R. C. Harvey Co. v. Commissioner

*432 The respondent determined deficiencies in income tax, declared value excess profits tax, and excess profits tax, of $ 282.06, $ 83.04, and $ 4,261.87, respectively, against petitioner for the fiscal year ended August 31, 1941. Petitioner has paid the deficiencies in income tax and declared value excess profits tax and has waived any contention relative thereto. As to the deficiency in excess profits tax of $ 4,261.87, petitioner assigns but one error, namely:

The determination that the payment of $ 15,000 made to one Gordon under a contract of employment be not allowed for excess profits tax purposes*126 in the base period year 1939 on the ground that the payment did not constitute the payment of a "claim" within the intendment of the Internal Revenue Code.

In a statement attached to the deficiency notice the respondent explained the adjustment thus contested as follows:

The disallowance for excess profits tax purposes in the base period year 1939, of a payment of $ 15,000.00 made to one Gordon under a contract of employment, has been reversed, on the ground that the payment did not constitute the payment of a "claim" within the intendment of section 711 (b) (1) (H) of the Internal Revenue Code. Moreover, if the payment did constitute a claim within the meaning of said section, then the abnormality alleged by reason of such payment was a consequence of a decrease in the amount of some other deduction (commissions) in the base period (year 1939) and the disallowance of the deduction is precluded by the provisions of section 711 (b) (1) (K) (ii). Furthermore, it is held that the payment was made pursuant to your contract with the said Gordon which provided for commissions to be paid to Gordon for services rendered and since the payment of commissions was a normal element of your business*127 during the base period years no disallowance is justified under the provisions of section 711 (b) (1) (J) (ii) of the Code, since the deduction for commissions in 1939, including the payment in question, was not in excess of 125 per cent of the average amount of deductions of such class for the four preceding taxable years.

FINDINGS OF FACT.

Petitioner is a corporation, duly organized under the laws of the Commonwealth of Massachusetts. Its place of business is Waltham, Massachusetts. The purpose for which the corporation was organized was to engage in the business of dealing in garnetted wool and similar products.

Petitioner filed with the collector at Boston, Massachusetts, for the fiscal year ended August 31, 1941, a corporation income, declared value *433 excess profits, and defense tax return and also an excess profits tax return.

Upon its organization petitioner issued 1,000 shares of cumulative 6 percent preferred nonvoting stock of the par value of $ 100 per share and 500 shares of common stock of the par value of $ 100 per share, the total authorized capital stock being $ 100,000 preferred and $ 50,000 common.

After the organization, Arthur L. Norton was treasurer *128 and the holder of 750 shares of preferred and 249 shares of common stock; Ralph C. Harvey was president and the holder of 250 shares of preferred and 249 shares of common; and Harry E. Waldron was a clerk and the holder of two shares of common. These three were the directors of the corporation.

Petitioner started to do business immediately after its incorporation and has so continued uninterruptedly to the present time.

On May 7, 1935, a contract was entered into between petitioner, Norton, individually, and one Jacob Gordon. Gordon was neither an officer nor a stockholder of the petitioner at that time.

The Charles River Garnetting Co. Inc., sometimes hereinafter referred to as "Charles River," was a subsidiary corporation, organized by petitioner on April 1, 1934, for the purpose of processing materials for petitioner. Petitioner was the sole owner of all the corporate stock of Charles River except for three qualifying shares held by the officers of petitioner. Charles River was liquidated on March 31, 1938, and the assets were taken over and the liabilities assumed by petitioner.

At a stockholders' meeting held November 12, 1935, article III of the bylaws of petitioner was amended*129 by adding thereto the following sentence: "A director need not be a stockholder of the corporation."

On November 12, 1935, the common stock of petitioner was authorized to be changed and was changed from par value to no par value stock, and 500 shares were authorized and issued, of which Norton and Harvey each held 249 shares and Gordon held two shares.

