Keeler v. Commissioner , 23 B.T.A. 467 ( 1931 )

ISAAC P. KEELER, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Keeler v. Commissioner

Docket Nos. 30338, 38754, 42440.

United States Board of Tax Appeals

23 B.T.A. 467; 1931 BTA LEXIS 1863;

May 29, 1931, Promulgated

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1. Where petitioner, as the result of investments made in his individual capacity but in order to benefit the partnership of which he was a member, expended amounts in defense of a law suit, held, that such expenditures are deductible from his individual gross income as ordinary and necessary expenses of his business.

2. Upon the evidence, held, that petitioner is not entitled to certain deductions claimed on account of losses.

3. A fee paid by petitioner in connection with the controversy over income tax upon his personal income held not deductible from petitioner's gross income.

Clarence W. McGuire, C.P.A., for the petitioner.

John D. Kiley, Esq., for the respondent.

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MCMAHON

These proceedings, duly consolidated for hearing, are for the redetermination of deficiencies in income taxes as follows:

Docket No.	Year involved	Asserted deficiency
30338	1922	$2,870.39
30338	1923	988.25
38754	1924	882.11
38754	1925	2,375.86
42440	1926	7,686.89
Total		14,803.50

The petition in each of Docket Nos. 30338 and 38754 alleges error on the part of the respondent in failing to allow as deductions certain fees paid by the petitioner for legal services during the years in question, incurred in defending a suit brought against him for an accounting of his business profits arising from his business transactions with the Greenville Finishing Company, Inc., and the Acme Finishing Company. Petitioner contends that these expenses were ordinary and necessary business expenses.

The petition under Docket No. 42440 sets forth the following assignments of error, among which it will be noted is an assignment of error similar to that under Docket Nos. 30338 and 38754.

(a) The failure of the Commissioner to find that a loss was sustained in business by the taxpayer resulting from an agreement of settlement made with A. F. Shaw, whereby the taxpayer paid said Shaw $12,412.17. This amount was equal to one-half of loss suffered by Shaw through being forced to surrender stock of Acme Finishing Company as part of settlement of suit for accounting brought by Acme Finishing Company against I. P. Keeler, A. F. Shaw and the Greenville Finishing Company;

(b) The failure of the Commissioner to find that a loss was sustained in business by the taxpayer, when as part of terms of settlement of suit brought against taxpayer by Acme Finishing Company, he was compelled to surrender 200 shares of stock of said Company, which he purchased in 1914 at a cost of $12,000;

(c) The failure of the Commissioner to find that legal fees paid to counsel during the taxable year, amounting to $6,231.49, for defense of suit against him by Acme Finishing Company were ordinary and necessary expenses incurred in the course of business;

(d) The failure of the Commissioner to find that fee paid to C. W. McGuire during the taxable year, amounting to $2,000 for services in connection with taxpayer's income-tax returns of business income received from partnership of Tilton & Keeler, was an ordinary and necessary expense incurred in the course of business; and

(e) The failure of the Commissioner to allow these losses and expenses as deductions from the gross income of the taxpayer for the calendar year 1926.

FINDINGS OF FACT.

The petitioner is an individual residing at East Orange, N.J.

In 1902, the petitioner entered into a partnership with his brother-in-law, S. U. Tilton, under the firm name of Tilton and Keeler, for the purpose of engaging in the business of the manufacture and sale of draperies and lace curtains and printing and finishing of cotton piece goods. This business is commonly known as the cotton goods converting business. Gray goods were purchased from gray mills and commission houses and were then sent to the finishing works to be bleached, dyed, or printed, according to specifications, after which the finished merchandise was sold.

