Chestnut Farms Dairy v. Commissioner

*192 Respondent has determined a deficiency in income tax against the petitioner, Chestnut Farms Dairy, Inc., for the year 1924 in the amount of $7,295.13, and deficiencies in income tax against petitioner, Henry N. Brawner, Jr., hereinafter referred to as Brawner, for the years 1922, 1923, and 1924 in the respective amounts of $10,303.78, $11,065.53, and $3,010.40. Petitioner, Chestnut Farms Dairy, Inc., assets that respondent erred in disallowing as a deduction from gross income the sum of $55,000, which represented a payment made in 1924 in settlement of litigation brought about in the ordinary course of business operations. Petitioner, Brawner, in his original petition asserts that respondent erred in disallowing as deductions the amounts of $25,300 and $29,589.71 which represented necessary business*2467 expenses paid in the years 1922 and 1923 in settlement of litigation in the ordinary course of business operations. In his amended petition Brawner asserts that respondent erred in disallowing as a deduction from gross income for the year 1923 the amount of $109,889.71, representing the total amount paid in settlement of litigation with Mrs. George M. Oyster.

FINDINGS OF FACT.

Petitioner, Chestnut Farms Dairy, Inc., is a corporation which was organized under the laws of Delaware in January, 1924, and has its principal office in Washington, D.C. Petitioner, Brawner, is a citizen of the United States residing in Washington, D.C. The accounts of Brawner are kept on an accrual basis.

Petitioner, Brawner, entered the employ of George M. Oyster, Jr., hereafter referred to as Oyster, on August 1, 1901. Oyster was then engaged and had been prior thereto in the dairy business under the trade name of Chestnut Farms Dairy. Prior to March 17, 1921, *193 and at dates not shown Brawner had borrowed from members of his family about $20,000, which he advanced to the dairy business to pay current debts. Under date of March 17, 1921, Brawner and Oyster entered into a partnership*2468 agreement the material parts of which read:

THIS AGREEMENT made this 17th day of March, A.D. 1921, by and between GEORGE M. OYSTER, Jr., of the City of Washington, District of Columbia, party of the first part, and HENRY N. BRAWNER, Jr., of the same place, party of the second part:

WHEREAS the said party of the first part has for a number of years conducted the dairy, butter and egg business in the District of Columbia, and in connection therewith has maintained a farm and certain receiving stations in the State of Maryland; and

WHEREAS the party of the second part has been in the employ of the party of the first part for more than nineteen years, and for the greater portion of the years last past has been entrusted with the actual management and conduct of the said business by the party of the first part, remaining in such employ and assuming the responsibilities of such management and conduct under the promise and agreement on the part of the party of the first part that he, the party of the first part, when thereto requested by the party of the second part, would sell, transfer and assign to the party of the second part an interest as partner in the said business; and

WHEREAS*2469 the management and conduct of the said business will hereafter to a great extent be dependent upon the personal efforts and services of the party of the second part; and

WHEREAS the party of the first part is desirous of recognizing the faithful services of the party of the second part and carrying out his agreement with the said party of the second part in the matter of the said partnership interest; NOW, THEREFORE, THIS AGREEMENT WITNESSETH:

That for and in consideration of the premises, the covenants and agreements hereinafter set forth and of the sum of Ten Thousand Dollars ($10,000.00) in cash in hand paid by the party of the second part to the party of the first part, the receipt whereof is hereby acknowledged, the said parties, each for himself and for their respective personal representatives, do hereby covenant and agree to and with the other in the manner following, that is to say:

1. The said George M. Oyster, Jr., and the said Henry N. Brawner, Jr., shall be and do hereby become partners in the dairy, egg and butter business heretofore conducted by the party of the first part under the trade name of "The Chestnut Farms Dairy"; the party of the first part hereby sells, *2470 assigns and transfers into the party of the second part in fee and absolutely, a 45/100 undivided interest in and to all the real estate, assets, fixtures, paraphernalia of trade, good will and personal property hereinafter mentioned and referred to.

2. The said partnership shall be deemed to have begun as and on the first day of January, A.D., 1921, and shall continue for the term of ten (10) years from said date.

