Ferguson v. Commissioner , 14 B.T.A. 820 ( 1928 )

CHARLES A. FERGUSON, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Ferguson v. Commissioner

Docket No. 11313.

United States Board of Tax Appeals

14 B.T.A. 820; 1928 BTA LEXIS 2904;

December 19, 1928, Promulgated

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PARTNERSHIP - SALE OF ASSETS TO NEW PARTNERSHIP - INVENTORY ADJUSTMENT - INCOME. - A partnership organized for a term of years was dissolved by limitation on December 31, 1918, and another partnership organized to take over and continue the business beginning January 1, 1919. The new partnership agreed to take over the merchandise of the old at cost less a fixed sum and opened its books with entry of such cost, set up and satisfied the indebtedness to the old partnership on this basis and computed its profits during that calendar year upon such cost. Held, that the transfer of merchandise by the old partnership to the new constituted a sale at cost less the allowance agreed upon and the profits of the new partnership for the calendar year 1919 should be computed on such basis.

Jacob Wasserman, Esq., for the petitioner.

L. L. Hight, Esq., for the respondent.

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TRUSSELL

Petitioner appeals from a deficiency of $19,419.64, in income tax for the calendar year 1919, determined and advised of by respondent on December 1, 1925. This deficiency arises from respondent's action in reducing the total of the opening merchandise inventory of a partnership of which petitioner was a member, this action resulting in a computed increase in partnership earnings for that year and in petitioner's individual distributive share of same.

FINDINGS OF FACT.

Petitioner is a resident of Malden, Mass., and was for six years prior to the calendar year 1919, a special partner in the wholesale dry goods firm of Blodgett, Ordway and Webber of Boston, Mass. For 60 years prior to the taxable year here involved a succession of partnerships under this name had been carrying on business in Boston. The term of existence of these partnerships in each case was limited, usually to three years, and in each instance upon the dissolution of the existing partnership by limitation, a new partnership to carry on business under the same name would be organized by those interested in the old partnership, or some of them, in some cases with the addition of new parties. It had for many years been the custom for the new partnership in each case upon organization to acquire the merchandise of the old at book value less some estimated allowance as representing depreciation and shortages.

For the three years preceding the calendar year 1919, a firm of Blodgett, Ordway and Webber was in existence, consisting of John A. Ordway, Frederick S. Blodgett, Ernest J. Bartlett, Walter W. Webber, and L. A. Warren, all general partners participating in profits and assuming the liabilities of the business, and certain special partners, of whom petitioner was one, who received an agreed interest return on their capital contributions and assumed liabilities only to the extent of such contributions. This firm, hereafter referred to as the "old partnership" was dissolved by limitation on December 31, 1918. On December 30, 1918, a new firm of the same name, hereafter referred to as the "new partnership," was created by contract of that date, for the purpose of taking over the assets of the old partnership, and to begin business January 1, 1919. This new partnership had as general partners the three general partners of the old partnership first named above and two new general partners, one of whom was petitioner. Webber and Warren, general partners in the old partnership, became special partners in the new, and two additional special partners were admitted.

By the new contract of partnership, John A. Ordway, Frederick S. Blodgett and Ernest J. Bartlett agreed to contribute to the new partnership such amounts as might be standing to their credit on the books of the old partnership at December 31, 1918. Petitioner and the other general partner agreed to contribute $10,000 each and the special partners agreed to contribute various fixed sums.

The old partnership closed its books as of December 31, 1918, its closing merchandise inventory, taken on the basis of "cost," being in the sum of $1,051,060. This merchandise was taken over by the new partnership on the basis of cost less an allowance of $75,000 made by the old partnership to cover depreciation and shortage, its opening entries being as follows:

Opening entries. (New) Blodgett, Ordway & Webber, January 1, 1919, journal page 92
Debits	Credits
1,051,060.00 Blodgett, Ordway & Webber "B" Mdse. per Inventory	1,051,060.00
262,885.00 Blodgett, 275 M.U.S. Liberty bonds at Market value	262,885.00
2,244.50 Blodgett, Accrued int. on Liberty Bonds	2,244.50
836.00 Blodgett, 1000 U.S. War Stamps	836.00
12,900.00 Blodgett, Policy on life of J.A. Ordway - cash value	12,900.00
2,000.00 Blodgett, Furniture & Fixtures P. & L	2,000.00
9,000.00 Blodgett, Auto Trucks (5) P. & L	9,000.00
490.00 Blodgett, Trav. Expenses Advanced:
A. S. Colburn	100.00
C. A. McNally	40.00
O. A. McFarland	200.00
E. J. Ruggles	150.00
		1,341,415.50
383,149.68 J.A. Ordway, Cap. Acct. Blodgett Ordway &
235,200.99 F. S. Blodgett Cap. Acct. Webber "B"	839,337.05
215,986.38 E. J. Bartlett Cap. Acct. New Concern
5,000.00 C. A. Ferguson Special
307,301.54 Deposit Accounts. Blodgett Ordway & Webber "B".		307,301.54

Journal entry, January 1, 1919, page 103
Debit	Credit
Blodgett, Ordway & Webber "A" 1918 concern	75,000.00
To Profit & Loss	75,000.00

ALLOWANCE ON MERCHANDISE INVENTORY

The merchandise and profit and loss accounts of the new partnership and its balance sheet were as shown by its books for the calendar year 1919 as follows:

Merchandise account, Jan. 1 to June 30, 1919
Jan. 1. Mdse. per Inventory		$1,051,060.00
Jan. Purchases	$664,660.65
Feb. Purchases	212,395.88
Mar. Purchases	240,822.18
Apr. Purchases	382,388.64
May Purchases	481,387.58
June Purchases	577,106.34
		2,558,761.27
Jan. Goods returned	$6,388.28
Feb. Goods returned	22,458.39
Mar. Goods returned	26,613.77
Apr. Goods returned	13,321.48
May Goods returned	15,867.56
June Goods returned to old partnership	13,011.95
(6 mo.)	46,835.24
		$144,496.67
To Profit & Loss		292,475.08
		4,046,793.02
Jan. Sales	381,505.59
Feb. Sales	411,058.21
Mar. Sales	482,897.69
Apr. Sales	470,473.39
May Sales	588,014.54
June Sales	735,848.30
Fire Loss Depts. H & W	10,618.00
		3,080,415.72
June 30 Balance		966,377.30
		4,046,973.02
Merchandise account July 1 to Dec. 31, 1919.
July 1. Balance		$966,377.30
July Purchases		1,251,217.88
Aug. Purchases		722,703.25
Sept. Purchases		837,122.60
Oct. Purchases		742,943.85
Nov. Purchases		723,733.06
Dec. Purchases		960,978.48
		6,205,076.42
July Goods returned	$13,905.97
Aug. Goods returned	17,963.29
Sept. Goods returned	26,190.42
Oct. Goods returned	32,037.27
Nov. Goods returned	23,458.84
Dec. Goods returned	30,761.50
Dec. Goods returned to old concern	133.63
		144,450.92
Dec. 31. To Profit & Loss		1,210,760.61
		7,560,287.95
July Sales	779.755.12
Aug. Sales	1,104,137.76
Sept. Sales	1,041,081.22
Oct. Sales	1,043,589.89
Nov. Sales	872,314.40
Dec. Sales	1,037,190.32
		5,878,068.71
Dec. 31. Reduction in Stock to inventory		5,200.24
Dec. 31. Mdse. per Inventory		1,677,019.00
		7,560,287.95
Profit & Loss, Jan. 1 to June 30, 1919
Credits. Allowance on inventory by previous partnership		$75,000.00
6/30 Allowance by previous partnership on goods retd 6 mos		10,182.58
Mdse. profits 6 mos		292,475.08
Balance Fire Ins. Acct		16,422.96
		394,080.62
Debits:
Jan. 1, Allowance to previous partnership accrued Int. on Liberty Bonds	$2,244.50
Furniture & Fixtures	2,000.00
Auto Trucks	9,000.00
June 30 Expenses 6 mos	257,972.76
Net Interest	35,150.84
		306,368.10
Balance		87,712.52
Profit & Loss. July 1 to Dec. 31, 1919
Credits:
June 30 Balance		87,712.52
Dec. 31 Mdse. Profits		1,210,780.24
Accred. Value J.A.O. life policy		1,150.00
		1,299,642.76
Debits:
Bad Debts & Costs	$11,054.29
Expenses	479,563.41
Net Interest	51,197.83
Reducing book inventory to physical inventory	5,200.24
		547,015.77
		752,626.99
Division to partner's accts		200,000.00
		552,626.99

