Opinion
Docket No. 88456.
1963-12-12
J. GORDON TURNBULL, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
W. A. Falsgraf and S. E. Parker, for the petitioner. Charles B. Sklar, for the respondent.
W. A. Falsgraf and S. E. Parker, for the petitioner. Charles B. Sklar, for the respondent.
Where petitioner accumulated earnings substantially in excess of its working capital requirements; where it was not necessary for petitioner to retain its earnings to meet any contingent liability it might have had on certain tort suits because there was virtually no possibility of liability with respect thereto; and where petitioner made large investments of funds in property unrelated to its architectural and engineering services business. Held, that under section 102, I.R.C. 1939, petitioner was availed of during the taxable years involved for the purpose of preventing imposition of surtax upon its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed. Held, further, that a fee paid to a tax firm on an obligation incurred by some of petitioner's key employees for their personal benefit was not deductible as an ordinary and necessary expense of petitioner.
DAWSON, Judge:
Respondent determined deficiencies in petitioner's income tax as follows:
+--------------------------------+ ¦Taxable year ended—¦Deficiency ¦ +-------------------+------------¦ ¦Nov. 30, 1952 ¦$29,423.11 ¦ +-------------------+------------¦ ¦Nov. 30, 1953 ¦37,355.29 ¦ +-------------------+------------¦ ¦Feb. 4, 1954 ¦93,359.35 ¦ +--------------------------------+
Certain issues raised by the pleadings have been settled by the parties by stipulation which will be given effect under Rule 50. The remaining issues are: (1) Whether petitioner was availed of during the taxable years before us for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided or distributed; and (2) whether a fee paid to J. K. Lasser & Co. was deductible as an ordinary and necessary expense of petitioner for its taxable year ended February 4, 1954.
FINDINGS OF FACT
Some of the facts have been stipulated by the parties and are found accordingly. The stipulation of facts and exhibits attached thereto are incorporated herein by reference.
Issue 1
J. Gordon Turnbull, Inc. (hereinafter referred to as petitioner), was organized under the laws of the State of Ohio in August 1941, and maintained its principal place of business at 3626 Chester Avenue, Cleveland, Ohio. The petitioner's principal source of income was fees received for engineering, architectural, and construction management services rendered in connection with the building of military bases and installations, manufacturing plants, and other large structures. J. Gordon Turnbull was the controlling stockholder, president, and chief executive officer of petitioner until his death on April 1, 1953.
Petitioner kept its books and records and prepared its income tax returns on the basis of a fiscal year ending November 30, and on a cash method of accounting. Its corporate income tax returns for the fiscal year ended November 30, 1952, and November 30, 1953, were filed with the district director of internal revenue, Cleveland, Ohio, and its separate income tax return for the taxable period December 1, 1953, through February 4, 1954, was also filed with the district director of internal revenue at Cleveland.
Exhibits A and B attached to that letter dated July 10, 1959, which is contained in Joint Exhibit 41-00, set forth the cash flow of petitioner for the fiscal years ending November 30, 1951, and November 30, 1952, and Exhibit C attached to the letter of July 10, 1959, sets forth a monthly summary of cash receipts and disbursements of petitioner for the period December 1, 1950, through November 30, 1952. The letter dated July 10, 1959, signed by a duly authorized representative of the petitioner, was submitted to Internal Revenue Service in answer to registered mail notice sent on May 11, 1959, pursuant to section 534 of the Internal Revenue Code of 1954, and sets forth the grounds upon which the petitioner relied to establish that no part of its earnings and profits had been permitted to accumulate beyond the reasonable needs of the business.
The National City Bank of Cleveland granted a line of credit to the petitioner, and its borrowings against this line of credit and the dates of repayment of the amounts borrowed are as follows:
+------------------------------------------------------------------------+ ¦Borrowed ¦Repaid ¦ +----------------------+-------------------------------------------------¦ ¦ ¦ ¦Amount ¦ ¦ ¦Date of ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦Note dated ¦Amount ¦paid ¦Check No.¦Date ¦cancellation of¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦ ¦ ¦ ¦ ¦ ¦note ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦May 13, 1952 ¦$100,000¦$100,000¦5990 ¦July 11, 1952 ¦July 14, 1952 ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦Aug. 4, 1952 ¦100,000 ¦100,000 ¦6500 ¦Sept. 29, 1952¦Sept. 30, 1952 ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦Feb. 23, 1953¦200,000 ¦200,000 ¦7519 ¦Mar. 9, 1953 ¦Mar. 9, 1953 ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦Mar. 23, 1953¦250,000 ¦200,000 ¦7651 ¦Mar. 25, 1953 ¦ ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦ ¦ ¦50,000 ¦7674 ¦Mar. 27, 1953 ¦Mar. 27, 1953 ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦Apr. 29, 1953¦100,000 ¦100,000 ¦7914 ¦May 5, 1953 ¦May 5, 1953 ¦ +-------------+--------+--------+---------+--------------+---------------¦ ¦May 26, 1953 ¦65,000 ¦65,000 ¦8104 ¦June 8, 1953 ¦June 8, 1953 ¦ +------------------------------------------------------------------------+
During its fiscal year ended November 30, 1952, the number of separate jobs on which petitioner received and disbursed cash and petitioner's total cash receipts and disbursements were:
+--------------------------------------------------------------------+ ¦ ¦ ¦Amount ¦ +---------------------------------------------+-------+--------------¦ ¦Particulars ¦Number ¦fiscal year ¦ +---------------------------------------------+-------+--------------¦ ¦ ¦of jobs¦ended Nov. 30,¦ +---------------------------------------------+-------+--------------¦ ¦ ¦ ¦1952 ¦ +---------------------------------------------+-------+--------------¦ ¦Total cash disbursements ¦48 ¦$1,951,544.15 ¦ +---------------------------------------------+-------+--------------¦ ¦Total cash receipts ¦22 ¦1,811,105.18 ¦ +---------------------------------------------+-------+--------------¦ ¦Excess of total cash disbursements over total¦ ¦ ¦ +---------------------------------------------+-------+--------------¦ ¦cash receipts ¦ ¦140,438.97 ¦ +--------------------------------------------------------------------+
Under the terms of an agreement for the assignment of accounts receivable dated February 4, 1954, between petitioner and Price Construction Co., Price assumed any contingent liability the petitioner might have as a result of an accident which occurred on November 15, 1951, during the construction of the Reynolds Metals Co. plant at Gregory, Tex.
For the construction of its plant at Gregory, Reynolds Metals Co., the landowner, entered into six prime contracts: One with H. R. Henderson & Co. and Henry C. Beck Co., who acted as general contractor as a joint venture, one with the petitioner, who was the architectural engineer, and four others. James Stewart Co. was a subcontractor who built the storage silo in which the accident occurred.
