Oliver v. Commissioner , 4 T.C. 684 ( 1945 )

Lawrence Oliver, Petitioner, v. Commissioner of Internal Revenue, Respondent

Oliver v. Commissioner

Docket No. 111745

United States Tax Court

4 T.C. 684; 1945 U.S. Tax Ct. LEXIS 243;

January 31, 1945, Promulgated

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Decision will be entered under Rule 50.

Petitioner, married and residing with his wife in California since prior to July 29, 1927, had on that date an established business which he continued to operate thereafter through the taxable years 1938 and 1939. Petitioner had an ascertained separate property capital invested in the business at July 29, 1927. The business was profitable, the earnings and profits thereof being due in part to the capital invested, but mainly due to the activities, management, and skill of petitioner, whose full time was devoted to its operation. Held, that that part of the business income which equals a reasonable return on a long term, well secured investment is the separate property of petitioner and that the remainder of such income is the community property of petitioner and his wife.

Raymond C. Sandler, Esq., and Nathan Schwartz, Esq., for the petitioner.

Byron M. Coon, Esq., for the respondent.

Hill, Judge.

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HILL

This proceeding involves income taxes for 1938 and 1939 in the respective amounts of $ 416.12 and $ 4,033.61. Petitioner claims an overpayment in tax for each of the years involved.

FINDINGS OF FACT.

Petitioner is and has been since 1915 a married individual residing with his wife in San Diego, California. During the years 1938 and 1939, involved herein, the petitioner and his wife filed separate income tax returns for each year. In his returns for the years 1938 and 1939 petitioner reported net income in the amounts of $ 29,508.41 and $ 48,972.55, after excluding $ 13,558.85 and $ 25,366.32, respectively, as his wife's share of the community net income taxable to her, and he paid the tax shown thereon to be due in the amount of $ 3,298.25 for 1938 and $ 8,315.73 for 1939. The respondent determined that the correct share of petitioner's wife was $ 11,748.70 for 1938 and $ 13,561.47 for 1939, instead of the amounts above stated. He increased petitioner's taxable income accordingly and determined the deficiencies herein involved. This proceeding was commenced within three years of the date of the payment of the 1939 tax.

Petitioner's present business was begun in 1922 with the purchase of a plant from a local bank in San Diego, California, at a total cost of $ 20,000, on which he paid down $ 1,000 with borrowed money.

This business was chiefly the business of fish rendering. Petitioner purchased spoiled fish and the scraps and unused portions of fish from canneries and manufactured from this raw material products used as poultry feed and fertilizer. In addition, this business included the furnishing of ice to fishing boats. Petitioner had facilities for preparing and loading ice, which he purchased in block form for fishing vessels.

In 1931 petitioner entered upon the additional business of processing offal from slaughterhouses and butchering establishments. This addition to his business was financed from the accumulations of his business prior thereto. He had trucks and drivers go from butcher to butcher to pick up the material. At the fish rendering plant it was ground, cooked, and dried. The tallow was extracted to a minimum and the remaining substance was ground into meal and poultry feed. He had a monopoly on that business in San Diego, except that the Cudahy Packing Co. had its own rendering plant, using only its own waste products.

Petitioner is an American citizen of Portuguese extraction. A large proportion of the fishermen to whom petitioner sold ice and who operated fishing boats in that locality were likewise of Portuguese extraction. Petitioner's ability to obtain favorable arrangements with the canneries for securing his raw materials depended largely upon his maintaining a personal relationship with all of these fishermen, as he was able thereby to influence the places where they sold their respective catches. This personal relationship and contact likewise contributed to the success of the ice-selling phase of the petitioner's business. Within the past fifteen years there has been a substantial increase in the fishing business operating from San Diego and extending as far south as the Central American waters. The increase in fishing business aided the increase in both petitioner's fish rendering and his icing business. Also the San Diego area has shown a constant and steady growth in population in recent years and consequently not only were there increasing local demands for petitioner's feed and fertilizer products, but markets therefor were established in various places outside the local area and as far away as the State of New York.

From the time of the commencement of business, petitioner withdrew from the business such amounts as he needed for all personal living expenses for himself, his wife, and his family. These amounts varied in accordance with petitioner's needs. He likewise withdrew sums from the business to make outside investments. These investments were comparatively numerous and included, among other things, the purchase of interests in fishing boats, stocks and bonds, real property, a barber shop, a cafe, etc. Petitioner expended no time and effort with respect to these outside investments. The balance of the income from the business remained in the business and was used by the petitioner for expansion purposes. Petitioner borrowed money from time to time for use in his business and repaid it therefrom. Otherwise, he employed no outside capital therein.

Petitioner conducted his entire business personally. He had no other executive help or assistance. His highest paid employee was a foreman at the plant, who received a salary of $ 250 per month. Petitioner hired and fired all employees. He personally made all contacts and arrangements for the purchase of all raw material and personally arranged for its sale and distribution through brokers. Practically all of such arrangements were in the form of oral agreements. He spent his entire time and effort in the conduct of the business. In each line of his business he succeeded where others, some of whom were competitors, failed.

