DocketNumber： Docket No. 31390
Citation Numbers： 18 T.C. 1045, 1952 U.S. Tax Ct. LEXIS 99
Judges： Black
Filed Date： 9/19/1952
Status： Precedential
Modified Date： 1/13/2023
*99
1. Mrs. Malone was an experienced and able executive of petitioner and rendered valuable services during busy war years.
2. The Commissioner in his deficiency notice has determined that "The dividend of $ 6,864.00, the payment of which occurred in February 1924 while a deficit existed, is deemed to have been paid from capital, and your equity invested capital for the years 1942 and 1943 has been reduced accordingly."
3. The Commissioner in his deficiency notice has determined that the evidence submitted to him fails to establish the forgiveness of officers' salaries in 1936 was accomplished under circumstances constituting a contribution to capital. Accordingly, he has excluded from petitioner's *100 paid-in surplus for the years 1942 and 1943 the respective amounts of $ 31,809.68 and $ 32,309.68.
4. Petitioner included moneys advanced to Leventhal Patents, Inc., in its equity invested capital, but respondent determined that these advances constitute inadmissible assets. In 1936, petitioner received stock for its expenditures of $ 54,588.79 between 1931 and 1936.
*1046 Respondent determined deficiencies in petitioner's taxes as follows:
| Declared value | ||
| excess-profits | Excess profits | |
| Year | tax | tax |
| 1942 | $ 541.20 | $ 38,910.53 |
| 1943 | 992.30 | 21,038.27 |
| Total | $ 1,533.50 | $ 59,948.80 |
*101 The contested adjustments are explained in the deficiency notice as follows:
Schedule 1A
(a) The salary of $ 18,200.00 paid to Helen Suess [Mrs. Malone] for each of the years 1942 and 1943 is deemed to be excessive to the extent of $ 8,200.00.
* * * *
Schedule 4A
* * * *
(b) Equity invested capital, claimed in the amount of $ 204,309.68, is decreased by $ 38,673.68, by reason of the following adjustments: (1) It is held that the evidence fails to establish that the forgiveness of officers' salaries in 1936 was accomplished under circumstances constituting a contribution to capital. Accordingly, there has been excluded from your paid-in-surplus for the years 1942 and 1943 the respective amounts of $ 31,809.68 and $ 32,309.68. (2) The dividend of $ 6,864.00, the payment of which occurred in February 1924 while a deficit existed, is deemed to have been paid from capital, and your equity invested capital for the years 1942 and 1943 has been reduced accordingly. * * * *
* * * *
(b) The stock of Leventhal Patents, Inc., acquired by you through the performance of experimental services which cost $ 72,521.67, is deemed to represent an inadmissible asset, and your invested*102 capital has been adjusted accordingly, computed as follows:
* * * *
It is held that in computing your excess profits tax liability for the year 1942 you are not entitled to any credit for a carry-over of unused excess profits tax credit from a prior year.
* * * *
*1047 Schedule 7A
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(b) The amount of $ 4,283.64, designated as amortization of machinery and equipment, has been disallowed in the absence of information showing the items of machinery and equipment with respect to which such amortization is claimed and the cost and times of acquisition of such items.
* * * *
By amendment to its petition, petitioner assigned additional error to the disallowance of $ 8,200 salary of Mrs. Malone for the year 1941, solely for the purpose of 1941 excess profits credit carry-over to 1942. The year 1941 is not before the Court.
The following issues have been raised by the pleadings and are now before us: (1) was $ 8,200 of the $ 18,200 annual salary paid to Mrs. Malone in 1942 and 1943 unreasonable and not allowable as a deduction, (2) was $ 8,200 of the $ 18,200 annual salary paid to Mrs. Malone in 1941 unreasonable and not an allowable deduction in computing the excess profits *103 credit carry-over to 1942, (3) should a dividend of $ 6,864 paid in 1924 reduce petitioner's equity invested capital, (4) were accrued officers' salaries which were forgiven contributions of capital includible in equity invested capital, (5) were expenditures made in performing experimental services for Leventhal Patents inadmissible assets to be excluded from equity invested capital, and (6) should Leventhal Patents expenditures be amortized between 1941 and 1948 so that the amortization deductions are allowable in the years before us.