Balance sheets
ASSETS
	January 1, 1919	June 30, 1919	December 31, 1919
Cash		51,431.32	61,887.46
Mdse	1,051,060.00	966,377.30	1,677,019.00
Accts. Rec		1,122,779.31	1,937,514.90
Notes Rec		9,467.98	80,798.65
Lib. Bonds	262,885.00	193,735.00	246,853.00
W. S. Stamps	836.00	836.00	836.00
Accd. Int. Lib. Bds			2,550.00
Ins. Policy	12,900.00	12,900.00	14,050.00
Profit & Loss	13,244.50
Trav. Exp. Advanced	490.00	690.00	239.14
Suspense Acct		460.17	3,269.25
Total	1,341,415.50	2,358,677.08	4,025,017.40
LIABILITIES
Due Prior Part	194,776.91	170,747.55	191,483.98
Deposit Accts	307,301.54	337,784.82	346,022.46
Accts. Payable		442,378.32	1,221,880.96
Notes Payable		255,000.00	450,000.00
Salesmen's Com		13,754.94	4,880.09
Accrued Expense		7,087.34	60,901.66
J.A.O. Cap. Acct	383,149.68	377,552.22	403,939.44
F.S.B. Cap. Acct	235,200.99	237,254.84	259,082.81
E.J.B. Cap. Acct	215,986.38	210,514.70	253,818.51
C.A.F. Cap. Acct	5,000.00	6,839.83	42,911.65
J.J.B. Cap. Acct		6,250.00	37,468.85
Special Capital		205,800.00	200,000.00
Profit & Loss		87,712.52	552,626.99
Total	1,341,415.50	2,358,677.08	4,025,017.40

The items shown on the merchandise account, in the amounts of $46,835.24 and $133.63, as "Goods returned to old Partnership" represented goods sold by the old partnership and returned by the purchasers to the new partnership.

The amount of $194,776.91 set up as an indebtedness to the old partnership and shown on the balance sheet of the new for January 1, 1919, was computed by deducting from the total cost to the new partnership of the assets acquired and amounting to $1,341,415.50, and in which total the merchandise is included at a cost of $1,051.060, the capital accounts of $839,337.05 allowed in the new partnership to the partners who had been members of the old and representing their distributive shares of the proceeds of the sale of these assets of the old partnership which proceeds were by them agreed to be contributed to the new, and the sum of $307,301.54 representing the indebtedness of the old partnership to certain individuals for loans, the payment of which was assumed by the new partnership, and designated in the original capital entries as "Deposits Accounts."

John A. Ordway was the senior managing general partner of the old and new partnerships. As such he had charge of all matters of general policy and was in supervision of the books and accounts, and the income-tax returns of each were made up under his supervision and executed for them by him. Under date of June 16, 1919, Ordway for the old partnership executed and duly filed a return of net income for the calendar year 1918. In this return the net income of the old partnership for that year was computed upon the basis of a closing merchandise inventory in the sum of $901,045 and the following certificate was attached to the return;

BASIS OF VALUING INVENTORIES

The inventory taken by this partnership on December 31, 1917, was on the basis of "cost."

On December 31, 1918, this partnership took an inventory at cost in conformity with the law as then expressed, namely, that the inventory of December 31, 1918, must conform in method to that of December 31, 1917, but now avails itself of the relief offered by Congress and regulations, and figures the inventory at market value, which inventory totals $901,045.00.

