Arnold v. Commissioner , 14 B.T.A. 954 ( 1928 )

JOHN B. ARNOLD AND METTE L. ARNOLD, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

N. B. ARNOLD AND MARY F. ARNOLD, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

JOHN B. ARNOLD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

N. B. ARNOLD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Arnold v. Commissioner

Docket Nos. 20887-20890.

United States Board of Tax Appeals

14 B.T.A. 954; 1928 BTA LEXIS 2881;

December 28, 1928, Promulgated

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">*2881 1. Respondent's determination of fraud held to be erroneous.

2. Net income of the several petitioners redetermined.

Arnold R. Baar, Esq., Arthur R. Foss, Esq., Thorwald Hansen, Esq., John B. Arnold, Esq., and N. B. Arnold, Esq., for the petitioners.

James A. O'Callaghan, Esq., and De Witt M. Evans, Esq., for the respondent.

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GREEN

">*954 The four above entitled proceedings were by agreement of counsel consolidated for hearing and decision. John B. and N. B. Arnold are brothers. The taxes involved are income taxes for the years 1921, 1922, and 1923. For the year 1921 John B. Arnold and his wife and N. B. Arnold and his wife filed joint returns, but for the remaining years each filed a separate return. In each of the proceedings here involved the Commissioner has asserted a fraud penalty. The deficiencies and penalties asserted are as follows:

Year	Name	Deficiency in tax	Penalty	Total
1921	John B. Arnold and wife	$2,464.84	$1,232.42	$3,697.26
1922	John B. Arnold	14,045.20	7,022.60	21,067.80
1923	to	6,589.51	3,294.76	9,884.27
	Total			34,649.33
1921	N. B. Arnold and wife	4,074.53	2,037.27	6,111.80
1922	N. B. Arnold	21,375.70	10,687.85	32,063.55
1923	do	13,496.43	6,748.22	20,244.65
	Total			58,420.00

">*2882 In each instance the respondent made jeopardy assessments, only one of which assessments, namely, that against N. B. Arnold and wife for the year 1921, has been paid, such payment being subsequent to the filing of the petition in that case.

The principal error alleged in each of the proceedings is that the respondent erred in assessing the fraud penalties against each of ">*955 the petitioners for all of the years involved. The other errors alleged are:

John B. Arnold and Wife - 1921

(1) That the amount included in gross income as legal fees is excessive by the amount of $7,348.39;

(2) That the basis and manner used by respondent in computing the net income of petitioners for 1921 does not clearly reflect the income for that year;

(3) That the respondent failed to allow the following deductions:

(a) Taxes	$11,025.11
(b) Interest	604.43
(c) Loss on options in re Extension Copper Co	5,469.58
(d) Loss on options in re Minnesota Indian Lands	603.07

N. B. Arnold and Wife - 1921

(4) That the amount included in income as legal fees is excessive by the amount of $16,005.45;

(5) Same as (2) above;

(6) That the respondent">*2883 failed to allow the following deductions:

(a) Loss on options in re MinnesotaIndian lands	$201.76
(b) Repairs to St. Louis River farm	2,500.00

John B. Arnold - 1922 and 1923

(7) That for the years 1922 and 1923 the amount of gross income is excessive by the amounts of $19,534.08 and $23,084.42, respectively;

(8) That for the years 1922 and 1923 the amount determined to be joint income of petitioner and N. B. Arnold is excessive by the amounts of $4,818.81 and $5,799.43, respectively.

(9) That for the years 1922 and 1923 the joint income of petitioner and N. B. Arnold has been erroneously computed in that no deductions for salaries to their wives and J. B. Arnold, Jr., were allowed;

(10) That the respondent failed to allow the following deductions:

	1922	1923
(a) Repairs on Brule property	$2,600.40	$643.23
(b) Interest	1,538.98	1,650.00
(c) Taxes	3,970.02	2,929.66
(d) Bad debts:
Edward Finch	59.55
Finch, Anderson, et al.	320.70
C. J. Petruschke	448.96
J. C. Smith	184.40
A. Arnold	476.17
John G. Howard	856.45
Lake Superior Copper Co	1,050.00
Superior Copper Mines Co	2,600.84
(d) Bad debts - Continued:
C. E. Fitzgerald	$2,000.00
E. A. Arnold		$7,660.77
(e) Losses:
Mars Oil Co. stock	5,737.50
San Antonio Oil & Development Co. stock	2,841.10
Investment Canadian lands	5,670.00
Investment Brule property	3,650.51
Holt Power-Light Co. stock		2,500.00
St. George Mining Co	500.00

">*2884 ">*956 N. B. Arnold - 1922 and 1923

(11) That for the years 1922 and 1923 the amount of gross income as determined by the respondent is excessive by the amounts of $51,086.19 and $54,782.20, respectively;

(12) Same as (8) above;

(13) Same as (9) above;

(14) That the respondent has disallowed a deduction for an investment loss in Holt Power-Light Co. stock $2,500;

(15) That the respondent has disallowed a deduction for a bad debt of E. A. Arnold, $3,584.50.

FINDINGS OF FACT.

John B. and N. B. Arnold are attorneys at law residing in Duluth, Minn. N. B. Arnold has practiced law in that city since 1913. John B. Arnold has been engaged in the practice of law in Duluth, Minn., and Superior, Wis., for many years, except for a period of four years during which time he practiced law in New York City. During the absence of John B. Arnold in New York City, N. B. Arnold occupied his law office and closed up or cared for some matters incident to the law business which John B. Arnold left behind him.

In October, 1918, there occurred in northern Minnesota what is known as the great fire. This fire devastated several areas occupied by thousands of people and occasioned">*2885 tremendous losses to those residing or owning property in the burned-over areas. It followed naturally that the fire sufferers should seek to be reimbursed for their losses and in due time different ones consulted various counsel as to the possibility of recovery. N. B. Arnold interested himself in the matter and went into the burned-over territory, made a preliminary investigation of the sources of the fires, and concluded that they were to be attributed to the railroads passing through the devastated territory. These railroads, with one exception, were then being operated by the United States Railroad Administration.

Thereafter, N. B. Arnold discussed with his brother the advisability of undertaking the prosecution of claims against the Railroad Administration and it was agreed between them that they should undertake to handle jointly such claims as came to them, sharing the expenses and proceeds equally.

