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L. E. Shunk Latex Products, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent. The Killian Manufacturing Company, Petitioner, v. Commissioner of Internal Revenue, RespondentL. E. Shunk Latex Products, Inc. v. CommissionerDocket Nos. 27143, 27144
United States Tax Court August 29, 1952, Promulgated *112
Decisions will be entered under Rule 50 .1. Petitioners were two manufacturing corporations which, together with a partnership to which they sold their products, were owned or controlled directly or indirectly by the same interests.
Held , respondent's allocations of part of the income of the partnership to petitioners undersections 22 (a) and45 , disapproved, where petitioners were prohibited by maximum price regulations from receiving the very income sought to be allocated to them.2. Period for the amortization of certain leasehold improvements determined.
Donald Gottwald, Esq., Numa L. Smith, Jr., Esq *113 ., andRobert N. Miller, Esq ., for the petitioners.Clarence E. Price, Esq ., for the respondent.Raum,Judge .RAUM*940 The Commissioner determined the following deficiencies in petitioners' taxes:
L. E. Shunk Latex Products, Inc. -- Docket No. 27143 Declared Excess profits Year Income tax value excess- tax profits tax 1942 $ 4,178.44 $ 35,496.91 $ 224,961.61 1943 40,029.77 383,909.21 1944 6,086.53 1945 416.37 142,206.18 $ 4,178.44 $ 75,943.05 $ 757,163.53 The Killian Manufacturing Company -- Docket No. 27144 Declared Excess profits Year Income tax value excess- tax profits tax 1940 $ 7,773.33 1942 $ 3,210.60 $ 75,771.63 514,596.36 1943 7,919.94 47,044.74 589,018.06 1945 46,611.88 412,032.65 $ 11,130.54 $ 169,428.25 $ 1,523,420.40 The principal question in both proceedings is whether, under
sections 45 or22 of the Internal Revenue Code , respondent erred in *941 allocating to each petitioner income of a partnership, Killashun Sales Division. A minor issue relates to the period over which certain leasehold improvements are to be amortized. Another minor issue *114 relating to a claimed deduction of $ 2,298.54 for personal property taxes paid by L. E. Shunk Latex Products, Inc., during the year 1943 has been conceded by respondent.These proceedings were consolidated for trial.
FINDINGS OF FACT.
The stipulations of fact submitted by the parties and the exhibits annexed thereto are incorporated herein, and the facts therein are adopted as part of these findings.
L. E. Shunk Latex Products, Inc., (hereinafter also referred to as "Shunk") and The Killian Manufacturing Company (hereinafter also referred to as "Killian") are corporations which were organized under the laws of the State of Ohio in 1928 and 1930, respectively. Each had its office and principal place of business in Akron, Ohio. The Federal tax returns of both petitioners were made out on the accrual basis and for calendar year periods, and were filed with the collector of internal revenue for the eighteenth district of Ohio.
Since their organization, both Killian and Shunk were engaged in the manufacture and sale of rubber prophylactics. During the years in issue, and for some years theretofore, they were major manufacturers in the field and each was the other's principal competitor. *115 Competition was severe, each often undercutting the prices of the other.
Prior to June 1937, Killian sold its output to many outlets. Prior to June 1937, Shunk sold its entire output to Akron Drug & Sundries Company (hereinafter referred to as "Akron Drug"), which acted as exclusive distributor for Shunk. This distributorship arrangement existed pursuant to oral understanding between Akron Drug and Shunk. After June 1937, Shunk no longer sold to Akron Drug, but Akron Drug instead bought from Killashun Sales Division, a partnership more fully described hereinafter.
Akron Drug was controlled by Maurice Gusman (hereinafter also referred to as "Gusman") and Charles E. Jenkins (hereinafter also referred to as "Jenkins"), who were officers of Akron Drug and who, with their wives, owned all its stock. Jenkins was a son-in-law of L. E. Shunk, who dominated Shunk's operations. Akron Drug was located in a corner of the building occupied by Shunk.
During the period from 1930 to the middle of 1937, Shunk manufactured its products under the "Gammeter patents," while Killian manufactured its products under the "Killian patents."
The Killian patents pertained to a "continuous machine" and *116 to a "ring-roller" device used in the manufacture of thin rubber articles. *942 The "continuous machine" was a fully automatic machine which converted raw latex into the finished product in a continuous activity. The "ring-roller," physically a part of the "continuous machine" though not covered by the patent for that machine, formed a bead or ring on the open end of the product. For its license to use these patents, Killian paid its licensor, for each gross produced on these patented devices, $ 0.04 per gross on the "ring-roller" and $ 0.06 per gross on the "continuous machine."
