DocketNumber： Docket No. 38408.
Judges： Marquette
Filed Date： 11/4/1931
Status： Precedential
Modified Date： 11/2/2024
*1620 1. Payments made by the petitioner, under the guise of commissions, to a partnership composed of all of petitioner's common stock holders, the interest of each member of the partnership being fixed in direct proportion to his holdings of petitioner's common stock,
2. Amounts accrued on petitioner's books as commissions due to a foreign corporation for services actually rendered are ordinary and necessary expenses of carrying on the petitioner's business and constitute proper deductions in computing net income.
3. Upon the evidence,
4. A contribution made by the petitioner to a fund raised by various cotton exchanges, to be used in the control and eradication of the boll weevil in the cotton-producing States, and certain expenditures for advertising in manazines published or sponsored by the American Legion and various labor*1621 and trade organizations, were ordinary and necessary in the conduct of petitioner's business and constitute proper deductions in computing net income.
5. Respondent's adjustment of the inventory of the Charlotte branch office sustained for lack of evidence to show error in such adjustment.
6. During the taxable year, the petitioner paid a fee to a firm of attorneys for prosecution of a claim for refund of war risk insurance premiums paid by itself and its predecessor in business, a partnership.
7. Certain expenditures made during the year by the petitioner, *1622 and claimed by it in the return as deductions for repairs,
8. Respondent's adjustment of the inventory of the Wilmington office sustained for lack of evidence to show error in such adjustment.
9.
10. The expense incurred by the petitioner in moving a cotton compress from one branch to another
11. Payments made by the petitioner during, the taxable year, *1623 totaling $350,000, to holders of petitioner's certificates of paid-in surplus were dividend distributions and not interest payments, and the amounts so distributed may not be deducted in computing net income.
12. The petitioner and the partnership of Alexander Sprunt & Son, Bremen, are separate and distinct taxable entities; and there is no provision of law under which the net loss of the Bremen firm for 1923 may be deducted in computing the petitioner's net income for that year.
*600 This proceeding is for the redetermination of a deficiency asserted by the respondent for 1923, in the amount of $71,729.51. Of the fourteen assignments of error in the amended petition, two have been waived, leaving twelve for our consideration, which are as follows:
1. The Commissioner has erred in failing to allow as a deduction from gross income commissions of $286,071.30 paid to the partnership of Alexander Sprunt & Son, Bremen, Germany.
2. The Commissioner has erred in failing to allow as a deduction*1624 from gross income commissions of $33,736.28 paid to a French corporation by the name of Societe Cotonniere Franco-Americaine.
3. The Commissioner has erroneously increased the income from the Houston branch in the amount of $601.05.
4. The Commissioner has erred in failing to allow as a deduction from gross income certain alleged donations in the amount of $19,120.32.
5. The Commissioner has erred by increasing the closing inventory for the Charlotte office in the amount of $11,185.96.
6. The Commissioner has erred in failing to allow as a deduction from gross income legal expenses in the amount of $7,500.
7. The Commissioner has erred in failing to allow as a deduction from gross income certain warehouse expenses in the amount of $7,315.07.
8. The Commissioner has erred in failing to decrease the closing inventory for the Wilmington office by $33,412.60.
9. The Commissioner has erred in failing to reduce taxable income by the amount of $15,622.53 which represents a write-up of certain assets.
*601 10. The Commissioner has erred in failing to allow as a deduction from gross income the amount of $8,335.19 cost of removing a press from Wilmington, *1625 North Carolina, to Houston, Texas.
11. The Commissioner has erred in failing to allow as a deduction from gross income, interest paid in the amount of $350,000.
12. In the alternative, if the United States Board of Tax Appeals sustains the Commissioner's position with respect to the commissions paid to the foreign partnership (Alexander Sprunt & Son, Bremen), then the Commissioner has erred in failing to use the losses of the foreign partnership in the amount of more than $100,000 to reduce the gross income of the petitioner.
FINDINGS OF FACT.
The petitioner, a North Carolina corporation with its principal office at Wilmington, was organized on June 9, 1919, as successor to the business theretofore carried on by the partnership of Alexander Sprunt & Son (hereinafter referred to as the Wilmington firm), and throughout 1923 was engaged in buying raw cotton in the United States and reselling that commodity, principally in Central European markets.
1. The Wilmington firm was organized in 1868 and, until succeeded by the petitioner, had been engaged continuously in buying and exporting raw cotton. In June, 1913, the partnership was composed of James, William H., Walter*1626 P., J. Lawrence, and T. E. Sprunt. On or about July 1, 1913, a new partnership known as Alexander Sprunt & Son, Bremen (hereinafter referred to as the Bremen firm), was formed by the above named five persons with Devereaux H. Lippitt and William L. Walker. Lippitt and Walker did not have any interest in any other firm organized, owned or controlled by the five Sprunts.
The Bremen partnership agreement, after fixing the working capital at 2,000,000 marks, sets forth the following provisions:
2nd. As the Bremen firm was established primarily to subserve the interests of the parent firm of Alexander Sprunt & Son in Wilmington, North Carolina, U.S.A., and as the relations of the two firms are now mutually dependent upon each other it is understood and agreed that the Bremen firm will always give preference to the Wilmington firm in buying, and that the Wilmington firm will confine its business in Germany, Austria, Italy, Russia and Holland to the Bremen firm, it being understood and agreed that any departure from this rule shall be first approved by the respective firms. It is also agreed that the Bremen firm shall endeavor to promote the interests of the various firms of Alexander*1627 Sprunt & Son by active preferential cooperation.
3rd. The management of the firm in Bremen shall at the discretion of the majority of the interests continue to be vested in a resident partner and an assistant resident partner, such resident partner being entitled to withdraw from the running expenses of the business as a living allowance the equivalent of $10,000.00 (ten thousand dollars) per year, and the assistant resident partner the equivalent of $5,000.00 (five thousand dollars) per year.
*602 4th. It is hereby agreed that at the discretion of the majority of the interests Devereaux H. Lippitt shall remain resident partner, and that William L. Walker shall remain assistant resident partner.
* * *
7th. This partnership agreement shall come into force on the first day of July nineteen hundred and thirteen, and shall continue in force for a period of five years from that date, after which time it shall continue from year to year unless dissolved by mutual agreement and consent, but any partner may retire from the partnership at the expiration of the five years withdrawing his interests as determined by the annual balance sheet upon giving his partners in writing*1628 six months notice of his intention.