When the original partnership was formed petitioner did not put in any specified amount of money. Tilton risked his capital against petitioner's experience, and each was to share equally in the profits or losses. This condition existed until 1904, when one Hart became entitled to a part of the profits. Hart did not become a partner. The original partnership agreement did not provide for salaries, but in 1916 a new agreement was entered into by which the profits of the partnership were divided on the basis of 55 per cent to petitioner and 45 per cent to Tilton. Petitioner's salary was $40,000 per year and Tilton's salary was $20,000 per year. The petitioner managed the business and assumed not only the financial but also the merchandising part of the business. Tilton did no buying or selling. He did occasionally entertain the trade. He knew nothing of the business and left the entire management to the petitioner.

This partnership continued up to the end of June, 1920, when two new partners, Latimer and Allpass, were admitted. The partnership continued under the same name until either December 30, or December 31, 1920, when the business was incorporated. It thereafter continued under the same name.

The capital investment in the partnership was $960,000. Of this total capitalization Latimer and Allpass had invested $30,000. When the business was incorporated the capitalization was $650,000, of which $390,000 represented common stock and $260,000 represented preferred stock. At the time of incorporation the petitioner owned about 58 per cent of the total of 6,500 shares of stock outstanding, as follows:

	Shares
Preferred stock	1,504
Common "A"	1,729
Common "B"	528
Total	3,761

In 1926 all the preferred stock was retired. Petitioner's holding was then 2,257 out of 3,370 shares, or about 67 per cent.

It was found by the partnership that the average job-printing plant made deliveries as specified when business was dull, but during the busy season deliveries ran very often from a week to six weeks late. These late deliveries destroyed the confidence of the customers of the partnership and resulted in the cancellation of contracts in the majority of cases.

To remedy this situation the petitioner, in the summer of 1915, purchased 100 shares of stock, approximately a 5 per cent interest, in the Acme Finishing Company. The Acme Finishing Company conducted a business of bleaching, dyeing, printing and finishing the type of materials which Tilton and Keeler were using and Tilton and Keeler had been giving a large part of their business to the Acme Finishing Company. The petitioner felt that the purchase of this stock would bring the partnership in closer touch with the Acme Finishing Company and would result in better deliveries, as well as price concessions. Shaw, who was the president and general manager of the Acme Finishing Company at that time, held about one-fifth of the stock and the greater portion of the balance of the stock was held by one Decker, his relatives and some of his very close friends. The petitioner never held office in the Acme Finishing Company.

The 100 shares of stock of the Acme Finishing Company which the petitioner purchased were paid for by check of Tilton and Keeler, but the amount of the check was charged to petitioner's personal account. The petitioner often paid for personal items by partnership checks and then had his personal account charged. Petitioner purchased this stock personally because he owned the larger share in the partnership and because Tilton was not actively engaged in the business. At this time petitioner had a much larger interest in Tilton and Keeler than Tilton had because Tilton had been withdrawing from the partnership both profits and capital. Because of this petitioner was of the opinion that sooner or later there would be a change in the partnership. The stock of the Acme Finishing Company cost petitioner $11,000. Later, by a stock dividend, the 100 shares were increased to 200 shares. A dividend of $1,000 voted by the Acme Finishing Company was never turned over to petitioner.

As the result of the purchase by the petitioner of this stock, Tilton and Keeler, for the first year and one-half thereafter, obtained price concessions from the Acme Finishing Company and also received preference in deliveries. Thereafter Acme Finishing Company obtained an excessive number of customers and was, therefore, unable to give Tilton and Keeler the prompt deliveries as before. It also ceased making concessions in prices to Tilton and Keeler.

When this condition occurred in 1916, the Greenville Finishing Company was organized and petitioner took an interest of approximately one-third therein. This interest was paid for by Tilton and Keeler, but the amount was charged to the petitioner's personal account. Checks in the following amounts were issued on the following dates, in payment for Greenville Finishing Company stock:

November 20, 1916	$10,000
November 27, 1916	5,000
December 28, 1916	10,000
March 10, 1917	10,000
Total	35,000

At or about this time the partnership of Tilton and Keeler purchased an interest of approximately 10 per cent to 12 1/2 per cent in the Arcadia Print Works, for about $20,000. At the time the partnership was incorporated in 1920, the Arcadia Print Works had become insolvent and the amount of the purchase price was charged off to profit and loss. Petitioner, after the incorporation, retained his interest in the Greenville Finishing Company and the Acme Finishing Company.