This partnership respectfully claims that this inventory, - towit: $901,045.00, - is the proper inventory which they should use in determining their cost of goods sold rather than the inventory which totalled $1,051,060.00, taken at cost basis; and the return to which this memorandum is attached is based on the smaller inventory.

JOHN A. ORDWAY.

On March 15, 1920, Ordway, for the new partnership, executed and duly filed a return of income for the calendar year 1919. In this return the profits for the calendar year 1919 of the new partnership were computed by the use of an opening merchandise inventory of $901,045, the schedule attached to the return and showing the cost of goods sold for that year being as follows:

Inventory December 31, 1918	$901,045.00
Mdse. bought for sale	8,086,407.98
Total	$8,987,452.98
Less Inventory Dec. 31, 1919	1,677,019.00
Cost of goods sold	$7,310,433.98

Note

This partnership took inventory on December 31, 1918, "at cost," which inventory totaled $1,051,060 and closed its books on that basis. It later availed itself of the relief offered by Congress and regulations and refigured this inventory at "cost or market whichever is lower," which inventory totaled $901,045 and was the one used in determining the cost of goods sold in making returns for the year 1918. This necessitates the using of the smaller inventory in the return now rendered while the larger inventory upon which the books were actually closed on December 31, 1918, appears in Schedule "E".

Petitioner's duties in respect to the partnership business was the supervision and direction of the activities of the firm through its traveling salesmen. He had no duties in connection with the accounts and was not advised of the fact that the income of the new partnership for the calendar year 1919, had been computed upon the basis of an adjusted merchandise inventory. His information as to the net profits of the new partnership for that calendar year was merely as to the final figure determined by the accounting force, this being furnished him, and he reporting in his personal income-tax return for that year his distributive share of the total so computed. Subsequently, upon audit the Commissioner redetermined the net income of the new partnership for the calendar year 1919 by use of the opening merchandise inventory as shown by the books, in the sum of $1,051,060, and accordingly determined an overassessment of tax for that year in respect to petitioner. Later the Commissioner reconsidered the matter and made another determination in respect to the new partnership income, in which he held that the adjustment of the closing merchandise inventory of the old firm in the sum of $901,045 necessitated the adjustment of the opening merchandise inventory of the new partnership upon the same basis, and determined a deficiency on the part of petitioner in the amount formerly determined as having been overassessed.

When the new partnership acquired the merchandise assets of its predecessor it purchased such assets for the amount of $1,051,060 less a credit allowance of $75,000, and paid therefor the resulting amount of $976,060, the payment being in cash, the assumption of outstanding obligations, and credited allowances for capital contributions to said new partnership.

OPINION.

TRUSSELL: The record in this proceeding shows that the old partnership of Blodgett, Ordway & Webber was in existence during the calendar years 1916, 1917, and 1918, and that it was dissolved by limitation on December 31, 1918, on which date it transferred its merchandise on hand at cost less an allowance for depreciation and shortage to a new partnership organized to take it over and begin business on January 1, 1919. Respondent has allowed the old partnership in making its return of net income for the calendar year 1918 to adjust its closing inventory of merchandise on the basis of "cost or market whichever is lower" and has carried such adjustment into the books of the new partnership and determined the net profits of that partnership for the calendar year 1919 upon this adjusted basis. The theory upon which this action has been taken is not entirely clear, as no argument was made upon the hearing of this proceeding and respondent did not file a brief, but from the statements in the notice of deficiency it may be gathered that respondent has assumed that there was no sale by the old partnership of its assets but a distribution in kind and a contribution by the old partners of its distributed assets to the new partnership, and that the latter took such assets at their inventory value to the old partnership, which at that time was "cost," but the subsequent reduction of that inventory adjustment to "cost or market whichever is lower" now calls for a corresponding adjustment in the asset accounts of the new.

