Stein v. Commissioner

Estate of Esther M. Stein, Deceased, Samuel Stein, Executor and Samuel Stein, et al., ^{Stein v. Commissioner}

Docket Nos. 47465, 47466, 47467, 47475

United States Tax Court

25 T.C. 940; 1956 U.S. Tax Ct. LEXIS 279;

January 31, 1956, Filed

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Decisions will be entered under Rule 50.

National Thread Company, Inc., (NTC), was organized by the father of Esther M. Stein in 1913. Esther was NTC's sole stockholder from 1916 until January 27, 1944, on which date she transferred all her stock to Samuel Stein, her husband. Esther died on March 27, 1944. Prior to the years in issue (1942-1945) Esther directed NTC's affairs and, although she remained active until her death, Samuel took an increasingly greater part, and was dominant (as between himself and Esther), in running NTC from about 1942 on. Carolina Thread Mills (Carolina) was a business name registered by Samuel.

1. It was stipulated that certain sales made in the names of NTC, Carolina, and Samuel, the proceeds of which were for the most part deposited in Samuel's and Esther's bank accounts, were not reported by any of the petitioners. Petitioners contend that they were sales by Samuel in his individual capacity. Held, the sales were those of NTC taxable first to it and then, as corporate distributions, to NTC's stockholder. Held, further, certain minor amounts of deposits to Esther's bank accounts in 1942 and 1943 represented unreported income to her. An estimated 50 per cent of certain other deposits to Samuel's and Esther's bank accounts during the years in issue were unreported proceeds of sales by NTC and represented income taxable first to it and then, as corporate distributions, to NTC's stockholder. Held, further, petitioner NTC is entitled to deduct as cost of goods sold, in addition to the amounts already deducted, 25 per cent of the above unreported sales during each year in issue as representing cash purchases of merchandise not recorded on its books.

2. Held, prior to January 27, 1944, NTC was owned entirely by Esther, its sole stockholder of record. Thereafter it was owned entirely by Samuel. NTC's corporate distributions during the years in issue must be taxed accordingly.

3. NTC was on the accrual basis. Samuel and Esther were on the cash basis. The proceeds of some of the stipulated unreported sales were not received by Samuel or Esther until the year following the applicable sale. Held, such proceeds cannot be taxed as corporate distributions to Samuel or Esther until the year of receipt.

4. Held, for each year in issue NTC is entitled to deduct "traveling and selling expenses" $ 1,000 in excess of those allowed by respondent.

5. Held, deductions claimed for "traveling," "entertainment," and "necessary" expenses incurred by Samuel and Esther on NTC's behalf disallowed for lack of substantiation.

6. Held, the returns filed by NTC for 1942, by Samuel and Esther jointly for 1942, and by Samuel for 1943, were not false or fraudulent with intent to evade tax and assessment of deficiencies applicable to those returns is barred by the statute of limitations. Held, further, the returns filed for 1943 by NTC and by the Estate of Esther were false and fraudulent with intent to evade tax and assessment of deficiencies applicable to those returns is not barred by the statute of limitations.

7. Held, portions of the deficiencies determined against NTC for 1943, 1944, and 1945, against the Estate of Esther for 1943, and against Samuel for 1944 and 1945, were due to fraud with intent to evade tax and the Commissioner's imposition of fraud additions for those years is sustained.

8. Held, although assessments of deficiencies against Samuel and Esther jointly for 1942, and against Samuel for 1943, are barred by the statute of limitations, the full 25 per cent of the difference between the tax he and Esther reported for 1942, and their correct tax for that year is, under section 6(d) (2) of the Current Tax Payment Act of 1943, includible in the deficiency determined against Esther for 1943.

9. Held, fraud additions applicable to NTC's 1943 excess profits tax deficiency must be calculated as 50 per cent of the total deficiency for such year. It is not calculated by first deducting from the deficiency the 10 per cent postwar refund credit allowed under section 780(a) of the 1939 Code, and then taking 50 per cent of the remainder.

10. Held, in calculating NTC's earnings and profits available for dividends, each fraud addition here determined against NTC must be deducted in the year in which the return, to which the fraud addition applies, was filed.

11. Held, Samuel and Esther received their distributions from NTC under a claim of right and without restriction as to use. Consequently, those distributions impairing capital are (after allowance for tax-free recovery of the cost of NTC's stock) taxable to them as capital gains, as the Commissioner has determined.

Joseph Getz, C. P. A., and Murray L. Brinn, Esq., for the petitioners.

William G. O'Neill, Esq., and Maurice E. Stark, Esq., for the respondent.

Black, Judge.

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BLACK

The Commissioner determined the following deficiencies, and additions for fraud, in the taxes of the petitioners herein:

Docket No. 47467 -- National Thread Company, Incorporated
	Deficiencies
Year				Additions for
		Declared value		fraud
	Income tax	excess-profits	Excess-profits
		tax	tax
1942		$ 322.81	$ 16,878.52	$ 9,180.32
1943	$ 8.73	8,271.58	65,915.68	37,563.66
1944	3,136.19	39,332.25	21,234.23
1945	2,812.22	8,070.09	62,677.21	36,779.77

Docket No.	Petitioner	Year	Income tax	Additions for
			deficiency	fraud
47465	Estate of Esther M. Stein, Deceased,	1942	$ 8,418.61	$ 4,209.31
	Samuel Stein, Executor, and
	Samuel Stein.
47466	Estate of Esther M. Stein, Deceased,	1943	22,389.07	11,194.54
	Samuel Stein, Executor.
47475	Samuel Stein	1943	20,998.12	10,499.06
		1944	15,885.73	7,942.87
		1945	33,581.04	16,790.52

For convenience the corporate petitioner, National Thread Company, Incorporated (Docket No. 47467), will sometimes hereinafter be referred to as NTC; the fiduciary petitioner, Estate of Esther M. Stein, Deceased, et al. (Docket Nos. 47465, 47466), and its decedent, will sometimes hereinafter be referred to, respectively, as the estate and Esther; and the individual petitioner, Samuel Stein (Docket Nos. 47465, 47475), will sometimes hereinafter be referred to as Samuel.

Many adjustments were made by the Commissioner in his determination of the deficiencies and additions for fraud. Some of these were either not contested by petitioners, were disposed of by stipulation of the parties, or were conceded or abandoned on brief. They will be reflected in the computations under Rule 50.

The issues remaining for consideration may be stated as follows:

Issues Applicable to All Petitioners.

1. It was stipulated that the following proceeds of sales made in the names of Samuel, Carolina Thread Mills, and NTC were received by Samuel and/or Esther and were not reported by any of the petitioners herein:

Year	Amount
1942	$ 1,092.36
1943	59,882.06
1944	35,784.36
1945	59,504.85

Were those sales actually sales of NTC, resulting in the proceeds thereof being reportable both as income by NTC and as corporate distributions by NTC's stockholders? Or were they the sales of Samuel and reportable as taxable income only by him?

2. The following bank deposits (among others) were made during the years in issue to the accounts of Samuel and Esther:

Year	Amount
1942	$ 8,478.06
1943	11,413.67
1944	2,985.23
1945	35,986.61

Were portions of those deposits, not in excess of (from 1942 to 1945, respectively) $ 6,595.63, $ 4,459.78, $ 1,794.66, and $ 34,817.86, receipts from unreported sales of NTC and therefore taxable both to NTC and (as corporate distributions) to NTC's stockholders? If not, were they taxable income, in whole or in part, of Samuel and/or Esther?

3. In determining the unreported net income from the sales referred to in issue 1 and (if any bank deposits are found to represent unreported sales) in issue 2, should deductions be allowed for cost of merchandise applicable to those sales? If so, in what amounts?

Issues Applicable to NTC.

4. Did the Commissioner err in disallowing, for lack of substantiation, the following amounts of NTC's claimed deductions for "traveling and selling expenses"?

Year	Amount
1942	$ 2,250.00
1943	2,500.00
1944	2,500.00
1945	3,724.85

5. Is any part of NTC's deficiencies for each of the years in issue due to fraud?

6. If the answer to 5 is in the affirmative, then should the calculation of the 50 per cent addition for fraud applicable to the excess profits tax deficiencies for 1942 and 1943 be made only after first deducting from each of those deficiencies the postwar refund credit of 10 per cent allowed under section 780(a) of the Internal Revenue Code of 1939?

7. Are the assessments of deficiencies for 1942 and 1943 barred by the statute of limitations?

Issues Applicable to the Estate of Esther M. Stein and to Samuel.

8. Prior to Esther's death on March 27, 1944, who, as between Samuel and Esther, owned the stock of NTC and in what proportions did they own it?