The parties have settled issues originally raised to be given effect under Rule 50, as follows: Respondent conceded the allowance of deduction of $ 1,500 accrued for services to Joseph Gorodiz, petitioner's president, for 1943. Petitioner has conceded the following issues: (1) reduction of equity invested capital for 1943 by eliminating accumulated earnings and profits of $ 32,563.31 at the beginning of the year, (2) disallowance of salaries and wages (other than officers' salaries) of $ 2,000 for 1943 paid in contravention of Salary Stabilization Regulations, and (3) the invested capital of petitioner for the years 1940 to 1943, inclusive, should *104 not be increased in the amount of $ 20,000 representing contributions by stockholders.
FINDINGS OF FACT.
The petitioner was formerly known as Akeley Camera, Inc., a corporation organized under New York State laws on August 12, 1914, by Carl Akeley. Petitioner's name has been duly changed to Akeley Camera & Instrument Corp.
Petitioner's income and excess profits tax returns for the years here involved were filed with the collector of internal revenue for the second *1048 district of New York. Petitioner filed its returns on a calendar year and accrual basis.
Kenyon V. Painter, hereinafter called Painter, had met Carl Akeley in Africa in 1914. Akeley had a camera for taking motion pictures. Painter became interested in the camera and agreed to back him financially in its development. Petitioner in its early days made commercial moving picture cameras, tripods, and camera equipment. Painter, a stockholder, first gave financial backing to petitioner about 1919 or 1920. Petitioner always had to finance every contract it ever had and Painter provided the funds until his death in 1940.
Painter was a banker with large real estate holdings, including office buildings, *105 mercantile buildings, apartments, residences, vacant properties used as parking lots, etc. His assets in 1928 amounted to about $ 20,000,000. He lived in Cleveland, Ohio, and Painter's only business interest outside Cleveland was in petitioner.
Mrs. Helen T. Malone who, prior to her marriage, was known as Helen Suess, hereinafter called Mrs. Malone, lives at St. Joseph, Missouri. She was secretary to Painter in Cleveland from 1925 until his death in 1940, and acquired a great deal of experience and knowledge in business and financial affairs. She had been employed prior to her employment with Painter, and lived in Cleveland for about 25 years.
Painter often traveled abroad on trips lasting several months. At such times, Mrs. Malone was in general charge of running his business and affairs. This included the maintenance of the buildings, purchasing supplies, employing necessary help for operation and maintenance of buildings, boilers, elevators, etc., collection of rents and dividends, banking, and payment of all bills in connection with the business and property. While away Painter sometimes could not be reached and Mrs. Malone had the discretion and responsibility of making*106 all decisions, including sales of property up to $ 20,000. Within certain limits Mrs. Malone was authorized to make loans, in her discretion, to petitioner when they were needed. Mrs. Malone received around $ 7,500 per year as compensation from Painter, and sometimes more depending upon profits.
Painter suffered serious financial reverses in 1929, and a bank in Cleveland took over many of his assets. He thereafter decided to try to build up petitioner's business and about 1934 became active in its affairs and management. Efforts were made to start manufacturing precision instruments.
Mrs. Malone became well acquainted with the affairs of petitioner. While she was Painter's secretary she saw various documents, including *1049 minutes of meetings and correspondence, and kept acquainted with monthly statements, receipts, inventories, contracts, and, in fact, with everything petitioner was doing. In 1938, she came to New York to live in order to become more active in petitioner's business. She devoted most of her time to the business. At that time Mrs. Malone was voted a salary of $ 250 a month, but petitioner seldom was able to pay it. She continued her work with the understanding*107 that she would be adequately paid when there were sufficient earnings.
About 1937 or 1938, Painter had a heart attack and Mrs. Malone had full power of attorney over his affairs. Painter died in 1940. Mrs. Malone was sole executrix of his estate. This required her to spend some time in Cleveland to look after the estate. Since Painter's death in 1940, she continued to devote substantially all of her time to petitioner's business until 1944.
In 1938, John L. Spence, Jr., was the president of petitioner and supervised the technical aspects of the business. John Howell was secretary-treasurer and in charge of the office, which had two girl employees, and administrative work before Mrs. Malone came to New York. When Mrs. Malone became active, Howell spent more of his time selling. Spence and Howell each received a salary of $ 18,200 in each of the years 1941, 1942, and 1943, the same salary received by Mrs. Malone.