On December 6, 1937, a new contract was entered into in which petitioner, Charles River, Norton, and Gordon were principals. Under this contract the parties mutually agreed as follows:

1. The said Jacob Gordon hereby agrees to act as purchasing agent for the corporations for the term of three years and six months from December 15, 1937. He is to be the sole buyer of all raw stock during that term, provided, however, that before consummating any purchase involving more than One Thousand ($ 1000.) Dollars, he is to obtain the approval of the Treasurer of the R. C. Harvey Company.

2. The said corporations agree to pay the said Jacob Gordon for his services as aforesaid, a sum equal to three-quarters of one cent per pound on all purchases of stock or textile material made by them respectively, whether said purchases be made by the said*130 Jacob Gordon or otherwise. All commissions are to be paid to the said Jacob Gordon monthly.

*434 In addition, the said Jacob Gordon is to receive as compensation for his services, a sum equal to twenty (20%) per cent of the net earnings of the corporations before dividend, which shall be paid to him on or before September 15th of each year, covering earnings to August 31st of that year.

It is expressly agreed and understood that the first accounting and payment to said Jacob Gordon after December 15, 1937, shall include earnings and compensation due him as hereinbefore set forth, between the date as of which the last accounting to him was made by both corporations, to December 15, 1937, to date when the term of this agreement is to commence.

3. The corporations further agree that during the term of this agreement, they will not, without the consent of the said Jacob Gordon:

(a) Make any extraordinary purchases.

(b) Make any change in the present manner or method of conducting the business or affairs of the corporations which will in any way affect their earnings.

(c) Increase the present compensation of any of their officers.

(d) Increase the present rate of compensation of *131 any of the employees, or add to their regular stipulated salaries or commissions.

(e) Change in any way to affect the earnings of the corporations, the value of inventory, real estate, or any other assets of the corporations.

4. During the term of this agreement the said Jacob Gordon shall not be obliged to devote his entire time in the interests of the said corporations, but may conduct or be affiliated with any other business.

5. The said Arthur L. Norton agrees for himself, his heirs and assigns, that during the term of this agreement, he will not withdraw from the corporations any of the money now invested in or loaned by him to them, without the consent of the said Jacob Gordon.

On December 7, 1937, Waldron resigned as a director of petitioner and Gordon was elected a director to fill the vacancy caused by the resignation of Waldron.

No purchases of material were made directly by Charles River, all materials to be garnetted being purchased by petitioner and forwarded to Charles River for processing; after processing, the goods were then delivered to petitioner and part of the payment to Gordon on the material purchased was charged against Charles River.

During the period from *132 May 7 to August 31, 1935, the total amount paid Gordon for commissions was $ 2,905.12, all paid by petitioner. During the fiscal year ended August 31, 1936, the total amount paid Gordon as commissions on purchases was $ 20,229.75, of which $ 13,086.12 was paid by petitioner and $ 7,143.63 by Charles River. During the fiscal year ended August 31, 1937, the total amount paid Gordon on these commissions was $ 18,549.20, of which $ 13,725.77 was paid by petitioner and $ 4,823.43 by Charles River. For the next fiscal year ended August 31, 1938, the total amount paid Gordon on commissions was $ 9,018.52, of which $ 6,686.25 was paid by petitioner and $ 2,332.27 by Charles River. From September 1 to October 27, 1938, the amount paid Gordon for commissions was $ 2,500, all paid by petitioner on October 27, 1938.

*435 In connection with the provisions of the various contracts for the payment of 20 percent of earnings before dividends, nothing was paid to Gordon from May 7 to August 31, 1935. During the fiscal year ended August 31, 1936, Gordon was paid $ 19,233.98 by reason of this provision, of which $ 16,295.75 was paid by petitioner and $ 2,938.23 by Charles River. In the fiscal*133 year ended August 31, 1937, Gordon was paid $ 18,432.36 on this item, of which petitioner paid $ 13,849.66 and Charles River was paid $ 4,582.80. In the fiscal year ended August 31, 1938, Gordon was paid nothing on this item by petitioner and $ 2,023.28 by Charles River. From September 1 to October 27, 1938, nothing was paid to Gordon on account of this item.

