Sherin v. Commissioner

Harry Sherin, Petitioner, v. Commissioner of Internal Revenue, Respondent. Joseph Berger, Petitioner, v. Commissioner of Internal Revenue, Respondent. Berger and Sherin, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Sherin v. Commissioner

Docket Nos. 18222, 18228, 18229

United States Tax Court

13 T.C. 221; 1949 U.S. Tax Ct. LEXIS 107;

August 19, 1949, Promulgated

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Decisions will be entered under Rule 50.

1. Petitioner corporation is held not taxable on "commissions" received by Berger pursuant to illegal agreements between Biehl and seven firms to secure preferences in amounts, allocations, and deliveries of goods manufactured by the corporation, Berger having been paid 90 per cent of such commissions, as agreed by him and Biehl.

2. Petitioner Berger filed a false and fraudulent return for the year 1941, omitting therefrom the amounts so received from Biehl. An amended return executed three days after the termination of proceedings by OPA against Berger et al., resulting in the payment of a $ 35,000 fine by him and his payment of the tax due, did not cure the fraudulent return. Aaron Hirschman, 1223">12 T. C. 1223, followed.

3. Commissioner's determination of deductible depreciation allowable to corporation, approved.

4. The corporation is entitled to an addition to its equity invested capital represented by stock issued to officers for unpaid salaries.

5. Amount of interest paid on borrowed capital determined.

6. Amount of traveling and entertainment expenses deductible by corporation determined.

7. Commissioner's allowance of traveling and entertainment expenses to Eclipse Fabrics Co., a partnership composed of the individual petitioners, approved.

Bernard Weiss, Esq., for the petitioners.

Henry C. Clark, Esq., for the respondent.

Van Fossan, Judge.

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VAN FOSSAN

The respondent determined deficiencies in the petitioners' tax liabilities and penalties as follows:

			Income tax
Docket	Taxpayer	Year
No.			Tax	Penalty
18229	Berger & Sherin, Inc	1941	$ 8,546.63	$ 4,273.31
		1941
		1942
		1942
		1943
		1944	295.44
18228	Joseph Berger	1941	None	5,936.18
		1944	3,906.00
18222	Harry Sherin	1944	2,576.00

	Declared value
Docket	excess profits tax		Excess profits tax
No.
	Tax	Penalty	Tax	Penalty
18229
			$ 13,524.52	$ 6,762.26
	$ 1,079.85	$ 539.93
			71,666.10	35,833.05
			10,374.95
18228
18222

The issues are as follows:

(1) Was petitioner Berger & Sherin, Inc., taxable on moneys received by Berger in payment of a price per yard over the ceiling price for goods manufactured by Berger & Sherin, Inc., and was its failure to report such receipts as its own income fraudulent?

(2) Was the original return for the year 1941 filed by petitioner Berger false and fraudulent in that it failed to report $ 26,905.50 so received by him in that year?

(3) May the Commissioner impose a fraud penalty on petitioner Berger for the year 1941 when he has determined no deficiency due from him for that year?

(4) The proper amount of depreciation deductible by petitioner Berger & Sherin, Inc., for the years 1940 to 1944, inclusive.

(5) Is petitioner Berger & Sherin, Inc., entitled to an addition to its equity invested capital represented by stock issued to its officers?

(6) In computing its excess profits net income, is one-half of the interest paid on borrowed capital properly added to the normal tax net income of Berger & Sherin, Inc.?

(7) Is petitioner Berger & Sherin, Inc., entitled to a deduction for 1944 of $ 3,743 as traveling and entertaining expenses?

(8) Did respondent correctly disallow to petitioner Berger, a partner in the firm known as the Eclipse Fabrics Co., the sum of $ 4,200 as his share of an item of $ 7,000 disallowed as to such company for traveling and entertainment expenses of the company for 1944?

FINDINGS OF FACT.

Petitioner Berger & Sherin, Inc., sometimes herein called the corporation, is a corporation organized in 1933 under the laws of the State of New York and is engaged in the manufacture of textile rayon goods in the gray state. It filed its income tax returns for the taxable years with the collector of internal revenue for the twenty-eighth district of New York. The individual petitioners also filed their respective income tax returns for such years with the same collector, except that petitioner Joseph Berger filed his income tax returns for the years 1942 and 1944 with the collector of internal revenue for the third district of New York.

