Eagleton v. Commissioner

*552 This is a proceeding for the redetermination of a deficiency in income taxes for the year 1932 in the amount of $9,940.34. The deficiency results from respondent's disallowance of a claimed stock loss in the amount of $25,000; disallowance of $19,000 claimed as compensation paid; disallowance of $2,153.22 claimed as expenses paid; and by adding to income from law profession an amount of $16,618.84.

FINDINGS OF FACT.

Petitioner is an individual, residing in St. Louis, Missouri. During the taxable year he was engaged in the practice of law. He keeps his book and files his income tax returns upon a cash receipts and disbursements basis.

Issue 1. - The Bethlehem*861 Pipe Fittings Corporation was organized under the laws of the State of Delaware, in 1930, for the purpose of manufacturing and selling supplies, tools, and equipment for use in the business of mechanical and contracting engineers and others, as set forth in its certificate of incorporation, and particularly to develop an invention of J. M. Readey. The organization of the corporation was promoted by J. M. Readey, Mark D. Eagleton (petitioner), and James A. Waechter. The corporation maintained offices and did business in St. Louis, Missouri. Petitioner was a director of the corporation. In 1930 petitioner bought $25,000 preferred stock of the corporation in a transaction entered into for profit. During the years 1930 and 1931 petitioner advanced various sums of money to the corporation. The corporation gave J. M. Readey $150,000 common stock for the right to develop his patent. The corporation was not successful and did no business after September 1931, after which time no products were moved in the factories. At a special meeting of the directors, September 24, 1932, a resolution was adopted to dissolve the corporation. On October 27, 1932, the State of Delaware issued a certificate*862 of dissolution. At a special meeting of the directors, February 27, 1932, a resolution was adopted to transfer all the assets of the corporation, including real property, personal property, *553 accounts receivable, and all other property to the petitioner in consideration for extinguishment of an indebtedness of the corporation to petitioner in the sum of $44,034.48, money loaned during 1930 and 1931. Accordingly, there were transferred to petitioner assets of a book value of $96,110, as follows: Building, $45,091.49; equipment, $49,271.77; Chicago equipment, $990.18; and furniture and fixtures, $756.60. The building had been purchased by the corporation for a price of $15,000 and $11,408 was still due on the purchase price when transferred to petitioner. Petitioner paid $145.88 per month principal and interest on the balance due. Petitioner still owns these assets. In his return for 1932 petitioner claimed as a deduction a stock loss in the amount of $25,000, which was disallowed by respondent as being "not substantiated."

Issue 2. - Waechter, an attorney, was employed by petitioner during 1932 to try cases for the petitioner at an agreed salary of $2,000 per month, *863 or $24,000 per year. Almost every month two checks for $1,000 each were given to Waechter. During the year 1932 petitioner gave Waechter 22 checks, totaling $24,000, as payment of salary, which were accepted as such. Waechter cashed only 5 of these checks in 1932, totaling $5,000. He retained 17 checks, totaling $19,000, and did not cash them for the reason that he did not need the money at the time. The checks have never been cashed. Petitioner had no knowledge, until about the date of January 1, 1933, of the fact that Waechter did not cash these checks. At that time, the petitioner, Waecher, and others, formed a partnership. Petitioner agreed to furnish the initial capital under a partnership agreement. When Waechter told the petitioner that he had not cashed $19,000 of the checks made payable to him in 1932, he agreed with petitioner that he would take a credit on the books of the partnership in the amount of $19,000 subject to his withdrawal at any time. Waechter gave the unendorsed checks to a clerk in petitioner's office in December 1932 and petitioner on January 1, 1933, credited him with $19,000, the full amount of the checks, on the books of the new partnership. *864 Petitioner's bank balance, as of December 31, 1932, was $3,713. The unendorsed checks were drawn against a bank account standing in the name of the petitioner individually. They could not have been cashed after the close of 1932 because the bank account of the petitioner was changed from his name individually into the partnership name of "Eagleton, Henwood and Waechter", beginning January 1, 1933. Waechter reported in his income tax return for the year 1932, $24,000 as salary received from petitioner. Respondent disallowed the petitioner $19,000 of the claimed deduction of $24,000 for compensation to Waechter for the reason that it was "not substantiated as a deduction on a 'cash' basis."