3. That the firm name and style of said partnership shall continue in the name of George M. Oyster, Jr., the said business to be conducted at its present location, or elsewhere, as said partners, each with the other, may from time to time agree.

4. It is understood and agreed that there is included in and as a part of the assets of said partnership, the establishment now or hereafter maintained in the City of Washington, District of Columbia, the farm located near *194 Walkersville, in the State of Maryland, the receiving stations at Walkersville, Frederick, New Midway and Kalmia, located in the State of Maryland, together with all of the lands, buildings, machinery, equipment, and personal property of every kind and character now used in connection with*2471 the said business or upon any of the said receiving stations or at the said farm, especially including all wagons, horses and stock of every kind and character, whether pedigreed or otherwise, together with the bank account and bills receivable as of January 1, 1921.

5. It is further covenanted, understood and agreed that the interest and title of the parties hereto in and to the said copartnership business, and the assets, property, real and personal thereto appertaining, shall be Fifty-five (55) per cent thereof to the said George M. Oyster, Jr., party hereto of the first part, and Forty-five (45) per cent thereof to Henry N. Brawner, Jr., party hereto of the second part; it being further understood and agreed that the present outstanding obligations and liabilities of the said business are assumed by the parties hereto in proportion to their aforesaid interest in said business.

* * *

11. It is further covenanted and agreed by and between the parties hereto that upon the death of either of said partners, the surviving partner shall have the right to continue the said business until the said partnership shall be wound up, which shall not be later than fifteen months from*2472 the qualification of the representatives of the estate of the deceased, the right being hereby given to the surviving partner to purchase the interest of the deceased partners in all of the assets of said partnership or such parts thereof as the survivor may elect, by paying therefor to the representatives of said deceased's estate the value thereof as fixed by the last inventory of said partnership assets and accounts, prior to the death of the deceased partner and adding thereto the proportionate net profits accruing to such deceased's interest from the date of such inventory to the date of his death, the purchaser being hereby given the right either to pay in cash for the interest of the said deceased partner so purchased, or in five annual instalments to be evidenced by the notes of the purchaser, to bear interest at the rate of five per cent per annum, and in case of said purchase, the survivor shall be permitted to keep and retain the said business, together with all of the assets, real and personal, for his individual use and benefit; that in the event that said surviving partner shall conclude within the said fifteen months not to purchase the same, then the said business and*2473 property is to be sold at public or private sale and the proceeds thereof distributed according to the respective interests of the parties in said business.

The above agreement was signed by the parties and their signatures were attested by two witnesses. It was further acknowledged by Brawner before a notary public on August 3, 1921. Oyster died testate April 24, 1921. On August 3, 1921, Brawner formally notified the executor of the Oyster estate that he elected to purchase the entire interest of Oyster in Chestnut Farms Dairy, and tendered to such executor his five notes, dated April 24, 1921, each for the sum of $22,635.75 payable in one, two, three, four, and five years, respectively, and bearing interest at the rate of 5 per cent per annum. The total amount of the purchase notes was $113,178.75. The notes were accepted by the executor and all of them have *195 been paid. The purchase by Brawner was based on the value of the property as shown by the books of the Chestnut Farms Dairy as of April 24, 1921. The following are the assets and values on said date as shown by the books:

*2474 The lease of the property No. 1116 Connecticut Avenue expired in February or March, 1923, and the lessee did not have the right of removal and did not remove the building. The machinery set forth above was old and it was necessary to replace it shortly. When the business was removed to a new location in 1925 only about $2,000 worth of the machinery was removed. Depreciation had been taken on the machinery at the rate of 10 per cent per annum which was an inadequate rate of depreciation of dairy machinery. The Kalmia plant at a later date, not shown, was sold for $7,000. The new Midway plant was not worth $15,000, and at the present time could not be sold for $7,000. Chestnut Farm was located in Walkersville, Md., and contained 146 acres of land. It was purchased by Oyster in 1918 at a cost of $30,000. He expended further amounts on the property in the shape of the cost of buildings, roads, stock and horses. The sum of $4,000 which was expended for roads did not enhance the value of the property to that extent. The farm was sold by Brawner at a date not shown for $103,000, but whether the stock and horses above mentioned were included in the sale does not appear. At a later*2475 date, not shown, the farm was resold for $48,000. Chestnut Farms Dairy purchased milk from about 200 farmers, whose bills were payable on the fifteenth of the month following the month of delivery. At the time of Oyster's death, and prior thereto for a time not shown, such bills were not paid on the fifteenth of the month but sometime subsequent to the first of the following month and in one case not until three months after the due date. These delays in payments were caused by lack of funds.

