 1964 conference with the agent. At that meeting, in an obvious attempt to mitigate his failure to file, the petitioner had with him copies of his 1962 and 1963 returns and a check for the amount of the additional tax due as shown on the returns. However, he did not bring his 1961 return or any funds with which to pay his tax liability for that year. Unless petitioner believed that he had filed a return for that year, such154 action was inconsistent with his intent to lessen the impact of his failure to file timely returns for the years in question by filing those returns and paying the tax due at the conference, especially in a situation where full disclosure would have been in his best interest. With respect to the taxable years 1962 and 1963, respondent argues that the petitioner's conduct in response to the agent's request for copies of his returns for those years - specifically that he had his returns delivered to the agent without informing him that he had not filed returns for those years - was a misrepresentation which indicated the petitioner's fraudulent intent. We do not agree with this argument. We have found that petitioner prepared his 1962 and 1963 income tax returns in response to the agent's request for those returns. This request was transmitted to the petitioner through Wooden and Williams and not by the agent directly to the 949 petitioner. After completing the returns, petitioner submitted them to those same intermediaries to give to the agent. While petitioner did not inform anyone that he had failed to file returns for those years, he also did not represent to anyone that155 he had filed them. In these circumstances, where both the request for and transmission of the returns took place through intermediaries and where petitioner made no direct representations, petitioner's action cannot properly be considered a misrepresentation indicating fraudulent intent. Respondent also contends that the fact that petitioner failed to file his returns and pay the taxes owed for the years in question after a series of contacts with the internal revenue service was indicative of his fraudulent intent. We find respondent's contention without merit. During a period beginning with the June 26, 1964 conference with the agent and ending with the March 1, 1965 interview with the intelligence division, the petitioner believed that he was already being considered for criminal prosecution. When he learned that his failure to file returns could affect the issue of willfulness, he filed his returns. During this period, petitioner knew that his failure to file returns for 1961, 1962 and 1963 had been discovered. He also cooperated with internal revenue service employees, giving them all the information they requested. In these circumstances, it is clear that petitioner believed156 that once his failure to file returns was known to the internal revenue service, the subsequent filing or nonfiling of his returns would not affect the decision of the service to prosecute or the outcome of his case. Any other reason would have been inconsistent with his best interest and his cooperation with the service. Therefore, we do not find a fraudulent intent in the petitioner's failure to file in the course of his dealings with the internal revenue service. Furthermore, petitioner filed his 1957 and 1959 returns 13 months and 10 months late, respectively, and paid the penalty for such late filing in each of those years. There is no evidence in the record nor does respondent contend that these late filings and penalty payments were not entirely voluntary. In the case before us, at the time petitioner's failure to file for 1962 and 1963 was discovered in May of 1964, the 1962 return was almost 13 months late, and the 1963 return was only a few weeks late. Thus, petitioner's failure to file timely 1962 and 1963 returns was consistent with his past tardiness in filing returns, and the circumstances of the case do not indicate that he would not have filed his returns for those157 years. Finally, petitioner also failed to file his Maryland income tax returns for the years in question. In each of the years 1961, 1962 and 1963 he would have received a refund of his Maryland taxes. This indicates that petitioner was generally very careless with respect to his obligations to file returns and pay taxes and that his failure to file returns was due to such carelessness rather than an attempt to defraud. While the facts indicate gross negligence on the part of the petitioner, it is our conclusion that the evidence is insufficient to indicate the necessary fraudulent intent. Therefore, taking all of the circumstances of the case into consideration, we hold that the respondent has failed to prove fraud by clear and convincing evidence. Decision will be entered for the petitioner. Footnotes1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.↩2. SEC. 6653. FAILURE TO PAY TAX. (b) Fraud. - If any part of any underpayment (as defined in subsection (c)) of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 50 percent of the underpayment. In the case of income taxes and gift taxes, this amount shall be in lieu of any amount determined under subsection (a).↩3. SEC. 7454. BURDEN OF PROOF IN FRAUD, FOUNDATION MANAGER, AND TRANSFEREE CASES. (a) Fraud. - In any proceeding involving the issue whether the petitioner has been guilty of fraud with intent to evade tax, the burden of proof in respect of such issue shall be upon the Secretary or his delegate.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622064/	UNION TRUST CO. OF NEW JERSEY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Union Trust Co. v. CommissionerDocket No. 14760.United States Board of Tax Appeals12 B.T.A. 688; 1928 BTA LEXIS 3484; June 18, 1928, Promulgated 3484 1. No loss is sustained by a corporation from the sale of its own capital stock. 2. A corporation which acquires its own capital stock is none the less the owner thereof because it causes stock to be issued in the name of a nominee. 3. A purchase by one corporation of the assets of another for capital stock does not constitute a reorganization, consolidation or merger under section 202(b), Revenue Act of 1918. John M. Enright, Esq., and James D. Carpenter, Jr., Esq., for the petitioner. Eugene Meacham, Esq., for the respondent. PHILLIPS 688 This proceeding is for a redetermination of a deficiency in income and excess-profits taxes for the year 1920 amounting to $3,677.81. The amount of the deficiency in controversy is $3,459.00. FINDINGS OF FACT. Petitioner is a New Jersey corporation, operating as a bank and trust company. It has its principal place of business at #75 Montgomery Street, Jersey City. In the years 1913, 1914, and 1915, petitioner purchased in the open market, from time to time, as an investment, 628 shares of the capital stock of the City Bank of Bayonne, a state banking association, at a total cost3485 of $65,990, which stock was carried as an investment in petitioner's investment account. Such purchase of stock by the Union Trust Co. of New Jersey of the shares in another state banking association was permitted under the laws of the State of New Jersey. The total capital stock of the City Bank of Bayonne consisted of 1,000 shares of the par value of $100 each. On or about February 6, 1915, the following transactions took place: Union Trust Co. of New Jersey purchased all the assets and assumed all the liabilities of the City Bank of Bayonne. Union Trust Co. of New Jersey reduced its capital stock from 5,000 shares to 3,000 shares of the par value of $100 each. Five hundred shares of the new issue of Union Trust Co. of New Jersey stock were exchanged for the 1,000 shares of the City Bank of Bayonne stock and the City Bank of Bayonne passed into liquidation. The remaining 2,500 shares of the new issue of stock of Union Trust Co. of New Jersey689 were transferred to the stockholders of the Union Trust Co. of New Jersey in exchange for the 5,000 shares of the old issue of Union Trust Co. of New Jersey stock. The Union Trust Co. of New Jersey opened a branch in the3486 quarters formerly occupied by the City Bank of Bayonne. The legality of the above transactions was approved by the Commissioner of Banking and Insurance of the State of New Jersey. As a result of the liquidation of the City Bank of Bayonne petitioner became entitled to receive 314 shares of its own capital stock. It was unlawful for petitioner to own its capital stock. Certificates were, therefore, issued to E. J. Wiedeman and G. R. Hendrickson, employees of petitioner, for 314 shares of the new issue of Union Trust Co. of New Jersey stock. Wiedeman and Hendrickson discontinued relationship with petitioner on or about June 7, 1916. The said 314 shares were thereupon taken out of their names and put in the name of another employee, G. E. Bailey, and a certificate for the 314 shares, dated June 7, 1916, was issued to Bailey on or about June 7, 1916. Bailey endorsed the said certificate for 314 shares in blank on June 9, 1916. The said certificate was delivered to petitioner and placed by it in that portion of its vaults used for securities entrusted to it by customers for safe-keeping, where it was not subject to examination by the state bank examiner, and where Bailey had3487 no supervision or control over it. Petitioner received nothing for the 314 shares until they were sold in December, 1919, for $31,400. The proceeds of the sale were paid to petitioner during December, 1919, and January, 1920. Petitioner kept its books and made its tax returns on the cash receipts and disbursements basis until 1923. It had a net loss for 1919 in excess of its income for 1918. The Commissioner has not allowed petitioner to deduct as a loss for 1919 or 1920 the difference between the amount petitioner paid for the City Bank of Bayonne stock and the amount it received for such stock, to wit: $34,590. OPINION. PHILLIPS: The petitioner claims that it is entitled to deduct as a loss in 1920 the difference between the amount paid by it for 628 shares of the capital stock of the City Bank of Bayonne and the amount received from the sale of 315 shares of its own capital stock. At the hearing it appeared that a portion of these 314 shares was sold and the proceeds received in 1919 but inasmuch as the petitioner sustained a net loss in 1919 in excess of its income for 1918, it is 690 immaterial whether the loss now claimed, if any was sustained, is to be3488 attributed to 1919 or 1920. It appears that prior to 1915 the petitioner had purchased 628 shares of the capital stock of the City Bank of Bayonne. In February, 1915, it purchased the assets of that bank and assumed its liabilities. It paid for these assets 500 shares of its own capital stock. The City Bank of Bayonne had outstanding 1,000 shares of capital stock. On the liquidation of that bank each stockholder became entitled to receive one share of the stock of the petitioner for each two shares of capital stock held in the bank. The petitioner therefore became entitled to receive 314 shares of its own capital stock. It was unlawful, however, for the petitioner to own this stock. At that time its stock was selling for less than par and it did not wish to dispose of these 314 shares. It therefore caused these shares to be issued in the names of nominees. The stock, however, was endorsed in blank and delivered to the petitioner. It remained in the custody of the petitioner until sold. The Commissioner refused to permit the deduction of any loss upon the sale upon the ground that this represented a sale by the petitioner of its own capital stock and that no taxable3489 gain or loss results from the purchase or sale by a corporation of its own capital stock. The petitioner takes the position that the nominees who held the stock were trustees and that all the petitioner had at any time was the right to demand an assounting from such trustees. Such, however, is very evidently not the case. The petitioner was at all times the owner of 314 shares of its own capital stock, regardless of the subterfuges which it adopted to evade or comply with the terms of the law. The stock was in its own possession, under its own control, endorsed in blank, and the endorsee and nominal owner had no interest whatever. The only thing that was not done to complete the full legal ownership in the petitioner was a proper notation upon its own stock transfer books. We see no basis on which the petitioner can escape the conclusion that this stock was owned by it and that the sale was no more nor less than a sale by it of its own capital stock. The Board has previously held that no taxable gain or loss results when a corporation buys or sells its own capital stock. 3490 ; ; . There is a further ground upon which the claim of the petitioner would have to be denied. That which the petitioner sold was 314 shares of its own capital stock. This stock was acquired in 1915 as a liquidating dividend from the City Bank of Bayonne. At that 691 time its value was less than the price realized on the sale. If any profit or loss is to be accounted for upon such a transaction as we have here, we are of the opinion that it would be confined to the difference between the value of the stock when received as a liquidating dividend from the City Bank of Bayonne and the sales price. The petitioner contends that this would not be so, on the ground that the transaction which took place in 1915 was a reorganization, merger or consolidation within the meaning of section 202(b) of the Revenue Act of 1918 which provides: (b) When property is exchanged for other property, the property received in exchange shall for the purpose of determining gain or loss be treated as the equivalent of cash3491 to the amount of its fair market value, if any; but when in connection with the reorganization, merger, or consolidation of a corporation a person receives in place of stock or securities owned by him new stock or securities of no greater aggregate par or face value, no gain or loss shall be deemed to occur from the exchange, and the new stock or securities received shall be treated as taking the place of the stock, securities, or property exchanged. It is far from clear that this section is to be applied as relating to a transaction which took place in a year prior to the effective date of the Act. This question we leave for future decision, for even if we assume that it has such application, we are convinced that the transactions which took place in 1915 do not fall within its terms. That there was no merger or consolidation is perfectly clear and is emphasized by petitioner in its brief, where it points out that such a merger or consolidation was prohibited at that time by the laws of New Jersey. The evidence is clear that the transaction was a purchase of the assets of the City Bank of Bayonne and that the stock in question was received from the liquidation of that bank, *3492 and not because of any merger or consolidation. Nor were these 314 shares received as the result of a reorganization. The par value of the stock of the petitioner was reduced and the number of shares increased, but it was not as a result of this change in capitalization that petitioner received these 314 shares. It was out of the purchase of the assets of the City Bank of Bayonne and the liquidation of that corporation that these shares were received. Under no theory can it be said that these shares were received from a reorganization. It seems clear that the transaction which took place in 1915 was no such transaction as is contemplated by section 202(b) of the Revenue Act of 1918 and that if a sale by a corporation of its own capital stock, gives rise to a taxable gain or deductible loss, petitioner realized a gain rather than sustaining a loss. Decision will be entered for the respondent.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622066/	Appeal of WILLIAM E. SCRIPPS, GEORGE G. BOOTH, and EDGAR B. WHITCOMB, TRUSTEES under declaration of trust executed and delivered by JAMES E. SCRIPPS on May 4, 1906. Appeal of GRACE SCRIPPS CLARK and REX B. CLARK, BENEFICIARIES under declaration of trust executed and delivered by JAMES E. SCRIPPS on May 4, 1906, and under trust provided by will of JAMES E. SCRIPPS, executed under date of May 14, 1906, for and on behalf of the trust estate.Scripps v. CommissionerDocket Nos. 434, 536.United States Board of Tax Appeals1 B.T.A. 491; 1925 BTA LEXIS 2893; January 31, 1925, decided Submitted January 15, 1925. 2893 In applying section 219 of the Revenue Acts of 1918 and 1921 and determining whether the income of a trust is taxable to the fiduciary or the beneficiary all the facts and circumstances must be considered. The income has in fact and without question since the creation of the trust and for many years been distributed periodically, held not taxable to the fiduciary. Under the 1918 and 1921 acts the discretion of the fiduciary is not determinative of tax liability, and Art. 342, Reg. 45 and Reg. 62 is not controlling. Thomas O. Long, Esq., for the taxpayers in Docket No. 434. Charles F. Hutchins, Esq., and Byron C. Hanna, Esq., for the taxpayers in Docket No. 536. Arthur H. Fast, Esq. (Nelson T. Hartson, Solicitor of Internal Revenue) for the Commissioner. E. Barrett Prettyman, Esq., filed a brief amicus curiae.STERNHAGEN 491 Before JAMES, STERNHAGEN, TRAMMELL, and TRUSSELL. Both these appeals were heard on December 10, 1924, in the presence of representatives of all parties. Introduction of evidence in each case was kept separate from the other and the arguments were heard together. Since each is an appeal from2894 the determination contained in the letter dated September 11, 1924, from the Commissioner to the trustees and attacks the deficiency in income taxes for the calendar years 1919 to 1922, inclusive, asserted therein against the trustees, they will be decided together in one decision. The reason for the beneficiaries' separate appeal, Docket No. 536, is to present considerations regarded by them as material to a proper determination by the Board which are not presented by the trustees in Docket No. 434. 492 FINDINGS OF FACT. On May 4, 1906, James E. Scripps, of Detroit, Mich., created a trust by an instrument transferring certain stock to William E. Scripps, George G. Booth, and Edgar E. Whitcomb, of Detroit, Mich., hereinafter called the trustees, and their successors, in trust for certain specified uses. The trust property then transferred consisted of 41 3/4 shares of the capital stock of The Evening News Association; 6,997 shares of the capital stock of The James E. Scripps Corporation; and 24 shares of the Bay City Times Co. During the years 1919 to 1922, inclusive, the trust property consisted of 6,997 shares out of a total of 7,000 shares of The James E. Scripps2895 Corporation and 417 1/2 shares of The Evening News Association, which latter shares were on November 27, 1922, increased by stock dividend to 46,760 shares, and which represented 83 1/2 per cent of the total, the other 16 1/2 per cent being owned by strangers to the trust. The original holding of 24 shares in the Bay City Times was a minority holding and was sold a few years after the trust was created. The trust instrument contains the following provisions in respect of the income received from the trust property: (b) I have by my last will and testament provided that my home at Trumbull Avenue, in Detroit, Michigan, shall be maintained substantially as I am now maintaining it, by my wife, Harriet J. Scripps, and that she shall during her lifetime have and enjoy the use thereof. I hereby direct my trustees above named to pay during the lifetime of my said wife, Harriet J. Scripps, all taxes of every kind levied or assessed against said property, all expenses of keeping said home and contents in substantially the sam state of repair and condition that it now is in and pay to her for the purpose of defraying her living expenses in said home, a sum not less than six hundred2896 ($600.00) dollars per month, which sum may be increased to any amount my said trustees shall deem proper, either for the maintenance of said home, or enabling my said wife to carry out any desire she may have during her lifetime. enabling my said wife to carry out any desire she may have during her lifetime. annually, and more frequently if convenient, in the administration of this trust, at least fifty (50) per cent of all of the dividends, earnings, or other income or revenue that shall come into their hands as the holders of said stocks. in equal shares, to my four children - Ellen S. Booth, Anna S. Whitcomb, Grace S. Clark, and William E. Scripps, their heirs and assigns - it being my intention and purpose that should any of said children decease before the termination of the trust created hereby, that their share of any dividends, income, or revenue thereafter accruing from the stocks above referred to, or any other stocks or property into which the same shall be converted or reinvested, shall be paid to the heirs, legatees, or assigns of such deceased child. (d) The other fifty (50) per cent of all such dividends, income, or revenue from the stocks above referred to, or2897 any other stocks or property into which the same may be converted or reinvested, after deducting the expenses of administering this trust and meeting the obligations imposed upon them under paragraph (b) above herein, shall be either used to improve the properties owned by the corporations in which said stock is held, or be distributed in the same manner as above specified for the other fifty (50) per cent, as the judgment and discretion of my trustees above named shall deem best - it being my intention in this regard to vest in my said trustees the power to finally determine whether such remaining fifty (50) per cent of the income accruing from said stocks and property shall be distributed as provided in paragraph (c) above, in whole or in part, or that such remaining fifty (50) per cent of such income or any part thereof be used in connection with the improvement, development, or protection of the properties owned by said corporations or properties into which the same may be converted or reinvested, provided that my said trustees shall only convert such stocks or reinvest the same in other properties of like character, to-wit, personal property. 493 During the years in2898 question the income of the trust received by the trustees consisted practically entirely of dividends upon the stock mentioned and was in the following amounts: 1919$617,065.561920743,012.821921722,511.0319221,263,922.62All of these amounts were distributed to the beneficiaries of the trust before the end of each of the tax years in which they were respectively received by the trustees, and in accordance with the following allocations to the paragraphs of the trust instrument above set forth: 1919192019211922Paragraph (b)$15,023.97$19,318.93$18,168.62$18,228.00Paragraph (c)313,635.28376,277.72365,829.07637,227.34Paragraph (d)288,406.31347,416.17338,513.34608,467.28Total617,065.56743,012.82722,511.031,263,922.62Each beneficiary received his proper distributive share of these amounts and each included the entire amount so received in his income tax return as gross income received, and paid income tax upon the resulting net income. The trustees did not pay any tax upon any part of the income received by the trust estate. The Commissioner determined that in each year the amounts2899 received by the trustees and shown above as distributed under paragraphs (b) and (c) of the trust instrument were not subject to tax against the trustees and that the amounts received and shown above under paragraph (d) were taxable to the trustees. Upon these amounts the Commissioner determined the following taxes to be due from the trustees, which are the amounts in controversy in these appeals: 1919$130,553.791920167,382.191921161,773.411922275,193,64Total734,903.03DECISION. The deficiency determined by the Commissioner is disallowed. OPINION. STERNHAGEN: The appeal presents for our consideration and determination the construction of section 219 of the Revenue Act of 1918 and the same section of the Revenue Act of 1921, and particularly the application of those sections to that portion of the income received by the trustees as is covered by paragraph (d) of the trust instrument. The Revenue Act of 1918, section 219, is as follows: SEC. 219. (a) That the tax imposed by sections 210 and 211 shall apply to the income of estates or of any kind of property held in trust, including - (1) 494 Income received by estates of deceased2900 persons during the period of administration or settlement of the estate; (2) Income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests; (3) Income held for future distribution under the terms of the will or trust; and (4) Income which is to be distributed to the beneficiaries periodically, whether or not at regular intervals, and the income collected by a guardian of an infant to be held or distributed as the court may direct. (b) The fiduciary shall be responsible for making the return of income for the estate of trust for which he acts. The net income of the estate or trust shall be computed in the same manner and on the same basis as provided in section 212, except that there shall also be allowed as a deduction (in lieu of the deduction authorized by paragraph (11) of subdivision (a) of section 214) any part of the gross income which, pursuant to the terms of the will or deed creating the trust, is during the taxable year paid to or permanently set aside for the United States, any State, Territory, or any political subdivision thereof, or the District of Columbia, or any corporation organized and operated exclusively2901 for religious, charitable, scientific, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual; and in cases under paragraph (4) of subdivision (a) of this section the fiduciary shall include in the return a statement of each beneficiary's distributive share of such net income, whether or not distributed before the close of the taxable year for which the return is made. (c) In cases under paragraph (1), (2), or (3) of subdivision (a) the tax shall be imposed upon the net income of the estate or trust and shall be paid by the fiduciary, except that in determining the net income of the estate of any deceased person during the period of administration or settlement there may be deducted the amount of any income properly paid or credited to any legatee, heir, or other beneficiary. In such cases the estate or trust shall, for the purpose of the normal tax, be allowed the same credits as are allowed to single persons under section 216. (d) In cases under paragraph (4) of subdivision (a) and in the case of any income of an estate during the period of administration2902 or settlement permitted by subdivision (c) to be deducted from the net income upon which tax is to be paid by the fiduciary, the tax shall not be paid by the fiduciary, but there shall be included in computing the net income of each beneficiary his distributive share, whether distributed or not, of the net income of the estate or trust for the taxable year, or if his net income for such taxable year is computed upon the basis of a period different from that upon the basis of which the net income of the estate or trust is computed, then his distributive share of the net income of the estate or trust for any accounting period of such estate or trust ending within the fiscal or calendar year upon the basis of which such beneficiary's net income is computed. In such cases the beneficiary shall, for the purpose of the normal tax, be allowed as credits in addition to the credits allowed to him under section 216 his proportionate share of such amounts specified in subdivisions (a) and (b) of section 216 as are received by the estate or trust. The Revenue Act of 1921, sec. 219, subdivision (a), is identical in terms with the 1918 act. The remaining subdivisions were changed in the2903 later act and are as follows: (b) The fiduciary shall be responsible for making the return of income for the estate or trust for which he acts. The net income of the estate or trust shall be computed in the same manner and on the same basis as provided in section 212, except that (in lieu of the deduction authorized by paragraph (11) of subdivision (a) of section 214) there shall also be allowed as a deduction, without limitation, any part of the gross income which, pursuant to the terms of the will or deed creating the trust, is during the taxable year paid or permanently set aside for the purposes and in the manner specified in paragraph (11) of subdivision (a) of section 214. In cases in which there is any income of the class described in paragraph (4) of subdivision (a) of this section the fiduciary shall include in the return a statement of the income of the estate or trust which, pursuant to the instrument or order governing the distribution, is distributable to each beneficiary, whether or not distributed before the close of the taxable year for which the return is made. 495 (c) In cases under paragraphs (1), (2), or (3) of subdivision (a) or in any2904 other case within subdivision (a) of this section except paragraph (4) thereof the tax shall be imposed upon the net income of the estate or trust and shall be paid by the fiduciary, except that in determining the net income of the estate of any deceased person during the period of administration or settlement there may be deducted the amount of any income properly paid or credited to any legatee, heir, or other beneficiary. In such cases the estate or trust shall, for the purpose of the normal tax, be allowed the same credits as are allowed to single persons under section 216. (d) In cases under paragraph (4) of subdivision (a), and in the case of any income of an estate during the period of administration or settlement permitted by subdivision (c) to be deducted from the net income upon which tax is to be paid by the fiduciary, the tax shall not be paid by the fiduciary, but there shall be included in computing the net income of each beneficiary that part of the income of the estate or trust for its taxable year which, pursuant to the instrument or order governing the distribution, is distributable to such beneficiary, whether distributed or not, or, if his taxable year is different2905 from that of the estate or trust, then there shall be included in computing his net income his distributive share of the income of the estate or trust for its taxable year ending within the taxable year of the beneficiary. In such cases the beneficiary shall, for the purpose of the normal tax, be allowed as credits, in addition to the credits allowed to him under section 216, his proportionate share of such amounts specified in subdivisions (a) and (b) of section 216 as are received by the estate or trust. (e) In the case of an estate or trust the income of which consists both of income of the class described in paragraph (4) of subdivision (a) of this section and other income, the net income of the estate or trust shall be computed and a return thereof made by the fiduciary in accordance with subdivision (b) and the tax shall be imposed, and shall be paid by the fiduciary in accordance with subdivision (c), except that there shall be allowed as an additional deduction in computing the net income of the estate or trust that part of its income of the class described in paragraph (4) of subdivision (a) which, pursuant to the instrument or order governing the distribution, is2906 distributable during its taxable year to the beneficiaries. In cases under this subdivision there shall be included, as provided in subdivision (d) of this section, in computing the net income of each beneficiary, that part of the income of the estate or trust which, pursuant to the instrument or order governing the distribution, is distributable during the taxable year to such beneficiary. (f) A trust created by an employer as a part of a stock bonus or profitsharing plan for the exclusive benefit of some or all of his employees, to which contributions are made by such employer, or employees, or both, for the purpose of distributing to such employees the earnings and principal of the fund accumulated by the trust in accordance with such plan, shall not be taxable under this section, but the amount actually distributed or made available to any distributee shall be taxable to him in the year in which so distributed or made available to the extent that it exceeds the amounts paid in by him. Such distributees shall for the purpose of the normal tax be allowed as credits that part of the amount so distributed or made available as represents the items specified in subdivisions (a) 2907 and (b) of section 216. The income of the Scripps trust is divided into three classes in respect of its disposition - class (b), which is clearly distributable to and for the use of Harriet J. Scripps for the maintenance of herself and her home; class (c), which is clearly distributable at least annually equally among the four children; and class (d), which "shall be either used to improve the properties owned by the corporations in which said stock [the trust res ] is held, or be distributed in the same manner as" class (c), as the judgment and discretion of the trustees should deem best. The income of classes (b) and (c) is indisputably "to be distributed to the beneficiaries periodically," as described in subdivision (a), paragraph (4), of the section, and hence has, with the approval of the Commissioner, been returned for taxation by and taxed to the beneficiaries individually as provided 496 in subdivision (d) of the section. These amounts are not in controversy here. It is the class (d) income which is to be considered, the Commissioner asserting as the ground for the deficiency that the trustees are subject under subdivision (c) of the section to tax upon2908 this income, and the taxpayers asserting that the income is taxable distributively to the beneficiaries under subdivision (d) and not to the trustees. The beneficiaries, acting upon the latter theory, have included their several distributive shares in gross income in their individual returns and paid income tax thereon. Section 219(a) includes four classes of estates and trusts, the income of each of the first three of which is taxable as a whole to the fiduciary for the estate and of the fourth to the beneficiaries only. Of the first three classes, we are only concerned with the third, for the taxpayer here is neither a decedent estate nor a trust for unborn or unascertained persons or persons with contingent interests. Is the class (d) income "held for future distribution under the terms of the * * * trust," or is it rather "to be distributed to the beneficiaries periodically"? Certain it is that this income is subject to tax somehow, because the first clause of subdivision (a) of the section taxes all income "of any kind of property held in trust." The intendment is clear that trust income is not to escape behind any nicety of construction of the four enumerated classes. 2909 Such a question can arise for the purpose of determining not whether the income is taxable, but only whether such taxability falls in the first instance upon the trustees, with the incidence of tax upon the trust income as a whole before distribution; or directly upon the recipient beneficiaries, with the incidence of tax upon the separate share received by each. In view of the graduated surtax, the practical importance of the question can be readily seen. Whenever taxable income is to be determined, all the facts must be considered. It may be that some of the facts are creatures of the law (cf. Appeal of E. C. Huffman,1 B.T.A. 52">1 B.T.A. 52; Appeal of John K. Greenwood,1 B.T.A. 291">1 B.T.A. 291), and are therefore not so readily apparent as phyiscal or economic facts (cf. Appeal of Even Realty Co.,1 B.T.A. 355">1 B.T.A. 355, and Appeal of Union Metal Mfg. Co.,1 B.T.A. 395">1 B.T.A. 395), but all the facts of all kinds should be recognized and weighed. It is not sufficient to look only at the abstract legal facts or only at the more concrete and tangible facts. Hence we may not in applying the statute before us look only at the trust instrument and2910 the rights created thereby, and closing our eyes to what has happened in relation thereto, say whether the income in question is of one or the other class. The statute, it will be noted, wisely uses terms of actuality as the criteria of liability, and we must, therefore, look not alone to the bare language of the trust instrument but to the acts of the persons most interested in its correct enforcement. Since the creation of this trust in 1906 - almost 20 years - and particularly during the years since 1917, the class (d) income from the property has never been in fact withheld from the Scripps children by the trustees after its receipt, but has regularly been entirely distributed to them without delay. So far as we are advised by the record this distribution has never been the subject of doubt or question, but on the contrary has been regarded by everyone concerned as the proper duty of the trustees and the legal right of the children. 497 The only persons whose interests might be in any way adversely affected by such conduct, namely, the corporations in which the stock constituting the trust property is held, have raised no such question but have at all times acquiesced. 2911 How, then, can it be said that this income is "held for future distribution under the terms of the * * * trust," when it was not, and was not required or expected to be, so held? We think it clear that it is not within the class of income described in paragraphs (1), (2), or (3) of subdivision (a) of section 219 of the statute. The question then arises whether the income of class (d) is within the category of paragraph (4) as "income which is to be distributed to the beneficiaries periodically, whether or not at regulr intervals." It is suggested that this category is not necessarily an alternative to the income of paragraph (3), and that it is possible that the class (d) income may be covered by neither paragraph; in which event our attention is called to the insertion in subdivision (c) of the 1921 act of the provision that the tax is imposed upon the fiduciary, not only as to income in paragraphs (1), (2), and (3), but also "in any other case within subdivision (a) of this section except paragraph (4) thereof." This we need not consider unless we reach the conclusion that the facts before us do not fairly bring the class (d) income within paragraph (4). As we have already2912 stated, the class (d) income has, in fact, since the creation of the trust been distributed to the Scripps children periodically without objection. Was it then in the years after 1917 income "to be distributed to the beneficiaries periodically"? The fact that it was so distributed; that it had for 15 years been so distributed; that no one had objected to such distribution, not even the corporations which were thereby deprived of any possibility of receiving it, is reasonably persuasive of the conclusion that it was to be so distributed. Surely it can not be said that it was not to be distributed. Indeed, it is suggested by the taxpayers that it is doubtful whether there is any practical way to apply the income "to improve the properties of the corporations in which said stock is held," and whether the provision is not therefore entirely innocuous. It is difficult to say whether this gives the corporations a right to demand such improvement by way of gift or loan or stock subscription and whether the children were intended to suffer a diminution of their interests thereby. Since the trust income is all derived by way of dividends from these very corporations, the question2913 arises how they can at the same time be in a condition to demand that the trustee stockholder finance their improvement, development, and protection. Of course, if there is no way of enforcing this apparent alternative use of the income, there is an added reason for regarding it as distributable to the beneficiaries. When for many years irrespective of income tax the persons directly interested have consistently acted upon the view that the income was to be distributed, we are not inclined to recognize the right of the Government to adopt a contrary view as the basis of tax. For all other purposes and by all the parties concerned the administration of the trust has been regarded as resulting in the immediate distribution of the income to the beneficiaries, and the Government must take the situation as it finds it and impose its tax accordingly. 