9. If it is found that Esther and/or Samuel received distributions from NTC as detailed in issue 1, then should those distributions be included in their income for the year in which NTC made the sales resulting therein, or for the year in which Esther and/or Samuel actually received the proceeds of those sales?

10. If it is found that Esther and/or Samuel received distributions from NTC as detailed in issues 1 and 2, then --

(a) in calculating NTC's earnings and profits, so as to determine what parts of those distributions are taxable to Esther and/or Samuel as constructive dividends, at what time should the additions determined herein (if any) to NTC's taxes for fraud be deducted therefrom;

(b) to the extent that those distributions exceed NTC's earnings and profits and the adjusted basis of NTC's stock, are they taxable as capital gains to Esther and/or Samuel or are they nontaxable as not having been received under a claim of right?

11. Did the Commissioner err in disallowing, for lack of substantiation, the following claimed deductions for expenses in connection with employment and in connection with transactions entered into for profit?

	Esther and
Year	Samuel (joint	Esther	Samuel
	return)
1942	$ 950
1943		$ 650	$ 640
1944			1,525
1945			1,785

12. Is any part of Esther's and Samuel's deficiencies for each of the years in issue due to fraud?

13. Are the assessments of deficiencies in Esther's and Samuel's income taxes for 1942 and 1943 barred by the statute of limitations?

FINDINGS OF FACT.

Many of the facts were stipulated, are found as stipulated, and the stipulation is incorporated herein by reference.

Petitioner NTC was organized under the laws of the State of New York. It kept its books and filed its returns on the accrual basis. Samuel Stein and Esther Stein were husband and wife, had no children, and lived in New York City. They filed a joint income tax return for 1942, which they both signed. Esther died on March 27, 1944, prior to her filing a return for 1943, and Samuel, who was appointed her executor, filed and signed a 1943 individual return for the deceased. Samuel also filed individual returns for himself for 1943, 1944, and 1945. Esther's and Samuel's returns were filed on the cash basis. All petitioners filed their returns with the collector of internal revenue for the second district of New York.

Samuel was born in Russia and came to the United States when about 15 years old. At the time of the hearing in this cause he was 78 years old, in poor health and, since about 1941, has been afflicted with cataracts making it difficult for him to read without the aid of a magnifying glass. Samuel received very little formal education in Russia and none in the United States. However, he understands English, can read and speak it well, and can write it a little. He is an experienced businessman notwithstanding his limited education.

Following his arrival in this country Samuel held a series of jobs in men's retail clothing stores and, for a short unsuccessful period, he and another man were equal partners in such a store. In 1908, he married Esther. At that time Esther's father was conducting a sole proprietorship business engaged in sales of trimmings and thread.

In May 1913, Esther's father formed NTC with 50 shares of capital stock, 48 of which he owned. By 1916, those 50 shares had been transferred to Esther, and an additional 50 had been issued to her with the result that Esther became sole owner of all of NTC's stock. The par value and amount paid in for that stock was $ 10,000. Esther's father made Samuel president and treasurer of NTC in 1913 (and Samuel signed all the stock certificates as such), but those offices were only nominal and Samuel then had no financial interest in, nor voice in the running of, NTC. In fact Samuel did not begin working for NTC until 1915, at which time he became a salesman and was paid a salary. Esther was then in complete charge of the business.

Until 1923, NTC was engaged solely in wholesale selling of thread, commonly termed jobbing. In that year it began, and has thereafter continued, manufacturing operations. This latter consists of buying natural yarn, customarily from mills, having it mercerized and dyed by a subcontractor, and then "converting" it into lots of varying yardages and weights on different sizes of cones, tubes, and wooden spools per the specifications of customers (who were generally clothing manufacturers). The converting operation was performed in a plant in Hoboken, New Jersey, by Carolina Thread Mills (hereinafter sometimes referred to as Carolina) which was a business name registered by Samuel in New Jersey and later in New York. Samuel supervised the work of Carolina, and NTC gave Samuel cash each week to meet Carolina's payroll, cash with which to meet Carolina's rent, and additional cash for him to pocket as a "profit." Carolina was, in essence, a subsidiary of NTC.

In 1935, Carolina's equipment was transferred from Hoboken to NTC's place of business in New York City and NTC absorbed, and thereafter carried on under its own name, Carolina's converting operations. The move was made because Samuel found it too difficult to commute to Hoboken. At that time Samuel asked Esther to transfer to him some stock in NTC but Esther refused, promising instead to pay him a share of the corporation's profits. It was Esther's practice to give Samuel cash from NTC when he needed it.

In 1943, as a result of further discussions regarding Samuel's share in the business, Esther converted most of her individual bank accounts into joint accounts with Samuel, giving him for the first time power to make withdrawals therefrom. On January 27, 1944, Esther, who was in poor health, gratuitously transferred all her stock in NTC to Samuel.

Esther remained active in running NTC's business and shaping its policies until just prior to the transfer of her stock to Samuel. Samuel, however, took an increasingly larger part in the executive functions as each year went by and was the more dominant of the two from about 1942 on. He was then NTC's president and chief administrative officer in fact as well as in name.

NTC paid no dividends during the years in issue. It paid Samuel and Esther, and they reported, the following salaries: ^{YearSamuelEsther1942$ 6,000.00$ 6,000.0019436,000.006,760.8519448,717.415,842.86194511,933.24}

The only other item of income reported by them in each year was identified simply as interest income (containing no explanation of the source). The amounts thereof reported, and the gross incomes (i. e., interest income plus salaries from NTC) and net incomes reported by them, follow:

	Reported by Samuel			Reported by Esther
Year
	Interest	Gross income	Net income	Interest	Gross income	Net income
1942	$ 1,462.50	$ 13,462.50	$ 4,803.06	1	1
1943		6,000.00	4,810.00	$ 1,585.04	$ 8,345.89	$ 5,425.19
1944	1,485.00	10,202.41	6,615.15		5,842.86	4,373.05
1945	1,788.25	13,721.52	9,358.87

On its returns for each year in issue NTC reported the following sales, cost of goods sold, gross profit from sales, and net income (or loss): *947

Year	Sales	Cost of goods	Gross profit	Net income
		sold		(or loss)
1942	$ 501,133.20	$ 420,800.39	$ 80,332.81	$ 6,864.33
1943	490,633.21	416,355.20	74,278.01	6,510.43
1944	467,856.31	389,924.52	77,931.79	15,397.19
1945	410,659.92	336,260.67	74,399.25	(1,533.60)

NTC's accumulated earnings and profits available for dividends as of January 1, 1942, were $ 57,893.14.

NTC claimed in its returns, and respondent took the following action in regard to, deductions for "traveling and selling expenses":

		Respondent's action
Year	NTC's claim
		Allowed	Disallowed
1942	$ 4,990.03	$ 2,740.03	$ 2,250.00
1943	4,608.27	2,108.27	2,500.00
1944	7,651.00	5,151.00	2,500.00
1945	6,994.64	3,269.79	3,724.85

The amounts disallowed by respondent were in general represented by checks drawn either to the order of Samuel or to "cash" and not substantiated by any further records. Some of those checks were actually reimbursements to Samuel and NTC's salesmen for traveling and selling expenses incurred by them. For each of the years in issue NTC's traveling and selling expenses were $ 1,000 in excess of those allowed by respondent.

Samuel and Esther claimed the following deductions on their returns for unreimbursed "traveling," "entertainment," and "necessary" expenses incurred on behalf of NTC:

	Esther and
Year	Samuel (joint	Esther	Samuel
	return)
1942	$ 950
1943		$ 650	$ 640
1944			1,525
1945			1,785

Respondent disallowed these claimed deductions. Petitioners failed to prove that these expenditures were actually incurred.

It was stipulated that, during the years in issue, sales of natural yarn and thread were made in the names indicated in the following table and that those sales were not reported in the returns of any of the petitioners. The table also shows the portion of the proceeds of each year's unreported sales which was not actually received until the following calendar year:

	Unreported sales in name of --				Portion of
				Total	proceeds not
Year				unreported sales	received till
	Samuel Stein	Carolina	NTC		year following
		Thread Mills			sale
1942		$ 1,092.36		$ 1,092.36
1943	$ 20,622.94	33,108.72	*294 $ 6,090.40	59,822.06	1944	19,620.32	16,164.04		35,784.36	3,364.84
1945	32,308.37		59,504.85	3,285.84
Totals	$ 72,551.63	$ 50,365.12	$ 33,286.88	$ 156,203.63

The proceeds of these unreported sales were received in checks by Samuel and/or Esther, which checks were cashed by them in 1942 and were either cashed or, except as noted in footnotes 1 and 2 of the above table, were deposited (a) in their joint bank accounts in 1943, (b) partially in those joint accounts, but mostly in Samuel's individual accounts in 1944, and (c) entirely in Samuel's individual accounts in 1945.