*196 On December 8, 1921, Cecile R. Oyster filed her bill of complaint in the Supreme Court of the District of Columbia against the executor and trustee of the estate of Oyster, and against the brothers, sisters, nephews, and nieces of Oyster and Brawner. It is alleged in the bill that Cecile R. Oyster married Oyster January 15, 1921; that Oyster died a resident of the District and left surviving him no descendants, and that his only heirs and next of kin were his widow and certain brothers, sisters, nephews and nieces; that a paper purporting to be his will and a codicil thereto had been admitted to probate in the District of Columbia; that she, the widow, had filed a petition and*2476 caveat in the administration cause; and that on November 8, 1921, she had filed in said cause her renunciation and quit claim of any devise, and bequest under said will and codicil. The plaintiff alleged that she was born January 17, 1895, and was in good health. The remaining allegations of the bill which are pertinent to this proceeding are that at the time the alleged articles of partnership between Oyster and Brawner were executed the said Oyster was 72 years of age; that his health and mental capacity had begun to fail; that the articles were executed at the request and under the undue influence and coercion of Brawner and for the purpose of depriving plaintiff of her just and legal right as widow of said decedent; that Brawner did not pay value for the 45 per cent interest in the business purchased by him from decedent. After alleging that the inventory taken by the executor did not disclose all the assets nor the true value of decedent's estate, she made the following allegations in the tenth paragraph of her bill.

10. That said inventory of goods and chattels and said inventory of money and debts due to deceased are inaccurate, incomplete and unreliable and they undervalue*2477 the estate of deceased to the extent of several hundred thousand dollars, and probably to the extent of one million dollars, since the milk and dairy business alone, owned by the deceased at the time of his death, is the largest business of that kind in the District of Columbia and has produced net profits for several years in the neighborhood of $1,000,000.00 per annum, which fixes its value at $1,000,000.00 on the basis of a net ten per annum, on the investment, and which was valued at or stated by the deceased to be worth in the neighborhood of from one to two million dollars, and accordingly said inventories and appraisements of the goods and chattels and of the moneys and debts due to the beceased should be rejected and declared void and held for naught and said executor should be charged with and held responsible for the full and entire estate of deceased, including all the goods and chattels and moneys and debts due, as herein set forth or referred to or mentioned, and any other property hereinafter disclosed belonging to the estate of deceased or to which the estate of deceased is entitled.

Plaintiff asserted dower rights in the farm and other real estate of her late husband*2478 being Chestnut Farms located at Walkersville, Md., and the real estate located at Frederick, Md., Kalmia, Md., and New Midway, Md. The bill concludes with numerous prayers among *197 which are that the articles of partnership be declared null and void; that the sale by the executor of the partnership business to Brawner be set aside; that a temporary restraining order and an injunction be granted preventing Brawner from disposing of any of the assets of the estate of decedent; that a receiver be appointed to operate the dairy business under the control of the court until the final disposition of the cause; that a general accounting be had and that plaintiff be granted and have transferred to her plaintiff's share and part of all the real and personal estate of said decedent. Brawner filed his answer in said cause April 12, 1922. The answer admitted the marriage of Oyster and the plaintiff, the allegations relative to the heirs and next of kin of Oyster, and that the plaintiff had filed her renunciation and quit claim of devises and legacies under the will. The answer denies that the execution of the articles of partnership were procured by undue influence; asserts that at*2479 the time they were executed the mental condition of Oyster, who had been a business man of high standing and long experience, was as good as it ever had been; asserts that the relations between him and Oyster were those which usually existed between father and son, and that the contract of partnership was made at the instance of Oyster.