Norton died on May 29, 1938. After the death of Norton, Gordon assumed, or attempted to assume, authority beyond the duties specified in the contract of December 6, 1937.

During the summer of 1938 differences arose between Harvey and Gordon as to the extent and classes of the merchandise inventory purchased by Gordon, there being an excess poundage of undesirable material. As early as August 12, 1938, Gordon employed counsel, who was later reinforced with other counsel, with particular reference to the acquisition by Gordon of the stock held by Norton in the petitioner corporation. On August 17, 1938, there was further controversy between petitioner and Gordon in regard to the amount of undesirable inventory of merchandise purchased by Gordon and also in regard to unnecessary purchases of shoddy material being made by Gordon.

*134 On or about September 12, 1938, the president of petitioner (Harvey) notified Gordon to cease and desist from acting under his contract and the contract was declared by the president to be inoperative and at an end.

Between September 12 and September 20, 1938, there were various conferences with and threats of litigation by Gordon. On September 20, 1938, there was a conference at the office of David Stoneman, one of Gordon's counsel, at which were present the president of petitioner, its treasurer, and counsel representing it, Gordon, and two of the counsel representing him. The subject matter of the conference was Gordon's claim that there was a breach of contract by petitioner and his threat that he would claim damages, but petitioner declined to retreat from its position and notified Gordon to that effect.

On October 23, 1938, Gordon announced to Harvey that legal proceedings would be started against petitioner on the following day. Following that threat of litigation, various other conferences between counsel representing petitioner and counsel representing Gordon were had, which resulted on October 27, 1938, in the making of a settlement with Gordon for his claim for damages*135 for breach of the contract of December 6, 1937.

*436 Counsel for Gordon was paid a total sum of $ 17,500, of which $ 2,500 was admitted to be the amount earned by Gordon under his contract for commissions on the purchases of material from September 1 to October 27, 1938, and $ 15,000 was paid in settlement of his claim for damages for the breach of the contract. Releases were signed and delivered by Gordon to petitioner, the two shares of common stock held by him were turned over to petitioner, and he resigned as a director. The payment of $ 17,500 was entered on the books of petitioner as $ 2,500 due Gordon on account of materials purchased in September and October, 1938, and $ 15,000 as "settlement of contract with purchasing agent."

The pounds of material purchased by petitioner during the fiscal years ended August 31, 1936, to August 31, 1940, inclusive, were as follows:

For the period from September 1, 1940, to June 15, 1941, the date Gordon's contract would have expired by limitation, petitioner purchased approximately 2,040,000 pounds of material. During the months of September and*136 October, 1938, petitioner purchased 301,729 pounds of material, on which Gordon would have been entitled to a commission of $ 2,263.

The total net sales of the petitioner for the fiscal years ended August 31, 1936 to August 31, 1941, inclusive, were as follows:

The auditor's report for the fiscal year ended August 31, 1939, shows a deficit of $ 4,242.05 before dividends. That includes the deduction of $ 15,000 paid to Gordon. The auditor's report shows a profit of $ 47,701.84 before dividends for the full fiscal year ended August 31, 1940, and of $ 47,253.25 for the full fiscal year 1941.

R. Wallace Mollison was employed by petitioner from August 15, 1938, to November 30, 1939. From October 27, 1938, the date Gordon's employment was terminated with petitioner, to November 30, 1939, Mollison performed some of the duties previously performed by Gordon. Throughout this period Mollison continued to perform duties originally assigned to him prior to Gordon's departure from the company. Mollison was paid $ 7,166.53 during the fiscal year ended August 31, 1939, and*137 $ 2,003.41 for the period of September 1 to November 30, 1939. None of the above amounts paid to Mollison represents *437 any increase due to performing duties previously performed by Gordon.

Beginning November 2, 1938, and continuing to June 15, 1941, Earle G. Farnsworth, who was previously employed by petitioner at a salary of $ 2,600 per annum, was given authority, in addition to Mollison, to make purchases of material. His salary was increased $ 375 in the fiscal year ended August 31, 1939; $ 1,300 in the fiscal year ended August 31, 1940; and $ 920.79 for the period ended June 15, 1941, such increases being due to the additional duties of purchasing materials formerly performed by Gordon. Mollison and Farnsworth were the only persons employed by petitioner to perform the duties previously performed by Gordon.

The books of petitioner are kept on an accrual basis.

Petitioner in schedule A of its excess profits tax return for the taxable year ended August 31, 1941, reported an excess profits net income of $ 10,299.09 for the base period year ended August 31, 1939, computed as follows:

*138 Petitioner attached to its return the following statement in explanation of line 17 (c):

The expense deductions for this year on federal form 1120 included an item of $ 15,000 which represented a payment to the purchasing agent, in November, 1938, to obtain cancellation of a contract between the corporation and said purchasing agent for the services of the latter, from which the company was thus relieved.

The respondent, in the statement attached to the deficiency notice, determined a deficit in excess profits net income of $ 5,967.22 for the base period year ended August 31, 1939, computed as follows:

Petitioner agrees that adjustment (a) 2 was proper, but contests adjustment (a) 1.

The deduction attributable to the payment of the $ 15,000 claim by Gordon against*139 petitioner was an "abnormal" deduction for petitioner *438 as that term is used in code section 711 (b) (1) (H), as amended. The said abnormality is not a consequence of an increase in the gross income of petitioner in its base period or a decrease in the amount of some other deduction in the base period, and is not a consequence of any change in the type, manner of operation, size, or condition of the business engaged in by petitioner.

Any part of the stipulation not specifically set forth herein is incorporated herein by reference and made a part of these findings of fact.

OPINION.

The question presented involves petitioner's excess profits tax liability for the fiscal year ended August 31, 1941, under subchapter E of chapter 2 of the Internal Revenue Code, which subchapter was inserted in the code by Title II, section 201, of the Second Revenue Act of 1940, and is sometimes cited as the "Excess Profits Tax Act of 1940." These provisions of the code have been amended from time to time. Only those amendments which are here material will be noted.

Under section 710 (a) (1) ¹ the tax is imposed on the "adjusted excess profits net income" as defined in section 710 (b) as*140 meaning "the excess profits net income (as defined in section 711) minus the sum of" (1) a specific exemption of $ 5,000; (2) the "excess profits credit" allowed under section 712; and (3) an item not present in this proceeding. The question here arises in connection with the computation of the excess profits credit, which in turn involves the application of section 711 (b) (1) (H) and (K), as will more fully appear below.

Under section 711 (a), the determination of the "excess profits net income" depends in part upon whether the "excess profits credit" is computed under section 713 or section 714. Section 712 (a), as amended by sections 13 and 17 of the Excess Profits Tax Amendments of 1941, provides in part that:

In the case of a domestic corporation which was in existence before January 1, 1940, the excess profits credit for any taxable year shall be an amount computed under section 713 or section 714, *141 whichever amount results in the lesser tax under this subchapter for the taxable year for which the tax under this subchapter is being computed.

The excess profit credit when computed under section 713 is based on income, and when computed under section 714 it is based on invested capital. In the statement attached to the deficiency notice the respondent, among other things, said:

Inasmuch as you are a domestic corporation and were in existence prior to January 1, 1940, your credit has been computed under section 713 (the income *439 credit method) for the purpose of this determination of tax liability, due to the fact that the credit so computed results in a lesser excess profits tax as contemplated by section 712 of the said Code. It follows, therefore, that your excess profits net income for the year in question has also been computed under the income credit method herein in accordance with the provisions of section 711 (a) (1) of the above-mentioned Code.

Petitioner does not contest the respondent's method of computation mentioned in the last sentence of the above quotation from the deficiency notice. As previously stated, the contest arises in connection with the computation*142 of the excess profit credit.

One of the many steps which the parties agree must be taken in the determination of petitioner's excess profits credit under section 713, as amended, is to determine under section 713 (f) (1) "for each of the taxable years of the taxpayer in its base period, the excess profits net income for such year, or the deficit in excess profits net income for such year." The parties agree that the "taxable years of the taxpayer in its base period" are the fiscal years ended August 31, 1937, to August 31, 1940, both inclusive. See section 713 (b) (1) (A), as amended. They disagree only as to the "excess profits net income" or the "deficit in excess profits net income" for the fiscal year which began September 1, 1938, and ended August 31, 1939. See sec. 713 (c), as amended.