The above unreported sales were made to purchasers who simply ordered from NTC's offices without specifying or caring about the seller's name which appeared on the invoices received by them covering the purchases. The purchasers wrote their checks in payment for an order to whichever of the three names happened to appear on the invoice relating thereto. It was Samuel who decided in which of the three names a sale was to be billed. As regards the sales billed in his or Carolina's name, Samuel performed no services relating thereto, and exerted no efforts to make such sales, which in any way differed from the normal services and efforts performed by him as president of NTC.

The sales were made from stocks of yarn and thread located in one stockroom on NTC's premises. There was no physical segregation of that stock into lots purporting to be owned by Samuel or Carolina, as distinguished from NTC. All the above sales (in no matter whose name) were made from stock which was purchased by, and belonged to, NTC.

When Samuel discovered that some of the proceeds of sales made in NTC's name in 1943 and 1945 were deposited in NTC's bank account (as per footnotes 1 and 2 of the above table), he had the bookkeeper credit those amounts to him in NTC's "Loans and Exchanges" account. In certain other instances where sales had been originally entered on NTC's books, Samuel removed them from those books by ordering the bookkeeper to make entries for credit memos (implying returned merchandise) despite the fact that no such merchandise was returned by the purchasers.

Prior to 1943, the practice generally followed was to include in NTC's income any sales made in Carolina's name and NTC reported its income for tax purposes with such sales (except those comparatively small amounts stipulated as unreported in 1942) included therein.

NTC had a regular set of books which was kept by a bookkeeper who took instructions both from Samuel and the independent accountant (now deceased) retained by NTC. A charge book containing duplicate copies of invoices was maintained for Carolina and it appears that some other records also were kept for Carolina. The evidence does not show that any business records were kept for Samuel individually other than copies of the invoices sent out in Samuel's name.

The aforementioned unreported sales stipulated for 1942 through 1945 were all sales of NTC and the proceeds thereof are taxable first to NTC and then, as corporate distributions (the nature of which will be discussed), to Esther in 1942 and 1943 and to Samuel in 1944 (except for the $ 2,417.84 received prior to January 27, 1944) and 1945.

Respondent, in the deficiency notices applicable to the petitioners herein, determined that certain "unexplained" or "unidentified" bank deposits made to the accounts of Samuel and/or Esther were taxable to NTC as additional unreported income from sales, and taxable to Esther and/or Samuel as constructive dividends from NTC. Respondent later (a) stipulated that certain of those deposits did not represent additional income to any of the petitioners, and (b) stipulated that certain other of those deposits did not represent additional income to NTC but continued to allege that they represented additional unreported income to Samuel and/or Esther. The following table is illustrative:

"Unexplained" or "Unidentified" Bank Deposits
			Deposits in issue
	Originally
	determined
	taxable to	Stipulated not		Stipulated not	Alleged taxable
Year	NTC and to	taxable to any		taxable to	both to
	Samuel &/or	petitioners	Remaining	NTC but	NTC and to
	Esther		total	alleged taxable	Samuel &/or
				to Samuel	Esther
				&/or Esther
1942	$ 17,594.02	$ 9,115.96	$ 8,478.06	$ 1,882.43	$ 6,595.63
1943	22,033.83	10,620.16	11,413.67	6,953.89	4,459.78
1944	7,004.56	4,019.33	2,985.23	1,190.57	1,794.66
1945	37,004.98	1,018.37	35,986.61	1,168.75	34,817.86
Total	$ 83,637.39	$ 24,773.82	$ 58,863.57	$ 11,195.64	$ 47,667.93

The deposits were made (a) to Esther's individual bank accounts in 1942, (b) to Esther's individual accounts and to the joint accounts of Samuel and Esther in 1943, (c) to Samuel's individual accounts and to the joint accounts in 1944, and (d) to Samuel's individual accounts in 1945.

A breakdown of the $ 11,195.64 in deposits alleged by respondent to represent additional unreported income to Samuel and/or Esther (but not to NTC) follows:

Source of deposits	1942	1943	1944	1945	Total
U. S. Govt. bond
interest		$ 604.10	$ 1,190.57	$ 68.75	$ 1,863.42
Jewel Cotton Mills bond
interest				150.00	150.00
Rent -- Paradise Inn		1,100.00		750.00	1,850.00
Rent -- Normandie Hotel		5,000.00			5,000.00
Checks drawn on banks
in upper N. Y. State	$ 1,882.43	249.79			2,132.22
Max Broder				200.00	200.00
Totals	$ 1,882.43	$ 6,953.89	$ 1,190.57	$ 1,168.75	$ 11,195.64

During the years in issue, United States Government bonds were purchased by Samuel and/or Esther at the following costs:

Year	Cost
1942	$ 43,375
1943	29,125
1944	44,000
1945	70,000
Total	$ 186,500

The bonds were purchased in their joint names, except for a small amount which was taken in Esther's name only. Some of the bonds were bought entirely with Esther's money.

Petitioners concede that the $ 604.10 in United States Government bond interest for 1943 is taxable to Esther and was not reported by her. In 1944, Samuel reported $ 294.43 more in interest income than he received from United States bonds; and in 1945, he reported $ 1,569.50 more in interest income than he received from United States and Jewel Cotton Mills bonds. The source of this additional interest which Samuel reported in 1944 and 1945 is unexplained but there is no claim by petitioners that it does not represent taxable income in the years when reported.

Esther owned the Paradise Inn, a summer roominghouse near South Fallsburg, New York, and the Normandie Hotel, a summer resort hotel in Liberty, New York -- both of which are in the Catskill Mountain area of New York State. During 1942, Esther herself operated the two properties. She rented them to others for operation in 1943, and Paradise Inn was so rented in 1945, after her death. The income received from such rentals (in amounts set forth in the above table) was not reported by Esther or Samuel. However, there were incurred allowable, but unclaimed, deductions attributable and at least equal to that income.

Between May 11 and September 12, 1942, Esther deposited to her account in the South Fallsburg National Bank 6 checks, totaling $ 1,882.43, which were drawn by others on banks in Liberty, New York, in the following sequence: $ 1,500, $ 130.43, $ 50, $ 52, $ 50, and $ 100. Those checks represented income to her from the Normandie Hotel, which income she failed to report in 1942. In 1943, there were deposited to Esther's and Samuel's joint account in the same bank 5 checks, totaling $ 249.79, drawn on banks in Hurleyville, Albany, and Woodridge, New York, in the following sequence: $ 50 on August 13 and, all on December 20, $ 36.62, $ 6.78, $ 137.49, and $ 18.90. Those checks do not represent additional income to Esther or Samuel.

The $ 200 received from Max Broder in 1945 was in repayment for a loan and did not represent taxable income to Samuel.

As aforementioned, the remainder of the deposits in issue (totaling from 1942 to 1945, respectively, $ 6,595.63, $ 4,459.78, $ 1,794.66, and $ 34,817.86) are alleged by respondent to represent additional unreported income both to NTC and (in the nature of constructive dividends) to Samuel and/or Esther. It was heretofore found that Samuel reported interest income which was greater, by $ 294.43 in 1944 and $ 1,569.50 in 1945, than the interest identified as derived by him from known sources. To that extent, therefore, the contested deposits represent income to Samuel only and were actually reported by him. Accordingly, the deposits remaining to be considered for 1944 and 1945 are reduced, respectively, to $ 1,500.23 and $ 33,248.36.

During 1942, Esther received $ 1,800 in interest from the mortgage held on the parcel of property in the Bronx, New York, but reported (on the joint return filed with Samuel) interest income of only $ 1,462.50. The deposits in issue for 1942 represent unreported income, to Esther only, to the extent of the $ 337.50 difference between those two amounts.

Fifty per cent of the remaining contested deposits for 1942 through 1945 (or $ 3,129.07, $ 2,229.89, $ 750.11, and $ 16,624.18, respectively) does not represent additional income to the individual petitioners. It represents (1) part of the proceeds of salary checks received by Samuel and Esther from NTC, cashed by them and (to the extent not expended for living costs) accumulated and later deposited; (2) funds borrowed from NTC and debited to the personal accounts of Samuel and Esther; (3) exchange items, i. e., checks received by Samuel and Esther from NTC merely in exchange for cash or for other personal or third party checks (which NTC checks Samuel and Esther cashed and, to the extent not expended, later deposited the proceeds therefrom), and the like.

The 50 per cent balance of the 1942-1945 contested deposits was proceeds of yarn and thread sales made by NTC and unreported either by NTC, Samuel, or Esther.

The unreported sales (both those stipulated to be so and the bank deposits found to represent unreported proceeds of sales) were made in large part from NTC stocks the costs of which were already deducted by NTC in reporting its income. However, NTC did make some cash purchases which it did not report as cost of goods sold in determining its income. In each of the years in issue such unreported cash purchases amounted to approximately 25 per cent of the unreported sales.

The following table contains a calculation, in summary, of NTC's additional gross profit and net income (they are equal) resulting from our findings regarding sales and unreported cash purchases made by NTC:

	1942	1943	1944	1945
Unreported sales stipulated	$ 1,092.36	$ 59,822.06	$ 35,784.36	$ 59,504.85
Unreported proceeds of sales
reflected in bank deposits	3,129.06	2,229.89	750.12	16,624.18
Total unreported sales	$ 4,221.42	$ 62,051.95	$ 36,534.48	$ 76,129.03
Less unreported cash purchases
(25 per cent of total
unreported sales)	1,055.36	15,512.99	9,133.62	19,032.26
Additional gross profit and
net income	$ 3,166.06	$ 46,538.96	$ 27,400.86	$ 57,096.77

The independent accountant retained for NTC came to NTC's premises monthly and there worked on the corporation's books. That accountant, who prepared the returns of all petitioners herein, always discussed a client's affairs with the client at the year's end prior to making out the required tax returns. He followed this procedure with Samuel. NTC's 1942 returns were signed by Samuel, as president, and by Esther (apparently as treasurer). Its returns for 1943, 1944, and 1945 were signed by Samuel only.

The tax returns of petitioners' for the years 1942 and 1943 were filed more than 5 years prior to the mailing of respondent's deficiency notices applicable thereto.

The returns filed by NTC for 1942, by Samuel and Esther jointly for 1942, and by Samuel for 1943 were not false or fraudulent with intent to evade tax.

The returns filed by NTC and by the Estate of Esther for 1943 were false and fraudulent with intent to evade tax.

Part of the deficiencies determined against NTC for the years 1943, 1944, and 1945, part of the deficiency determined against the Estate of Esther for the year 1943, and part of the deficiencies determined against Samuel for the years 1944 and 1945 are due to fraud with intent to evade tax.

OPINION.

Issues 1, 2, and 3.

We first consider to what extent and to whom certain stipulated unreported sales and certain alleged "unexplained" or "unidentified" bank deposits represent unreported taxable income.

1. The parties stipulated that during the years 1942 through 1945, sales totaling $ 156,203.63 were made in the names of Samuel, Carolina, and NTC (as fully detailed in our Findings of Fact), that the proceeds thereof were received by Samuel and/or Esther, and that such sales were not reported for tax purposes by any of the petitioners herein. Petitioners contend that those sales are reportable only by Samuel on the grounds that (a) the sales in Samuel's name were just what they purported to be, (b) the sales in Carolina's name were Samuel's because Carolina was a trade name registered by Samuel and under which he conducted business operations, and (c) the sales in NTC's name were erroneously billed by NTC and were actually Samuel's. Respondent maintains that all the sales were NTC's and are taxable first to NTC and then, as corporate distributions, to Samuel and Esther.

Whether the stipulated unreported sales were, in the first instance, Samuel's or NTC's is a question of fact. Miller-Smith Hosiery Mills, 22 T. C. 581. We have carefully studied the extensive and complex record before us and have concluded that they were NTC's sales.

Those sales were made to purchasers who ordered, as they usually did, from NTC's offices without indicating in any way that they wished to buy from Samuel as an individual, or from Carolina, rather than from the corporation. Samuel merely made the unilateral decision that certain of the sales were to be billed in his name or in Carolina's name. Samuel exerted no efforts to make those sales and performed no services in relation thereto which in any particular differed from his routine duties as president of NTC.

Further, the sales were in fact made from stock which was purchased by and belonged to NTC. Such stock was located in NTC's stockroom and no attempt was made to segregate any of it into lots purporting to belong to Samuel or Carolina, as distinguished from NTC. Although petitioners contend that Samuel replaced the NTC merchandise used to make the disputed sales with merchandise he purchased for cash, the record contains no convincing evidence indicating that he made any such cash purchases with funds belonging solely to him. See Jack M. Chesbro, 21 T.C. 123">21 T. C. 123, affd. (C. A. 2) 225 F.2d 674">225 F. 2d 674.

In their brief petitioners concede that Carolina's operations in 1942 were conducted on behalf of NTC and, consequently, that the stipulated unreported sales for 1942 (all of which were made in Carolina's name) were taxable to NTC. They contend, however, that Carolina was originally Samuel's business; that in 1935, he agreed Carolina would be conducted in NTC's behalf in return for a promise that he get a share in NTC's business; that in 1943, he rescinded this arrangement when he was not given the share in NTC which he desired; and that thereafter Carolina was conducted in Samuel's individual behalf and the sales in its name were Samuel's. We are unable to credit this explanation. We have found that, from its inception in 1923, Carolina was NTC's creature. It was originally established to perform "converting" operations for NTC and was located in Hoboken, New Jersey. Although the Carolina trade name was registered by Samuel and Samuel supervised its operations, Carolina was entirely underwritten by NTC, which each week gave Samuel the cash to meet Carolina's payroll, gave him cash to pay Carolina's rent, and also gave him cash for his own use.

In 1935, Carolina's operation was moved to NTC's place of business because Samuel found it too difficult to commute to Hoboken. Petitioners contend that, contemporaneously with the move, Carolina was transferred from Samuel to NTC in return for which Esther promised to give Samuel a stock ownership share in NTC. Petitioners would then have us believe that 8 years later, in 1943, Samuel realized that he would not get the share in NTC promised him in 1935, so he rescinded the Carolina transfer and thereafter ran Carolina for his own benefit.

Even were we to believe that prior to 1935, Carolina was Samuel's individual operation (which, as noted above, we do not), we would be unable to agree that there was a rescission in 1943 of the alleged 1935 transfer thereof to NTC. There is no extrinsic evidence of any actual separation between Carolina and NTC in 1943. Indeed, all operations appear to have been conducted without change, and the proceeds of Carolina's unreported sales in 1943 were actually deposited in Samuel's and Esther's joint bank accounts.

Considering the record as a whole, and in particular the matters discussed above, we conclude that in substance the stipulated unreported sales were sales of NTC and are taxable to it. See Miller-Smith Hosiery Mills, supra. The fact that some of the sales proceeds did not pass through the corporation's hands does not affect this conclusion. Essex Construction Co., 12 T.C. 1212">12 T. C. 1212.

2. Respondent determined in his deficiency notice that $ 83,637.39 in "unexplained" or "unidentified" bank deposits made to the individual and joint accounts of Samuel and Esther constituted additional taxable income to petitioners. After further study respondent stipulated that $ 24,773.82 thereof was not taxable to any petitioners. Respondent also stipulated that $ 11,195.64 of the remaining $ 58,863.57 was not taxable to NTC, but still alleges that such deposits are taxable to Samuel and/or Esther. He also alleges that the $ 47,667.93 balance of that $ 58,863.57 represents unreported proceeds of sales by NTC which are taxable first to NTC and then, as corporate distributions, to Samuel and/or Esther.

Our Findings of Fact detail the sources of the $ 11,195.64 which respondent maintains is taxable to Samuel and/or Esther. The major part of it, $ 6,850, represents rent received by Esther in 1943 and by Samuel in 1945 for the leasing of a resort hotel and resort roominghouse owned by Esther in upper New York State. Although Esther and Samuel failed to include those rents in gross income, respondent concedes that unreported deductible expenses were incurred in connection with, and were at least equal to, those rents and consequently that petitioners are not taxable for any additional net income.

Also included in the $ 11,195.64 were checks, totaling $ 2,132.22, drawn by others on banks located in the same general upstate New York area as Esther's aforementioned resort hotel and roominghouse, which checks were deposited by Esther. Esther herself operated those two properties in 1942, in which year $ 1,882.43 of the aforementioned checks were received. The 1942 checks, 6 in number, were all for sums of $ 50 or more and, with one exception, were for even dollar amounts. These factors (i. e., Esther's operation of the hotel and roominghouse and the banks on which, and sums for which, the checks were drawn), coupled with the fact that petitioners gave no convincing explanation of the source of those deposits, lead us to conclude that they represent payments received by Esther from guests of the hotel and roominghouse and, as such, are taxable to her in 1942.

On the other hand, such factors are not present as regards the $ 249.79 in checks received by Esther in 1943. The two resort properties were operated in that year by others to whom she had leased them and the checks composing the $ 249.79, five in number, were in general for small, odd amounts. We think some of those checks were merely cashed by Esther as an accommodation, then deposited by her, and that the others likewise represent items of a non-income nature. The $ 249.79, therefore, does not represent taxable income to Esther or Samuel in 1943. However, petitioners do concede that in 1943 Esther failed to report and is taxable on $ 604.10 in bond interest.

The final items included in the $ 11,195.64 are $ 1,409.32 received in bond interest by Samuel in 1944 and 1945, and $ 200 received by him from one Max Broder in 1945. The latter we have found to be a loan repayment, nontaxable to Samuel. As for the former, Samuel actually reported more interest income in 1944 and 1945 than the amount of the bond interest received in each of those years. The excess interest income so reported totaled $ 1,863.93.

We next consider the $ 47,667.93 balance of the alleged "unexplained" or "unidentified" bank deposits. We have found that $ 1,863.93 of those deposits represented interest income to Samuel in 1944 and 1945 which, as noted in the preceding paragraph, he reported in those years. On the other hand, $ 337.50 thereof represents the excess of mortgage interest received by Esther in 1942 over interest income reported in her joint return filed with Samuel for that year and is consequently taxable solely to her. After reducing the $ 47,667.93 by those two sums we are left with a total of $ 45,466.50 in deposits the nature of which must be determined.

Petitioners contend that none of those deposits are of unreported taxable funds. We have carefully examined the testimony and exhibits, taken note of the amounts and frequency of the deposits involved and of their relation to the cash Samuel and Esther probably had on hand from either nontaxable sources or taxable and reported sources, and have considered the effect of respondent's concessions regarding the nontaxability of some of the deposits originally determined to represent unreported income. The testimony of petitioners' witnesses, as it bore on the matter, was general and unconvincing and their attempt to identify the deposits as stemming from nontaxable sources was not buttressed by the available documentary evidence. Our analysis, therefore, compels us to conclude that petitioners' contention cannot be sustained in its entirety.

However, we feel that some portion of the deposits does not represent additional taxable income to petitioners but, rather, was savings of Samuel and Esther from their NTC salaries, loans and exchange items from NTC, and the like. Exercising our best judgment, but bearing heavily against petitioners, Cohan v. Commissioner, (C. A. 2) 39 F.2d 540">39 F. 2d 540, we have concluded that 50 per cent of the $ 45,466.50 (or $ 22,733.25) was from such sources and therefore is not taxable income to any of the petitioners.

On the other hand, we hold, after a consideration of the whole record, that the remaining $ 22,733.25 of deposits constitutes the proceeds of unreported sales by NTC.

Petitioners argue that Samuel and Esther lived frugally and accumulated a great deal of money prior to the years in issue from which the disputed deposits were made. Even assuming the thriftiness of Samuel and Esther, however, there is no convincing evidence in the record indicating a cash accumulation of funds necessary to make deposits of the magnitude in question in addition to those deposits conceded by respondent, and those heretofore found by us, not to represent additional taxable income.

We therefore conclude that the $ 22,733.25 in disputed deposits made during the years in issue was derived from a current source or sources of income and that the only possible source thereof was NTC. Consequently, those deposits represent unreported sales of NTC.

3. We next consider to what extent NTC's unreported sales proceeds totaling $ 178,936.88 ($ 156,203.63 stipulated, plus $ 22,733.25 reflected in the "unexplained" or "unidentified" bank deposits) should be offset, in determining its net income for each year in issue, by unreported purchases. Respondent contends that NTC made no purchases which were not in fact already deducted in reporting its net income. Petitioners argue, however, that additional unreported purchases were made and must be taken into account in arriving at NTC's unreported net income (which, for present purposes, equals NTC's unreported gross profit).

Despite the lack of specific evidence, we think that some purchases were made which were not reflected in NTC's returns. There is no way to accurately determine the amounts thereof so, again resorting to the Cohan principle, we have concluded that such unreported purchases total 25 per cent of the $ 178,936.88 in total unreported sales. Consequently, the aggregate unreported gross profit and net income for 1942-1945 resulting from those sales equal $ 134,202.65. (These figures are broken down in our findings to reflect the amount allocable to each year in issue.)

Our determination that, in computing NTC's additional net income, allowance must be made for unreported purchases has no bearing upon calculation of the amount of corporate distributions to Samuel or Esther. The entire $ 178,936.88 in NTC's unreported sales proceeds was either deposited in Samuel's and Esther's bank accounts, taken by them in cash, or entered to their credit on NTC's books and it is that amount which we regard as corporate distributions. See, e. g., E. T. Schuler, 29 B. T. A. 415. Whether, in any one year, Samuel or Esther is to be regarded as the recipient of those distributions, and the tax treatment to be accorded the distributions (i. e., ordinary income, capital gains, or return of capital) is hereinafter considered.

Issues 8 and 9.

Logical presentation would seem to indicate that we now discuss to whom, i. e., Samuel or Esther, and in what years, the $ 178,936.88 proceeds of NTC's unreported sales constituted corporate distributions. The parties do not appear to dispute that, if we determine (as we have) that those unreported proceeds were from sales by NTC, such proceeds also represent distributions in the nature of constructive dividends (taxable as ordinary income) to Samuel or Esther to the extent of NTC's earnings and profits, and that the first $ 10,000 distributed in excess of earnings and profits is a nontaxable return of capital ($ 10,000 being the cost of NTC's stock). See Jack M. ;United Mercantile Agencies, Inc., 23 T. C. 1105; E. T. Schuler, supra; sec. 115 (a), (b), and (d), 1939 Code. Issues are raised, however, regarding the computation of earnings and profits and the treatment of any distributions which are in excess of earnings and profits plus the $ 10,000 cost of stock. Those issues will be considered at a later point.

Whether or not Samuel or Esther was the recipient of the corporate distributions turns, the parties agree, on who was the true owner of NTC's stock. As regards 1942, this question is not of importance, since Samuel and Esther filed a joint return for that year. It is also not disputed that Samuel was the sole owner of NTC's stock during all of 1945, with the result that the distributions are taxable entirely to him in that year.

Respondent contends that Samuel and Esther each owned 50 per cent of NTC's stock until March 27, 1944, the date of Esther's death, whereupon Samuel became the owner of all the stock. Petitioners' position is that Esther owned all the stock until January 27, 1944, on which date she transferred it to Samuel making him the sole owner thereof. We agree with petitioners.

Since 1916, Esther had been the record owner of all of NTC's stock, at least half of which she got from her father. Although Samuel signed her stock certificates as NTC's president, he was then president in name only, with no actual control whatever over NTC's operations or policies. Esther ran the business and made all policy decisions for many years. It is true that Samuel gradually took an increasingly larger part in the business and that from about 1942 on he was the more dominant of the two in directing NTC's affairs. However, Esther by no means abdicated all authority. She continued to remain active until she became ill just prior to her gratuitous transfer of the NTC stock to Samuel on January 27, 1944 -- which transfer was formally made with the aid of an attorney and prior to which Samuel never had any of NTC's stock in his name. In this context the fact alone that Samuel was the dominant manager of NTC during the years in issue does not also mean that he was a part owner thereof. Cf. Willis H. Vance, 14 T.C. 1168">14 T. C. 1168.

All things considered, therefore, we conclude that Esther was the true owner of all NTC stock until January 27, 1944, and that, from and after that date, Samuel was the sole owner thereof. Consequently, Esther was the recipient of all the corporate distributions in issue made prior to January 27, 1944, and Samuel was the recipient of the distributions made on and after that date.

A table in our findings shows that $ 4,921.74, $ 3,364.84, and $ 3,285.84 of the proceeds of the stipulated unreported sales made in 1943, 1944, and 1945, respectively, were not received in each case until the year following the sales giving rise thereto. Those proceeds are properly includible in NTC's income for the year of sale, rather than the year of receipt, since NTC kept its books and filed its returns pursuant to the accrual method of accounting. However, they are includible in determining Esther's or Samuel's income (depending upon whether they were received before or after January 27, 1944, as set out in our findings) in the year of receipt, Esther and Samuel being on the cash basis. Regs. 111, sec. 29.41-2. Appropriate adjustment will be made in the Rule 50 computation.

Issues 4 and 11.

For each year in issue NTC deducted on its return certain sums for "traveling and selling expenses," and respondent disallowed a portion of those deductions. (Our findings contain the pertinent figures.) The amounts disallowed were in general represented by checks drawn either to the order of Samuel or to "cash" and not substantiated by any further records. We are convinced that some of those checks were actually reimbursements to Samuel and NTC's salesmen for traveling and selling expenses incurred by them and, as such, represent ordinary and necessary expenses deductible under section 23(a)(1)(A) of the 1939 Code. Since, however, we are unable to determine from the record which of those checks do represent such expenditures, we have resorted to the Cohan principle and concluded that NTC may deduct, in each taxable year, $ 1,000 more for traveling and selling expenses than the amount allowed therefor by respondent.

As noted in our findings the returns filed for the years in issue by Samuel, Esther, and the estate (for Esther) claimed various deductions for unreimbursed "traveling," "entertainment," and "necessary" expenses allegedly incurred on NTC's behalf, which deductions respondent disallowed. Petitioners presented no proof that those claimed expenditures were actually incurred (let alone that they were ordinary and necessary). We therefore conclude that respondent's disallowances were not in error.

Issues 5, 7, 12, and 13.

It is the contention of petitioners that assessment of deficiencies against all of the petitioners herein for 1942 is barred by the statute of limitations, section 275(a) of the 1939 Code, and that assessment is also barred for the year 1943, except to the limited extent permitted by section 275(c) of the 1939 Code. It is clear that the bar of the statute of limitations does exist in favor of all the petitioners for 1942 unless respondent has proved by clear and convincing evidence that their returns for 1942 were false or fraudulent with intent to evade the tax. After an examination and consideration of all the evidence, we have made a finding as to each of petitioners that their returns for that year were not false or fraudulent with intent to evade tax. It is true that there were some omissions of income from the returns, as has been pointed out in our Findings of Fact, but these omissions for 1942 were comparatively small in amount and we are not convinced that they were falsely or fraudulently omitted from the returns. We therefore hold in petitioners' favor on the issue of the statute of limitations for the year 1942.

We do not hold in petitioners' favor for the year 1943, except as to Samuel. The amounts omitted in 1943, except as to Samuel, were too large to admit of our believing that they were innocently made. We have therefore found that the returns of NTC and the Estate of Esther for 1943 were false and fraudulent with intent to evade tax. Only small omissions were made from Samuel's return for 1943, when it is considered that we have held that the unreported sales were sales of NTC and not sales of Samuel, and that the constructive dividends resulting therefrom in 1943 were the dividends of Esther, because she was the sole owner of NTC's stock in 1943. We have therefore made a finding of fact that Samuel's return for 1943 was not false or fraudulent with intent to evade tax.

It follows from what we have just said above that for the year 1943 the bar of the statute of limitations provided in section 275(a) has not run in favor of NTC or the Estate of Esther. Sec. 276(a), 1939 Code. It has run in favor of Samuel. Petitioners do not contend that the statute of limitations bars assessment for the years 1944 and 1945.

We next consider as to those years where the statute of limitations has not barred assessment of the deficiencies, whether the deficiencies determined against the petitioners are due in whole or in part to fraud with intent to evade tax. Sec. 293 (b), 1939 Code.

In a civil action respondent must prove fraud by clear and convincing evidence; that is, he must prove that the petitioner intentionally evaded a tax believed to be owing. Sec. 1112, 1939 Code; Wiseley v. Commissioner, (C. A. 6) 185 F. 2d 263. The question of fraud is one of fact and must be decided on the basis of all the conditions and circumstances surrounding the transaction. Wallace H. Petit, 10 T.C. 1253">10 T. C. 1253; William W. Kellett, 5 T. C. 608; M. Rea Gano, 19 B. T. A. 518.

Samuel was NTC's president and, from about 1942 on, the dominant figure in both operating and policy planning for NTC. In 1942 and 1943, Esther, who then owned all of NTC's stock, was still active in the business but after January 27, 1944, on which date she transferred all her stock to Samuel, Samuel in effect took over all the reins of NTC. Although Samuel immigrated to this country when he was 15 and had little formal education, we think he had a great deal of business intelligence and was a successful businessman. During the years in issue he was in his middle sixties. He was then afflicted with cataracts but was able to and did read with the aid of a magnifying glass. We cannot, in brief, agree with petitioners that understatements of income, of the magnitude herein found from 1943 on, were the result of Samuel's ignorance, oversight, or lack of comprehension.

The evidence of intentional wrongdoing is by no means meager. First we note that (a) NTC's actual net income for 1943, 1944, and 1945 exceeded by well over 100 per cent the net income reported in its return for those respective years, and (b) Esther's actual net income for 1943 and Samuel's actual net income for 1944 and 1945 exceeded the net income reported in their respective individual returns for the applicable year by far more than 100 per cent. Such discrepancies over a period of successive years strongly evidences an intent to defraud. Rogers v. Commissioner, (C. A. 6) 111 F.2d 987">111 F. 2d 987.

Second, as regards the $ 156,203.63 in stipulated unreported sales made in the names of Samuel, Carolina, and NTC, it was Samuel who determined in the first instance the name in which such sales would be billed. Moreover, when the proceeds of some of those unreported sales which were made in NTC's name were found by Samuel to have been deposited in NTC's bank account, he had those sums credited to him in the corporation's "Loans and Exchanges" account. On a few occasions Samuel also ordered sales originally entered on NTC's books to be offset by credit memos, implying returned merchandise, when the purchasers had not in fact returned the merchandise. Spies v. United States, 317 U.S. 492">317 U.S. 492.

Third, the proceeds of some sales made by NTC were deposited directly in Samuel's and Esther's bank accounts, without being recorded in any books or records. See Spies v. United States, supra.

All the petitioners' returns herein were prepared by an accountant but it was the accountant's practice to discuss with Samuel the affairs of NTC and of Samuel and Esther prior to making out their returns. Petitioners attempt to show that the accountant was given or took complete records of all NTC's transactions and that any understatements were solely the accountant's fault and were unnoticed by Samuel. The evidence does not support that explanation. Certainly Samuel, who directed NTC's operations, could not fail to note the omission of such large sums of income from NTC's returns or his own individual returns, unless he completely ignored the returns he was signing. This last is what petitioners wish us to believe, but Samuel's business sense, plus the accountant's practice of discussing his clients' affairs before preparing their returns, belie such a conclusion.

The circumstances set forth above clearly evince a pattern of willful failure to report income. They leave us in no doubt that first, as regards NTC, the deficiencies in its returns for 1943 through 1945 were due, at least in part, to fraud, which is imputed to NTC through Samuel, its president and dominant administrative officer, who was the chief perpetrator of the unlawful conduct. George M. Still, Inc., 19 T. C. 1072, affd. (C. A. 2) 218 F.2d 639">218 F. 2d 639.

By the same token the deficiencies in Samuel's individual returns for 1944 and 1945 were due in part to fraud. However, our determination that the proceeds from NTC's unreported sales for 1943 represented corporate distributions entirely to Esther leads to a different conclusion anent Samuel's 1943 return. The understatement of income in that return was minor in nature (resulting from excess deductions for traveling, etc., expenses), and there is no proof of circumstances from which it can be concluded that such understatement was due to fraud. Consequently, as noted heretofore, the assessment of any deficiency against Samuel for 1943 is barred by the statute of limitations. Sec. 275 (a).

Esther died prior to the filing of her return for 1943. Her return for that year was, therefore, signed and filed by Samuel, her executor. Petitioners argue, without citing authority, that Esther "cannot be found to have perpetrated a fraud on a tax return not drawn or signed by her."

Under sections 142 (a) (1) and 3797 (a) (6) of the 1939 Code, Samuel, as Esther's executor, was the fiduciary who was required to file Esther's return for 1943. Section 142 (c) provides that "Any fiduciary required to make a return under this chapter shall be subject to all the provisions of law which apply to individuals." Such a "[provisions] of law" is the addition for fraud under section 293 (b). In view of the above statutory language and the nature of the addition for fraud -- which is not a punishment but is remedial in nature, intending to compensate the Government for the heavy expense of investigation and the loss resulting from the fraud, Helvering v. Mitchell, 303 U.S. 391">303 U.S. 391; Estate of Charles Louis Reimer, 12 T. C. 913, affd. (C. A. 6) 180 F. 2d 159 -- we see no more objection to applying the fraud addition in this case than in other instances wherein the owners of the income were not personally fraudulent. See, e. g., George M. Still, Inc., supra (corporations); Myrna S. Howell, 10 T.C. 859">10 T. C. 859, affd. (C. A. 6) 175 F. 2d 240 (joint returns). Such a conclusion, of course, may have unfortunate consequences for the deceased's successors but their remedy must lie by way of action against the fiduciary.