In December, 1918, the Arnolds entered into an arrangement with one James F. Walsh, under and by virtue of which Walsh agreed to devote his time to an investigation of the losses of the various fire sufferers whose claims the Arnolds had, and to assist in the preparation">*2886 of the claims and the collection of facts and data for the trial of cases, if such became necessary, in consideration of which Walsh ">*957 was to receive one-third of the net earnings. Such expenses as were incurred by Walsh were to be paid by him in the first instance and reimbursed to him out of the fees received in the settlement of the fire claims.

The arrangement between the three contemplated, roughly, that John B. Arnold should handle the office work incident to the claims, that N. B. Arnold should conduct investigations, interview clients and handle the trial work, and that Walsh should assist in the investigations and in the collection of information and data necessary to the successful handling of the claims.

N. B. Arnold had had some fifteen years of trial experience and had had a great deal of experience in the woods and understood lumber cruising and the lumber business. He was accustomed to handle foreigners, of whom there were a great many in that territory, and particularly was he accustomed to dealing with Finnish people, whose habits and characteristics he understood very well.

Walsh was very well acquainted with a large part of the devastated territory, ">*2887 having previously been engaged by railroads to assist in the acquisition of rights of way therein. He was also an experienced woodsman and cruiser and qualified to do a great part of the work incident to examination and determination of the losses and the collection of the information necessary for the handling of the claims.

The fires occurred on the lines of the Great Northern Railroad, the Duluth, Minneapolis & Northern Railroad, the Duluth & Minneapolis Railroad, the Duluth & Iron Mountain Railroad, Northern Pacific and Soo Lines, the Warehouse Logging Railroad - all of which were under the control of the Railroad Administration, and the Duluth, Winnipeg & Pacific Railroad, which was a Canadianowned road and not under the control of the Railroad Administration.

There were a number of different fires. Those occurring in St. Louis and Carleton Counties covered areas approximately 30 miles long and 15 miles wide, and those occurring in Carleton and Pine Counties covered an area of approximately the same size. The total losses as the result of the fires have been estimated at $20,000,000. The total amount recovered as damages was approximately $11,000,000, of which about">*2888 $6,000,000 was collected in what was known as the "Cloque" district. Most of the claims against the Railroad Administration were small in amount. Of the total number, the Arnolds and their associates were interested in approximately one-half.

Suit was instituted by the Arnolds against the Railroad Administration on a test case which came on for trial in May, 1919, and resulted in a verdict for the defendant. A second case tried in the ">*958 same month also resulted in a verdict for the defendant. Another case was tried in June and July of 1919 and the jury disagreed. This same case was retried in November of the same year with the same result. In January, 1920, another case was tried by other attorneys and a verdict for the plaintiff secured. In February, 1920, another case was tried by the Arnolds, which trial consumed some three weeks, with the result that the jury disagreed. A retrial of this case produced a similar result.

In April, 1920, an agreement was reached between counsel for the Railroad Administration and the various counsel representing the fire claimants, the substance of which was that another test case should be tried before five district judges">*2889 sitting in bank at Duluth. This case, together with associated cases, came on for trial on the 5th of May, and on the 16th day of September, 1920, the five judges rendered a decision in favor of the claimants. In April, 1921, the decision of the five judges was appealed to the Supreme Court of the State of Minnesota. In the latter part of June of the same year the third trial of one of the cases above mentioned was commenced and resulted in a verdict for the plaintiff. In August of the same year another case was tried, and during the trial thereof counsel for the Railroad Administration announced their willingness to settle cases arising out of fires which had occurred in a substantial portion of the total devastated area.

During the time that these test cases were being tried by the Arnolds other lawyers were trying cases growing out of fires in the same and other territories, and finally another group of attorneys tried another group of cases before another group of judges and it was ultimately agreed to settle the cases there involved. The Arnolds were interested in 5,000 or 6,000 claims prior to the decision of the five judges and thereafter, when it became apparent from">*2890 the decision of that case that the Railroad Administration would be held liable, they became interested in some 2,000 or 3,000 additional claims. All suits had to be instituted prior to February 28, 1922.

A large number of attorneys had been retained by different persons or corporations to handle the claims against the Railroad Administration. For various reasons these different attorneys found it advisable to form groups or associations for the expedient and economical prosecution of the suits against the Railroad Administration. The Arnolds were associated in one way and another with some 25 or 30 different attorneys. The arrangements with these various attorneys were made both orally and in writing and in every instance called for a division of the fees to be received after the litigation terminated successfully. In so far as the Arnolds and their associates ">*959 were concerned these agreements for the division of fees were a most prolific source of disagreement and controversy. In at least two instances, suits having for their purpose a determination of the amount of fees collected and the net amount to be distributed therefrom were instituted against them. At">*2891 least one of these suits had not been finally disposed of at the date of this hearing. Some of the suits instituted in behalf of the fire claimants are still pending in the Supreme Court of the State of Minnesota.

Because of the tremendous number of suits instituted, it was recognized that it would be impossible to have a separate jury trial in each case. The only practical solution of the problem was to try test cases in the various areas. These cases were very carefully prepared and tried as described above. In each case a large number of witnesses was called and the trial occupied many days. Each of these test cases, as was originally contemplated, served to determine and fix generally the liability of the Railroad Administration for the fire occurring in the area from which the claim arose.

During the years 1919, 1920, and 1921 the Arnolds devoted practically all of their time to the handling of the fire claims and advanced expense money in the amount of some $70,000 or $80,000. The first returns from the settlement of the cases were received in December, 1921. A large number of cases were settled in the year 1922, and fees in large amounts were collected for the various">*2892 claimants.

As the fees came in they were deposited in the First National Bank of Duluth and the Northern National Bank of Duluth under the heading of "Arnold & Arnold Fire Case Account". Checks drawn against such accounts would be signed "Arnold & Arnold as Attorneys by" one of the petitioners.

During the years 1922 and 1923 some seven or eight claimants, contending that the Arnolds had not properly handled their claims, sought to hold them responsible for the amount of damages which they contended should have been collected. The disputes thus arising are for the most part as yet undisposed of.