*554 Issue 3. - In February 1932 petitioner took over premises at 2318 Randolph Street Formerly occupied by the Bethlehem Pipe Fittings Corporation, pursuant to the transfer of assets of that corporation to him. In March petitioner opened an office in this building, in connection with his law practice, for investigators and stenographers. The Bethlehem Pipe Fittings Corporation had ceased production and business. All equipment and stock had been transferred to the petitioner and*865 were kept in storage in the Randolph Street building.

Petitioner reported in his income tax return office expenses in connection with his business totaling $14,595.68. Respondent disallowed as "not substantiated" $2,153.22. The total amount disallowed was made up of the following items: $551.30 which petitioner described as rent paid; $254.75 which petitioner described as telephone service; $1,347.17, miscellaneous expenditures, which petitioner described as insurance, supplies, repairs, towel service, and stationery.

During the taxable year petitioner paid $1,167.04 in payment of principal and interest due on the mortgage outstanding on the property at Randolph Street. Of this amount, $551.30 is payment of interest on the mortgage.

During the taxable year petitioner paid a total of $245.75 to the local telephone company for telephone service at the branch of his law office operated in the Randolph Street building.

During the taxable year petitioner paid, by check, miscellaneous items totaling $1,414.46. This total amount was made up of the following subtotals:

*866 Out of the various payments made by petitioner, the amount of $551.30 is interest paid on indebtedness. The amounts of $245.75 for telephone service, $10.90 for towel service, $72.71 for electricity, and $36.81 for gas, are ordinary and necessary expenses of carrying on petitioner's law business in the office at the Randolph Street property.

Issue 4. - Petitioner's law practice consists chiefly of personal injury suits, most of which are brought to him by outside attorneys for handling. Petitioner's office does all the work in connection therewith and petitioner collects the moneys derived from these cases Petitioner charges against these collections costs and attorneys' fees. The net balance is paid to the client by petitioner. The costs of handling the suits are deducted from petitioner's gross income as business expense. The "attorneys' fees" are broken down into petitioner's *555 fee and the fee of the outside attorney who referred the case. This is in accordance with the agreement under which attorneys bring cases to the petitioner. The petitioner and the outside attorneys have a proportionate interest in the fees resulting from these cases.

During the*867 taxable year petitioner collected a total of $186,152.60. Out of this amount his fees were $117,974.71. He included this amount in his gross income for the year, which totaled $132,797.08. He credited to associate attorneys their fees totaling $68,177.89. He did not include this last amount in his gross income because he did not consider this as his own income for the reason that he agreed with outside attorneys that in taking cases from them he would share equally with them the fees received.

Petitioner keeps a journal accounting record of this part of his business, entitled "Mark D. Eagleton and associates", which was introduced in evidence. This record has two sets of accounts for each month. One set, the left page set, records collections from cases disposed of and disbursement of the collections. The disbursements cover expenses, attorneys' fees and net payment to client. This set of receipts and disbursements balances. The other set of accounts, the right page set, shows only disbursements each month for the account of various cases named. This record shows in detail all disbursements and includes payments to clients, advances to clients, expenses, advances and payments*868 to associate counsel, investigators, office, salaries. The right page set of disbursements does not have a receipts account to balance it and is not intended to balance with any of the left page set of accounts. This record shows that during 1932 petitioner paid to outside associate attorneys $51,559.05, made up partly of collections and partly of cash advances in anticipation of collections. The outside associate attorneys were not regarded as employees and these payments were not included in "expense" and so were not deducted from petitioner's gross income.