The petitioner was never an officer in the Greenville Finishing Company, but was one of its three directors. He received no salary from that company. His duties with that company required only an occasional attendance at directors' meetings.

At the time the Greenville Finishing Company was organized, Decker, Shaw, and the petitioner were the only stockholders except a few stockholders who held only nominal interests. Shaw owned nearly one-third of the stock. In July, 1917, the company was reorganized and was called Greenville Finishing Company, Inc. Preferred stock in the amount of $50,000 was issued at that time and was purchased by friends and relatives of Decker. The preferred stock did not carry voting privileges. From 1920 to 1926, petitioner owned approximately one-third of the outstanding stock of the Greenville Finishing Company, Inc.

At the time of the organization of the Greenville Finishing Company it bleached, mercerized, and dyed cotton cloths and finished the same. In the late spring of 1919, it had erected a printing plant to print and finish the type of cloth which Tilton and Keeler were buying for that purpose. The petitioner's purpose in procuring a substantial interest in the Greenville Finishing Company was to protect his interest in Tilton and Keeler. As a result of the purchase of an interest by petitioner, Tilton and Keeler were able to get proper deliveries and also some concessions in price. As nearly as possible, Tilton and Keeler gave all it printing and finishing to the Greenville Finishing Company which the latter was in a position to handle. The work furnished by Tilton and Keeler has averaged from 50 to 60 per cent of the total business done by Greenville Finishing Company.

In October, 1919, the petitioner was made a party defendant in a law suit instituted in the Superior Court of Providence, R. I., by the Acme Finishing Company. The other respondents were the Greenville Finishing Company, Inc., and A. F. Shaw.

The bill of complaint filed in the suit recited in part: that from January 26, 1916, to the beginning of the action, Frank A. Decker was a stockholder, secretary and treasurer, agent and a director of Acme Finishing Company, that Isaac P. Keeler was a stockholder of the Acme Finishing Company, and that Alexander F. Shaw was a stockholder, vice president, general manager, and a director of the Acme Finishing Company; that on or about January 26, 1916, Shaw, Keeler and Decker organized a corporation under the laws of the State of Rhode Island, known as the Greenville Finishing Company, and that Shaw, Keeler, and Decker were at all times its sole stockholders, directors and officers; that Decker, Shaw and Keeler stated that the corporation would not compete with the Acme Finishing Company; that on or about August 9, 1917, a new corporation under the name of Greenville Finishing Company, Inc., was caused to be organized by Shaw, Keeler and Decker to carry on the business of the Greenville Finishing Company; that the new corporation was financed by Shaw, Keeler and Decker; that each owned approximately one-third of its stock; that Shaw and Keeler were directors of the corporation, Shaw was president, Decker was secretary and treasurer until September 17, 1919, when Benjamin C. Stanton was elected secretary and treasurer, and that Shaw was general manager of the corporation; that it was the duty of Shaw to work in the interest of the Acme Finishing Company and not in the interest of any competitor; that it was the duty of Keeler and Decker to refrain from assisting Shaw in the doing of certain acts; that the respondents conspired and contrived with intention to injure the Acme Finishing Company, to build up a competitive business at the expense and to the detriment of the Acme Finishing Company; that the competitive business had the benefit, advantage, and use of Shaw and the use of the agents, servants, employees, equipment, materials and supplies of the Acme Finishing Company; that this business actively competed with the Acme Finishing Company; that the respondents solicited and sought business from the customers of the Acme Finishing Company and diverted business from the Acme Finishing Company; that Shaw caused to be transferred from the Acme Finishing Company certain orders for printing and other work from the firm of Tilton and Keeler and other firms; that Keeler diverted all the business of Tilton and Keeler to the respondent corporation which that corporation could handle; that Shaw and Keeler caused the Acme Finishing Company to undertake and complete a large amount of work for the respondent corporation at grossly inadequate prices, thereby causing the Acme Finishing Company to lose large gains and profits; and that the acts and conduct of the Acme Finishing Company's officers, directors and agents, in building up the respondent corporation's business, so that the respondent corporation competed with the Acme Finishing Company and prospered at its expense, were in violation and breach of their fiduciary relations to the Acme Finishing Company.