In 1925 petitioners Berger and Sherin formed a partnership for the purpose of operating a mill manufacturing silk piece gray goods. The partnership bought 16 new looms and started a mill in Paterson, New Jersey. The mill remained in Paterson for 2 years, when it was moved to another location in that city, and 20 additional looms were purchased. In 1929 the firm moved its mill to Milton, Pennsylvania, where it remained for 3 years after installing 24 additional looms. It then moved to Elmira, New York, in 1932. At that time it owned 92 looms, having purchased 32 more in Milton.

After establishing its plant in Elmira, the firm and its corporate subscribers acquired a total of 240 looms, all of which it still has in operation, together with the necessary equipment therefor, such as slashers, spinners, wharvers, etc. As heretofore stated, the petitioner was organized in 1933. The first 16 looms cost $ 500 each; the next 20, $ 300 each; the next 24 (new), about $ 2,700, including motor; the next 24 (quilt changing), about $ 1,700 each; and the next 8 (shuttle changing), $ 1,000 each. Then 120 secondhand looms were purchased for $ 150 each. A subsequent lot of 16 looms was bought at a cost of $ 1,000 each and 8 secondhand looms at about $ 300 each. The price of the remaining 4 looms was not specified.

Upon its organization, the petitioner corporation took over the assets of the business of the partnership. It issued initially 644 shares of its stock, par value $ 100 per share, equally to Berger and Sherin. On December 15, 1936, June 20, 1942, and December 31, 1942, it issued additional 25, 32, and 32 shares, respectively, of its stock to Berger and Sherin each, making a total of 868 shares of stock outstanding up to 1945.

Petitioner Berger was president and petitioner Sherin was secretary-treasurer of the corporation. Berger was in full charge of sales and maintained an office in New York City for that purpose. Sherin supervised production in Elmira and kept the general accounting records of the corporation at its plant in that city. All funds of the corporation were kept in Elmira banks.

All sales of piece goods made by the corporation were covered by a standard form contract specifying the quantity, construction, yardage, price, and terms of payment. The corporation sold all of its accounts receivable arising from such sales to United Factors Corporation, hereinafter called United, of New York City, to whom all payments therefor were made by the corporation's customers. Shortly after the end of each month the corporation would receive a statement from United showing the sales assigned and moneys due as of the preceding month. The statements would be checked with the corporation's books. They were found to be in agreement therewith at all times.

After the middle of 1941 the demand for the corporation's goods was greater than its supply. This condition continued through 1944.

Ernest Biehl was a sales agent of the corporation and assistant to Berger in the New York office. He was not an officer, director, or stockholder of the corporation. His contract of employment provided that he would give his full time and services to the corporation and that his compensation would be $ 7,500 a year, plus one-sixth of the net profits of the corporation. He continued to work for the corporation until July 1, 1943.

Prior to 1941 Mannis & Singer, Kosiner-Silverman Co., J. Bialkin & Son, City Fabric Sales Co., G. Canelstein, Loring Fabrics, Inc., and Jorocco Silk Corporation were not customers of the corporation. In the summer of 1941 Biehl approached various customers with a proposition that if they would pay a certain percentage commission of a few cents a yard in excess of the ceiling prices he would secure for them large quantities of merchandise manufactured by the corporation and render various kinds of special services such as allocation of goods, preferential and expeditious deliveries, advice on dyeing, etc. Biehl discussed the proposal with Berger, who gave him permission to receive such commissions under the agreement that Biehl would retain 10 per cent and turn over to Berger the remaining 90 per cent thereof. This arrangement for brokerage commissions and fees was made with the concerns mentioned above, with the same division of commissions between Biehl and Berger.

The corporation had over 100 regular customers, all of whom were charged the OPA ceiling price for goods. Petitioner Sherin had no knowledge of the "brokerage commission" between Biehl and the seven firms, or of Berger's participation in it. Neither the corporation nor petitioner Sherin officially authorized Biehl or Berger to receive any amounts over the contract sales price from any of the seven customers. The corporation's books contained no items relating to such excess prices. The corporation never received any part of the illegal exactions.