Since 1932, petitioner's principal business was manufacturing commercial moving picture cameras and tripods. It also had Government subcontracts with Sperry to make theodolites (measuring instruments) and experiment on spotting sets in conjunction with the Army Signal*108 Corps. Being on the lookout for new business, petitioner did experimental work on several inventions. Efforts were being made to obtain direct Government contracts. Petitioner received its first prime contract about 1941 to make 68 spotting sets for a total price of $ 452,000. The company was not prepared for such a large volume of business. Before receiving the award petitioner had to post a large bond requiring it to prove financial responsibility. It had to have one-fifth of the contract price in the bank. At that time the company was not in good financial condition and had only $ 54 in cash. Mrs. Malone had to arrange necessary financing from outside sources since Painter was dead and his assistance was no longer available. The company had never before borrowed money except from Painter and had no credit standing. Since Painter's death in 1940, Mrs. Malone arranged all financing necessary to perform Government contracts. The company could not have carried out Government contracts without these large borrowings.
Mrs. Malone not only negotiated loans, but had to keep track of expenditures, signing all checks, seeing to the disposition and management *1050 of the *109 money, making collections, and meeting the obligations to the banks. Collections from the Government were sometimes complicated.
For the year ending December 31, 1942, the company had prime contracts with the Government in the total amount of $ 426,000. From time to time the theodolite contract was increased by the Government until the contract provided for a contract price of around $ 600,000.
It was necessary to buy materials in advance whenever available with the result that the cash supply was usually short, but the company managed to meet all its bills.
A new purchasing department was established. During the years 1940 to 1943, Mrs. Malone was in general charge of making purchases and receiving deliveries for the company. She kept a chart which showed what was ordered each day and how deliveries had been made so that she would know when she would have to meet the bills. It was necessary to stagger the deliveries so that there would be sufficient cash in the treasury to meet the bills as they came due.
When the large contracts were taken Mrs. Malone had to assume complete charge of running the office and nontechnical part of the business. Petitioner had never had that amount*110 of business before. It was necessary to revise each department and add personnel, to rent additional office space and install a new bookkeeping system required by the Government. The Government required a change in the inventory system so that physical inventories would be taken. Mrs. Malone worked on setting up the new system. Mrs. Malone had supervision of the books and checked all trial balances. A bookkeeping department was added under her supervision, employing about five girls who had to be taught the bookkeeping system. She was responsible for hiring and firing of the office help.
Petitioner was classified by the Government as "top secret." Employment was a problem. New shop men were employed by the foremen, but such employment had to be approved on security forms by the Government. Many employees were foreign born. Mrs. Malone reviewed all applications for employment, was responsible for the security forms and screened the employees.
In charge of budgeting and financing, Mrs. Malone took part in renegotiation of contracts and tax matters with Government representatives. She often consulted with petitioner's attorneys and had to approve all contracts. She worked *111 with the Government expediters in obtaining scarce materials. In submitting bids to the Government and making estimates, she took a part.
Everyone, including Mrs. Malone, put in considerable overtime. During 1942 and 1943, the Government awarded petitioner contracts up to $ 1,000,000. There was a great increase in petitioner's business *1051 from 1940 through 1944. The increase was due largely to making precision instruments for the Government. Gross sales increased as follows:
| Year | Sales |
| 1940 | $ 53,641.78 |
| 1941 | 199,490.91 |
| 1942 | 452,686.84 |
| 1943 | 588,783.30 |
About 1940, Mrs. Malone became assistant secretary and treasurer. On April 10, 1941, the board of directors authorized annual salaries of $ 18,200 each to Spence, Howell, and Mrs. Malone, commencing in 1941. It was intended to compensate Mrs. Malone for services performed not only in the year when she received her salary, but for past years when she had received insufficient compensation. She reported this annual salary of $ 18,200 in her 1941, 1942, and 1943 income tax returns.
Mrs. Malone has never been a stockholder in the petitioner and she is not related to any stockholder. She possessed business ability*112 and was the executive responsible for financial arrangements and office management, as well as participating in the general management. These were hectic war years during which petitioner's business expanded very rapidly. The annual salary of $ 18,200 paid to her in 1941, 1942, and 1943 was for services actually rendered to petitioner, past and present, and was reasonable.
Petitioner paid dividends of $ 6,864 in February 1924. As of December 31, 1923, petitioner had an operating deficit of $ 10,215.54, but for the year 1924, a net income of $ 16,400.71.
Painter had deposited his 8,000 shares of stock of petitioner as collateral for a loan with the Union Trust Company of Cleveland. In 1932 that bank closed, and in winding up its affairs a suit was instituted against Painter, Howell, and Spence in connection with petitioner. In 1935, a settlement was made whereby, in consideration of the payment of money, the bank sold to Painter's wife these 8,000 shares of stock and an account receivable of $ 6,672 salary owed to Painter by petitioner. In 1935, Howell owned 3,175 shares of stock in the Akeley Company and Spence owned 3,275 shares. After the 1935 settlement*113 Mrs. Painter, Howell, and Spence were the only stockholders.