On July 29, 1927, the effective date of section 161 (a) of the Civil Code of the State of California, petitioner had a capital of $ 60,583.82, of which $ 51,053.51 was income producing and $ 9,530.31 was not income producing. Of the $ 51,053.51 income producing capital, $ 36,320.14 was invested in petitioner's business, whereas $ 14,733.37 was invested in outside investments.

Since July 1927 petitioner has commingled his income and has not segregated his separate property from the community. Petitioner's chief business success has come since 1927. Since that time to the present he has made annual withdrawals for living expenses, but has made no attempt to take out all the earnings from the business. Earnings over and above living expenses were put back into the business or placed in other investments. Petitioner's income for 1938 from his business amounted to $ 49,647.84. His investments showed a loss for that year of $ 1,312.51. For 1939 petitioner's business showed earnings of $ 51,941.66 and income from investments amounted to $ 24,113.74.

The two tables next below show for the years therein indicated (1) the segregated income from business and investments, the total income, and the drawings of petitioner and (2) the segregated business and other income-producing capital, the nonincome-producing capital, and the total capital:

	Income from	Income from
Period	business	investments	Total income	Drawings
July 29 to Dec. 31, 1927	$ 6,506.54	$ 1,580.80	$ 8,087.34	$ 2,213.45
1928	32,542.99	940.93	33,483.92	3,991.18
1929	47,813.38	1,726.12	49,539.50	7,095.28
1930	48,985.88	12.20	48,998.08	9,349.78
1931	13,083.93	(1,967.14)	11,116.79	10,543.06
1932	(2,402.89)	(2,303.43)	(4,706.32)	6,219.14
1933	29,280.40	(4,521.81)	24,758.59	8,398.37
1934	54,052.57	699.67	54,752.24	12,088.87
1935	78,687.33	(546.99)	78,140.34	16,441.90
1936	80,691.38	(8,059.30)	72,632.08	23,530.70
1937	57,246.40	17,827.10	75,073.50	15,398.60
1938	49,647.84	(1,312.51)	48,335.33	30,692.42
1939	51,941.66	24,113.74	76,055.40	18,941.74

		Income-	Nonincome-
	Business	producing	producing	Total capital
	capital	nonbusiness	capital
		capital
7/29/27	$ 36,320.14	$ 14,733.37	$ 9,530.31	$ 60,583.82
12/31/27	36,599.15	19,983.38	9,875.29	66,457.82
12/31/28	58,694.19	27,381.07	9,875.29	95,950.55
12/31/29	79,981.19	49,577.59	8,835.39	138,394.17
12/31/30	101,436.04	69,921.29	6,685.74	178,043.07
12/31/31	94,514.44	77,416.62	6,685.74	178,616.80
12/31/32	91,492.00	69,513.60	6,685.74	167,691.34
12/31/33	108,416.89	68,948.93	6,685.74	184,051.56
12/31/34	141,725.18	82,082.01	6,685.74	230,492.93
12/31/35	148,382.59	83,285.76	62,579.55	294,247.90
12/31/36	153,251.51	115,458.36	63,611.69	332,321.56
12/31/37	91,051.24	222,702.18	63,611.69	377,365.11
12/31/38	121,316.38	210,080.05	63,611.69	395,008.12
12/31/39	145,338.51	243,171.48	63,611.69	452,121.68

The following table shows the income from petitioner's business during the years from July 29, 1927, to 1939, inclusive, and the allocation made by the respondent as to services and return on capital, in determining the deficiencies:

		Personal	Return on
Year	Income	services	capital
1927	$ 6,506.54	$ 3,000.00	$ 3,506.54
1928	32,542.99	12,000.00	20,542.99
1929	47,813.38	15,000.00	32,813.38
1930	48,985.88	15,000.00	33,985.88
1931	13,083.93	10,543.06	2,540.87
1932	(2,402.89)		(2,402.89)
1933	29,280.40	12,000.00	17,280.40
1934	54,052.47	18,000.00	36,052.47
1935	78,687.33	18,000.00	60,687.33
1936	80,691.38	18,000.00	62,691.38
1937	57,246.40	18,000.00	39,246.40
1938	49,647.84	18,000.00	31,647.84
1939	51,941.66	18,000.00	33,941.66

At July 29, 1927, petitioner had a successful business on a stable basis. From that time forward the business expanded and on the whole the profits progressively increased. The capital invested in the business was secure. Petitioner's credit with the banks was such that he could and did borrow large sums of money at from 5 to 7 percent interest on his unsecured note. The earnings from petitioner's business were primarily due to his activities, skill, ability, and business acumen. The success of the business was due primarily to petitioner's efforts and not to the capital invested therein.

In California if no rate of interest is specified by contract the rate is fixed by statute at 7 percent per annum. The going rate of interest in San Diego from 1934 to 1939, inclusive, was 6 to 7 percent on other than a long term, well secured investment, and 5 percent on the latter type of investment. The net income of petitioner's business in each year from and after July 29, 1927, through 1939, not in excess of 7 percent of the capital employed therein, is a reasonable amount to be allocated to a return on capital. The remainder of such income is attributable to the services of petitioner.