Fred L. Killian was the inventor under the Killian patents. Prior to 1932, the Killian patents were held by a corporation, in which Fred L. Killian had a 75 per cent interest and Perry H. Stevens (hereinafter also referred to as "Stevens") had a 25 per cent interest. Fred L. Killian died in 1932, and his 75 per cent interest was divided between his wife, Elizabeth Killian, and his son, Frank B. Killian, each of whom then owned a 37 1/2 per cent interest in the corporation. In or about 1935, the corporation was dissolved, and the patents were then held by Frank B. Killian as trustee (hereinafter *117 also referred to as the "Killian Trustee") under an indenture of trust, in which Stevens held a 25 per cent beneficial interest and Frank B. and Elizabeth Killian each held a 37 1/2 per cent beneficial interest.
At some time prior to 1940, Elizabeth Killian died, leaving an estate which contained two main assets: (1) 1,249 shares of common stock in Killian; and (2) the 37 1/2 per cent beneficial interest in the Killian patents. Elizabeth Killian left a will, in which these two assets were placed in trust for 20 years. One of the beneficiaries, a nephew of Elizabeth Killian, was James L. Tyrrell, Jr. (hereinafter also referred to as "Tyrrell"), who received a 5 per cent interest in the trust; the other beneficiaries likewise were related rather closely to Elizabeth Killian. Tyrrell was also named trustee and was given the following powers with respect to this trust:
During said twenty (20) years period, said James Tyrrell as Trustee shall hold and manage the said rest and residue of my estate and pay the income therefrom to said beneficiaries equally and ratably as they are entitled thereto respectively, he to serve without compensation and without bond, and to have full power and*118 authority to do and perform everything in connection therewith as I personally could do if alive.
Thereafter the beneficial interests in the Killian patents were held as follows: Tyrrell (as trustee under the will of Elizabeth Killian) -- 37 1/2 per cent; Frank B. Killian -- 37 1/2 per cent; Stevens -- 25 per cent. In 1938 and 1939, two beneficiaries, together holding a one-half interest in Elizabeth Killian's trust, died and their one-half interest was bought by Gusman, acting in behalf of himself, Jenkins, and Tyrrell (as an individual and not as trustee). The patents continued to be held by Frank B. Killian as trustee until 1941 or 1942, after which they were held by Frank B. Killian & Company, a partnership in *943 which substantial interests were held by Stevens, Tyrrell, Jenkins, and Gusman, or members of their families.
On November 7, 1935, the Killian Trustee started suit in the United States District Court, Northern District of Ohio, against Shunk for infringement of the Killian patents. Legal action usually had been brought with diligence against infringers of the Killian patents. At the time the foregoing suit was brought, Shunk's competition was having a depressing*119 effect on royalties being received under the Killian patents. This suit was settled and terminated by a consent decree filed on June 11, 1937.
In connection with the settlement of this suit, Shunk and the Killian Trustee entered into a written agreement (hereinafter referred to as the "license agreement") dated June 11, 1937. Under this agreement Shunk was given a license under the "ring-roller" patent for 10 years, for which Shunk agreed to pay a royalty of $ 0.04 per gross (less an allowance for scrap) on articles made by it on that device.
The agreement provided:
VI. "Shunk" hereby agrees that, during the existence of this agreement, the "Trustee" may from time to time, as herein provided, establish prices which the "Trustee" shall decide are just, equitable and fair market prices for articles on which royalty is payable hereunder; and "Shunk" hereby agrees not to sell or otherwise dispose of any of such articles at prices lower than the prices so established by the "Trustee" and then in effect. The "Trustee", with the assent of "Shunk", hereby establishes as fair, just and equitable, prices as of the date of this agreement, a price of seventy cents (70 cents) per gross for *120 such articles in bulk, and the prices set out in Exhibit A attached hereto and made a part hereof, for such articles in package form. The "Trustee" agrees not to establish selling prices lower or higher than those established herein without the mutual and unanimous consent of the "Trustee", "Shunk" and the Killian Manufacturing Company.