In October of 1922 Walsh instituted suit against the Arnolds, in which he contended that he was entitled to a one-third interest in all fees and that in addition thereto he was entitled to a one-eighth interest by reason of other services rendered. This suit was finally disposed of by arbitration in the early part of 1924. In the latter part of 1926, one of the attorneys associated with Arnolds brought suit against them, seeking to have a determination of the amount of fees to which he was entitled, and the principal questions involved were decided by the court in the same year, ">*2893 though the matter was not completely disposed of until after 1927.

">*960 The actual settlements of the cases in which the Arnolds were interested were in part consummated by them and part by their associates, and from time to time the fees earned as the result of the disposition of these cases were in part distributed to the interested attorneys, one attorney having received $25,000 in fees and notes in the year 1922. At no time from the date the fees first began to come in down to the date of this hearing has it been possible to accurately determine the amount of the expenses and costs incident to the handling and settlement of the various cases. During all of this time some of the cases of the fire claimants have been pending and during all of this time there have been disputes, some of which are still unsettled, between the various interested attorneys or between attorneys and laymen who contended that they were entitled to a proportion of the profits.

On March 15, 1923, the following entry was made on page 7 of the journal of Arnold & Arnold:

Date	Items	Folio	Debits	Credits
15	Metta L. Arnold (Services)	625	$11,000.00
	J. B. Arnold	31		$11,000.00
	Mary F. Arnold (Services)	626	11,000.00
	N. B. Arnold	32		11,000.00
	The above entries made by order of J.B.A. to show services rendered during year of 1922 in Fire cases.

">*2894 The account of Mette L. Arnold, the wife of John B. Arnold, in the ledger of Arnold & Arnold for the year 1923, is as follows:

Date	Items	Folio	Debits	Date	Item	Credits
1923				1923
Jan. 4	Check	D1	$500.00	Dec. 31	Balance	$22,735.48
Feb. 2	do	4	500.00
Mar. 2	do	8	500.00
15	L. M. Wilcuts	10	183.87
15	Check	10	5,000.00
15	1922	J7	11,000.00
Apr. 3	Check	D13	500.00
May 8	do	D21	500.00
June 4	do	D28	500.00
14	L. M. Wilcuts	D30	183.87
July 3	Check	35	500.00
Aug. 2	do	43	500.00
Sept. 4	do	51	500.00
14	L. M. Wilcuts	53	183.87
Oct. 4	Check	59	500.00
Nov. 3	do	66	500.00
Dec. 5	Check (book 2)	D1	500.00
14	Collector of Internal Revenue - St. Paul	D3	183.87
	Total		22,735.48			22,735.48

Mette L. Arnold returned $22,735.48 as salaries and wages in her income-tax return for the year 1923, although she only actually received $11,735.48.

">*961 The account of Mary F. Arnold, the wife of N. B. Arnold, in the ledger of Arnold & Arnold for 1923, is as follows:

Date	Items	Folio	Debits	Date	Item	Folio	Credits
1923				1923
Jan. 3	Check	D1	$250.00	Dec. 31		J30	$11,000.00
8	do	2	250.00	do	Balance		22,976.00
Feb. 3	do	4	500.00
8	do	4	2,000.00
28	do	7	1,500.00
Mar. 15	L. M. Wilcuts	10	168.75
15	Check	10	5,000.00
15	1922	J7	11,000.00
Apr. 3	Check	D13	500.00
5	do	13	7,500.00
5	do	13	500.00
June 6	do	28	500.00
14	L. M. Wilcuts	30	168.75
14	Check	31	300.00
July 14	do		500.00
Aug. 1	do	42	500.00
Sept. 4	do	51	500.00
Sept. 4	do	51	500.00
20	Check	55	500.00
Oct. 6	do	59	101.00
16	do	62	150.00
25	do	63	250.00
Nov. 9	do	67	500.00
Dec. 15	do	D4	500.00
15	Collector of Internal Revenue - St. Paul	D3	168.75
			33,976.00				33,976.00

">*2895 Mary F. Arnold returned the sum of $22,976 as salaries and wages on her income-tax return for that year.

On December 31, 1923, the following entry was made on page 30 of the journal of Arnold & Arnold:

Date	Items	Folio	Debits	Credits
Dec. 31	N. B. Arnold	32	$11,000.00
	Mary F. Arnold	626		$11,000.00
	To reverse entry of Mar. 15, 1923.

It was the understanding of N. B. Arnold that both he and his wife, Mary F., would have to pay an income tax on the amount paid to her as salary for the work she performed and that the returns were made out on that basis.

Sparen, the bookkeeper who made out the 1923 returns, thought he had included the $11,000 in N. B. Arnold's income for 1923 which was debited to Mary F. Arnold's account on March 15, 1923, and credited to her account on December 31, 1923, and did not know until it was pointed out to him on the witness stand that he had not done what he had intended.

It was the understanding of J. B. Arnold that he and his wife, Mette L., would pay a double tax on the salary paid to her.

At no time did the Arnolds agree to enter into partnership between themselves or with other attorneys.

">*962 ">*2896 J. B. Arnold employed one Thomas G. Alvord to make up the 1921 income-tax returns. Alvord was president and manager of a bank and believed to be an expert accountant in connection with income-tax matters. He was given no particular instructions other than to make up the returns from all of their books and records, which were made available to him. It was the belief of the petitioners that sufficient records had been kept from which anyone capable of examining them could determine the net income. Alvord attempted to prepare the returns so that they would show as gross income only the portion of the fees which had actually been withdrawn by each of the Arnolds out of the joint "Arnold & Arnold Fire Case Account."

Several bookkeepers and accountants were engaged from time to time during the period here in question. A man named Medworth followed Alvord, but left before it was time to prepare the 1922 returns. Edwin L. Pearson followed Medworth and made out the returns for the year 1922. Before the returns for the latter year were made a public accountant by the name of W. W. Blackshaw was called in for consultation. Three methods of preparing the returns were suggested. Pearson">*2897 and Blackshaw agreed and that method was followed. At no time prior to 1923 was there a way of ascertaining the exact portion of the fees received that could be classed as earnings of the Arnolds, for the reason that others having some interest therein were claiming a greater portion of the fees than the Arnolds thought their contracts or agreements warranted. It was, therefore, decided that the 1922 returns should be made upon the same basis as the 1921 returns, by reporting as the gross income the actual cash withdrawn.