Petitioner insists that the new partnership was wholly distinct from the old and that it purchased from the latter its merchandise at cost, which was its then book value according to the closing inventory, less a fixed allowance of $75,000 to cover depreciation and shortage, and opened and maintained its books upon such a cost basis and consequently should have its profits computed on that cost, irrespective of any later adjustment of inventory values secured by the old partnership, as an incident to the determination of its income-tax liability for a prior year.

The record shows that the new partnership of Blodgett, Ordway & Webber, created on December 30, 1918, was not merely a continuation of the former partnership under that name, but a new partnership with distinctly different interests. Its contract of partnership evidences the fact that the purpose of its organization was to acquire certain assets and assume certain of the liabilities of the old partnership. Its opening entries on January 1, 1919, evidence the fact that the merchandise was taken at cost less an allowance of $75,000 made by the old firm. Its indebtedness to the old firm is set up and paid on this basis and the capital accounts of its general partners, who were general partners of the old firm, and the amount of whose distributive capital interests in that firm as of December 31, 1918, was contributed by them to the new firm, were computed and entered on its books on that basis, and by its contract of partnership it obligated itself to pay the large capital accounts of the retiring general partners of the old firm, who acquired comparatively small interests as special partners in the new. The separation of the interests of the old and the new partnerships appear to have been definitely recorded and maintained upon the books of the new.

The record shows the circumstances attending the taking over of the merchandise of the old firm. Petitioner testifies that at the time of organization of the new partnership a conference was held by representatives of the old and new partnership to determine the basis upon which the merchandise would be taken. At this conference Ordway and Webber, general partners in the old concern and having an interest in its profits and in the assets in question, represented the partners with such interest and petitioner represented the new general partners, who had no interest in the property of the old firm but were concerned wholly with the interests of the new. At this conference it was agreed that the price to be allowed by the new firm for the merchandise was $1,051,060, or cost, less $75,000, to cover depreciation and shortage.

Following this it is shown that this merchandise was entered on the books of the new partnership at $1,051,060, and a credit of $75,000 taken against the account of the old partnership and this sum credited by the new firm to its profit and loss account. The books of the new partnership show that this cost was maintained without adjustment and its profits computed and entered upon this basis throughout the year 1919. No question was raised in respect to the 1918 closing inventory of the old partnership until June, 1919, when that partnership made its return of income for the year 1918 to show the distributive shares of its general partners. In making this return that partnership adjusted the inventory from cost to "cost or market whichever is lower," thus reducing it to the sum of $901,045. This adjustment reduced, by the difference between the two inventory figures, the net profit returned by that partnership for that year, and the individual distributive portions of its general partners. In the making of this return the new partnership was not concerned, and as to the adjustment in question, petitioner testifies that he was wholly ignorant of same and this we may well believe, considering the fact that he was not affected by any action increasing or decreasing the distributive shares of the general partners of the old firm. The question before us for decision is whether or not the adjustment made and permitted in the closing inventory of the old partnership must be carried into effect to reduce the opening inventory of the new.

The new partnership, and incidentally this petitioner, as a general partner therein, assumed a definite indebtedness to the old firm for the merchandise in question of $1,051,060 less a credit of $75,000 The question of the correctness of the inventory made some months after the negotiated sale at $1,051,060 less $75,000, by which the property in question was ascribed a market value at the time of sale of only $901,045, is not before us, nor need we consider the correctness of respondent's action in allowing any inventory value in respect to merchandise already disposed of. If the later inventory was correct it merely means that petitioner and his new associates made an unwise purchase, but having made it and being obligated to pay that price, the true profit of the new partnership must be determined by use of that figure. If error was made in the allowance of a reduction in the inventory figure to the old partnership as of December 31, 1918, it can not be corrected by carrying into the accounts of the new partnership the amount by which the closing inventory of the old partnership was adjusted.

The new partnership of Blodgett, Ordway & Webber having acquired the merchandise of the old firm at $1,051,060 less an allowance of $75,000, its profit for the calendar year 1919 should be computed upon the basis of such cost.

The deficiency should be redetermined in accord with the foregoing findings of fact and opinion.

Reviewed by the Board.

Judgment will be entered pursuant to Rule 50.