The bill requested, in part, that the respondents be ordered and directed to render to the Acme Finishing Company a just and true account of all the gains and profits which the respondents enjoyed and received as a result of the acts complained of, that the respondents be directed and required to pay over to the Acme Finishing Company such sum or sums as should be ascertained to be due and payable to the Acme Finishing Company and all damages and losses that may have resulted to the Acme Finishing Company from the acts complained of, and that Shaw and Keeler be decreed to hold the common stock of the respondent corporation that stood in their names as trustees of the Acme Finishing Company and be ordered to transfer such stock to the Acme Finishing Company for its own use.

The Greenville Finishing Company, Inc., Shaw, and the petitioner engaged the law firm of Edwards and Angell, of Providence, R.I., to represent them in defense of this suit. Parkhurst, of the firm of Edwards and Angell, suggested that since the suit was brought against the three parties, the expenses should be shared equally among the three. This was done. In 1924 or 1925, the Greenville Finishing Company, Inc., Shaw, and the petitioner, also engaged the firm of Platt, Field and Taylor, of New York, to represent them in the matter. Petitioner's attorneys advised him that there was no basis for the action by the Acme Finishing Company against him, but they filed an answer to the suit in his behalf.

The court appointed a master in the latter part of 1919 or the early part of 1920. Hearings were had in the case from October, 1919, to February, 1926. The petitioner attended some of the hearings before the master was appointed, but not thereafter.

The case was finally settled in March or April, 1926, and a decree was entered dismissing the proceeding. The settlement agreement was in writing, and is now in the possession of Blair, of Platt, Field and Taylor. In settlement of the suit petitioner paid Shaw $12,412.17, and contributed his 200 shares of stock inthe Acme Finishing Company to the Greenville Finishing Company, Inc. Shaw surrendered to the Greenville Finishing Company, Inc., 738 1/2 shares of stock which he owned in the Acme Finishing Company. This was 538 1/2 shares more than petitioner surrendered and the difference was represented by the amount of $12,412.17 which petitioner paid to Shaw.

From 1922 to 1924, petitioner had advanced to Shaw, as loans, a total of over $17,000. These payments to Shaw had been made in monthly installments of $500. During the time the suit was pending Shaw's salary was limited and petitioner loaned him this amount for living expenses. At the time of the settlement the amount of $12,412.17 which petitioner was to pay Shaw under the settlement agreement was set off against the amount Shaw owed petitioner and canceled that much of the indebtedness of Shaw to petitioner. The payment by petitioner of $12,412.17 to Shaw was not in payment of Shaw's legal expenses. The surrender, by petitioner, of his 200 shares of Acme Finishing Company stock to the Greenville Finishing Company, Inc., was not in payment of the legal expenses of that company, but was paid because it was one of the terms of the settlement.

Despite the fact that petitioner was advised by his attorneys that there was no basis for the suit against him, he settled the case because he was largely interested in Shaw, and in the Tilton and Keeler business, which was being handicapped by the loss of his own time and that of Shaw.

Whenever Edwards and Angell wanted money on account in defense of the action they would send Greenville Finishing Company, Inc., Shaw, and the petitioner each a bill for one-third of the amount wanted. Likewise, when payments were due to the master and the court stenographer, the three were notified and each contributed one-third of the amount.