In the event that "Shunk" sells or otherwise disposes of any of said articles at a price lower than those so established by the "Trustee" and applicable to said articles, "Shunk" shall pay to the "Trustee" an additional royalty on such articles equivalent to three (3) times the amount of the difference between the fixed and applicable price then in effect and the price at which "Shunk" sold or otherwise disposed of such articles, said payment to be made within ten (10) days after the facts of such sale or disposal shall have been admitted by "Shunk", or ascertained by arbitration as hereinafter provided. The "Trustee" agrees to include, in all licenses granted hereafter under the said patent, including the license about to be granted to the Killian Manufacturing Company, substantially the same terms, conditions and obligations as are included herein, *121 including minimum selling prices, regular royalties, additional royalty and payment thereof, installation and use of meters, the basis of calculation of royalties as to waste, and agrees to enforce said obligations strictly and promptly in all cases, which license shall not be modified or altered without the consent of all the parties.
"Shunk" agrees to sell or otherwise dispose of all the articles it makes under this agreement through the Killashun Agency, or a substitute agency, so long as such agency exists. The "Trustee" agrees that if the Killashun Agency or a substitute agency ceases to exist at any time hereafter through no fault of *944 "Shunk", "Shunk" shall be released forthwith from the agreement to sell therethrough, and additionally shall have no obligation to pay the aforesaid royalty of four cents (4 cents) per gross during the last half of the period of the then unexpired term of the patent.
Thereafter, and during the years in issue, Killian proceeded "along the same lines as specified in the Shunk contract [the license agreement]" and observed similar restrictions on the disposition of its products as applied to the disposition of Shunk's products. Killian*122 continued to manufacture under the license it had theretofore obtained relating to the Killian patents.
At about the same time in June 1937, there were executed two written agreements, one between Shunk and an organization called Killashun Agency, and another between Killian and Killashun Agency. Both agreements were signed for Killashun Agency by Adam J. Killian, a brother of the deceased Fred L. Killian, and by Jenkins. Except for the difference in parties, the terms of these agreements were the same, and they provided as follows:
(1) That the said "Manufacturer" [Shunk and Killian, respectively] grants to the said "Sales Agency" [Killashun Agency] the exclusive right to sell its entire output and production of prophylactics in the United States of America and all foreign countries, but as Agent only, which articles shall be sold at a price of not less than seventy cents (70 cents) per gross F. O. B. factory for regular bulk merchandise, and in case of special brand or packaged merchandise, for such additional price over and above seventy cents (70 cents) per gross as fixed in "Schedule A" hereto attached or as revised from time to time in writing by all the supervisors and directors*123 of sales.
(2) That the said "Sales Agency" shall keep and maintain accurate books of account, vouchers and other records which shall show and reflect clearly and in detail at all times the sales made by the "Sales Agency", and the nature and extent of its transactions; and to transmit at the time of making each sale, a duplicate memorandum thereof to the "Manufacturer"; and that all of said books of account, vouchers and other records shall be open to the inspection of the "Manufacturer" at any and all reasonable times.
(3) Said "Sales Agency" agrees to use its best efforts to advertise and promote the trade in and sale of said articles in the United States of America, and in all foreign countries, but in such manner as shall keep the good will of the public, and maintain the reputation of the "Manufacturer".
(6) This agreement shall continue for a period of ten (10) years from the date hereof, and may be renewed by consent of the parties in writing, for an additional period of ten (10) years, or extended for such further period of time as may be mutually agreed*125 upon between the parties hereto, unless sooner terminated by the expiration or termination of the license agreements between the "Manufacturer" and Frank B. Killian, Trustee.
* * *
Although the parties sold their products for a brief period in June 1937 through the Killashun Agency, the latter was abandoned, and they then sold their products to Killashun Sales Division (hereinafter referred to as "Killashun"), which was organized as a partnership under the laws of the State of Ohio in 1937. At the time of its organization, the partners in Killashun were Gusman, Jenkins, Tyrrell (individually), and Adam J. Killian, each of whom owned a one-quarter interest. There was no written partnership agreement between these persons relating to Killashun; the partnership was based on oral agreement. Adam J. Killian died in 1939. The Federal tax returns of Killashun for the subsequent fiscal years listed as partners Gusman, Jenkins, and Tyrrell (individually), and their wives, who were Hannah Gusman, Arline Jenkins, and Julia Tyrrell.