498 The Commissioner in his regulations for the administration of the law has adopted the rule that, wherever the accumulation or the distribution is placed in the discretion of the trustee, the income is taxed to the trustee irrespective of the exercise of the discretion. Art. 342, Reg. 45 and Reg. 62. This is, perhaps, a reasonable2914 instruction for the guidance of subordinates in the bureau who, without the facts before them, must make some sort of a classification in the first instance. But it can not serve to modify the statute so as to impose a tax upon the trustees which the statute itself does not impose. If discretion were to be the test of liability of the trustee, Congress could easily have said so, as it did in the revenue act of 1924. "We can not supply the omission in the earlier act." Smietanka v. First Trust & Savings Bank,257 U.S. 602">257 U.S. 602; 42 Sup.Ct. 223. We hold, therefore, that the income covered by paragraph (d) of the trust instrument is within the intendment of paragraph (4) of subdivision (a) of section 219 of the Revenue Acts of 1918 and 1921, and hence that in accordance with subdivision (d) of section 219 no tax was imposed upon the trustees here and no deficiency in respect thereof may properly be asserted. This makes it unnecessary, even if it were proper, for us to consider the collateral issues raised by the beneficiaries in Docket No. 536.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622067/	Estate of Henri P. Watson, Deceased, Henri P. Watson, Jr., Executor, Petitioner v. Commissioner of Internal Revenue, RespondentEstate of Watson v. CommissionerDocket No. 31911-85United States Tax Court94 T.C. 262; 1990 U.S. Tax Ct. LEXIS 16; 94 T.C. No. 16; March 1, 1990March 1, 1990, Filed 16 Decision will be entered under Rule 155. Held, where a trust failed to provide for the disposition of the trust corpus after the termination of the trust, a beneficial interest in the trust corpus reverted to the settlor of the trust when the trust terminated and was included in his gross estate under sec. 2033. Held, further, the widow's allowance paid under Mississippi law to the decedent's widow qualifies for the marital deduction provided in sec. 2056(a). Held, further, respondent failed to meet his burden of proving that rental proceeds from the decedent's farmland were improperly omitted from the gross estate on the decedent's estate tax return. Lauch M. Magruder, Jr., for the petitioner.Robert W. West, for the respondent. Hamblen, Judge. HAMBLEN262 Respondent determined a deficiency of $ 437,231 in the Federal estate tax liability of the estate of Henri P. Watson. After trial, respondent amended his answer to conform the pleadings to the proof. In his amended answer, respondent asserted that the correct deficiency in petitioner's estate tax is $ 470,370.72. After concessions, the issues remaining to be decided are: (1) Whether the full17 value of 1,073.18 acres of farmland located in Sunflower County, Mississippi, is included in the decedent's gross estate; (2) whether the widow's allowance paid to the decedent's surviving spouse qualifies for the marital deduction; and (3) whether rent proceeds from decedent's farmland were assets of the decedent's estate that were omitted from the gross estate on decedent's estate tax return.FINDINGS OF FACTSome of the facts have been stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated herein by this reference.263 When the petition in this case was filed, petitioner was an estate domiciled in and administered under the laws of Mississippi, under the jurisdiction of the Chancery Court of Holmes County, Mississippi. At the time the petition was filed, the executor, Henri P. Watson, Jr., was a resident of Jackson, Mississippi. Petitioner filed a Federal estate tax return which was prepared by Robert Wingate, the decedent's accountant. Mr. Wingate has been a certified public accountant for almost 40 years. Mr. Wingate, who had known the decedent for about 40 years, did all of the decedent's accounting work.Decedent, Henri18 P. Watson, was a resident of Lexington, Mississippi, until his death on January 19, 1982. Decedent was born on August 4, 1892, which made him 89 years old at his death. Decedent had been a farmer all of his life, farming in and around Holmes and Sunflower Counties, Mississippi.On September 27, 1927, the decedent acquired a tract of farmland in Sunflower County, Mississippi, containing 1,073.18 acres. This farmland was approximately 70 to 75 miles from the decedent's home in Lexington. Decedent farmed this land from 1927 until late 1978, which was through the 1978 crop year.Prior to 1969, the decedent's son, Henri P. Watson, Jr., lived near his father. In 1942, Henri P. Watson, Jr., acquired approximately 1,020 acres adjoining his father's land. Prior to 1969, the decedent and his son farmed the two tracts of land (1,073.18 acres and 1,020 acres) as a partnership. However, the decedent and his son never formally conveyed their land to the partnership. Decedent and his son established a bank account in the name of "Watson and Watson" for use in the farming operation.On October 23, 1961, the decedent executed a deed transferring an undivided one-half interest in his 1,073.18-acre19 tract of land to his son, Henri P. Watson, Jr., as trustee for the use and benefit of the decedent's four grandchildren. The deed stated that the trust would terminate when the youngest of the beneficiaries became 21 years of age. The youngest grandchild became 21 years old on July 31, 1981. There was no provision in the trust deed for the disposition of the corpus of the trust after the trust 264 terminated. No subsequent conveyance of the half interest in the 1,073.18 acres of farmland was made to the decedent's grandchildren, and the record is silent as to the ultimate disposition of the property.The October 1961 deed provided that the trustee had the authority to use any part of the income or corpus of the trust property for the support and maintenance of the grandchildren. The deed authorized the trustee to --handle, manage, operate, rent, lease for oil and gas and other mineral purposes, encumber by deed of trust or otherwise, and to sell all or any part of, or any interest in, the aforesaid property on any terms deemed proper by said trustee, all with the same authority and discretion and to the same extent as though said property was owned in fee simple by said20 trustee, and my trustee shall have full authority to invest, reinvest and otherwise handle any funds or other property received from any sale or other transaction involving said land with the same authority and discretion as though said funds or other property belonged to said trustee personally, and my said trustee shall have full authority to expend any part of the income or corpus from any of such funds as he sees fit for the proper support and maintenance of my said grandchildren * * .The trustee appointed under the October 1961 deed, Henri P. Watson, Jr., did not maintain any trust books or records and did not file any Federal income tax returns for the trust. No distributions of the original trust corpus were made to the beneficiaries. However, the decedent's four grandchildren reported rental income from farmland on their Federal income tax returns as follows:YearNormanJamesMaryHenri III1982$ 9,250$ 14,250$ 2,9001981198019791,2501,2501,25019781,2501,2501,250$ 1,25019771,2501,2501,250(1) 19761,2501,2501,25019751,2501,2501,25019744,2504,2504,2504,25019734,2504,2504,2504,250Mr. Wingate21 prepared Federal income tax returns for each of the beneficiaries. The rent to the grandchildren was paid 265 from the Watson and Watson bank account. Rental income from the property placed in trust was paid into accounts for the benefit of or directly to the beneficiaries. A 1,077-acre farm in Sunflower County similar to the Watson land, but of better quality, was rented for about $ 13 an acre from approximately 1963 to 1968, around $ 18 an acre from approximately 1968 to 1973, and about $ 27 an acre from 1973 to 1978.1Mr. Wingate prepared gift tax returns for the decedent and his wife reflecting a gift to the decedent's four grandchildren of a half interest in the decedent's 1,073.18 acres of farmland. The gift tax returns reflected no reservation of any interest in the property. However, the Atlanta Service Center of the Internal Revenue Service, where the returns should have been22 filed, has no record that the decedent ever filed gift tax returns for the transfer at issue.The trust deed was drafted by Lee Spence, an attorney who worked for the trust department of Deposit Guaranty National Bank in Jackson, Mississippi. Mr. Spence came to the office of Pat Barrett, the decedent's lawyer, in Lexington, Mississippi, to draft the trust deed. Mr. Spence held himself out to Mr. Barrett as an expert in trust instruments. After Mr. Spence drafted the trust deed, it was typed by Mr. Barrett's secretary. Mr. Spence went over the draft with the secretary very thoroughly before the draft was typed. After Mr. Spence left the office, the draft was typed and Mr. Barrett read the typed document. After Mr. Barrett read the document, he mailed it to Mr. Spence. Mr. Spence then wrote Mr. Barrett a letter stating that in Mr. Spence's opinion, the document was sufficient for Mr. Watson's purpose.The decedent's son, Henri P. Watson, Jr., also conveyed a portion of his own land to his children in trust. The form of this conveyance was similar to the form of the decedent's trust deed. However, Henri P. Watson, Jr., never paid any rent to his children for his use of the property. 23 In approximately 1969, Henri P. Watson, Jr., moved to Jackson, Mississippi, which is about 125 to 130 miles away from the two parcels of farmland. From the time Henri P. Watson, Jr., moved to Jackson until 1980, all of the income and expenses associated with farming both parcels of land 266 were reported by the decedent on his Federal income tax returns. The decedent and his son agreed that after Henri P. Watson, Jr., moved to Jackson, the decedent would get the income from the two parcels and Henri P. Watson, Jr., would get improvements to his 1,020 acres. The improvements to Henri P. Watson, Jr.'s land consisted of land-leveling of his 1,020 acres to a grade that could be flood irrigated. After 1967, at the suggestion of the Watsons' accountant, Mr. Wingate, no partnership tax returns were filed by the decedent or his son. Mr. Wingate's recommendation that the Watsons stop filing partnership returns was based on the fact that as Henri P. Watson, Jr., became less active in the farming venture and became involved in other business activities, it became more difficult for Mr. Wingate to determine what was the partnership's and what was Henri P. Watson, Jr.'s. Mr. Wingate24 insisted that the Watsons stop filing partnership returns and simply report the income from the farming venture on their individual returns. Henri P. Watson, Jr., did not report any of the farm income or expenses on his Federal income tax returns from 1969 to 1979.From the time the decedent purchased the 1,073.18 acres until his death, he paid the property taxes on the land. After the Watson and Watson bank account was established, the payments for property tax were made by checks drawn on that account. In 1968 and before, the property tax payments were deducted on the partnership tax return. After 1968, the property tax payments were deducted as an expense on the decedent's individual Federal income tax returns. The decedent treated the payments for insurance premiums on improvements to the land in the same manner as the property tax payments. The property taxes on the 1,020 acres of farmland owned by Henri P. Watson, Jr., were also paid from the Watson and Watson account. After 1968, the decedent deducted these taxes as an expense on his Federal income tax return. After 1968, the decedent paid property taxes, insurance premiums, improvement costs, and other expenses for25 the 1,020 acres owned by Henri P. Watson, Jr., from the Watson and Watson account. After 1968, all income in excess of expenses from farming the two parcels went into the Watson and Watson account.267 From 1969 to 1977, the decedent was responsible for day-to-day operations of farming both tracts of land. The decedent visited the farm about once a week from 1968 to 1978. During these weekly visits, the decedent would give his instructions to his farm manager. During this period from 1968 to 1978, Henri P. Watson, Jr., visited the farm two or three times a month and sometimes more frequently. If the decedent was not feeling well, his son would go up to the farm and pay the payroll. From 1968 to 1978, decedent would deliver the farm financial information to his accountant, Mr. Wingate, each month, unless he was sick or otherwise unable to deliver the information. If the decedent was unable to take the information to Mr. Wingate, his son would take it.In early 1979, the decedent and his son decided that all active farming by either of them on the two parcels of land would cease. Most of the farm equipment was sold at auction on February 27, 1979. The total amount received26 from the auction was $ 90,008.23. During the crop year 1979 and thereafter until decedent's death, both tracts of farmland were rented to Morgan Brothers for a cash rental per year. The decedent and his son agreed that the rental income received from Morgan Brothers would go to the decedent to build up money for his widow. The decedent and his son agreed that if at some point the improvements to Henri P. Watson, Jr.'s land were not sufficient, Henri P. Watson, Jr., might take part of the rent.On his Federal income tax returns, the decedent reported farm rental income of $ 70,800 for 1979, $ 57,074 for 1980, and $ 9,929 for 1981. In 1980, Henri P. Watson, Jr., reported $ 25,000 in rental income on his Federal income tax return. In 1981, Henri P. Watson, Jr., received $ 67,202.76 in rental income and reported it on his own Federal income tax return.The 1979 rental payment of $ 70,800 was deposited in the Watson and Watson bank account on January 31, 1979, at the First National Bank of Holmes County. The 1980 rental payment was paid by a check dated February 20, 1980, in the amount of $ 78,211.92. The check was endorsed "Watson and Watson, Henri P. Watson, Jr.," and was deposited27 in the Unifirst Federal Savings & Loan Association of Jackson, 268 Mississippi. The 1981 rent was paid by two checks. The first check, dated January 14, 1981, was for $ 6,000, and was deposited in the Watson and Watson account at the First National Bank of Holmes County. The second check, dated February 11, 1981, was for $ 71,131.76 and was deposited in the account of H.P. Watson, Jr., in the Bank of Hazelhurst, Mississippi.The Agricultural Stabilization and Conservation Service office made program payments that were attributable to the 1,073.18-acre tract of land owned by the decedent and the 1,020-acre tract owned by Henri P. Watson, Jr., All of these payments were made to the decedent and were deposited in the Watson and Watson bank account. The decedent retained these payments and reported them on his Federal income tax returns.About 5 years before his death in 1982, the decedent suffered a stroke. The decedent remained mentally alert until his death, but he had difficulty walking and seeing after the stroke, and it hurt him to ride in a car. As a result, after the decedent's stroke, his son assumed control of the farming venture and made the decisions relating to28 the farming venture, although he continued to discuss business decisions with the decedent and visited the decedent every week until he died.In the years after Henri P. Watson, Jr., moved to Jackson, Mississippi, he had several business interests that cumulatively constituted his full-time occupation. Henri P. Watson, Jr., was engaged in the sale of land on a commission basis (1970 to 1986), the leasing of farmland (1970 to 1982), owning oil leases (1970 to 1982), the leasing of oil lands (1970 to 1982), owning a small business corporation (1970 to 1982), owning a cattle and grain farm (not the 1,073.18 acres or the 1,020 acres) (1970 to 1982), buying and selling land (1968 to 1981), the sale of timber (1973 to 1976), and being a partner in Annandale Farms of Lexington, Mississippi (1970). The cattle farms were located in Texas, and in Hinds and Madison Counties, Mississippi. Annandale Farms was located at Hazelhurst, Mississippi, approximately 35 miles south of Jackson. The small business corporation was also located at Hazelhurst, Mississippi. The 269 other farms and other business activities of Henri Watson, Jr., were located in and around Jackson, Mississippi.The 29 decedent's widow, Corrinne W. Watson, dissented from her husband's will and elected to take her statutory share. She later settled her claim against the estate for $ 290,000. In addition, Mrs. Watson was allowed 1 year's support of $ 30,000 by the Chancery Court. This support allowance is known as a widow's allowance.OPINIONThe first issue for our decision is whether the decedent's gross estate includes the entire value of the 1,073.18-acre tract of farmland. Respondent contends that the decedent's gross estate includes the entire value of the 1,073.18 acres of farmland. Respondent bases this contention on three separate arguments. First, respondent argues that when the trust terminated prior to the decedent's death, the corpus reverted to the decedent's ownership and left the decedent with a full fee ownership in the 1,073.18 acres which must be included in his gross estate under section 2033. 2 Second, respondent argues that the decedent retained for his life the use, possession, control, and enjoyment of the entire parcel of farmland despite the 1961 trust deed and that as a result, the entire value of the parcel is included in the decedent's gross estate under section30 2036. Finally, respondent argues that if the decedent transferred the use, possession, enjoyment, and right to income from the land, he did so within 3 years of his date of death, and that the entire value of the farmland is therefore included in the gross estate under sections 2035(a) and 2035(d)(2).Petitioner contends that the trust corpus did not revert to the decedent after the termination of the trust because the decedent intended the trust corpus to pass to the trust beneficiaries after the trust terminated. Petitioner further contends that the decedent did not retain the use, possession, control, and enjoyment of the entire parcel of farmland after the creation of the trust in 1961.270 We will first address the question of whether the entire interest in the farmland must31 be included in the decedent's estate under section 2033. The value of the decedent's gross estate includes, under sections 2031 (a)3 and 2033, 4 the value of all property to the extent of his interest therein at the time of his death. The value of the gross estate includes the value of all property "beneficially owned by the decedent at the time of his death." Sec. 20.2033-1(a), Estate Tax Regs. Property in which the decedent does not have beneficial ownership is not includable in the decedent's gross estate, even if the decedent had legal title to the property. Estate of Spruill v. Commissioner, 88 T.C. 1197">88 T.C. 1197, 1224 (1987).32 Respondent contends that the decedent had a beneficial interest in the entire value of the farmland because the trust corpus reverted to the decedent after the termination of the trust. The trust instrument makes no provision for the trust corpus upon termination. Petitioner argues that the decedent intended the trust corpus to pass to the beneficiaries of the trust after the termination of the trust, and that the decedent's intent on this point can be determined from extrinsic evidence. Petitioner contends that the facts and circumstances surrounding the creation of the trust deed show that the decedent intended the entire undivided interest in the trust corpus to vest in the beneficiaries after the termination of the trust. Petitioner does not argue that the decedent transferred any interest in the property at issue to the trust beneficiaries outside of the trust instrument, and no evidence before the court suggests that the decedent made any such transfer. Respondent contends that extrinsic evidence cannot be used to show the intent of the decedent because there is no ambiguous language in the trust. Respondent made a continuing objection to the admission of testimony concerning33 the decedent's intent regarding disposition of the trust corpus after the termination of the trust. Respondent's objection was based on the grounds of relevancy and 271 hearsay. To determine whether the testimony at issue is relevant, we must determine whether extrinsic evidence can be used to determine the intent of the decedent.Generally, for purposes of the estate tax, we first must determine the legal interests and rights created under State law, and then decide whether the interests and rights so created are sufficient to justify including the property in the gross estate. Morgan v. Commissioner, 309 U.S. 78">309 U.S. 78, 80-81 (1940); United States v. Manny, 645 F.2d 163">645 F.2d 163, 166 (2d Cir. 1981); Estate of Pfohl v. Commissioner, 70 T.C. 630">70 T.C. 630, 633 (1978). As we stated in Ward v. Commissioner, 87 T.C. 78">87 T.C. 78, 92 (1986),In making this determination, we are, "in effect, sitting as a state court," being bound by decisions of the Supreme Court of [Mississippi] and "giving 'proper regard' to relevant rulings of other courts of the State." [Commissioner v. Estate of Bosch, 387 U.S. 456">387 U.S. 456, 465 (1967);34 Estate of Fulmer v. Commissioner, 83 T.C. 302">83 T.C. 302, 306 (1984).]Therefore, to determine if extrinsic evidence regarding the decedent's intent is relevant, we must determine whether extrinsic evidence could be used by a Mississippi court construing the decedent's trust. Mississippi courts apply general rules of construction of written instruments to the construction of trust instruments whether they are contracts, deeds, or wills. Hart v. First National Bank of Jackson, 233 Miss. 766">233 Miss. 766, 103 So. 2d 406">103 So. 2d 406, 409 (1958). Under Mississippi law, the duty of a court in construing wills and trusts "is to ascertain and give effect to the intention of the testator. In arriving at this intention, the court is required to consider the entire instrument, sometimes said 'From the four corners of the instrument.' Where the instrument is susceptible of more than one construction, it is the duty of the court to adopt that construction which is most consistent with the intention of the testator." Malone v. Malone, 379 So. 2d 926">379 So. 2d 926, 928-929 (Miss. 1980). In ascertaining the settlor's intent, "effect35 must be given to the plain and unambiguous language used in the trust instrument." Hart v. First National Bank of Jackson, 103 So. 2d at 409. In Hart v. First National Bank of Jackson, 103 So. 2d at 410, the Mississippi Supreme Court quoted 54 Am. Jur., Trusts, sec. 17, as follows:272 In the case of a trust based on a written instrument, the intention of the trustor is to be ascertained from the language thereof, and the court may not go outside the language in an effort to give effect to what it conceives to have been the actual intent or motive of the trustor. If the language is unambiguous and perfectly clear, there is no field for the play of construction; if the trustor has clearly expressed one intention, the court cannot impute to him another, and parol evidence is inadmissible to add, take away from, or even to explain such clear expression of intention. * * An instrument is not considered ambiguous on a given point just because the instrument is silent on that point. See Stovall v. Stovall, 360 So. 2d 679">360 So. 2d 679 (Miss. 1978). "The expressed intent36 of the testator is the guiding star rather than 'what he wished' or may have wished." Stovall v. Stovall, supra at 681. Mississippi courts have authority to give effect to a settlor's intent only where that intent has received some form of expression in the trust instrument. See Tinnin v. First Bank of Mississippi, 502 So. 2d 659 (Miss. 1987). Since the decedent made no expression within the trust instrument of his intent regarding the disposition of the trust corpus after the termination of the trust, we cannot give effect to the decedent's intent as expressed in parol evidence. Accordingly, we find that the testimony on the subject of the decedent's intent is irrelevant and therefore inadmissible. Since we have decided that the testimony at issue is inadmissible because it is irrelevant, we need not decide whether it is inadmissible as hearsay.The decedent's accountant, Mr. Wingate, testified that he prepared gift tax returns for the decedent regarding the transfer of the half interest in the decedent's 1,073.18 acres. Mr. Wingate's drafts of these returns were introduced into evidence. Petitioner maintains that37 Mr. Wingate's preparation of gift tax returns indicates that the decedent intended to transfer the entire income and remainder interest in the property. We conclude that the drafts and Mr. Wingate's testimony regarding the preparation of gift tax returns are irrelevant on the issue of the decedent's intent because they are extrinsic evidence that would not be admissible to prove intent under Mississippi law. In addition, we conclude that the drafts are of no probative value regarding whether a gift of the entire income and remainder interest occurred because petitioner has not proven that the decedent actually 273 filed gift tax returns for the transfer at issue. The Government maintains a permanent file of all gift tax returns that have been filed. The record contains evidence that no gift tax returns were filed by the decedent for the transfer of the half interest in the farmland. Even if they had been filed, the contents of the gift tax returns would not have been dispositive of the issue before us. Since the decedent apparently decided not to file gift tax returns for the transfer of the half interest in the farmland, the drafts prepared by Mr. Wingate are of no probative38 value. Even if gift tax returns had been filed, that fact would not be dispositive of the issue before us. If the decedent had made a gift of income only (and not the income and remainder interests) gift tax returns would still have been required. Thus, the alleged fact of filing proves nothing. Accordingly, we give the handwritten drafts prepared by Mr. Wingate no weight in our determination of whether a gift of the entire income and remainder interest in the property occurred.Since the decedent did not express his intent in the trust instrument regarding disposition of the trust corpus after the termination of the trust, we must look to Mississippi law to determine whether a beneficial interest in the trust corpus returned to the decedent on the termination of the trust. Respondent cites Andrews v. Brumfield, 32 Miss. 107 (1856), for the proposition that a reversion exists under the circumstances of the instant case. In Andrews v. Brumfield, supra, a decedent died and left property to his surviving widow for life, with the power to dispose of the property as she thought proper. The widow retained possession of39 the property for her life, and upon her death, she bequeathed the property to her children. A representative of her husband's estate brought suit, claiming that the property belonged to the husband's estate as unadministered property, and that the widow had no right to make distribution of the property by will. The court found that the widow only had a life estate with a power of disposition in the property, not a fee interest. The court stated that --No disposition was made of the property beyond the bequest to Mrs. Andrews; and upon the assumption that she took, under the will, a limited estate, a reverter, or, to speak with greater accuracy, a quasi 274 reverter existed by the operation of law, in property bequeathed to her. [Andrews v. Brumfield, 32 Miss. at 112.]Therefore, where a will provides for a life estate but fails to make any provision for the disposition of the property after the end of the life estate, the property will revert to the estate of the testator after the end of the life estate.While Andrews v. Brumfield, supra, is not directly on point, we agree with respondent that Andrews v. Brumfield, supra,40 suggests that the Mississippi Supreme Court would find that a beneficial interest in the trust corpus returned to the decedent after the termination of the trust in the present case. In both Andrews v. Brumfield, supra, and the present case, an interest in property was transferred for a limited period, and no provision was made for the disposition of the interest after that period. The Mississippi Supreme Court held that in the life estate situation of Andrews v. Brumfield, supra, a reverter or a quasi-reverter would exist, and the property would belong to the testator's estate. By analogy, in the present case, where a beneficial interest in property was passed for a limited period with no disposition of the beneficial interest after that period, the beneficial interest would return to the settlor of the trust after the end of the limited period.Respondent also cites Bond v. Dukate, 118 Miss. 516">118 Miss. 516, 79 So. 86">79 So. 86, 87 (1918), in which the Mississippi Supreme Court stated that if a testamentary trust created by a valid will were inoperative, a trust would result in favor of the 41 decedent's heirs under the will. The court quoted from 1 Jarman on Wills 481 (6th ed.) as follows:Sometimes a testator distinctly shows an intention to create a trust but does not go on to denote with sufficient clearness who are to be its objects; the effect of which obviously is that the devisees or legatees in trust (whom we suppose to be distinctly pointed out) hold the property for the benefit of the person or persons on whom the law, in the absence of disposition, casts it; in other words, the gift takes effect to the legal interests but fails as to the beneficial interests.Bond v. Dukate, supra, is not directly on point since in that case the court was discussing the disposition of the trust corpus upon the failure of a trust for vagueness, not the termination of a trust after the period of the trust. Bond v. Dukate, supra, indicates that where a beneficial 275 interest is not adequately disposed of, the beneficial interest returns to the settlor. In the present case, the beneficial interest passed to the trust beneficiaries until the youngest beneficiary turned 21. However, 42 the decedent did not provide for the disposition of the beneficial interest after this point. Bond v. Dukate, supra, suggests that the Mississippi Supreme Court would rule that the decedent owned a beneficial interest in the trust corpus after the termination of the trust. Accordingly, we find that the decedent was the beneficial owner of the trust corpus after the trust terminated. Since no evidence indicates that the decedent gave up this interest before his death, we find that the decedent was the beneficial owner of the entire interest in the 1,073.18 acres of farmland on the date of his death. Consequently, the entire interest in the 1,073.18 acres is included in his gross estate under section 2033.The next issue for our decision is whether the widow's allowance paid to the surviving spouse qualifies for the marital deduction provided in section 2056(a). Petitioner claimed a section 2056(a) marital deduction for, among other things, a $ 30,000 widow's allowance granted to the decedent's widow by the Holmes County, Mississippi, Chancery Court. Respondent contends that petitioner is not entitled to the marital deduction for the43 widow's allowance because the allowance is a nonqualified terminable interest. The burden of proof is upon petitioner to establish that the widow's allowance at issue qualifies for the section 2056(a) marital deduction. Rule 142(a).Under section 2056(a), the value of the taxable estate is generally determined by deducting from the value of the gross estate an amount equal to the value of any interest in property passing from the decedent to his surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate. See also section 2051. This deduction is known as the marital deduction.An estate is entitled to the marital deduction only with respect to a qualifying property interest passed from the decedent to his surviving spouse. A terminable interest in property may not qualify for the marital deduction. Sec. 2056(b)(1). Section 20.2056(b)-1(b), Estate Tax Regs., defines a "terminable interest" as "an interest which will terminate 276 or fail on the lapse of time or on the occurrence or the failure to occur of some contingency." Under section 2056(b)(1), a terminable interest in property will not qualify for the marital44 deduction if (1) another interest in the same property passed from decedent to some other person for less than adequate consideration and (2) by reason of its passing, such other person or his heirs or assigns may possess or enjoy any part of the property after the termination of the spouse's interest. Congress only intended to allow the marital deduction to a decedent's estate in those situations where the qualifying property interest "will be includible in the gross estate of the beneficiary or donee spouse unless it has been dissipated in the interval." S. Rept. 1013, 80th Cong., 2d Sess. (1948), 1 C.B. 285">1948-1 C.B. 285, 305. See also Estate of Holland v. Commissioner, 64 T.C. 499">64 T.C. 499, 502 (1975). Thus, the statute was designed so as to prevent qualifying property from escaping the estate tax a second time upon the subsequent death of the surviving spouse.Whether the widow's allowance as provided under Mississippi law constitutes a terminable interest within the meaning of section 2056 must be determined as of the date of the decedent's death. Jackson v. United States, 376 U.S. 503">376 U.S. 503, 508 (1964); Estate of Radel v. Commissioner, 88 T.C. 1143">88 T.C. 1143, 1146 (1987);45 Estate of Abely v. Commissioner, 60 T.C. 120">60 T.C. 120, 123 (1973), affd. 489 F.2d 1327">489 F.2d 1327 (1st Cir. 1974); see also Estate of Snider v. Commissioner, 84 T.C. 75">84 T.C. 75, 79 (1985). The decedent's widow's right to the widow's allowance as of the date of the decedent's death must be determined under the law of Mississippi. Estate of Abely v. Commissioner, supra.If, under Mississippi law, the widow's right to a widow's allowance vests upon the decedent's death but terminates or fails upon the occurrence or nonoccurrence of certain contingencies, then the widow's allowance is a terminable interest within the meaning of section 2056(b)(1). Estate of Abely v. Commissioner, supra at 123; Hamilton National Bank of Knoxville v. United States, 353 F.2d 930">353 F.2d 930, 932 (6th Cir. 1965); see Estate of Green v. United States, 441 F.2d 303">441 F.2d 303, 305 (6th Cir. 1971). In making the determination of Mississippi law, we are bound by decisions of the Supreme Court of Mississippi and must give proper regard to 277 46 relevant rulings of other courts of Mississippi. Commissioner v. Estate of Bosch, supra.Miss. Code Ann. section 91-7-135 (1972) provides a widow's allowance of 1 year's support for the widow of a decedent. Court-appointed appraisers are required by the statute to set aside the widow's allowance. Miss. Code Ann. secs. 91-7-135, 91-7-109 (1972). The action of the appraisers in making the widow's allowance is not final, but is advisory only, and the chancellor may increase or decrease the amount. Beckett v. Howarth, 237 Miss. 394">237 Miss. 394, 115 So. 2d 48">115 So. 2d 48 (1959); Moseley v. Harper, 202 Miss. 442">202 Miss. 442, 32 So. 2d 192">32 So. 2d 192 (1947); Prentiss v. Turner, 170 Miss. 496">170 Miss. 496, 155 So. 214">155 So. 214 (1934). If the widow renounces her husband's will, the chancellor may, within his discretion, provide for the allowance of 1 year's support. Sandifer v. Sandifer, 237 Miss. 464">237 Miss. 464, 115 So. 2d 46">115 So. 2d 46 (1959).Petitioner contends that Miss. Code Ann. section 91-7-135 (1972) gives the decedent's widow an absolute unconditional47 right to receive the widow's allowance and that this right was vested as of the date of the decedent's death. Petitioner cites Westbrook v. Shotts, 200 Miss. 456">200 Miss. 456, 27 So. 2d 683">27 So. 2d 683 (1946), and Edwards v. McGee, 27 Miss. 92">27 Miss. 92 (1854), in support of its contention. In Westbrook v. Shotts, supra, the Mississippi Supreme Court considered Miss. Code section 561 (1942), which is virtually identical to Miss. Ann. Code section 91-7-135 (1972). In Westbrook v. Shotts, supra, the court held that the widow's allowance is not conditioned on the payment by the widow of amounts she owed to the estate. The Mississippi Supreme Court made the following statement in Westbrook v. Shotts, 27 So. 2d at 683:Appellant attacks that part of the decree making conditional her right to allowance as widow for a year's support. We think this point is well taken. Her right thereto is absolute, Code 1942, Secs. 561, 564, and ought not to be involved in issues raised by claims of the administrator against48 her. Prentiss v. Turner, 170 Miss. 496">170 Miss. 496, 155 So. 214">155 So. 214; Pratt v. Pratt, 155 Miss. 237">155 Miss. 237, 124 So. 323">124 So. 323.In Edwards v. McGee, supra, the guardian for the minor children of a decedent petitioned the Probate Court of Holmes County, Mississippi, to appoint three commissioners to set aside a 1-year support allowance for the minor children from the estate of the decedent. The guardian for 278 the minor children applied for the support allowance because the widow of the decedent died without making the application for the support allowance. The statute at issue provided that:It shall be, and is hereby made the duty of the probate judges of the several counties of this State, upon the application of the widow of any deceased person, to appoint three commissioners, whose duty it shall be to select and set apart, out