The account receivable of $ 6,672 which had been sold to Mrs. Painter by the Union Trust Company was never paid by petitioner. In 1936, *1052 she canceled the indebtedness as a contribution to capital. Spence was owed back salary by the Akeley company as of June 1936 in the amount of $ 13,761.02, which was never paid. In 1936, he relinquished this claim as a contribution to capital. Howell was owed unpaid salary in the sum of $ 15,676.54 as of June 1936. In 1936, this claim was relinquished by Howell as a contribution to capital. These salaries had been accrued on the books. The forgiveness of officers' salaries in 1936 constituted contributions to petitioner's capital includible in equity invested capital.
J. L. Spence, Jr., and J. F. Howell, who were officers of petitioner, were also officers of Leventhal Patents, Inc., which was incorporated in 1931. On June 23, 1931, Spence and Howell entered into an agreement to conduct experiments for Leventhal Patents, Inc., in return for which they were to receive stock of the corporation for themselves. Leventhal Patents owned valuable patents.
*114 Between 1931 and 1936, petitioner spent $ 54,588.79 doing experimental work for Leventhal Patents. Petitioner's original intention was to be paid for its work and to share in future profits by mass producing certain instruments. Petitioner did not make the expenditures as a stock investment, and did not originally intend to acquire the stock of Leventhal Patents. No stock was received for the $ 54,588.79 spent prior to 1936, and the expenditures were entered in the books as sales and accounts receivable. However, Leventhal Patents was unable financially to pay petitioner for its work. In order to salvage its expenditures, petitioner entered into a contract on November 30, 1936, with Howell, Spence, and Leventhal Patents, Inc., under which petitioner took over the stock rights of Howell and Spence in Leventhal Patents and also could purchase preferred stock in the future. Petitioner had not acquired any stock up to that time for its expenditures. As a result of the assignment petitioner received stock of Leventhal Patents for its expenditures.
Subsequent to the 1936 contract, petitioner began to receive Leventhal Patents stock in proportion to its expenditures. Those subsequent*115 expenses amounted to $ 18,000. Petitioner completed 10 or 15 projectors under the Leventhal Patents by 1941 but they were not successful. It put nothing further into the venture after 1941. The expiration date of the Leventhal patents was 1948. In 1948, there was a settlement between petitioner and J. F. Leventhal for Leventhal Patents. Petitioner received $ 8,000 in cash and retained the physical assets, including tools, dies, jigs, etc., most of which were finally sold for scrap.
*1053 Subsequent to the contract of November 30, 1936, petitioner became an investor in Leventhal Patents as evidenced by its receipt of stock for its experimental services and expenditures.
OPINION.
There are six issues raised in this proceeding and they have already been stated in our preliminary statement.
The respondent determined that $ 8,200 of $ 18,200 annual salary received by Mrs. Malone in 1942 and 1943 is unreasonable salary and should not be allowed as a deduction. The development of petitioner's business and Mrs. Malone's position have been traced in considerable detail in our Findings of Fact. After consideration of all the evidence, we found as an ultimate fact that*116 $ 18,200 annual salary of Mrs. Malone was reasonable. The experience, ability, and responsibility of Mrs. Malone were of essential importance to petitioner. These were hectic war years and petitioner having large Government contracts expanded rapidly. Mrs. Malone rendered valuable services to the corporation in an executive capacity, being primarily responsible for financial and administrative matters and much of the general management. In fact, from the evidence at the hearing we would conclude that Mrs. Malone was petitioner's most valuable employee and executive. The other two executives also received $ 18,200 annually. Mrs. Malone was not a stockholder, nor related to the stockholders, but was a bona fide employed executive. We find no reason at all to disturb the salary which petitioner's directors and officers decided to pay Mrs. Malone and which was, in fact, paid to her. On this first issue, we hold that $ 18,200 annual salary of Mrs. Malone in 1942 and 1943 was reasonable and a deductible expense.