Three revenue agents commenced investigation of the petitioners' 1921 and 1922 returns on November 22, 1923, which investigation lasted over a year. They were present when it became time to file the 1923 returns and recommended to Edwin H. Sparen, Arnold's bookkeeper at that time, that the returns for 1923 be made upon the same basis as those for the two prior years, which Sparen proceeded to do. One of the agents stated that he thought the method used by the Arnolds was a fair method of reporting income in their cases. During the course of their preparation, J. B. Arnold said to Sparen, "Well, whatever you do, make the returns enough; I would rather pay more">*2898 than have it less."

The petitioners attempted to engage competent help in keeping their records and making their returns, and had no intention of understating their income or evading any income-tax liability.

">*963 A comparison of the income and deductions of the petitioners as reported by them on their several returns and as found by the revenue agents is as follows:

J. B. Arnold and wife, calendar year 1921
	Return	Agent's report
Income:
Fees from fire cases	$37,135.97	$44,981.14
Fees from other sources	None.	567.50
Profits from stock sales	4,091.80	4,091.80
Interest	721.37	None.
Profits from real estate sales	None.	733.39
Total income	41,949.14	50,373.83
Deductions:
Interest	3,793.59	3,199.80
Taxes	354.63	1,170.78
Losses from real-estate sales	1,008.01	None.
Bad debts	None.	106.65
Dues to bar association	None.	24.00
Total deductions	5,156.23	4,501.23
Net income	36,792.91	45,872.60

J. B. Arnold, calendar year 1922
	Return	Agent's report
Income:
Fees from fire cases	$85,650.41	$69,240.41
Salary from own business	None.	35,000.00
Rents and royalties	None.	237.55
Total income	85,650.41	104,477.96
Deductions:
Interest	13,012.84	7,794.87
Taxes	1,062.06	4,578.99
Bad debts	14,619.63	7,470.96
Losses -
Extension Copper Co	5,469.57	None.
District of Dorion	1,650.00	None.
Concession 8	3,020.00	None.
Mesozois Oil Investment	4,000.00	4,000.00
Refugio Deal	382.82	382.82
Sullivan-Fitzgerald	2,200.00	None.
Mars Oil Co	3,000.00	None.
Texas Oil Deal	1,000.00	1,000.00
Dues to bar association	None.	24.00
Loss account - Power & Light Plant deals	None.	1,515.33
Total deductions	49,416.92	26,766.97
Net income	36,233.49	77,710.99

">*2899

J. B. Arnold, calendar year 1923
	Return	Agent's report
Income:
Fees from fire cases	$65,288.32	$85,791.63
Fees from other business	None.	110.00
Interest	1,489.12	1,504.24
Rents and royalties	229.52	229.52
Total income	67,006.96	87,635.39
Deductions:
Interest	8,996.23	8,997.23
Taxes	8,819.25	8,819.17
Bad debts	4,842.81	487.04
Contributions	None.	279.50
E. A. Arnold	3,584.50	None.
Vermillion, E. & D. Co	1,750.00	None.
Premier car expense	211.50	None.
Donations	85.15	None.
Interest	173.76	None.
Woodland litigation	1,708.27	None.
Duluth Holt Power-Light Co	1,925.91	3,752.42
Auto expense	1,153.15	1,153.15
Loss Superior property	2,396.35	1,373.83
Loss on French franc bonds	None.	293.97
Bad debts	None.	179.70
Error	.50
Total deductions	35,646.38	25,336.01
Net income	31,360.58	62,299.38

N. B. Arnold and wife, calendar year 1921
	Ruturn	Agent's report
Income:
Fees from fire cases	$28,478.90	$44,981.13
Deductions:
Interest	1,463.80	1,375.30
Taxes	50.00	121.15
Farm losses	500.00	None.
Contributions	102.00	102.00
Total deductions	2,115.80	1,598.45
Net income	26,363.10	43,382.68

">*2900

N. B. Arnold, calendar year 1922
	Return	Agent's report
Income:
Fees from fire cases	$54,098.30	$69,240,40
Interest	601.58	601.58
Salary from own business	None.	35,000.00
Total income	54,699.88	104,841.98
Deductions:
Interest	483.01	483.01
Taxes	172.03	172.03
Contributions	100.00	350.00
Loss -
Farmers Dairy Stock	250.00	250.00
Stanley auto	1,000.00	500.00
Murray-Colburn case	500.00	500.00
Traveling expense	600.00	600.00
Loss -
Power & Light plant venture	None.	1,515.33
Farming	600.00	None.
Total deductions	3,705.04	4,370.37
Net income	50,994.84	100,471.61

N. B. Arnold, calendar year 1923
	Return	Agent's report
Income:
Fees from fire cases	$33,570.54	$85,791.63
Interest	868.46	1,048.37
Total income	34,439.00	86,840.00
Deductions:
Interest	574.20	574.20
Taxes	573.38	573.38
Contributions	54.40	54.40
Loss - Farmers Dairy Association	150.00	150.00
Auto expense	1,297.62	1,434.18
State bar association	13.00	13.00
E. A. Arnold	3,584.50	None.
Vermillion Exp. and D	1,750.00	None.
Premier Car Exp	211.05	None.
Donations	85.15	None.
Interest	173.76	None.
Woodland litigation	1,708.27	None.
Duluth Holt Power & Light Co	1,925.91	3,752.42
Error	.50
Total deductions	12,101.19	6,551.58
Net income	[*]	80,288.42

">*2901 ">*965 Following the revenue agents' investigation the petitioners filed a brief with the respondent, in which the following statements were made:

According to the report of the examining officers, the total net income of John B. Arnold and N. B. Arnold received from the fire loss business in 1921, 1922 and 1923 was $406,043.16. To this amount should be added the salaries of $35,000 to each of these taxpayer for 1922 and the sum of $20,000 paid to Walsh on account of his share in the profits, making a total net income from the fire loss adventure for these three years of $496,043.16. The additional net income for the succeeding three years when the fire loss business will be practically finished will bring the grand total for these years to about $600,000.00.