8th. The death or retirement of any partner shall not dissolve the partnership as to the other partners, but in the event of the death of a partner during the term of this five-year agreement it is mutually agreed that for the remainder of the then current season his estate is to receive his regular proportion of profits and share in any losses, and at the end of the then current season his estate is to withdraw one-half of the deceased's capital from the firm and for the remaining seasons, if any, until the expiration of this five-year agreement said estate is to share in the profits and losses of the firm in proportion of one-half of the deceased's former interest, and at the expiration of this five-year partnership agreement said estate is to withdraw balance of deceased's capital from the firm.
After its formation, the Bremen firm purchased raw cotton in the United States and sold it in Central Europe, principally in Germany, Austria and Italy. Almost all of its raw cotton purchases were made from the Wilmington firm, but it did make some purchases from other sources.
Upon the outbreak of hostilities between the United States and the*1629 Imperial German Government, Lippitt and Walker, who were the only members of the Bremen firm located and actively engaged in the business in Europe, and who were American citizens, returned to the United States, and the properties of the firm in Germany were seized by a representative of the German Government. After the conclusion of hostilities the members of the Bremen firm decided not to resume operations in Bremen, because of the heavy taxes being levied by the German Government, and the Bremen office of the firm was reopened solely for the purpose of liquidating the assets and business of the firm. Throughout the period of the war, and thereafter until it was revived in 1922, as will hereinafter more fully appear, the Bremen firm did not engage in any business activities.
As heretofore stated, the petitioner corporation succeeded to the business of the Wilmington firm on June 9, 1919. In September, 1919, the petitioner opened a branch office in Rotterdam, Holland, for the conduct of all of its European affairs. Walker, who had been the assistant resident partner of the Bremen firm, was made manager and placed in charge of this branch office, and no other member of the Bremen*1630 firm had any connection therewith. All subsequent sales of *603 raw cotton in Europe were handled through this branch office. Such sales were made principally in the territory in which the Bremen firm had operated and practically to the same trade.
About the latter part of 1921, the members of the Bremen firm made representations to the petitioner that the current sales of the latter in Central Europe were being made to the trade which they, as members of the Bremen firm, had built up and that they felt they were entitled to receive commissions upon such sales. After much discussion of the matter, the seven members of the Bremen firm, together with seven other persons who in the interim had become stockholders of the petitioner corporation, entered into an agreement, amending the Bremen partnership agreement of July 1, 1913, or thereabout, which reads as follows:
The foregoing partnership agreement of Alexander Sprunt & Son, Bremen, Germany, is hereby continued in force under the following amended conditions:
From and after this first day of January, 1922, it is hereby agreed that the division of the profits or losses arising from the old business, still in course*1631 of liquidation, of this firm shall be prorated among the seven original partners on the following basis:
James Sprunt 8/40
Walter P. Sprunt 4/40
It is hereby further agreed that this partnership shall include hereafter the following additional members:
Alex. Sprunt
Dalziel Hedderwick
These new partners only to share in the profits on current business, and in commissions, accruals, etc., received from the Rotterdam office of Alex. Sprunt & Son, Inc. The basis of division on this new and current business is hereby mutually agreed shall be as follows, from the first day of January, 1922:
| James Sprunt | 25% |
| W. H. Sprunt | 23% |
| J. L. Sprunt | 10% |
| Walter P. Sprunt | 10% |
| D. H. Lippitt | 7% |
| T. R. Orrell | 5% |
| T. E. Sprunt | 4% |
| W. L. Walker | 3% |
| J. H. Wood | 3% |
| W. J. Bergen | 2% |
| Alex. Sprunt | 2% |
| H. M. Crosswell | 2% |
| L. B. McKoy | 2% |
| Dalziel Hedderwick | 2% |
This supplemental agreement to become effective this first day of January nineteen hundred and twenty-two and to remain in force one year*1632 and thereafter by mutual consent.
The fourteen members of this new Bremen firm were the owners of all of the outstanding common stock of the petitioner corporation, *604 and each was given a proportional share in the profits of the new Bremen firm which bore the same ratio to the whole as his holdings of common stock of the petitioner corporation bore to the total of such stock outstanding.
After the new Bremen firm came into existence, Walker continued in his post as manager of petitioner's Rotterdam office. He was the only member of the new Bremen firm actively engaged in the affiairs of the firm in Europe. He spent about one-half of his time in Bremen attending to the affairs of the old and new Bremen firms. Lippitt and W. H. Sprunt, executive officers of the petitioner, as well as members of both Bremen firms, made several trips to Europe for the purposes of assisting in the liquidation of the affairs of the old Bremen firm and of further developing and retaining the business of the firm for the petitioner's benefit.
As sales were made through its Rotterdam office, the petitioner credited the account of the new Bremen firm with "commissions" ranging from 1 to*1633 3 per cent of invoice price, less freight. The amount of "commissions" to be paid on any sale was agreed upon at the time of sale. The "commissions" allowed to the Bremen firm were the same as those customarily paid by the petitioner to its other agents in Europe, as between whom and itself no other relation existed that that of principal and agent.
During 1923 the petitioner kept its books of account of an accrual basis. In that year it credited to the account of the new Bremen firm net "commissions" on sales made through the Rotterdam office in the amount of $336,554.48. This entire amount was distributed by the petitioner to the members of the new Bremen firm, during 1923 and the early part of 1924, in accordance with their respective partnership interest. The members of the new Bremen firm have reported, for the purposes of the income tax, the amounts so distributed to them by the petitioner, and have paid the tax thereon, and the amounts so reported have not been excluded from their returns by the respondent. In its return for 1923 the petitioner claimed the entire amount paid or credited to the new Bremen firm for commissions, $336,554.48, as a deduction from gross income. *1634 Of the amount so claimed, the respondent has allowed the sum of $50,483.18, and has disallowed the remainder of $286,071.30.