Sherin first learned of the conduct of Biehl and Berger when OPA inspectors examined the corporation's books and records. Then it was disclosed to him that Biehl and Berger had accepted money from certain of the corporation's customers for special services rendered to them. Sherin remonstrated with Berger, but for the welfare of the corporation decided to drop the matter and "never talk about it again." He never discussed the situation with Biehl and he never claimed or received a share of such commissions for himself or for the corporation.

During 1941 Biehl received as commissions, as above set forth, the sum of $ 29,895, of which he gave Berger his share of 90 per cent, or $ 26,905.50, and in 1942 he so received $ 82,825, of which he gave Berger $ 74,542.50. With minor exceptions, all commissions were collected in cash and Biehl paid Berger his share in cash. By direction of Berger on September 1, 1941, Biehl opened a safe deposit box in the Chemical Trust or Chemical National Bank. The cash so collected was placed in the box to which Berger had access. The box was closed on June 26, 1942. Biehl reported his share of such receipts in his income tax returns for 1941 and 1942 under the heading, "Sundry Income from Fees." In his original return for 1941, filed March 12, 1942, Berger did not report his share of the commissions paid to him by Biehl during that year.

In August 1942 Biehl and Berger were questioned at the OPA office in New York City concerning the cash or premiums which they had received in the manner above set forth. They each denied having received such premiums or "commissions." In April 1943 an information was filed with the United States District Court for the Southern District of New York charging Biehl, Berger, and the corporation with violations of price schedules fixed by the Office of Price Administration. The charges were based on a portion of the sales, as heretofore mentioned, during the year 1942. Berger pleaded guilty and was fined $ 35,000, which he paid by his personal check dated June 1, 1943. Berger retained and paid the only counsel in the case. The fine was paid by him personally. Neither Sherin nor the corporation ever reimbursed Berger for the fine or legal fees.

On August 13, 1943, Berger filed an amended return (termed "Corrected Return") for the year 1941. The return was subscribed and sworn to on June 4, 1943. In that return he included the $ 26,905.50 as "Income from Sundry Fees." The amended return showed a tax of $ 13,225.95 while the original return indicated a tax of $ 1,355.58.

On June 4, 1943, Berger subscribed and swore to his income tax return for the year 1942. It was filed on June 17, 1943, he having obtained from the collector of internal revenue an extension of time for filing. Berger's original income tax return for 1941 was false and fraudulent and filed by him with intent to evade tax.

In his notice of deficiency the Commissioner added to Berger's income for the year 1941, based on his original return, the sum of $ 26,905.50, with the explanation, "Additional income of $ 26,905.50 received on sales made through Berger and Sherin, Inc. is held to be includible in your taxable income."

In his notice of deficiency to the corporation the Commissioner added to its income for the year 1941 the sum of $ 26,905.50, with the following explanation:

It has been determined that sales for the year 1941 in the amount of $ 26,905.50 was [sic] neither recorded on your books nor reported in the return for the year and your income has been adjusted accordingly.

He took similar action, with the same explanation, as to the sum of $ 74,542.50 received by Berger in 1942.

The excess commissions collected by Biehl and Berger, as above indicated, were not income to the corporation and the returns filed by the corporation for 1941 and 1942 were not fraudulent or filed with the intention of evading taxes due.

The rate of depreciation of the machinery and equipment owned and operated by the petitioner corporation and its predecessor partnership, as allowed by the Commissioner in prior years, was 7 1/2 per cent. The condition of the corporation's plant was very poor during the period from 1940 to 1944, inclusive. Until 1941 it could not afford to purchase new looms and after that time it could secure none, due to the refusal of manufacturers to accept orders. Consequently, it could not compete with plants operating modern machinery.

In 1940 secondhand looms comparable to those operated by the corporation were sold by manufacturers at $ 15 a loom. The purchaser would then repair and resell them.

