Wyandotte County Gas Co. v. State Commission of Revenue & Taxation ( 1942 )

The opinion of the court was delivered by

Allen, J.:

The appellant was the operating gas company of the Cities Service organization in the Kansas City area. Appellant objected to the disallowance of certain expenses listed as deductions from gross income in its state income tax returns for 1937 and 1938. After hearings before the director of revenue and before the commission of revenue and taxation, the gas company appealed to the district court of Wyandotte county. The district court affirmed the orders of the commission and the gas company has brought the case to this court for review.

In the district court the matter was heard largely on a stipulation of facts. In the taxpayer’s 1937 income tax statement a deduction of $30,120.20 from gross income was claimed for a management fee paid by the taxpayer to the Cities Service Company. This claimed deduction was disallowed by the commission and the district court. It appears from the1 record this fee had not been allowed as a deductible expense in prior years and the taxpayer had never before raised the question that it should be considered a proper deduction. The stipulation sets out the further pertinent facts concerning this claimed deduction as follows:

“That in its return for the year 1937, taxpayer deducted from its gross revenue as an operating expense the sum of $30,120.20, which was a management fee paid to Cities Service Company computed on a basis of 1% percent of its gross revenue, the same being a charge which had' been paid by the taxpayer either to Henry L. Doherty & Company or Cities Service Company since May, 1929.

“The commission disallowed this deduction for the following reasons, as stated in its order:

“ ‘The facts disclose and the commission finds that the taxpayer pays a management fee of one and three-fourths percent of its gross revenues to the Cities Service Company under a contract dated September 1, 1929.’

“The commission further finds that the New York management fees paid to the Cities Service Company were based upon a percentage of gross income and were computed without regard to actual services rendered. Such fees, therefore, do not constitute an ordinary and necessary business expense within the meaning of section 79-3206 (a), (1) General Statutes of Kansas Supplement, 1939, and are not an allowable deduction.”

The part of the statute involved, now appearing in G. S. 1941 Supp. 79-3206, reads:

“(a) In computing net income, there shall be allowed as deductions: (1) All the ordinary and necessary expenses paid during the taxable year in carrying on any trade or business. . ”

The regulation of the commission adopted under authority of statute reads:

“Art. 39. Compensation Paid for Personal Services. A reasonable allowance for salaries or other compensation paid for personal services actually rendered is deductible. The test of deductibility of such payments is whether they are reasonable consideration for the services rendered and whether they are in fact payments purely for service. If an ostensible salary paid by a corporation is in excess of those ordinarily paid for similar services and the excessive payments correspond 'or bear a close relationship to the stock holdings of the recipients, the excess deduction will be disallowed to the corporation .and taxed as a dividend to the recipient. ...”

The position of the gas company before the director of revenue and before the commission seems to have been that the commission had no authority to question either the reasonableness of this management fee or the good faith of the officers of the utility company in entering into the contract. No attempt was made before the commission or in the district court to show the value of any services rendered the taxpayer by the Cities Service Company or in fact that any services had been rendered.

In the district court attention of the court was directed to the cases of Wichita Gas Co. v. Public Service Comm., 126 Kan. 220, 268 Pac. 111; Wichita Gas Co. v. Public Service Commission, 3 F. Supp. 722; Wichita Gas Co. v. Public Service Commission, 2 F. Supp. 792. In these cases the above contract for management fees, as it pertained to other subsidiaries of the Cities Service organization was mentioned in connection with the fixing of gas rates. In some of these cases the fees- provided for by the contract had been considered in finding a proper base for the calculation of gas rates. Appellant’s contention seems to be that because the fees were taken into account in those cases in fixing gas rates, the commission cannot now disallow them in assessing appellant’s income tax. The appellant does not go so far as to contend that the question is res judicata, as of course it is not. The parties and issues in the former cases were different from those in this case. The court is of the opinion that nothing said in the above-mentioned cases has any real bearing upon the issues now before the court.

