Central Union Trust Co. v. Commissioner

*757 This proceeding involves a deficiency in income tax for the year 1919 of $124,167.75, determined by the Commissioner to be due from the estate of Daniel T. Garrie, who died on October 4, 1922. Of the deficiency determined by the Commissioner, $98,524.53 *758 was assessed on March 13, 1925, under the provisions of section 274(d) of the Revenue Act of 1924, and a fraud penalty of 50 per cent, amounting to $49,262.27, was assessed at the same time.

A claim for abatement of the total tax and penalty amounting to $147,786.80 was filed on April 2, 1925, by the executors of the estate of Daniel T. Garrie. On August 12, 1927, the Commissioner notified the estate of his final determination of the income-tax liability of Garrie for the years 1918 and 1919, advising that the claim for abatement would be rejected for the full amount for the reason that "the tax due is in excess of the amount shown in the claim." In this notice of deficiency there is proposed for assessment the sum of $25,643.22 in addition to the amounts previously assessed for*1493 1919.

At the hearing the respondent withdrew his claim for the penalty in the amount of $49,262.27.

FINDINGS OF FACT.

Petitioner is an executor of the last will and testament of Daniel T. Garrie, deceased.

Prior to May 1, 1918, Daniel T. Garrie obtained an order to furnish cigarettes to the Knights of Columbus. At this time there was a great demand for cigarettes for Army use. Garrie was wholly unacquainted with the tobacco business, but knew A. H. Hillman, who had been connected with the tobacco business for over fifty years and who was then publishing the Tobacco Record, a trade paper. Hillman's acquaintance with the trade enabled him to procure and he did procure a tobacco factory to fill the orders for cigarettes which Garrie had obtained from the Knights of Columbus.

On May 1, 1918, an agreement was reached between Garrie and Hillman and A. H. Hillman Company, a corporation of which Hillman was the president, with respect to the division of profits from the sale of cigarettes for export to the Knights of Columbus, which agreement was ratified and accepted by A. H. Hillman Company on August 21, 1918. The terms of this contract are not known.

On December 23, 1918, another*1494 contract was entered into between the same parties, canceling the contract dated May 1, 1918, by which A. H. Hillman Company was to continue to carry out the contracts for 150,000,000 cigarettes which had been entered into with the Turko-American Tobacco Company, trading under the name of Oriental-American Tobacco Company, until the full amount of cigarettes so ordered from the Turko-American Tobacco Company should have been delivered. It was provided that out of the net profits arising out of the sale and delivery of this order for 150,000,000 cigarettes Garrie should be entitled to receive a sum equal to 10 cents for each 1,000 cigarettes, together with 50 per cent of the *759 net profits arising therefrom. It was further provided that any future orders for cigarettes obtained by Garrie from the Knights of Columbus should be filled by Garrie, trading as the Oriental-American Tobacco Company, and that Garrie should receive 50 per cent of the net profits of such orders in addition to a bonus equal to 15 cents for each 1,000 cigarettes delivered thereunder.

On December 30, 1918, the same parties entered into a contract cancelling all agreements theretofore entered into between*1495 the parties or any of them, it being provided that the parties should retain payments already made and that Garrie should recieve any payments due him on account of the profits derived from the sale of the 150,000,000 cigarettes originally ordered by the Knights of Columbus. It was further provided that Garrie should continue to have the sole and exclusive right to use the trade name of Oriental-American Tobacco Company and that nothing should preclude any one of the parties from entering into contracts with each other for the purchase and sale of cigarettes on a commission basis or otherwise. On the same day Garrie entered into contracts of employment with A. H. Hillman, H. M. Konwiser (Hillman's associate in the publication of the Tobacco Record) and Hillman's three sons, Fred J., Walter E., and Albert W. Under each of these contracts Garrie agreed to pay, in consideration of services in procuring and filling cigarette orders, a fixed commission representing a percentage of the gross sales of the Oriental-American Tobacco Company, and to make an allowance for expenses not to exceed a specified sum, one-half of the commissions due thereunder to be paid in 1919 and the balance payable*1496 on the date of the President's proclamation of peace with Germany, or in any event not later than three years from the date of the instrument.

Garrie conducted the business in the year 1919 under the trade name of Oriental-American Tobacco Company and his books were kept on the accrual basis in that name.

The gross sales of cigarettes to the Knights of Columbus in 1919 amounted to $2,411,581.96. The commissions payable by Garrie under the contracts of employment dated December 30, 1918, totaled 15 per cent of this amount, or $361,737.30, and this is the sum shown on his income-tax return for 1919 as a deduction for commissions. Sums totaling one-half of these commissions, or $180,868.65, plus expense allowances amounting to $26,000, were paid in 1919 by checks drawn by Garrie to Konwiser and the four Hillmans and these payments on account of commissions were entered on Garrie's books under the names of the several payees. The remaining one-half of the total commissions due was entered on his books as "accrued commissions." These accrued commissions were subsequently paid by Garrie in cash and bonds, and receipts therefor dated January 14, *760 1921, signed by Konwiser*1497 and the four Hillmans, were given to Garrie. Of these payments made in January, 1921, $62,000 represented Liberty bonds and $50,000 represented New York Central Equipment bonds, for which Liberty bonds had been exchanged. An entry of payment of the balance due on the accrued commissions was made on Garrie's books as of December 31, 1920.