On its returns the corporation deducted depreciation on its machinery and equipment and the Commissioner allowed such deductions, as follows:

Year	Deducted	Allowed
1941	$ 13,417.52	$ 5,329.66
1942	14,677.58	5,656.21
1943	13,387.56	5,685.26
1944	4,091.99	5,685.26

The depreciation on machinery and equipment for the same period, based on a 7 1/2 per cent rate on the adjusted basis thereof, was as follows:

1940	$ 11,206.48
1941	11,506.94
1942	10,999.42
1943	9,974.93
1944	9,303.73

The original cost of the corporation's machinery and equipment, the depreciation reserve at the beginning and end of the respective years, the percentage of depreciation reserve to cost, and the residual value at the end of each year, appearing on the corporation's books, are as follows:

	Cost of machinery	Depreciation	Depreciation
Year	and	reserve at	reserve at end
	equipment	beginning of	of year
		year
1940	$ 172,874.67	$ 108,871.00	$ 121,196.82
1941	181,093.42	121,196.82	134,614.34
1942			149,019.65
1943	186,787.33		158,040.92
1944			162,132.91

	Percentage of
	depreciation	Residual value
Year	reserve at end	at end of year
	of year to cost
	Per cent
1940	70	$ 51,677.85
1941	75	46,479.08
1942	79	37,767.68
1943	88.5	20,459.93
1944	90.5	16,367.94

During 1940 through 1944 the corporation operated its plant from 131 to 168 hours per week, in four shifts. In 1942, 1943, and 1944 it had a high turnover of employees. The breaking in of new personnel resulted in damage to the machinery, which had to be repaired constantly. Certain new parts therefor were unobtainable.

On June 30 and on December 31, 1942, the corporation issued $ 3,200 of its capital stock to Joseph Berger and Harry Sherin each, in payment of indebtedness arising from unpaid salaries. In 1940 the corporation paid $ 91.64 as interest on notes and $ 259.73 as interest on trade acceptances. In 1941 it paid $ 382.25 as interest on notes and $ 1,572.82 as interest on trade acceptances.

In its income tax return for 1944 the corporation deducted as traveling and entertaining expenses the amount of $ 3,743, of which the Commissioner disallowed $ 3,000 representing monthly payments of $ 250 each to Harry Sherin, purporting to cover such expenditures made by him. Sherin was required to make frequent trips to Allentown, Pennsylvania, Paterson and Newark, New Jersey, and New York City. Due to failing eyesight, an escort was required on such trips. The expenses of the escort were paid from the above mentioned monthly allowances. He also entertained customers in Elmira, where, as superintendent of the mill, he was required to deal with salesmen and others. He kept no accurate account of the sums so expended by him, but averaged the amount over the year. The sum of $ 2,000 is a reasonable amount allowable as a deduction for traveling and entertainment expenses paid by the corporation during 1944.

Eclipse Fabrics is a partnership formed in July 1943 by Joseph Berger and Harry Sherin for the purpose of engaging in the business of converting rayon goods. Berger had a 60 per cent interest and Sherin had a 40 per cent interest therein. In its income tax return for 1944 the partnership deducted the sum of $ 13,610.01 as traveling and entertaining expense. The Commissioner disallowed $ 7,000, of which sum Berger's share was $ 4,200, this sum being added to his income.

In 1944 Berger made two western trips of four and five weeks, respectively, on behalf of the partnership. He visited Cleveland, Chicago, Seattle, Portland, San Francisco, Los Angeles, St. Louis, Kansas City, and other cities. In each city he opened from 5 to 10 new accounts. The partnership did over $ 2,000,000 worth of business during the year and placed about 100 new accounts on its books. Biehl accompanied Berger on some of the trips. Berger paid all of his own expenses and also some of Biehl's out of the allowance of $ 200 a week. Railroad fare and some of Biehl's expenses were included in the amount allowed by the Commissioner. The amount so allowed by him was a reasonable sum for traveling and entertainment expenses.

OPINION.

The first issue presents the question whether or not the corporation is taxable on the amounts in excess of OPA ceiling prices paid by the seven "new" customers under their agreements with Biehl to obtain preferences in quantity, deliveries, and speed of shipment of goods manufactured by the corporation and to receive the benefit of other special services rendered by him.