On November 15, 1951, during the construction of an ore storage silo at the Reynolds plant, an accident occurred when a scaffolding or platform supported by reinforcing bars extending inside the silo collapsed. Twenty-two or twenty-three men who were on the scaffolding when it collapsed were injured, and of these, one, Vincent Charo, was killed. The injured men were all employed by James Stewart Co. or another James Stewart Corp.
James Stewart Co. had drawn the plans for the actual construction of the silo in which the accident occurred. It also had control over the method of construction to be used in building the silo. The method of using a platform supported by reinforcing bars was decided upon and executed by James Stewart Co. It was not specified by petitioner and was not a part of its design.
As architectural engineer, the petitioner was responsible for drawing the plans for the finished product, the design of the entire plant, including specifications and working drawings, but they did not draw the construction plans for the actual building of the silo. Petitioner's duty of inspection on the premises was to determine that the finished product complied with their plans and specifications, as for example, ascertaining that the proper concrete mixture was being used. It was not petitioner's job to control in any way a subcontractor or his method of installation.
As a result of the accident at the Reynolds Metals plant, eight tort suits were filed. Seven of these actions sought damages for personal injuries and one for alleged wrongful death (Mary Lamar Charo). In each case, by the original or amended petition, four defendants were named: H. R. Henderson & Co., Inc., Henry C. Beck Co., Reynolds Metals Co., and the petitioner. Each of these suits was filed by a person employed by James Stewart Co. at the time of the injury, or by such person's representative. Hubert L. Stone, Jr., was attorney for each of the plaintiffs, and the original petitions were filed on the following dates:
+---------------------------------------+ ¦Petitioner ¦Docket¦Date petition ¦ +-----------------+------+--------------¦ ¦ ¦No. ¦filed ¦ +-----------------+------+--------------¦ ¦Manuel Garcia, Sr¦8238 ¦Dec. ¦31, 1952¦ +-----------------+------+-----+--------¦ ¦Lloyd G. Bazar ¦8371 ¦May ¦15, 1953¦ +-----------------+------+-----+--------¦ ¦Antonio Vasquez ¦8186 ¦Oct. ¦25, 1952¦ +-----------------+------+-----+--------¦ ¦Antonio Canales ¦8376 ¦May ¦15, 1953¦ +-----------------+------+-----+--------¦ ¦Everett O. Rippee¦8430 ¦July ¦3, 1953 ¦ +-----------------+------+-----+--------¦ ¦Mary Lamar Charo ¦8174 ¦Oct. ¦11, 1952¦ +-----------------+------+-----+--------¦ ¦L. D. Bolter ¦8586 ¦Nov. ¦13, 1953¦ +-----------------+------+-----+--------¦ ¦Ramon Maldonado ¦8519 ¦Sept.¦12, 1953¦ +---------------------------------------+
Stone, as attorney for the plaintiffs, investigated the accident, including examining the contracts, the plans for the finished project, and the plans for construction of the silo, as well as talking to witnesses, and taking statements and depositions. Based on the information so obtained he determined what parties to name as defendants in the tort suits he filed. At the time the petitions were filed Stone believed he had the best chance for recovery against H. R. Henderson & Co., Henry C. Beck Co., and Reynolds Metals Co. At no time did he feel he had sufficient evidence to establish a prima facie case against the petitioner, but since petitioner had duties on the premises where the accident occurred, it was necessary under Texas procedure to name the petitioner as a codefendant in order to prevent the possible use of the sole proximate cause doctrine to bar any recovery.
Based on his analysis of the cases, Stone disagreed with any prospect of liability on the part of the petitioner. Under the terms of the contract, the Beck-Henderson joint venture was required to indemnify Reynolds Metals Co. against any loss from any cause of action arising from work done under the contract. In its contract with Beck-Henderson, James Stewart Co. agreed to accept and assume all the liabilities, duties, and responsibilities created by the contract between Reynolds and Beck-Henderson. Since petitioner's contract was directly with Reynolds, there was no privity of contract between the injured employees of James Stewart Co. and petitioner. Furthermore, Reynolds retained control over the premises and there was no significant delegation of control to petitioner.
During November 1951, the petitioner carried a comprehensive general liability policy with Bankers Indemnity Insurance Co., and a general liability policy with Employers Casualty Co. The insurance coverage under each policy was $50,000.
Employers Casualty Co. was first notified of the accident by a letter dated January 13, 1953, from W. D. McArthur. Bankers Indemnity Co. was similarly advised, as McArthur's letter was written to both companies. Bankers Indemnity Insurance Co. disclaimed liability under its policy, but Employers Casualty Co. undertook to investigate and defend the cases after receiving a nonwaiver of rights agreement from the petitioner.
Falsgraf, Reidy & Shoup, attorneys for petitioner, believed that Bankers Indemnity Insurance Co. was still liable under the provisions of the insurance policy and had no grounds for disclaiming liability. They advised Bankers that petitioner did not waive any of its rights under its policy and would hold them responsible for all expenses and judgments obtained against it.
Employers Casualty Co. completed its investigation of the accident on January 29, 1954. At that time, or shortly thereafter, based on the facts obtained from their investigation, Employers Casualty Co. determined that there was no liability against petitioner on the lawsuits. Employers Casualty Co. advised its reinsurer, Security Mutual Casualty Co., of the Reynolds plant accident and the facts developed by Employers' investigation thereof. With a knowledge of these facts, Security Mutual did not request Employers Casualty to take any special action with regard to the possible liability of J. Gordon Turnbull, Inc., and stated that it appeared doubtful that Turnbull was guilty of any negligence.
All of the cases filed against petitioner were disposed of by a settlement which was finally arranged in October 1954, and judgments were entered on November 1, 1954. In settlement of the suits Employers Casualty Co. paid $5,000 on behalf of petitioner and obtained releases in all cases as a part thereof. Travelers Insurance Co. paid $40,000 as insurer for Henry C. Beck Co. and H. R. Henderson & Co., and James Stewart Co. paid $4,350 in its own behalf. All the lawsuits were settled by the defendants for a total payment of $49,350. One reason the damage suits were settled for a total of $49,350 was all of the injured men, except Vincent Charo who was killed, had recovered, had returned to work, and were earning good money by the time the cases were settled.
In its accrual basis balance sheet of November 30, 1953, the petitioner was careful to show many reserves for various expenses, including a $10,000 reserve for legal expenses on suits, but no reserve was established for any contingent liability on the lawsuits filed as a result of the Reynolds plant accident. The suits are not mentioned in a footnote to the balance sheet, although the petitions had all been filed prior to November 30, 1953.
The officers of Price Construction Co. were of the opinion that the extent of contingent liability on the lawsuits would not exceed insurance coverage of $50,000, and no further indication of any contingent liability was made on the balance sheet of Price Construction Co. as of February 28, 1954, which statement was examined by Q. B. Carlile, CPA, and as to which he rendered a qualified opinion.
At no time did either the petitioner or Price Construction Co. make any payment with regard to the lawsuits resulting from the Reynolds plant accident.