2. Prior to 1921 the petitioner maintained a branch office at Havre, France, through which it sold cotton to French merchants and mills. Two brothers, T. R. and F. B. Orrell, were managers of the office. In 1921 the petitioner closed this branch bacause of heavy taxation in France. The two Orrell brothers had resided in France for several years and were desirous of continuing in business there and, to satisfy their wishes, the petitioner organized a French corporation, known *605 as Societe Cotonniere Franco-Americaine, for the purpose of acting as petitioner's selling agent in France. The entire capital of this corporation, 1,000,000 francs, was furnished by the petitioner, and though the certificates of capital stock were held by the Orrell brothers, petitioner was at all times the owner thereof. The Orrell brothers were made managers of the corporation, and the petitioner delegated to them full authority to act in all matters.
The French corporation was in existence and sold cotton for the petitioner's account throughout all of 1923. Its*1635 operations, however, were not confined exclusively to sales for the petitioner's account; the major part of its earnings were derived from commissions received from other sources. In all business transactions between them, the petitioner dealt with the French corporation on the same basis as with its other agents, and the commissions allowed to it, ranging from 1 to 2 per cent of invoice price, did not exceed those usually paid to petitioner's other agents for like services.
The petitioner carried an account on its books with the French corporation, known as "Havre Special." During 1923 the petitioner allowed to the French corporation and credited the said account with net commissions of $39,689.75 on sales made within the year. At the request of the managers of the French corporation, these commissions were withheld and not paid by the petitioner in 1923, the purpose of the request being to avoid the heavy taxation of money in France. In its return for 1923 the petitioner, in computing taxable net income, claimed the amount of said commissions as an expense deduction, and of the whole amount so calaimed, the respondent has allowed $5,953.47 and disallowed $33,736.28.
3. The*1636 petitioner maintained a branch office of Houston, Tex. The employees at that branch received stated salaries and in 1923 some of them received bonuses also, amounting in all to $601.05. It was the petitioner's desire that the fact of payment of the bounses, and the amount thereof, should not appear on the books of the Houston branch. Consequently, payment thereof was made directly from the petitioner's home office at Wilmington. When the profits of the Houston branch, as reported by that branch, were taken up on the books of the home office, a charge was made against them for the amount of the bonus payments. The respondent has held that the profits of the Houston branch were understated by $601.05, and he has increased the net income reported by the petitioner by that amount.
4. During 1923 various cotton exchanges and cotton merchants united in raising a fund to be used in eradicating the boll weevil, and the petitioner contributed $5,000 to such fund. The presence of the boll weevil in the cotton-producing centers was a serious *606 menace to the cotton industry as a whole, as it tended to reduce, very materially, the crop yield. The petitioner was not engaged*1637 in growing cotton, but its business of exporting cotton and of operating a warehouse for the storage of that commodity was dependent upon the amount and quality of cotton produced; and inroads by the boll weevil would seriously menace the successful conduct of the petitioner's business. The amount so contributed was claimed as a deduction by the petitioner in computing net income in its return, but the respondent disallowed the deduction.
During 1923 the petitioner expended $287.50 for advertising in magazines published by the Order of Railway Yardmen, the American Legion, and various labor and trade organizations. The advertising was done in good faith and with the expectation of results similar to those derived from advertising in other mediums. The amount so expended was claimed as a deduction by the petitioner in computing net income in its return, but the respondent disallowed the deduction.
5. It has been the petitioner's consistent inventory practice to include in its annual inventories bales of cotton which had been purchased by its agents at distant points but which have not been actually received at destination at the inventory date. These bales of cotton are referred*1638 to as "en route cotton." Such cotton was inventoried on the basis of the cost, weight and grade used by the agents in its purchase. When the cotton was received at its destination, the bales were reweighed and regraded and adjustments were made with the sellers. In making adjustments, sometimes the petitioner paid additional amounts to the sellers and sometime the sellers were required to make refunds to the petitioners. Adjustments with sellers in respect of en route cotton included in the preceding year's inventory were currently recorded in the accounts of the year in which the adjustments were made, either as an expense, if the petitioner was required to make additional payments for the cotton, or as income, if the sellers were required to make refunds to the petitioner. There was never a revision of the preceding year's inventory so as to reflect the adjustments made with the sellers.
At the close of 1923 there were 1,396 bales of cotton which had been purchased by the petitioner's agents and not received at destination at the inventory date, but were en route to the petitioner's warehouse at Charlotte. Consistent with its inventory practice, these 1,396 bales of cotton*1639 were included in the 1923 inventory, on the basis of the cost, weight and grade used by the agent at Charlotte in making the purchases. At the time the 1922 inventory, which was the opening inventory for 1923, was taken, there were 96 *607 bales of cotton en route to the warehouse at Charlotte. The respondent increased the 1923 inventory of the Charlotte office by $11,185.96, and thereby increased the net income reported by the petitioner in its return by that amount. The respondent did not make any adjustment in the 1922 inventory on account of any adjustments made with the sellers of the 96 bales of en route cotton not received at destination at the date of that inventory.
6. In 1923 the petitioner paid $7,500 to Goldman and Unger, a New York firm of lawyers, for services rendered in connection with legal proceedings to recover the sum of $2,225,521.36 which had been paid by the petitioner and the predecessor partnership, during the period 1914 to 1920, for war risk insurance premiums. The "bulk" of these premiums had been paid by the predecessor partnership in 1917. Upon reorganization, the petitioner took over all of the assets and business, and assumed all of the*1640 liabilities, of the predecessor partnership. If any part of the sum so paid for war risk insurance premiums is recovered, it will be received and retained by the petitioner. The amount paid in 1923 for legal services was claimed as a deduction by the petitioner in computing net income for that year, and the deduction has been disallowed by the respondent.
7. The petitioner owned a warehouse at Charlotte, N.C., which was located in a gully between two railroad embankments. The building rested on wooden props and was surrounded by a wooden wall to prevent the flow of water down the railroad embankments from washing away the underpinning. In 1923, in order to better protect the wooden props from water flowing down the embankments, the petitioner built a concrete retaining wall extending the full length of the building along the foot of the railway embankments. The cost of the retaining wall was $4,200 and the petitioner deducted that amount as an expense in computing net income. The respondent disallowed the deduction.
In 1923 the petitioner completely renovated an old office building which it owned at Wilmington, for the purpose of renting it. The work included, among other*1641 things, a complete overhauling of the plumbing system, rewiring for electricity, replacement of window sashes, screen doors and window screens, painting, new glass in windows, etc. The preliminary estimate of the cost, made by the petitioner's superintendent and based upon the use of new materials, amounted to $3,050.07. However, considerable old material on hand was utilized for the work and the actual cost of the completed work was only $1,630.44. In computing net income the petitioner deducted the entire cost of the work as an expense. The respondent held that the entire amount was expended for additions and betterments and *608 no part thereof constituted a proper deduction; however, instead of restoring to income the actual cost of the work and the amount deducted by the petitioner in the return, to wit, $1,630.44, the respondent added to income the amount of the superintendent's preliminary estimate of cost, to wit, $3,050.07.