of the stock of provisions or effects of said deceased person, one year's provision for the widow and children. Hutch. Co., p. 680.The court stated that the statute "gives to the widow and children of a deceased person, a clear right to one year's support49 out of his estate. It gives no greater right to the widow, than it gives to the children." Edwards v. McGee, 27 Miss. at 93. The court further stated that "The question is, Did the law confer upon the children the right asserted; and if so, was it absolute, or dependent entirely upon the life of their mother? It is clear that the law conferred the right. It is equally clear that when, in consequence of her death, she could not assert the right for them, the guardian might do so." Edwards v. McGee, 27 Miss. at 93. The court thus held that the support allowance for the children was not dependent on the decedent's widow surviving to apply for the support allowance.Westbrook v. Shotts, supra, refers to the right to the widow's allowance as "absolute," and Edwards v. McGee, supra, states that the widow and children have "a clear right" to the support allowance. Petitioner argues that because a widow has an "absolute" right and "a clear right" to the widow's allowance, the right to the widow's allowance is a vested interest. Black's Law Dictionary50 at 1401 (5th ed. 1979) defines "vested" as, in part, "Fixed; accrued; settled; absolute. Having the character or given the rights of absolute ownership; not contingent; not subject to being defeated by a condition precedent." Therefore, we agree with petitioner that under Westbrook v. Shotts, supra, and Edwards v. McGee, supra, the Mississippi widow's allowance is a vested interest. However, respondent argues that the interest is terminable because the widow can lose her right to the widow's allowance under some circumstances. In Thomas v. Bailey, 375 So. 2d 1049 (1979), the 279 Mississippi Supreme Court held that even though a widow was entitled to a widow's allowance as a matter of right, the widow's allowance was properly denied where the widow did not make a motion for the allowance or otherwise indicate that she wanted a widow's allowance prior to the closing of the estate. Therefore, a widow can lose the right to widow's allowance by failing to act prior to the closing of the estate.Respondent argues that the Mississippi widow's allowance is a terminable interest51 because (1) a widow can lose her right to the widow's allowance by her failure to act, and (2) at the time of the decedent's death, the amount of the widow's allowance was not fixed because the chancellor has final authority over the amount of the allowance. We must decide, therefore, whether the possibility that a widow could lose her otherwise absolute vested right to the widow's allowance through her failure to act and the requirement that the chancellor make a final decision regarding the amount of the allowance are contingencies that could cause the widow's allowance to terminate or fail for purposes of section 2056.Respondent's argument is similar to the argument that the Government made in Estate of Green v. United States, supra. In Estate of Green v. United States, supra, the Sixth Circuit held that the requirements that the widow file a petition for the widow's allowance and that the Probate Court fix the amount of the allowance do not make the Michigan widow's allowance a terminable interest. The Sixth Circuit stated that --The government's main argument appears to us to be that even if the Michigan widow's52 allowance statute creates a property right in the widow which vests as of her spouse's death, and is not terminated by her death or her remarriage, it should nonetheless be held to be terminable under section 2056(b) because 1) the vested right is "inchoate" and can only be fixed in amount by the Probate Court proceeding and order determining "reasonable allowances," and 2) because in any event, the widow must file a petition for the allowance and, hence, impliedly might waive the allowance by failing to file. [Estate of Green v. United States, 441 F.2d at 307.]The Sixth Circuit went on to state that --280 it seems to us if either of these conditions were held to be an "event or contingency" occasioning terminability under section 2056(b), that we would be holding that Congress for all practical purposes had repealed the Allowance for Marital Deduction. [Estate of Green v. United States, 441 F.2d at 307.]The Sixth Circuit stated that the Government's interpretation was absolutely repugnant to the specific language and purposes of section 2056(a). The Sixth Circuit quoted from Hamilton National Bank of Knoxville v. United States, 353 F.2d 930">353 F.2d 930, 932-933 (6th Cir. 1965),53 on the subject of the widow's allowance, as follows:It has been uniformly held the compensation qualifies for the marital deduction, and invoking the necessary legal procedures to enforce the right is not a condition or contingency precedent to its existence. [Citations omitted.]To hold that an interest is terminable only because legal procedures are invoked to enforce an interest which is otherwise vested at the date of the husband's death, is to hold that all elective rights, such as the widow's allowance and the statutory interest in lieu of dower, are disqualified as marital deductions. [Footnote reference omitted.]In the instant case, we are faced with a situation very similar to the situation in Estate of Green v. United States, supra. In Mississippi, a widow has an "absolute" and "clear right" to the widow's allowance, but a widow can lose her right to the widow's allowance by failing to file for the allowance before the close of the decedent's estate, and the chancellor is required to fix the amount of the allowance. Because of the similarity of the Michigan widow's allowance and the Mississippi widow's allowance, the reasoning of the54 Sixth Circuit in Estate of Green v. United States, supra, applies to the issue of whether the Mississippi widow's allowance is a terminable interest.Under Mississippi law, a widow has an absolute right to the widow's allowance provided for in Miss. Code Ann. section 91-7-135 (1972). Westbrook v. Shotts, supra;Edwards v. McGee, supra. The possibility that, as a practical matter, a widow could lose that right if the appraisers fail to set aside the widow's allowance and the widow fails to claim the allowance before the decedent's estate closes does not change the fact that the widow had an absolute right under Miss. Code Ann. section 91-7-135 (1972) at the date of the decedent's death. We agree with 281 the Sixth Circuit that "To hold that an interest is terminable only because legal procedures are invoked to enforce an interest which is otherwise vested at the date of the husband's death, is to hold that all elective rights, such as the widow's allowance and the statutory interest in lieu of dower, are disqualified as marital deductions." Estate of Green v. United States, 441 F.2d at 308.55 Without a clear expression of intent from Congress that all rights such as the Mississippi widow's allowance should be considered terminable interests, we will not treat the necessity of invoking legal procedures as a condition or contingency making the Mississippi widow's allowance a terminable interest for purposes of section 2056. Accordingly, we hold that the requirement under Mississippi law that the chancellor make a final determination of the amount of the allowance and the possibility that the widow may lose her right to the allowance by failing to take some action to request the allowance are not conditions or contingencies that make the Mississippi widow's allowance a terminable interest. Consequently, we hold that the widow's allowance paid to the decedent's widow qualifies for the marital deduction provided in section 2056(a).The final issue for our decision is whether rental proceeds from the decedent's farmland were assets of the decedent's estate that were omitted from the gross estate on the decedent's estate tax return. Respondent contends that the portion of the 1980 and 1981 rent attributable to the decedent's farmland is an asset of the decedent's estate includable56 in the gross estate under sections 2031 and 2033. Respondent bears the burden of proof on this issue because he raised the issue after issuing the notice of deficiency. Rule 142(a). The value of the decedent's gross estate includes the value of all property to the extent of the decedent's interest therein at the time of his death. Secs. 2031(a) and 2033. The value of the gross estate includes the value of all property "beneficially owned by the decedent at the time of his death." Sec. 20.2033-1(a), Estate Tax Regs. Respondent must therefore prove that the decedent had an interest includable in the decedent's gross estate under section 2033.282 The decedent and his son, Henri P. Watson, Jr., rented the decedent's 1,073.18-acre parcel of farmland and Henri P. Watson, Jr.'s 1,020-acre parcel of farmland to Morgan Bros. in 1980 and 1981. For 1980, the decedent reported $ 57,074 in rental income, and Henri P. Watson, Jr., reported $ 25,000 in rental income. For 1981, the decedent reported $ 9,929 in rental income, and Henri P. Watson, Jr., received and reported $ 67,202.76 in rental income. The 1980 rental payment in the amount of $ 78,211.92 was deposited in the Unifirst57 Federal Savings & Loan Association of Jackson, Mississippi. The 1981 rent was paid by two checks. One check, in the amount of $ 6,000, was deposited in the Watson and Watson account at the First National Bank of Holmes County. The other check, in the amount of $ 71,131.76, was deposited in the account of H.P. Watson, Jr., in the Bank of Hazelhurst, Mississippi.Respondent's basic argument seems to be that decedent was entitled to $ 79,644.70 in rental income in 1980 and 1981, but that he only received $ 6,000 of this amount, and that as a result, decedent had a beneficial interest at his date of death in the remaining $ 73,644.70. Respondent contends that Henri P. Watson, Jr., owed the decedent a balance due of $ 73,644.70. (Respondent took the total rental income received for 1980 and 1981 of $ 155,343.68 ($ 78,211.92 plus $ 6,000 plus $ 71,131.76) and multiplied it by 51.27 percent (1,073.18 divided by the total acreage of 2,093.18) to arrive at a share for decedent of $ 79,644.70. Respondent then reduced this amount by the $ 6,000 deposited in the Watson and Watson account to arrive at the $ 73,644.70 he claims is the balance due to the decedent.) Respondent contends that58 "No matter what the reason the decedent's son kept this money, it belonged to his father and, on the date of his father's death, it was an asset of the estate." Respondent stated on brief that "The decedent's son had no 'right' to the decedent's share of the income. Petitioner has not contended that the son had such a right. Such a right could only arise on a gift made by the decedent to his son. No gift (likely taxable) has been alleged."Respondent appears to be arguing that the decedent had a beneficial interest at the date of his death in the rental 283 proceeds from his 1,073.18 acres for 1980 and 1981 unless petitioner can prove that there was a gift from the decedent to his son. In reality, petitioner does not have the burden of proving that there was a gift from the decedent to his son. Respondent bears the burden of proving that the decedent had a beneficial interest at the date of his death in $ 73,644.70 that was not included in his gross estate.Respondent contends that the 1980 rental payment of $ 78,211.92 deposited in the Unifirst Federal Savings & Loan Association was never transferred to the decedent and that the decedent never had possession and control59 of this money. Respondent further contends that the second 1981 rental payment of $ 71,131.76 was retained by the decedent's son in his bank account, and that no portion of this amount was ever paid or transferred to the decedent.The record is not clear regarding the 1980 rental payment of $ 78,211.92. At one point, Henri P. Watson, Jr., testified that the entire amount remained in the account at Unifirst Federal Savings & Loan Association. At another point, Henri P. Watson, Jr., testified that he only took $ 25,000 of the rental income for 1980. With regard to the 1981 rental payment, Henri P. Watson, Jr., testified that he kept the difference between the $ 9,929 reported by the decedent and the 1981 total rent of $ 77,131.76 (i.e., $ 6,000 plus $ 71,131.76). We find the testimony regarding the 1981 rent to be clear and credible. Accordingly, we find that Henri P. Watson, Jr., retained $ 67,202.76 of the rental proceeds for 1981. However, even if we assume that Henri P. Watson, Jr., kept the entire $ 78,211.92 for 1980 in addition to the $ 67,202.76 he kept for 1981, we find that respondent has failed to prove that the decedent had a beneficial interest at the date of his60 death in $ 73,644.70 that was kept by Henri P. Watson, Jr.The decedent and his son agreed when they rented their land that the decedent would at first keep all of the rental proceeds, and Henri P. Watson, Jr., would get improvements to his land. They also agreed that if the improvements were ever not a sufficient return for Henri P. Watson, Jr., Henri P. Watson, Jr., would take part of the rent. For 1981, the decedent and his son agreed that the decedent would take $ 9,929 and that Henri P. Watson, Jr., would take the rest of 284 the rent. Petitioner contends that these agreements concerning the division of rental proceeds were part of a partnership agreement between the decedent and his son. Respondent contends that after 1967 there was no partnership and therefore no partnership agreement. We need not resolve the issue of whether a partnership existed after 1967 because we find that regardless of whether a partnership existed after 1967, respondent has not met his burden of proving that the decedent had a beneficial interest on the date of his death in rent proceeds held by Henri P. Watson, Jr. Even if the agreement is not considered a partnership agreement, respondent*61 has not introduced sufficient evidence to prove that the decedent did not intend to make a gift to his son in 1980 and 1981 or that the son did not keep a larger portion of the rent proceeds in those years in exchange for his greater managerial role as the decedent's health failed. Furthermore, respondent introduced no evidence to show that the division of the rent proceeds was a result of a loan from the decedent to his son or that Henri P. Watson, Jr., was acting as a trustee of the rent proceeds for his father. The evidence in the record indicates no intention on the part of the decedent that the rent proceeds that went to Henri P. Watson, Jr., would ever be returned to the decedent. Consequently, we find that respondent has failed to prove that the decedent had a beneficial interest at his date of death in any of the rental proceeds retained by his son.To reflect the foregoing,Decision will be entered under Rule 155. Footnotes1. The blanks for 1976 and 1977 for Henri III and for 1975 for James signify that returns were not available for these years.↩2. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect as of the date of decedent's death, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩3. SEC. 2031. DEFINITION OF GROSS ESTATE.(a) General. -- The value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.↩4. SEC. 2033. PROPERTY IN WHICH THE DECEDENT HAD AN INTEREST.The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622068/	WILLIAM F. HUMPHREY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Humphrey v. CommissionerDocket No. 68237.United States Board of Tax Appeals33 B.T.A. 442; 1935 BTA LEXIS 752; November 12, 1935, Promulgated 752 1. The taxpayer and others made a contract to build a tunnel and agreed among themselves to share the profits and losses in stated proportions. They then organized a construction company to perform the contract; each acquired shares therein, in proportion to his interest in the contract, for his promissory note; and the contract was sublet to the construction company. Before the contract had been completed, the taxpayer and an associate owning a like interest transferred their stock to a cattle company in which they each owned one half of the stock, and the latter gave the construction company a note for the subscription price of the stock. The construction company completed the contract at a loss, which resulted in its insolvency. After the loss became known the taxpayer and his associate reacquired the stock previously transferred to the cattle company and assumed and paid the liability of the cattle company on its note and a proportionate share of the remaining liabilities of the construction company. Held, that neither the corporate entity of the construction company, the acts and circumstances surrounding its creation and existence, nor the fact that the taxpayer was753 not the owner of its stock when the loss was sustained, can be disregarded in determining whether the taxpayer sustained a deductible loss in the transaction. 2. The evidence as a whole does not justify a finding that, when the construction company's stock became worthless, the cattle company held the shares of such stock previously acquired from the taxpayer as nominee or trustee, or in any capacity other than that of an actual owner, and the taxpayer therefore may not take a deduction for a loss on the theory that he was at all times the owner of an interest in the construction company. 3. The reacquisition of the stock of the construction company by the taxpayer from the cattle company and the assumption by him of the liabilities of the latter, including the liability on the note given to the construction company, does not entitle the taxpayer to deduct any loss as cost to him of the construction company stock, since he knew when he reacquired the stock that the transaction would not result in a profit, but would make him liable for a part of the loss previously sustained by the construction company. 4. Where a stockholder assumes and pays his pro rata share of a particular754 debt of a corporation, which the corporation is able to pay but for which he is liable under the state law, and the evidence does not show that he disposed of his stock in the corporation or that it became worthless in the year in which the debt was paid, and there is no evidence of the cost or other basis of the stock, he may not deduct the amount paid as a loss sustained on his investment in the corporation. In such case, he is entitled only to increase (to the the corporation. In such case, he is entitled only to increase (to the the stock is actually disposed of or sold. Walter E. Barton, Esq., Joseph P. Tumulty, Esq., and R. C. Cushwa, Esq., for the petitioner. W. F. Gibbs, Esq., for the respondent. MURDOCK 443 In this proceeding the petitioner contests the Commissioner's determination of a deficiency in income tax for the calendar year 1929 in the amount of $29,468.87. The sole issue raised by the pleadings is whether the petitioner sustained a deductible loss in the amount of $126,993.66. FINDINGS OF FACT. The petitioner is an individual, residing in San Francisco, California. The County of Alameda, State of California, 755 in March 1925 asked for bids for the construction of a concrete traffic tunnel under the waters of the Oakland estuary between the cities of Oakland and Alameda, California. The petitioner and J. A. McCarthy, became interested in the project, partly because of the possibility of profit to the Old Mission Portland Cement Co., of which they were the highest officers and important stockholders, and also because of the profit which they expected to realize from the construction of the tunnel. They had previously joined with each other in various ventures on an equal basis. A. J. Crocker Co. and the Provident 444 Security Corporation decided to join them in this venture. These parties agreed that the petitioner and McCarthy would each take one half of a 35 percent interest, the Provident Security Corporation a 35 percent interest, and A. J. Crocker Co. a 25 percent interest in the venture. The remaining 5 percent was reserved for future subscription by employees or other disposition to be agreed upon later. Any losses sustained on the construction of the tunnel were to be paid by the respective parties in the same proportions. These parties intended to organize a corporation756 to construct the tunnel, but, due to shortness of time, they agreed that A. J. Crocker Co. should act as trustee for those interested and submit a bid to Alameda County. The bid was submitted by A. J. Crocker Co. and the contract was awarded to it by Alameda County on April 25, 1925. The total contract price was $3,882,958.40. A. J. Crocker Co. was required to give two bonds to Alameda County of $1,942,000 each. The surety companies, before writing the bonds, insisted that $500,000 in cash be deposited as collateral in the Anglo & London-Paris Bank of San Francisco and that certain of the parties give their personal bonds to the Surety Co. to indemnify the latter in the event of loss on account of writing the bonds. The petitioner did not give any bond in that connection. The Old Mission Portland Cement Co. deposited $300,000 and Louis Schoenberg, who was interested in the Provident Security Corporation, deposited $200,000 of the required $500,000. The Old Mission Portland Cement Co. made this deposit of $300,000 because the parties interested in the construction contract agreed to purchase all cement from it; because they also agreed that before resorting to this cash deposit, 757 the bonds the individuals and corporations interested would first be exhausted; and because they also agreed that they would be liable severally to repay the Old Mission Portland Cement Co. the $300,000, or any part thereof, that should be used for indemnification of the surety companies. Cement was purchased from the Old Mission Portlant Cement Co.The California Bridge & Tunnel Co. (hereinafter called the Tunnel Co.) was organized on May 18, 1925, under the laws of the State of California, for the purpose of completing the construction of the tube under the contract awarded to A. J. Crocker Co. The authorized capital stock of the Tunnel Co. was 10,000 shares each having a par value of $100. Only 5,000 shares were issued and they were subscribed for on July 15, 1925, as follows: SharesPercentageProvident Security Corporation1,75035A. J. Crocker Co1,25025J. A. McCarthy (for himself and the petitioner)1,75035Thornton Wilson (trustee)2505445 A certificate of 1,748 shares of the Tunnel Co.'s stock was made to J. A. McCarthy, and a certificate for one share each to E. I. Fitzpatrick and E. L. Hammond. The certificate made758 out to McCarthy was never detached from the stock certificate book, although he receipted for it. No cash was paid in for the stoc, but the stockholders gave their promissory notes therefor to the Tunnel Co. on July 2, 1925, in the following amounts: Provident Security Corporation$175,000A. J. Crocker Co125,000J. A. McCarthy (for himself and the petitioner)175,000Thornton Wilson, trustee25,000In order to obtain working capital the Tunnel Co. discounted its own $500,000 note at the Anglo & London-Paris National Bank, putting up its stockholders' notes aggregating $500,000 as collateral. A small amount of work on the tube was done by A. J. Crocker Co. That company sublet its contract to the Tunnel Co. on July 2, 1925. After the contract was sublet, the Tunnel Co. performed the work to be done under the contract, but the subcontract was not recognized by Alameda County. A. J. Crocker Co. continued to be responsible to the county. It collected the contract price and paid the same over to the Tunnel Co. in accordance with the terms of the subcontract. Contractors and cement companies complained because McCarthy was interested in the Old Mission759 Portland Cement Co. and at the same time was engaged in the construction business. It was, therefore, deemed advisable to allay this criticism. The 1,750 shares of Tunnel Co. stock which McCarthy subscribed for on behalf of himself and the petitioner were transferred on September 23, 1926, to the Mission Land & Cattle Co. (hereinafter called the Cattle Co.), a California corporation, all of the stock of which was owned by McCarthy and the petitioner in equal proportions. The Cattle Co. gave the Tunnel Co. its note dated October 8, 1926, for $175,000 for the 1,750 shares of stock and this note was placed in the Anglo & London-Paris National Bank as collateral security for the indebtedness of the Tunnel Co. The record does not show what became of McCarthy's note for $175,000. The 250 shares of stock held by Thornton Wilson, trustee, were transferred in September 1926 to F. S. Smith, trustee, and held by him until about July 11, 1929. F. S. Smith was the secretary of the Cattle Co. That company on October 8, 1926, gave its note for $25,000 to the Tunnel Co. The Tunnel Co. completed the Oakland-Alameda Tube in July 1929 at a loss of approximately $750,000, which resulted in760 the insolvency of the company. It was known for some time that such a loss would result. The Tunnel Co. called upon its stockholders to 446 pay their respective notes aggregating $500,000 given in payment for its capital stock. The board of directors of the Tunnel Co. on July 15, 1929, held a special meeting for the purpose of considering and acting upon offers received relating to the payment of these promissory notes. The minutes of that meeting recite the desire of the petitioner and J. A. McCarthy to acquire the 1,750 shares of the Tunnel Co.'s capital stock owned by the Cattle Co. and in payment therefor to assume the indebtedness of that company to the Tunnel Co. in the sum of $175,000. A resolution was adopted at the meeting consenting to the assumption of this indebtedness by these two individuals in equal proportions. The minutes also recite the desire of A. J. Crocker Co., Provident Security Corporation, J. A. McCarthy, and the petitioner to acquire the 250 shares of the capital stock of the Tunnel Co. owned by the Cattle Co. and to assume the indebtedness of that company to the Tunnel Co. in the sum of $25,000, and a resolution was adopted consenting to the761 assumption of that indebtedness as follows: A. J. Crocker Co$6,580Provident Security Corporation9,210William F. Humphrey4,605J. A. McCarthy4,605A resolution was also adopted that upon the assumption by those individuals and corporations of the $200,000 indebtedness due the Tunnel Co. from the Cattle Co. the officers of the Tunnel Co. would cancel and return to the Cattle Co. its promissory notes in the amount of $200,000. The 1,750 shares of stock of the Tunnel Co. issued in the name of the Cattle Co. were transferred on July 15, 1929, to McCarthy, 875 shares; to the petitioner, 874 shares; and to F. S. Smith, trustee, 1 share. On or about the same date, the 250 shares of Tunnel Co. stock owned by the Cattle Co. were taken over by A. J. Crocker Co., Provident Security Corporation, McCarthy, and the petitioner in the same proportions as their original investments, McCarthy and the petitioner each receiving 46.05 shares. The capital stock of the Tunnel Co. was worthless prior to July 15, 1929. The petitioner, McCarthy, A. J. Crocker Co., and the Provident Security Corporation borrowed the following amounts from the Anglo & London-Paris National762 Bank on their promissory notes dated July 15, 1929: Petitioner$93,358.74J. A. McCarthy93,358.74A. J. Crocker Co133,398.60Provident Security Corporation186,717.48The amounts borrowed by A. J. Crocker Co. and the Provident Security Corporation were deposited in their checking accounts at the 447 bank and they gave the Tunnel Co. their checks for $133,398.60 and $186,717.48, respectively, which were deposited by that company on July 18, 1929, in its account at the bank. The petitioner and McCarthy each directed that the amounts they borrowed be credited to the account of the Tunnel Co. The vice president and cashier of the bank, on July 30, 1929, made out two cashier's checks for $93,358.74 each, one payable to the order of the petitioner and the other to the order of J. A. McCarthy, and these checks were endorsed in the names of the petitioner and McCarthy, respectively, by the vice president and cashier of the bank and deposited to the credit of the Tunnel Co. on July 30, 1929. Previously, on July 5, 1929, the Cattle Co. paid $2,799.84 in cash to the Tunnel Co. After receiving these amounts the Tunnel Co. drew a check on the Anglo & London-Paris763 National Bank for $506,833.56 in payment of its own note of $500,000 and accrued interest thereon of approximately $6,833.56. The notes of the Cattle Co. in the amounts of $175,000 and $25,000 were surrendered by the bank on July 30, 1929. The Tunnel Co., after paying its note of $500,000 at the Anglo & London-Paris National Bank, still owed other creditors about $188,166.44. The Tunnel Co. borrowed $188,166.44 at the Anglo & London-Paris National Bank on July 30, 1929, and the stockholders guaranteed their proportionate share of this amount. The petitioner guaranteed 18.42 percent. The petitioner paid cash to the Tunnel Co. in the amount of $2,763 on November 30, 1929. The Tunnel Co. was liquidated and dissolved in December 1929. The company's note for $188,166.44 had been reduced by that time to $160,000. The bank demanded on December 2, 1929, that the stockholders make good their guaranty by paying the unpaid balance of $160,000. The petitioner then gave to the Anglo & London-Paris National Bank his personal note for $29,472 dated December 2, 1929 He gave the bank a new note for $122,830.74 dated December 31, 1929, in place of his note for $29,472 and his note for $93,358.74, 764 above mentioned. The petitioner used the cash receipts and disbursements method of accounting for and reporting his income. OPINION. MURDOCK: The petitioner was on the cash receipts and disbursements basis and could not, under any circumstances, deduct as a loss for 1929 more than he actually paid in that year. A payment of $2,799.84 in cash to the Tunnel Co. was made on July 5, 1929. But that payment was made by the Cattle Co. The petitioner stated that one half of that amount was paid on his behalf. He was not a 448 stockholder of the Tunnel Co. at that time. The petitioner paid $2,763 in cash to the Tunnel Co. on November 30, 1929. The evidence does not disclose the purpose of either of those payments. The petitioner borrowed $93,358.74 from a bank on his promissory note and paid the money thus borrowed to the Tunnel Co. Of that payment $87,500 represented payment at par for one half of the 1,750 shares of Tunnel Co. stock; $4,605 represented a similar payment for 46.05 shares; and $1,253.74 represented a proportionate part of the interest on the Tunnel Co.'s note for $500,000. The petitioner includes in the amount of the deduction which he claims not only765 all of the above items, but also an item of $29,472. The petitioner and other stockholders of the Tunnel Co. on July 30, 1929, guaranteed a loan which was made to the Tunnel Co. by a bank on a note of the Tunnel Co. The bank demanded on December 2, 1929, that the stockholders make good their guaranty by paying the unpaid balance of the note in the amount of $160,000. The petitioner's share of this unpaid balance was $29,472. He gave his promissory note to the bank for that amount. That bank then held two of his promissory notes - the one for $93,358.74, above described, and the one just given for $29,472. He combined the amounts of those two notes and gave a new note for the total of $122,830.74 either on the 31st of December 1929 or early in January 1930. Evidence of both dates came from the petitioner's witnesses. There might be considerable doubt as to whether all of these amounts were paid in 1929 and represented losses by one on the cash receipts and disbursements basis. However, the questions thus suggested need not be decided, for reasons which will later appear. The petitioner advances three different arguments to support his claim that he is entitled to deduct766 $126,993.66 from his income for 1929 as a loss under section 23(e)(2) of the Revenue Act of 1928. 1 The first argument which he makes is that he became liable under the original agreement of the parties for a certain share of any loss which might result from the construction of the tube; his share of the loss turned out to be $126,993.66; he paid this amount in 1929; the transaction was entered into for profit and therefore he is entitled to deduct the amount in controversy as a loss under section 23(e)(2). He reasons, in this connection, that the Tunnel Co. was a mere agency created for the sole purpose of constructing the tube; the parties to the original agreement contributed to the Tunnel Co. 449 only what they would have been required to pay if the corporation had never been organized; therefore the corporate entity of the Tunnel Co. should be disregarded. 767 The petitioner originally entered into the transaction for profit and agreed to share a portion of any loss which might result. In the end he assumed, and probably paid, his share of the loss which resulted from the construction of the tube. But between the original agreement and the ultimate payment of the loss a number of transactions having tax significance intervened. Those intervening transactions can not be ignored. The original parties to the venture formed a corporation. The contract to construct the tube was turned over to that corporation. The corporation actually constructed the tunnel and sustained the loss. Furthermore, it paid for the loss. The petitioner subscribed for stock of that corporation. Instead of paying cash for the stock at the time of his subscription his associate gave a note in the amount of $175,000 to the corporation. That note represented merely a promise to pay. Later, for reasons satisfactory to the petitioner and his associate, they ceased to be stockholders of the corporation and allowed the shares which they had previously owned to become the property of the Cattle Co. The Cattle Co. gave its note to the corporation for $175,000. The768 evidence does not show that the note given by McCarthy was surrendered, but certainly the petitioner can derive no benefit from the lack of proof in regard to what became of that note. The note was never paid. If he remained liable on that note he should have proven the facts to show his liability. If any inference were to be drawn, the natural one would be that McCarthy's note was surrendered when the note of the Cattle Co. was received by the Tunnel Co. In any event the Cattle Co. became the owner of the stock and the petitioner ceased to be the owner of any stock in the Tunnel Co. The Cattle Co. was the owner of the Tunnel Co. stock when that stock became worthless. Thereafter the petitioner reacquired some of the stock of the Tunnel Co. from the Cattle Co. and voluntarily assumed liability thereon for a proportionate part of the loss of the Tunnel Co. There is no sound reason in this case for disregarding the corporate entity of the Tunnel Co., the acts and circumstances surrounding its creation and existence, or the fact that its stockholder, at the time the loss was sustained and its stock became worthless, was the Cattle Co., not the petitioner. The following statement769 of the Supreme Court in , is apposite: "While unusual cases may require disregard of corporate form, we think the record here fails to disclose any circumstances sufficient to support the petitioner's claim. Certainly the Improvement Company and the estate were separate 450 and distinct entities; the former was avowedly utilized to bring about a change in ownership beneficial to the latter." Consequently the first argument advanced by the petitioner is rejected as unsound. The petitioner next argues that he and McCarthy were at all times the owners of 1,750 shares of stock of the Tunnel Co. and were at all times personally responsible for their proportionate part of the 250 shares which were held in trust; the Cattle Co. never owned any of the stock; and, therefore, he is entitled to deduct a loss of $126,993.66, representing his investment in the stock of the Tunnel Co. which became worthless in 1929. This contention is not supported by the facts. The petitioner and McCarthy originally subscribed for 1,750 shares of stock. They did not pay for this stock in cash, but merely gave a note whereby770 they promised to pay $175,000 in the future. The note was never paid. They never received a certificate for the shares. The Cattle Co. acquired the 1,750 shares in question in 1926. It did not pay cash at that time, but gave its promissory note for $175,000 to the Tunnel Co. It was the actual owner of the 1,750 shares of stock when those shares became worthless. Although the petitioner's contention finds some support, the evidence as a whole does not justify a finding that the Cattle Co. held the stock merely as nominee, or that it held the stock in any other fiduciary capacity. Two hundred and fifty shares of Tunnel Co. stock were held in trust. The trustee was changed from time to time. When the stock became worthless the stockholders of the Tunnel Co. other than the trustee were liable for the entire loss which the Tunnel Co. had sustained. The Tunnel Co. then called upon its stockholders to pay for their stock. The petitioner had ceased to own any interest in the Tunnel Co. prior to that call for payment of the subscription price and prior to the time that the Tunnel Co. stock became worthless. The record does not show that the Cattle Co. was unable to shoulder its771 entire responsibility as a stockholder of the Tunnel Co. If it had paid its share of the loss the petitioner would have had no loss to pay. The petitioner is not entitled to deduct the loss which he claims on the theory that at all times he was the owner of one half of a 35/95 interest in the Tunnel Co. He maintains, as a sort of alternative to this second contention of his, that he is entitled to deduct the amount in question as the cost of the Tunnel Co. stock, even if it be held that he and McCarthy purchased the 1,750 shares from the Cattle Co. in July 1929. The acquisition by the petitioner of the Tunnel Co. stock from the Cattle Co. in July 1929 was not a transaction entered into for profit. He was fully aware before he entered into that transaction that it would 451 not result in a profit, but, on the contrary, would make him liable for a part of the loss sustained by the Tunnel Co. in the construction of the tube. Any loss from that transaction would not be deductible under section 23(e)(2), since it was not sustained in a transaction entered into for profit. Neither would it be deductible under section 23(e)(1), since it was not a loss sustained in connection772 with the petitioner's trade or business. No effort was made to show what the petitioner's trade or business was. He has not shown and he does not claim that the loss was sustained in connection with his trade or business. The Cattle Co., as owner of the Tunnel Co. stock in July 1929, was liable for 35/95 of the loss sustained by the Tunnel Co. in the construction of the tube. The petitioner, by voluntarily assuming one-half of the liability of the Cattle Co. on account of the loss of the Tunnel Co. did not become entitled