W. A. Falsgraf, an attorney of Cleveland, Ohio, represented J. Gordon Turnbull from the summer of 1942 until the death of J. Gordon Turnbull on April 1, 1953. During said period, and at all times pertinent to this case, Falsgraf also represented the petitioner. Falsgraf was elected assistant secretary of petitioner in 1945, secretary in 1947, and director in 1948. He served as secretary and director from 1948 through the taxable periods involved herein. Prior to the death of J. Gordon Turnbull, Falsgraf and Turnbull had decided that immediately upon Turnbull's death the petitioner should be put into immediate dissolution and should not be permitted to continue the active conduct of any business. Immediately after Turnbull's death Falsgraf went to Turnbull's residence in Los Angeles and met with the vice president and treasurer of petitioner. He called the home office of petitioner in Cleveland and instructed that all bids and quotations were to be recalled and no further contracts were to be signed. This course of action was followed by Falsgraf because of the decision reached by him and Turnbull prior to Turnbull's death. As a part of the plan for the liquidation of petitioner, uncompleted contracts for job agreements at its Kansas City office were assigned to E. G. Novak, the manager of such office for completion.
In 1944, the General Corporation Law of the State of Ohio was amended to prohibit corporations from engaging in the business of rendering architectural and/or engineering services. The amending act, however, permitted corporations having charters granted prior to its effective date containing power to engage in such activities to continue to do so. Under the so-called ‘grandfather’ clause, the corporate charter of petitioner was not affected by the amendment of 1944, and it could continue to act in its corporate capacity as a consulting and superintending engineer and architect.
At all times pertinent hereto the petitioner was licensed and qualified to do business as a foreign corporation in the following States: Arizona, Arkansas, California, Illinois, Indiana, Michigan, Missouri, Ohio, Wisconsin, New York, Texas, and Washington.
In late April or early May 1953, certain employees of petitioner sought to acquire the corporate stock and keep the corporate charter alive. A plan was developed whereby these employees could purchase the petitioner's treasury shares for $50,000. An advance ruling on this plan was requested from the Internal Revenue Service to determine whether proposed distributions to the Estate of J. Gordon Turnbull and to Susan A. Turnbull would constitute distributions in partial liquidation under section 115(c) of the Internal Revenue Code of 1939, and that no part of such distributions would be taxable as ordinary dividend income. The advance ruling was requested on behalf of the Estate of J. Gordon Turnbull and Susan A. Turnbull for the reason that the case of Zenz v. Quinlivan, 106 F.Supp. 57, had been decided by the U.S. District Court for the Northern District of Ohio, Western Division, on June 27, 1952. Falsgraf advised Susan Turnbull and told the employees who sought to purchase the company's stock so as to keep the corporate entity in existence that he would not approve such sale in the absence of an advisory ruling from Internal Revenue Service that the Zenz case would not be applicable to the transaction, but that it would qualify as a partial liquidation.
As counsel for Susan Turnbull and the Estate of J. Gordon Turnbull, Falsgraf would have preferred a sale of the stock of the corporation to a liquidation because of the pending litigation.
In addition to negotiating for the sale of the petitioner's stock to its employees, Falsgraf negotiated with other interested parties with a view to a sale of petitioner's stock. These included Reynolds Metals Co., Peter Kiewit, Allen & Co., and the Guy B. Pinero organization. These potential purchasers would not go forward with an acquisition of petitioner's stock and one of the reasons given was the existence of the pending lawsuits resulting from the Reynolds plant disaster.
During its 6 fiscal years ended November 30, 1948, through November 30, 1953, the petitioner's income tax returns, with minor adjustments, had net income after taxes, current earnings available for dividends, dividends paid, and earned surplus balances, as reflected in table 1.
+------------------------------------------------------------------------------------------+ ¦TABLE 1 ¦ +------------------------------------------------------------------------------------------¦ ¦ ¦ ¦ ¦Current ¦Other ¦Current ¦ ¦Earned ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Fiscal¦Current net ¦Deduct: ¦net income¦adjustments¦earnings ¦Dividends¦surplus ¦ ¦year ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦ended—¦income ¦Current ¦after ¦to ¦available ¦paid ¦balance ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦ ¦ ¦taxes ¦taxes ¦earned ¦for ¦ ¦end of ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦ ¦ ¦ ¦ ¦surplus ¦dividends ¦ ¦year ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦ ¦ ¦ ¦ ¦ ¦ ¦$158,726.82¦ ¦1947 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦$206,822.25 ¦($107,185.65)¦$99,636.60¦$4,961.98 ¦$104,598.58¦($40,775)¦222,550.40 ¦ ¦1948 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦153,646.19 ¦(58,385.55) ¦95,260.64 ¦ ¦95,260.64 ¦(16,240) ¦301,571.04 ¦ ¦1949 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦300,066.40 ¦(139,496.86) ¦160,569.54¦ ¦160,569.54 ¦(16,240) ¦445,900.58 ¦ ¦1950 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦217,629.88 ¦(117,385.85) ¦100,244.03¦ ¦100,244.03 ¦0 ¦546,144.61 ¦ ¦1951 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦31,737.67 ¦(10,580.67) ¦21,157.00 ¦ ¦21,157.00 ¦(16,240) ¦551,061.61 ¦ ¦1952 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦Nov. ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦30, ¦200,090.80 ¦(82,740.11) ¦117,350.69¦ ¦117,350.69 ¦0 ¦668,412.30 ¦ ¦1953 ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------+------------+-------------+----------+-----------+-----------+---------+-----------¦ ¦ ¦1,109,993.19¦(515,774.69) ¦594,218.50¦4,961.98 ¦599,180.48 ¦(89,495) ¦ ¦ +------------------------------------------------------------------------------------------+
During these fiscal years the changes in petitioner's assets and liabilities, its financial position, and its ratios of current assets to current liabilities and cash to current liabilities were as shown in table 2 (p. 366).
Petitioner's financial position and the ratios of its current assets to current liabilities, cash to current liabilities, and current assets to total liabilities as of November 30, 1953, on an accrual basis, were as follows:
+---------------------------------+ ¦ASSETS ¦ +---------------------------------¦ ¦ ¦ ¦ +--------------------+------------¦ ¦Cash ¦$521,713.77 ¦ +--------------------+------------¦ ¦Other current assets¦669,008.14 ¦ +--------------------+------------¦ ¦Total current assets¦1,190,721.91¦ +--------------------+------------¦ ¦Fixed assets ¦260,861.60 ¦ +--------------------+------------¦ ¦Total assets ¦1,451,583.51¦ +--------------------+------------¦ ¦ ¦ ¦ +---------------------------------+
LIABILITIES AND CAPITAL Liabilities: Current liabilities 11,888.24 Reserves 433,251.77 Total liabilities 445,140.01 Capital: Capital stock 137,124.80 Retained earnings 869,318.70 Total liabilities and capital 1,451,583.51 Ratio of— Current assets to current liabilities 100.16:1 Current assets to total liabilities 2.67:1 Cash to current liabilities 43.88:1 Cash to total liabilities 1.17:1
During petitioner's fiscal year ended November 30, 1952, J. Gordon Turnbull received a salary of $60,000 from petitioner but no salary was paid to Susan A. Turnbull. For its fiscal year ended November 30, 1953, petitioner paid J. Gordon Turnbull a salary of $35,000 and Susan A. Turnbull a salary of $12,500. These salaries are included in the deduction for compensation of officers claimed on petitioner's income tax return for each year.