8. The petitioner's inventory of December 31, 1923, showed that there were on hand in and en route to its warehouse at Wilmington, 25,130 bales of cotton, of 26 different grades, having a total weight of 12,235,930 pounds and a total value*1642 of $4,122,404.33. Sometime after filing the return for 1923, it was discovered that the inventory weights of six grades of cotton were wrong. The following statement shows, for those six grades, the inventory weights, the correct weights, the inventory value of those grades based on inventory weights, and the revised value of those grades based on corrected weights and unit prices used in the inventory:
| Grade | Inventory weight | Correct weight | Inventory value | Revised value |
| FLM | 1,356,049 | 1,322,077 | $450,886.29 | $439,590.60 |
| LM | 614,557 | 601,727 | 196,658.24 | 192,552.64 |
| FMT | 394,696 | 378,216 | 132,223.16 | 126,702.36 |
| MT | 421,041 | 405,219 | 134,733.12 | 129,670.08 |
| FLMT | 55,564 | 48,952 | 17,224.84 | 15,175.12 |
| LWT | 56,700 | 47,250 | 17,010.00 | 14,175.00 |
| Total | 948,735.65 | 917,865.80 |
In the deficiency notice the respondent reduced the net income reported in the return by $3,403.29, with the following explanation: "This item represents the decrease necessary in the closing inventory of cotton of the Wilmington Agency."
9. On or about December 31, 1923, the petitioner made an inventory of its compress equipment and ascertained that*1643 the value of the same was understated on its books of account. To bring the book value of that equipment into accord with the petitioner's valuation, property account was charged and profit and loss account was credited with the sum of $15,622.53. The amount so credited to profit and loss was included by the petitioner in the gross income reported in the 1923 return, but the respondent, in the deficiency notice, eliminated $4,173.16 from income.
10. In 1923 the petitioner removed one of its cotton compresses from Wilmington, N.C., to Houston, Tex. The cost of such removal was $8,355.19, which included only the cost of the dismantling at Wilmington, freight charges to Houston, and the expense of reassembling at Houston, and did not include any part of the cost of the foundation for the compress at Houston. The entire cost of removal was charged to capital accounts on the petitioner's books, *609 and no part thereof was claimed by the petitioner as a deduction in computing net income, nor has any portion of such cost of removal been allowed as a deduction by the respondent.
11. The petitioner was incorporated with an authorized capital of $3,000,000, consisting of*1644 30,000 shares of common stock of the par value of $100 per share. No other kind or class of capital stock was authorized to be issued by the charter or any subsequent amendment thereto. Included in the liabilities of the predecessor partnership assumed by the petitioner were partners' credit balances, amounting in the aggregate to approximately $9,000,000, in respect of which the following resolution was unanimously adopted at the stockholders' meeting of June 9, 1919:
WHEREAS: Alexander Sprunt & Son, a partnership with principal office at Wilmington, North Carolina, and with a capital contributed by the partners and employed in the business of the partnership on June 7th, 1919, amounting to $9,000,000 (nine million dollars) was, on June 9th, 1919, duly incorporated under the laws of North Carolina, providing for the incorporation and organization of business companies;
AND WHEREAS the charter of the aforesaid corporation provides for an authorization of three million dollars ($3,000,000) of common stock consisting of thirty thousand shares of the par value of One Hundred Dollars each, but that only two million dollars of such common stock so provided for shall be issued for*1645 a like amount and value of the assets of the partnership;
AND WHEREAS it is the purpose and intention of the partners aforesaid to dedicate to the corporation succeeding the partnership all the capital employed in the business of the partnership;
NOW, THEREFORE, RESOLVED: I. That the capital of the partnership employed in its business on June 7th, 1919, in excess of the aforesaid two million dollars for which a like amount of common stock of Alexander Sprunt & Son, Incorporated, are to be issued, shall be taken, held and employed by said corporation as Paid-in-Surplus;
III. That the acceptance by the corporation of the sum of seven million dollars ($7,000,000) aforesaid as Paid-In-Surplus and the issuance therefor of its certificates*1646 of interest and the acceptance by the contributors of such Paid-In-Surplus of the certificates of interest therein issued by the corporation aforesaid shall be full and complete evidence and acquitance of the fact and bona fide of the dedication of said Paid-In-Surplus as property of the corporation, to the risks of the corporation's business.
Pursuant to the foregoing resolution, there were issued to the members of the predecessor partnership, in satisfaction of the amounts shown to be due them by the partnership books, common stock of a total par value of $2,000,000, and certificates of paid-in *610 surplus of a total par value of $7,000,000. The certificates of paid-in surplus were in the following form:
THIS IS TO CERTIFY THAT is the owner of shares, fully paid and non-assessable, of the par value of $100.00 (one hundred dollars) each in the paid-in surplus capital of Alex. Sprunt & Son, Incorporated, transferable only in person or by attorney upon the books of the said corporation upon the surrender of this certificate. The holders of certificates of interest in the paid-in-surplus capital shall be entitled to receive, when and as declared as of the first day of*1647 June and December in each year, from the surplus or net profits of the corporation, yearly dividends at the rate of seven per centum, and no more, payable semi-annually as of the dates herein specified or as may be otherwise determined as to them by the by-laws. The dividends on said certificates of interest shall be cumulative, and shall be payable before any dividend on the common stock shall be paid or set apart, so that if in any year dividends amounting to seven per centum shall not have been paid thereon, the deficiency shall be payable before any dividends shall be paid upon or set apart for the common stock. When all cumulative dividends on the certificates of interest for all previous years shall have been declared, and shall have become payable, and the accrued installments for the current year shall have been declared, and the corporation shall have paid such cumulative dividends for previous years and such accrued semi-annual installments, or shall have set aside from its earned surplus or net profits a sum sufficient for the payment thereof, the board of directors may declare dividends on the common stock payable then or thereafter, out of any remaining earned surplus*1648 or net profits. In the event of any dissolution or winding up (whether voluntary or involuntary) of the corporation, the holders of the certificates of interest in the paid-in surplus capital shall be entitled to be paid in full both the par amount of their shares and the unpaid dividends accrued thereon, before any amount shall be paid to the holders of the common stock, and after the payment to the holders of the certificates of interest on their par value, and the unpaid accrued dividends thereon, the remaining assets and funds shall be divided and paid to the holders of the common stock according to their respective shares. The certificates of interest in paid-in surplus may, at the election of the corporation and on ninety days previous notice given next preceding any dividend date, said notice to be in writing addressed to each certificate holder at his last known address or by publication in the public press as the corporation may elect, retire any part or all of the certificates of interest in paid-in surplus at one hundred and five and accrued dividends. Any retiring of the certificates of interest in paid-in surplus shall be ratably according to the holdings thereof as*1649 evidenced by the records of the corporation.