under section 23(e) to any deduction from his income tax. The petitioner's final argument is that he was liable as a stockholder of the Cattle Co. for one half of the indebtedness of the Cattle Co. on its note for $175,000 which it had given to the Tunnel Co.; he assumed and paid one half of the debt and interest, or $88,753.74; his investment in the Cattle Co. was a transaction entered into for profit; and he is entitled to deduct $88,753.74 as a loss sustained by him in a transaction entered into for profit. The parties agree that in California a stockholder is liable for his proportionate part of the debts of the corporation in which he owns stock contracted773 during the period of his stockholding. Nevertheless, the petitioner is not entitled to deduct any amount on this theory. The Cattle Co. was liable for its debt to the Tunnel Co., and if the Cattle Co. was unable to pay that debt, such fact does not appear in this record. If he paid the amount in question because he held one half of the stock in the Cattle Co., that payment was a voluntary one on his part and merely served to increase the basis for gain or loss in his hands of the Cattle Co. stock. ; affd., ; certiorari denied, ; . The cost of the Cattle Co. stock to the petitioner has not been shown. There is no evidence to indicate that the Cattle Co. stock was worthless in 1929. The petitioner still held his stock in the Cattle Co. at the end of 1929. His investment in the stock of the Cattle Co. may have been a transaction entered into for profit, although there is no proof on that point. Since the Cattle Co. stock was not worthless in 1929 and was not disposed of any the petitioner in 1929, no gain or loss for 1929 based upon774 his investment in the Cattle Co. stock can be computed for that year. The additional amount which he 452 invested in the stock of the Cattle Co. by paying the $888,753.74 will be taken into consideration in computing his gain or loss when he disposes of his Cattle Co. stock. The petitioner has not claimed the right to deduct more than $88,753.74 on this theory. However, the Tunnel Co. sustained its entire loss while the Cattle Co. was a stockholder. The Cattle Co. was liable as a stockholder of the Tunnel Co. for the latter's indebtedness. If the petitioner were to argue that as a stockholder of the Cattle Co. he was liable for a part of this additional indebtedness and for the loss which its payment represented to him, the answer would be that any payment which he made in this connection would likewise represent additional investment in the stock of the Cattle Co. Thus on no theory that has been suggested would the petitioner be entitled to deduct the loss which he claims. The petitioner originally joined with others in a joint venture. At that time he was in position to become liable for a share of any future losses of the venture, as well as to share in its future775 profits. The form for carrying out the venture was changed when the individuals organized the corporation and transferrred to it the contract for the construction of the tube. There was no longer a joint venture with individual liability for future loss and individual rights to future gains. Thereafter it was a corporate venture. The petitioner ceased to be a stockholder in the Tunnel Co. Thereafter he was no longer responsible, on his original agreement, for any future losses sustained in the construction of the tube. The original parties to the venture, prior to the organization of the corporation, also made themselves personally liable to the parties who deposited cash for the protection of the indemnity company, and they also made themselves liable to the parties who gave their personal bonds for the protection of the depositors of the cash. The liability thus created may have persisted until and throughout 1929. However, the depositors of the cash lost nothing, those who gave their personal bonds were not called upon to make good any loss of the depositors, and the petitioner was not called upon to indemnify the ones who had given their bonds. Thus he sustained no loss776 as a result of those original agreements. The Tunnel Co., in taking over the contract for the construction of the tube, agreed to indemnify and hold harmless the general contractor. The loss of the Tunnel Co. was paid without recourse to the bonds or deposits made before it was organized. The Cattle Co., as one of the stockholders of the Tunnel Co., was liable for its share of the loss of the Tunnel Co. There is nothing in the record to indicate that it was not at all times able to meet 453 its obligations. It thus stood between the petitioner and any possible loss on his part. But the petitioner voluntarily assumed a part of the liability of the Cattle Co. to the Tunnel Co. The revenue act, however, does not permit the transfer of a loss of a corporation to its stockholders under such circumstances. Deductions are purely statutory and if no specific authorization can be found in the statute no deduction can be taken. The Board is not called upon at this time to decide whether or not the Cattle Co. might be entitled to deduct a loss. The plan whereby the Cattle Co. became a stockholder in the Tunnel Co. was designed to serve useful purposes of the petitioner and777 McCarthy. If the Tunnel Co. had made a profit on the construction of the tube, the Cattle Co. could have received its share of the profit tax free as dividends. Since the Tunnel Co. sustained a loss, it is to the petitioner's advantage to disregard his act of substituting the Cattle Co. for himself as a stockholder. Having voluntarily made the Cattle Co. the stockholder for the benefits which that step offered, he must likewise accept its inherent disadvantages. Decision will be entered for the respondent.Footnotes1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * (e) Losses by individuals. - In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise - * * * (2) if incurred in any transaction entered into for profit, though not connected with thre trade or business; * * * ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622069/	Harold E. Ryman and Marion J. Ryman, Husband and Wife v. Commissioner. John D. Thompson and Suzette D. Thompson, Husband and Wife v. Commissioner.Ryman v. CommissionerDocket Nos. 37408, 37409.United States Tax Court1953 Tax Ct. Memo LEXIS 111; 12 T.C.M. (CCH) 1093; T.C.M. (RIA) 53390; September 21, 1953John C. Ristine, Esq., 920 Southern Building, Washington, D.C., for the petitioners. A. E. Carpens, Esq., for the respondent. LEMIRE Memorandum Findings of Fact and Opinion These consolidated proceedings involve deficiencies in income tax for the year 1944 as follows: Harold E. Ryman and Marion J.Ryman$861.07John D. Thompson and SuzetteD. Thompson872.93The sole contested issue is whether the gain realized upon the sale in 1944 of Davis Shores lots is taxable as ordinary income. The stipulated facts are found accordingly. Findings of Fact The petitioners and their respective wives are individual taxpayers residing at St. Augustine, Florida. Their respective joint tax returns for the year 1944 were filed with112 the collector of internal revenue at Jacksonville, Florida. Harold E. Ryman and John D. Thompson, hereinafter referred to as the petitioners, since October 1925 have operated a real estate and insurance business in the City of St. Augustine, Florida, as equal partners under the name of Thompson-Ryman Realty Company. The business was operated under an oral agreement until September 30, 1942, when the petitioners entered into a written agreement containing, inter alia, the following provision: "FIRST: That the only business held, owned and operated by them, made the subject matter of this contract, is the business conducted by them under the partnership name of Thompson-Ryman Realty Co., dealing with (a) real estate sales, rentals, and life insurance, (said life insurance agency held in the name of J. D. Thompson, but actually a part of the foregoing partnership assets or business) and (b) with First Insurance, Casualty Insurance and Fidelity and Surety Bonds; and all matters pertaining to or connected with said business." The partnership rented office space but owned its office equipment. The petitioners have been licensed real estate brokers since 1925 and advertise and hold113 themselves out as real estate brokers. During the period of their activities from 1925 they have dealt with a substantial number of buyers of real estate and are well known in St. Augustine, Florida. A partnership return was filed for the taxable year 1944 which was prepared by Lloyd Clark, a public accountant. In preparing the partnership return for 1944, the accountant took the information on the Davis Shores lots and other land sales from the books and put it on a Form 1065. He then put the information on the operations of the partnership on another Form 1065 and consolidated the information on the two forms on to one Form 1065, which was filed with the collector of internal revenue. The partnership listed the business as "Real Estate & Insurance Agency" and under the line provided for answering the question as to the nature of the organization stated, "Partnership & Joint Venture." The return was signed by petitioner John D. Thompson, as partner. The Davis Shores property involved in these proceedings consisted of 1,062 lots in a subdivision which had been subdivided prior to May 8, 1935. There were 810 lots with clear title and 252 lots with clouded title. Davis Shores, 114 Inc., was incorporated on April 20, 1935. The entire capital stock consisted of 30 shares of which George D. Reddington held 12 shares and the petitioners 9 shares each. The charter of Davis Shores, Inc., provided that the nature of the business to be transacted was - * * "to purchase or otherwise acquire and deal in real and personal property and any interest therein; * * * to survey, plat, sub-divide, sell, improve, manage, develop, lease, mortgage, dispose of, turn to account or otherwise deal with all or any part of any real estate which may be acquired by the corporation., * * ." On May 8, 1935, the corporation acquired the Davis Shores properties. The lots were of varying size. There were a few graded streets and curbing was in place in some areas. Only one street was paved and that was the United States highway. There were a few sewer lines and a few sidewalks. The city had also extended the water lines. On January 20, 1941, George D. Reddington died and the petitioners jointly acquired from his estate the 12 shares of the capital stock of Davis Shores, Inc. On April 30, 1941, Davis Shores, Inc., was dissolved and its assets, including the Davis Shores property consisting115 of an estimated 746 lots, were distributed to the petitioners in exchange for the 30 shares of its outstanding stock. A deed dated April 30, 1941, executed by Davis Shores, Inc., conveyed the property to Harold E. Ryman and John D. Thompson, the petitioners herein. A schedule of liquidation was included in the minutes of a special meeting of the stockholders of Davis Shores, Inc., held on April 30, 1941. A copy of such schedule was filed with the final income tax return of Davis Shores, Inc., for the period May 1, 1940, to April 30, 1941. On its final income tax return Davis Shores, Inc., returned a gross profit of $7,652.57. This was income returned from the sale of lots during the fiscal year ended April 30, 1941. During the period of the existence of Davis Shores, Inc., the Thompson-Ryman Realty Company was the exclusive sales agent for the lots owned by Davis Shores, Inc. During the period of the corporation's existence approximately 50 lots were sold or otherwise disposed of each year. The books and records of Davis Shores, Inc., were kept in the offices of the Thompson-Ryman Realty Company and the entries were made there. After the petitioners acquired the Davis Shores116 properties the books were still kept in the same office. The petitioner, John D. Thompson, either made or supervised the day-to-day entries and the deposits were made in a separate bank account. The accountant went to the office at irregular intervals of from one to six months and consolidated the information kept by petitioners. The separate books and records pertaining to the Thompson-Ryman Realty Company were kept by John D. Thompson and were used by the accountant for the purpose of making up the tax returns. From May 1, 1941, through December 31, 1951, the petitioners made the following sales of Davis Shores lots: NumberNumberTotalofof lotsconsider-YearsalessoldationMay 1941-December 19411335$ 4,828.58194249700.001943692,550.00194415307,006.30Subtotal3883$ 15,084.881945229423,925.001946197423,690.001947135417,750.001948206334,748.75194982415,060.0019503510753,991.431941165642,945.00Total171555$227,195.06The 1944 return of the Thompson-Ryman Realty Company shows real estate sales as follows: Date acquiredDescriptionGross priceGain5- 1-41Lots - Davis Shores$ 7,006.30$6,150.872- 7-41Lots - Surfside2,497.062,063.084-30-41WPB - Property15,000.008,946.681942Acreage642.00381.173- 9-35Lot St. Augustine6,000.003,965.98(Installment Sale - Collected, $1,500)Total gross sales price$31,145.36Total profit on real estate sales$21,405.78117 Ordinary net income in the amount of $13,169.51 from other activities was shown on the 1944 partnership return. The petitioners' shares of income and credit shown on the partnership return for 1944 of the Thompson-Ryman Realty Company were as follows: OrdinaryCapitalincomegainJohn D. Thompson$ 7,584.75$4,633.33Harold E. Ryman5,584.764,633.33Total$13,169.51$9,266.66Petitioners John D. Thompson and wife, Suzette D. Thompson, on their 1944 income tax return reported income as follows: Dividends and interest$ 187.50Income from rents and royalties(107.18)Net capital gain4,633.33Income from Thompson-RymanRealty Company (a partner-ship)7,584.75Total$12,298.40Petitioners Harold E. Ryman and wife, Marion J. Ryman, on their 1944 income tax return reported income as follows: Income from United States Navy$ 540.00Dividends and interest524.28Net capital gain4,851.50Income from Thompson-RymanRealty Company (a partner-ship)5,584.76Total$11,500.54During the taxable year 1944 the petitioners were engaged in the real estate business and the Davis Shores lots sold by118 them were property held by them primarily for sale to customers in the ordinary course of their trade or business. Opinion LEMIRE, Judge: The sole question presented is whether the gains realized from the sale of certain real estate known as the Davis Shores lots, in the taxable year 1944, under the facts set forth in our findings of fact are taxable as ordinary income or as profits from the sale of capital assets. The issue is one of fact and is to be resolved upon an appraisal of all the pertinent facts and circumstances presented by the particular case under review. Reynolds v. Commissioner, 155 Fed. (2d) 620; Van Suetendael v. Commissioner, 152 Fed. (2d) 654; South Texas Properties Co., 16 T.C. 1003">16 T.C. 1003. The respondent contends that the facts revealed by this record clearly establish that the Davis Shores lots were property held by the petitioners for sale to customers in the ordinary course of their trade or business and are not capital assets as defined by section 117 (a) of the Internal Revenue Code. Viewing the pertinent facts in the light of their relative importance, we are convinced that the properties in question119 were not capital assets, and the profit realized from the sale in the taxable year 1944 constitutes ordinary income. Without reiterating all of the facts set forth in our findings, we will summarize those factors which we think support the conclusion that the petitioners were dealers and not mere investors with respect to the real property in question. Since 1925 the petitioners have been licensed real estate brokers conducting a partnership under the name of the Thompson-Ryman Realty Company. The principal business of the partnership was operating a real estate and insurance agency. In 1935 the petitioners and one Reddington formed a corporation to acquire 1,062 lots of varying sizes in a subdivision which had been divided by prior owners. The corporation was authorized to deal generally in real estate. Between 1935 and 1941, the corporation sold several hundred of these properties, known as the Davis Shores lots, returning the profit realized as ordinary income. During such period the partnership acted as exclusive sales agent for the corporation on a commission basis. In 1941 Reddington died and the petitioners jointly acquired the shares of the capital stock of the corporation120 from his estate. In 1941 the petitioners, owning all of the stock of the corporation, caused the remaining lots to be deeded by the corporation to themselves jointly and the corporation was dissolved. While the corporation was in existence its books and records were kept at the office of the partnership and the entries in the books were made by an accountant. After the dissolution of the corporation the same procedure was followed throughout the succeeding years, including the taxable year involved. After the Davis Shores lots were conveyed by the corporation to the petitioners, sales of the lots continued. During the period May 1941 through the calendar year 1944, a total of 83 lots was sold, 30 of which were sold in the taxable year 1944. When the properties were acquired by the corporation, a few sidewalks and curbs had been laid and the water mains had been extended. Neither the corporation nor the petitioners made additional improvements. The lots were not advertised for sale by either the corporation or the petitioners. The fact that the petitioners followed the same method pursued by the corporation and continued to make frequent sales of the lots, in our opinion, serves121 to demonstrate the status of petitioners as dealers. In support of their contention that the lots in question were capital assets, the petitioners point to their partnership agreement indicating that the Thompson-Ryman Realty Company conducted only a real estate and insurance agency; that separate books and records were kept covering the partnership business and the activities in connection with the Davis Shores lots; and that the petitioners did not advertise or engage in sales activity with respect to the lots. Petitioners seek to explain away the reporting on the partnership return filed by the Thompson-Ryman Realty Company of the profits realized from the sale of the Davis Shores lots as an error of the accountant who made out the return. We think the evidence upon which the petitioners rely, when viewed in the light of its relative importance to all of the facts, does not establish that the petitioners held the Davis Shores lots as investors. The fact that the partnership agreement refers only to the character of the business conducted by the partnership, carried on under the name of the Thompson-Ryman Realty Company, and makes no reference to the Davis Shores lots is without122 significance. The petitioners could and, we think, did carry on two separate business activities. That the petitioners did not advertise or carry on sales activities with respect to the lots in question, while one of the factors we have taken into consideration, is of slight relative importance, since the petitioners were well known as licensed real estate brokers and the owners of the lots, and the two businesses were conducted from the same office. The petitioners did advertise the Thompson-Ryman Realty Company and actively engaged in selling properties for other owners. The fact that the profits realized from the sale of the Davis Shores lots were reported on the partnership return, filed by Thompson-Ryman Realty Company, is likewise without significance. That return stated the nature of the organization as "Partnership & Joint Venture" and, we think, the latter term was intended to cover the activities of the petitioners in connection with the sale of the Davis Shores lots. Giving due consideration to all pertinent facts and circumstances and their relative importance, we hold that the Davis Shores lots were property held primarily for sale to customers in the ordinary course123 of petitioners' trade or business. Therefore, we sustain the respondent's determination that the profits realized from the sale of such lots in the year 1944 are taxable as ordinary income. Decisions will be entered for the respondent.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622070/	THE ANN ARBOR RAILROAD COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. MANISTIQUE AND LAKE SUPERIOR RAILROAD COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Ann Arbor R.R. v. CommissionerDocket Nos. 25869, 35337.United States Board of Tax Appeals29 B.T.A. 331; 1933 BTA LEXIS 958; November 14, 1933, Promulgated 958 1. The guaranty income received by a carrier under section 209 of the Transportation Act, 1920, is taxable under the Revenue Act of 1918 at 10 percent. 2. The allowance made by the Director General for undermaintenance during Federal control must be subtracted from the total maintenance expenditure for 1920 to determine the carrier's deduction for maintenance expense. L. H. Strasser, Esq., for the petitioners. E. C. Algire, Esq., for the respondent. STERNHAGEN 331 The respondent determined deficiencies in income and profits taxes of the Ann Arbor Railroad Co. and the Manistique & Lake Superior Railroad Co. for 1920 in the amounts of $88,611.79 and $516.11, respectively. The petitioners assign the following errors: (1) The disallowance of a deduction of $685.42, being an assessment made by the Association of Railway Executives; (2) The inclusion in gross income of $315,261.85 and $36,686.60, received by the petitioners from the United States under the guaranty provisions of section 209(c) of the Transportation Act, 1920; (3) Alternatively to (2), the computation of the tax upon the amounts received at the rate of 10 percent instead959 of 8 percent; (4) The disallowance of deductions of $574,191.51 and $23,979.75, expenditures in the period March 1 to December 31, 1920, for maintenance; (5) The failure to restore to earned surplus, for invested capital purposes, $2,725,556.79, alleged cost of additions and improvements made to petitioners' properties in prior years, and charged to operating expenses of those years; (6) The inclusion in gross income of $11,877.51 and $2,082.08, credits to profit and loss and to operating expenses, respectively, on the books of The Ann Arbor Railroad Company, in connection with the sales of certain equipment to the Manistique and Lake Superior Railroad Company; (7) The inclusion in gross income of $1,452.55, alleged profit realized by the Ann Arbor Railroad Company upon the purchase and retirement of its Two Year 6% Collateral Gold Notes; (8) The omission of a deduction of $31,000, operating expenses related to the sale of a certain spur track; (9) The omission of a deduction of $37,007.36, alleged loss sustained in the sale of a certain spur track; and (10) The computation of the normal income tax at 10 percent upon the entire net income instead of 8 percent upon the960 net income earned in January and February and 10 percent upon the balance. The petitioners withdrew the fifth assignment of error. The respondent confesses the errors charged in the first, sixth, and tenth assignments. 332 FINDINGS OF FACT. The Ann Arbor Railroad Co., hereinafter referred to as the Ann Arbor, and its subsidiary, the Manistique & Lake Superior Railroad Co., hereinafter referred to as the Lake Superior, are corporations, with their principal offices at St. Louis, Missouri. They filed a consolidated return for 1920. On January 30, 1931, they agreed in writing that any deficiencies in income and profits taxes, computed upon the basis of consolidated returns for 1920 and 1921, should be assessed against, and any overassessment of such taxes for the above named years should be abated, credited, or refunded to the Ann Arbor. The petitioners' books of account were kept upon an accrual basis. I. The petitioners accepted section 209 of the Transportation Act, 1920. Pursuant thereto the United States paid to the Ann Arbor and the Lake Superior $315,261.85 and $36,686.60, respectively, in accordance with certificates of amounts due issued by the Interstate961 Commerce Commission, dated June 4, 1921, and December 17, 1923, respectively. II. The amounts of the guaranty income stated in findings I were, in respondent's determination, subjected with other income to normal tax at the rate of 10 percent. III. The railroad properties of the petitioners were under Federal control throughout the period January 1, 1918, to February 29, 1920, inclusive. There was no Federal control agreement with the Director General of Railroads. On August 13, 1920, the Ann Arbor filed a claim with the Director General pertaining to matters arising out of Federal control, in the aggregate amount of $1,346,515.99, made up of the following items: Deferred maintenance for the period of Federal control:Way and structures$507,968Equipment515,431$1,023,399.00Material and supplies150,000.00Interest and depreciation on additions and betterments173,116.99Total of claim1,346,515.99333 On February 28, 1921, the Ann Arbor filed a supplemental claim with the Director General, in the aggregate amount of $221,661.16, made up of the following items: Increase of standard return based on adjustment of back mail pay$5,302.44Additional amount claimed for deferred maintenance during Federal control:Equipment216,358.72Total of supplemental claim221,661.16962 On March 23, 1921, the Ann Arbor filed another supplemental claim with the Director General, in which an additional $92,679.42 was claimed for deferred maintenance or undermaintenance of freight train cars during Federal control. That claim was accompanied by the Lake Superior's claim against the Director General for $20,631.95, an additional maintenance allowance in respect of way and structures during Federal control. On March 29, 1921, the petitioners filed their final claims and statements of accounts with the Director General, as follows: Ann ArborLake SuperiorDue to Corporation:Compensation$1,148,138.62$46,424.46Less advances, loans, etc1,107,780.0040,358.6246,424.46Rental interest on completed additions and betterments8,437.771,614.80Cash, December 31, 1917149,343.4133,107.13Agents and Conductors balances, Dec. 31, 191759,893.9413,444.77Assets December 31, 1917, collected283,995.3236,141.90Total542,029.06130,733.06Due from Corporation:Liabilities December 31, 1917, paid1,114,976.1153,505.13Corporate transactions139,995,8913,696.22Expense prior to January 1, 1918177,124.408,103.79Revenue prior to January 1, 191845,162.991,477.55Additions and betterments213,369.4428,739.33Total1,690,628.83105,522.02Balance due from Corporation on quarterly settlement accounts1,148,599.7725,211.04Other items due to Corporation:Materials and supplies (net)150,000.0015,144.75Accrued depreciation - Equipment150,933.3311,482.82Equipment retired46,446.72572.07Road property retired and not replaced20,264.27Interest on deferred compensation$5,699.27Interest on open accounts due to corporation14,505.50Additional depreciation on equipment$123,912.80Interest and depreciation on car ferry and equipment183,166.99Additional compensation account back mail pay5,302.44Total680,026.5547,404.41Other items due from Corporation:Net interest due Government other than rental136,359.86Materials and supplies, February 29, 192024,167.42Total136,359.8624,167.42Balance due to Corporation on other items543,666.6923,236.99Balance due from Corporation604,933.08Balance due to Corporation48,448.03Maintenance:Maintenance of way and structures (under)507,968.0020,631.95Maintenance of equipment (under)700,566.34Balance due to corporation on maintenance1,208,534.3420,631.95Net balance due to Corporation603,601.2669,079.98963 334 After protracted negotiations in which all items in their claims were discussed, the petitioners, on April 1, 1921, entered into separate written agreements with the Director General, covering the complete and final settlement of all demands growing out of Federal control. By these agreements, the Ann Arbor acknowledged its indebtedness to the Director General of $600,000, and the Lake Superior acknowledged receipt of $50,000 from the Director General. The settlement was effected and accounted for by the Ann Arbor crediting $50,000 to the account of the Lake Superior on its books, and giving to the Director General its demand note for $337,000 and its time note, maturing March 1, 1930, for $213,000. The Director General did not advise the Ann Arbor how the $600,000 was determined. By journal entry of June 1921 the Ann Arbor cleared its books of all accounts with the United States pertaining to Federal control, resulting in a net credit of $463,494.02 to "Profit & Loss - 607 Miscel. Credits." By journal entries of August and November 1921 and of January 1922, the Lake Superior cleared its books of all accounts with the United States pertaining to Federal control, 964 resulting in a net credit of $23,316.83 to profit and loss. The respondent determined that the Ann Arbor and the Lake Superior, in their final settlements with the Director General, were allowed $574,191.51 and $23,979.75, respectively, for undermaintenance of their properties during Federal control. During the period March 1 to December 31, 1920, the Ann Arbor expended and charged to operating expenses for maintenance of way and structures, exclusive of any charges for insurance, $796,740.09, and for maintenance of equipment, exclusive of any charges for depreciation, insurance and retirements, $804,074.10, a total of $1,600,814.19; and the Lake Superior expended and charged to operating expenses for maintenance of way and structures, exclusive of any charges for insurance, $43,207.20, and for maintenance of equipment, exclusive of any charges for depreciation, insurance and retirements, $30,426.15, a total of $73,633.35; and the aggregate grand total of $1,674,447.54 was included in the total operating expenses of $4,298,461.44 deducted in the consolidated return for 1920. Of the total amount so deducted for operating expenses in the consolidated 335 return, the respondent965 disallowed $574,191.51 and $23,979.75, a total of $598,171.26, on the ground that the Ann Arbor and the Lake Superior had expended such sums, respectively, to make good the Director General's undermaintenance of their properties during Federal control, and that they had been reimbursed therefor by the Director General in the final settlements of Federal control. The Ann Arbor's average expenditures (exclusive of any expenditures for insurance) for maintenance of way and structures during the test period, July 1, 1914, to June 30, 1917, excluding the months of January and February of each of those years, amounted to $244,496.46; and for maintenance of equipment, exclusive of any charges for depreciation, insurance and retirements, the average expenditures for the same period amounted to $259,390.11. In the 1920 period the Ann Arbor expended $1,631,814.19 for maintenance of way and structures and maintenance of equipment. In an average ten months of the test period the Ann Arbor expended, for the same purpose, $503,886.57. By applying to the several subdivisions of the test period figure, equation factors for the ten-month period, determined in the manner in which the Interstate966 Commerce Commission determined the equation factors for the six-month guaranty period, the resulting equated test period figure is $1,480,721.90. The comparison of this equated test period figure with the 1920 expenditure shows that in 1920 the Ann Arbor spent $151,092.29 more for maintenance of way and structures and maintenance of equipment than the equated expenditure of the test period. The Lake Superior's average expenditures (exclusive of any expenditures for insurance) for maintenance of way and structures during the test period, July 1, 1914, to June 30, 1917, excluding the months of January and February of each of those years, amounted to $23,713.46; and for maintenance of equipment, exclusive of any charges for depreciation, insurance and retirements, the average expenditures for the same period amounted to $10,832.96. In the 1920 period the Lake Superior expended $73,633.35 for maintenance of way and structures and maintenance of equipment. In an average ten months of the test period the Lake Superior expended, for the same purpose, $34,546.42. By applying to the several subdivisions of the test period figure equation factors for the ten-month period, determined967 in the manner in which the Interstate Commerce Commission determined the equation factors for the six-month guaranty period, and without taking into consideration the differences in amount and use of property maintained, as between the test and 1920 periods, the resulting equated test period figure is $94,473.81. The comparison of this equated test period figure with the 1920 expenditure shows that in 1920 the Lake Superior 336 spent $20,840.46 less for maintenance of way and structures and maintenance of equipment than the equated expenditure of the test period, assuming similarity in amount and use of such property. IV. At the hearing the parties stipulated as follows: On May 1, 1919, the petitioner issued and sold for $720,077.92 cash, its two-year six percent notes of the face value of $750,000, maturing May 1, 1921. At various times during the year 1920 it purchased for cash in the open market and retired $27,200 par value of these two-year notes, paying therefor $25,024. In reporting its net taxable income for the year 1920 petitioner did not include as part thereof the difference between the par value of the notes purchased, namely $27,200 and the cash968 cost of such notes, namely $25,024, at which they were retired, said difference being $2,176. The respondent in his letter of October 27, 1922, in connection with an audit of petitioner's income tax return for the year 1920, added $2,176 to petitioner's taxable income, and the petitioner paid the tax thereon. No further adjustment of petitioner's taxable income has been made by either the petitioner or the respondent with respect to the item of $2,176 thus added to petitioner's taxable income. If, as a matter of law, the difference between the purchase price and the sales price of these notes is taxable income, the correct amount to be included in the petitioner's taxable income is $1,452.55, being the difference between the issue price of the notes $26,114.83, plus $361.72, amount of discount previously amortized, or a total of $26,476.55, and the repurchase price of the bonds $25,024, instead of $2,176, the amount which was added by the Commissioner to the petitioner's taxable income. V. On December 5, 1908, the Ann Arbor, therein referred to as the Railroad Company, and the New Haven Coal Mining Co., therein referred to as party of the second part, entered into an969 agreement which, so far as material here, is as follows: WHEREAS, the Railroad Company has constructed, or is about to construct, a side or spur track, (a blue print map of the location of which is annexed hereto and made a part hereof) together with a bridge crossing Shiawassee River running to the mines of said party of the second part located in Shiawassee County, Michigan, through townships of Caledonia and New Haven, a distance of about seven (7) miles, and the Railroad Company agrees to operate the same on the terms hereinafter written. Now, THEREFORE, This Agreement, Witnesseth, That for and in consideration of the premises and of the mutual advantages to accrue to the parties hereto, the Railroad Company covenants that it will maintain and operate the said track and bridge upon the terms hereinafter set forth, and the party of the second part hereby licenses and consents to the construction, maintenance and operation of such track and bridge, and to the possession and use of the land upon which the same is constructed, and hereby grants and conveys to the Railroad Company, its successors and assigns, the right to enter upon said land for the purpose of constructing, maintaining970 and operating the said track and bridge, and exercising any right existing under this agreement. 337 It is mutually Covenanted and Agreed by and between the parties hereto as follows: 1 - The party of the second part shall ship and send all freight or material to be forwarded from or destined to said siding, by the railroad of the Railroad Company. 2 - It is mutually agreed that both parties to this agreement shall have the right to serve notice that, after six (6) months from date of such notice they will cancel this agreement, and upon payment of either party to the other of all expenditures made in the construction of the spur track, and bridge, they will have full and peaceful rights and title to the spur track, bridge and right of way. 3 - The title in and to the ownership of the bridge, rails, ties, fastenings and all other material of every kind and description used in the construction of the said track are and shall remain in the Railroad Company, and the Railroad Company, its agents, servants and employees, shall have the right at any time peaceably to enter upon the premises of said party of the second part for the purpose of taking up and removing said971 track, whenever it may determine, under the terms of this agreement, to remove the same. * * 6 - Second party agrees to furnish all right of way without cost to the Railroad Company. Said second party further agrees to establish all drainage, to do all grading and provide a roadbed in good condition and suitable for laying track, and to furnish all cross and switch ties necessary to the construction of main track or tracks. All the cost and expense of right of way, roadbed in suitable shape to lay track, shall be paid by said second party without any liability on the part of the Railroad Company. And further the said second party agrees to fence the said right of way on each side of its property, and furnish said first party, the Railroad Company, with good and perfect titles to all right of way and real estate pertaining to said spur track, also all franchises pertaining to rights and uses of all public highways, streets and alleys that cities or corporations may have granted to the said second party through the City of Owosso, Michigan, or any other village or incorporated towns along its lines. 7 - After completion of track the second party will submit to the Railroad972 Company an itemized statement of expense in connection with mine track. After such statement shall have been properly checked and accepted by the Railroad Company, the expense so decided upon shall be used as a basis upon which a refund shall be made to second party by the Railroad Company at the rate of One ($1.00) Dollar per car on all carload shipments over said mine track. Such refunds to be made monthly and to continue until the second party has been reimbursed for the amount of their expenditure as agreed upon for said mine track, as above outlined in this article, subject, however, to the conditions of paragraph eight (8) hereof. When spur track has been completed the Railroad Company agrees to maintain it thereafter so long as used by said Railroad Company. 