+------------------------------------------------------------------------------------------------+ ¦TABLE 2 ¦ +------------------------------------------------------------------------------------------------¦ ¦ ¦Fiscal year ended— ¦ +------------+-----------------------------------------------------------------------------------¦ ¦Particulars ¦Nov. 30, ¦Nov. 30, ¦Nov. 30, ¦Nov. 30, ¦Nov. 30, ¦Nov. 30, ¦Nov. 30, ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦ ¦1947 ¦1948 ¦1949 ¦1950 ¦1951 ¦1952 ¦1953 ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦ASSETS ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Current ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦assets: ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Cash ¦$182,282.56¦$214,261.70¦$153,041.11¦$399,976.64¦$290,997.09¦$205,505.89¦$563,463.77¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Notes and ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦other ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦accounts ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦receivable: ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Computer ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Research ¦ ¦ ¦ ¦ ¦103,945.68 ¦194,775.36 ¦ ¦ ¦Corp ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Other ¦31,012.33 ¦30,462.91 ¦36,412.69 ¦13,177.39 ¦97,175.20 ¦(2,005.36) ¦71,351.01 ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Total ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦current ¦213,295.44 ¦244,724.61 ¦189,453.80 ¦413,154.03 ¦492,117.97 ¦398,275.89 ¦634,814.78 ¦ ¦assets ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Investments:¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Big Island, ¦ ¦ ¦ ¦ ¦ ¦33,700.00 ¦ ¦ ¦Inc., stock ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Computer ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Research ¦ ¦ ¦ ¦ ¦ ¦5,070.00 ¦ ¦ ¦Corp. stock ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Treasury ¦59,350.00 ¦59,350.00 ¦62,875.20 ¦62,875.20 ¦62,875.20 ¦62,875.20 ¦62,875.20 ¦ ¦stock ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Partnership ¦ ¦29,721.39 ¦80,481.51 ¦26,561.98 ¦ ¦ ¦ ¦ ¦investment ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Fixed and ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦other ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦assets: ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Automobiles ¦12,349.92 ¦17,732.19 ¦25,811.35 ¦36,771.27 ¦35,533.99 ¦38,837.42 ¦14,637.13 ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Furniture ¦45,964.35 ¦56,749.61 ¦59,975.87 ¦77,415.36 ¦101,002.14 ¦105,185.95 ¦58,836.48 ¦ ¦and fixtures¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Building ¦66,473.63 ¦70,455.00 ¦135,455.00 ¦158,133.56 ¦127,257.97 ¦128,550.05 ¦119,152.73 ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Less: ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Reserve for ¦(26,990.78)¦(36,798.76)¦(45,600.53)¦(61,275.64)¦(74,680.98)¦(87,370.29)¦(62,027.74)¦ ¦depreciation¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Land ¦75,416.87 ¦75,533.42 ¦85,533.42 ¦82,283.42 ¦215,158.42 ¦155,062.37 ¦130,263.00 ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Deposits ¦950.00 ¦1,021.85 ¦1,049.65 ¦3,109.30 ¦610.85 ¦672.85 ¦989.07 ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Leasehold ¦ ¦ ¦ ¦ ¦232.83 ¦7,128.15 ¦ ¦ ¦improvements¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +------------+-----------+-----------+-----------+-----------+-----------+-----------+-----------¦ ¦Total assets¦446,809.43 ¦518,489.31 ¦595,035.27 ¦799,028.48 ¦960,108.39 ¦847,987.59 ¦959,540.65 ¦ +------------------------------------------------------------------------------------------------+
LIABILITIES AND CAPITAL Current liabilities: Accounts payable Deposits 50.00 payable Accrued 66,302.13 78,592.46 58,385.55 139,496.86 119,382.94 10,580.67 82,740.11 income taxes Employees 21,730.48 17,346.45 10,921.13 13,631.04 19,955.84 25,222.67 8,388.24 tax Total current 88,082.61 95,938.91 69,306.68 153,127.90 139,338.78 35,803.34 91,128.35 liabilities Bonds, notes, and 24,157.55 74,625.00 61,122.64 mortgages payable Total 88,082.61 95,938.91 93,464.23 153,127.90 213,963.78 96,925.98 91,128.35 liabilities Capital 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00 stock Earned surplus and 158,726.82 222,550.40 301,571.04 445,900.58 546,144.61 551,061.61 668,412.30 undivided profits Total liabilities 446,809.43 518,489.31 595,035.27 799,028.48 960,108.39 847,987.59 959,540.65 and capital Ratio of: Current assets to 2.42:1 2.55:1 2.73:1 2.70:1 3.53:1 11.12:1 6.97:1 current liabilities Cash to current 2.07:1 2.23:1 2.21:1 2.61:1 2.09:1 5.73:1 6.18:1 liabilities
At its meeting on January 18, 1954, the board of directors of H. R. Henderson & Co., in considering the possibility of purchasing the stock of petitioner, knew and took recognition of the fact that, in the event of such a purchase, it would be possible for Henderson to obtain a large part of the purchase price from petitioner.