No authority was ever requested of, or received from, the State of North Carolina for the issuance of these certificates of paid-in surplus. No taxes were paid to the State of North Carolina, under section 1218 of the corporate laws of that State, upon the issuance of these certificates, and such certificates have always been excluded from capital-stock returns, for the purposes of the franchise tax of that State.
During 1923 certificates of paid-in surplus of a total par value of $5,000,000 were outstanding. Payments at the rate of 7 per cent per annum upon the par value of the certificates were made semiannually *611 to the certificate holders as a matter of course, without any special authorization by petitioner's board of directors. The total payments made to certificate holders in 1923 amounted to $350,000. No part of the amount so paid to certificate holders has been allowed as a deduction by the respondent in computing net income for 1923.
12. During 1923 the original partnership of Alexander Sprunt & Son, Bremen, sustained a net loss of $130,434.30 in connection with the liquidation of its prewar business. No*1650 part of that loss has been allowed as a deduction by the respondent in computing the petitioner's net income for 1923.
OPINION.
MARQUETTE: 1. The first issue has been somewhat beclouded by the different positions taken by the petitioner in the pleadings and in its brief. In the preliminary statement of this report, we have quoted verbatim under (1) the assignment of error as set forth in the petition. In the statement of facts contained in the petition, the petitioner alleged as follows:
These commissions were taken as a deduction from gross income in the 1923 tax return filed by the petitioner. The respondent has in its 60-day letter disallowed these commissions as a deduction from gross income and has stated in its 60-day letter the following reason for the disallowance:
"This item represents commissions earned through your Bremen agency and represents taxable net income to you."
In his answer the respondent, though denying any error in his determination, admitted the above allegation of fact; and upon the basis of these pleadings the case came on for hearing. In its brief the petitioner entirely ignores the question of whether the amount credited on its books to*1651 the Bremen firm in 1923 and subsequently paid as commissions constitutes a proper deduction from the gross income of that year, and, contending that the respondent is bound by the explanation of his determination in the deficiency notice and that he must win or lose accordingly as the Board finds that such explanation does or does not legally support his determination, it sets forth that the sole question for decision is whether the commissions received by the Bremen firm are properly chargeable to the petitioner as its income. Devoting its entire brief to an argument on the latter question, the petitioner asserts that the evidence conclusively proves that the Bremen firm and the petitioner are separate and distinct taxable entities; consequently, that the income of the Bremen firm can not be charged to this petitioner; and that the respondent's deficiency determination, so far as based on the addition of $286,071.30 to the reported net income, must fail. In other words, the petitioner argues that, since the respondent explained the addition of $286,071.30 to the reported net income as income of *612 its "Bremen agency" properly includable in its tax return, and since he did*1652 not specifically say that the addition was based upon the disallowance of a portion of the deduction which the petitioner claimed for commissions paid or credited to the Bremen firm, the Board must assume that the respondent's determination is that the petitioner is entitled to a deduction for the entire amount of such commissions and it must set aside so much of the deficiency as is based upon this item, if it finds that the petitioner is not properly chargeable with the income of the Bremen firm.
There are fundamental weaknesses in this line of argument that are not easily disposed of. In the first place, the pleadings contain allegations by the petitioner, readily admitted by the respondent, to the effect that the petitioner claimed "a deduction from gross income in the 1923 tax return" for the commissions paid to the Bremen firm, in the amount of $286,071.30, and that "the respondent has in its 60-day letter disallowed these commissions as a deduction from gross income," though the respondent admits further that the explanation of his action in the deficiency notice was entirely different. Further, as was stated by the Board in *1653 :
The phrasing of the notice of deficiency relating to the item in controversy, even if clear, is not the cause of action and does not frame the issues. The petitioner may not, without an expressly pleaded admission or a stipulation, treat the notice as an official acquiescence by the Commissioner in all petitioner's propositions as to this item except those expressly determined adversely to him. If the Commissioner finds one fact or reason which he believes supports his adverse determination, he is not required to express his views on any or all other matters relating to the item, and his failure to deal with them carries no implication as to their treatment. It is not the Commissioner's method of determination or computation which is the substance of the proceeding, for the deficiency may be correct despite a weakness in arriving at it or explaining it. ; . "It is immaterial whether the Commissioner proceeded upon the wrong theory in determining the deficiencies. In any event the burden was on the petitioner to show that*1654 the assessment was wrong." .
On the record before us, it is clear that the petitioner claimed a deduction, in computing taxable net income for 1923, of $336,554.48 for "commissions" paid or accrued in that year; and that the respondent allowed a deduction of only $50,483.13 and disallowed $286,071.30. The question, therefore, to be decided is whether the petitioner is entitled to the whole amount of the deduction claimed.
It is obvious that if this item is a proper deduction in computing net income, authority therefor must be found in section 214(a)(1) of the Revenue Act of 1921, since no other section of the statute is broad enough to include an item of this character. That section *613 provides for the deduction of "All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered * * *."
It seems clear enough from the findings of fact that the new Bremen firm and the petitioner corporation are separate and distinct entities, though*1655 composed of the same persons, with like interests in both. These two entites were entirely free to deal with each other and fix their relations, by formal or informal agreements, as though they were composed of different persons, and business transactions between them are entitled to the same respect and consideration, in fixing their income-tax liabilities, as are accorded to dealings between less closely related business organizations, so long as their relations are not availed of as a mere vehicle for evasion of the tax. Cf. . If, therefore, the payments made by the petitioner to the new Bremen firm were ordinary and necessary in the conduct of its business and in the earning of its income, and were reasonable in amount, considering the services rendered, there is no bar to their deduction in the computation of net income. For what then were these payments, totaling $336,554.48, made by petitioner to the new Bremen firm?