8 - The Railroad Company agrees to build a bridge over the shiawassee River in connection with said spur track of such character as will be approved by the Drain Commissioners of Shiawassee County, and to maintain it thereafter so long as it is used by said Railroad Company. After the completion of the bridge the Railroad Company will submit to the Coal Company an itemized statement of expense in connection with the973 building of the same. After such statement shall have been properly checked and accepted by the Coal Company, the expense so agreed to shall be the amount to be paid to the Railroad Company 338 by the Coal Company, and the Coal Company hereby agrees to pay said amount as follows: The One ($1.00) Dollar refund provided in paragraph seven, hereof, shall be retained by said Railroad Company until the same shall have liquidated the amount of the Railroad Company's expenditure for said bridge as agreed upon, and only after the liquidation of said amount of expenditure of said Railroad Company for said bridge, shall the refund provided in paragraph seven be paid to said Coal Company. The Coal Company agrees to furnish a satisfactory bond to insure the payment to said Railroad Company for its expenditure for the said bridge. In the event that the Coal Company do not ship a sufficient number of cars to provide for the payment of the said amount as hereinabove set forth. 9 - After the said second party shall have been reimbursed as above provided for said track, the mine track in its entirety, including the bridge, shall revert to the Railroad Company. It is understood, however, 974 that the expense borne in the first instance by the second party shall not be considered as a lien on spur track, and said spur track shall at all times remain in possession of Railroad Company in all respects as if spur track had been constructed at original and sole expense of the Railroad Company as hereinbefore provided. The bridge and spur track mentioned in the foregoing agreement were constructed between 1908 and 1910. The total amount expended by the Ann Arbor under the agreement was $28,131.73, which it charged to appropriate capital accounts. The New Haven Coal Mining Co., pursuant to paragraph seven, furnished the Ann Arbor with a statement of expenses amounting to $41,642.44. The Ann Arbor made an effort to verify the expenditures listed in that statement, and made some minor objections; but the statement was never accepted or rejected by the Ann Arbor for the purpose for which it was intended. The New Haven Co. discontinued operations and went out of business in 1912. In the interim it had rendered statements to the Ann Arbor for refunds of $2,300 or $2,400 due it under the agreement, but no cash refunds were ever made by the Ann Arbor. The Ann Arbor made no accounting975 on its books, at the time or subsequently, to reflect the discontinuance of operations of the bridge and spur track or any effect it may have had upon its capital accounts. By agreement of September 28, 1920, the Ann Arbor sold to the Owosso Sugar Co. "all its right, title and interest in and to the right of way, track and rails, bridges, fences, and all other property of the so-called New Haven Coal Mining Spur Track of said The Ann Arbor Railroad Company," extending approximately 7.26 miles in length, for $31,000 cash. Title was conveyed by quitclaim deed of September 29, 1920. On its books of account, the Ann Arbor credited the proceeds from the sale to operating expenses subaccounts as follows: Account 214 - Rails, $15,125; Account 216 - Other track material, $5,175; Account 212 - Ties, $6,500; Account 220 - Track laying and surfacing, $4,200; and no revision of this accounting has ever been made. This accounting for the sale has never been questioned 339 by the Interstate Commerce Commission, and the original charge of $28,131.73 to capital accounts is still there. The spur track was later sold by the Oswosso Sugar Co, to the Michigan Sugar Co.; and it was abandoned976 by the latter and taken up in 1923 or 1924. On March 1, 1913, it was worth no more than its original cost of $28,131.73. VI. The consolidated net income determined by the respondent in the deficiency notice is allocable to that portion of 1920 during which the properties of the petitioners were under Federal control, January 1 to February 29, 1920, and to that portion of 1920 after Federal control, March 1 to December 31, 1920, as follows: Jan. 1 to Feb. 29, 1920March 1 to Dec. 31, 1920TotalNet deficit as reported on original return$5,249.31$216,839.35$222,088.66Adjustments made by Bureau:Additional income or unallowable deductions:Ann Arbor Railroad Co.Railway tax accruals6,624.576,624.57Guaranty period income315,261.85315,261.85Miscellaneous income10,965.5828,354.9339,320.51Undermaintenance574,191.51574,191.51Property abandoned315.62703.031,054.65Loss on equipment retired1,237.381,237.38Assessment Ass'n. Ry. Executives685.42685.42Manistique & Lake Superior Railroad Co.Undermaintenance23,979.7523,979.75Guaranty period income36,686.6036,686.60Total additions6,067.89770,885.69776,953.58Additional deductions or nontaxable income:Ann Arbor Railroad Co.Miscellaneous income charges32,714.125,747.9438,462.06Amortization of discount2,778.4313,892.1716,670,60Back mail pay5,579.905,579.90Interest on quarterly balances due USRA4,768.2823,841.4128,609.69Compensation2,188.672,188.67Material and supplies29,869.4029,869.40Manistique & Lake Superior Railroad Co.Compensation75.9475.94Material and supplies2,223.012,223.01Total deductions42,525.4481,153.83123,679.27Net income as corrected by 60-day letter 2/1/271 36,457.55689,731.86653,274.31977 OPINION. STERNHAGEN: As shown in the preliminary statement, several of the assignments of error have been removed from controversy. The adjustment of these matters will be reflected in the final judgment. The matters at issue are considered in this opinion under Roman numerals which are correlated to the findings of fact. I. The issue covered by the second assignment is the propriety of including the so-called guaranty income received from the United 340 States by virtue of section 209(c) of the Transportation Act, 1920, within petitioners' taxable income. In view of texas & , the petitioners now concede that the inclusion was proper, and the respondent's determination is therefore affirmed. II. The petitioners urge that the aforesaid guaranty income paid by the United States pursuant to section 209 of the Transportation Act of 1920, is subject only to an 8 percent rate of tax and not the ordinary 10 percent rate. They argue that, since the income received during Federal control as just compensation was relieved from the normal tax of 2 percent, see 978 , and the guaranty income was measured by the same standard, namely, the railway operating income of the test period, the guaranty income must be likewise relieved. Otherwise, it is said, the guaranty income will fall short of its purpose to give the carrier an equal measure of operating income with that of the pre-war period. This view can not, we think, be sustained. The statute does not so provide expressly and there is no reason for its implication. The Ontario & Western case not only involved an entirely different question, whether the express release from the normal tax of 2 percent could itself be treated as taxable income, but was founded in a special provision of the Revenue Act of 1918, which has no force here. ; . Section 230(b) was by its terms limited to the purposes of the Federal Control Act, which ended February 28, 1920, and the lower tax rate therein prescribed was clearly not, without more, to be applied to the income derived after that date. That this is true as979 to income actually earned from operations should be beyond doubt. So that a carrier, which by reason of its adequate earnings could not invoke the guaranty, could furthermore not claim an 8 percent tax rate. See . A Congressional intent to give more than this to a carrier receiving its income through the guaranty we may suppose would be plainly stated and not left for a holdover construction of an obsolete provision covering Federal control. III. Petitioners urge that the respondent has erroneously disallowed $598,171.26 of the deduction for maintenance of way and structures and of equipment during the period of the last ten months of 1920. This amount is part of the actual expenditures for the period which were accounted for as maintenance, but the disallowance is based 341 on the respondent's determination that to this extent the petitioners' ostensible maintenance cost was really not its own, but a burden assumed by the Director General, the liability for which accrued during the ten-month period. See 980 . Unlike , there is no evidence here, outside the carriers' claim, that the Director General failed in his contractual duty to maintain the petitioners' properties adequately during Federal control. But the respondent has determined that they received, in their final settlements in 1921, allowances for undermaintenance of their properties during Federal control in the respective amounts of $574,191.51 and $23,979.75, a total of $598,171.26, and this is the amount by which the respondent has reduced the petitioners' deduction for maintenance expenses. As in New York, Chicago & St. Louis R.R. Co., the question arises not because respondent calls the Director General's allowance income, but because he reduces the petitioners' deduction for maintenance expense by the amount of the Director General's allowance. Thus the issue, as to the measure of petitioners' actual and deductible maintenance expenses, is quite different from 981 ; certiorari denied, ; ; ; ; ; and ; ; . In those cases whether gross income was received as a matter of fact (), or whether, being received in fact, the amount was gross income in law (, and ), were questions which imposed a different and less burden on the petitioning taxpayer than the question of his right, despite the respondents determination, to deduct all amounts expended for maintenance without regard for the extent to which, as determined by respondent, such expenditures embodied an amount derived from the Director General in discharge of his contractual obligation. The petitioners did not enter into the standard982 agreement provided for by section 1 of the Federal Control Act, but by acceptance of the benefits of section 2 thereof they brought themselves within the entire provisions of the act; consequently, their properties were taken over and used by the Director General subject to the same conditions as those contained in the standard agreement so far as they provided for the return of the properties to the carriers "in substantially as good repair and in substantially as complete equipment as it was in at the beginning of federal control." At the end of Federal control, the petitioners filed claims with the Director 342 General setting forth numerous items due from and to the Director General. The Ann Arbor's claim contained, among others, a claim for undermaintenance of way and structures of $507,968, and a claim for undermaintenance of equipment of $700,566.34, a total for undermaintenance of $1,208,534.34, and claimed a net balance due the corporation of $603,601.26. The Lake Superior's claim contained an item for undermaintenance of way and structures of $20,631.95, and claimed a net balance due the corporation of $69,079.98. In the final settlement agreements, the Ann Arbor983 acknowledged an indebtedness of $600,000 to the Director General, and the Director General acknowledged an indebtedness of $50,000 to the Lake Superior, and the account was closed by the Ann Arbor giving two notes, of a total face amount of $550,000 to the Director General. The petitioners contend that nothing whatever was allowed by the Director General for undermaintenance. They say: Instead of receiving any money as the result of the settlement, the petitioner paid a large sum to the Director General. An analysis of the claims presented and the settlement consummated leads irresistibly to the conclusion that nothing whatever was allowed on the claim for undermaintenance. The Ann Arbor Railroad Company's claim (91, Respondent's Exhibit A) contains an item of $1,208,534.34 for undermaintenance. If this item had been allowed, the net amount due the Ann Arbor would have been $603,601.26. If the claim for undermaintenance be eliminated, the statement would show a balance of $604,933.08 due the Director General, and since the Ann Arbor paid the Director General $600,000 in the settlement, it is obvious that nothing whatever was allowed petitioner for undermaintenance on its984 claim. The Manistique and Lake Superior Railroad Company's claim (93, Respondent's Exhibit B) contained an item of $20,631.95 for undermaintenance. If this claim had been allowed, petitioner would have been entitled to receive in settlement $69,079.98. If the claim for undermaintenance be eliminated, the statement would show a balance of $48,448.03 due the railroad Company. It was actually allowed $50,000 by the Director General in the final settlement. The logical conclusion, therefore, is that the claims for undermaintenance in the case of both the Manistique and Lake Superior and the Ann Arbor Railroad Companies were wholly disallowed, and that neither company was allowed anything whatever for undermaintenance in the final settlement. This assumes that all items in the claims, except the two undermaintenance items, were allowed by the Director General, and that the claims for undermaintenance were wholly eliminated. This assumption is not justified by the evidence. The only witness on this matter was one of the Ann Arbor's representatives in the conferences with the Director General, which cluminated in the final settlement agreement. He testified: We went down; 985 the representatives of the Ann Arbor Railroad went to Washington in, as I recall it, April, 1921; I know we left on Easter Sunday morning, and we had conferences with the representatives of the Director General, Mr. Tracy being the Comptroller of the Railroad Administration at that time and Mr. Alexander Smith, I believe, was their counsel, and we sat around the table for about a week, and there was a question of give and take all the way 343 through, there was Mr. Erb, our president, he was there and he made certain concessions to the counsel for the Director General, who, in turn, of course allowed similar concessions, and when the thing all wound up there was a lump sum settlement agreed upon. Q. What was the - what credit was allowed the Ann Arbor in that settlement of the account? A. I do not know; the balance was against the Ann Arbor to the extent of six hundred thousand dollars, when the final figures were computed and agreed to by the President of the Company and the Director General's representatives. Q. Mr. Kiefaber, you testified this morning that the closing journal entry in both of these cases, or rather in the case of both petitioners recording the986 final settlement with the Director General was made in accordance with the I.C.C. regulations issued on January 25, 1922, which has been introduced here as Petitioner's Exhibit No. 4; I call your attention to paragraph 2 of that letter, or of that order which provides that items on which the amount of settlement may be mutually agreed upon between the Director General and the carrier, whether or not previously recorded in the account, shall be recorded in the accounts in accordance with the effective accounting regulations on the basis of settlement agreed upon. Now, as I understand it, you did not record these items which you had agreed upon in accordance with the I.C.C. regulations in effect at that time, but you carried the entire net credit to profit and loss, or the net debit, as the case may be, instead of allocating these items which had been agreed upon to the accounts where they belonged; is that a fact? A. We could not identify the whole, because our inability to allocate the entire amount of six hundred thousand dollars charged by the Director General, prevented us from making a definite division of that figure, therefore all we could do was to wipe off the open accounts987 standing on the corporation's books, and then setting up this liability for the $600,000 and calling the rest profit and loss; we have no other way of determining what the amounts were other than what were on our books. Q. In other words, you made no allocation of the net balance as between different items? A. No, sir, we did not know what the $600,000 represented. As to the Lake Superior's claim and the settlement agreed upon, the witness testified that according to notations which he made during the course of the conferences with the Director General, the items of $5,699.27 for interest on deferred compensation and $14,505.50 for interest on open accounts due the corporation were entirely eliminated. Q. Now the remaining item is maintenance of way and structures under $20,631.95; what is your recollection with respect to that? A. Apparently from my recollection of the transaction and the notations which I have on my working copy, that amount evidently was practically allowed in full by the Director General, for this reason you will note that the total of the statement to which you refer is $69,079.98 due to the corporation, the items of interest or deferred compensation988 amounting to $5,699.27, and interest on open accounts due to corporation $14,505.50, or a total of $20,204.77, have been shown as having been deducted from the total of $69,079.98, leaving a balance of $48,875.21, due the corporation from the Director General, and in view of the fact that in setting this thing down and making final settlement 344 with the Director General, he allowed the M. & L.S. a flat figure of $50,000 and called it square, so that it would indicate that all other items had been allowed, there was only a difference of $1,200 between the amended claim and his round flat settlement figure of $50,000. That is all the evidence to indicate whether the Director General made allowances for undermaintenance. The petitioners, however, do not rest their case entirely upon the proposition that no allowances were made to them for undermaintenance, but urge that, even if the amounts in question be regarded as allowances for undermaintenance and within the field of the so-called reimbursement rule, still the respondent's action is erroneous, because "no part of the expenditures for maintenance in 1920 were made for the purpose of rehabilitating the property or making989 good deferred maintenance, but on the other hand the entire amount included as maintenance expenses covered only the usual, ordinary and necessary maintenance expenses in the operation of petitioner's property." Upon this proposition was predicated the introduction of elaborate statistical studies and opinion testimony to show that the petitioners' maintenance expenditures during the last ten months of 1920 were no more than can properly be attributed to the current maintenance requirements of that period. The petitioners' first method of demonstrating that the maintenance charges of the last ten months of 1920 do not include restoration of the prior undermaintenance is an equated comparison with the cost figures of the test period. Applying this process, the Ann Arbor's actual average test period charges for maintenance become an equated figure of $1,480,721.90 in comparison with the 1920 figure of $1,600,814.19, and the Lake Superior's average test period charges become an equated figure, without adjustment for differences in the quantity of property used and in the extent of such use, of $94,473.81 in comparison with the 1920 figure of $73,633.35, which shows that the 1920 maintenance990 cost was $120,000 greater for the Ann Arbor, and $20,800 less for the Lake Superior, than the normal test period cost. The Ann Arbor's greater 1920 maintenance cost, as disclosed by the statistical study, is explained by the petitioners as due to unusual conditions in that year, such as numerous derailments and breakdown of equipment, caused by the bad condition and the lack of proper maintenance of the Ann Arbor's roadway, and to excessive running (minor) repairs to equipment, which were made necessary by the Ann Arbor's failure to provide the usual classified (major) repairs. To support this explanation, there was introduced the testimony of three witnesses and several other statistical studies. Parvin, superintendent of the Ann Arbor, testified that he made weekly inspection trips over the road; that he kept himself intimately 345 acquainted with the condition of the road, from day to day and month to month; and when asked what the condition of the road was during the years 1920 and 1921, he replied as follows: Putting it mildly, the condition was bad, basing that statement on the physical condition of the road from a standpoint of maintenance during the years 1920991 and 1921, and on the further basis of our derailment record for those two years, notwithstanding every precaution that the Transportation Department could exercise over its men, - that is the department I had charge of, educating its men to operate as cautiously and as carefully as possible, and by placing slow orders to protect bad track, some of which if it is permissible, I will insert into the record, in the year 1920 we had 122 main line derailments on our 292 miles of railroad; 391 side track derailments. I think I should qualify that, though, by the statement that for the first three months in 1920, 16 of the main line derailments were occasioned by ice on the track, - we had a very severe ice storm in the first of 1920, which resulted in sixteen derailments on that account, but in 1921 we had no unusual conditions, we had 72 main line derailments, 289 side track derailments. Your Honor has been connected with the railroad, and for your information we had departmental jurisdiction - there is always considerable controversy between the departments when you have derailments, particularly when conditions were as I have stated. By the MEMBER: Q. Do you mean controversy as992 to which department is at fault? A. Yes, sir; also the track will contribute to other causes, such as broken arch bars on cars; broken springs on locomotives, and in several instances the Grand Trunk Railroad complained of the condition of our track because they could not keep springs under our locomotives. Conditions got to the point where our vice-president and general manager at that time, Mr. Blomeyer, walked a lot of the track with me; we walked as much as seventeen miles a day; he finally remarked that from then on when I reported a derailment due to track conditions there would not be any further argument about it. That conditions did not only exist during 1920 and 1921, but right up until 1925, when the Wabash bought the property and started rehabilitating the property. As an offset, in 1930 we had 18 main line derailments, two chargeable to track. If it would be permissible, and to support my statement as to the conditions, I could put into the record for the month, say, of November, 1921 and November 1920, the slow orders over the track that were in effect at that time, but in view of these slow orders we still had those derailments, for instance in 1920, in November, 993 we had twelve main line derailments, and in November 1921, we had ten derailments, - main line derailments, and we had a page full of slow orders at the time, as slow a speed over some of the track as five miles per hour. Q. Do you, as an experienced railroad man, attribute any relation of cause and effect, between the number of derailments you had during 1920 and 1921, and the state of maintenance of the track? A. Derailments certainly indicate poor maintenance, or lack of maintenance. Q. Now, do you have any knowledge of the state of maintenance of the mechanical and car equipment of the Ann Arbor during this same period? A. * * * I would not care to state as to the maintenance of equipment, but I can state as to the maintenance of the locomotives, which was poor and in direct line with the track maintenance. 346 Q. Can you state whether or not any rehabilitation of the Ann Arbor track or roadway was undertaken or conducted during either 1920 or 1921? A. No rehabilitation was undertaken or conducted. Q. Now, can you state whether or not any rehabilitation of locomotives, cars or other equipment was undertaken in either of these years, or conducted994 during those years? A. In the case of locomotives there was not; in the case of cars, if you consider rebuilding some express cars, why I do not think I am prepared to say whether that would be or would not be. He further testified that the track was very poorly maintained in 1920 and 1921; that such failure to maintain "naturally would cause considerable increase in your operating expenses"; that the derailments or wrecks to which he referred tended to increase expenditures in connection with track maintenance, equipment maintenance, operation of wrecking outfits, and claim payments; and that expenses of 1920 were materially increased, due to those wrecks and derailments. On cross-examination he testified, in part, as follows: Q. Mr. Parvin, what do you understand by rehabilitation of properties? A. Go ahead and putting your property in shape to do that for which the property was intended. Q. That is to say, assuming in the beginning that it was grossly undermaintained. A. Yes. Butler, master mechanic of the Ann Arbor, testified that he inspected the power - locomotives, stationary boilers, pump stations and all of that sort of equipment - when he first became995 associated with the company in 1922; that he found all of such equipment to be in very bad condition; that the condition of the power was such as to lead him to believe that since 1920 it had not been kept in good condition or maintained in good repair up to the best standard of condition; and that he would even say that far less than the ordinary and necessary repairs had been made since March 1, 1920. After examining petitioners' Exhibit 43, being a statement of monthly expenditures for repairs to locomotives in an average ten months of the test period and in the last ten months of 1920, segregated as between classified (major) and running (minor) repairs, he testified that the exhibit indicated to him that the power was not in proper condition either in the test period or in the last ten months of 1920; that in order to keep locomotives in proper condition, classified and running repairs should be made thereto on a fifty-fifty basis; that unless approximately the same amount of money is spent for classified repairs as for running repairs, the power is not in proper condition and you are spending too much money on running repairs trying to operate the railroad; and that, judging996 from the condition of the equipment in 1922, it is his opinion that the locomotives had not been put in proper condition or rehabilitated in 1920. He testified: 347 Q. Do you mean anything more than this: that when you saw them in 1922 they were in bad condition and if they had been properly maintained before 1922 they probably would not have been in such bad condition? A. No, sir. Q. And from that you concluded that at some time before 1922 they were permitted to get in bad condition? A, That is right. Q. And you do not know at what time before 1922 they were permitted to get in bad condition, do you? A. No, I do not. Q. You just know they did not have as much maintenance as they should have had in the period prior to 1922? A. I know they had not been properly maintained. Q. At any time prior to 1922? A. Prior to 1922. Q. You do not have any information of any period prior to 1922, do you? They might have been in bad condition in 1916 or in 1918 or in 1920, and all of those things would result in the bad condition in which you found them in 1922? A. That is right; what I mean is if you had a bunch of fifty engines in good condition997 that it would take more than two years to put them in the condition that I found them in. Q. So you do not know, as a matter of fact, what was done to them in 1920? A. No, sir, I was not there. Exhibit 21, containing data taken from the annual reports of the chief inspector of locomotive boilers to the Interstate Commerce Commission, shows, in respect of the Ann Arbor's locomotives, as follows: Number Number Number Percentage Ordered ownedinspecteddefectiveof inspec-out ofted foundservicedefectiveTest period:Average444016403Federal control period:19184523835019194734267651920513123745Exhibit 43, previously referred to in connection with Butler's testimony, shows repairs applied to Ann Arbor's locomotives, as follows: RepairsClassifiedPercentRunningPercentTotalAverage for ten months of test period$38,100.3233.70$74,965.7266.30$113,066.04Average for ten months of test period - equated97,998.1533.70192,820.0466.30290,818.19Last ten months of 1920124,275.5136.01220,847.0663.99345,122.57998 348 Treacy, car foreman of the Ann Arbor since 1918, testified that he has been at car work since 1896, and that he supervises all of the Ann Arbor's car work; that the condition of the Ann Arbor's car equipment was "quite bad" from March 1, 1920, to the end of 1921; that the ordinary and necessary repairs were not made to the Ann Arbor's car equipment in 1920; that it was the practice in 1920 to make only necessary repairs to good cars; that during and after Federal control the cars were operated "all over the country, and when they came back to us, they were in bad condition"; that "we picked out the lightest cars [cars needing the least repairs] that we could get and made repairs and let the other ones stand"; that "we did not work full force or full time in 1920, because we did not have the money to do it with"; and that the bad order cars "coming in on the line" for repairs in 1920 were heavier than usual. Exhibits 44, 46, and 47 show that the number of Ann Arbor freight cars in bad order in March 1920 was 191, which is 9.10 percent of the number of cars owned and leased in that month; and that the number of freight cars in bad order in December 1920 was 293, which999 is 13.88 percent of the number of cars owned and leased in that month. Exhibits 45, 46, and 47 show that the average number of Ann Arbor freight cars repaired during each month of the test period was 620, which is 26.90 percent of the average number of cars owned and leased in that period; and that the average number of cars repaired during each of the last 10 months of 1920 was 358, which is 16.89 percent of the average number owned and leased during those months. The petitioners contend that this oral and documentary evidence "discloses facts which rationally account for the excess expenditure [greater maintenance cost of the 1920 period] indicated by the result of the study [comparison of 1920 period maintenance cost with test period maintenance cost], and supports our contention that no rehabilitation of the Ann Arbor property occurred during 1920." From the foregoing, it will be observed that the petitioners' position is that maintenance expenditures of the 1920 period in an amount equal to the equated expenditures of the test period are to be regarded as having been made for current maintenance and as necessarily excluding prior undermaintenance; that the statistical1000 study of comparative maintenance costs of the 1920 and test period discloses that all but approximately $120,000 of the Ann Arbor's 1920 maintenance expenditures was for current maintenance, and that all of the Lake Superior's 1920 maintenance expenditures was for current maintenance; that the greater 1920 maintenance cost in the case of the Ann Arbor is rationally accounted for by the facts disclosed by the oral 349 and documentary evidence; hence, there was no restoration of prior undermaintenance in 1920. This is the identical proposition which was presented in , and . It was fully and carefully considered and rejected in those opinions, the decision in , to the contrary, being pro tanto expressly overruled. Since the statistical study, or comparison of 1920 maintenance cost with test period maintevance cost, is the only evidence we have, in the case of the Lake Superior, bearing upon the question of whether Federal control undermaintenance was made good by that company in the 1920 period, it follows, 1001 in line with the decision in the Southern Ry. case, that the respondent's determination, so far as it affects that company, must be sustained. As to the Ann Arbor, it remains to be determined whether the evidence, other than the statistical study of comparative maintenance costs of the 1920 and test periods, justifies overturning the respondent's determination as to it. It is clear from the evidence that the Ann Arbor's roadway, locomotives, and freight train cars were not in good repair in 1920. As to structures, miscellaneous facilities, passenger train cars, floating equipment, and miscellaneous equipment, for the maintenance of which the Ann Arbor expended $403,115.56 in the last ten months of 1920, there is no evidence as to their condition or state of maintenance in the 1920 period, or as to any other facts pertaining to them; and, consequently, there is no proof that the expenditure of $403,115.56 for the maintenance of these facilities in the 1920 period contains nothing for restoration of prior undermaintenance. The fact that the Ann Arbor's roadway, locomotives, and freight train cars were not in good repair in 1920 does not prove that the 1920 expenditures included1002 nothing for restoration of prior undermaintenance. The question can not be decided by reference to the condition of the facilities in 1920; for, if no more than a single item of maintenance had been performed in the 1920 period - in which event, the condition of repair might obviously be very bad - the question would still remain as to whether the particular item of maintenance performed was one which the Director General had undertaken. The proposition was considered in , and rejected in the following language: The petitioner's assistant chief engineer stated that he had inspected the railroad according to his periodic wont and found it to be in his opinion in no better condition at the end of 1920 than at the beginning. This opinion adds little or no force to the petitioner's contention, for, aside from the fact that this is an opinion of an interested person regarded by the Director General as inadequate for official recognition (Director General's Report to the President, 350 supra, p. 17), and not controlling with this Board (1003 ), the physical appearance of the road in general is not shown to disclose whether $459,000 of the year's maintenance expense had been devoted to such restoration of road as the Director General had failed in his contractual duty to maintain. Likewise, in , it was said: The fact that there was no improvement in the average condition of maintenance by the expenditures of the 1920 period is of no importance; that, like the accounting test, indicates only that not more than the usual and normal amount of maintenance was accomplished in the period, or that such maintenance as was performed was not greater than current necessity required. The real question here is, Was the maintenance performed in the 1920 period, or some portion thereof, that which actually belonged to the Federal control period for which the petitioner was reimbursed by the Director General?; and that cannot be answered by a mere comparison of maintenance conditions at the beginning of the period with the conditions existing at the end of the period, as was held in the Missouri Pacific case, but requires1004 an examination of particular items of maintenance performed. * * * Parvin's statement that there was no rehabilitation of the Ann Arbor's roadway and locomotives in 1920, and similar statements by Butler in respect of locomotives and Treacy in respect of freight train cars, are inconsistent with other evidence. Exhibit 33 shows the application of labor and materials to roadway in the 1920 period in greater quantities than in the test period; and Parvin testified that these were applied at points where most needed. Butler did not become associated with the Ann Arbor until 1922; and, consequently, he had no knowledge of what had been done in 1920 in respect to locomotives. his statement was based entirely upon what he saw in 1922 and his judgment that the locomotives could not have reached the condition in which he found them in 1922 had they been kept in a state of good repair after March 1, 1920. Exhibit D, however, being a photostatic copy of the supplemental claim which the Ann Arbor filed with the Director General, received in evidence without objection by petitioners' counsel, shows that of the number of locomotives turned back by the Director General at the end of Federal1005 control in bad condition, 10 were fully repaired and 22 partially repaired between March 1 and December 31, 1920, at a cost of $157,416.32. And, as to freight train cars, Exhibit E, a photostatic copy of a further supplemental claim which the Ann Arbor filed with the Director General, also received in evidence without objection by petitioners' counsel, shows that 799 "heavy bad order cars" were "returned to our line for rebuilding during the period January 1, 1920, to January 31, 1921," and that the cost of "actual rebuilding" of 675 of said cars amounted to $351,836.58. The respondent's determination that petitioners' maintenance deductions must be cut down so as to exclude the Director General's 351 undermaintenance allowance is sustained, the disallowance of the Lake Superior being apparently properly admitted by respondent to amount of $20,631.95, instead of $23,979.75 originally disallowed. IV. The parties have stipulated that on May 1, 1919, the petitioner issued its two-year 6 percent notes, of the face value of $750,000, maturing May 1, 1921, for $720,077.92 cash; that in 1920, the petitioner purchased and retired $27,200 face value of such notes, paying therefor1006 $25,024; that the issuing price of the notes retired in 1920 was $26,114.83; that the discount allocable to the notes retired in 1920 previously amortized is $361.72; and that if, as a matter of law, the difference between the purchase price and the sale price of the notes retired in 1920 is taxable income, the amount to be included in respect of the transaction is $1,452.55. On the brief, the petitioners concede that the amount of $1,452.55 is taxable income. . Since the amount included in income by the respondent is $2,176, net income shown in the deficiency notice should be reduced by $723.45. V. The proposed findings in this subdivision relate to the eighth and ninth assignments of error, which are considered together. In the eighth assignment the Ann Arbor contends that the deduction for operating expenses allowed by the respondent is understated by reason of an offset of $31,000, representing the proceeds from the sale of the spur track to the Owosso Sugar Co.; and in the ninth assignment it is charged that the Ann Arbor sustained a loss of $37,007.36 upon the sale of the spur track, which loss the respondent1007 has not allowed as a deduction. The property in question was acquired prior to March 1, 1913. Under the applicable statute, the Revenue Act of 1918, the basis for determining any gain from the sale is cost or March 1, 1913, value, whichever is higher, and the basis for determining any loss is cost or March 1, 1913, value, whichever is lower. . On the brief, the petitioners contend that the cost of the track was $69,774.17; that the fair market value at March 1, 1913, was $68,494.43; and, using the alleged March 1, 1913, value as the basis, that the Ann Arbor sustained a deductible loss of $37,494.43. The alleged cost of $69,774.17 represents the $28,131.73 expended by the Ann Arbor plus the $41,642.44 alleged to have been expended by the New Haven Co. Clearly no amount expended by the New Haven Co. can be included in the Ann Arbor's cost basis, and this is not argued. The evidence shows that no cash refunds were ever 352 paid by the Ann Arbor to the New Haven Co. under paragraph 7 of the agreement. The findings show that the New Haven Co. had rendered statements of amounts due it under paragraph 7, in the1008 total sum of $2,300 or $2,400, and the Ann Arbor's auditor testified that "I can recall there was one bill made against them [the New Haven Coal Mining Co.] for around $5,400 for a bridge, and my best recollection is that these refunds that were due them [the New Haven Coal Mining Co.] was [sic] credited to that bill as part of the track." Evidently, then, the Ann Arbor had not been reimbursed for the cost of the bridge at the time the New Haven Co. discontinued operations and went out of business. The evidence does not prove a greater cost then $28,131.73; and, since the track and bridge were disposed of for $31,000, no loss resulted to the Ann Arbor from the transaction; and none is deductible. As to the eighth assignment, we are of opinion that the basis to be used is the original cost to the Ann Arbor of $28,131.73 and that the profit of $2,868.27 is properly within its income. This transaction has nothing to do with the deduction for expenses. We are not persuaded that the theoretical construction of a figure to represent the fair market value of the property on March 1, 1913, is demonstrative of the value in fact or that the evidence establishes a value on March 1, 1913, in*1009 excess of the cost of $28,131.73. We also find no sufficient evidence to support a finding that 1,132 feet of the track were omitted from the sale. The respondent's determination in respect of the sale of the spur track is modified, by reducing the determined net income by $28,131.73. VI. The net income for January and February 1920, taxable at the rate of 8 percent, and the net income for the period March 1 to December 31, 1920, taxable at the rate of 10 percent, will be determined in accordance with the findings. Judgment will be entered under Rule 50.Footnotes1. Net loss. ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622071/	GARY WEISBART and HALENE WEISBART, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentWeisbart v. CommissionerDocket No. 8152-73.United States Tax CourtT.C. Memo 1976-54; 1976 Tax Ct. Memo LEXIS 354; 35 T.C.M. (CCH) 241; T.C.M. (RIA) 760054; February 26, 1976, Filed 354 Gilbert Goldstein, for the petitioners. Fredrick B. Strothman, for the respondent. FAYMEMORANDUM FINDINGS OF FACT AND OPINION FAY, Judge: Respondent determined a deficiency of $70,257.37 in the Federal income tax of Gary and Halene Weisbart for 1968. A concession having been made by the respondent, it remains for us to decide: whether G. Weisbart & Company (a Subchapter S corporation) paid $100,106 in feed expenses during its taxable year August 14-December 31, 1968; and if so, whether the deduction of those expenses in that year resulted in a material distortion of the income of Gary Weisbart, the sole shareholder of G. Weisbart & Company. FINDINGS OF FACT Some of the facts have been stipulated and are so found. Petitioners Gary and Halene Weisbart are husband and wife. They filed a joint Federal income tax return for the year in issue with the Director, Southwest Service Center, Austin, Texas. Petitioners were residents of Colorado when they filed their petition with this Court. For several years prior to 1968 Gary Weisbart conducted a cattle feeding operation in Tucumcari, New Mexico, as its sole proprietor. On August 4, 1968, Gary organized355 a corporation styled "7A Land & Feeding Company" (7A) under the laws of Colorado. In exchange for shares of stock Gary transferred to 7A certain of the assets of his business: land, office equipment, feed lot equipment and feed lot improvements. With these assets 7A engaged in the business of buying and selling cattle feed and of commercial and custom feeding of the cattle of various owners. At all times relevant Gary owned 92 percent of the shares of 7A stock outstanding. Again pursuant to the laws of Colorado Gary organized a corporation styled "G. Weisbart & Company" (Weisbart Co.) on August 14, 1968. In exchange for shares of stock, Gary transferred to the Weisbart Co. his cattle inventory and his rights under contracts to purchase cattle. At all times relevant, Gary owned all of the outstanding shares of stock of the Weisbart Co. On December 16, 1968, the Weisbart Co. purchased cattle feed from 7A for $100,106. The price at which the feed was sold to the Weisbart Co. equalled the cost of the feed to 7A. Lacking cash to pay for the feed, the Weisbart Co. transferred to 7A cattle contracts into which it had previously entered with several unrelated parties and on which it356 had made downpayments totaling $100,106. When Gary caused the Weisbart Co. to transfer the contracts to 7A, he did so with the intention that they be returned to Weisbart Co. when it had sufficient credit to cover the purchase price of the feed. On December 20, 1968, the Bank increased Weisbart Co.'s line of credit sufficiently that the purchase price of the feed could be covered. On March 31, 1969, the Weisbart Co. purchased the unexercised cattle contracts back from 7A for $100,106. For its taxable year August 14-December 31, 1968, the Weisbart Co. elected to be treated as a small business corporation within the meaning of Subchapter S (Secs. 1371 etseq., Internal Revenue Code of 1954, as amended.) 1 It therefore filed a U.S. Small Business Corporation Income Tax Return for the above year. 2 On that return it reported income in accordance with the cash receipts and disbursements method of accounting. OPINION The Weisbart Co. reported income and expenditures in accordance with the cash receipts and disbursements357 method of accounting. Under that method the cost of cattle feed is properly expensed in the year when payment for the feed is made. John Ernst,32 T.C. 181">32 T.C. 181 (1959). The first issue presented is whether the Weisbart Co. paid $100,106 for cattle feed during its taxable year ended December 31, 1968. Petitioner contends that payment was made on December 16, 1968, when the Weisbart Co. transferred its rights, title and interest in several cattle contracts to 7A. The resolution of this controversy depends upon petitioners being able to prove that the transfer of legal title to the contracts to 7A was more than a mere formality; that the parties to the transfer intended that beneficial ownership of the contracts pass to 7A. Cf. J. H. Baird Publishing Co.,39 T.C. 608">39 T.C. 608, 618 (1962). 3 Only if beneficial ownership did indeed pass to 7A would petitioners be entitled to prevail. In our opinion, however, petitioners have failed to prove that this was the case. It would not have been consistent with Gary's plans in dividing his business between the two corporations if 7A had exercised rights*358 under the cattle contracts transferred to it. In fact 7A never exercised those rights. Rather on March 31, 1969, 7A reconveyed the contracts to the Weisbart Co. In consideration of the reconveyance, the Weisbart Co. paid to 7A $100,106, the very amount which the Weisbart Co. owed to 7A for the feed. All of this suggests that the transfer of the cattle contracts on December 16, 1968, was an empty formality, a contrivance made possible by the control which Gary exercised over the parties to the transfer, designed to secure for the Weisbart Co. a cattle feed expense deduction for 1968. It may well have been intended that the Weisbart Co. pay 7A for the feed atsometime. The Weisbart Co.'s repurchase of the contracts may in fact have constituted such a payment. Those matters are not at issue here. It is clear, however, that the transfer of the cattle contracts, not intended to confer upon 7A beneficial ownership of these contracts, cannot be considered to have been a payment for the feed. This being the case, we need not decide the second issue presented. Decision will be entered under Rule 155.Footnotes1. Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954, as amended. ↩2. The election was subsequently, terminated.↩3. Welch v. Helvering,290 U.S. 111">290 U.S. 111↩ (1933).	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622072/	ESTATE OF ANTHONY GERACI, Deceased, Norma Geraci, Executrix, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.Estate of Geraci v. CommissionerDocket No. 6523-71United States Tax CourtT.C. Memo 1973-94; 1973 Tax Ct. Memo LEXIS 194; 32 T.C.M. (CCH) 424; T.C.M. (RIA) 73094; April 23, 1973, Filed Rudolph J. Geraci, for the petitioner. Buckley D. Sowards, for the respondent. TANNENWALDMEMORANDUM FINDINGS OF FACT AND OPINION TANNENWALD, Judge: Respondent determined a deficiency of $2,408.24 in petitioner's estate tax and an addition 2 thereto under section 6651(a) 1 of $361.23. 2196 Petitioner having conceded all but one item involved in the deficiency notice, the sole issue remaining for decision is whether petitioner's failure to file an estate tax return within the prescribed time was due to reasonable cause and not due to willful meglect. Anthony Geraci died on March 27, 1967, a resident of Shaker Heights, Ohio. Norma Geraci, decedent's widow, 3 was appointed executrix of the estate on May 1, 1967, in accordance with the last will and testament of Anthony Geraci. A Federal estate tax return was required to be filed within 15 months after the date of decedent's death. Section 6075(a). The due date for petitioner's estate tax return was therefore June 27, 1968. No extension of time for filing the return was granted under section 6081. Petitioner's estate tax return was not filed with the district director of internal revenue, Cleveland, Ohio, until August 28, 1968.The return as filed showed a gross estate of $378,041.28, a taxable estate of $118,784.67, and net estate tax payable of $25,474.85. The attorney for the decedent's estate was out of his office due to illness for a period of six weeks to two months commencing at the end of May or197 in early June 1968. His office, consisting of two other attorneys besides himself, conducted a general practice. In a letter accompanying the estate tax return, the attorney for decedent's estate stated that "[the] reason for the late filing without obtaining an extension is that we were under the impression that the return was due 15 months from the date of the appointment of the executrix rather than the date of death." 4 Respondent has asserted a 15-percent addition to petitioner's estate tax under section 6651(a) for such failure to make a timely estate tax return. In order to avoid the addition to tax under section 6651(a), petitioner has the burden of proof to establish that its failure to file the required return within the prescribed time was due to reasonable cause; merely demonstrating an absence of willful neglect does not satisfy that burden. Paula Construction Co., 58 T.C. 1055">58 T.C. 1055, 1061 (1972), affirmed per curiam ( C.A. 5, 1973, 31 A.F.T.R.2d (RIA) 73">31 A.F.T.R. 2d 73-926, 73-1U.S.T.C. par. 9283). Reasonable cause exists when the person required to make the return establishes that he exercised ordinary business care and prudence. Estate of Henry P. Lammerts, 54 T.C. 420">54 T.C. 420, 445 (1970),198 affirmed as to this issue, 456 F.2d 681">456 F.2d 681, 683 (C.A. 2, 1972); section 301.6651-1(a) (3), Proced. & Admin. Regs. In this case, the executrix was the person required to file the return within the prescribed time. Section 6018(a) (1). Whether the failure to file on time was due to reasonable cause is primarily a question of fact to be determined from all the circumstances in a particular case. Estate of Frank Duttenhofer, 49 T.C. 200">49 T.C. 200, 204 (1967), affirmed 410 F.2d 302">410 F.2d 302 (C.A. 6, 1969). Petitioner 5 assigns the following facts as the basis of its contention that reasonable cause existed in the present case: (1) The executrix relied entirely upon the attorney for the estate to file the estate tax return; (2) the attorney was incapacitated by illness from June until late August of 1968; and (3) the attorney was under the mistaken impression, as he stated in a letter accompanying the return, that "the return was due 15 months from the date of the appointment of the executrix rather than the date of death." We do not think that those facts constitute reasonable cause for the late filing. As we stated in Estate of Henry P. Lammerts, supra at 446,199 an executor has "a positive duty to ascertain the nature of his responsibilities as such." This duty is not satisfactorily discharged by delegating the entire responsibility for filing the estate tax return to the attorney for the estate. The executor is required, at a minimum, to ascertain when the return is due and to take appropriate steps to see that the obligation to file is fulfilled; inexperience in handling the administration of an estate does not excuse the failure of an executor to take such action. Ferrando v. United States, 245 F.2d 582">245 F.2d 582 (C.A. 9, 1957); Pfeiffer v. United States, 315 F. Supp. 6 392, 395-396 (E.D. Cal. 1970). See Estate of Frank Duttenhofer, supra at 204. Neither do we think that the asserted illness of the attorney constitutes reasonable cause within the circumstances of this case. Assuming without deciding that the attorney's indisposition might, under certain circumstances, constitute reasonable cause, we do not think it constitutes a sufficient excuse in this case. There is no indication in the record that the executrix was unaware of such indisposition and no reason has been shown for her failure to make other provisions200 for the filing of the return or to seek an extension of time under section 6081 before the actual due date of the return. Moreover, the record indicates that the attorney had colleagues in his office who, for aught that appears, could have undertaken to make a timely filing of the return. Robinson's Dairy, Inc. v. Commissioner, 302 F.2d 42">302 F.2d 42, 45 (C.A. 10, 1962), affirming 35 T.C. 601">35 T.C. 601, 608 (1961). 3The third fact relied upon by petitioner - counsel's mistake as to the due date of the return - must fail for the same reason as the first. Cf. Estate of Lammerts v. Commissioner, 456 F.2d 681">456 F.2d 681, 683 (C.A. 2, 1972), affirming 54 T.C. 420">54 T.C. 420 (1970). 7 This is not a case where there was a question as to whether a return needed to be filed, so that reliance upon expert advice might be considered reasonable cause. Cf. Estate of Daisy F. Christ, 54 T.C. 493">54 T.C. 493, 553-554 (1970); Estate of Michael Collino, 25 T.C. 1026">25 T.C. 1026, 1035-1036 (1956). Nor does it involve a situation where the executrix had performed all the necessary acts preparatory to filing, 201 including the execution of the return, relying upon her attorney to perform the necessary ministerial act to perfect compliance with the statutory requirment. It is in this latter respect that In re Fisk's Estate, 203 F.2d 358">203 F.2d 358 (C.A. 6, 1953), reversing a Memorandum Opinion of this Court, is distinguishable. In that case, the return had obviously been completed in time and the only question was whether the ministerial act of the attorney in mailing the return on the day it was due rather than the next day, when the return was received, constituted a sufficient failure of compliance to warrant the conclusion that the "reasonable cause" requirement had been satisfied. The circuit court of appeals, in holding for the taxpayer, was obviously influenced by the shortness of the time gap involved. 4 The same situation obtained in 8 McIntyre v. Commissioner, 272 F.2d 188">272 F.2d 188 (C.A. 6, 1959), reversing per curiam a Memorandum Opinion of this Court. The narrow scope of these decisions is clearly revealed by Estate of Duttenhofer v. Commissioner, 410 F.2d 302">410 F.2d 302 (C.A. 6, 1969), affirming 49 T.C. 200">49 T.C. 200, 204 (1967), in which the same circuit court202 of appeals, in circumstances very similar to those involved herein, held that a five-month delay was not reasonable. The key to our decision herein lies in the fact that the executrix played an entirely passive role and did not, as far as the record reveals, make any attempt to discharge her "positive duty." See Estate of Henry P. Lammerts, supra at 446. In this connection, we note that the record does not contain any direct testimony as to whether the executrix herein had actual knowledge that an estate tax return was required to be filed, but, given the size of the estate, it is not unreasonable to infer that she either did or should have had such knowledge. In any event, lack of knowledge that a return is required to be filed or of the due date thereof does not constitute reasonable cause. Cronin's Estate v. Commissioner, 164 F.2d 561">164 F.2d 561, 566 (C.A. 6, 1947), affirming on this issue 7 T.C. 1403">7 T.C. 1403, 1414 (1946). 9 We conclude that reasonable cause for the late filing herein did not exist. Accordingly, the addition to tax is203 sustained. In order to permit a possible deduction for expenses incurred in this proceeding (see Rule 51, Tax Court Rules of Practice), Decision will be entered under Rule 50. Footnotes1. Statutory references are to the Internal Revenue Code of 1954 as amended. SEC. 6651. FAILURE TO FILE TAX RETURN OR TO PAY TAX. (a) Addition to the Tax. - In case of failure - (1) to file any return required under authority of subchapter A of chapter 61 * * * on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate; ↩2. The total amount of addition to tax under section 6651(a) is $4,182.46, of which $3,821.23 was previously assessed. ↩3. See also Estate of Louis Lewis, T.C. Memo. 1963-331↩. 4. In this connection, we note that timely mailing of a return now constitutes timely filing. Section 7502. ↩	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4537571/	Nebraska Supreme Court Online Library www.nebraska.gov/apps-courts-epub/ 05/29/2020 08:07 AM CDT - 527 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 State of Nebraska, appellee, v. Patrick W. Schroeder, appellant. ___ N.W.2d ___ Filed April 17, 2020. No. S-18-582. 1. Sentences: Death Penalty: Appeal and Error. In a capital sentenc- ing proceeding, the Nebraska Supreme Court conducts an independent review of the record to determine if the evidence is sufficient to support imposition of the death penalty. 2. Sentences: Aggravating and Mitigating Circumstances: Appeal and Error. When reviewing the sufficiency of the evidence to sustain the trier of fact’s finding of an aggravating circumstance, the relevant ques- tion for the Nebraska Supreme Court is whether, after viewing the evi- dence in the light most favorable to the State, any rational trier of fact could have found the essential elements of the aggravating circumstance beyond a reasonable doubt. 3. ____: ____: ____. A sentencing panel’s determination of the existence or nonexistence of a mitigating circumstance is subject to de novo review by the Nebraska Supreme Court. 4. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Appeal and Error. In reviewing a sentence of death, the Nebraska Supreme Court conducts a de novo review of the record to determine whether the aggravating and mitigating circumstances support the imposition of the death penalty. 5. Rules of Evidence. In proceedings where the Nebraska Evidence Rules apply, the admissibility of evidence is controlled by the Nebraska Evidence Rules; judicial discretion is involved only when the rules make discretion a factor in determining admissibility. 6. Constitutional Law: Statutes: Appeal and Error. The constitutionality of a statute presents a question of law, which an appellate court indepen- dently reviews. 7. Sentences: Death Penalty: Homicide: Aggravating and Mitigating Circumstances: Appeal and Error. Under Nebraska law, the death - 528 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 penalty is imposed for a conviction of murder in the first degree only in those instances when the aggravating circumstances existing in connec- tion with the crime outweigh the mitigating circumstances. 8. Trial: Rebuttal Evidence. Rebuttal evidence is confined to new mat- ters first introduced by the opposing party and limited to that which explains, disproves, or counteracts the opposing party’s evidence. 9. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Evidence. In a death penalty case, a sentencing panel has the discretion to hear evidence to address potential mitigating circumstances regardless of whether the defendant presents evidence on that issue. 10. Sentences: Evidence. A sentencing court has broad discretion as to the source and type of evidence and information which may be used in determining the kind and extent of the punishment to be imposed, and evidence may be presented as to any matter that the court deems relevant to the sentence. 11. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Evidence. In a death penalty case, a sentencing panel may permit the State to present evidence to contradict potential mitigators even though a defendant failed to present affirmative evidence. 12. Sentences: Death Penalty: Homicide. A sentencing order in a death penalty case must specify the factors the sentencing panel relied upon in reaching its decision and focus on the individual circumstances of each homicide and each defendant. 13. Constitutional Law: Sentences: Death Penalty: Aggravating and Mitigating Circumstances. The U.S. Constitution does not require the sentencing judge or judges to make specific written findings in death penalty cases with regard to nonstatutory mitigating factors. 14. Sentences: Aggravating and Mitigating Circumstances: Appeal and Error. The Nebraska Supreme Court will not fault a sentencing panel for failing to discuss a nonstatutory mitigating circumstance that it was not specifically asked to consider. 15. Death Penalty: Aggravating and Mitigating Circumstances. During the consideration of statutory mitigating factors in a death penalty case, the mere identification of a history of incarceration, without more, is insufficient to allege unusual pressures or influences or establish extreme mental or emotional disturbance. 16. Sentences: Homicide: Aggravating and Mitigating Circumstances: Judgments: Juries: Presentence Reports. When an offender has been convicted of first degree murder and waives the right to a jury determi- nation of an alleged aggravating circumstance, the court must order a presentence investigation of the offender and the panel must consider a written report of such investigation in its sentencing determination. - 529 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 17. Presentence Reports. A presentence investigation and report shall include, when available, any submitted victim statements and an analy- sis of the circumstances attending the commission of the crime and the offender’s history of delinquency or criminality, physical and mental condition, family situation and background, economic status, education, occupation, and personal habits. 18. Presentence Reports: Probation and Parole. A presentence investiga- tion and report may include any matters the probation officer deems relevant or the court directs to be included. 19. Constitutional Law: Criminal Law: Sentences: Right to Counsel. An accused has a state and federal constitutional right to be represented by an attorney in all critical stages of a criminal prosecution which can lead to a sentence of confinement. 20. Right to Counsel: Waiver. A defendant may waive the right to counsel so long as the waiver is made knowingly, voluntarily, and intelligently. 21. Constitutional Law: Right to Counsel. The same constitutional provi- sions that provide a defendant the right to counsel also guarantee the right of the accused to represent himself or herself. 22. Attorney and Client. The right to self-representation plainly encom- passes certain specific rights of the defendant to have his voice heard, including that the pro se defendant must be allowed to control the orga- nization and content of his own defense. 23. Sentences: Death Penalty: Attorney and Client: Aggravating and Mitigating Circumstances: Evidence: Waiver. Control of the orga- nization and content of a defense may include a waiver of the right to present mitigating evidence during sentencing in a death penalty case. 24. Criminal Law: Sentences: Death Penalty: Appeal and Error. Because a death sentence is different from any other criminal penalty and no sys- tem based on human judgment is infallible, the Nebraska Supreme Court has taken, and should continue to take, the extra step to ensure fairness and accuracy with the imposition of the death penalty. 25. Criminal Law: Statutes. Penal statutes are to be strictly construed in favor of the defendant. 26. Sentences: Evidence: Presentence Reports. Even if the State presents evidence in favor of a specific sentence and the defendant declines to present contrary evidence, a court receives and must consider indepen- dent information from a presentence investigation report. 27. Sentences: Death Penalty: Evidence: Presentence Reports. In a death penalty case, a sentencing panel is required to review a presentence investigation report and determine whether it contradicts the State’s evi- dence of aggravating factors and whether any mitigating circumstances exist, including specifically delineated statutory mitigators. - 530 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 28. Death Penalty: Aggravating and Mitigating Circumstances: Proof. While the State must prove aggravating circumstances beyond a rea- sonable doubt in a death penalty case, there is no burden of proof with regard to mitigating circumstances. 29. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Judgments. Once a sentencing panel in a death penalty case makes its determinations about the existence of aggravating and mitigat- ing circumstances, the panel is then required to undertake a proportion- ality review. 30. Criminal Law: Sentences: Death Penalty: Words and Phrases. A pro- portionality review in a death penalty case looks at whether the sentence of death is excessive or disproportionate to the penalty imposed in simi- lar cases, considering both the crime and the defendant. Proportionality review is not constitutionally mandated. 31. Sentences: Death Penalty: Statutes: Appeal and Error. The propor- tionality review in a death penalty case exists in Nebraska by virtue of statutes which direct the Nebraska Supreme Court to conduct a propor- tionality review in each appeal in which a death sentence is imposed. 32. Sentences: Death Penalty. A court’s proportionality review spans all previous cases in which a sentence of death is imposed and is not depen- dent on which cases are put forward by the parties. 33. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Judgments: Juries. Even when a jury determines the existence of an aggravating circumstance, a sentencing panel is required to put in writing its consideration of whether the determined aggravating circum- stance justifies the imposition of a sentence of death, whether mitigating circumstances exist, and whether a sentence of death would be excessive or disproportionate to penalties imposed in similar cases. 34. ____: ____: ____: ____: ____. A sentencing panel’s order imposing a sentence of death where a jury has determined the existence of an aggravating circumstance must specifically refer to the aggravating and mitigating circumstances weighed in the determination of the panel. 35. Sentences: Death Penalty: Statutes. Nebraska’s capital sentencing scheme provides additional statutory steps and considerations to ensure fairness and accuracy, and these safeguards exist regardless of a defend ant’s strategy at the penalty phase. 36. Sentences: Death Penalty. Due to Nebraska’s statutory capital sentenc- ing scheme, a defendant cannot “choose” the death penalty. 37. Courts: Sentences: Death Penalty. A sentencing decision in a death penalty case rests with the court alone. 38. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Evidence: Presentence Reports. In order to sentence a - 531 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 defendant to death, the statutory scheme requires that a sentencing panel consider not only evidence and argument presented by the parties but also an independently compiled presentence investigation report to determine whether the alleged aggravating circumstance exists, deter- mine whether any mitigating factors are present which would weigh against the imposition of the death penalty, and conduct a proportional- ity review weighing the aggravating and mitigating factors and compar- ing the facts to previous cases where the death penalty was imposed. 39. Trial: Parties. A defendant is entitled to present a defense and is guar- anteed the right to choose the objectives for that defense. 40. Attorney and Client. A self-represented defendant must be allowed to control the organization and content of his own defense. 41. Constitutional Law: Right to Counsel: Sentences: Aggravating and Mitigating Circumstances: Evidence: Waiver. When a defend ant waives counsel and the presentation of mitigating evidence, the appointment of an advocate to present evidence and argue against the imposition of a sentence overrides that defendant’s constitutional right to control the organization and content of his or her own defense dur- ing sentencing. 42. Right to Counsel: Waiver. A criminal defendant has the right to waive counsel and present his or her own defense. 43. Sentences: Death Penalty: Right to Counsel: Evidence: Waiver. In a death penalty case, a defendant’s right to waive counsel and present his or her own defense includes the right of the defendant to elect not to present additional evidence or argument during the penalty proceedings. 44. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Appeal and Error. In reviewing a sentence of death, the Nebraska Supreme Court conducts a de novo review of the record to determine whether the aggravating and mitigating circumstances support the imposition of the death penalty. 45. ____: ____: ____: ____. In reviewing a sentence of death, the Nebraska Supreme Court considers whether the aggravating circumstances justify imposition of a sentence of death and whether any mitigating circum- stances found to exist approach or exceed the weight given to the aggra- vating circumstances. 46. ____: ____: ____: ____. The Nebraska Supreme Court is required, upon appeal, to determine the propriety of a death sentence by conducting a proportionality review, comparing the aggravating and mitigating cir- cumstances with those present in other cases in which a court imposed the death penalty. 47. Sentences: Death Penalty. The purpose of a proportionality review in a death penalty case is to ensure that the sentences imposed in a case are - 532 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 no greater than those imposed in other cases with the same or similar circumstances. 48. Sentences: Death Penalty: Aggravating and Mitigating Circum stances: Appeal and Error. The Nebraska Supreme Court’s propor- tionality review looks only to other cases in which the death penalty has been imposed and requires the court to compare the aggravating and mitigating circumstances of the case on appeal with those present in those other cases. 49. Death Penalty. A proportionality review in a death penalty case does not require that a court “color match” cases precisely. 50. Sentences: Death Penalty. The question when conducting a propor- tionality review in a death penalty case is simply whether the cases being compared are sufficiently similar, considering both the crime and the defendant, to provide the court with a useful frame of reference for evaluating the sentence in the instant case. 51. Sentences: Death Penalty: Aggravating and Mitigating Circum stances. One aggravating circumstance may be sufficient under Nebraska’s statutory system for the imposition of the death penalty. 52. ____: ____: ____. In a proportionality review, the evaluation of whether the death penalty should be imposed in a specific case is not a mere counting process of “X” number of aggravating circumstances and “Y” number of mitigating circumstances and, instead, asks whether the reviewed cases are sufficiently similar to provide a useful reference for that evaluation. Appeal from the District Court for Johnson County: Vicky L. Johnson, Judge. Affirmed. Sarah P. Newell, of Nebraska Commission on Public Advocacy, for appellant. Douglas J. Peterson, Attorney General, and James D. Smith, Solicitor General, for appellee. Christopher L. Eickholt, of Eickholt Law, L.L.C., Cassandra Stubbs, of American Civil Liberties Union Foundation, and Amy A. Miller, of ACLU of Nebraska Foundation, for amicus curiae ACLU and ACLU of Nebraska. Heavican, C.J., Miller-Lerman, Cassel, Stacy, Funke, and Papik, JJ., and Moore, Chief Judge. - 533 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 Funke, J. Patrick W. Schroeder appeals his sentence of death for first degree murder of Terry Berry, Jr. This is a mandatory direct appeal pursuant to Neb. Rev. Stat. § 29-2525 (Cum. Supp. 2018) and article I, § 23, of the Nebraska Constitution. Schroeder waived counsel, pled guilty without a plea agree- ment, waived the right to a jury on the issue of aggravating factors, declined to present evidence of aggravating or mitigat- ing factors, and declined to cooperate for the preparation of the presentence investigation report. On appeal, Schroeder was appointed counsel and now con- tends that the sentencing panel erred in allowing the State to introduce evidence to refute unpresented mitigating evidence, failing to consider and weigh mitigating evidence from the presentence investigation report, failing to request documenta- tion from the Department of Correctional Services (DCS) of Schroeder’s time in custody for mitigation purposes, sentenc- ing Schroeder to death with insufficient safeguards to prevent arbitrary results, and finding Schroeder should be sentenced to death after balancing the aggravating evidence and mitigating evidence. For the reasons set forth herein, we affirm. BACKGROUND Factual Background At the time of the events leading to Schroeder’s instant conviction, Schroeder was incarcerated at Tecumseh State Correctional Institution (TSCI). This incarceration was pur- suant to a 2007 conviction for the first degree murder of Kenneth Albers in which Schroeder was sentenced to life imprisonment. In March 2017, while housed in a cell intended for one occupant, Schroeder was asked if he would consider a room- mate due to overcrowding. Schroeder agreed but wanted a roommate with whom he was compatible. Prison officials assigned Berry to Schroeder’s cell. Schroeder did not consider Berry to be compatible with him and told prison officials that he did not want Berry as a cellmate. Schroeder did not know - 534 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 Berry personally before the assignment but knew of Berry as “‘a loudmouth, a punk.’” Berry was 22 years old and convicted of second degree forgery and a confined person violation. Berry was due for release approximately 2 weeks after his assignment to Schroeder’s cell. Schroeder had described Berry as a constant talker with extremely poor hygiene. During their shared confinement, Schroeder would urge Berry to be quieter and clean up after himself. Schroeder alleged that he had told prison staff that placing Berry with him would be an unworkable, bad arrange- ment. Schroeder described that prison staff who came by his cell would acknowledge the poor fit and even joke that it was surprising Schroeder had not killed Berry yet. By April 13, 2017, Schroeder decided to himself that “‘[s]omething was gonna happen’” if Berry was not moved. On April 15, 2017, Berry was watching “UFC” on televi- sion in the cell and, as Schroeder explained, Berry “‘would not shut up.’” Schroeder instructed Berry to move his chair to face the television with his back to Schroeder. Schroeder proceeded to put Berry in a chokehold and locked his hands. He continued to choke Berry for about 5 minutes until his arms got tired and then took a nearby towel, wrapped it around Berry’s neck, and continued to choke him for about 5 more minutes. At that point, Schroeder let up on the towel, believ- ing Berry was dead. Schroeder claimed he then tried to push the call button in his cell to alert staff to Berry’s condition. Around 30 minutes later, Schroeder alerted a passing guard that Berry was on the floor by asking, “‘How do you deal with a dead body in a cell?’” The guard believed Schroeder was joking until Schroeder picked up and dropped Berry’s leg. Schroeder has stated that he summoned the guard not for Berry’s benefit, but because he wanted Berry’s body removed from the cell. Berry was transported to a medical facility. On April 19, 2017, Berry died, having been declared brain dead. A search of the cell revealed a torn “kite,” a form inmates use to com- municate with prison staff, dated April 13, 2017, and located in - 535 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 the trash. The discarded kite stated that prison staff had to get Berry out of the cell before he got hurt. Procedural Background Pursuant to these events, Schroeder was charged in April 2017 with first degree murder and use of a weapon to commit a felony. Within an information filed in June, the State submit- ted a notice of aggravation alleging Schroeder had been con- victed of another murder, been convicted of a crime involving the use or threat of violence to the person, or had a substantial prior history of serious assaultive or terrorizing criminal activ ity. 1 Schroeder was appointed counsel and entered a plea of not guilty. A hearing was held following Schroeder’s subsequent request to dismiss counsel and represent himself. The court granted Schroeder’s motion and discharged his counsel but also appointed that same counsel to act in a standby role. Representing himself, Schroeder withdrew a pending motion to quash and requested leave to withdraw his prior plea of not guilty. The court granted Schroeder leave to withdraw his prior plea and rearraigned him. Thereafter, Schroeder pled guilty to both counts and the court found him guilty of those charges beyond a reasonable doubt. Presentence Investigation Report The court ordered a presentence investigation report. Schroeder declined to answer questions or participate in its preparation. However, the current report did attach the 2007 presentence investigation report from Schroeder’s earlier con- victions, which supplies more background information. According to the report, Schroeder was born in June 1977. Schroeder’s biological father abandoned his family when Schroeder was an infant. Schroeder’s mother and stepfather raised him in his early years. Schroeder