On February 4, 1954, petitioner's board of directors recognized its cash position was such that it could loan $800,000 to H. R. Henderson & Co. This loan was utilized by Henderson in its purchase of petitioner's stock. Petitioner actually loaned H. R. Henderson & Co. $801,108.37 in order that Henderson might purchase petitioner's outstanding stock. Funds for the purchase of the outstanding shares of petitioner were provided:
+------------------------------------------------------------+ ¦By H. R. Henderson & Co.: ¦ ¦ +-------------------------------------------------+----------¦ ¦Borrowed from Cameron McElroy and H. R. Henderson¦$25,000.00¦ +-------------------------------------------------+----------¦ ¦Borrowed from J. Gordon Turnbull, Inc. ¦801,108.37¦ +-------------------------------------------------+----------¦ ¦Total ¦826,108.37¦ +-------------------------------------------------+----------¦ ¦By J. Gordon Turnbull, Inc. (treasury shares) ¦148,891.63¦ +-------------------------------------------------+----------¦ ¦Total ¦975,000.00¦ +------------------------------------------------------------+
On or about February 4, 1954, H. R. Henderson & Co. acquired all of the outstanding shares of petitioner for a total price of $975,000, paid as follows:
+-----------------------------------------------------------------------------+ ¦ ¦Number of ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦ ¦shares ¦Amount ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Paid by H. R. Henderson & Co. to— ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Susan A. Turnbull ¦330 ¦$198,121.92¦ +-----------------------------------------------------+-----------+-----------¦ ¦J. Gordon Turnbull Estate ¦1,046 ¦627,986.45 ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Total amount paid by H. R. Henderson & Co. ¦ ¦826,108.37 ¦ +-----------------------------------------------------+-----------+-----------¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Paid by J. Gordon Turnbull, Inc., to: Estate of J. ¦248 ¦148,891.63 ¦ ¦Gordon Turnbull ¦ ¦ ¦ +-----------------------------------------------------+-----------+-----------¦ ¦Total ¦1,624 ¦975,000.00 ¦ +-----------------------------------------------------------------------------+
As specified in the offer to purchase dated January 25, 1954, Susan A. Turnbull purchased from petitioner for cash the following assets at their book value as of December 31, 1954:
+----------------------------------------+ ¦1/2-ton Chevrolet truck ¦$1,036.08 ¦ +-----------------------------+----------¦ ¦1952 Cadillac ¦3,537.03 ¦ +-----------------------------+----------¦ ¦Moraga Drive property ¦56,111.15 ¦ +-----------------------------+----------¦ ¦San Fernando ranch ¦118,280.50¦ +-----------------------------+----------¦ ¦Chester Avenue property ¦49,068.17 ¦ +-----------------------------+----------¦ ¦Ranch machinery and equipment¦12,087.47 ¦ +-----------------------------+----------¦ ¦Total ¦240,120.40¦ +----------------------------------------+
During the years 1951, 1952, and 1953, all of petitioner's issued and outstanding capital stock was owned by J. Gordon Turnbull, Susan A. Turnbull, and the Estate of J. Gordon Turnbull.
In its income tax return for the year December 1, 1953, through November 30, 1954, the petitioner reported a gain on sale of its accounts receivable in the amount of $158,726.20. In computing the tax due on this return, the petitioner prorated this gain, along with all its taxable income, between its separate return for the taxable period December 1, 1953, through February 4, 1954 (66 days), and the period February 5 through November 30, 1954 (299 days). For the latter period, the income of petitioner, so prorated, was included in the consolidated return filed with and in the name of its parent company, H. R. Henderson & Co.
In the notice of deficiency pertaining to the short taxable year of petitioner, ended February 4, 1954 (docket No. 88456), respondent determined that the $158,726.20, which petitioner reported as gain on sale of accounts receivable, should be completely reallocated to said short taxable year.
In the notice of deficiency pertaining to the consolidated return of H. R. Henderson & Co. and the petitioner, for the taxable year 1954 (docket No. 1285-62), respondent determined that the income reported on said consolidated return should be increased by the amounts collected on the accounts receivable of petitioner during the period from February 4, 1954, through December 31, 1954, which collections amounted to $423,777.25. Respondent further determined that this sum could properly be reduced by a basis in said accounts of $41,273.80, collection expenses of $13,550.48, and the gain from sale of receivables reported by petitioner on its return for the period December 1, 1953, through November 30, 1954, in the amount of $158,726.20, leaving the determined increase in reported consolidated income for 1954 from this adjustment of $210,226.77.
As a result of the issuance of the notices of deficiencies dated May 13, 1960 (docket No. 88456), and January 22, 1962 (docket No. 1285-62), the sum of $158,726.20 was twice included in income, since the sale of the accounts receivable was recognized by the respondent in his notice dated May 13, 1960 (docket No. 88456), for the taxable year ended February 4, 1954, and the sale was not recognized by the respondent in his notice dated January 22, 1962 (docket No. 1285-62), for the year ended December 31, 1954, but was considered to have been income which was not reported on the consolidated return of H. R. Henderson & Co. and petitioner for the year 1954.
On May 13, 1960, respondent issued his notice of deficiency in which he determined that with respect to the taxable years ended November 30, 1952, November 30, 1953, and the taxable year December 1, 1953, through February 4, 1954, the petitioner was formed or availed of for the purpose of preventing the imposition of surtax upon its shareholders by permitting earnings or profits to accumulate instead of being distributed, and that petitioner was subject to the provisions of section 102 of the Internal Revenue Code of 1939.
Issue 2
In connection with their negotiations to purchase the stock of petitioner and the ruling requested with regard thereto, certain of petitioner's employees retained the firm of J. K. Lasser & Co. This firm was not employed by petitioner, but was retained by key employees in their own behalf. After H. R. Henderson & Co. acquired the stock of petitioner, J. K. Lasser & Co. sent a bill for $3,500 to W. D. McArthur who represented the employees. At first W. A. Falsgraf, acting for petitioner, refused to pay this bill on the ground that it was an obligation of the employees, but Cameron McElroy authorized the payment by petitioner since he was fearful that certain key employees might resign if the petitioner did not pay the bill.
In his notice of deficiency dated May 13, 1960, the respondent disallowed the fee paid to J. K. Lasser & Co. as a deduction because it was not regarded as an ordinary and necessary expense of petitioner.
ULTIMATE FINDINGS
1. During each of its taxable years ended November 30, 1952, November 30, 1953, and February 4, 1954, petitioner permitted its earnings to accumulate beyond the reasonable needs of its business.
2. For each of its taxable years ended November 30, 1952, November 30, 1953, and February 4, 1954, petitioner was availed of for the purpose of preventing the imposition of surtax on its shareholders through the medium of permitting its earnings to accumulate instead of being divided or distributed.
3. The $3,500 fee paid by petitioner to J. K. Lasser & Co. for some of its key employees was not an ordinary and necessary expense of petitioner.
OPINION
Issue 1
Section 102(a) of the Internal Revenue Code of 1939 provides that if a corporation is availed of for the purpose of preventing the imposition of surtax on its shareholders by permitting earnings or profits to accumulate instead of being distributed, then the corporation is subject to a surtax on the amount of undistributed section 102 net income. Section 102(c) provides that the accumulation of earnings or profits beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon shareholders unless the corporation proves to the contrary by the clear preponderance of evidence.
Under section 534, I.R.C. 1954, which is applicable to this case, if respondent sends the taxpayer a notification of the proposed determination regarding accumulated earnings tax, and in response thereto the taxpayer submits an adequate statement of grounds on which the taxpayer relies, along with supporting facts, then respondent must bear the burden of proving, with respect to the relevant grounds set forth in said statement, that the taxpayer permitted its earnings or profits to accumulate beyond the reasonable needs of its business. To be adequate to shift to respondent the burden of proof with respect to the grounds set forth in the taxpayer's statement, the supporting facts submitted by the taxpayer must be substantial, material, definite, and clear. American Metal Products Corporation, 34 T.C. 89 (1960), affd. 287 F.2d 860 (C.A. 8, 1961).