It may be conceded, upon the evidence, that the old Bremen firm had enjoyed a very lucrative business in the cotton markets of Central Europe, and, at the outbreak of hostilities between the United States*1656 and the German Government, was possessed of an established good will of considerable value. With the outbreak of hostilities, however, it was forced to cease its business activities at Bremen, the seat of its operations, and apparently elected to remain inactive during that emergency. After the close of the war, it definitely abandoned the thought of resuming the business and reopened the Bremen office solely for the purpose of liquidation. In the interim, the petitioner had opened a branch office at Rotterdam and through that office had established connections with the former customers of the old Bremen firm and was carrying on business with those customers with apparently much success and not at all handicapped by reason of the former connections of those customers with the old Bremen firm. Such were the conditions existing at the time of the alleged demands of the members of the old Bremen firm for some sort of compensation, because the petitioner was capitalizing upon the business which they had built up, and when the petitioner was actually in possession of and enjoying the benefits of that business and its good will. What then was the necessity for the payment of these so-called*1657 "commissions" to the members of the old Bremen *614 firm? The only explanation therefor is to be found in the testimony of the petitioner's president, who was a member of the old and new Bremen firms and a stockholder in the petitioner, that it was very much to the petitioner's interest "to keep the former partners of the Bremen partnership in a friendly frame of mind." We are left to draw upon our own imagination as to the probable consequences of petitioner's failure to meet those alleged demands.
The record does not show that the new Bremen firm was directly responsible for a single dollar's worth of petitioner's sales in 1923, that is, that the members of the firm consummated a single dollar's worth of sales for the petitioner's benefit. If any portion of the petitioner's 1923 cotton sales in Central Europe can be attributed to the activities of any of the fourteen members of the firm, they may likewise be attributed to their activities as officers, directors and stockholders of the petitioner corporation. So far as we have been able to discover, the only services rendered by the new Bremen firm in 1923, for the petitioner's benefit, were represented by the activities*1658 of only three of its fourteen members, Walker, Lippitt and W. H. Sprunt. Walker was also manager of petitioner's branch office at Rotterdam, and Lippitt and Sprunt were executive officers of the petitioner, located at Wilmington, N. C. Walker divided his time about equally between Rotterdam and Bremen, at the latter place attending to the affairs of the old and new Bremen firms. Lippitt and Sprunt made several trips to Europe for the purposes of assisting in the liquidation of the affairs of the old Bremen firm and of further developing and retaining the business of that firm for the petitioner's benefit. It is wholly impossible from the evidence to draw any line of demarcation between their activities, as members of the Bremen firm, in the interests of the petitioner and their activities as officers, directors and stockholders of the petitioner. In any event the evidence does not justify the conclusion that they, as partners, rendered any services to the petitioner which would not ordinarily have been required or expected of them as officers of the petitioner. The fact that the payments made to the Bremen firm were not in excess of the commissions usually paid to selling agents*1659 does not of itself prove the reasonableness of these payments. The question is, was the total amount paid reasonable for the services rendered by the Bremen firm to the petitioner; and the answer must be in the negative, since the evidence is far from convincing that the firm rendered any services of substantial benefit to the petitioner. If the respondent had no more before him upon which to reach a determination in the matter than the evidence presented to us, we think he was more than reasonable in the allowance which he made.
*615 We think the true character of these payments to the Bremen firm is best indicated by the fact of the admission to the partnership, apparently without any contribution of capital or services, of the seven individuals who were not members of the old Bremen firm but who, at the time of the organization of the new firm, were holders of common stock in the petitioner corporation, and the allotment to each of the fourteen members of the firm of an interest proportionate to his holdings of common stock in the petitioner. Asked if he could explain the admission to the firm of the seven new members under such circumstances, the petitioner's president*1660 testified that they were admitted "merely by agreement to satisfy their claim." What claim had these seven new members which could be satisfied only in this fashion? They had no interest in the old Bremen firm and no claim upon its business and good will. They contributed nothing in the way of capital or services to the new firm. All of the circumstances of which we have been apprised tend to indicate that their sole claim was the right to share with the majority of petitioner's common stock holders in any distribution of profits. We find no error in the respondent's determination in this matter.
2. The second issue raises the question as to whether the entire amount of commissions accrued on the petitioner's books, to the credit of the Societe Cotonniere Franco-Americaine, may be deducted in computing net income. The respondent contends that the French corporation is "merely an incorporated branch office of the petitioner," and that the accruals in its favor, on the petitioner's books, represent nothing more than distributions of profits. We think that the respondent's determination in this matter is erroneous. The evidence leaves no room to doubt the separateness of the*1661 two corporations, and there is no indication of fraud, attempt at tax evasion, or other circumstance which might justify or require a disregard of the separate corporate entities. The allowance of commissions to the French corporation could hardly be termed distributions of profits, since the corporation owned none of the petitioner's capital stock. The only question which might arise in connection with these commission allowances would be the matter of the bona fides of the allowances, and as to that, the evidence shows clearly that the allowances were made for services actually rendered in the consummation of sales for petitioner's benefit, and were computed at rates customarily allowed to petitioner's other selling agents. They represent a proper charge against the petitioner's gross sales as a part of their cost, and are a proper deduction in computing net income. The net income shown in the deficiency notice should be reduced by $33,736.28.
3. The third issue relates to respondent's action in adding to the reported net income an item of $601.05 on the ground that the net *616 income of the Houston branch office had been understated by that amount. The evidence*1662 shows that the respondent's determination in this matter is erroneous. The alleged understatement is due to the petitioner's payment of bonuses of $601.05 to employees of the Houston branch office. For reasons of its own, the petitioner made payments direct from its Wilmington office and without making any record thereof in the books of account of the branch office. In accounting for the profits of the branch office on the books of the home office, a charge was made against those profits for the amount of the bonus payments; consequently, the profits of the branch office as shown by the home office books were less, by the stated amount, than the profits shown by the branch office books. The net income shown by the deficiency notice should be reduced by $601.05.