Petitioner filed an individual income tax return for the calendar year 1932. His gross income was $132,797.08, including the $117,974.71 fees referred to above. He deducted expenses of $107,773.18, including expenses of the cases referred to above. His net income thereafter was $25,023.90. Respondent added to net income, as an unsubstantiated item, $16,618.74. Respondent arrived at this figure by trying to balance the account in the left page set of accounts, fees collected for associate attorneys totaling $68,177.89, with the account in the right page set of accounts, disbursements to associate attorneys $51,559.05. *869 The left page account and the right page account are two separate sets of accounts, although they appear in the same journal book. The two columns used by respondent in arriving at the sixteen thousand dollar amount do not have any relation to each other within *556 the requirements of elementary bookkeeping rules. There is not in evidence a credit account to offset the disbursements account totaling $51,559.05 in the taxable year.

OPINION.

HARRON: Issue 1. - The first question for determination is whether the petitioner is entitled to deduct from gross income of the year 1932 the amount of $25,000, his investment in the preferred stock of the Bethlehem Pipe Fittings Corporation. Respondent disallowed the claimed deduction for the reason that it was "not substantiated."

Section 23(e)(2) of the Revenue Act of 1932 allows deductions from gross income for losses sustained during the taxable year if incurred in any transaction entered into for profit. Article 174 of Regulations 77 of the Bureau of Internal Revenue sets forth regulations applicable to obtaining allowance of a deduction for a loss arising from an investment in stock and provides that "If stock*870 of a corporation becomes worthless * * * its cost or other basis * * * is deductible by the owner in the taxable year in which the stock became worthless, provided a satisfactory showing is made of its worthlessness."

The rule is well established that to deduct a loss arising out of an investment in stock the taxpayer must deduct the loss in the year in which it is sustained. ; ; ; . In the instant proceeding the question to be determined is whether the loss in question was sustained in the taxable year, 1932. If the stock had been worthless in 1931, as well as in 1932, petitioner would not be allowed to take the deduction for loss in 1932. ; certiorari denied, ; ; .

In September 1931 the Bethlehem Pipe Fittings Corporation ceased all manufacturing and business operations. There is*871 no evidence before us to show what the financial status of the corporation was at that time, but it appears from the record that the directors of the corporation decided then that the venture was not profitable and should be discontinued. The petitioner was the chief financial backer of the corporation, a director, owner of 50 percent of the preferred stock (according to his testimony), a creditor, and in close touch with those actively conducting the business. It is reasonable to assume that he was in a position to ascertain whether the corporation was solvent in 1931 and whether his stock had any value then, but the record is silent on this point. Petitioner at the hearing *557 was put on notice by respondent that this item was disputed as a matter of fact and that proof as to facts was necessary.

In 1932 the corporation was dissolved. Prior to its dissolution, all assets were transferred to the petitioner in payment of the indebtedness to him of $44,000. The only evidence relating to the aggregate value of the corporation's assets is petitioner's testimony that in his opinion they were worth approximately $20,000. These assets consisted principally of a building*872 which had cost the corporation $15,000 and against which there was a first mortgage lien of $11,000, which petitioner assumed, machinery, and other equipment which had been used. From the evidence it is doubtful whether these assets had a value greater than the amount of the debt to petitioner. We are of the opinion that the stock was worthless in 1932.

It is material to petitioner's contention to show that the stock in question had some value at the end of the year 1931 to overcome any presption that the loss was sustained prior to the taxable year, 1932. The petitioner, in effect, has asked that this be assumed. However, it is certainly doubtful whether the assets transferred to petitioner in 1932 had any greater value at the end of 1931 than they had in 1932 and there is no evidence before us to show that the corporation had any other assets in 1931 or that it was in a better financial condition at the end of that year than in 1932. From the record and in the absence of evidence to show that the corporation was solvent at the end of 1931, we are unable to assume that the corporation was in fact solvent at the end of 1931. If the corporation was insolvent at the end*873 of the year 1931, the loss on its stock was sustained in that year and petitioner should have deducted the loss in his return for the year 1931 without waiting until the corporation was liquidated or dissolved. See ;

The petitioner cites ; ; ; and . However, those cases are distinguishable from the instant proceeding in that they involved going concerns whereas in the instant proceeding the corporation had ceased to do business in the prior year. The case of , cited by the petitioner, is not here governing. There it appeared that although the corporation did not operate until about four years after the taxpayer first purchased its stock, it did not become insolvent, and its stock worthless, until the year in which the loss was claimed on the stock.