The determination of whether petitioner had an excess profits net income or a deficit in excess profits net income for the base period year ended August 31, 1939, depends upon the proper application to the facts herein of section 711 (b) (1), as amended by sections 3 and 17 of the Excess Profits Tax Amendments of 1941, the material provisions of which are set forth in the margin. ²

*143 *440 The respondent in his brief contends that his determination should be sustained for the same reasons as are given in the statement attached to the deficiency notice, which statement we have set out at the beginning of this report. Petitioner contends that its treatment of the $ 15,000 item in its excess profits tax return was proper as falling within the provisions of section 711 (b) (1) (H); that the facts show that the payment of the $ 15,000 to Gordon was "not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period," and was "not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by the taxpayer" as the quoted matter is used in section 711 (b) (1) (K) (ii); and that section 711 (b) (1) (J) (ii) has no application to this proceeding.

We agree with the petitioner's contentions, and shall consider first the application of section 711 (b) (1) (H). We think the payment of $ 15,000 to Gordon was attributable to a "claim" by Gordon for damages due to a breach of contract by petitioner. In his *144 brief the respondent argues that the said payment "was not the payment of a claim but merely the payment of anticipated commissions and share of net profits." We do not agree. On or about September 12, 1938, when petitioner's president declared its contract with Gordon to be inoperative and at an end, the contract had several years yet to run. Gordon immediately threatened to sue petitioner for damages for breach of contract and engaged counsel for that purpose. As a result a settlement was reached on October 27, 1938, whereby petitioner paid Gordon the $ 15,000 in question, plus $ 2,500 on account of purchases of materials covering the period September 1 to October 27, 1938. Thereupon Gordon executed a complete release to petitioner of all demands against it. It is our opinion that the payment of the $ 15,000 was in settlement of Gordon's "claim" for damages for breach of contract, and we have so found as a fact.

Was the deduction attributable to the claim "abnormal for the taxpayer" as that term is used in section 711 (b) (1) (H)? We think it was. Webster's New International Dictionary, Second Edition, Unabridged, defines abnormal as "Deviating from the normal condition; *145 not corresponding to the type; markedly or strangely irregular." *441 We are of the opinion that the claim in question comes within this definition. The respondent cites section 30.711 (b)-2 of Regulations 109, inserted by paragraph 10 of T. D. 5045, Cumulative Bulletin 1941-1, p. 69, which, among other things, provides that "A class of deductions is abnormal only if the taxpayer had no deductions of that class in the taxable years prescribed for determining average deductions." (Emphasis supplied.) From this citation the respondent in effect argues that our holding should be against the petitioner for lack of proof, since "It is submitted that nowhere in the record of this case has petitioner established that it had no other deductions in other years of the base period for obtaining cancellation of contracts." In schedule A of its excess profits tax return for the taxable year in question, which was introduced in evidence by respondent, petitioner did not claim on line 17 (c) or elsewhere any similar adjustment for any other taxable year of the base period. This schedule A is headed "Excess Profits Credit Based on Income" and covers the years*146 ended August 31, 1937, to 1940, inclusive, and line 17 thereof is divided as follows: "(a) Abnormal judgment liabilities." Of these none are shown for any of the base period years. "(b) Abnormal expenditures for intangible drilling and development costs." Of these none are shown for any of the base period years. "(c) Other abnormal deductions." Of these none are shown for any of the base period years, except the $ 15,000 here in question for the fiscal year ended August 31, 1939. This evidence being in the record, we can not sustain respondent's contention that petitioner has failed to prove that the deduction which it claims was an abnormal one.

The respondent also argues that the payment of $ 15,000 to Gordon was not an abnormal deduction for petitioner because petitioner, as the respondent contends, was the real party benefited, in that it was released from certain dictatorial control given Gordon by the contract and was further benefited by not having to pay such large sums to Gordon for the remaining years of the contract. In determining whether a deduction attributable to a claim against the taxpayer is "abnormal for the taxpayer" we do not regard as material the factor *147 as to whether the taxpayer was or was not benefited by the payment of the claim. We find no such requirement in the statute itself. We think the payment of the $ 15,000 in question was such a deviation from the normal conduct of petitioner's business that the deduction attributable thereto was "abnormal for the taxpayer" as that term is used in section 711 (b) (1) (H). It follows that the adjustment provided for under this subparagraph (H) must be made unless petitioner has failed to establish what is required of it under subparagraph (K) (ii) of section 711 (b) (1).

*442 The fact to be established by petitioner under section 711 (b) (1) (K) (ii) is a negative fact. William Leveen Corporation, 3 T. C. 593. In that case, among other things, we said:

To establish such a negative may be a difficult task, and how it is to be accomplished can not be formulated in a rule. Perhaps the proof is best made by proving affirmatively that the abnormal deduction is a consequence of something other than the increase in gross income and that such proven cause is the converse or opposite of an increase in gross income and could not be identified*148 with an increase in gross income. But, difficult as the proof of the negative may be, it is what the statute requires; and, since it is required in clear and express terms, its rigors may not be abated by softening construction.

The respondent in the instant proceeding does not contend that the abnormality is a consequence of an increase in the gross income of petitioner in its base period. He does contend, however, that if we should find for the petitioner under section 711 (b) (1) (H), then "the facts in the case affirmatively establish that the payment was a consequence of a decrease in another deduction (commissions for materials purchased) in the base period, and the disallowance of the deduction is precluded by the provisions of Section 711 (b) (1) (K) (ii) of the Code."

The decrease in commissions referred to by the respondent is the decrease that occurred after the payment of $ 15,000 to Gordon had been made. The respondent points out that if Gordon had continued his contract he would have been entitled to receive from petitioner $ 62,877.10 for the period from October 27, 1938, the date the $ 15,000 payment was made, to June 15, 1941, the date his contract *149 would have expired, whereas it only cost petitioner $ 2,595.79, the total additional amount paid Farnsworth for performing the duties formerly performed by Gordon. From this the respondent argues that the payment of the $ 15,000 to Gordon was a consequence of a decrease in commissions. We think the respondent has a misconception of the word "consequence" as used in the statute. In his reply brief the respondent quotes the following definition of the word from Webster's New International Dictionary, Second Edition:

Consequence * * * 1. That which follows something on which it depends; that which is produced by a cause or ensues from any form of necessary connection, or from any set of conditions; a natural or necessary result; -- contrasted with mere sequence; as, the consequences of one's acts.

Immediately following the quoted definition the respondent makes this statement: "Respondent does not believe the above definition of the word or its use in the statute warrants the conclusion that where a relationship is shown between an abnormal deduction and a decrease in another deduction Section 711 (b) (1) (K) (ii) is ineffective unless the abnormal deduction follows rather *150 than precedes the decrease in the other deduction." We must construe the statute as we find it. The decrease in commissions as argued by the respondent may have *443 been the consequence of the termination of the contract with Gordon, but it is difficult to see how the termination and payment of damages to Gordon could be a consequence of the subsequent reduction of commissions. The respondent seems to have placed "the cart before the horse."

All of this, however, does not relieve petitioner of the burden of establishing the "crucial though negative fact" required by section 711 (b) (1) (K) (ii). William Leveen Corporation, supra. We think that petitioner has successfully shown that the abnormality in question was the direct consequence of the differences between petitioner (through Harvey) and Gordon that arose shortly after the death of Norton and was not the consequence of one or more of the factors enumerated in section 711 (b) (1) (K) (ii). We have so found as an ultimate fact and, therefore, we sustain the petitioner on this point.

Having found that the $ 15,000 payment in question falls within the provisions of section 711 (b)*151 (1) (H), we also agree with the petitioner that section 711 (b) (1) (J) (ii) has no application to this proceeding.

Decision will be entered under Rule 50.