In addition to the payments made by Garrie in 1919 to cover one-half of the commissions due under the contracts of employment, Garrie paid to Konwiser and the three Hillman sons in 1919 an aggregate amount of $112,000, or $28,000 each. These payments of $28,000 to each were made by checks drawn by Garrie and were not entered on his books as disbursements on account of commissions, but were charged to "Liberty bond account." On December 31, 1919, there appeared as an asset on Garrie's books $112,000 in Liberty bonds, of which amount $50,000 was later exchanged for New York Central Equipment bonds. Interest on these bonds was entered on Garrie's books and reported in his income-tax return for 1919.

A. H. Hillman returned to Garrie in cash during the year 1919 an aggregate amount approximating, but not more than, $120,000.

An income-tax return*1498 for the year 1919 was filed by Garrie on March 15, 1920. Garrie died on October 4, 922. The notice of deficiency is dated August 12, 1927.

OPINION.

MATTHEWS: In the notice dated August 12, 1927, there is asserted against the estate of Daniel T. Garrie a deficiency in tax for 1919 in the total sum of $124,167.75, of which amount the sum of $98,524.53 represents a timely assessment made in March, 1925. The fraud penalty amounting to $49,262.27, which was also assessed in March, 1925, was withdrawn by the respondent at the hearing. It was admitted by the respondent that the balance of the deficiency in the sum of $25,643.22 was barried from assessment by the statute of limitations unless fraud could be shown and the respondent assumed the burden of proof in respect of fraud, in accordance with the provisions of section 601 of the Revenue Act of 1928. The total deficiency asserted was claimed by the respondent to have arisen out of the fraudulent understatement of income from the sale of cigarettes. Although the notice of deficiency does not clearly set out the method used in arriving at the proposed additional tax, it is stated in the brief filed for the respondent that the*1499 additional assessment in the sum of $98,524.53 was based on the disallowance by the respondent of a deduction for commissions which was claimed by Garrie in the sum of $361,737.30, and that the unassessed portion of the deficiency in the sum of $25,643.22 resulted from the action of the respondent in adding to the income reported by Garrie one-half *761 of the profits from the business carried on under the name of A. H. Hillman Company.

We shall not discuss in detail the evidence which was introduced at the hearing, but a brief resume of the essential facts will prove helpful in outlining the issues presented for determination.

At the beginning of the taxable year Garrie was the holder of valuable orders for the sale of cigarettes to the Knights of Columbus and he had enlisted the aid of A. H. Hillman, who had been closely connected with the tobacco business for many years, in securing manufacturing sources to be utilized in filling these orders. Hillman testified that it was easy to get orders for cigarettes at this time, but that it was not so easy to supply the cigarettes. Hillman procured a factory in 1918 to manufacture cigarettes and the total output was applied*1500 toward filling the orders which had been obtained by Garrie from the Knights of Columbus. For several months during 1918 the sales were handled through the A. H. Hillman Company under contracts with the Turko-American Tobacco Company trading under the name of Oriental-American Tobacco Company. After December 23, 1918, the orders were filled by Garrie trading as the Oriental-American Tobacco Company. Garrie's books were kept on the accrual basis, in the name of Oriental-American Tobacco Company. On December 30, 1918, Garrie entered into contracts with Hillman, with Konwiser (who was Hillman's associate in publishing a trade paper) and with Hillman's three sons, by the terms of which he agreed to pay to these parties commissions totaling 15 per cent of the gross sales of the Oriental-American Tobacco Company. These contracts determined the division between Garrie, on the one hand, and the Hillmans and Konwiser, on the other, of all profits derived in 1919 from the sale of cigarettes to the Knights of Columbus. The gross sales of cigarettes in 1919 amounted to $2,411,581.96, and 15 per cent of this amount is $361,737.30.

We do not know the underlying reasons for the execution*1501 of these contracts of employment. The petitioner claims that A. H. Hillman was in a position to dictate terms to Garrie and that Hillman contrived to spread his share of the profits by having Garrie pay over such profits to himself, his three sons and Konwiser under the guise of commissions, it being contended by the petitioner that the three sons and Konwiser were dummies for Hillman and that he ultimately received the entire amount of the commissions which Garrie agreed to pay under the several contracts of employment. The respondent questions the bona fides of the contracts of employment, claiming that they were only a blind intended to obscure the real nature of the transactions. The respondent admits that the gross sales of cigarettes were correctly reported by Garrie, but *762 has wholly disallowed the deduction for commissions in the sum of $361,737.30, on the ground that the sums making up this item were not in fact paid out by Garrie. It is further claimed by the respondent that certain payments which were apparently made in 1919 under the contracts of employment were repaid to Garrie in the same year.