In this case the respondent did, as we have heretofore found, send a notification to the petitioner in accordance with the provisions of section 534; and the petitioner submitted a timely statement in which it purported to set forth certain grounds and supporting facts on which it relies to establish that its earnings and profits had not been permitted to accumulate beyond the reasonable needs of its business during the years in controversy.
But respondent contends that the facts contained in the petitioner's statement dated July 10, 1959, do not meet the requirements of the statute and the regulations and are insufficient to shift the burden of proof to respondent. His contention is based on the following points:
1. All the information submitted by the petitioner regarding cash receipts and disbursements pertain to the fiscal years ended November 30, 1951, and November 30, 1952. It did not submit any such information for its fiscal years ended November 30, 1953, and February 4, 1954, although these years were included in the notice mailed to petitioner on May 11, 1959. That the information submitted was carefully considered by respondent is shown by the fact that the fiscal year ended November 30, 1951, was not included in the notice of deficiency, but petitioner did not submit any information on its cash flow or cash position for 2 of the 3 years now before us.
2. The few allegations contained in the statement regarding the Reynolds plant accident were so vague and indefinite that respondent was not informed as to the basis or reasons for the petitioner's position. Specific facts should be set forth in petitioner's statement, not mere allegations of its contention. See Wellman Operating Corporation, 33 T.C. 162, 184 (1959); and American Metal Products Corporation, supra. Petitioner's statement contains the following incorrect information: (a) The accident occurred on November 15, 1951, not during petitioner's fiscal year 1953, as stated: (b) the storage silo was not constructed by petitioner; (c) the entire silo did not collapse; (d) ‘many’ construction workers were not killed; (e) only one action for wrongful death was filed, not ‘numerous wrongful death lawsuits'; (f) the one suit for wrongful death filed named three other parties as codefendants along with petitioner. The facts omitted from petitioner's statement regarding the accident left respondent completely uninformed concerning it. Petitioner did not name any of the parties involved; where, when, or how the accident occurred; what suits had been filed and where; who were petitioner's insurers; the amount of coverage; or that one such company undertook to investigate the accident. Petitioner did not specify what prospective purchasers were contacted and any facts as to what happened during any negotiations which might have occurred.
3. Petitioner's stated ground that case was required for completion of contracts on hand was merely an allegation. No facts were submitted in support thereof. Petitioner offered no explanation of why a business, which was inactive and accepting no new work after April 3, 1953, needed such large amounts of working capital. Petitioner also did not state that on or about July 1, 1953, some of its contracts had been assigned to E. G. Novak for completion.
In view of the foregoing we have concluded that the petitioner's statement was not sufficiently clear and definite to affect a shift in the burden of proof in relation to accumulations beyond the reasonable needs of the business. See I. A. Dress Co., 32 T.C. 93 (1959), affd. 273 F.2d 543 (C.A. 2, 1960), certiorari denied 362 U.S. 976. However, irrespective of the burden-of-proof issue, we think the record in this case persuasively demonstrates that petitioner's financial position at the beginning of and during the years in question was adequate to meet its business needs, both immediate and anticipated, that additional accumulations were unreasonable, and that the corporation was availed of for the purpose of preventing the imposition of surtax upon its principal shareholders. Cf. Barrow Manufacturing Co. v. Commissioner, 294 F.2d 79 (C.A. 5, 1961), affirming a Memorandum Opinion of this Court.
We turn now to a consideration of the grounds asserted by the petitioner and of the evidence pertinent thereto, bearing in mind that whether a corporation was availed of for the purpose of avoiding the income tax with respect to its shareholders and whether earnings and profits were permitted to accumulate beyond the reasonable needs of the business are both questions of fact. Helvering v. National Grocery Co., 304 U.S. 282 (1938), and James M. Pierce Corporation, 38 T.C. 643, 652 (1962).
Petitioner argues that it retained certain of its earnings to meet its reasonable business needs for the following reasons:
(a) The nature of petitioner's engineering, consulting, and contracting services required extensive working capital to cover expenditures against work in progress which generally exceeded collections on fees during the greatest portion of the time the job was on the company's books. Such expenditures were required to be made during the progress of the work, but fee collections were almost always deferred to the close of the job, and in many instances retentions of up to 10 percent of the contract price could be held for extended periods.
(b) Petitioner's cash position during the years here involved was so precarious as to require the establishment of a line of credit for borrowings to meet payrolls and its needs for short-term working capital.
(c) The disaster at Gregory, Tex., on November 15, 1951, confronted petitioner with claims for damages exceeding $500,000, against which it had insurance in force of not to exceed $100,000, the carriers of which had disclaimed liability.
Petitioner further argues that there was a complete absence of intent on its part to avoid the imposition of surtax on its shareholders and that such intent is evidenced by these circumstances:
(a) During the period from 1947 until the death of J. Gordon Turnbull, the petitioner had paid substantial cash dividends whenever its cash position was such that they were warranted.
(b) After the date of death of J. Gordon Turnbull, the petitioner was in a de facto status of liquidation, and distribution of its assets could have been accomplished at any time with favorable capital gain treatment to its shareholders.
(c) The plan proposed by certain of its employees involving a stock purchase followed by a redemption of the remaining shares held by the Estate of J. Gordon Turnbull and his widow was deemed by Internal Revenue Service in its ruling letter to be a partial liquidation within the meaning of section 115(c) of the Internal Revenue Code of 1939.
(d) Petitioner was not liquidated because of the value of the corporate entity with its charter permitting the rendering of engineering services and because of the potential transferee liability to the Estate of J. Gordon Turnbull and his widow from the Texas litigation.
Working capital requirements and cash position.— The record reveals that for its 6 fiscal years ended November 30, 1947, through November 30, 1953, the petitioner had total current earnings available for dividends of $599,180.48, from which it paid dividends of $89,495, or a total of 14.94 percent. It is apparent, as shown in our Findings of Fact, that the largest part of these dividends was paid before 1951. But even more significant is that for the latter 3 fiscal years, the petitioner had current earnings available for dividends of $238,751.72, and paid only one dividend in 1952 of $16,240, or only 6.80 percent. While in its fiscal year ended November 30, 1952, the first year at issue here, the petitioner paid out a large part of its earnings in dividends, for its next year ended November 30, 1953, it had much larger current earnings available ($117,350.69), but paid no dividends at all. Thus, during the years November 30, 1952, and November 30, 1953, the petitioner's retained earnings, even after the 1952 dividend, increased $4,917 and $117,350.69, respectively, or a total of $122,267.69.