Against the net income from the fire loss business, various credits were made, which, computed upon the aggregate net income, would have been as follows:

James F. Walsh, 1/3 interest in all fire cases	$200,000.00
James F. Walsh, 1/8 interest in all except Cloquet cases (estimated)	53,125.00
H. S. Campbell, 1/2 interest in about 120 cases	7,500.00
H. S. Campbell, 1/8 interest in all other cases (Complaint on both claims asks judgment for $85,000)	73,125.00
Joseph N. Franklin, 1/8 interest in all fire cases	75,000.00
Cloquet Fire Reimbursement Association $10,868.16 of the claim has been paid	20,000.00
Fire sufferers (21) for failure to institute action on their fire claims before statute of limitations tolled (see Exhibit 4a attached hereto)	92,221.98
I. L. Lewis, 1/4 interest in certain cases (no estimate attempted here) has been paid	25,000.00
O. J. Larson, Woodland fire cases (no estimate attempted here), has been paid	5,000.00
Total claims	550,971.98

">*2902 ">*966 These claims aggregating almost as much as the total net income from the fire loss business may be divided into two general classes; those in which the fact of liability was admitted but the amount thereof was in controversy such as the Walsh one-third interest; and those in which the liability was denied.

All of these liabilities have been pressed for settlement and most of them have been or are now pending the courts. In settling several of the claims, these taxpayers have already paid out more than ten per cent of the aggregate liability. About $300,000 of this aggregate liability is still unsettled and the largest part is being prosecuted in the courts.

During 1921 J. B. Arnold paid taxes on property which he owned in the amount of $4,280.15. The respondent only allowed $1,170.78 of the amount paid.

During 1922 J. B. Arnold paid taxes on property which he owned in the amount of $5,169.50. The respondent only allowed $3,864.30 of the amount paid.

On February 28, 1922, J. B. Arnold paid taxes on property which he and one Poss owned as cotenants in the amount of $1,429.35. The respondent only allowed $714.69 of the amount paid.

During 1923 J. B. Arnold">*2903 paid taxes on property which he owned in the amount of $9,542.54. The respondent only allowed $8,819.17 of the amount paid.

During 1922 and 1923 J. B. Arnold paid taxes on property which was owned by the Douglas Holding Co., a corporation, in the amounts of $99.79 and $1,454.82, respectively. The respondent properly refused to allow these amounts as deductions from J. B. Arnold's gross income.

Mary F. Arnold assisted her husband, N. B. Arnold, substantially in preparing briefs and doing the work that an assistant in that line would ordinarily do. A reasonable compensation for the services rendered by her during 1922 and 1923 is $5,000 each year.

John B. Arnold, Jr., the son of J. B. Arnold, commenced working for Arnold & Arnold in 1919. His work at that time consisted of driving cars on trips of investigation and doing office work. He attended the Superior State Normal School from 1919 to 1922, inclusive, graduating in the latter year, and worked for Arnold & Arnold after school, Saturdays and holidays. He also examined clients relative to contracts. In the fall of 1922 he enrolled as a law student at the University of Minnesota and while there made such investigations">*2904 in that vicinity as were required, and frequently came home for the week-ends to work on questionnaires. He was paid $2,200 for his services in 1922 and $1,800 for his services in 1923. These amounts were not allowed as a deduction from the joint income of the Arnolds by the respondent.

About 1913 J. B. Arnold had an arrangement with Edward Finch, one Pakkala, Fred Rossan and Nels Anderson to acquire certain lands ">*967 in St. Louis County, Minnesota. The three associates were to pay all of the expenses in connection with clearing up the title and Arnold was to have an equal interest in the fee after the title was perfected. During the course of the acquisition Arnold advanced $320.70 on account of abstracts and witness fees in connection with a suit. In 1922 Arnold was served with a notice of bankruptcy in the case of Finch. The other three associates had died prior to that time and Finch died soon after the bankruptcy. Arnold properly determined in 1922 that all hope of collecting the advances made by him was gone and charged the account off to profit and loss. The respondent did not allow any deduction from gross income on account of this item.

Prior to 1921, ">*2905 J. B. Arnold handled some litigation for one C. J. Petruschke and advanced $450.96 for expenses. On September 20, 1922, he determined the account to be worthless and ordered it charged off, together with a $500 attorney fee, which was done. Petruschke had gone out of business and left no property. The account became worthless in 1922 and was so ascertained by the petitioners and charged off. The respondent did not allow any deduction from gross income on account of this item.

Prior to 1922 J. B. Arnold advanced $184.40 as expenses in connection with a trial for one J. C. Smith. After investigation Arnold correctly determined that his account with Smith was worthless and had it charged off on September 20, 1922. No deduction was allowed for this by the respondent.

A. Arnold was the father of the petitioners. He was self-supporting and able to take care of himself. J. B. Arnold acted as banker for him, collected all of the money that was coming to him from different sources, and paid him from time to time what he wanted. He also advanced his father $476.17 up to the time of his father's death in 1919, at which time the father's estate was sufficient to pay his son's account">*2906 in full. The estate was not probated. In 1922 all of the property left in the estate was stolen, whereupon J. B. Arnold charged the account off to profit and loss. The debt became worthless in 1922. The respondent did not allow any deduction on account of this item.

During 1919 or 1920 John G. Howard retained J. B. Arnold to prepare abstracts and other papers in connection with the sale of a mine near Chicago. Arnold advanced at least $400 to Howard. Howard died in 1922. His estate was insolvent. Arnold's claim was worthless. He so determined it and charged it off. The respondent allowed no deduction for the loss.

The Lake Superior Copper Co. was organized by J. B. Arnold and his friends about the year 1916. Arnold advanced $1,647.49 to the company. In 1922 the company lost its assets by foreclosure.

">*968 The petitioner's advances to the company were a total loss. He ascertained the total amount to be worthless and had the same charged off on his books. The respondent allowed only $597.49 of the loss as a bad debt.

J. B. Arnold, during 1919 or 1920, advanced $2,600.84 to the Superior Copper Mines Co. to meet their pay roll, the secretary's expenses, ">*2907 and other items of that character. Those advances were never repaid. All the property of this company was taken on a foreclosure in 1922, at which time J. B. Arnold correctly determined that his account with them was worthless and had the same charged off on his books. The respondent disallowed this item as a deduction from gross income.