Respondent contends that although the terms of the contract*1502 between Garrie and Hillman dated May 1, 1918, are not known, it may be inferred from other evidence that it provided for an equal division of the profits between them and that this original contract was revived by the cancellation on December 30, 1918, of the contract of December 23, 1918, so that the terms of the contract of May 1, 1918, remained in force throughout the taxable year. In addition to disallowing the deduction for commissions the respondent has included in Garrie's income one-half of the profits from the business carried on under the name of A. H. Hillman Company.

On the basis of all the evidence adduced at the hearing we believe that petitioner has sustained the burden of proving that the respondent's determination is incorrect and that the respondent has failed to establish that Garrie was guilty of fraud with intent to evade tax. Although the method of dividing profits from the sale of cigarettes may seem to be unusual, we find nothing in the record to impeach the bona fides of the contracts of employment. We have found that in compliance with the terms of these contracts Garrie paid by check in 1919 sums totaling one-half of the commissions due thereunder, *1503 proper entries being made on his books under the names of the several payees, and that the remaining one-half of the total commissions due was entered on his books as "accrued commissions." Inasmuch as his books were kept on the accrual basis, such an entry was authorized and he was entitled to claim as a deduction the full amount of the commissions, whether paid or accrued. Petitioner introduced in evidence Garrie's books and records, together with a number of canceled checks, vouchers, receipts and other papers and this documentary evidence is relied upon to support the petitioner's position. The book entries were not always made on the dates the respective transactions occurred, but were entered by Garrie's accountant from time to time from vouchers, check stubs, invoices, receipts and other memoranda. The cash book entries show the numbers of the checks and the checks themselves were offered in evidence to show that the money was received by the payees or by A. H. Hillman. The commissions which were accrued were shown to have been paid in cash and bonds in January, 1921, and an entry of payment of the balance due on the accrued commissions was made on Garrie's books as of December 31, 1920.

*1504 *763 The respondent is claiming that even if these sums were paid to the persons "employed" by Garrie, the money was repaid to Garrie in the same year. An examination of the checks drawn by Garrie to Konwiser and the three Hillman sons shows that some of these checks were endorsed to A. H. Hillman and it was testified that no consideration moved from A. H. Hillman to his sons or to Konwiser for the amounts so received. Hillman testified that he turned back to Garrie in 1919 cash amounting to approximately $120,000. His testimony with respect to repayments to Garrie was greatly weakened by his imperfect recollection of the transactions and nothing in the record indicates that they exceeded $120,000.

We think the respondent has failed to establish that any of the amounts returned by Hillman to Garrie represented income to Garrie or was kept by him for his own use. On the contrary, we have found that Garrie paid to Konwiser and the three Hillman sons in 1919, in addition to the payments covering one-half of the commissions due under the contracts of employment, an aggregate amount of $112,000, or $28,000 each, which payments were made by checks drawn by Garrie and were*1505 not charged on his books to the accounts of the several payees, but were charged in each instance to the Liberty bond account. No deduction is claimed on Garrie's income-tax return for 1919 on account of the payment of these amounts totaling $112,000. We do not know why Garrie should have paid out these sums only to take them back and invest them in Liberty bonds, which were subsequently turned over to the Hillmans in payment of accrued commissions, but we find the petitioner's explanation, supported by Garrie's books and the contracts, to be more plausible than the theory advanced by the respondent.

It must be borne in mind that Garrie is dead and can not come before us to explain the full nature of the transactions or to defend against the charge of fraud. The evidence leaves many loopholes and it is difficult to ascertain the true facts. Where no convincing explanation is given, we must draw whatever conclusion appears to be most reasonable, but fraud will not be imputed to a taxpayer in the absence of persuasive evidence.

The presumption that the respondent's determination is prima facie correct does not extend to that portion of the deficiency in the sum of $25,643.22*1506 which has not been assessed and which, in the absence of fraud, is barred by the statute of limitations. The respondent's determination in respect of this amount admittedly rests upon the conclusions drawn by him from the books of the A. H. Hillman Company, but he has not produced those books. No evidence has been introduced to show that Garrie failed to report *764 any income received by him in 1919 from the business of the A. H. Hillman Company, or that he was entitled to any share of the profits from such business.

It not appearing in the instant case that Garrie understated his income for 1919, and his return being supported in all particulars by his books and records, we are of the opinion that the respondent erred in rejecting the claim for abatement which was filed by the executors of his estate.

Judgment will be entered for the petitioner.