The facts, in brief, are these:

In the summer of 1941 Ernest Biehl, sales agent and assistant of Berger, president of the petitioner corporation, with the approval of Berger, entered into agreements with seven concerns providing that he would secure large quantities of merchandise manufactured by the corporation, obtain preferential and expeditious deliveries thereof, and render other special services, in consideration of a commission or premium of a few cents a yard over the OPA ceiling price charged to all regular customers. The arrangement was made on the specific understanding that Biehl would pay to Berger 90 per cent of the profits. Biehl turned over to Berger his share of the profits as agreed. All such payments were in cash. Petitioner Sherin knew nothing of the agreement until OPA inspectors examined the corporation's books. Thereupon he disavowed any connection with or responsibility for such practices.

The standard form of contract was used and the ceiling prices of goods were stated in such contracts with the seven new customers as well as in the contracts made with other customers of the corporation. The payments of the stated prices were made to the United Factors in identical fashion and settlements were made, all on the ceiling price basis. The corporation's books show no entry in any way relating to the Biehl arrangement with the seven firms.

The respondent argues that Berger's activities in respect to the Biehl agreements and the performance by the corporation were in his capacity as president of the corporation and that, therefore, the corporation is responsible for such actions on his part for the tax consequences thereof. We do not agree with the respondent. The corporation, as such, never authorized the illegal arrangements. It never received, directly or indirectly, any of the fruits of such transactions. Albeit Berger owned 50 per cent of the corporate stock, Sherin owned an equal amount, and, on learning of Berger's action, he repudiated the illegal agreements. The corporate entity may not, in these premises, be disregarded. It has often been said that command over the income is a primary test of taxability. Here the corporation never had command over the illegal commissions. In accepting from Biehl 90 per cent of the excess payments, Berger acted for himself as an individual and not on behalf of Sherin, the other stockholder. Certainly it can not be said on the record here that he intended to act for the corporation, nor may any doctrine of estoppel be invoked to close the corporate mouth.

The action of the respondent in including the sums of $ 26,905.50 and $ 74,502.50 in the corporation's income for the years 1941 and 1942, respectively, is disapproved. Cf. Wallace H. Petit, 10 T.C. 1253">10 T. C. 1253. With the above holding as to income, the Government's case of fraud falls so far as the corporation is concerned.

The second and third issues raise the question of fraud in connection with Berger's failure to report the $ 26,905.50 received by him from Biehl in 1941. The original return for 1941 was timely filed by Berger on March 12, 1942. It was dated March 11, 1942. It did not include the $ 26,905.50 received from Biehl and showed a total tax of $ 1,353.58 due. On August 13, 1943, Berger filed an amended or "corrected" return in which he included the said $ 26,905.50 as "income from sundry fees." The amended return was sworn and subscribed to on June 4, 1943, and showed a total tax of $ 13,225.95. On June 1, 1943, he paid the fine for violation of the price schedules fixed by OPA.

Petitioner Berger contends (1) that since he paid the tax due in the amended return for 1941 and no deficiency was determined by the Commissioner for that year, the respondent is precluded from asserting a fraud penalty, and, (2) that he considered the transactions a joint venture whose fiscal year ended in 1942.

In the recent case of Aaron Hirschman, 12 T. C. 1223, we held that the petitioners, having originally filed fraudulent income tax returns, might not, by the subsequent filing of amended returns and the payment of the taxes due, eliminate the fraudulent elements from their original returns and thereby bar the respondent from assessing in respect thereto 50 per cent additions to the tax for fraud under section 293 (b) of the Internal Revenue Code.

On the authority of the Hirschman case, therefore, we hold that the Commissioner is not precluded from asserting the fraud penalty in the case at bar. We hold and have found as a fact that the petitioner Berger was guilty of filing his original income tax return for 1941 with intent to evade tax and that his return, therefore, was false and fraudulent.

On June 1, 1943, Berger paid his fine in the OPA proceeding. On June 4, 1943, he executed his amended or "corrected" return for 1941. On the same day he executed his return for 1942, including therein the $ 74,542.50 received by him from Biehl during that year. The juxtaposition of these dates is highly significant. Upon the final determination of the OPA case it became apparent that the execution of the "corrected" return for 1941 and the simultaneous execution of the 1942 return, both including the amounts received from Biehl, were clear admissions of the propriety of returning these amounts as income during the respective calendar years. Berger should have included the $ 26,905.50 so received in his original 1941 return, but he failed to do so.