OPINION.

This proceeding involves income taxes for 1938 and 1939. The respondent determined deficiencies in petitioner's income tax as a result of reducing the amount of the community income of petitioner and wife as claimed by him in his income tax returns and correspondingly increasing his separate income. The petitioner now claims an overpayment in tax for each of the years for failure to allocate a sufficient portion of the income of the business to services rendered by him therein and consequently community income, only one-half of which was taxable to him.

At July 29, 1927, all of the capital employed in petitioner's business and represented in his investments was, for the purposes of Federal income tax, his separate property. ; . From that date forward the management, activities, and skill of petitioner constituted the principal contribution to the earnings of the business. It is clear, therefore, that the income from the business from the above date through the years 1938 and 1939 embraced both separate and community income. To a large extent such income was either retained for use as capital in the business or was withdrawn for outside investments, part of the latter being income producing and part nonincome producing.

Petitioner contends that 6 percent of the business capital represents the amount of the business income properly attributable to capital and that the income so attributable is separate and community income in the proportions of the separate and community character of such capital. The remainder of such business income, as petitioner contends, is properly attributable to petitioner's services in the management and operation of the business and hence is community income. Respondent's contention is that only the fair and reasonable compensation for petitioner's services in the conduct of the business is the proper measure of the community portion of the business income and that the remainder of such income is attributable to capital. Respondent claims that in determining the deficiencies in conformity with his stated contention he determined a fair and reasonable compensation for such services of petitioner and consequently properly determined the amounts of the community and separate income.

It will be observed that the parties agree that the business income is attributable in part to capital and in part to petitioner's services. They disagree as to the proportions of such attributions. In order to determine what proportion of the income involved for each of the years 1938 and 1939 was the separate income of petitioner and what proportion was community income it is necessary to determine a proper basis of allocation between separate and community income throughout the period from July 29, 1927, through 1939, and also to compute the addition of community income to the capital of the business yearly for such period as well as the relative amounts of separate and community income from the investments outside of the business. ; ; ; ; ; ; ; . In such allocation the portion to be attributed to capital should amount at least to the usual interest on a long term, well secured investment and the remainder should be attributed to services. ;; .Cf. , and (p. 658).

The facts in the instant proceeding are sufficiently analogous to those in the Pereira, Gold, and Caswell cases above cited to warrant us in adopting in this case the principal of the formula of the allocation therein applied. The Supreme Court of California in the Pereira case said:

* * * the decision of the court was made upon the theory that all of his gains received after marriage, from whatever sources, were to be classed as community property, and that no allowance was made in favor of his separate estate on account of interest or profit on the $ 15,500 invested in the business at the time of the marriage. This capital was undoubtedly his separate estate. The fund remained in the business after marriage and was used by him in carrying it on. The separate property should have been credited with some amount as profit on this capital. It was not a losing business, but a very profitable one. It is true that it is very clearly shown that the principal part of the large income was due to the personal character, energy, ability and capacity of the husband. This share of the earnings was, of course, community property; but without capital he could not have carried on the business. In the absence of circumstances showing a different result it is to be presumed that some of the profits were justly due to the capital invested. There is nothing to show that all of it was due to defendant's [husband's] efforts alone. The probable contribution of the capital to the income should have been determined from all the circumstances of the case and as the business was profitable, it would amount at least to the usual interest on a long investment well secured. [Citing cases.]

The court, on rehearing, approved a 7 percent return on the capital invested in the business as the profit attributable thereto.

In , the court stated the rule as follows:

It is the rule that where at the time of his marriage the husband has a definite amount of his separate property invested as capital in his business which he continues to conduct, the entire profits therefrom are not necessarily his separate property but may be the result of his energy and ability. . In determining what portion of such profits is community property, while it must be presumed in the absence of evidence that some thereof were due to the capital invested and would equal at least the usual interest on a long term investment well secured, yet, if the husband claims that his capital was entitled to a greater return than legal interest, the burden of showing the fact rests upon him. [Citing cases.]

We hold that the income from petitioner's business from and after July 29, 1927, through 1939 should be apportioned between the capital invested and his services; that the apportionment to capital should be an amount equal to 7 percent of such capital, and that the remainder of the business income should be apportioned to petitioner's services in conducting such business. The latter is community income and the former is separate and community income in the proportions that the capital comprises separate and community property.

Investments from withdrawals from the business accumulated prior to July 29, 1927, together with the issues and profits thereof, are the separate property of petitioner. Investments from withdrawals from the business accumulated subsequent to July 29, 1927, together with the issues and profits thereof, are the separate property of the petitioner and the community property of petitioner and wife in the proportions of the separate income from the business to the community income therefrom as hereinabove allocated.

We have found that petitioner drew certain sums of money from the earnings of the business for living expenses and support of himself and family. There is no showing that such withdrawals were from petitioner's separate property. We hold, therefore, that such withdrawals are chargeable to the community earnings. .

Decision will be entered under Rule 50.