On April 2, 1917, J. B. Arnold entered into a written contract with one C. E. Fitzgerald, whereby Arnold advanced Fitzerald $2,200 to enable the latter to put a mining property which the latter owned in Texas on a paying basis. The property was heavily mortgaged at this time. The money was lost and the venture proved a failure. On February 18, 1920, the District Court of Bexar County, Texas, gave a judgment in favor of the mortgagee against Fitzgerald and others for $65,303.30, with interest at 10 per cent and ordered the property to be sold to satisfy the debt. After investigation in 1922 J. B. Arnold ascertained that his advance to him of $2,200 was worthless and had the same charged off to profit and loss. No deduction was allowed by the respondent on account of this bad debt.

Prior to 1923 J. B. Arnold and N. B. Arnold jointly loaned">*2908 their brother, E. A. Arnold, the sum of $7,169, and J. B. Arnold individually had loaned him the sum of $4,076.27. E. A. Arnold for many years prior to 1923 had been engaged in the real estate business in Superior. Neither J. B. nor N. B. Arnold had contributed to the support of E. A. Arnold prior to 1923. In March, 1923, E. A. Arnold had a stroke of paralysis and has done practically no business since that time, thereby necessitating his brothers donating him a sufficient amount to live on. The loans previously made to E. A. Arnold became worthless in 1923, and were so determined by the Arnolds and charged off on their books of account. The respondent has refused to allow any deduction for the loans made.

During 1916 or 1917, J. B. Arnold purchased stock in the Mars Oil Co. at a cost of $4,800. In addition to the cost of the stock, he advanced $937.50 to the company for operating expenses. In 1922 the company lost its lease through foreclosure proceedings. Its stock became worthless and it had nothing left with which to pay its debts. Arnold ascertained that both his investment and advances in this company had no value and had the same charged off to profit and loss in">*2909 ">*969 1922. The respondent allowed no deduction for the petitioner's loss of $4,800, sustained in 1922 due to the worthless stock or the bad debt of $937.50 ascertained to be worthless and charged off in 1922.

During 1917 J. B. Arnold paid $1,650 for stock in the San Antonio Oil & Development Co. In addition to the cost of the stock, he advanced $1,191.10 to the company for operating expenses. In May, 1922, Arnold ascertained that both his investment and advances in this company of $2,841.10 had no value and had the same charged off to profit and loss. Both the cost of the stock and the advances became worthless in 1922. The respondent allowed the petitioner no deduction for the loss sustained of $1,650 or the debt ascertained to be worthless and charged off in the amount of $1,191.10.

During August and October of 1917, J. B. Arnold and one Thomas Merritt jointly purchased for speculation about 600 acres of land on the Brule River in Township 48, Douglas County, Wisconsin, from W. H. Bonnell and wife and A. J. Hogan and wife for a total consideration of $11,680.56, itemized as follows:

First mortgage running to the Webb Co. assumed	$5,000.00
Purchase mortgage given by J. B. Arnold, individually	2,350.00
Cash paid by J. B. Arnold	3,400.00
1915 back taxes paid by J. B. Arnold	323.25
1916 back taxes paid by J. B. Arnold	289.22
1917 back taxes paid by J. B. Arnold	318.09
Total	11,680.56

">*2910 Later the first mortgagee brought foreclosure proceedings and on December 16, 1920, a judgment of foreclosure and sale was entered in the Circuit Court for Douglas County, Wisconsin. The mortgaged premises were advertised for sale. On February 10, 1922, W. H. Bonnell bought in the property for $6,500, he being the highest bidder therefor. On the same date, the referee deeded the property to W. H. Bonnell. The property was not redeemed by either Arnold or Merritt. In settling with Merritt, J. B. Arnold was successful in collecting only $2,056.56 of the $4,330.56 actually expended by him prior to the foreclosure sale. After the sale and during the first six months in 1922, J. B. Arnold paid off the second mortgage note of $2,350 plus interest of $534.07, which brought his total loss on this venture up to $5,158.07. The respondent has allowed no deduction for such loss.

On June 21, 1922, J. B. Arnold purchased for himself individually from W. H. Bonnell the above mentioned Brule property for a cash consideration of $7,385.34. He had previously subscribed for stock in the Douglas Holding Co., a Wisconsin corporation, and as part payment for such stock he had the Brule property">*2911 deeded direct from W. H. Bonnell to the corporation.

">*970 On May 1, 1922, J. B. Arnold purchased for himself and N. B. Arnold 25 shares of preferred and 125 shares of common stock in the Holt Power-Light Co., a Delaware corporation, for a consideration of $2,500 cash. Both stocks became worthless in 1923. The respondent did not allow the petitioners any deduction for such loss.

In 1920, J. B. Arnold purchased 500 shares of stock in the St. George Mining Co., a Missouri corporation, and paid $500 in cash for it. In 1922, after investigation, Arnold found that the stock was worthless. The stock became worthless in 1922. No deduction was allowed by the respondent for such worthless stock.

On May 1, 1922, N. B. Arnold purchased for himself and J. B. Arnold, equally, 25 shares of preferred and 125 shares of common stock in the Holt Power-Light Co., a Delaware corporation, for a consideration of $2,500 cash. Both stocks became worthless in 1923. The respondent has allowed the petitioners no deduction on account of such losses.

OPINION.

GREEN: The dominant question in these cases is whether the respondent was correct in determining that all of these petitioners">*2912 in all of the years in question filed false and fraudulent returns with intent to evade tax. At the time these cases were heard the rule of this Board was that the determinations of the respondent, both as to the amount of the tax and the proposal of a fraud penalty, were presumed to be correct. However, the burden of proof with respect to the correctness of determining fraud was by an act of Congress changed shortly thereafter and now such burden of proof is upon the respondent. (Section 601, 1928 Act.)

The petitioners in this case are in a situation of being compelled to disprove the fraud which the respondent has determined existed in accordance with the then existing rule. Nowhere, either in the preliminary or 60-day letters addressed to these petitioners or in the pleadings, is there to be found any specification or enumeration of the alleged fraudulent acts. From the statements of counsel and their arguments and briefs, we gather that the respondent's position is that in three respects the returns of these petitioners were false and fraudulent. The first of these apparently relates to the method of reporting and the amount reported as income from the legal services referred">*2913 to in the foregoing findings of fact. The second is the reduction of the amount of income reported by the amounts paid to the wives as salaries. The third relates to certain statements contained in the briefs filed with the respondent during the time that matters were pending in the Bureau of Internal Revenue. Our task would have been greatly simplified if there had been precise allegations ">*971 as to the acts which the respondent determined to be fraudulent. As it is we have some difficulty in determining to what the presumption of correctness attaches.

It is clear that as to each of the years in question the petitioners employed persons whom they believed to be competent to prepare their returns and that as to the first two years they relied entirely upon their judgment as to the accounting methods to be followed in determining income. It further appears that as to the third year those employed by them to prepare the returns consulted certain revenue agents then in the offices of the petitioners, auditing their returns and accounts, and were by them advised to continue to report the income in the manner theretofore followed. The advice of these supposedly competent">*2914 persons was relied upon explicitly and there is nothing in the record to indicate that the method of reporting income thus adopted was chosen for any improper purpose. We hold that no fraud was committed in choosing the method of reporting income.

The method of reporting income thus chosen by the petitioners was not the correct one, but such an error on their part having been made in good faith can not be the basis for the imposition of fraud penalties. The true question is whether these petitioners, in accordance with the method of reporting income which they had chosen, honestly and in good faith attempted so to report such income.

In these cases the petitioners have accepted the method of computing income chosen by the respondent and, using his computation as the basis, have endeavored to prove their net income in conformity with that method. They have taken no exception to the use of this method by the respondent, and therefore the question of its correctness is not before us and we discuss this phase of the matter only as bearing upon the good faith of the petitioners. From an examination of the relative merits of the method of reporting income chosen by the petitioners">*2915 and the method of reporting chosen by the respondent, we are inclined to believe that the method chosen by the petitioners more accurately reflects their income.

The more difficult question is whether these petitioners earnestly and in good faith attempted to report, according to the method chosen by them, all of their income for the years in question. In an examination of this question we must of necessity consider all the facts and circumstances surrounding the conduct of the petitioners' business and all of the facts and circumstances incident to the preparation of the returns. The record discloses that, while the Arnolds were lawyers, they were unfamiliar with income-tax laws and that they had given practically no consideration to questions relating to ">*972 income taxes. It further discloses that they were engaged in the handling and prosecution of a great number of claims against the Railroad Administration involving in the aggregate a tremendous sum of money and necessitating almost endless labor. Under such circumstances we do not think it improper for these petitioners to employ and rely upon those whom they believed to be competent to prepare their returns, bearing">*2916 in mind the very unusual circumstances then existing and the uncertainty still existing as to the correct method of reporting the income derived by these petitioners. At the time the fees began to come in it was extremely difficult, if not, indeed, impossible, to determine what proportion of the fees thus received would become the undisputed property of the Arnolds due to the claims of the various persons interested therein, and these matters of dispute continue undermined through all the years in question and some of them are still undisposed of. One Alvord prepared the returns for the year 1921. He determined the method to be used in their preparation. Their preparation occupied some 30 days of his time. On the witness stand he testified that he thought the method adopted was correct and that he still thought so. We are convinced that Alvord honestly exercised his best judgment in the preparation of these returns and that he earnestly sought to have them correctly reflect the petitioners' income.

The returns for 1922 and 1923 were prepared in the same manner and several persons who participated in their making took the stand and testified as to the good faith employed therein. ">*2917 In each of the years it was the intent of those preparing the returns to cause to be set out in the returns, as gross income, the fees which were actually withdrawn by each of the Arnolds out of the joint "Arnold and Arnold Fire Case Account", it being their belief that such was the correct method of reporting income under the circumstances.

Some two or three months prior to the hearing of these proceedings, the witness Sparen, in whose honesty and integrity we have the utmost confidence, went over the personal accounts of the Arnolds for the purpose of determining the exact amounts of cash withdrawn by them. The result of his examination is as follows:

N. B. Arnold
Year	Deposited in personal account	Paid to Mary F. Arnold	Investments	Miscellaneous	Total
1921	$30,275.00				$30,275.00
1922	50,023.30	$12,000	$1,200.00	$865.83	64,089.13
1923	38,623.90	12,976	12,677.03	767.27	65.044.20
	118,922.20	24,976	13,877.03	1,633.10	159,408.33

J.B. Arnold
	Deposited	Paid to
Year	in personal	Mette L.	Paid to J.B.	Invest-	Miscella-	Total
	account	Arnold	Arnold	ments	neous
1921	$52,500.00					$52,500.00
1922	65,327.72	$8,500.00	$300.00	$4,974.50	$779.82	79,882.04
1923	58,201.22	12,235.48	1,748.30	14,235.46	2,453.89	88,874.35
	176,028.94	20,735.48	2,048.30	19,309.96	3,233.71	221,256.39

">*2918 A comparison of the amounts of cash thus found to be withdrawn with the amounts reported by the Arnolds as fees is as follows:

N. B. Arnold			J. B. Arnold
Year	Reported in returns	Reexamination by Sparen	Year	Reported in returns	Reexamination by Sparen
1921	$28,478.90	$30,275.00	1921	$37,135.97	$52,500.00
1922	54,098.30	62,023.30	1922	85,650.41	73,827.72
1923	33,570.54	51,599.90	1923	65,288.32	70,436.70

">*973 In the totals set forth as having been withdrawn are included in each instance, the amounts paid to the wives. If these amounts are excluded we find nothing in the returns to indicate that they were not made in good faith in an honest endeavor to correctly report income. Disregarding for the moment the deductions for wives' salaries, which matter we discuss later, we find nothing to indicate that any of the returns were false or fraudulent.