described his stepfather as an alcoholic. Schroeder’s mother and stepfather separated 1 See Neb. Rev. Stat. § 29-2523(1)(a) (Cum. Supp. 2018). - 536 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 when Schroeder was 9 years old, and Schroeder moved with his mother to Kearney, Nebraska. Schroeder has not had con- tact with his stepfather since he was 12 years old. Schroeder has two older brothers but, at the time of the 2007 report, was not close to either of them. While Schroeder’s biological father did take him in for a brief period of time when he was 12 years old, Schroeder was removed and sent to a juvenile facility because his father caught him smoking marijuana. Schroeder denied being abused or neglected and described his childhood as “‘typical.’” Schroeder has a history of “placement in foster care and group home situations including a number of run- aways.” At one point as a teenager, Schroeder was placed with his grandparents for a period of time. Schroeder was married in 1998 and has one child from that marriage, but the couple has since divorced. At the time of the 2007 report, Schroeder described that the child was adopted by his ex-wife’s present husband and that Schroeder has no contact with the child. Schroeder remarried in 2003, and his wife had three children from prior relationships. However, Schroeder said in the 2007 report that while the couple was then together, he expected the situation to change under the circumstances. The presentence investigation report provides that Schroeder has an eighth grade education. Before he was incarcerated in 2007, he had been employed in various farmwork and con- struction jobs. Schroeder reported that he first used alcohol when he was 13 years old and that he experimented with marijuana and cocaine when he was 15 years old. Schroeder also admitted he had used methamphetamine on a daily basis for approximately 3 to 4 months, with the last use in 2003. While Schroeder denied receiving treatment, previous prison records indicated he was placed in substance abuse programming in 1991. Schroeder asserted that from April 2005 until his 2006 arrest, he was “‘hooked on opiates’” and was taking between 500 and 800 pills per month, some of which were prescribed and some of which were not. - 537 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 The report explained that in 1985, Schroeder was first charged with criminal mischief in juvenile court when he was 12 years old. Between 1987 and 1992, Schroeder was also charged in juvenile court with aiding and abetting, escape, theft, minor in possession of alcohol, and theft by exercis- ing control. He was ordered to serve probation as well as being placed in the Youth Rehabilitation and Treatment Center in Kearney. Since reaching the age of majority, in addition to his 2007 convictions, Schroeder has been convicted of bank robbery, forgery, escape, theft, assault, driving under suspension, con- tributing to the delinquency of a child, driving under the influence, and issuing bad checks. He has been sentenced to multiple terms of incarceration and terms of supervision. He has had two of his terms of probation revoked and completed others unsatisfactorily. Sentencing Proceedings A scheduling hearing was held in August 2017. Schroeder waived his right to a jury for a determination of the aggrava- tion allegation. The court accepted this waiver after making inquiry and finding, beyond a reasonable doubt, that Schroeder was competent and that his decision was made freely, volun- tarily, knowingly, and intelligently. Thereafter, a three-judge panel was convened for a sentencing hearing on Schroeder’s first degree murder conviction. On the aggravation allegation, the State presented evidence of Schroeder’s 2007 conviction for Albers’ murder. A ser- geant with the Nebraska State Patrol testified that he was the lead investigator for that case. His testimony and a video of his interview with Schroeder described that Albers was a 75-year-old farmer who had previously employed Schroeder. Believing Albers had several thousand dollars in cash at his residence, Schroeder had driven to Albers’ house, rung the doorbell, entered the home, and awakened Albers. Schroeder demanded money, threatened Albers, and hit him in the head with a nightstick. Albers recognized Schroeder during this - 538 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 exchange and called him by name. Schroeder forced Albers to open a lockbox in which Schroeder believed the cash was kept, after which Schroeder took Albers outside to an adjacent shop. At the shop, Albers turned toward Schroeder, attempting to defend himself. Schroeder struck Albers with the nightstick four or five times. With Albers on the floor, Schroeder dragged him out of the shop, tied him up with battery cables, and placed him in the back of Albers’ pickup. Schroeder then drove Albers, who was still alive, to an abandoned well on the prop- erty and dumped him into it. Schroeder explained to the ser- geant that he had made the decision to kill Albers a few days before the robbery. The doctor who performed the autopsy on Albers testified that the cause of Albers’ death was blunt force trauma to his head. Schroeder declined to cross-examine the State’s witnesses, present rebuttal evidence, or argue against the State’s claim on the aggravation allegation. As to mitigating factors, Schroeder again declined to pre sent any evidence or argument. However, the State requested, and the court granted, permission to present evidence to negate possible statutory mitigating circumstances. Here, the State presented evidence related to Berry’s murder. Investigator Stacie Lundgren of the Nebraska State Patrol testified to her interview with Schroeder where he described how and why he killed Berry. This interview was also described in the pre- sentence investigation report. The doctor who performed the autopsy of Berry opined that the cause of death was compres- sional asphyxia, a form of strangulation where the structures of the neck are compressed. Cpl. Steve Wilder explained that he was the correctional officer whom Schroeder flagged down to remove Berry after Schroeder had choked him. Cpl. Joseph Eppens testified he had moved Schroeder from his cell follow- ing the incident. Eppens explained that Schroeder told him he had previously informed correctional staff he did not want a cellmate and that he joked, “[T]his is what happens when we watch UFC.” Finally, a TSCI employee testified that he had notarized a writing in which Schroeder stated: - 539 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 My name is Patrick Schroeder. I’m 40 years old and I killed Terry Berry on April 15[,] 2017[.] I killed Berry because I wanted to, I knew I was going to kill him the moment staff put him in my cell on April 10[,] 2017. . . . I’m writing this statement to inform the court that if given another life term I will kill again and we will be right back in court doing this all over again. The court allowed the parties to make arguments. Schroeder declined. On the aggravation allegation, the State noted that it provided a certified copy of Schroeder’s previous murder conviction and testimony concerning the events leading to that conviction. As to mitigating circumstances, the State stated, in part: [T]he State has offered evidence considering the statutory mitigating circumstances, and the purpose of the evidence was to affirmatively show that there were no statutory mitigators that exist in this case. The circumstances to be considered for mitigation include whether or not the defendant acted under unusual pressure or influence. I want to emphasize the word “unusual.” His justification[s] for his actions are more of a nuisance than they are unusual pressure. It was displeasure or disagreement with a roommate and how the roommate either talked too much or his hygiene wasn’t appropriate for . . . Schroeder’s standards, and I don’t think that constitutes unusual pressure or influence. He’s not under the . . . dominion of another. . . . Schroeder acted by himself, and I would say he probably was the boss in the cell. There is no undue influence of extreme mental or emo- tional disturbance. . . . Schroeder was clear thinking, and by the evidence that’s been presented, his thought process started almost immediately upon . . . Berry becoming his cellmate. And in his written statement, that is really clear. And even in his interview with the investigator, he - 540 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 started thinking about this several days before it actu- ally happened. So he wasn’t under any influence of extreme mental or emotional disturbance. This was a thought process delib- erate and pretty cold blooded. .... The evidence shows that he was the sole person com- mitting this crime. There is no accomplice. And his par- ticipation is the . . . death-causing participation. The State would argue that . . . Berry’s habits as described by [Schroeder do] not make him a participant [in the incident]. .... [Schroeder] was a prisoner at the institution. No evi- dence of impairment. The only evidence is that he’s clear- headed, he’s thinking, and he planned. Order of Sentence In the panel’s order of sentence, the panel found the State proved the aggravation allegation beyond a reasonable doubt, citing Schroeder’s previous conviction and the testimony describing the events leading to that conviction. The panel also addressed possible statutory mitigating cir- cumstances, noting, “The State was allowed to present evi- dence that is probative of the non-existence of statutory or non- statutory mitigating circumstances, and did so[, and Schroeder] was allowed to present evidence that is probative of the exis- tence of a statutory or non-statutory mitigating circumstance[, but] chose not to . . . .” After analyzing each of the mitigating grounds defined by § 29-2523(2) and giving Schroeder the benefit of all inferences, the panel did not find there were any statutory mitigating circumstances. The panel addressed various nonstatutory mitigating factors. The panel found two of these factors existed and weighed in Schroeder’s favor, including that Schroeder’s guilty plea spared Berry’s family the trauma of a trial and the State the expense of - 541 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 a trial and that Schroeder’s childhood and family were dysfunc- tional. While finding three other factors did not exist, the panel noted the following: Schroeder is not well educated, but there is no evidence of a borderline intellect or diminished cogni- tive ability and he clearly knows right from wrong; Schroeder takes medication for depression, but there is nothing to suggest that this depression contributed to his actions and there is no evidence that his psychiatric or psychological history rises to the level of a mitigating circumstance; and the record does not suggest Schroeder has generally been a problem to officials during his confinement, but this prior conduct does not rise to the level of a mitigating factor. The panel acknowledged that Schroeder apparently “expressly welcomes a death sentence” but explained this was not considered and that “[i]t is the law, and not [Schroeder’s] wishes, that compels this Panel’s ulti- mate conclusion.” The panel concluded that the two nonstatutory mitigating circumstances were given little weight because these two fac- tors did not approach or exceed the weight given to the aggra- vating circumstance. The panel then conducted a proportional- ity review and found that a sentence of death is not excessive or disproportionate to the penalty imposed in similar cases. Based upon all of the above, the panel sentenced Schroeder to death. ASSIGNMENTS OF ERROR Schroeder assigns, restated, that the sentencing court erred in (1) allowing the State to introduce evidence to rebut unpre- sented mitigating evidence, (2) failing to consider and prop- erly weigh mitigating evidence from the presentence inves- tigation report, (3) failing to request DCS documentation of Schroeder’s time in custody for mitigation purposes, (4) sen- tencing Schroeder to death with insufficient safeguards to prevent arbitrary results, and (5) sentencing Schroeder to death after balancing the aggravating evidence and mitigating evi- dence and conducting the proportionality review. - 542 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 STANDARD OF REVIEW [1] In a capital sentencing proceeding, this court conducts an independent review of the record to determine if the evidence is sufficient to support imposition of the death penalty. 2 [2-4] When reviewing the sufficiency of the evidence to sustain the trier of fact’s finding of an aggravating circum- stance, the relevant question for this court is whether, after viewing the evidence in the light most favorable to the State, any rational trier of fact could have found the essential ele- ments of the aggravating circumstance beyond a reasonable doubt. 3 The sentencing panel’s determination of the existence or nonexistence of a mitigating circumstance is subject to de novo review by this court. 4 In reviewing a sentence of death, the Nebraska Supreme Court conducts a de novo review of the record to determine whether the aggravating and mitigating circumstances support the imposition of the death penalty. 5 [5] In proceedings where the Nebraska Evidence Rules apply, the admissibility of evidence is controlled by the Nebraska Evidence Rules; judicial discretion is involved only when the rules make discretion a factor in determining admissibility. 6 [6] The constitutionality of a statute presents a question of law, which an appellate court independently reviews. 7 ANALYSIS Rebuttal of Mitigating Circumstances [7] Under Nebraska law, the death penalty is imposed for a conviction of murder in the first degree only in those 2 State v. Jenkins, 303 Neb. 676, 931 N.W.2d 851 (2019). 3 State v. Torres, 283 Neb. 142, 812 N.W.2d 213 (2012). 4 Jenkins, supra note 2. 5 Id. 6 Torres, supra note 3. 7 Jenkins, supra note 2. - 543 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 instances when the aggravating circumstances existing in connection with the crime outweigh the mitigating circum stances. 8 When, as here, a defendant waives the right to a jury determination of alleged aggravating circumstances, the process for a sentencing panel to consider, find, and weigh the applicable aggravating and mitigating circumstances is set out by Neb. Rev. Stat. § 29-2521(2) (Cum. Supp. 2018). Section 29-2521(2) states: In the sentencing determination proceeding before a panel of judges when the right to a jury determination of the alleged aggravating circumstances has been waived, the panel shall . . . hold a hearing. At such hearing, evidence may be presented as to any matter that the presiding judge deems relevant to sentence and shall include matters relating to the aggravating circumstances alleged in the information, to any of the mitigating circumstances set forth in section 29-2523, and to sentence excessiveness or disproportionality. The Nebraska Evidence Rules shall apply to evidence relating to aggravating circumstances. Each aggravating circumstance shall be proved beyond a reasonable doubt. Any evidence at the sentencing deter- mination proceeding which the presiding judge deems to have probative value may be received. The state and the defendant or his or her counsel shall be permitted to pre sent argument for or against sentence of death. The mitigating circumstances required to be considered under § 29-2521 and set forth in § 29-2523(2) include: (a) The offender has no significant history of prior criminal activity; (b) The offender acted under unusual pressures or influences or under the domination of another person; (c) The crime was committed while the offender was under the influence of extreme mental or emotional disturbance; (d) The age of the defendant at the time of the crime; 8 Neb. Rev. Stat. § 29-2519 (Cum. Supp. 2018). - 544 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 (e) The offender was an accomplice in the crime com- mitted by another person and his or her participation was relatively minor; (f) The victim was a participant in the defendant’s con- duct or consented to the act; or (g) At the time of the crime, the capacity of the defend ant to appreciate the wrongfulness of his or her conduct or to conform his or her conduct to the requirements of law was impaired as a result of mental illness, mental defect, or intoxication. [8] Schroeder initially claims that the sentencing panel erred by allowing the State to present evidence to rebut the statutory mitigating circumstances even though Schroeder did not offer any evidence on mitigation. In making this claim, Schroeder cites the proposition that rebuttal evidence is confined to new matters first introduced by the opposing party and limited to that which explains, disproves, or counteracts the opposing party’s evidence. 9 [9-11] Contrary to Schroeder’s assertions under this assign- ment, a sentencing panel has the discretion to hear evidence to address potential mitigating circumstances regardless of whether the defendant presents evidence on that issue. As quoted above, § 29-2521(2) allows a sentencing panel to receive “[a]ny evidence” at the sentencing proceeding which the presiding judge deems to have probative value relevant to the sentence including to any of the statutory mitigating circumstances. 10 A sentencing court has broad discretion as to the source and type of evidence and information which may be used in determining the kind and extent of the punishment to be imposed, and evidence may be presented as to any mat- ter that the court deems relevant to the sentence. 11 Although § 29-2521(2) dictates that the Nebraska Rules of Evidence 9 See State v. Sandoval, 280 Neb. 309, 788 N.W.2d 172 (2010). See, also, State v. Molina, 271 Neb. 488, 713 N.W.2d 412 (2006). 10 See Jenkins, supra note 2. 11 Id. - 545 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 apply when determining the aggravating circumstances alleged by the information, it contains no such requirement for con- sideration of mitigating circumstances. Because a sentencing panel is required to consider and weigh any mitigating cir- cumstances in imposing a sentence of death, the introduction of evidence of the existence or nonexistence of these potential mitigators has probative value to the sentence. Thus, the panel could permit the State to present evidence to contradict poten- tial mitigators even though Schroder failed to present affirma- tive evidence. Schroeder argues the State’s evidence purported to rebut the statutory mitigating circumstances was actually offered to support uncharged aggravating circumstances. Specifically, Schroeder alleges the State’s evidence was offered to show the nonstatutory aggravating circumstance of future dangerous- ness and “both prongs” 12 of § 29-2523(1)(d), which provides a statutory aggravator when a murder was especially heinous, atrocious, or cruel or manifested exceptional depravity by ordi- nary standards of morality and intelligence. During the portion of the hearing devoted to mitigating circumstances, the State’s evidence related to Berry’s murder. Lundgren testified about her interview with Schroeder where he described how and why he killed Berry. This same interview was also described in the presentence investigation report. The doctor who performed the autopsy on Berry explained that Berry was killed by strangulation. Wilder explained the events surrounding his discovery of Berry’s murder and Schroeder’s reaction. Eppens explained that Schroeder told him he had pre- viously informed correctional staff he did not want a cellmate and joked, while Eppens was moving him following the dis- covery of Berry’s unconscious body, “[T]his is what happens when we watch UFC.” Additionally, through the testimony of a TSCI employee, the State introduced a notarized writing in which Schroeder confessed, explained his reasons for killing Berry, and stated he would kill again if given another life term. 12 Brief for appellant at 28. - 546 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 This evidence surrounding Berry’s murder was relevant to the statutory mitigating circumstances the panel was required to consider. The mitigating circumstances listed under § 29-2523(2) involve, in part, circumstances surrounding the underlying crime. These circumstances include pressure or influences which may have weighed on the defendant, poten- tial influence on the defendant of extreme mental or emotional disturbance at the time of the offense, potential victim partici- pation or consent to the act, the defendant’s capacity to appre- ciate the wrongfulness of the act at the time of the offense, and any mental illness, defect, or intoxication which may have contributed to the offense. 13 The State’s evidence informed the panel’s analysis and was relevant to consideration of these mitigators; and, as explained above, the panel had discretion to hear this evidence. Schroeder fails to allege that the introduction of this evi- dence influenced the panel’s finding of the existence of the charged aggravator—namely that Schroeder had been convicted of another murder, been convicted of a crime involving the use or threat of violence to the person, or had a substantial prior history of serious assaultive or terrorizing criminal activity. 14 It is undisputed that Schroeder had previously been convicted of the murder of Albers and was incarcerated for that crime at the time of Berry’s killing. Schroeder does not challenge the pre- sentation of evidence related to this aggravating circumstance for failing to comply with the Nebraska Evidence Rules. 15 The panel had discretion to hear any evidence relevant to sentencing, the panel was required to consider mitigating cir- cumstances even though Schroeder failed to allege or present evidence in support of them, and the evidence presented by the State was relevant to the panel’s review of these mitigators. As such, the panel did not err in allowing the State to present evidence on the existence of mitigating circumstances. 13 § 29-2523(2). 14 § 29-2523(1)(a). 15 See § 29-2521(2). - 547 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 Weighing of Mitigating Circumstances Schroeder next assigns the panel failed to properly con- sider mitigating information contained within the presentence investigation report and available from the State’s evidence. Schroeder claims proper consideration of this evidence would have led the panel to find additional statutory and nonstatutory mitigating circumstances. [12] As explained, § 29-2521 requires a sentencing panel to consider mitigating circumstances. Neb. Rev. Stat. § 29-2522 (Cum. Supp. 2018) describes the weighing of the aggravat- ing and mitigating circumstances in imposing a sentence of death and requires that the determination be in writing and refer to the aggravating and mitigating circumstances weighed. Accordingly, the sentencing order must specify the factors it relied upon in reaching its decision and focus on the individual circumstances of each homicide and each defendant. 16 We first address Schroeder’s claims that the panel should have applied additional nonstatutory mitigating evidence, including (1) that the State had ulterior motives for pursu- ing the death penalty to avoid and detract from potential civil liability for failing to protect Berry, (2) that Schroeder was institutionalized from consistent incarceration, and (3) that Schroeder had used money elicited from his murder of Albers to provide clothes and food for his family. [13,14] The U.S. Constitution does not require the sen- tencing judge or judges to make specific written findings with regard to nonstatutory mitigating factors. 17 In State v. Jenkins, 18 we addressed an assignment of a sentencing panel failing to address nonstatutory mitigators and explained that 16 State v. Dunster, 262 Neb. 329, 631 N.W.2d 879 (2001). 17 State v. Bjorklund, 258 Neb. 432, 604 N.W.2d 169 (2000), abrogated on other grounds, State v. Mata, 275 Neb. 1, 745 N.W.2d 229 (2008). Accord State v. Reeves, 234 Neb. 711, 453 N.W.2d 359, cert. granted and judgment vacated 498 U.S. 964, 111 S. Ct. 425, 112 L. Ed. 2d 409 (1990). 18 Jenkins, supra note 2. - 548 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 we will not fault the panel for failing to discuss a nonstatu- tory mitigating circumstance that it was not specifically asked to consider. Additionally, the underlying facts Schroeder uses as sup- port for these nonstatutory mitigators are included in the presentence investigation report which the panel explained it considered in determining his sentence. The panel also specifi- cally acknowledged many of these facts in its sentencing order. On the allegation that the State had ulterior motives due to potential liability, the panel explained the cell Schroeder and Berry shared was intended for a single inmate, Berry was set for release 2 weeks after moving in with Schroeder, Schroeder was serving a life sentence for Albers’ murder, and Schroeder warned that issues might arise if he were incompatible with whoever was assigned as his roommate. As to institutional- ization, the panel described Schroeder’s current incarceration for Albers’ murder and noted his dysfunctional childhood and that “[h]e was involved in the juvenile court at a young age.” Finally, on the use of money he attained from Albers’ murder, the panel described that he took several thousand dollars from Albers after leaving him for dead and “drove around the area, paying off bills and making purchases.” It is clear the panel considered and weighed these facts even though it did not state a finding that they led to the specific nonstatutory mitigating circumstances Schroeder presently claims. Because the panel was not required to make specific writ- ten findings on the application of nonstatutory mitigating fac- tors, and taking into account the panel’s consideration of the facts Schroeder alleges support these factors, Schroeder’s claims involving the nonstatutory mitigators do not demon- strate reversible error. We next turn to Schroeder’s claim that the panel failed in its analysis of statutory mitigating circumstances. Of the statutory mitigating factors, Schroeder claims the panel should have determined the following applied: Schroeder acted under unusual pressures or influences or under the domination - 549 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 of another person, 19 Berry’s murder was committed while Schroeder was under the influence of extreme mental or emo- tional disturbance, 20 and Berry was a participant in Schroeder’s conduct or consented to the act. 21 For Schroeder’s claims that he was under unusual pressures or influences and extreme mental or emotional disturbance, he first alleges the panel failed to acknowledge his efforts to get Berry removed as a cellmate and his incompatibility with Berry. He supports this allegation by referencing the panel’s determination that Schroeder had calculated Berry’s murder for several days and chose no method of obviating his annoyance. Schroeder further quoted the panel’s explanation that finding the kite in the trash “suggests a premeditative and depraved mentality” in that Schroeder “did not ask that [Berry] be moved” and in that Schroeder “did not tell the guards that . . . Berry was in mortal danger if he were not moved.” Schroeder contends this determination and the findings supporting it are contradicted by the evidence. Specifically, Schroeder points to the summaries of his interviews with Lundgren, included in the presentence investigation report, wherein he told Lundgren that he had “‘told all of the staff’” that he did not want Berry as a cellmate, that he told staff members he was not compatible with Berry when they assigned him to Schroeder’s cell, that a TSCI caseworker had tried to get the assignment switched prior to Berry’s moving in, and that corrections officers would laugh at the arrangement and joke they were surprised Schroeder had not killed Berry yet. Schroeder also points to Lundgren’s case synopsis noting that the TSCI caseworker Schroeder described in his interview explained that she did have concerns prior to Berry’s moving into the cell based on a “‘gut feeling’” that the arrangement would be “‘a bad idea’” but that she was unsuccessful in get- ting it switched. 19 See § 29-2523(2)(b). 20 See § 29-2523(2)(c). 21 See § 29-2523(2)(f). - 550 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 However, the panel’s statements that Schroeder did not ask for Berry to be moved and did not warn that Berry was in mortal danger are not contradicted by Lundgren’s summaries. Lundgren’s summary of Schroeder’s interview only described Schroeder’s assertions that he told staff prior to Berry’s mov- ing in that he did not want Berry as a cellmate and was incompatible with him. Lundgren’s summary did not describe that Schroeder asserted he continued these complaints after the move was made and did not allege he made any actual requests for Berry to be moved. Moreover, there is nothing in Schroeder’s description of his interactions with TSCI officials where he indicated Berry was in mortal danger if they con- tinued to share the cell. While Schroeder alleged corrections officers would joke they were surprised he had not killed Berry yet, such statements do not imply that Schroeder requested that Berry be moved or that they believed or had reason to believe that Berry was actually in mortal danger. Similarly, while the TSCI caseworker attempted to get Berry’s assignment to Schroeder’s cell switched prior to his move, there is nothing indicating that she was doing so at Schroeder’s request or that her “‘gut feeling’” was based upon a belief such an arrange- ment might lead to Berry’s death. The panel reviewed the presentence investigation report and Lundgren’s summaries prior to determining whether there were mitigating circumstances. The panel’s findings that Schroeder did not request Berry’s removal from his cell and did not warn officials of potential danger to Berry is uncontradicted by the report. Instead, the report shows that Schroeder acted with premeditation and depravity in that Schroeder explained he had made up his mind to kill Berry days before he did so and in that he made no real attempts to avoid this result, even having made the decision to discard the kite which could have helped avoid the killing. Schroeder’s explanations in his interview that he killed Berry because he was unclean and annoying do not rise to the level of accounts of unusual pressure or influence or extreme - 551 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 mental or emotional disturbance. Nothing in the record indi- cates that Schroeder continually sought Berry’s removal from the cell or that any such requests were unheeded by TSCI staff. Schroeder references the effect incarceration can have on inmates in support of his unusual pressures or influences and extreme mental or emotional disturbance claims. Schroeder cites to several articles, while acknowledging he did not pro- vide them to the court because he did not present any evidence, which discuss the effects of institutionalization and incarcera- tion in solitary confinement on an inmate’s mental health as well as articles and reports of security and staffing issues at TSCI and DCS. [15] We have previously addressed the effect incarceration and, specifically, isolated confinement can have on individu- als. In Jenkins, we analyzed the application of a nonstatutory mitigating factor of solitary confinement and quoted the under- standing that “‘[y]ears on end of near-total isolation exact a terrible price.’” 22 However, we also noted that prison officials must have discretion to decide that in some instances, tem- porary solitary confinement is a useful or necessary means to impose discipline and to protect prison employees and other inmates. 23 Because of the defendant’s own extensive and vio- lent actions in that case, the prison officials needed to have some recourse to deal with such an inmate, and we found that it was reasonable in not rewarding such behavior by consider- ing the resulting confinement as a mitigating factor. 24 For the same reasons, the mere identification of a history of incar- ceration, without more, is insufficient to allege unusual pres- sures or influences or establish extreme mental or emotional 22 Jenkins, supra note 2, 303 Neb. at 727, 931 N.W.2d at 888, quoting Davis v. Ayala, 576 U.S. 257, 135 S. Ct. 2187, 192 L. Ed. 2d 323 (2015) (Kennedy, J., concurring). 23 Jenkins, supra note 2. 24 Id. - 552 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 disturbance. Schroeder’s incarceration was due to his own actions, including, most recently, his murder of Albers. Contrary to Schroeder’s assertions and as discussed in our analysis of Schroeder’s claims of the nonstatutory mitigat- ing factors of institutionalization and the State’s alleged ulte- rior motive to avoid possible litigation, the underlying facts of Schroeder’s claims were acknowledged and weighed by the court. In its order, the panel acknowledged that the cell Schroeder and Berry shared was intended for a single inmate, Berry was set for release 2 weeks after moving in with Schroeder, Schroeder was serving a life sentence for Albers’ murder, and Schroeder had a history of incarceration includ- ing his history within the juvenile court system and his current sentence for Albers’ murder. The panel reasonably found that on their own, these facts and the reality of the effect incarcera- tion can have on individuals were insufficient to establish that Schroeder acted under unusual pressures or influences or was under extreme mental or emotional disturbance. Under our de novo review, we reach the same conclusion. Schroeder’s remaining claim, that the panel erred in fail- ing to find Berry was a participant in Schroeder’s conduct or consented to the act, is without merit. Schroeder supports this proposition by noting, “Berry complied with Schroeder’s request that he turn the chair around and face away from Schroeder after Schroeder expressed extreme annoyance with his behavior.” 25 However, Berry’s facing away from Schroeder does not indicate participation or consent to his murder. Schroeder expressed frustration and requested Berry to turn away from him. How Berry would have understood this as Schroeder’s asking for aid in his strangulation and not as a method to avoid conflict is unclear. Schroeder offers no further argument to support this mitigating circumstance, and we agree with the panel’s finding that there was no evidence establishing this mitigating factor. 25 Brief for appellant at 40. - 553 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 Duty to Request DCS Chapter 83 Custody Reports Schroeder claims the panel had a duty to request additional records of Schroeder’s incarceration from DCS. These records are required to be kept by DCS under Neb. Rev. Stat. § 83-178 (Reissue 2014) and include records concerning Schroeder’s background, conduct, associations, and family relationships; records regarding Schroeder’s “Central Monitoring,” 26 which may be relevant to the propriety of his placement with Berry; and any medical or mental health records. [16-18] When an offender has been convicted of first degree murder and waives the right to a jury determination of an alleged aggravating circumstance, the court must order a pre- sentence investigation of the offender and the panel must consider a written report of such investigation in its sentenc- ing determination. 27 The presentence investigation and report shall include, when available, any submitted victim statements and an analysis of the circumstances attending the commis- sion of the crime and the offender’s history of delinquency or criminality, physical and mental condition, family situation and background, economic status, education, occupation, and per- sonal habits. 28 The investigation and report may also include any other matters the probation officer deems relevant or the court directs to be included. 29 In this case, the court ordered a presentence investigation and report, a report was prepared, and the panel considered it during its sentence determination. Schroeder does not allege this report failed to analyze and present any of the areas required by § 29-2261(3). Instead, Schroeder claims the court had a duty to request the presentence investigation report to include specific incarceration records. Schroeder relies on State 26 Id. at 42. 27 § 29-2521(2) and Neb. Rev. Stat. § 29-2261(1) (Reissue 2016). 28 § 29-2261(3). 29 Id. - 554 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 v. Dunster 30 for this claim that the panel should have requested additional documents. In that case, the defendant was sentenced to death after pleading guilty to first degree murder. 31 Prior to sentencing, the district court instructed the probation officer conducting the presentence investigation to include information in the possession of DCS as part of the report. 32 The court explained that access to this information was restricted by law and that it would not be released to the public except upon written order. 33 On appeal, the defendant assigned the district court’s consider- ation of this information, which included confidential mental health information provided by DCS, as reversible error. 34 However, we found the district court had given adequate notice to the defendant of its intent to consider such evidence to sat- isfy his due process rights. 35 Additionally, when the bill of exceptions was completed in that case, the DCS records were not included. As a result, we determined that in our de novo review, we could request and consider the additional documents just as the district court had requested and considered them. 36 In reaching this determina- tion, we noted that our request of these documents did not indicate in advance how we would rule on appeal but merely followed our statutory requirements for review and honored the intent of the Legislature to provide “‘the most scrupulous stan- dards of fairness and uniformity’” in reviewing the imposition of a sentence of death. 37 30 Dunster, supra note 16. 31 Id. 32 Id. 33 Id. 34 Id. 35 Id. 36 Id. 37 Id. at 372, 631 N.W.2d at 913. - 555 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 Dunster neither explicitly nor implicitly required a lower court to receive and review documents of a defendant’s prior incarceration. Instead, it only evaluated the process of a district court seeking to consider specific documents during a sentenc- ing proceeding and our ability to review the same information upon which the lower court relied. 38 Accordingly, Dunster did not add further requirements for the preparation of a presen- tence investigation report under § 29-2261(3). Because the district court complied with its duties under § 29-2261(1) in requesting the presentence investigation and report, because the presentence report included the requisite analysis of the § 29-2261(3) elements, and because there is no requirement that a sentencing court must request access to spe- cific § 83-178 DCS records, the district court did not err by not requesting that the DCS records be included in the presentence investigation report. Sufficiency of Safeguards to Prevent Arbitrary Results Schroeder claims Nebraska’s death penalty is unconstitu- tional as applied to him under the 8th and 14th Amendments to the U.S. Constitution and article I, §§ 3, 9, and 15, of the Nebraska Constitution. Schroeder argues that insufficient safeguards exist to prevent arbitrary results when, as here, a defendant waives his right to counsel and refuses to introduce mitigating or proportionality evidence or argument. [19,20] An accused has a state and federal constitutional right to be represented by an attorney in all critical stages of a criminal prosecution which can lead to a sentence of confine- ment. 39 However, a defendant may waive this right to counsel 38 Dunster, supra note 16. 39 See, U.S. Const. amends. VI and XIV; Neb. Const. art. I, § 11; Scott v. Illinois, 440 U.S. 367, 99 S. Ct. 1158, 59 L. Ed. 2d 383 (1979); Argersinger v. Hamlin, 407 U.S. 25, 92 S. Ct. 2006, 32 L. Ed. 2d 530 (1972); Jenkins, supra note 2; State v. Wilson, 252 Neb. 637, 564 N.W.2d 241 (1997); State v. Dean, 246 Neb. 869, 523 N.W.2d 681 (1994), overruled on other grounds, State v. Burlison, 255 Neb. 190, 583 N.W.2d 31 (1998). - 556 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 so long as the waiver is made knowingly, voluntarily, and intelligently. 40 [21-23] The same constitutional provisions that provide a defendant the right to counsel also guarantee the right of the accused to represent himself or herself. 41 This right to self-representation plainly encompasses certain specific rights of the defendant to have his voice heard, including that the pro se defendant must be allowed to control the organiza- tion and content of his own defense. 42 We have previously explained that such control may include a waiver of the right to present mitigating evidence during sentencing in a death penalty case. 43 Schroeder does not challenge the validity of his waiver of counsel for the penalty phase or his election not to present miti- gating evidence or proportionality argument. Instead, Schroeder argues that the exercise of the right to self-representation and, derived therefrom, the right to waive the presentation of evidence and argument conflicted with the constitutional restrictions against cruel and unusual punishment. Specifically, Schroeder addresses the effect such waivers have on the pro- portionality review by the sentencing panel. To establish the cruelty and unusualness of such punishment, Schroeder notes first that the proportionality requirement under Neb. Rev. Stat. §§ 29-2521.01 to 29-2521.04 (Cum. Supp. 2018) only requires the sentencing panel to review those cases in which the death penalty was imposed. Schroeder also asserts propor- tionality review is further limited depending on whether jury determinations in the reviewed cases were waived because, 40 Jenkins, supra note 2; State v. Hessler, 274 Neb. 478, 741 N.W.2d 406 (2007). 41 Faretta v. California, 422 U.S. 806, 95 S. Ct. 2525, 45 L. Ed. 2d 562 (1975); Jenkins, supra note 2; Wilson, supra note 39; State v. Green, 238 Neb. 328, 470 N.W.2d 736 (1991). 42 McKaskle v. Wiggins, 465 U.S. 168, 104 S. Ct. 944, 79 L. Ed. 2d 122 (1984); Dunster, supra note 16; Wilson, supra note 39. 43 Dunster, supra note 16. - 557 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 when they are waived, a sentencing panel is required to issue written findings of fact as to any proven aggravating circum- stances, but when there is no waiver, the jury does not issue such analysis. Schroeer argues that when a defendant waives counsel and refuses to meaningfully participate, the record on which the panel makes its proportionality determination is lim- ited to what it requests and the State presents, which has the potential to be limited and biased in favor of the imposition of a death sentence. [24,25] Because a death sentence is different from any other criminal penalty 44 and no system based on human judg- ment is infallible, we have taken, and should continue to take, the extra step to ensure fairness and accuracy with the imposition of the death penalty. 45 Taking this into account, the Legislature has enacted a statutory scheme to provide additional safeguards, 46 and in interpreting these statutes, we have followed the fundamental principle of statutory construc- tion that penal statutes are to be strictly construed in favor of the defendant. 47 [26] Part of this statutory scheme, as explained, requires a court to order a presentence investigation report. 48 The sentenc- ing panel must consider this report in reaching its sentence. Thus, contrary to Schroeder’s argument, even if the State pre sents evidence in favor of a specific sentence and the defendant declines to present contrary evidence, the court receives and must consider independent information from the report. [27,28] In a death penalty case, the sentencing panel is required to review this report and determine whether it contra- dicts the State’s evidence of aggravating factors and whether any mitigating circumstances exist, including specifically 44 State v. Hochstein and Anderson, 262 Neb. 311, 632 N.W.2d 273 (2001). 45 Id. 46 Neb. Rev. Stat. §§ 29-2519 to 29-2546 (Cum. Supp. 2018). 47 Hochstein and Anderson, supra note 44. 48 §§ 29-2261(1) and 29-2521(2). - 558 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 delineated statutory mitigators. 49 While the State must prove the aggravating circumstances beyond a reasonable doubt, 50 there is no burden of proof with regard to mitigating circumstances. 51 Accordingly, the panel’s evaluation of the independently com- piled presentence investigation report and any evidence the defendant chooses to introduce is under the less restrictive mitigation standard and provides another safeguard to ensure fairness and accuracy in a death penalty determination. [29-32] Once the panel makes its determinations about the existence of aggravating and mitigating circumstances, the panel is then required to undertake a proportionality review. This review looks at whether the sentence of death is excessive or disproportionate to the penalty imposed in similar cases, considering both the crime and the defendant. 52 Proportionality review is not constitutionally mandated. 53 It exists in Nebraska by virtue of §§ 29-2521.01 to 29-2521.04, which direct this court to conduct a proportionality review in each appeal in which a death sentence is imposed. 54 A court’s proportionality review spans all previous cases in which a sentence of death is imposed and is not dependent on which cases are put forward by the parties. 55 Schroeder takes issue with proportionality review requiring a panel to compare only those cases in which the death penalty was imposed. 56 Instead, Schroeder argues the statutory scheme explicitly requires review of all homicide cases regardless of the resulting sentence. 49 §§ 29-2521 to 29-2523. 50 Torres, supra note 3. 51 State v. Vela, 279 Neb. 94, 777 N.W.2d 266 (2010); State v. Victor, 235 Neb. 770, 457 N.W.2d 431 (1990). 52 § 29-2522(3). 53 State v. Gales, 269 Neb. 443, 694 N.W.2d 124 (2005). 54 Id. 55 See id. 56 See State v. Palmer, 224 Neb. 282, 399 N.W.2d 706 (1986), overruled on other grounds, State v. Chambers, 233 Neb. 235, 444 N.W.2d 667 (1989). - 559 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 It is unclear how Schroeder is arguing this fits under his assignment alleging unconstitutionality in the interplay of his waiver of counsel and election not to present evidence or argument with Nebraska’s capital sentencing scheme. The introduction of further evidence or whether or not Schroeder was represented by counsel does not affect what previous cases the panel was required to consider. In any case, we decline Schroeder’s invitation to overrule our decision in State v. Palmer 57 which interpreted §§ 29-2521.01 to 29-2521.04 to only require review of previous cases in which the death pen- alty was imposed. Additionally, we are unconvinced by Schroeder’s claim that the proportionality review is unconstitutionally flawed due to having less analysis of the reviewed cases in which a jury determines the existence of the aggravating circumstance than of the reviewed cases in which a sentencing panel makes the determination. Again, it is unclear how Schroeder relates this alleged flaw to this assignment. If Schroeder is claiming that waiver of counsel and lack of argument would prohibit the panel from taking into account that previous aggravation deter- minations were decided by juries, this information would be apparent from the previous opinions and would be able to be considered by the panel independently of whether the defend ant or an advocate explained such difference to the panel. [33,34] Moreover, even when a jury determines the exis- tence of an aggravating circumstance, a sentencing panel is required to put in writing its consideration of (1) whether the determined aggravating circumstance justifies the imposition of a sentence of death, (2) whether mitigating circumstances exist, and (3) whether a sentence of death would be excessive or disproportionate to penalties imposed in similar cases. 58 This writing must specifically refer to the aggravating and mitigat- ing circumstances weighed in the determination of the panel. 59 57 Id. See, also, State v. Gales, supra note 53. 58 § 29-2522. 59 Id. - 560 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 As such, the basis of Schroeder’s argument that cases where a jury determines the existence of aggravating circumstances provide insufficient information for comparison in a propor- tionality review is without merit. [35-38] Considering all of the above, Nebraska’s capital sentencing scheme provides additional statutory steps and con- siderations to ensure fairness and accuracy, and these safe- guards exist regardless of a defendant’s strategy at the pen- alty phase. Due to this statutory scheme, a defendant cannot “choose” the death penalty. The sentencing decision rests with the court alone. 60 In order to exercise this authority, the statutory scheme requires that a sentencing panel consider not only evidence and argument presented by the parties but also an independently compiled presentence investigation report to determine whether the alleged aggravating circumstance exists, determine whether any mitigating factors are present which would weigh against the imposition of the death penalty, and conduct a proportionality review weighing the aggravating and mitigating factors and comparing the facts to previous cases where the death penalty was imposed. 61 These considerations exist and are weighed regardless of the evidence presented by the parties or their arguments. [39,40] A defendant is entitled to present a defense and is guaranteed the right to choose the objectives for that defense. 62 As previously stated, the self-represented defendant must be allowed to control the organization and content of his own defense. 63 However, Schroeder suggests that in a death pen- alty case, the substantial nature of the proceedings requires an advocate in opposition to a sentence of death irrespective of the defendant’s chosen objective. To this end, he suggests §§ 29-2519 to 29-2546 implicitly require the appointment of a 60 Dunster, supra note 16. 61 See Torres, supra note 3. 62 McCoy v. Louisiana, ___ U.S. ___, 138 S. Ct. 1500, 200 L. Ed. 2d 821 (2018); Jenkins, supra note 2. 63 Dunster, supra note 16. - 561 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 guardian ad litem to present evidence and argument as to why the death penalty should not be imposed. [41] This suggestion is similar to that addressed in Dunster. 64 The defendant therein had waived trial counsel for the penalty stage and chose not to present any mitigating evidence. On appeal, he claimed the court should have appointed “amicus counsel” to advocate against the imposition of the death pen- alty by presenting evidence and “‘argu[ing] for life,’” which is identical to the role Schroeder now envisions for an appointed guardian ad litem. 65 As noted in Dunster, when a defendant waives counsel and the presentation of mitigating evidence, the appointment of an advocate to present evidence and argue against the imposition of a sentence overrides that defendant’s constitutional right to control the organization and content of his or her own defense during sentencing. [42,43] A criminal defendant has the right to waive counsel and present his or her own defense. 66 In a death penalty case, this includes the right of the defendant to elect not to present additional evidence or argument during the penalty proceed- ings. Even if a defendant makes such waiver and election, the Legislature has enacted safeguards to ensure fairness and accu- racy in the resulting sentence. As explained above, these safe- guards apply regardless of the defense strategy an individual defendant implements. Therefore, Schroeder’s assignment that Nebraska’s capital sentencing scheme is unconstitutional due to insufficient safeguards to prevent arbitrary results when a defendant waives counsel and elects not to present evidence or argument fails. Excessiveness and Proportionality Review [44,45] In reviewing a sentence of death, we conduct a de novo review of the record to determine whether the 64 Id. 65 Id. at 361, 631 N.W.2d at 906. 66 See Dunster, supra note 16. - 562 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 aggravating and mitigating circumstances support the imposi- tion of the death penalty. 67 In so doing, we consider whether the aggravating circumstances justify imposition of a sentence of death and whether any mitigating circumstances found to exist approach or exceed the weight given to the aggravat- ing circumstances. 68 We first note Schroeder does not contest the factual basis for the § 29-2523(1)(a) aggravation allegation that Schroeder was convicted of Albers’ murder. It is undisputed that in 2006, Schroeder murdered Albers, who was at the time Schroeder’s 75-year-old previous employer. It is also undisputed that Albers was robbed and that Schroeder had made the decision to kill Albers days before the robbery. Schroeder threatened and beat Albers, tied him up, threw him in the back of a pickup, and dumped him in an abandoned well, leaving him for dead. Based upon our de novo review, we determine this murder conviction, which was proved beyond a reasonable doubt at the sentencing hearing, is sufficient as an aggravating circumstance under § 29-2523(1)(a) to justify the imposition of the death penalty. In coordination with our analysis con- cerning the panel’s mitigating circumstance findings, we also agree with the panel’s determination that the applicable statu- tory and nonstatutory circumstances apparent from the record do not approach or exceed the aggravating circumstance in this case. [46-48] In addition, we are required, upon appeal, to deter- mine the propriety of a death sentence by conducting a propor- tionality review, comparing the aggravating and mitigating cir- cumstances with those present in other cases in which a court imposed the death penalty. 69 The purpose of this review is to ensure that the sentences imposed in this case are no greater than those imposed in other cases with the same or similar 67 Torres, supra note 3. 68 Id. 69 Id. - 563 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 circumstances. 70 Our proportionality review looks only to other cases in which the death penalty has been imposed and requires us to compare the aggravating and mitigating circumstances of the case on appeal with those present in those other cases. 71 In this case, we have reviewed our relevant decisions on direct appeal from other cases in which the death penalty was imposed. 72 Like the sentencing panel, we find Dunster particularly pertinent to our review. 73 The defendant therein was convicted of murdering his cellmate by strangling him with an electrical cord. 74 The defendant had previously been convicted of the earlier murder of a woman while attempting to collect a debt from her husband, and he had confessed to a different murder of another inmate while incarcerated for the first murder. 75 At the penalty phase, the State alleged a single aggravating circumstance of § 29-2523(1)(a) and presented evidence of the two previous killings. 76 After the trial court sentenced the defendant to death, we affirmed. 77 Such factual basis is similar to that in the instant case. As did the defendant in Dunster, Schroeder murdered his cellmate by strangulation. Schroeder’s previous murder of Albers was also pursuant to a plan to take money from his victim. 70 See id. 71 Id. 72 See, e.g., Jenkins, supra note 2; Torres, supra note 3; State v. Ellis, 281 Neb. 571, 799 N.W.2d 267 (2011); Hessler, supra note 40; Dunster, supra note 16; State v. Lotter, 255 Neb. 456, 586 N.W.2d 591 (1998), modified on denial of rehearing 255 Neb. 889, 587 N.W.2d 673 (1999); State v. Williams, 253 Neb. 111, 568 N.W.2d 246 (1997); State v. Ryan, 233 Neb. 74, 444 N.W.2d 610 (1989); State v. Joubert, 224 Neb. 411, 399 N.W.2d 237 (1986); State v. Otey, 205 Neb. 90, 287 N.W.2d 36 (1979). 73 Dunster, supra note 16. 74 Id. 75 Id. 76 Id. 77 Id. - 564 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 Schroeder attempts to differentiate his case from Dunster by emphasizing that while only one aggravating circumstance was alleged in Dunster, the allegation therein concerned two previous murders. Additionally, Schroeder argues those underlying murders were committed with more serious facts, including that there was suspected sexual assault of one of the victims. First, it is not evident that the underlying murders in Dunster included any more or less serious facts surrounding their execution. Schroeder threatened, beat, and robbed Albers and threw him bound and alive into a well to die. The murders the defendant in Dunster committed involved binding, beating, killing, and possible sexual assault. In both cases, the defend ants acted with violence toward the persons. [49,50] Additionally, while there were two underlying mur- ders in Dunster, this does not mean Dunster cannot be used in a proportionality review. A proportionality review does not require that a court “color match” cases precisely. 78 It would be virtually impossible to find two murder cases which are the same in all respects. 79 Instead, the question is simply whether the cases being compared are sufficiently similar, considering both the crime and the defendant, to provide the court with a useful frame of reference for evaluating the sentence in this case. 80 As the factual connections show, Dunster is sufficiently similar for purposes of evaluating proportionality. [51-53] Along the same lines, Schroeder attempts to distin- guish his case from others cited by the sentencing panel and reviewed on appeal by noting that the majority of those cases had multiple aggravating factors. However, we have established that one aggravating circumstance may be sufficient under our statutory system for the imposition of the death penalty. 81 In 78 Ellis, supra note 72. 79 Id. 80 Id. 81 Dunster, supra note 16. - 565 - Nebraska Supreme Court Advance Sheets 305 Nebraska Reports STATE v. SCHROEDER Cite as 305 Neb. 527 our proportionality review, the evaluation of whether the death penalty should be imposed in a specific case is not a mere counting process of “X” number of aggravating circumstances and “Y” number of mitigating circumstances and, instead, asks whether the reviewed cases are sufficiently similar to provide a useful reference for that evaluation. 82 Thus, even though other cases may involve additional or different aggravating circumstances, they may still be sufficiently similar to provide such reference. Having reviewed our previous cases which have affirmed the imposition of a death penalty and compared the aggra- vating and mitigating circumstances present in those cases, we are persuaded that the sentence imposed in this case is not greater than those imposed in other cases with the same or similar circumstances. Accordingly, we affirm Schroeder’s death sentence. CONCLUSION In consideration of all of the above, Schroeder’s conviction and sentence for first degree murder are affirmed. Affirmed. Freudenberg, J., not participating. 82 See, Ellis, supra note 72; Dunster, supra note 16.	01-04-2023	05-29-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622073/	APPEAL OF H. J. SCHLESINGER.Schlesinger v. CommissionerDocket No. 6339.United States Board of Tax Appeals5 B.T.A. 943; 1926 BTA LEXIS 2741; December 23, 1926, Promulgated 2741 Deductions allowed under section 214(a) of the Revenue Act of 1921, but not connected with the trade or business regularly carried on by the taxpayer and not specially considered in the method of calculation of the "net loss," as set out in section 204(a) of the same Act, must be subtracted from the total deductions allowed under section 214(a) before the calculation is made, so that the result of the calculation will be the "net loss" defined in section 204(a) of the Act. Charles F. Fawsett, Esq., for the petitioner. Robert A. Littleton, Esq., for the Commissioner. MURDOCK 943 A deficiency of $344.09 individual income tax for the year 1923 resulted from the Commissioner's reduction of the petitioner's 1922 loss in applying section 204 of the Revenue Act of 1921, as interpreted by article 1601 of Regulations 62. FINDINGS OF FACT. The petitioner in the year 1922 had a gross income of $127,876.27. Of this amount $49,107.30 was income derived from a trade or business, and $78,768.97 was derived from sources not connected with a trade or business. His deductions under section 214(a) of the Revenue Act of 1921 amounted to $168,943.39. Of2742 this amount $77,874.16 was deducted for expenses of the business (farming) regularly carried on by the taxpayer, $82,312.82 was deducted for taxes (inheritance) paid, $6,998.60 was deducted for interest paid (not connected with the business of farming), and the balance, $1,757.82, was deducted as a loss (not sustained in farming). In computing the tax upon the income for the year 1923 the Commissioner refused to allow a net loss for the year 1922 under the provisions of section 204(a) of the Revenue Act of 1921. OPINION. MURDOCK: We are satisfied that article 1601 of Regulations 62 is not in accordance with section 204(a) of the Revenue Act of 1921, because the article gives a double effect to deductible losses not sustained in a trade or business regularly carried on by the taxpayer. This double effect is not authorized or intended under section 204(a). The difficulty, however, is to make a calculation which is in accordance with this section and which will stand the test in every case. If there is a possible interpretation of the Act which will give effect to the intent of Congress, of course it is our duty to adopt such an interpretation. 944 This section2743 of the Act reads as follows: Sec. 204. (a) That as used in this section the term "net loss" means only net losses resulting from the operation of any trade or business regularly carried on by the taxpayer (including losses sustained from the sale or other disposition of real estate, machinery, and other capital assets, used in the conduct of such trade or business); and when so resulting means the excess of the deductions allowed by section 214 or 234, as the case may be, over the sum of the following: (1) the gross income of the taxpayer for the taxable year, (2) the amount by which the interest received free from taxation under this title exceeds so much of the interest paid or accrued within the taxable year on indebtedness as is not permitted to be deducted by paragraph (2) of subdivision (a) of section 214 or by paragraph (2) of subdivision (a) of section 234, (3) the amount by which the deductible losses not sustained in such trade or business exceed the taxable gains or profits not derived from such trade or business, (4) amounts received as dividends and allowed as a deduction under paragraph (6) of subdivision (a) of section 234, and (5) so much of the depletion deduction2744 allowed with respect to any mine, oil or gas well as is based upon discovery value in lieu of cost. In the first part of the section Congress said that "net loss" means only net losses resulting from the operation of any trade or business regularly carried on by the taxpayer. In the latter part of the same section Congress indicated a calculation or a method of arriving at such net loss, "when so resulting." By this method Congress indicated, among other things, the effect which it intended that deductible losses not sustained in such trade or business, and taxable gains or profits not connected with such trade or business, should have upon the net loss resulting from the operation of the trade or business regularly carried on by the taxpayer. Bear in mind that in this case we are concerned with an individual, and as deductible losses not sustained in such trade or business are included in the deductions allowed by section 214, and, as taxable gains or profits not derived from such trade or business are included in gross income, "(3)" of the method indicated in the section of the Act so functions or operates that, should the taxable gains or profits not derived from such trade2745 or business exceed the amount of the deductible losses not sustained in such trade or business, the "net loss" will be decreased in the exact amount of the excess, and, where that excess is greater than the loss from the operation of the business, there will be no "net loss." Thus "(3)" carries out the intent of Congress in regard to losses deductible under section 214(a) but not connected with the trade or business of the taxpayer. As a result of it a net loss from the operation of a trade or business regularly carried on by the taxpayer may never be increased by deductible losses outside of that business, but will be decreased by any excess of outside profits or gains over deductible 945 losses sustained outside of such business; "(2)" functions in much the same way in regard to certain interests; "(4)" and "(5)" serve a similar purpose in regard to other deductions. But what is the situation in regard to that portion of the taxes deductible under section 214(a)(3), of the debts deductible under section 214(a)(7), of the contributions or gifts deductible under section 214(a)(11), and of any other deductions under section 214(a), which the section 204(a) calculation does2746 not obviously take care of - all of which deductions are in no way connected with the trade or business regularly carried on by the taxpayer? We are speaking about that portion only of these deductions which is in no way connected with the taxpayer's regular trade or business. One interpretation of section 204(a) would be to consider "deductions" and "deductible losses" as equivalent. If we can do this, the method prescribed in the Act is all-inclusive, and in every case will determine whether or not there is a "net loss," if the indicated calculation is made. The difficulty which arises when there are taxes, debts, contributions, etc., not connected with the business is thus avoided because they are deductions equivalent to deductible losses and under "(3)" are given the effect which Congress intended they should have upon "net loss." Our objection to this solution is that it does not give any effect to the words "when so resulting," which appear in this section of the Act. It holds that the "net loss," as defined in the first clause of section 204(a), will be determined in every case if the calculation in the remainder of section 204(a) is carried out. It assumes2747 that the Act would have been just the same if the words "when so resulting" had been omitted. If deductible losses are equivalent to deductions, why did Congress deem it advisable, when framing this section of the Act on deductions, to mention, in addition to three kinds of losses, taxes, debts, and contributions? We think that taxes, debts, and contributions, which may be deducted under section 214(a), are essentially different from any losses deductible thereunder and are not losses in any sense of the word. Another objection is apparent in the instant case, where this interpretation would allow the taxpayer a net loss of $28,766.86, which would have been decreased and wiped out by an excess of taxable gains outside of the regular business over outside losses had it not happened that in this particular year this taxpayer paid a large inheritance tax which, as a "deductible loss," stepped in and prevented the cancellation. Considering the whole section, we do not think that such was the intent of Congress. There is another and more reasonable interpretation which avoids these absurdities and gives meaning to the words "when so resulting." 946 In it we hold that2748 the specific provisions of the calculation indicated in the latter part of the section are only applied in any given case in connection with the general provisions of the definition in the first part of the section, and it is only after consideration of both of these parts of the section that we get the true "net loss" as intended by Congress. The remainder of section 204 is inapplicable if the "net loss" results from something other than the operation of such trade or business. We do not assume that deductible losses and deductions are equivalent. Deductible taxes, debts, and contributions not connected with the trade or business regularly carried on by the taxpayer will not receive consideration under "(3)," and it is apparent that they will not be given any effect at any other place in the prescribed calculation. However, it does not follow that the effect upon "net loss," which Congress intended they should have, can not be given by the application of a common sense rule. When a net loss is claimed and when, and only when, there are losses shown on the return from the operation of a trade or business regularly carried on by the taxpayer, we first subtract from the deductions2749 allowed by section 214(a) those portions of taxes, debts, gifts, and contributions, which have no connection with the business but which are included in the total deduction, and then proceed with the calculation indicated in section 204(a) to arrive at the "net loss." Effect has thus been given to all parts of the section. If the return does not show a loss from the operation of a trade or business regularly carried on, then there can be no net loss, and it makes no difference that the entire return may show a loss, since we are not concerned with that loss which may have resulted from the deduction of taxes, debts, and contributions not connected with the regular trade or business, deductible losses not sustained in such trade or business in excess of taxable profit not derived from such trade or business, interest, or from some other deduction. Under this interpretation it will be noted that the excess of taxable gains or profits outside the business over deductible losses outside the business decreases and, if large enough, wipes out the loss from the business regularly carried on, and it is not prevented from so doing by the fact that in the same year the taxpayer may have2750 paid an inheritance tax, charged off bad debts, or made gifts or contributions all of which were deductible, but had no connection with the trade or business regularly carried on. This is the only case in which this interpretation gives a different result from the interpretation which we first discussed. When there are losses shown on the return, we must first inquire whether these losses are the net losses defined in the first part of 947 section 204(a), or whether they are due to the deduction of taxes, debts, or contributions which had no connection with the business. If it appears that the losses are due entirely to the deduction of such taxes, debts, or contributions, we have arrived at the answer to our problem, which is that there is no "net loss." In some close cases it may be necessary to eliminate these taxes, debts, gifts, and contributions and then to apply the calculation indicated in the Act to see if there is a "net loss." These taxes, debts, gifts, and contributions can be subtracted from the deductions allowed by section 214(a) before the calculation is made or subtracted afterwards from the answer. In either case the result is the same. We think that2751 this interpretation is reasonable and that it carries out the intent of Congress. If there is a net loss resulting from the operation of any trade or business regularly carried on by the taxpayer, that net loss is determined by this method. If the loss as shown by the return results from something other than such trade or business, by this method no "net loss" results. In the instant appeal the petitioner's loss was partly due to the payment of an inheritance tax of $82,312.82. If he had not paid this inheritance tax in this particular year he would not have had a "net loss" for the year 1922, and therefore in this case it is not necessary to make the calculation, but if the calculation is made the result is the same - there is no "net loss." The reason that the petitioner does not have a "net loss" is that the loss which resulted from his farming operations was overcome and wiped out by the excess of his taxable gains outside of that business over his deductible losses outside of that business. It is a mere incident that in this year he paid inheritance taxes, and Congress never intended, by section 204(a) of the Revenue Act of 1921, that a loss in one year due to such a*2752 cause should be carried over as a net loss in the following year. Judgment will be entered for the Commissioner.TRUSSELL dissents.	01-04-2023	11-21-2020
https://www.courtlistener.com/api/rest/v3/opinions/4622074/	ADA SMALL MOORE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Moore v. CommissionerDocket No. 88944.United States Board of Tax Appeals39 B.T.A. 147; 1939 BTA LEXIS 1067; January 19, 1939, Promulgated 1067 Where a person transfers property to a trustee under an indenture of trust which provides that the income shall be paid to the settlor for life and that upon his death the corpus shall be paid over to whomsoever the settlor leaves real estate located in a particular place under his last will and testament, the settlor has not made a gift of the remainder interest within the purview of section 501 of the Revenue Act of 1932 as amended by section 511 of the Revenue Act of 1934. Horace N. Taylor, Esq., and Winthrop G. Brown, Esq., for the petitioner. John R. Wheeler, Esq., for the respondent. SMITH 147 OPINION. SMITH: This is a proceeding for the redetermination of deficiencies in gift tax for 1934 and 1935 in the respective amounts of $87,768.18 and $3,649.68. The petition alleges that the respondent erred (1) in including $654,531.62 representing the alleged remainder interest in a transfer made by the petitioner to a trustee on December 3, 1934, under the provisions of which she was to receive the income for her life and upon her death the corpus should be paid over to whomsoever she should devise her real estate at Pride's Crossing, 1068 Massachusetts, and (2) that the respondent erred in the determination of the deficiency for 1935 by allowing the deduction of $5,000 instead of $10,000 upon gifts made to two grandsons in that year. The respondent concedes the correctness of the petitioner's contention upon the second point. The petitioner is a resident of New York City. On December 3, 1934, she was a widow 76 years of age and had living two sons and a number of grandchildren and great grandchildren. On the date named she executed an indenture of trust under which she transferred to the Bankers Trust Co. of New York City, the trustee therein named, on December 6, 1934, securities constituting the corpus of the trust fund. These consisted of $300,000 face value United States of America Liberty Loan 3 1/2 percent bonds, due 1932-1947, having a fair market value of $310,687.50 at the time of transfer, and 5,000 shares of American Can Co. common stock, having a fair market value at the time of $525,625. Under the terms of the trust indenture the petitioner retains and reserves the income from the trust during her lifetime. The remainder of the trust fund is to be paid upon the death of the settlor to "whomsoever1069 said Ada Small Moore [the petitioner] may leave her 148 property at Pride's Crossing, Massachusetts, under her Last Will and Testament", and in default of such designation the remainder is to go to the lawful issue of the petitioner in equal shares per stirpes. The trust instrument specifically provides that it is created under the laws of the State of New York and shall be governed in all respects by the laws of that state. The trust instrument does not declare that the trust is irrevocable and makes no provision whereby the settlor can revoke the trust. The question presented by this proceeding is whether the petitioner made a gift in 1934 of any part of the property transferred to the Bankers Trust Co. as trustee under the trust indenture of December 3, 1934. The respondent contends that she did. In his deficiency notice he says: * * Under the terms of the trust the income therefrom is payable to Ada Small Moore for life and the remainder at her death was to be paid over to whomsoever Ada Small Moore may leave her property at Pride's Crossing, Massachusetts, under her last will and testament and in default of such devise the corpus of the trust is to be distributed1070 to the settlor's issue surviving at her death in equal shares per stirpes and not per capita. This office holds that the remainder interest in the trust vests in the remainderman even though such interest may later be divested by the exercise of a power of appointment. Section 501(c) of the Revenue Act of 1932 provides that the gift tax will not apply to a transfer of property in trust where the power to revest in the donor title to such property is vested in the donor. The donor not being the sole beneficiary even though she retained the substantial equivalent of a power of appointment, such power did not prevent the vesting of the remainder in the class designated as takers upon failure of the exercise of the power. It is to be noted that the trust instrument in the instant case specifically says that it is to be "governed in all respects by the laws of that State [New York]." Under the laws of the State of New York the instant transfer is not a gift because the donee is not named. ; 1071 ; ; ; ; ; ; ; affirmed without reference to this point, ; ; ; ; ; . In the last named case the New York Court of Appeals said: An absolute gift requires a renunciation by the donor and an acquisition by the donee of all interest in and title to the subject of the gift. The decisions of this Board are consonant with the above cited authorities. ; affd., ; ; . 149 The contentions of the respondent in this proceeding are the same as those made by him in 1072 ; certiorari denied, ; and , and the facts in the last named case are substantially the same as in the proceeding at bar. Upon the authority of those cases it is held that the petitioner is not liable to gift tax in respect of any portion of the value of the securities transferred to the Bankers Trust Co. pursuant to the provisions of the trust indenture of December 3, 1934. Judgment will be entered under Rule 50.	01-04-2023	11-21-2020

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