As part of the arrangement put into effect after settlement of the infringement suit against Shunk, it was also agreed that, for each gross resold by Killashun, *126 10 cents would be set aside in a fund which would be divided equally between Shunk and Killian, without regard to whether particular goods originated with Shunk or Killian. The amounts received or accrued by Shunk and Killian in this fund were as follows for the indicated years:
Year To Shunk To Killian 1937 (7 months) $ 46,312.07 $ 31,370.32 1938 40,145.12 40,095.02 1939 50,060.28 57,904.47 1940 47,361.26 50,311.38 1941 78,802.32 79,421.99 1942 78,254.25 71,015.80 1943 117,352.25 103,291.75 1944 149,134.70 155,031.20 1945 199,587.25 213,728.00 Stock in Killian was held as follows: (1) From June 1, 1937, to about July 9, 1938, Killian had authorized common stock of 3,000 shares, of which 2,001 shares were outstanding and owned as follows: *946
Stockholder No. of shares Tyrrell (as trustee under will of Elizabeth Killian) 1,249 Rua Bertsch 750 Adam J. Killian 1 E. S. Killian 1 (2) From about July 9, 1938, to about July 5, 1939, Gusman, Jenkins*127 and Tyrrell (individually) acquired full ownership of 1,751 shares of Killian common stock, 999 shares of which represented theretofore unissued shares, as well as 5,000 shares of Killian 6 per cent cumulative preferred stock; these persons also acquired equitable ownership of 624 1/2 shares of Killian common stock, legal title to which was held by Tyrrell as trustee under the will of Elizabeth Killian. (3) About July 5, 1939, Killian was recapitalized, its 3,000 shares of common stock being split into 300,000 shares. Thereafter, and throughout the years in issue, Killian's capital stock consisted of 5,000 shares of preferred ($ 100 par), owned as aforesaid in equal amounts by Gusman, Jenkins, and Tyrrell (individually), and 300,000 shares of common stock (no par) owned as follows:
Stockholder No. of shares Gusman 100,000 Jenkins 100,000 Tyrrell (individually) 37,750 Tyrrell (as trustee under will of Elizabeth Killian) 62,450 On June 1, 1937, the outstanding capital stock of Shunk consisted of 4,270 shares of common stock. No part of that stock was owned by Adam J. Killian, Gusman, Jenkins, or Tyrrell (individually or as trustee) on that date or thereafter until*128 about February 5, 1939; on or about the latter date, Gusman, Jenkins, and Tyrrell (individually) bought the entire outstanding stock of Shunk. They then transferred that stock to Killian, and received in return the 5,000 shares of preferred stock in Killian referred to above. Thereafter, and throughout the years in issue, Shunk was a wholly owned subsidiary of Killian.
The acquisitions by Gusman, Jenkins, and Tyrrell of stock in Shunk and Killian were motivated by their desire to protect Killashun's source of supply.
On or about March 1, 1939, a written agreement was executed by Gusman, Jenkins, and Tyrrell, in which it was recited that they owned or controlled all the stock in Killian, and in which they appointed Tyrrell as their "Trustee, agent and proxy" for 10 years to vote their Killian common stock "in accordance with their joint and several wishes and instructions which may be mutually and unanimously agreed upon, from time to time, by and between them; provided, however, that said Trustee, agent and proxy shall vote said stock in such manner and for such purposes only when specifically authorized so *947 to do in writing signed by all three parties to this agreement." *129 The agreement also restricted transfer or sale of the Killian common stock, providing for a right of first option in the parties to the agreement.
Starting in 1939, the officers of Killian were Adam J. Killian, Tyrrell, Jenkins, and Gusman; after the death of Adam J. Killian in 1939, the remaining three continued as the sole officers through the years in issue. Each of these persons received a salary, as an officer of Killian, of $ 6,500 in 1940 and $ 15,600 in 1941, 1942, 1943, 1944, and 1945; except that Jenkins, who was then in the Army, received only $ 7,800 for 1943 and 1944 and $ 9,450 for 1945.
Starting in 1939, and through the years in issue, the officers of Shunk were Jenkins, Gusman, and Tyrrell. Each of them received a salary, as an officer of Shunk, of $ 8,333.31 for 1939, $ 9,999.66 for 1940, $ 10,000 for 1941, 1942, 1943, 1944, and 1945; except that for the years 1943, 1944, and 1945 Jenkins received $ 5,000, $ 5,000, and $ 6,250.02, respectively.
Both before and after June 1937, and during the years in issue, Shunk's office and plant were located at 355 Morgan Avenue, Akron, Ohio. During and prior to 1937, Killian's office was located at 1034 South High Street, Akron, *130 Ohio. Killashun commenced operations at 755 South High Street. From about August of 1937 until some time in 1939 Killian's office was at 755 South High Street. Beginning in 1939 and throughout the years in issue Killian's and Killashun's offices were at 355 Morgan Avenue. Killashun paid rent "for a while" for occupying space at the premises at 355 Morgan Avenue; but thereafter it paid no rent for space at those premises.