There is no dispute about the existence of the book entries relating to the wives' salaries. It is equally true that in each instance the wives reported as income the amounts shown by the books as having been credited to their accounts, though as a matter of fact in some">*2919 instances they actually received amounts which were substantially less. It is likewise true that one of the wives rendered services which were of substantial value and as to which we have found she was entitled to compensation. The proof as to the services rendered by the other wife is not so convincing, but it is apparent that each of the wives was forced to economize during the years involved and that each was promised substantial amounts if the litigation terminated successfully. Both of the Arnolds testified that it was their belief at the time the returns were filed that the amounts credited or paid to their wives should not be, and were not on their returns, treated as deductions in computing their net income and that such amounts should be reported as income by their wives. It is now evident that as to the year 1922 those preparing the returns did reduce gross income by these amounts. As to the year 1923, it is apparent that the witness Sparen, who prepared these returns, endeavored to adjust the net income shown on the Arnolds' returns ">*974 so as to include the amounts paid to the wives. His failure so to do was first brought to his attention while he was on the">*2920 witness stand and it was with some difficulty that he was convinced that the computation which he had made in his effort to include these amounts in gross income had not produced the desired result.

The system of accounting existing in the offices of the Arnolds at the time the fees began to come in was hopelessly inadequate, and to this inadequacy is to be charged a great portion of the confusion which has resulted. Because the Arnolds did not appreciate the necessity and importance of an adequate system of accounts, no thoroughgoing revision of the system was undertaken and an inadequate personnel was retained to maintain such accounts as were kept. There is, however, nothing to indicate that inadequate records were maintained to the end that the amount of gross income actually derived be concealed.

There is no affirmative proof of fraud in this respect and the Commissioner's case rests upon the presumption of the correctness of his determination and such inferences as may be drawn from the fact that these amounts were credited as salary to the accounts of the wives. Each of the petitioners took the stand and testified that there was no bad faith in the preparation of these">*2921 returns and that it was the belief of the Arnolds that the amounts credited to the accounts of the wives as salaries would be subject to double tax. Supporting their testimony, we have that of the several witnesses who participated in the preparation of the returns. We think the affirmative evidence more than sufficient to overcome the presumption in favor of the Commissioner's determination, and accordingly hold that there was no fraud in this respect.

The third charge of fraud grows out of what appears to be a not wholly justifiable misconstruction of a brief filed in the Bureau of Internal Revenue by the attorneys for the petitioners. We know this brief to have been prepared by a firm of reputable attorneys and it is inconceivable to us that this firm would be a party to any misrepresentation before the Bureau of Internal Revenue or elsewhere. Even if this brief did seek to misrepresent the situation, and it clearly does not, it could not serve as the basis for the imposition of a fraud penalty, for the returns themselves are the things which are subjected to the test.

Three revenue agents spent more than a year investigating the returns filed by these petitioners for">*2922 the three years in question. Their reports to the respondent have been placed before us. While it is to be noted (as set out in the findings of fact) that the agents recommended a great many changes in the income and deductions ">*975 from those shown on the returns, some of which were for and some against the petitioners, yet nowhere in the reports did the examiners suggest or even infer that fraud had been committed.

We have carefully considered all of the facts in the record presented to us and have weighed them carefully against the presumption to correctness and it is out opinion that the record does not establish fraud; that the affirmative proof of good faith far outweighs the presumption and that the action of the respondent in imposing the fraud penalties was erroneous.

In our preliminary statement we itemized all of the numerous errors other than fraud which were alleged in the several petitioners. We will not repeat them here. The petitioners withdrew any claim to a deduction for compensation to Mette L. Arnold and in the case of J. B. Arnold, the claim for a bad debt deduction of the account of Edward Finch in the amount of $59.55 was abandoned.

The remaining">*2923 errors can be best disposed of by summarizing our findings of fact in such a way as to show the corrected net income of each petitioner upon which the deficiencies should be recomputed.

The corrected net income of the petitioners for the years 1921 to 1923, inclusive, is as follows:

J. B. Arnold and wife, 1921
Net income as determined by respondent			$45,872.60
Deduct: Taxes			3,109.37
Corrected net income			42,763.23
J. B. Arnold, 1922
Net income as determined by respondent			$77,710.99
Deduct:
Taxes		$2,019.86
Salary, Mary F. Arnold		2,500.00
Salary, J. B. Arnold, jr		1,100.00
Bad debts:
Finch, Anderson, et al	$320.70
C. J. Petruschke	450.96
J. C. Smith	184.40
A. Arnold	476.17
John G. Howard	400.00
Lake Superior Copper Co	1,050.00
Superior Copper Mines Co	2,600.84
C. E. Fitzgerald	2,200.00
Advances Mars Oil Co	937.50
Advances San Antonio Oil & Development Co	1,191.10
		9,811.67
Losses:
Mars Oil Co. stock	$4,800.00
San Antonio Oil & Development Co. stock	1,650.00
Investment Brule property	5,158.07
St. George Mining Co. stock	500.00
		$12,108.07
			$27,539.60
Corrected net income			50,171.39
J. B. Arnold, 1923
Net income as determined by respondent			$62,299.38
Deduct:
Taxes		$723.37
Salary, Mary F. Arnold		2,500.00
Salary, J. B. Arnold, jr		900.00
Bad debt, E. A. Arnold		7,660.77
Loss, Holt Power-Light Co. stock		2,500.00
			14,284.14
Corrected net income			48,015.24
N. B. Arnold and wife, 1921
Net income as determined by respondent approved			$43,382.68
N. B. Arnold, 1922
Net income as determined by respondent			$100,471.61
Deduct:
Salary, Mary F. Arnold		$2,500.00
Salary, J. B. Arnold, jr		1,100.00
			3,600.00
Corrected net income			96,871.61
N. B. Arnold, 1923
Net income as determined by respondent			$80,288.42
Deduct:
Salary, Mary F. Arnold		$2,500.00
Salary, J. B. Arnold, jr		900.00
Bad debt, E. A. Arnold		3,584.50
Loss, Holt Power-Light Co. stock		2,500.00
			9,484.50
Corrected net income			70,803.92

">*2924 ">*976 The evidence with respect to the several assignments of error not reflected in the above redetermination of the petitioners' net income was insufficient to enable us to make any finding which would result in disturbing the position taken by the respondent.

In conclusion we find that the petitioners were not guilty of filing false or fraudulent income-tax returns with intent to evade any income tax for any of the years before us, and that the deficiencies should be recomputed in accordance with the corrected net income set out in this opinion.

Judgment will be entered under Rule 50.