From 1922 to 1926, the petitioner paid the following amounts on account of his individual defense in the suit brought by the Acme Finishing Company:

1922
To Edwards & Angell:
Jan. 25	$93.33
July 7	500.00
Oct. 6	2,000.00
Dec. 26	500.00
Dec. 30	506.76
For stenographer:
Apr. 27	18.90
Aug. 4	101.87
Dec. 5	279.92
Dec. 30	90.91
To the master:
Dec. 26	500.00
1923
To Edwards & Angell:
Sept. 28	1,666.66
Dec. 31	833.33
To the stenographer:
Sept. 29	103.36
Oct. 27	32.64
To the master:
Oct. 6	500.00
1924
To Edwards & Angell:
Mar. 28	10.07
Mar. 28	166.12
Apr. 18	1,000.00
July 29	2,500.23
Dec. 31	1,005.07
To the stenographer:
July 9	119.08
Nov. 29	259.17
To the master:
July 29	500.00
1925
To Edwards & Angell:
Apr. 2	$1,500.00
Sept. 26	1,666.67
Nov. 30	302.78
To the stenographer:
Apr. 2	261.82
July 28	257.25
To the master:
Apr. 18	500.00
Nov. 6	500.00
1926
To Edwards & Angell:
Mar. 19	263.09
Jan. 23	3,464.66
To the master:
Mar. 19	500.00

All of the above payments, except two, were made by checks payable to Edwards and Angell. The other two were paid by check to Elliott G. Parkhurst, a member of the firm of Edwards and Angell. All of the payments were for attorneys' fees except those which are listed as payments for master's and stenographer's fees. Petitioner was never reimbursed by the Greenville Finishing Company, Inc., for fees which he paid to Edwards and Angell.

On January 21, 1926, the petitioner also paid by check to the law firm of Platt, Field and Taylor, the amount of $1,753.74.

In the year 1926, the petitioner paid to C. W. McGuire the amount of $2,000 for services in connection with the income tax upon petitioner's income from Tilton and Keeler. Petitioner's salary had been questioned and various trips to Washington were made in this connection. Petitioner deducted this amount on his income-tax return for the year 1926. The deduction was disallowed by the respondent.

From 1922 to 1926 petitioner's sources of income were from salary, bonuses and dividends from Tilton and Keeler, Inc., and from his interest in the Greenville Finishing Company, Inc. The petitioner had no business interests other than these.

The petitioner kept no personal books of account and returned his income on the cash receipts and disbursements basis.

In the deficiency letter dated June 16, 1927, which is the basis for the proceeding under Docket No. 30338, the respondent disallowed deductions claimed by petitioner for the years 1922 and 1923 for attorneys' fees in connection with the Acme Finishing Company suit. The amount of the claimed deduction for the year 1922 is not shown. For the year 1923, the claimed deduction which was disallowed was in the amount of $3,165.99. The respondent held that "these attorneys' fees were of such a nature as to make them payable by the corporation against whom the suit in question was brought."

In the deficiency letter dated March 24, 1928, which is the basis for the proceeding under Docket No. 38754, the respondent disallowed as deductions from gross income of the years 1924 and 1925, respectively, the amounts of $5,559.72 and $10,206.32 claimed by petitioner as deductions for attorneys' fees incurred in defense of the Acme Finishing Company lawsuit. The respondent held that these expenses were personal expenses and, therefore, not deductible.

In the deficiency letter dated November 27, 1928, which is the basis for the proceeding under Docket No. 42440, the respondent held that the amount of $12,412.17 paid by petitioner to A. F. Shaw, and $12,000 stock surrendered, in the settlement of the lawsuit brought against petitioner by the Acme Finishing Company, did not constitute allowable deductions under the regulations and section 214(a)(1) of the Revenue Act of 1926, holding that the cost of settling the suit was not an ordinary and necessary business expense within the meaning of the statute. The respondent also disallowed as a deduction the amount of $6,321.49 representing attorneys' fees paid in the Acme Finishing Company suit, upon the same grounds as the loss sustained in settling the suit.