With respect to the 10th paragraph of the bill the answer makes the following allegations and denials:

10. Answering Paragraph Ten, or so much thereof as may be pertinent to the issue raised between the plaintiff and this defendant, he says that said dairy and milk business, being the business of the partnership between the said Oyster and this defendant, could not legally be included in said inventory, and this defendant denies that the said business was worth one million dollars at the time of the decedent's death, or that it ever was, or is now, worth one million dollars, and never did the decedent, in the presence of this defendant appraise said business at either one or two million dollars, nor did this defendant ever hear of said decedent making such an appraisement thereof, and has no reason to believe that the said decedent did make such*2480 an appraisement thereof. On the contrary, this defendant says that, at the time of and for some time prior to the decedent's death, the said business was heavily involved and that there were debts of approximately $450,000., against said business, and that its condition, at the time of this defendant's trip to Florida was such as to be a matter of grave concern to the said Oyster and this defendant, and by reason of the large expenditures and the extravagant demands of the said plaintiff upon said Oyster, it was necessary for him to withdraw from the said business larger sums of money than the business could fairly and justly stand, and how the said Oyster could meet the demands of the plaintiff and at the same time have sufficient cash in the business was a matter of grave concern to him. This defendant has no direct personal knowledge as to the other matters referred to in said paragraph with reference to said inventory and says that he is advised it is not necessary for him to make answer thereto.

*198 Brawner feared that the appointment of a receiver would have a bad effect upon the farmers who sold him milk. He also feared the effect a receivership would have on the*2481 procuring of new capital needed for new machinery and for the renewal of his lease or for the acquisition of a new location.

Due to the congestion of the dockets of the courts of the District of Columbia, trial of the cause and an affirmance or reversal thereof by the Court of Appeals of the District of Columbia could not have been had until some time in the year 1925. After several months of negotiation the action was settled as between the plaintiff and Brawner in 1923. It was settled by the payment by Brawner to the widow of a total sum of $40,000 in 1923 and by Brawner in that year giving to her his notes for $55,000. These notes were paid by Chestnut Farms Dairy, Inc. in 1924. Petitioner paid in 1923 as attorneys' fees and expenses of this litigation the sum of $14,889.71.

In computing taxable income, the Commissioner refused to allow any deduction for such payments.

OPINION.

PHILLIPS: The petitioners allege that the Commissioner erred in refusing to allow as deductions in computing taxable income the payments made to Mrs. Oyster and for attorneys' fees and expenses, as set out in the findings. The petitioners were originally drafted upon the theory that such*2482 payments were deductible in the year of payment, but at the hearing the petition of Brawner was amended to claim the entire amount of these payments as deductions in 1923, the year in which incurred. The petitioner, Chestnut Farms Dairy, Inc., did not urge the error assigned in its petition and the deficiency asserted against such petitioner is approved.

The sole question under the amended pleading is whether the payment to Mrs. Oyster and for attorneys' fees and expenses, made under the circumstances set out in the findings of fact, constitute ordinary and necessary expenses of Brawner's business for the year 1923. Brawner testified that his reason for compromising the suit was that he feared the appointment of a receiver would ruin the business and that he was confident of winning on the merits. We do not question the seriousness of the situation caused by the threat of a receivership, although it seems improbable that the results would have been as disastrous as the testimony would indicate was feared. Moreover, it can not be assumed that a receiver would have been appointed without a proper showing and the assumption by Brawner, acting under legal advice, that a receivership*2483 was probable does not support the theory that Mrs. Oyster's suit was without merit.

The receivership was asked only as an incident to the claim of an interest in the business and in the real estate. It was these claims *199 which were settled. However persuasive the threat of receivership may have been in inducing the settlement, the fact remains that Mrs. Oyster's claim to dower in the real estate (and the record does not indicate that this was not a sound claim) as well as her other claims, were satisfied. All of these claims were asserted against the title of Brawner to the assets of the business.

The Board has previously decided that expenses of defending title to capital assets ordinarily may not be deducted as expenses, but must be treated as a part of the cost of such assets. ; ; ; ; *2484 ; ; , affd., ; and it would seem clear that amounts paid by the ostensible owner in settlement of a suit attacking his title can not be classified as any expense, however unjustified such a suit may appear to him to be. Seletha O. Thompson, Murphy Oil Co., Newark Milk & Cream Co., all supra; .

Reviewed by the Board.

Decisions will be entered for respondent.