In Nutrena Mills, Inc., v. State Tax Comm., 150 Kan. 68, 91 P. 2d 15, a taxpayer claimed a deduction from its gross income for a management fee paid to a parent corporation. The fee in the Nutrena case had great similarity to the fee paid and set out in the case now under consideration. In the Nutrena case the taxpayer offered proof of the reasonableness of the fee. The commission allowed a deduction based upon only a part of the fee which had been paid. The same statutes and regulation of the commission were involved in the Nutrena case that are now under consideration in this case. On appeal this court affirmed the reasonableness of the commission’s order. As to the authority of the tax commission (now the commission of revenue and- taxation) to inquire into the propriety of expenses claimed as deductions from gross income, we said in.the Nutrena case:

“It is well settled that the tax found by the tax commission to be due is presumed to be valid; the taxpayer has the burden of showing its invalidity. (United States v. Reitmeyer, 11 F. 2d 648.) Deductions from gross income are allowed as a matter of legislative grace. A taxpayer seeking a deduction in computing taxable income must be able to point to an applicable statute and show that he comes within its terms. (White v. United States, 59 S. Ct. 179.) The fact the taxpayer has entered into a contract with stockholders, officers, or others to pay a fixed portion of its income for salary or other services does not, standing alone, make the amount paid under such a contract ‘ordinary and necessary expenses’ of conducting the trade or business. (Samuel Heath Co. v. United States, 2 F. Supp. 637; Hecht v. United States, 54 F. 2d 968; Traylor Engineering & Mfg. Co. v. Lederer, 271 Fed. 399; Moxa Building Co. v. Commissioner of Internal Revenue, 31 B. T. A. 457; affirmed, 79 F. 2d 1004.)

“Whether such payments are ordinary and necessary expenses of the business, and the reasonableness of the sums paid, are always open to inquiry. A variety of circumstances have been considered by the courts in the cases collected in American Digest System, Internal Revenue, Key No. 7 (17) (18). In some instances the deduction claimed was allowed, in others it was denied, depending on the facts shown. It would serve no useful purpose to cite and analyze these cases. We have examined all of them cited by counsel and many more. We find nothing in them which would require or justify the reversal of the judgment of the trial court in this case, and it is therefore affirmed.” (p. 75.)

The ruling in the Nutrena case is controlling as to the taxpayer’s contention concerning the management fee.

The remaining complaint of the taxpayer concerns the refusal of the commission to allow as a deduction from gross income the sum of $92,880 paid out by the taxpayer as interest on its bonds. This amount was claimed in both the income tax return filed by the gas company for 1937 and 1938. In denying the claimed deductions the commission made the following findings:

“The facts further disclose and the commission finds that the entire issue of 81,548,000 of 6 percent bonds upon which the interest in question was paid were owned in their entirety by the Cities Service Company, which company also owns the entire common stock of the taxpayer.

“The commission further finds that the interest paid to the parent company (Cities Service Company) was interest paid to the corporation stockholders, and was for money borrowed for the purpose of making expenditures of a capital nature, and such deduction is not allowable under section 79-3206 (a) (2), General Statutes of Kansas Supplement 1937, and article 42 of the regulations promulgated thereunder.”

The real question as to this phase of the case was before us in our recent decision in Natural Gas Pipe Line Co. v. Commission of Revenue and Taxation, ante, p. 416, 125 P. 2d 397. The opinion in that case had not been filed at the time appellant prepared its brief in this case. We are convinced there is no appreciable difference in the application of the provisions of the statute (G. S. 1941 Supp. 79-3206) to the two cases. The only real difference in the facts in the two cases is that in the Natural Gas Pipe Line case the bonds were issued directly to the stockholders and in this case it appears that the bonds in question were issued to the public but later the entire bond issue was acquired by the Cities Service Company which had also acquired the entire capital stock of the Wyandotte County Gas Company.

It is argued that if the interest on these bonds is held not to constitute a valid deduction then every corporation must change its accounting for income tax purposes each time a stockholder purchases some of the company’s bonds in the open market. It will not be necessary to decide the hypothetical case at this time. That is not this case. Here all the bonds and all the stock are in the hands of the same holder.

Appellant again objects that the deduction is disallowed purely on the ground of ownership and cites Mount Hope Cemetery Co. v. Pleasant, 139 Kan. 417, 32 P. 2d 500. The Mount Hope Cemetery case is fully discussed in the majority opinion in the Natural Pipe Line Company case (ante, p. 420).

There is no need to prolong this opinion. The judgment of the district court approving the orders of the commission was correct and is hereby affirmed.