From a review of all the evidence, we are unable to determine that the claimed loss was sustained*874 in 1932 so as to be deductible from gross income in the taxable year. The petitioner has failed to establish error in respondent's disallowance of the deduction. Therefore, *558 the respondent's action in disallowing the loss for 1932 is approved.

Issue 2. - There is no question in this issue with respect to whether Waechter earned the total amount of $24,000 claimed as compensation paid to him in the taxable year, nor as to whether the salary was reasonable. The question is whether petitioner, on a cash receipts and disbursements basis, may deduct the amount of $19,000 as a business expense in the taxable year when payment was by checks which have never been cashed. The question is whether this amount was "paid or incurred" in the taxable year so as to be deductible under the provisions of section 43 of the Revenue Act of 1932.

Section 23(a) of the Revenue Act of 1932 permits the deduction of salaries "paid or incurred" during the taxalbe year, and section 48(c) of such act states that the term "paid or incurred" shall be construed according to the method of accounting on the basis of which the net income is computed. Section 43 ¹ of the same act sets forth*875 the period for which deductions and credits shall be taken. (See also article 341 of Bureau of Internal Revenue Regulations 77.)

The petitioner was on a cash receipts and disbursements basis and he was required to make his return on that basis. If the amount in question was not paid in 1932 he may not take the deduction in that year. "It is the purpose of the [Revenue] Act to require returns that clearly reflect taxable income. That purpose will not be accomplished unless income received and deductible disbursements made are treated consistently." See . In that case the Court also stated that "it was not the purpose of the Act to permit gross income actually received to be diminished by taxes or other deductible*876 items disbursed in a later year, even if accrued in the taxable year. It is a reasonable construction of the law that the same method be applied to both sides of the account." The provisions of the revenue act referred to in the quotation are practically the same as the pertinent provisions in the Revenue Act of 1932 referred to above.

Payment by check is a conditional payment subject to the condition subsequent that the check is paid on presentation thereof to the drawee. When this method of payment is carried through to the performance of the condition subsequent, it is reasonable to conclude that the payment dates back to the time of giving the check, and it has been held accordingly. See , and , affirming . *559 In the case of the Estate of M. A. Bradley, it was pointed out by this Board that "to hold that delay in depositing a check suspends the maker's rights until deposit, would introduce uncertainty into the determination of income so as to make accuracy in accounting impossible. It would distort the reasonable intention*877 of the law." In that proceeding the facts showed that a check given in payment of taxes on June 25, 1926, was duly paid on September 21, 1926, and that the payment related back to the date of its delivery.

The issue here involved is not the same as in the case of Estate of M. A. Bradley, for the checks given to Waechter in 1932 were never cashed, were returned to the petitioner before the close of the year. Also, the checks could not have been cashed, for at the end of 1932 petitioner's bank balance was only $3,713 and on January 1, 1933, the bank account was closed. Waechter was credited with $19,000 on the books of the partnership on January 1, 1933. After giving Waechter this credit on the partnership books, Waechter could withdraw money and the withdrawals probably would be considered as dating back to the date of the credit. We are not required to pass upon the effect of the credit in 1933 for income tax purposes of petitioner for that year, because that year is not before us. But the transaction throws light on the issue that is before us. We are unable to conclude that the credit given in 1933 was the same as cashing the checks given in 1932 so as to relate the*878 payment back to 1932. Two methods of payment are involved - first, an attempted payment by checks which was not carried through to performance of presenting the checks to the drawee for payment; second, establishing a credit on a new set of books to the account of the employee involved. If the first method of payment had been carried out and the checks had been cashed in 1932 or 1933 payment would relate back to the time of giving the checks, under the general rule set forth in But the payment involved was effectuated by the second method and we can not find any support for holding that the credit transaction resulted in payment to Waechter as of any other date than the date of entry of the credit on the partnership books in 1933. In other words, we are unable to hold that the credit given in 1933 related the payment back to 1932. In so holding, we can see no element of uncertainty in determining petitioner's income in the taxable year or jeopardy to accuracy of accounting, the elements going to the reasonableness of the rule of the case of the *879 Shortly before the end of 1932 petitioner took back the checks, preventing any diminution of his income for the year 1932 and making it entirely possible to make accurate his accounting records for 1932 as to cash disbursed *560 or subject to reduction by any outstanding checks. From petitioner's testimony it is evident that he was aware that the arrangement with Waechter would keep cash on hand intact, for he stated as follows:

It takes a large sum of money to continue to try to do business with the necessity of advancing to clients. At one time we had over $200,000 in advances to clients alone. So, with that amount of money in the firm, I naturally wanted my partner to put in as much as he could, and if he could not put anything in, at least not to take any out.

It is therefore held that no payment was made in 1932 of the $19,000 involved, that petitioner is not entitled to the deduction, being on a cash basis, and the disallowance by the Commissioner is affirmed.

During 1932 petitioner gave Waechter a check for $10,000 for services performed in 1931 and Waechter cashed this check in 1932. Petitioner obtained a deduction*880 of this amount in his income tax return for 1931. Consequently, there is no issue before us as to an amount of $10,000 paid in 1932. Petitioner has stated in his brief as follows: "Petitioner has at no time claimed, and does not now claim, that he should receive credit in his 1932 return for that payment [$10,000 back salary], having received credit therefor in his 1931 return."

Issue 3. - The petitioner claims that the respondent erred in disallowing $2,153.22 of the deduction claimed as ordinary and necessary business expenses because the disallowed portion constitutes the expenses of maintaining the law office at 2318 Randolph Street. The evidence shows that the petitioner did use the office at 2318 Randolph Street in connection with his law practice, and, hence, any ordinary and necessary expenses paid in carrying on such business at that address are deductible. Sec. 23(a), Revenue Act of 1932. No business other than the petitioner's law practice was carried on at that address, since the business formerly carried on by the Bethlehem Pipe Fittings Corporation had been abandoned. The petitioner's acquisition, ownership, and use of that building, together with the machinery*881 and supplies stored therein, were not related to his law business, except, of course, the use of the office. Some of the expenditures, so far as the evidence shows, may have been capital expenditures rather than business expenses; others may have been incurred to protect petitioner's investment in the property and may not have had any relation to his law business.

Petitioner paid $551.30 interest on the mortgage outstanding on the Randolph Street property. In his income tax return he sought to deduct this amount as "rent" charged to himself as owner for office space. The building had been transferred to him by the Bethlehem Pipe Fittings Corporation. The facts show that this was payment of interest on the mortgage on the building. It is, therefore, not deductible *561 as a business expense, but is deductible under section 23(b) of the Revenue Act of 1932 as interest paid on indebtedness. It is held that this amount is deductible.

Petitioner sought to deduct $254.75 paid for telephone service as a business expense. It has been found as a fact that petitioner used the Randolph Street building office in connection with his law practice and that telephone service there*882 was in connection with his law practice. Petitioner testified that checks introduced in evidence totaling $245.75 were payments for telephone service. There is a discrepancy of $9 unexplained, which appears to result from some inaccuracy. It is held that the amount of $245.75 is deductible as a business expense.

Respondent disallowed as unsubstantiated, $1,347.17, miscellaneous payments claimed deductible. From the evidence and in accordance with the findings of fact it is held that the following payments for various services at the Randolph Street building law office are deductible as business expenses: $10.90, towel service; $72.71, electricity; $36.81, gas service; total, $120.42.

From examination of the evidence, we are able to identify the following totals as payments for repairs to roof, $111.50; purchase of stove, $53.05; insurance, $378.51, but there is no proof that all or any portion of each of these items were expenditures made in connection with the law office on Randolph Street. Also, there is no evidence to show whether any or all of the balance of $683.69 of miscellaneous expenditures relates to petitioner's business. It is, therefore, held that these miscellaneous*883 expenditures totaling $1,226.75 are not deductible.