This leaves only the argument that he "believed" that the amounts received by him and Biehl were from a joint venture whose fiscal year ended in 1942. This argument was not even presented in the petitioners' original brief, but was first made in the reply brief. There was testimony to the effect that Berger had some such notion, but we did not give it sufficient credence to find it as a fact. All the evidence points to the opposite conclusion. Biehl reported his share of the receipts in his returns for both 1941 and 1942. Berger is apparently a shrewd business man, fully cognizant of tax situations. It is not reasonable to suppose that Biehl, who was so closely associated with Berger in business and was his assistant, would make such return without Berger's knowledge. We have found as a fact that Berger's income tax return for the year 1941 was false and fraudulent and filed with intent to evade tax.

The next issue involves the proper rate of depreciation on machinery and equipment of the corporation during the taxable years. The petitioner does not challenge the Commissioner's right to alter the rate of depreciation when the facts warrant his so doing (see Lincoln Cotton Mills, 15 B. T. A. 680; Big Four Oil & Gas Co. v. Commissioner, 83 Fed. (2d) 891, affirming 28 B. T. A. 61), but bases his argument on the theory that the Commissioner improperly disallowed the depreciation claimed on the excessive use of such physical assets during the war years.

The petitioner corporation has shown in general terms that the plant was operated from 131 to 168 hours a week, that the turnover of employees was high, that the machinery was abused by the new and unskilled labor, and that adequate repairs could not be obtained. However, it did not prove that such factors actually resulted in a shortening of the remaining life of the machinery and equipment and thus entitled the petitioner to an amount of depreciation greater than that allowed by the respondent. In Copifyer Lithograph Corporation, 12 T. C. 728, we had the precise question before us. There we held that, where the taxpayer employs the straight line method of depreciation, as here, evidence of increased usage and other operating conditions do not, in the absence of a showing that such factors actually resulted in a shortening of the remaining useful life of the depreciable assets, warrant an allowance of abnormal or accelerated depreciation.

Upon examination of the corporation's returns the Commissioner discovered that the petitioner had been applying a rate of 7 1/2 per cent (or a 13-plus-year life) to its calculations of depreciation, although Bulletin F prescribes a life of 15 or more years for comparable equipment. He then determined that the rate should be decreased materially and made his computations accordingly. The petitioner has failed to demonstrate that the respondent has not allowed a reasonable amount of depreciation for the years in question. Therefore, his action will not be disturbed.

In the fifth issue the petitioner corporation asks for an increase in equity invested capital represented by the issuance of $ 3,200 in the corporation's stock to Berger and to Sherin on June 30 and on December 31, 1942, (or $ 6,400 to each stockholder) for unpaid salaries of equal amounts. The respondent challenges the facts on which petitioner's request is based, contending the transaction was a donation to capital. The record shows that the stock was issued for unpaid salaries and was not, as respondent suggests, a donation to capital. Berger and Sherin both accounted for the income so received in their tax returns. We sustain the petitioner.

The sixth issue is factual -- how much interest was paid on borrowed capital during 1940 and 1941? We have found from the record that the petitioner expended in this manner $ 351.37 in 1940 and $ 1,955.07 in 1941. These sums, therefore, are to be taken into consideration in computing the corporation's excess profits net income for 1941 and its unused excess profits credit carry-over for 1940.

In the seventh issue the corporation claims as expense for traveling and entertainment an item of $ 3,743. The respondent allowed $ 743, disallowing the balance. We have found that the sum of $ 2,000 is a reasonable allowance for such expenses. This item will be used in recomputing the corporate income.

In the eighth issue respondent increased petitioner Berger's income for 1944 in the amount of $ 4,200, due to his action in disallowing an item of $ 7,000 claimed by the partnership known as Eclipse Fabrics Co. for expenses of traveling and entertainment. The record made does not justify disturbing the respondent's action.

Decisions will be entered under Rule 50.