The premises at 355 Morgan Avenue were leased by Shunk in April 1937 for a term of seven years beginning January 1, 1937, with an option in Shunk to renew the lease for seven more years. The lessor was L. W. Camp Company, of Akron, Ohio. This property was bought in April 1939 by Jenkins personally, who was then president of Shunk. Beginning in 1937, improvements were made on the property by Shunk at a total cost of $ 51,207.29. On its books Shunk amortized this cost over the remaining life of its lease of the premises, including the 7-year renewal period, and on this basis Shunk deducted on its Federal tax returns an amount for each of the years 1942, 1943, 1944, and 1945. Respondent disallowed a portion of this deduction for each of these years on the ground*131 that the amortization taken by Shunk was excessive.
In 1937, Jenkins, acting in behalf of himself, Gusman, Tyrrell, and Adam J. Killian, bought the building at 755 South High Street, Akron, Ohio; they sold it three or four years later. By 1939, Gusman, acting for himself, Tyrrell, Jenkins, and Adam J. Killian, bought the building at 1034 South High Street, Akron, Ohio.
*948 During the years in issue, Shunk and Killian sold their entire production to Killashun. During the years in issue, the products of Shunk and Killian were sold by Killashun on its own account as principal, and not as agent of Shunk and Killian. There was no written agreement between Killashun and either Shunk or Killian; the latter sold their output to Killashun pursuant to oral agreement.
From about the time it was organized and during the years in issue, Killashun had office space for its partners, a reception room, and some shipping space. While Killashun was at 755 South High Street, it owned or rented a truck. Its employees consisted typically of a receptionist; a secretary who also did typing and filing; a part time bookkeeper, who was also employed by Killian; a shipping clerk; and a part time janitress. *132 From 1940 to some time in 1943, however, Killashun had no shipping clerk; that work was done by an employee on Shunk's payroll. In connection with orders from the Federal Government obtained during the war, more fully described hereinafter, additional men were hired to do shipping work during the latter part of 1943 and in 1944 and 1945. Killashun had no salesmen other than its partners, of whom Gusman was the most active in this connection.
Killashun had its own books of account, which were serviced by the same accountant who serviced Killian's books. Killashun's books of account accurately reflected income realized on its sales of products obtained from Shunk and Killian. There was an account for Killashun on the books of Shunk and Killian. Killashun had its own bank accounts; Killashun had lines of credit with some banks, and on some occasions it borrowed money from banks. Killashun had its own invoices, stationery, and telephone listing; and, at least in the early years of its existence, it carried on its own advertising in trade journals.
During the years 1937 through 1945, Killashun kept no inventory. When it had an order to be filled, the merchandise was obtained from*133 Shunk or Killian. Shunk or Killian never invoiced Killashun or made delivery until the latter had already obtained an order for the merchandise. Killashun invoiced the customer, and a copy of the invoice was sent to Shunk or Killian, whereupon Shunk or Killian made out an invoice to Killashun. Killashun sold petitioners' products to purchasers other than retailers or ultimate consumers (except for the sales to the Federal Government described herein); thus it sold to Akron Drug & Sundries Company, referred to above.
The terms on which Killashun acquired merchandise from Shunk and Killian included a 2 per cent discount on cash payment within ten calendar days from the time of sale. Killashun usually paid within the required time and received the discount. The terms on which Killashun sold the merchandise included a similar 2 per cent *949 discount on cash payment within 10 days. However, even where these terms as to payment were not satisfied, Killashun usually granted the discount in any event. In some cases Killashun also gave discounts based on the quantity purchased.
Killashun extended more than the usual credit to some customers, and from some customers it received*134 payment in merchandise rather than cash. Such transactions, and extension of unusual credit, happened only prior to the war years, and not during the years here in issue.
The deduction for bad debts taken by Killashun on its Federal tax returns was as follows:
Fiscal year ending May 31 Amount 1938 None 1939 $ 1,561.09 1940 904.15 1941 3,628.98 1942 1,400.00 1943 8,178.38 1944 3,850.00 1945 None 1946 2,000.65 In order to promote sales and to meet competition from certain manufacturers who became active prior to 1942, Killashun gave its customers a quantity of "free goods" with each quantity of goods they bought. Shunk and Killian made Killashun whole and gave it the same quantity of "free goods." The effect of the "free goods" was to reduce the real price of the goods bought. In addition, the holder of the Killian patents gave up any royalty respecting the "free goods." Shunk and Killian gave "free goods" as follows: