Fuller v. Commissioner

G. E. Fuller and Era Fuller, Petitioners, v. Commissioner of Internal Revenue, Respondent

Fuller v. Commissioner

Docket No. 38167

United States Tax Court

20 T.C. 308; 1953 U.S. Tax Ct. LEXIS 164;

May 13, 1953, Promulgated

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Decision will be entered under Rule 50.

Petitioner during the years 1948, 1949, and 1950 was engaged in the sale at wholesale and retail of whiskey in violation of the laws of Oklahoma. Some of his stocks were confiscated in 1948 and 1950. He did not for any of the taxable years file a declaration of estimated tax. Respondent imposed a fraud penalty for 1949 and penalties under section 294 for failure to file declarations of tax and underestimations of estimated tax based on zero amounts. Held, that petitioners realized gross profit of $ 85,088.41 in 1949 from sales of whiskey; that the fraud penalty was improperly imposed; that respondent did not err in imposing penalties under section 294; that the cost of confiscated whiskey is not deductible.

John E. Marshall, Esq., for the petitioners.

W. B. Riley, Esq., and John P. Higgins, Esq., for the respondent.

Johnson, Judge.

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JOHNSON

The respondent determined deficiencies in petitioners' income tax for the years 1948, 1949, and 1950, and assessed penalties as follows:

		Penalties	Penalties	Penalties
Year	Deficiency	sec. 293 (a)	sec. 293 (b)	sec. 294 (d)
1948	$ 2,634.26	$ 131.71		$ 688.03
1949	16,508.00		$ 8,254.00	2,969.12
1950	2,973.68	148.68		930.08

The issues for decision are whether respondent erred (1) in increasing petitioners' income for 1949 based upon alleged understatement by them of gross profits they received from the sale of whiskey; (2) imposing a fraud penalty for 1949; (3) imposing penalties for 1948, 1949, and 1950, due to taxpayers' failure to file declaration of estimated tax and substantial underestimate of same; (4) disallowance in 1948 and 1950 of a deduction for cost of purchased whiskey seized and confiscated by law enforcing agencies.

The proceeding was heard before Clyde Wendelken who was designated as a Commissioner for that purpose pursuant to Rule 48 of the Rules of Practice of the Tax Court and section 1114 (b), Internal Revenue Code.

FINDINGS OF FACT.

The stipulated facts are so found.

The following facts contained in Commissioner Wendelken's Report filed herein and served upon the parties are hereby found and adopted.

The petitioners are husband and wife residing in Oklahoma City, Oklahoma. They filed joint income tax returns for the taxable years with the collector of internal revenue for the district of Oklahoma.

The husband, G. E. Fuller, hereinafter referred to for convenience as the petitioner, was engaged during all of the taxable years in the business of buying tax-paid intoxicating beverages and selling them at wholesale and retail to customers in and around Oklahoma City, Oklahoma. He purchased stamps from a collector of internal revenue for the wholesale and retail sale of intoxicating beverages and had such stamps for the year 1949. The petitioner knew during the taxable years that it was contrary to the laws of Oklahoma to engage in the business of buying and selling intoxicating beverages.

After May 5, 1948, the petitioners were partners in a business of buying and selling salvage under the trade name of A & A Iron and Metal Company.

The headquarters of the business of petitioner and the partnership were in Oklahoma City. Separate books of account were maintained for each business. The income and deductions of each business were reported on separate schedules in the returns filed by the petitioners for the taxable years. The returns reported partnership losses of $ 4,991.50 and $ 4,302.58 in 1948 and 1949, respectively, and profits of $ 8,117.11 in 1950. The amounts reported for the partnership were not adjusted by the respondent in his determination of the deficiencies involved herein.

The petitioner kept a single entry set of books. One of the books, known as a journal, contained sheets having the following headings: "Merchandise Bought," "Rent," "Phone Bill," "General Operating Expenses," and "Help and Sales." He did not prepare invoices for all sales. He did not retain any of the invoices unless the selling price was not paid for at the time of sale. Petitioner did not have a cash register. Entries for cash sales were made on a tablet and the total amount so recorded for each day was entered in the journal under "Sales" without showing the quantity of whiskey sold. The tablet was destroyed after the entry was made in the journal to avoid exposing customers whose names appeared in the record.

Regulations of the Commissioner of Internal Revenue required wholesale liquor dealers to keep daily records on Form 52-A for purchases and on Form 52-B for sales and to render monthly transcripts of the forms and a summary thereof on Form 338. Provision was made in Forms 52-A and 52-B for listing the name of the seller or buyer, and quantity and brand bought or sold. Records on the forms were kept by the petitioner during the taxable years, except for the period from October 12, 1949, until August 1950, when the "Bone-Dry-Law" of Oklahoma was in effect. During the period from October 12, 1949, to August 1950 wholesale liquor dealers outside of Oklahoma who complied with the Commissioner's regulations for recording sales on Form 52-B would not make sales of intoxicating liquors to petitioner for transportation into Oklahoma. He did, nevertheless, acquire whiskey from some source during that period.

During 1949 petitioner made entries in his name on Form 52-B for whiskey transferred from the wholesale to the retail branch of his business for the purpose of making sales of less than 5 gallons. At times the whiskey so transferred was retransferred to the wholesale branch when there was not enough whiskey in that department to fill an order. In such cases the whiskey was reentered on Form 52-A.

Regulations of the Commissioner treat sales of five or more gallons of whiskey as wholesale sales and less quantities as sales at retail. Petitioner made sales of less than 5 gallons in the retail branch of his business at wholesale prices out of whiskey transferred from his wholesale department. Regulations did not require petitioner to record such retail sales on any prescribed form. Petitioner regarded a sale of one-fifth of a gallon or less as a retail sale but he made no sales of such quantities during 1949. Quantities in excess of one-fifth of a gallon were regarded by him as a wholesale sale. He made sales of less than 5 gallons of whiskey but made no separate record of the transactions for the Alcohol Tax Unit. His place of business was closed from October 13, 1949, to October 29, 1949, during which period he did not make any sales. He made some sales of from one-half of a case to 2 cases directly to the consumer.

Forty-eight half-pint, 24 pint, 12 quart or 12 four-fifths of a quart bottles constitute a case of liquor.

Petitioner was required to make all of his purchases on a cash basis and had no accounts payable for purchases. He did not maintain accounts receivable in books but retained invoices of credit sales until the purchase price was paid.

The sale of intoxicating beverages in Oklahoma is highly competitive. Petitioner did not place selling price markings on any of his stock of whiskey and his mark-up over cost was not the same for all customers. His policy was to sell for the highest possible price, but at times he reduced his selling price to meet competition.

The records petitioner kept on Forms 52-A and 52-B were examined by agents of the Alcohol Tax Unit at times during the taxable years to determine whether he was keeping them correctly. Petitioner cooperated with the agents when they made the examinations. The agents made no complaint about the entries appearing in the records.

Separate checking accounts were maintained for the business of petitioner and the partnership. Petitioner and his wife also had three savings accounts and petitioner had a safe deposit box during the year 1949. He did not deposit all of the receipts of his liquor business in the bank account kept for that business. Some of the cash received was used to purchase whiskey and to pay labor and other operating expenses of his business, fines and bail for employees who had been arrested, and living expenses.

Petitioner generally kept about $ 3,000 or $ 4,000 of actual cash on hand to purchase whiskey, to furnish bail for employees, or to meet emergencies. A single purchase of whiskey by petitioner cost from $ 600 to $ 9,000, which he paid for in actual cash or by checks drawn against his checking account, or cashier's checks. Petitioner did not deposit receipts of his liquor business in a safe deposit box.

The income tax returns filed by the petitioners for the taxable years were prepared by a public accountant solely from figures given to him by petitioner. After the receipt of the notice of deficiency mailed herein, the same accountant was employed by petitioner to make, and did make, an audit of his books and records. Commencing in May 1952, another accountant employed by petitioner made an audit of his books and records. The only sales invoices he found among petitioner's records were for three sales in August and September 1949 to B. F. Roland for a total of 6 1/4 cases of whiskey. The accountant did not inspect public records for real estate transactions and mortgages and notes.

The books and returns of petitioner for the taxable years show purchases and sales of intoxicating beverages as follows:

Year	Books	Returns
1948: Purchases	$ 219,867.95	$ 219,867.75
Sales	259,993.20	259,958.55
1949: Purchases	346,789.21	346,789.21
Sales	393,432.88	393,469.72
1950: Purchases	240,448.67	238,149.22
Sales	274,804.90	273,418.50

The whiskey account kept by petitioner reflects bank deposits totaling $ 289,025.05 in 1949. The bank account had balances of $ 1,239.74 and $ 8,271.55 at the beginning and close of 1949, respectively.

In his return for 1949 petitioner reported gross profit of $ 46,865.36 from sales of whiskey. In his determination of the deficiency for that year respondent increased the gross profit by $ 40,006.73, computed as follows:

		Gross profit	Gross
Buyers	Cases sold	per case	profit
Raymond and James	901 3/4	$ 8.30	$ 7,484.28
Virgil and Leonard	103 1/2	11.00	1,138.50
Booker and Davis	295 1/4	15.10	4,472.64
Osborne Coe	88	11.50	1,011.00
R. R. Rainey	25	6.00	150.00
Frank Lewis	263	6.98	1,836.96
Retail	3,945	16.00	63,120.00
Others	513 1/2	16.00	8,216.00
Sales to Oct., 1948 6,135
All sales, Oct., Nov. and Dec. 1948 1	1,047	6.00	6,282.00
Totals	7,182		$ 93,711.38
Less: Hauling			6,839.29
Corrected gross profit			$ 86,872.09

The respondent obtained the names of the buyers and the number of cases purchased by them from carbon copies of Form 52-B records retained by the petitioner. The number opposite "Retail" is the total determined from the records as transfers from the wholesale to the retail branch of petitioner's business. The number opposite "Others" represents numerous small sales by the wholesale branch to buyers entered in Form 52-B and not listed by name in the deficiency notice. The gross profit on sales to Raymond and James, Booker and Davis, and Frank Lewis was determined by subtracting from the selling price disclosed by records of the buyers, the cost to petitioner as shown by his purchase invoices and Form 52-B records. The gross profit per case of the sales to them is the approximate quotient. The gross profit per case of the remaining sales, except to Osborne Coe, was computed in accordance with a voluntary written statement made by petitioner of his mark-up over invoice cost. The statement shows $ 11 as the mark-up per case on sales to Osborne Coe.

An acting special agent and a revenue agent devoted about 30 working days investigating the returns filed by the petitioners for the taxable years. Their report was the basis for the deficiencies determined by the respondent. Petitioner cooperated with the agents in their investigation.

During the period in 1949 to October 12, petitioner lost 18 10/24 cases of whiskey by theft or breakage. During that period and thereafter to the close of the year, he realized gross profit of $ 91,927.70 from the following sales:

			Gross profit	Gross
Buyer	Cases	Cost	per case	profit
Raymond and James	911.25	$ 43,227.72		$ 8,654.28
Virgil and Leonard	163.5	7,228.94		1,527.56
Booker and Davis	301.25	14,852.04		4,448.46
Osborne Coe	90 5/24		$ 11.00	992.29
R. R. Rainey	28		6.00	168.00
Frank Lewis	263	12,612.64		1,401.96
B. F. Roland	6.25	264.19		55.81
"Others"	437 1/24		16.00	6,992.67
Retail	3,837 19/24		16.00	61,404.67
All Sales Oct. 12 to Dec. 31	1,047		6.00	6,282.00
Total	7,087 7/24			$ 91,927.70

During 1948, 1949, and 1950 law enforcement agencies confiscated whiskey which had been purchased by petitioner at a cost of $ 9,091.50, $ 9,304.08 and $ 9,486, respectively. The number of cases confiscated in 1949 was 201, of which 152 10/24 cases, costing $ 6,706.30, were confiscated prior to October 12. The purchase price of the liquor was treated by the petitioner as a part of the cost of goods sold during the year of confiscation. The amounts included for 1948 and 1950 were eliminated by the respondent in his determination of the deficiencies. The petitioner was not compensated by insurance or otherwise for the liquor so confiscated. Petitioner had no closing inventory on October 12, 1949.

In June 1948 an agent of the Bureau of Internal Revenue informed petitioner verbally, after consulting with the collector, that confiscated whiskey should be reflected in his books as part of the cost of goods sold.

Petitioner filed a declaration of estimated tax for one or more years prior to 1948. At the beginning of 1948 and 1950 petitioner expected, and at the beginning of 1949 he hoped, that he would at least make $ 600 during each of those years. He was aware in 1948, 1949, and 1950 that taxpayers were required to file declarations of estimated tax. Petitioner did not file a declaration of estimated tax for any of the taxable years.

In connection with his determination of the deficiencies involved herein respondent imposed the following penalties:

	1948	1949	1950
Failure to file declaration (Sec. 294 (d) (1) (A))	$ 425.92	$ 1,838.03	$ 575.76
Underestimate of estimated tax (Sec. 294
(d) (2))	262.11	1,131.09	354.32
Fraud (Sec. 293 (b))		8,254.00
Negligence (Sec. 293 (a))	131.71		148.68

The deficiencies and penalties, and interest in the amount of $ 2,135.17, were assessed on October 30, 1951.

OPINION.

Petitioner reported gross profit of $ 46,865.36 in 1949 on gross sales of $ 393,469.72, by wholesale and retail, of intoxicating beverages in a business he admits was illegal under the laws of Oklahoma. He computed the gross profit by the inventory method. After an examination of petitioner's income tax liability for 1948, 1949, and 1950 by a special agent and revenue agent during about 30 working days, respondent increased the gross profit in 1949 by $ 40,006.73, or to $ 86,872.09, after allowing $ 6,839.29 for hauling, an increase in gross profit of about 85 per cent. The determination was made on the basis of sales of 7,182 cases in petitioner's wholesale and retail departments, at a mark-up in most instances of certain amounts over invoice cost. He obviously resorted to that method of arriving at gross profit because of lack of reliance on the books maintained by petitioner.

Petitioner returned the gross profit entered in his books, which he insists were accurately kept. The number of cases of whiskey sold during the first 9 months was determined from Treasury Department forms kept by petitioner for purchases and sales, including transfers of whiskey from the wholesale to the retail department of his business, and vice versa. The forms were not maintained after October 12, when a bone-dry law was in effect in Oklahoma. The basis for the mark-up selling prices used by the respondent was an affidavit signed by petitioner.

Petitioner contends that the respondent's determination was arbitrary. To establish arbitrariness he relies upon the affidavit and alleged taxation in 1949 of sales made in 1948.

The affidavit was admitted in evidence without objection. Petitioner on cross examination was asked by respondent's counsel to read from the affidavit, whereupon petitioner's counsel suggested that the affidavit be put in evidence, rather than have the witness read therefrom, and respondent's counsel then offered it in evidence.

Petitioner testified that he signed the affidavit after reading it, and admitted that some statements therein differed from the testimony which he had given at the hearing; that he made it voluntarily and not under coercion. In answer to his counsel he said that he got tired of answering questions, and to keep from being further bothered he signed same.

At no time was a motion made to exclude the affidavit, and its validity was first attacked by petitioners in their brief, on the ground that it "flowered from an investigation demand not authorized by law." Then follows a discussion designed to show that the examination of petitioner by the revenue agent prior to the preparation and execution of the affidavit was not made in accordance with the regulations of the Bureau of Internal Revenue promulgated under the Administrative Procedure Act. If objection had been made to the admission of the affidavit on that ground, it would have been incumbent upon us to consider the argument and examine the authorities cited in petitioners' brief on this question, but since the affidavit was admitted in evidence without objection, all objections to its admissibility were waived and it "is entitled to its full and natural probative effect." ^{*180 There is no merit to the contention of petitioner that respondent taxed him in 1949 on sales made in 1948. The testimony establishes that the original report of the revenue agent for the year 1949 showed the sales before October and thereafter as transactions taxable for that year. In preparing the statement attached to the deficiency notice the year 1948 was erroneously inserted for the year 1949. It was obviously a typographical error, as we have found. In fact, petitioner now agrees with our finding that he sold 7,087 7/24 cases of whiskey in 1949.}

Evidence produced at the hearing established that the total gross profit on sales at wholesale of about 1,640 cases to four customers was about $ 1,000 in excess of the amount determined by the respondent. The gross profit, computed on actual cost and selling price, tends to support the accuracy of the mark-up price set forth in petitioner's affidavit. For instance, petitioner's affidavit shows a mark-up of $ 15 a case on sales to Booker and Davis. Actual profit was about $ 14.75 a case without taking into account a discount allowance of $ 3 a case to the buyer. In the case of Raymond and James, $ 8 was given as the mark-up and the actual profit was about $ 9.50 a case. Of the total sales prior to October 12, about 65 per cent was at retail. Petitioner informed the special agent that his mark-up on sales at retail was from $ 15 to $ 17 a case. The mean figure was shown in the affidavit.

The evidence before us fully sustains the method employed by respondent in determining petitioner's gross profits from sales of whiskey and the amount thereof to the extent of $ 91,927.70, less the allowance of $ 6,839.29, which is not in controversy.

As to fraud penalties for 1949 imposed under section 293 (b), Internal Revenue Code, in respondent's deficiency notice, after a careful review and consideration of all the evidence, the argument of counsel, and the authorities cited by the parties, we find that respondent has not sustained his burden of proof on the issue of fraud, and accordingly we hold for petitioners on this issue.

As to penalties for 1948, 1949, and 1950, imposed under section 294 (d) (1) (A) and (d) ( 2), Internal Revenue Code, by respondent in his deficiency notice, we sustain the respondent's determination and hold that he properly added both penalties for each of these years.

It has not been shown that the failure of petitioners to file declarations of estimated tax for the years 1948, 1949, and 1950 within the time prescribed was due to reasonable cause and was not due to willful neglect. Undoubtedly, therefore, the record sustains respondent's determination of penalties under section 294 (d) (1) (A) for each of these years.

The failure of petitioners to file declarations of estimated tax within the time prescribed for each of these years necessarily resulted in a substantial understatement of estimated tax. We can not agree with petitioners' contention that because they filed no declaration of estimated tax under section 294 (a) (1), they can not be held to have violated section 294 (d) (2) for making a substantial underestimate of the estimated tax. The regulation section 294 (d) (2) shall be zero, and that is the basis used by respondent in computing the deficiency under this subsection. The petitioners attack the regulation as being void in that it "distorted the will of Congress." The regulation is couched in the same language used by Congress in its Conference Report 2 on legislation covering this subject and follows the procedure therein prescribed. It therefore appears that the regulation actually reflects, rather than distorts, the will of Congress, and we uphold its validity.

Petitioner used the inventory method of computing gross profit in 1948 and 1950 from sales of whiskey. The respondent decreased the amounts reported for purchases by the cost of whiskey which was confiscated during those years and not compensated for by insurance or otherwise. The primary difference between the parties is whether the cost of the whiskey constitutes part of the cost of goods sold by petitioner.

Respondent agrees with petitioner that Lela Sullinger, 11 T. C. 1076, requires that the cost of goods sold be taken into account in arriving at gross income. Here, the whiskey involving the controverted amount was confiscated, and thereafter was not available for sale or actually sold by the petitioner during the taxable years. Since the goods were not sold and after seizure were not on hand for sale, the costs may not be used in any computation of gross receipts from sales under section 113. See Weather-Seal Manufacturing Co., 16 T. C. 1312, affd. 199 F.2d 376">199 F. 2d 376; Commissioner v. Weisman, 197 F.2d 221">197 F. 2d 221.

Petitioner contends in the alternative that the amounts are deductible as losses under the provisions of section 23 (e). He recognizes the rule, applied in numerous cases, of denying expense and loss deductions because allowance would frustrate sharply defined state or Federal policies but says that the rule was "badly crippled" in Lilly v. Commissioner, 343 U.S. 90">343 U.S. 90.

In Commissioner v. Heininger, 320 U.S. 467">320 U.S. 467, the Court said that if deduction of the litigation expenses involved were to be denied "it must be because allowance of the deduction would frustrate the sharply defined policies of" the statute authorizing issuance of fraud orders by the Postmaster General. It concluded that allowance of the expenses "would not frustrate the policy of these statutes." The Court's remarks disclose recognition of the rule. National Brass Works v. Commissioner, 182 F.2d 526">182 F. 2d 526; William L. Butler, 17 T.C. 675">17 T. C. 675; Pacific Mills, 17 T.C. 705">17 T. C. 705. The Lilly case, involving the deductibility as business expenses of amounts paid by an optician to doctors out of the retail price charged for filling their prescriptions, discussed its Heininger opinion and concluded that "Neither that decision nor the rule suggested by it requires disallowance of petitioners' expenditures as deductions in the instant case." It then remarked, under an assumption "for sake of argument," that expenses may not be allowable because they violate public policies, that "The policies frustrated must be national or state policies evidenced by some governmental declaration of them" and that during the taxable years involved in the case there were no such policies in effect. We do not regard the Lilly case as opposed to the application of the rule. Charles A. Clark, 19 T.C. 48">19 T. C. 48.