Issue 4. - This issue requires considering the character of petitioner's business in handling cases brought to him by outside attorneys and whether the total fees collected from this business and all disbursements thereof should be reported by petitioner in his income tax return. Petitioner explains and argues that only part of these fees constitute his income and that he is only the conduit through which there passes certain fees "earned by" and belonging to outside attorneys: and that as for the fees belonging to others, he is not bound to make report of receipt or disbursement. According to his argument, respondent is in error in adding to his taxable income the amount of $16,618.84, because it is not his income and because the figure itserlf is not the difference between two accounts which balance each other.

Respondent's theory is that all the fees collected by petitioner in the cases brought to him by outside attorneys are his fees and should be reported in his gross income; that the amounts paid to outside attorneys are in the nature of expense and should be deducted from *562 gross income; that as a matter*884 of logic, since petitioner collected $68,177.89 in fees for outside attorneys and paid them only $51,559.05, the difference must be in petitioner's possession and must be included in petitioner's taxable income. We do not agree with respondent that the amount of $16,618.84 is necessarily a true figure of a surplus of fees collected as against fees paid out.

It is elementary that the purpose of the income tax law is to tax income actually derived rather than constructively received, and it is assumed that individuals are not to be penalized for being the agency through which income is derived for someone else. See . It has been held that the purpose of the income tax laws is to tax income to the person having the beneficial interest therein but not the mere collector or conduit of income belonging to another. See . Hence, where a person receives money as trustee for another, the tax should not fall on the collector but on the person who has a beneficial interest therein, or if income is produced by property belonging*885 to individuals jointly, and total income is collected by one, it has been held that the individual receiving the total income is taxable only on the portion in which he individually had the beneficial interest, the portion paid his associate or associates being received merely in trust for such party or parties. See .

In the instant proceedings the undisputed testimony of petitioner shows that he received cases from outside attorneys under agreement with them to divide the fees equally. In 1932 petitioner collected from these cases, $186,152.60. His share of the fees totaled $117,974.71. Associates' fees totaled $68,177.89. Petitioner's fees were about 63 percent of the total fees paid. From the evidence, we are satisfied that the fees allocated to associates were their fees ab initio by the terms of the agreement by which the cases were turned over to petitioner so that petitioner was only taxable for part of the fees yielded by the cases. The petitioner and the outside attorneys had a joint interest in therse cases (the outside attorneys having obtained the cases in the first instance) and although petitioner collected*886 the total of fees (the total income produced), he is taxable only on the portion in which he had a beneficial interest. During the taxable year petitioner's interest in the total fees collected was $117,974.71. This he reported in his gross income. From the record and evidence before us, we are unable to determine that his interest consisted of any more than that amount. From petitioner's sworn testimony we are satisfied that he was not entitled to and did not retain any part of the $68,177.89 collected for associates.

*563 As for the amount of $16,618.84, we are not convinced that this figure represents an excess in petitioner's favor in the accounts with associates so as to constitute income as alleged by respondent. It is apparent that petitioner's associate attorneys had something of a drawing account with petitioner. He paid them fees which he collected for them, but he also advanced money to them in anticipation of making collections. At the end of a year the outside attorneys may not have received all held for them in their account of collections, or it is possible they might have overdrawn. But from the method of keeping the accounts, we believe respondent*887 was in error in regarding as one account the credit account of fees collected for associates in 1932 and the debit account of amounts disbursed to associates in 1932, for these two sets of figures are not debits and credits of one account. There is no possibility of a true balance. Upon the undisputed testimony of petitioner, we are satisfied that he reported his entire income in the taxable year and that he did not retain as his own unreported income any of the fees collected by him for associate attorneys.

From the record and the testimony of petitioner, was are of the opinion that he has reported his full income for the taxable year and that consequently respondent was in error in adding the amount of $16,618.84 to petitioner's taxable income.

Reviewed by the Board.

Judgment will be entered under Rule 50.

ARUNDELL and TURNER dissent on the holding covered by the second headnote.