The respondent made a similar disallowance of $ 8,200 of the $ 18,200 annual salary received by Mrs. Malone in 1941. Petitioner assigns error to this disallowance*117 only as affecting the unused excess profits credit to be carried forward in 1942, which year is before the Court. The year 1941 is not now before us, but
*1054
Petitioner paid a $ 6,864 dividend in February 1924. As of December 31, 1923, petitioner had an operating deficit of $ 10,215.54, but for the year 1924 a net income of $ 16,400.71 was derived. Respondent determined that equity invested capital for the years 1942 and 1943 should be reduced by $ 6,864, contending that dividends paid in 1924 were paid out of capital since they are to be deemed paid as of December 31, 1923. Petitioner's position is that these dividends*118 were paid from 1924 earnings. It must be remembered that the question we have here to decide is not what was petitioner's invested capital in 1923 and 1924. If that were our question there would probably be merit in respondent's contention. Our question is to determine petitioner's invested capital for 1942 and 1943 under
(b) Reduction in Equity Invested Capital. -- The amount by which the equity invested capital for any day shall be reduced as provided in subsection (a) shall be the sum of the following amounts -- (1) Distribution in previous years. -- Distributions made prior to such taxable year which were not out of accumulated earnings and profits;
Petitioner treated the $ 6,864 as paid out of earnings. Assuming respondent is correct and the payment was from capital, a deduction of $ 6,864 follows by applying
In accounting terminology, the final result of a declaration and payment of a dividend is a credit entry to cash and debit entry to either earned surplus or capital. Respondent debits (reduces) the capital account, while petitioner debits (reduces) earned surplus. But since the effect on equity invested capital is in issue and equity invested capital is computed by adding the balance in capital account and earned surplus (
The respondent excluded from equity invested capital $ 31,809.68 from 1942 and $ 32,309.68 from 1943, representing the forgiveness of officers' salaries in 1936. These officers were stockholders of petitioner and the facts show that in executing forgiveness of their accrued salaries in 1936, they clearly intended to make a contribution to petitioner's paid-in surplus and thus improve the financial condition of petitioner. Petitioner credited paid-in surplus for these salaries. However, respondent argues that the salaries were unreasonable, that the salaries were owed to stockholders and were not in fact paid and subsequently repaid to petitioner, and concludes that the credit should have been to earned surplus. Respondent also raises the question that capital has been increased twice because of the forgiveness of salaries. Respondent has not made clear whether he has abandoned any of these arguments.
*121 Respondent's argument that earned surplus should be credited is analogous to his argument in Issue 3 above. Forgiveness of accrued salaries owed by petitioner results accountingwise in a debit (decrease) to accounts payable and a credit (increase) to either paid-in surplus or earned surplus. Since by definition equity invested capital is made up by addition of several factors, including paid-in surplus and earned surplus (
Moreover, respondent's argument that the accrued salaries were unreasonable in the years accrued, 1931 to 1936, is also irrelevant. In those years the salary accounts were accrued as expenses, consequently reducing profits. If the salaries of those earlier years are now disallowed as expenses, then the earnings of those years should be increased and hence accumulated earnings and profits would thereby be increased the exact same amount. Since equity invested capital is in issue and includes accumulated earnings and profits, *122 the disallowance of ureasonable salaries automatically increases equity invested capital the same amount.
Of course, the proprietorship account should be increased only one time, whether it be the paid-in surplus or earned surplus account is irrelevant for the issue involved here. Equity invested capital should *1056 be increased by the forgiveness of officers' salaries, who were also stockholders, but should be increased only one time. Respondent seems to make some kind of an argument in his brief that he may have already increased petitioner's equity invested capital by the amount of this forgiveness of indebtedness. Of course, if that has been done it should not be done again. However, there is nothing before us to indicate that it has been done. A Rule 50 computation should follow what we have decided as to this issue.
The question presented here is whether the moneys advanced to Leventhal Patents constitute inadmissible assets to be excluded from equity invested capital.
The fact that the stock was acquired to salvage a bad debt is not germane here. In
Petitioner amortized the $ 54,588.79 expenditures in Leventhal Patents made between 1931 and 1936 over the period from 1941 to 1948. In 1941, petitioner let the venture become inactive by not putting any more money in it and in 1948 the patents expired. Aliquot*125 portions of these amortization deductions in 1942 and 1943 were disallowed by respondent. As stated in the preceding Issue 5, the petitioner spent $ 54,588.79 in experimental services for Leventhal Patents and for these services was reimbursed in shares of stock in 1936. There is, therefore, no basis for an allowance for amortization of what are considered as development expenses by the petitioner, inasmuch as the asset which would have been the subject of an annual amortization or depreciation adjustment has taken the form of a stock investment on the petitioner's books. Stock is not a depreciable asset. We hold for the respondent and disallow these deductions.