The extent to which the rule has been applied is shown by the various cases collected in Lawrence A. Wagner, 30 B. T. A. 1099, and Standard Oil Co., 43 B. T. A. 973, affd. 129 F.2d 363">129 F. 2d 363. The decisions disclose that each case is controlled by its peculiar facts.

Statutes of Oklahoma prohibit, under penalty of fine and imprisonment, the sale of intoxicating beverages or possession in excess of one quart thereof. Okla. Stats. Ann., Title 37, sections 1, 6. Petitioner was aware throughout the taxable years that the operation of his business was in violation of the laws of Oklahoma; hence there is no problem here as to his intention at the time of acquisition of the whiskey. His volume of sales and numerous violations of the state policy is indicated by gross sales of about $ 260,000 and $ 273,000 which he reported in returns filed for 1948 and 1950.

Petitioner acquired no property rights of any kind in the confiscated whiskey. Okla. Stats. Ann., Title 37, section 72. This provision, with other prohibitory liquor laws of Oklahoma, rendered the intoxicating liquor held by petitioner contraband property without property rights therein and he was not entitled to a return of the liquor even though it may have been seized under an illegal search warrant. Lee v. State, 180 Okla. 643">180 Okl. 643; 71 P.2d 1090">71 P. 2d 1090. The statutes of Oklahoma and the interpretation thereof by the courts of Oklahoma are cited by the respondent, without discussion, to require a denial of the claimed deductions upon the ground that petitioner had no property rights in the contraband liquor.

While the confiscated liquor constituted property, petitioner had not at any time rights therein sufficient to avoid confiscation by the state without compensation for loss. Only lack of complete administration of the existing statutes prevented petitioner from losing the whiskey the moment he was found with it in Oklahoma.

The point raised by respondent need not be considered to a conclusion for we are satisfied that the so-called public policy rule is applicable and bars allowance of the amounts in controversy, and so hold.

As to negligence penalties for 1948 and 1950 imposed under section 293 (a) in respondent's deficiency notice, which petitioners assigned as error, respondent on brief adopts the finding made by Commissioner Wendelken in his report that no part of these deficiencies was due to negligence, and accordingly we hold for petitioners on this issue.

When determining the deficiencies and imposing the penalties, respondent computed interest thereon without including the amount as part of the deficiencies. The interest which, with the deficiencies, has been assessed is set forth in the petition as amounts in controversy and petitioners pray that it be eliminated. No specific issue was raised in regard to the interest and it is not discussed on brief. No consideration has been given the question in view of lack of jurisdiction of this Court over matters relating to interest. Gussie P. Chapman, 14 T.C. 943">14 T. C. 943, affd. 191 F.2d 816">191 F. 2d 816.

Decision will be entered under Rule 50.

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Footnotes

• 1. The figure 1948 is a typographical error. The correct year is 1949.↩

• 1. [§ 190] b. Failure to Object -- (1) Statement of Rule. It is very generally held that a failure to object to evidence at the time it is offered is a waiver of all objections to its admissibility. The waiver is operative not only as affecting subsequent proceedings on the trial, but also as affecting the right to have questions of its admissibility reviewed on appeal or writ of error. * * * [64 C. J. 168].

  [§ 239] * * * incompetent evidence, when admitted without objection, has the same effect and must be given the same consideration as if it were legally admissible; hence it is entitled to its full and natural probative effect, and may establish a fact in issue, and sustain a verdict or judgment based thereon. * * * [64 C. J. 224].

  NOTE: Cited in support of above are authorities from many Federal and state courts.↩

• 2. * * * In the event of a failure to file the required declaration, the amount of the estimated tax for the purposes of this provision [section 294 (d) (2)] is zero. [Supplement to Regulations 111, sec. 29.294-1 (b↩) (3) (A), p. 438; Conference Rept. H. Rept. No. 510, 78th Cong., 1st Sess., p. 56].