What we have just said relates to the legality of the imposition of additions for fraud where the return has been filed by a fiduciary. It remains only to determine whether Samuel was in fact fraudulent in filing Esther's 1943 return. Our previous discussion makes it clear that he was. He obviously knew that the proceeds of NTC's unreported sales were received by Esther since he was instrumental in making those sales and channeling the income into both the joint bank accounts (in his and Esther's names) and Esther's individual accounts. Moreover, as aforementioned, we do not believe that he signed and filed Esther's return without paying attention to the contents thereof. We hold, therefore, that the Commissioner has sustained his burden of proving that part of the deficiency against the Estate of Esther for the year 1943 was due to fraud with intent to evade tax.

As heretofore stated we have held that the statute of limitations bars assessment against Samuel and Esther for 1942. But it should also be noted that the forgiveness feature of the Current Tax Payment Act of 1943 applies to their joint return for 1942. As regards 25 per cent of the 1942 tax which, pursuant to that forgiveness provision becomes part of a taxpayer's 1943 tax, section 6 (d) (2) of the Current Tax Payment Act makes it clear that where a joint return was filed by Samuel and Esther for 1942, and separate returns were filed by them for 1943, the liability for 25 per cent of their 1942 tax is "joint and several." This means that even though we have found that Samuel's 1943 return was not fraudulent and therefore that the statute of limitations bars assessment of deficiencies against him for 1943, 25 per cent of the difference between the tax he and Esther reported for 1942 and their correct tax for that year is all includible as part of the 1943 deficiency of Esther (who filed a 1943 return which was fraudulent, thereby resulting in removal of the statutory bar as to her for 1943). See Lawrence W. Carpenter, 10 T. C. 64; William W. Todd, 10 T.C. 655">10 T. C. 655; Tressler v. Commissioner, (C. A. 4) 206 F.2d 538">206 F. 2d 538.

Issue 6.

Having determined that NTC's deficiencies for 1943 through 1945 were due at least in part to fraud, we must now determine whether the 50 per cent fraud addition applicable to NTC's 1943 deficiency in excess profits tax should be calculated (a) on the total amount of such deficiency, or (b) only after first deducting from such deficiency the 10 per cent postwar refund credit allowed under section 780 (a) of the 1939 Code.

Section 780(a), as here applicable, provides for establishment of a credit to a taxpayer's account equal to 10 per cent of the excess profits taxes imposed for the 1942 and 1943 calendar years. ^*330 If such taxes, or any deficiencies therein (sec. 781(a)), Sec. 780 (b), (c), and (d). If, however, the taxes, or any deficiencies therein, are paid on or after July 1, 1945, section 781(c) provides that the 10 per cent credit attributable to the particular payment shall be paid to the taxpayer in cash. *331

Petitioners contend that the fraud additions applicable to NTC's 1943 excess profits taxes should be calculated, for such year, as 50 per cent of the sum remaining after deduction of the 10 per cent credit from the deficiency for such year. They rely on section 781 (c) and, after quoting part of that section in their brief, make their entire argument in the following single paragraph:

The effect of the above statute is to reduce the excess profits tax liability of the taxpayer where payment is made after July 1, 1945. Therefore, petitioners are of the view that it is inequitable to impose a penalty on an amount for which it is not liable and which in a practical sense it is not required to pay. Penalties, while punitive, should be fair and just. Unless the post war refund is deducted from the deficiency of excess profits tax, it would be unfair and the penalty would be based on an amount the taxpayer does not owe.

The plain words of the statute, however, give no support to petitioners' argument. Section 293 (b) provides that the addition for fraud is "50 per centum of the total amount of the deficiency." The pertinent provisions of sections 780 and 781 clearly do not contemplate that the refund credit is to be taken into account in calculating such "total amount of the deficiency," California Vegetable Concentrates, Inc., 10 T. C. 1158, *333 to be calculated on the basis of the total deficiency, without reduction for the refund credit. We sustain the Commissioner as to this issue.

Issues 10 (a) and (b).

(a) In determining what portion of NTC's corporate distributions to Samuel and Esther was taxable to them as ordinary income resulting from constructive dividends, respondent reduced NTC's earnings and profits for each taxable year in issue by the deficiencies determined against the corporation for that year but made no such reductions for the fraud additions determined. Petitioners contend that a fraud addition accrues, and is deductible in determining earnings and profits, at the end of the taxable year to which it applies or, in the alternative, when the tax return for that year is filed.

Respondent's brief contains no argument on this issue. We assume, however, that respondent relies on Revenue Ruling 107, 1953-1 C. B. 178, which is reproduced in its entirety in the margin. *335 support the proposition that, in determining earnings and profits at the end of a year, an accrual basis taxpayer must deduct its Federal taxes for that year, which taxes are deemed to accrue at the end of the year when all the events have occurred which fix their amount and determine the taxpayer's liability therefor. Regs. 111, sec. 29.115-3; *336 Commissioner v. South Texas Lumber Co., 333 U.S. 496">333 U.S. 496; United States v. Anderson, 269 U.S. 422">269 U.S. 422; Fawcus Machine Co. v. United States, 282 U.S. 375">282 U.S. 375; Rose v. Dobbs, (C. A. 5) 36 F. 2d 464; Lane-Wells Co., 45 B. T. A. 175; Lisk Manufacturing Co., Ltd., 11 B. T. A. 179. Any contention, based on the doctrine of Dixie Pine Products Co. v. Commissioner, 320 U.S. 516">320 U.S. 516, and Security Flour Mills Co. v. Commissioner, 321 U.S. 281">321 U.S. 281, that a contested tax may not be deducted from earnings and profits until the taxpayer's liability therefor has been finally determined has, we think, already been effectively answered by us in Stern Brothers & Co., 16 T.C. 295">16 T. C. 295. See also Pacific Affiliate, Inc., 19 T. C. 245; Geo. W. Ultch Lumber Co., 21 T.C. 382">21 T. C. 382.

We regard the Stern Brothers opinion of value not merely as interpreting a specific regulatory provision under the excess profits tax law but also as enunciating a general principle applicable alike to earnings and profits computations for income tax purposes. Here, for example, just as in Stern Brothers, it is important to calculate earnings and profits which "show the true financial status of an accrual basis taxpayer" in order that distributions which actually impair capital will not be taxed as dividends. To accomplish this the accrual basis taxpayer's true tax liability must be considered, whether or not such taxpayer is aware of, or agrees to, such liability.

Respondent, it has been noted, actually did reduce NTC's earnings and profits by the contested deficiencies determined against it. Apparently, therefore, he agrees with our interpretation that the Stern Brothers doctrine regarding contested taxes applies to earnings and profits computation for income tax purposes. Having gone this far, we fail to see any reason for respondent's not also applying the doctrine to fraud additions which a taxpayer contests but for which he is actually liable. True it is that Stern Brothers dealt in terms only with taxes, but clearly earnings and profits will only "show the true financial status of an accrual basis taxpayer" where additions to the tax (such as that for fraud) for which the taxpayer is actually liable at the time of the computation (though the taxpayer does not concede liability) are also reflected in the computation. We conclude, therefore, that the proper computation of NTC's earnings and profits requires the deduction of such fraud additions.

We must next determine when an accrual basis taxpayer's liability for a fraud addition first arises, since that is the time it "accrues" (whether or not contested) for purposes of computing earnings and profits. We think such liability arises when all the events determining it have occurred, United States v. Anderson, supra, and those events occur when the return is filed understating income with the intent to evade tax. Auerbach Shoe Co., 21 T.C. 191">21 T. C. 191, affd. (C. A. 1) 216 F. 2d 693; De Hardit v. United States, (C. A. 4) 224 F. 2d 673; John B. Arnold, 14 B. T. A. 954; United States v. Rachmil, (S. D., N. Y.) 270 F. 869">270 F. 869. This principle is so obvious in the cited cases that it would serve little purpose to discuss them.

Petitioners, however, contend that the fraud addition accrues at the same time as the deficiency -- that is, at the end of the taxable year to which it applies. They rely on the provisions of section 293 (a) and (b) which, when properly read together, declare that the fraud addition is to be "assessed, collected and paid in the same manner as if it were a deficiency," and on cases and rulings containing statements to the effect that the fraud addition is to be "added to" and is "a part of" the tax and that it and the tax constitute a "single liability." Petitioners jump from there to the conclusion that, for an accrual basis taxpayer, both the tax and the fraud addition accrue at the same time, viz, at the end of the year to which they apply.

An analysis of the Code provisions, plus two of the cases which petitioners themselves cite, Auerbach Shoe Co., supra, and Thomas J. McLaughlin, 29 B. T. A. 247, show that petitioners confuse the manner of assessment, collection, and payment of the fraud addition with the time of its accrual. It is true that the payment required under the section 293 (b) fraud provision is regarded as an "addition to the tax," but the aforementioned authorities clearly demonstrate that that does not mean the tax and the addition arise at the same time; it means only that they are to be dealt with similarly for administrative purposes. Since the fraudulent act is not committed until the return is filed, approving petitioners' contention would result in accrual of the fraud addition retroactively (to the end of the preceding year). That, we think, cannot be done.