Petitioner's cash basis balance sheets for these 2 years indicate that as retained earnings increased in such substantial amounts, the corporation's financial condition was both sound and liquid, and that its cash position was particularly strong. At the end of each of these 2 years, petitioner had no current liabilities other than accrued taxes; its current assets exceeded its total liabilities in each year by $301,349.91 and $543,686.43, respectively; and it had cash in excess of total liabilities in each year of $108,579.91 and $472,335.42, respectively. Its current ratio was 11.12 to 1 at November 30, 1952, and 6.97 to 1 at November 30, 1953. Moreover, the ratio of cash to current liabilities was 5.73 to 1 and 6.18 to 1 in these years. Petitioner's cash position was so strong that it could have easily paid all its liabilities and had excess cash of over $108,000 as of November 30, 1952, and over $472,000 as of November 30, 1953. In light of these facts, we are not persuaded that petitioner had any kind of cash problems, let alone that its cash position was precarious. Its working capital appears to have been entirely adequate for its needs.
That petitioner engaged in some short-term borrowing does not detract from the fact that its working capital was more than adequate. Only two loans were made in fiscal year 1952 for about 60 days each. The four loans made in fiscal year 1953 were all in the first part of the year and were for terms of 14, 4, 6, and 13 days, respectively. The fact that petitioner could obtain such loans and repay them in only a few days indicates the strength rather than the weakness of its finances. See Kerr-Cochran, Inc. v. Commissioner, 253 F.2d 121 (C.A. 8, 1958), affirming a Memorandum Opinion of this Court, involving quick bank loan repayments.
On an accrual basis, petitioner's financial condition at November 30, 1953, was even better than on a cash basis. The ratio of current assets to current liabilities was 100.16 to 1; the ratio of current assets to total liabilities was 2.67 to 1; the ratio of cash to current liabilities was 43.88 to 1; and the ratio of cash to total liabilities was 1.17 to 1.
By February 4, 1954, petitioner's liquidity and cash position was enhanced by Susan A. Turnbull's purchase, for cash, of various fixed assets owned by the petitioner at their book value as of December 31, 1953, in the total amount of $240,120.40.
At its meeting on January 18, 1954, the board of directors of H. R. Henderson & Co., in considering the possibility of purchasing the stock of petitioner, knew and took special recognition of the fact that in the event of such a purchase, it would be possible for Henderson to obtain a large part of the purchase price from petitioner. Similarly, on February 4, 1954, petitioner's board of directors recognized its cash position was such that it could loan $800,000 to H. R. Henderson & Co. This loan was utilized by Henderson in its purchase of petitioner's stock. As part of the purchase of its stock, petitioner actually loaned H. R. Henderson & Co. $801,108.37, and in addition paid $148,891.63 to the Estate of J. Gordon Turnbull, in order to acquire 248 shares of its own stock to be held as treasury shares. Thus, petitioner's accumulated earnings were utilized to finance the sale of petitioner's outstanding stock from Susan A. Turnbull and the Estate of J. Gordon Turnbull, petitioner's only stockholders, to H. R. Henderson & Co. We think this use of accumulated corporate earnings was essentially for the personal benefit of petitioner's stockholders and was the final step in the plan to avoid the imposition on these stockholders of surtax on accumulated corporate earnings. In our opinion, such a use indicates that the earnings and profits of the corporation have been accumulated beyond the reasonable needs of the business. See Pelton Steel Casting Co. v. Commissioner, 251 F.2d 278 (C.A. 7, 1958), certiorari denied 356 U.S. 958.
Still another reason why petitioner's working capital was not inadequate during its taxable years ended November 30, 1953, and February 4, 1954, is that after the death of J. Gordon Turnbull on April 1, 1953, petitioner's operations were greatly curtailed. Petitioner accepted no new work from April 1, 1953, through February 4, 1954. Additionally, on or about July 1, 1953, the petitioner assigned the uncompleted contracts in its Kansas City office to E. G. Novak, the manager of its Kansas City office, for completion. Petitioner therefore did not have any financial burden in connection with the completion of these jobs during the latter part of its fiscal year 1953.
During 1953 the petitioner was in the process of winding up its affairs, although no formal plan of liquidation had been adopted. The mere fact that a corporation is in the process of liquidation or winding up its affairs does not prevent the application of the tax on unreasonable accumulations of earnings. To the contrary, if a taxpayer's business has terminated or become inactive, usually there is no longer any reasonable business need for retaining accumulated earnings. In Egan, Inc. v. Commissioner, 236 F.2d 343 (C.A. 8, 1956), affirming a Memorandum Opinion of this Court, the accumulated earnings tax was imposed where the corporation had ceased doing business upon the termination of its franchise during the taxable year. See also Eastern Railway & Lumber Co., 12 T.C. 869 (1949).
Possible liability on tort suits.— Although petitioner earnestly contends that it was compelled to maintain large cash reserves to meet any contingent liability it might have had on the tort suits arising out of the accident at the Reynolds plant, we are satisfied that the evidence establishes that petitioner's belief was groundless and unfounded. We do not regard this as a realistically foreseeable contingency in view of all the facts and circumstances involved. The cases relied on by the petitioner, namely, Casey v. Commissioner, 267 F.2d 26 (C.A. 2, 1959), and William C. Atwater & Co., 10 T.C. 218 (1948), involved facts which differ substantially from those present in the instant case and, consequently, are distinguishable. In Casey, a suit filed by the estate of Brian T. Moran, a former employee of Bankers Development Corp., to recover claimed commissions was on appeal to the Court of Appeals of the State of New York; and in the Atwater case, where a large judgment would have to have been paid if an appeal were unsuccessful, an attachment of bank accounts already had been made, thus indicating the reality of the need. We are more inclined here to give considerable weight to evidence bearing on the likelihood of the occurrence of the contingency, even though we are cognizant of the normal uncertainties of litigation. Cf. Oyster Shell Products Corporation v. Commissioner, 313 F.2d 449 (C.A. 2, 1963), affirming a Memorandum Opinion of this Court; Gibbs & Cox v. Commissioner, 147 F.2d 60 (C.A. 2, 1945); and Trico Products Corporation v. McGowan, 169 F.2d 343 (C.A. 2, 1948).
This record shows that the petitioner was in no way responsible for the accident, which had occurred when a scaffolding or platform supported by reinforcing bars extending inside an ore storage silo collapsed injuring about 22 employees of James Stewart Co. James Stewart Co., which had drawn the plans for the actual construction of the silo, had complete control over the method of construction of the silo, had complete control over the method of construction utilizing the platform supported by reinforcing bars. This method was not specified by petitioner and was not part of its design. As architectural engineer, petitioner's responsibility was limited to drawing plans for the finished product, the design of the entire plant, and its duty of inspection was merely to determine that the finished product complied with their plans and specifications. Petitioner had no control over any subcontractor or his method of installation. The circumstances under which the accident occurred made any liability by petitioner highly improbable.
From his study of the case and investigation of the accident, Hubert L. Stone, attorney for each of the plaintiffs in the tort suits believed when he filed the suits that he had the best chance of recovery against the parties defendant other than the petitioner and at no time did he feel he had sufficient evidence even to establish a prima facie case against petitioner. It was only because of a rule of Texas procedure that he even named petitioner as a codefendant.