4. In this issue the petitioner questions the propriety of the respondent's action in disallowing as deductions eight items, totaling $19,120.32, which the petitioner had claimed in its return as a part of its general expenses. The respondent, in his brief, confesses error as to the disallowance of two of these items, to wit: bonuses to employees, in the amount of $13,682.82, and cost of purchases of cotton samples, *1663 in the amount of $50; and the petitioner, in its brief, withdraws the assignment of error as it relates to three other items, to wit: payment to the New York Cotton Exchange in the amount of $20, a further payment to the New York Cotton Exchange in the amount of $20, and Wilmington Light Infantry dues in the amount of $100. There are left for our consideration three items, to wit: a contribution of $5,000 to a fund to be used in eradicating the boll weevil; a payment of $25 to the Order of Railway Yardmen for advertising inserted in a magazine published by that order; and payments amounting to $262.50 for advertising inserted in magazines published by the American Legion and various labor and trade organizations.
The respondent contends that the contribution of $5,000 to the fund raised by various cotton exchanges, to be used in the eradication of the boll weevil, should not be allowed, for the reason that the petitioner has failed to show definitely that it was in any way benefited by this contribution. We are of a different opinion. The petitioner was engaged in the business of exporting raw cotton and of operating a warehouse for the storage of the same commodity. Its business*1664 was dependent upon a normal production and a crop of good quality, both of which were, in turn, dependent upon the successful control of the boll weevil. We may take judicial notice of a situation generally known to exist, the prevalence of the boll weevil and its destructive effects upon the cotton crops of our southern States, to remedy which much is being done by the States and *617 national and private enterprise. In making the contribution there was no thought of charity or philanthropy; the motives of the petitioner were purely mercenary, its expectation being that its business would be benefited proportionately to the degree of success attendant upon the campaign of eradicaiton or control of the pest. It is entirely unreasonable to ask the petitioner to measure the benefits of this contribution in terms of dollars and cents. The question always is whether balancing the outlay against the benefits
As to the amounts expended for advertising inserted in magazines published by the Order of Railway Yardmen, American Legion and various trade and labor organizations, totaling $287.50, the respondent contends that the names of the magazines in which the advertisements were inserted indicates that the expenditures were merely "good will donations." While such an inference might be drawn, it does not necessarily follow and it is negatived by the evidence.
Accordingly, the net income shown in the deficiency notice should be reduced by $13,682.82 for bonuses to employees; by $50 for cost of purchases of cotton samples; by $5,000 for contribution to the fund for eradication of the boll weevil; and by $287.50 for advertising in various magazines, a total of $19,020.32.
5. For some reason not disclosed by the deficiency notice, any admitted pleadings, or evidence, the respondent increased the 1923 inventory of petitioner's Charlotte branch office by $11,185.96. The petitioner asks us to set aside the respondent's determination in this matter, on two grounds: (1) Because his action, in holding that adjustments with sellers*1666 of en route cotton should be treated as additional cost of that cotton and reflected in its inventory value and not accounted for as an expense of the later year in which such adjustments are made, is contrary to the petitioner's consistent accounting practice and the best accounting practice in the industry; and (2) because the respondent failed to make a similar revision of the 1922 inventory, which is the opening inventory for 1923, in respect of the 96 bales of en route cotton included in that inventory, thus placing the opening and closing inventories for 1923 on different bases, with a resulting distortion in net income.
Both reasons are premised on the assumed fact that the increase made by the respondent in the Charlotte inventory reflects the adjustments made in 1924 with the sellers of the 1,396 bales of en route *618 cotton included in the 1923 inventory of the Charlotte branch. But we do not know whether the assumption is correct or not. Certainly, nowhere in the record is there an admission of the fact by the respondent - his brief is entirely silent on this issue; and there is no proof of a single fact which would indicate that the respondent's inventory adjustment*1667 is related to the 1,396 bales of en route cotton included in that inventory. For all we know, the respondent may have determined, in respect of the Charlotte inventory, that there was an erroneous count in the number of bales of cotton, or that inventory weights were incorrect, or any other of a number of possible errors which might be suggested. In short, we do not know why the respondent increased the Charlotte inventory by $11,185.96; consequently, the decision on this issue can not be limited to the consideration of any one particular element of the inventory valuation, but must embrace the whole matter of that valuation. Since the petitioner has failed to show that the Charlotte inventory was of a value less than that determined by the respondent, we are not in any position to disturb the respondent's determination. Furthermore, even if we could assume that the premise of petitioner's contentions is correct, there is no evidence that there were adjustments with sellers in 1923 in respect of the 96 bales of en route cotton included in the 1922 inventory; consequently, the petitioner has failed to prove that the respondent has been inconsistent in his treatment of adjustments*1668 with sellers in respect of the en route cotton in the opening and closing inventories for 1923 and thereby has placed the two inventories on different bases.
6. The record does not show whether the sum of $7,500 paid to Goldman and Unger in 1923, for services in connection with legal proceedings to recover war risk insurance premiums, was in payment of services rendered entirely to the petitioner or in payment of services rendered partly to the predecessor partnership and partly to the petitioner. If any part thereof was in payment for services rendered to the partnership, the payment was in satisfaction of a liability of the partnership which the petitioner assumed in part payment for the partnership's assets, and that part of the whole amount paid would represent a capital expenditure - additional cost to the petitioner of the partnership's assets, which would not be a proper deduction in computing net income.
Even if we assume that the payment was for services rendered entirely to the petitioner, the whole amount thereof still would not be deductible, because a portion thereof was expended in establishing petitioner's right, as assignee of the partnership by purchase, to*1669 recover amounts paid out by the partnership for war risk insurance premiums; and that portion of the payment represents an additional *619 cost to the petitioner of the partnership assets, a capital expenditure which may not be deducted in computing net income.
The evidence does not contain any facts upon which we could base a reasonable apportionment of the payment to the claims of the two entities, and we are unable, therefore, to determine what portion of the whole payment is a proper deduction in computing net income. Under the circumstances, the respondent's determination in the matter must stand.
7. This issue raises the question of the propriety of respondent's action in holding that certain expenditures made in 1923, and claimed as deductions by the petitioner in computing net income, were made for additions and betterments which materially prolonged the lives of the buildings, and, therefore, were of a capital nature and may not be deducted in computing net income.