OPINION.

MCMAHON: The respondent denied as deductions from gross income of the petitioner for the years 1922 to 1926, inclusive, amounts claimed by the petitioner as legal expenses incurred in the defense of a lawsuit brought against him, the Greenville Finishing Company, Inc., and A. F. Shaw, in 1919, by the Acme Finishing Company. The amounts expended by the petitioner in this connection were $4,591.69 in 1922, $3,135.99 in 1923, $5,559.74 in 1924, $4,988.52 in 1925, and $5,981.49 in 1926. Petitioner contends that these expenditures were ordinary and necessary business expenses incident to the converting business which he conducted in partnership with Tilton under the name of Tilton and Keeler, and are deductible from his individual gross income for the years in question. The respondent contends that the amounts in question are not deductible because the petitioner was not engaged in carrying on a trade or business during the years 1922 to 1926, inclusive, within the meaning of section 214(a)(1) of the Revenue Acts of 1921, 1924 and 1926.

From a careful consideration of the evidence which we have set forth in detail in our findings of fact, we conclude that the expenditures in question proximately resulted from petitioner's business and are deductible, as ordinary and necessary business expenses, from petitioner's gross income of the respective years in which the payments were made. See , in which the Supreme Court of the United States stated in part:

The basis of these holdings seems to be that where a suit or action against a taxpayer is directly connected with, or, as otherwise stated (, proximately resulted from, his business, the expense incurred is a business expense within the meaning of section 214(a), subd. 1, of the act. These rulings seem to us to be sound * * *.

The respondent erred in disallowing the above claimed deductions.

Petitioner contends that his payment of $12,412.17 to Shaw and his transfer of the 200 shares of Acme Finishing Company stock to the Greenville Finishing Company, Inc., in settlement of the Acme Finishing Company lawsuit constituted either losses sustained by him in his trade or business, or losses sustained in a transaction entered into for profit though not connected with the trade or business. Section 214 of the Revenue Act of 1926 provides:

(a) In computing net income there shall be allowed as deductions:

* * *

(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in trade or business;

(5) Losses sustained during the taxable year and not compensated for by insurance or otherwise, if incurred in any transaction entered into for profit, though not connected with the trade or business; * * *

Petitioner testified that the decree dismissing the suit was based upon the surrender to the Greenville Finishing Company, Inc., by the petitioner and Shaw of their stock in the Acme Finishing Company. He further testified that his payment of $12,412.17 to Shaw and his surrender of 200 shares of Acme Finishing Company stock to the Greenville Finishing Company, Inc., were in pursuance of the terms of the agreement of settlement. Neither the decree nor the settlement agreement was submitted in evidence, and from the other evidence adduced we are unable to understand the settlement. Even if the agreement of settlement does provide as stated by petitioner, we are without any proof to show that petitioner was required to enter into such an agreement. From the evidence before us we can not determine definitely that these payments did, in fact, constitute losses. With regard to the surrender of the 200 shares of Acme Finishing Company stock to the Greenville Finishing Company, Inc., we do not see how this could in any event be considered a total loss to the petitioner since petitioner owned a one-third interest in the Greenville Finishing Company, Inc. The transfer of this stock to the Greenville Finishing Company, Inc., would increase the value of petitioner's holdings in the Greenville Finishing Company, Inc.

The respondent did not err in disallowing the claimed deductions.

The respondent also disallowed as a deduction from gross income of the petitioner for the year 1926, an amount of $2,000 paid by the petitioner to C. W. McGuire for services in connection with the income tax upon petitioner's income from Tilton and Keeler. This expenditure was not an ordinary and necessary business expense and the respondent's action must be approved. , and .

Reviewed by the Board.

Judgment will be entered under Rule 50.