It is our conclusion, therefore, that in computing NTC's earnings and profits for the purpose of determining what portion of NTC's distributions to Samuel and Esther were dividends, each fraud addition for which we have determined NTC is liable must (even though it was contested by NTC) be deducted from earnings and profits in the year that NTC filed the return to which the particular fraud addition applies.

(b) Respondent treats the distributions received from NTC by Samuel and Esther as taxable dividends to the extent of NTC's earnings and profits, then as a tax-free return of capital to the extent of $ 10,000 (the cost of NTC's stock), and thereafter as taxable capital gains. Sec. 115 (a), (b), and (d), 1939 Code.

Petitioners argue that, under section 58 of the New York State Stock Corporation Law, ^{*968 taxable to them because they were not received under a claim of right and without restriction as to their use.}

The claim of right doctrine was established in North American Oil Consolidated v. Burnet, 286 U.S. 417">286 U.S. 417, wherein the Supreme Court said, at page 424:

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money and even though he may still be adjudged liable to restore its equivalent.

The liability imposed on the directors of a corporation by section 58 of the New York statute is in the nature of indemnity and is only for the loss actually sustained by the corporation or its creditors as a result of the distribution impairing capital. ^*342 The loss must be one in fact and the directors are not liable if, e. g., the corporation has no creditors or the creditors are able to collect their claims from the corporation out of corporate earnings accrued subsequent to the date of the distribution. Greene v. Boardman, 256 N. Y. S. 340; Waters v. Spalt, 80 N. Y. S. 2d 681; Hayman v. Morris, 36 N. Y. S. 2d 756. Consequently, circumstances may be such that no liability would be imposed on directors for declaring a corporate distribution impairing capital.

We conclude, therefore, that it could not be said at the end of each year in which the distributions in issue occurred that Samuel and Esther, as NTC's directors, would ever be called to account therefor under section 58 of the New York statute. Moreover, there would have been no possibility whatever of Samuel's and Esther's being held liable under section 58 had it not been for respondent's determination (subsequent to the years in issue) that the sums received by Samuel and Esther actually represented fraudulently unreported sales taxable to NTC and corporate distributions from NTC to Samuel and Esther. It was that determination, concurred in in part by us and ultimately resulting in our decision that NTC was liable for deficiencies and fraud additions which greatly reduced NTC's earnings and profits, that leads to the conclusion that the distributions in issue impaired NTC's capital.

The situation here, therefore, falls within the ambit of the North American Oil doctrine as applied by such cases as Healy v. Commissioner, 345 U.S. 278">345 U.S. 278; Estate of Henry E. Mills, 4 T.C. 820">4 T. C. 820; and Roberta Pittman, 14 T. C. 449. In those cases it was pointed out that where funds are received and treated by taxpayers as belonging to them (as certainly was the case here), they are received under a "claim of right" even though the claim is subsequently found to be invalid. Moreover, there is no "restriction on use" where it cannot be said at the end of the tax year that the recipient would be liable for the funds received. Specifically, where the liability of the recipient turns upon a subsequent determination by respondent, or may be avoided by the corporation itself satisfying its creditors through subsequent profitable operations, then there is no restriction on use of the funds received. As said in Healy v. Commissioner, supra, "a potential or dormant restriction, such as here involved, which depends upon the future application of rules of law to present facts, is not a 'restriction on use' within the meaning of North American Oil v. Burnet * * *." In such cases the basic tenet of the Federal income tax law, that there be an annual accounting of income, requires that the taxpayers report the funds as income in the years received.

We hold, therefore, that the distributions received by Samuel and Esther from NTC in excess of NTC's earnings and profits plus $ 10,000 (the cost of NTC's stock) are taxable to them as capital gains in the years received.

Decisions will be entered under Rule 50.

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Footnotes

• 1. The following proceedings are consolidated herewith: Estate of Esther M. Stein, Deceased, Samuel Stein, Executor, Docket No. 47466; National Thread Company, Incorporated, Docket No. 47467; and Samuel Stein, Docket No. 47475.↩

• 1. Overassessment.↩

• 2. The aggregate salary received by Esther from NTC for the years 1936 through 1940 was $ 25,125. There is no evidence regarding the year 1941 or regarding Samuel's salary for any of those years.↩

• 1. Joint return filed with Samuel.↩

• 3. NTC's aggregate net income reported for 1936 through 1940 was $ 7,523.67. There is no evidence regarding 1941.↩

• 1. $ 5,225.50 of the proceeds was deposited in NTC's bank account.

• 3. $ 2,417.84 of this sum was received before, and the balance thereof after, January 27, 1944.↩

• 2. $ 2,962.83 of the proceeds was deposited in NTC's bank account.↩

• 4. SEC. 780. POST-WAR REFUND OF EXCESS PROFITS TAX.

  (a) In General. -- The Secretary of the Treasury is authorized and directed to establish a credit to the account of each taxpayer subject to the tax imposed under this subchapter, for each taxable year ending after December 31, 1941 (except in the case of a taxable year beginning in 1941 and ending before July 1, 1942), and not beginning after December 31, 1943, of an amount equal to 10 per centum of the tax imposed under this subchapter for each such taxable year. * * *

• 5. SEC. 781. SPECIAL RULES FOR APPLICATION OF SECTION 780.

  (a) Effect of Deficiencies. -- If a deficiency in respect of the excess profits tax for any taxable year for which a credit is provided in section 780 (a) is paid by the taxpayer before July 1, 1945, an amount of such credit equal to 10 per centum of the excess of the tax imposed by this subchapter on the basis of which the deficiency was determined, over the tax imposed by this subchapter as previously computed and paid shall be available, as provided in section 780 (b)↩, for the purchase of bonds as provided under such section, * * *

• 6. December 31, 1946.↩

• 7. SEC. 781. SPECIAL RULES FOR APPLICATION OF SECTION 780.

  (c) Tax Payments After Cut-off Date. -- In the case of a payment of the tax imposed by this subchapter shown on the return for any taxable year for which a credit is provided in section 780 (a), or the payment of a deficiency in respect of such tax for any such taxable year, on or after July 1, 1945, the amount of the credit under section 780 (a) for such taxable year attributable to such payment shall be paid the taxpayer in cash. No interest for the period after December 31, 1945, shall be assessed or collected on that portion of the tax or deficiency so paid equal to the credit under section 780 (a) attributable to such payment. If after January 1, 1946, there is any credit under section 780 (a) remaining in favor of the taxpayer attributable to any taxable year for which a credit is provided in section 780 (a)↩, such remainder shall be paid to the taxpayer in cash. No amount of any payment made under this subsection to a taxpayer shall be included in gross income.

• 8. In that case we said, at pages 1171 and 1172:

  * * * The credit for post-war refund of excess profits tax provided by section 780 is not a credit against tax imposed, so as to reduce tax liability. It is a credit to the account of a taxpayer for which bonds or cash may be issued, depending upon when the tax is paid. Sec. 780 and 781. The amounts thereof, if any are allowable, form no part of the computation of a deficiency↩. * * * [Emphasis added.]

• 9. It is specifically provided in section 781 (c)↩ that, after December 31, 1945, the running of interest stops on that portion of any unpaid excess profits tax or deficiency which is equal to the refund credit applicable thereto. By contrast, the omission of any special provisions relating to computation of the fraud addition indicates that Congress did not intend any result other than that dictated by the plain words of the statute.

• 10. Fraud penalties recommended against a taxpayer should not be accrued as liabilities for the purpose of determining the amount of surplus and earnings available for dividends, until the liability therefor has become final and definite in amount, either by agreement or otherwise.↩

• 11. Earnings or Profits. -- In determining the amount of earnings or profits * * * due consideration must be given to the facts, and, while mere bookkeeping entries increasing or decreasing surplus will not be conclusive, the amount of the earnings or profits in any case will be dependent upon the method of accounting properly employed in computing net income. * * *

• 12. No stock corporation shall declare or pay any dividend which shall impair its capital, nor while its capital is impaired, * * *. In case any such dividend shall be paid, * * * the directors in whose administration the same shall have been declared * * * shall be liable jointly and severally to such corporation and to the creditors thereof to the full amount of any loss sustained by such corporation or by its creditors respectively by reason of such dividend. * * *↩

• 13. We also note, without pausing to consider, that the statute imposes liability on the corporate directors for declaring a distribution which impairs capital, not on the stockholders↩ who receive that distribution. Samuel's and Esther's duty to pay capital gains taxes here stems, of course, from receiving such distributions as stockholders.