As to the payment of $4,200 for the construction of a concrete wall around the petitioner's warehouse at Charlotte, the findings of fact clearly show the nature of this expenditure. Unquestionably, *1670 the concrete wall which replaced a wooden one no longer useful for the purposes for which constructed was a substantial and permanent betterment and rendered the building better suited to the purposes for which it was used. The expenditure for the construction of the concrete wall is of a capital nature and, therefore, is not a proper deduction in computing net income. Cf. ; ; affd., ; certiorari denied, .
It is also clear that much that was done in renovating Building A at Wilmington, for the purpose of renting the building, was in the nature of permanent betterments. The entire plumbing system was overhauled, the building was rewired for electricity, new window sashes were installed, and window screens and screen doors replaced. While these betterments may not have materially prolonged the life of the building, they unquestionably rendered it better suited to the petitioner's purposes. Some part of the work done might well be considered as ordinary repairs which may be deducted in computing net income; however, the*1671 record affords no basis for a segregation of these items from those of a capital nature and, consequently, we can not determine what part of the entire cost of renovating the building is a proper deduction. . However, the respondent restored to income the sum of $3,050.07, which was the superintendent's estimate of the cost of renovating the building, whereas the actual cost was only $1,630.44, and only the latter amount was deducted by the petitioner in computing net income.
Our conclusions on this issue require a reduction in the net income as shown by the deficiency notice, in the amount of $1,319.63.
*620 8. The petitioner contends that the inventory of the Wilmington branch, as of December 31, 1923, was overstated by $33,412.60, due to using incorrect and excessive weights in valuing the cotton of six grades, resulting in a like overstatement of net income. In the deficiency notice, the respondent reduced the net income reported in the return by $3,403.29; but the petitioner contends that there should be a further reduction of $30,009.31.
The petitioner placed in evidence the original inventory sheet showing the grades*1672 of cotton on hand, number of bales of cotton in each grade, weight of cotton in each grade, and value of the cotton in each grade. This sheet showed a total value for the inventory, of $4,122,404.33. It also put in evidence a revised inventory sheet showing corrected weights for six grades of cotton; and the total value of the inventory, as shown by this revised sheet, is $4,088,991.73, which is $33,412.60 less than the value shown by the original inventory sheet. Not all of the difference of $33,412.60 is due to a correction in weights. An examination of the revised inventory sheet shows that of the total difference, $2,526.73 is due to a change in the unit price per pound of cotton en route to destination - the original inventory showing a unit price of $0.345 per pound, while the revised inventory shows a unit price of $0.3325 per pound. No evidence was presented by the petitioner to support this change in price; hence, the change may not be allowed.
While we have found that incorrect weights were used as to six grades of cotton in valuing the inventory, there is not sufficient proof to show error in the respondent's determination as to the value of the inventory. After*1673 investigating the inventory, the respondent determined, as indicated by the deficiency notice, that the inventory reported in the return had been overstated by $3,403.29. The deficiency notice, pleadings and evidence do not show the basis of that determination. The fact that the respondent did not make as great a reduction in the inventory as might be required by a revision of weights in six grades of cotton indicates that in all probability he found offsetting errors elsewhere in the makeup of the inventory. He was under no obligation to set forth fully in the deficiency notice the basis of his determination. The obligation rested on the petitioner, therefore, to prove the value of the inventory and the inventory value used by the respondent in his deficiency determination. The first required proof of quantities, according to grades, basis used in valuing the inventory, whether cost or cost or market, whichever is lower, and the unit price of each grade, cost or market, according to the basis of valuation, but the petitioner failed to prove either the basis or the unit prices used. As to the inventory value used by the respondent in the deficiency determination, we can only*1674 assume that it was the value shown *621 by the original inventory sheet reduced by $3,403.29; the deficiency notice indicates only that the respondent reduced the inventory value reported in the return by $3,403.29, but the value reported in the return may have been entirely different from the value shown by the original inventory sheet. The evidence is insufficient to show error in the respondent's determination as to the value of the inventory of the Wilmington branch.
9. The petitioner increased the book value of its compress equipment in 1923 by $15,622.53, and credited profit and loss account with a like amount. The amount so credited to profit and loss was included in gross income in the return, but $4,173.16 was eliminated from income by the respondent in the deficiency notice. The revaluation of the compress equipment and the arbitrary write-up on the books of the value of that equipment on the books did not give rise to any taxable income, and the whole amount of the write-up should have been excluded by the respondent from income. The net income shown in the deficiency notice should be reduced by $11,449.37.
*1675 10. The expense of removing a cotton compress from Wilmington to Houston, was an ordinary and necessary expense of carrying on the petitioner's business, ; ; and since the cost thereof has not been allowed as a deduction by the respondent, the net income shown by the deficiency notice should be reduced by $8,355.19.
11. The petitioner complains of respondent's failure, in computing net income for 1923, to allow as a deduction the sum of $350,000 representing alleged interest paid to the holders of petitioner's certificates of paid-in surplus in that year.
In , it was held that the payments received from this petitioner on the certificates of paid-in surplus under consideration in this case were interest income and not dividend income to the trust, and were subject to both the normal and surtaxes. In the instant case, however, the evidence as to the nature of these payments is much more full and complete than that presented to the Board in the cited case, and clearly reveals the true nature of these*1676 payments to be dividends and not interest. Clearly the holders of these certificates of paid-in surplus are shareholders in the petitioner and not creditors. The resolution adopted at the stockholders' meeting of June 9, 1919, and the instrument itself disclose that the funds represented by these certificates have been invested in the business without any guarantee of return and subject to all the risks and hazards of the business. The semiannual payments to the certificate holders of 7 per cent upon the face value of the outstanding certificates are denominated "dividends" in the *622 certificate, and are required to be paid, by the provisions of the certificate, out of earned surplus or net profits of the corporation. The rights of the certificate holders to repayment of the principal sums or face values of their certificates and the accrued dividends thereon are subordinate to those of the general creditors of the business. They have only preferred rights over the holders of common stock. In the last analysis, these certificates are nothing more nor less than certificates of preferred stock, and the amounts paid to the holders thereof in 1923, in accordance with the*1677 provisions as to dividends, are dividends and not interest payments. The decision in
12. We have already held in our decision of the first issue that the Bremen firm and the petitioner are separate and distinct taxable entities; and there is no provision of law under which the net loss of the Bremen firm for 1923 may be allowed as a deduction in computing the petitioner's net income for that year.
Reviewed by the Board.