The record also shows that at no time were the officers and directors too concerned about any liability as a result of the Reynolds plant accident. Their lack of concern is evidenced by the fact that although the accident occurred on November 15, 1951, they did not notify either of their two insurers of the accident until January 13, 1953.
One of petitioner's insurers disclaimed liability under its policy and the other (Employers Casualty Co.) undertook to investigate and defend the case after receiving a nonwaiver of rights agreement. Petitioner's attorneys, Falsgraf, Reidy and Shoup, believed the disclaiming company was still liable under the provisions of the insurance policy and had no grounds for disclaiming liability.
After its investigation was completed about January 29, 1954, Employers Casualty Co. concluded there was no liability against petitioner on the lawsuits. In spite of the size of the alleged damages, Security Mutual Casualty Co., reinsurer for Employers Casualty Co., with knowledge of the facts, did not request Employers to take any special action because it appeared doubtful to them that petitioner was guilty of any negligence.
Although actual settlements of the suits were negotiated over a period of months, all were settled by October 1954, and judgments were entered on November 1, 1954. In settlement of the suits, Employers Casualty Co. paid only $5,000 on behalf of petitioner and obtained releases in all the cases. A total of $44,350 was paid by or on behalf of the other defendants, and all the lawsuits were therefore settled by all the defendants for a total payment of $49,350. Neither the petitioner nor Price Construction Co. ever made any payment as a result of the Reynolds plant lawsuits.
Furthermore, in its accrual basis balance sheet of November 30, 1953, the petitioner showed many reserves for various expenses, including a $10,000 reserve for legal expenses on suits, but no reserve was established for any contingent liability on the lawsuits filed as a result of the Reynolds plant accident.
The foregoing facts convince us that petitioner at no time had any appreciable contingent liability on the tort suits, and that petitioner's officers and directors were well informed as to all the facts regarding the accident as well as the extremely small chance of petitioner's having any liability with regard thereto. Reasonable business needs do not include the retention of earnings and profits to provide against such unrealistic contingencies. Moreover, whatever possibility of loss might have existed was more than adequately provided for by the earnings which petitioner had accumulated by November 30, 1951, prior to the years before us, which amounted to $546,144.61. It is recognized that prior years' retained earnings should be taken into consideration in determining whether the retention and accumulation of current year's earnings is required by the reasonable needs of the taxpayer's business. Casey v. Commissioner, supra.
Other factors.— While petitioner's business was to provide architectural and engineering services, it invested large sums in real estate unrelated to its business. The most significant of these unrelated investments was a ranch, or farm, in San Fernando, Calif., in which petitioner invested $119,625, and which was sold to Susan A. Turnbull for cash at its book value as of December 31, 1954. This property was operated as a farm and crops were grown on it for a few years. This large investment of funds in property unrelated to petitioner's business indicated that petitioner was accumulating its earnings beyond the reasonable needs of its business. See J. M. Perry & Co. v. Commissioner, 120 F.2d 123 (C.A. 9, 1941); and Raymond I. Smith, Inc., 33 T.C. 141 (1959), affd. 292 F.2d 470 (C.A. 9, 1961). This is another crystallizing agent for persuasion as to the lack of reasonable business needs.
During petitioner's fiscal year ended November 30, 1952, J. Gordon Turnbull received a salary of $60,000. For the fiscal year ended November 30, 1953, petitioner paid J. Gordon Turnbull a salary of $35,000 and Susan A. Turnbull a salary of $12,500. These salaries, which were included in the deduction for compensation of officers claimed on petitioner's income tax return for each year, show that J. Gordon Turnbull and his wife, who were the sole stockholders of petitioner, were in a tax bracket of approximately 67 percent and 66 percent for the years 1952 and 1953. Consequently, the retention of earnings by the corporation represented a substantial tax savings to petitioner's stockholders. See McCutchin Drilling Co. v. Commissioner, 143 F.2d 480 (C.A. 5, 1944).
Looking as we do at the totality of the evidence, we hold for the respondent on this issue.
Issue 2
With respect to the question involving the deductibility of the professional fee paid to J. K. Lasser & Co., the petitioner asserts that the payment was made under such circumstances and at such time as to encourage some of its key employees to remain in their same positions with its new owners. Therefore, the petitioner contends that the payment is analogous to the creation of a profit-sharing trust for the benefit of corporate employees or other employee benefits designed to encourage loyalty and continuity of service and, as such, it constitutes an ordinary and necessary expense of this petitioner. Respondent, on the other hand, contends that this paid fee is not an ordinary and necessary expense of petitioner because (1) the services for which the charge was made had been rendered to the petitioner's employees and for their benefit rather than to the corporation or for its benefit, and (2) the bill was not paid until after February 4, 1954, and thus was not deductible by petitioner, a cash basis corporation, in its taxable year ended February 4, 1954.
We agree with the respondent. According to the testimony of petitioner's witness, W. A. Falsgraf, J. K. Lasser & Co. was retained by the employees and rendered services to them for their benefit, not to petitioner corporation or for its benefit. Falsgraf himself at first refused to let petitioner pay this bill because it was an obligation incurred by the employees. Legal fees paid on behalf of, and for services rendered to, another are generally not deductible as ordinary and necessary expenses of the payer. See Royal Cotton Mill Co., 29 T.C. 761 (1958); and compare Schalk Chemical Co., 32 T.C. 879, 889 (1959), affd. 304 F.2d 48 (C.A. 9, 1962); Standard Linen Service, Inc., 33 T.C. 1, 17 (1959); and Baxter D. Whitney & Son, Inc., 20 B.T.A. 380 (1930). Our review of prior decisions relating to this particular area of the law convinces us that this expense should not be allowed to petitioner. To be sure, this situation is unlike Champion Spark Plug Co., 30 T.C. 295 (1958), where the taxpayer's payment of $33,750 to an employee disabled because of illness was held to be an ordinary and necessary business expense; or Cecil R. Hopkins, 30 T.C. 1015 (1958), where deposits made by the taxpayer at Christmas in savings accounts for children of its employees were treated as proximately related to the taxpayer's business and therefore deductible as ordinary and necessary expenses. The mere fact that the employees might have resigned if the corporation had not paid their obligation is not, in our opinion, sufficient to qualify the payment as an ordinary and necessary expense of petitioner. A taxpayer may not assume the deductions of another by the simple expedient of payment.
Falsgraf also testified that J. K. Lasser & Co. sent the bill in question to W. D. McArthur, the employee's representative, after H. R. Henderson & Co. had acquired petitioner's stock, and that Cameron McElroy, who was just getting started in the operation of petitioner, authorized the payment. Since H. R. Henderson & Co. did not acquire the stock of petitioner until February 4, 1954, and since the bill was not received and payment was not made until after that date, petitioner, being on a cash basis, could not in any event, properly claim a deduction in its taxable year ended February 4, 1954. Accordingly, respondent is sustained on this issue.
To reflect adjustments contained in the stipulation of the parties,
Decision will be entered under Rule 50.