Summary
involving separation of the business of a corporation, so that the original company handled the manufacturing, and a partnership of the stockholders handled the sales and servicing of customers
Summary of this case from Moke Epstein, Inc. v. Comm'r of Internal RevenueOpinion
Docket Nos. 1060 2332.
1945-04-30
SEMINOLE FLAVOR COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Robert A. Littleton, Esq., for the petitioner. F. L. Van Haaften, Esq., for the respondent.
The stockholders of petitioner, which was engaged in the manufacture and sale of concentrates to bottlers for processing and sale of soft drinks to the public, in order to effectively overcome merchandising difficulties provide better corporation with the bottlers, create an increased demand by the public for the bottlers' products and thereby increase sales of Robert A. Littleton, Esq., for the petitioner. F. L. Van Haaften, Esq., for the respondent.
By these consolidated proceedings petitioner challenges deficiencies in tax determined by the Commissioner for the calendar year 1940, Docket No. 1060, and the nine-month period January through September 1941, Docket No. 2332. The tax deficiencies are as follows:
+-------------------------------------------------------+ ¦ ¦1940 ¦1941 ¦ +---------------------------------+----------+----------¦ ¦Income tax ¦$41,381.30¦$41,338.39¦ +---------------------------------+----------+----------¦ ¦Declared value excess profits tax¦4,065.70 ¦ ¦ +---------------------------------+----------+----------¦ ¦Excess profits tax ¦9,487.87 ¦112,680.02¦ +-------------------------------------------------------+
The sole issue is whether Commissioner erred in including in petitioner's income under section 45 of the Internal Revenue Code the amounts of $177,441.25 for the taxable year 1940 and $242,248.15 for the taxable period in 1941 which were reported as income of the Seminole Flavor Co., Ltd., a partnership.
FINDINGS OF FACT.
The petitioner is a Tennessee corporation, organized on March 8, 1928, under the corporate name of Seminole Fruit Flavor Co. On or about December 31, 1929, the latter company acquired the assets of the Good Grape Co. in exchange for 550 shares of its capital stock. The corporate name was changed to Seminole Flavor Co. by amendment of the charter on January 29, 1932. Petitioner's principal place of business is in Chattanooga, Tennessee. Its tax returns for the taxable periods herein were filed with the collector of internal revenue at Nashville, Tennessee. Since November 7, 1934, through the taxable years petitioner's 750 shares of stock issued and outstanding have been held by the same stockholders without change. The term ‘petitioner,‘ as hereinafter used, includes the Seminole Fruit Flavor Co.
During the taxable periods the petitioner manufactured a full line of flavors, sometimes referred to as a ‘concentrate,‘ which it sold solely to bottlers engaged in the business of bottling soft drinks. The bottler diluted this concentrate with simple sirup, or sugar and water, aged the solution 24 to 72 hours, and then added carbonated water to make the bottled beverage distributed for consumption. Petitioner's concentrates were sold under the trade names of Double-Cola, Double-Orange, Double-Lemon, Double-Strawberry, Double-Peach, Double-Grape, Double-Root Beer, etc.
Petitioner's Double-Cola concentrate was introduced to the trade late in 1935 or early in 1936. In 1937 its sales of Double-Cola concentrate amounted to approximately 75 percent of its total sales, and during the taxable periods herein such sales amounted to more than 90 percent of the total sales. Double-Cola is manufactured from a secret formula consisting of approximately 16 different ingredients. The formula was perfected over a period of years by the efforts of C. D. Little and J. S. Foster, president and treasurer, respectively, of the petitioner, and no other persons have knowledge of the component parts of the formula.
When the petitioner brought out its Double-Cola concentrate its Cola accounts were very limited. Its fruit flavors, and a Cola concentrate known as Jumbo-Cola, were handled principally by independent bottlers and company owned or controlled bottling plants. Petitioner's first efforts to distribute Double-Cola followed the usual procedure of employing traveling salesmen to sell its product to established bottlers. Petitioner also attempted to interest people who wanted to go into the bottling business in the use of Double-Cola. Wherever possible petitioner entered into an agreement with the bottler granting him an exclusive franchise for bottling Double-Cola in his territory. Under this type of franchise the bottler agreed to bottle the flavors manufactured by petitioners and no other flavors. Other bottlers executed nonexclusive franchise agreements which did not restrict their use of flavor concentrates to petitioner's products. Both types of franchise agreements provided for advertising, merchandising, and supervising services by the petitioner with respect to and over the bottler's operations. Certain advertising matter was to be furnished the bottler free of cost, and the bottler agreed to put up and erect all advertising according to petitioner's instructions and to feature and advertise Double-Cola as his leading drink. Bottling and sanitary requirements were set up, petitioner's representatives could inspect the bottler's plant to ascertain whether the requirements were being met, and the bottler agreed to submit samples of the Double-Cola he was distributing for analysis by petitioner and obligated himself to keep and maintain the standards set by petitioner for its product.
The number of petitioner's Double-Cola accounts materially increased during the calendar years 1936, 1937, and 1938. Thereafter the number of Double-Cola accounts gradually declined through 1943, but petitioner's total sales increased each year from 1936 through the calendar year 1943. Petitioner's Double-Cola accounts were scattered over the United States and its facilities and organization were so inadequate that it was unable to give its bottlers the advertising, merchandising, and supervisory services called for in their franchise agreements. During 1937, 1938, and 1939 petitioner received numerous complaints from its bottlers about the unsatisfactory services petitioner was rendering. Petitioner lost a large number of bottling accounts during these years, some of which were potentially very good accounts, because it did not assist the bottlers with satisfactory advertising and merchandising services. Among other things, the bottlers demanded newspaper, billboard, moving picture, and radio advertising and sampling campaigns, none of which was being furnished by petitioner.
In 1936 petitioner brought into its home office the manager of its bottling plant at La Grange, Georgia, James M. Geeslin, and placed him in charge of the distribution of its products. Geeslin had developed a profitable business for the petitioner at La Grange during a period of depression after taking over a company owned plant that appeared to be hopelessly insolvent. Prior thereto he had been a specialty man for the petitioner, interviewing bottlers and assisting them in advertising and merchandising their products.
After working with company owned or controlled bottling plants and with plants owned by individual bottlers, Geeslin became convinced that company owned plants were far superior. He found that many of the independent bottlers did not know how to do business, did not have the proper facilities for doing business, and needed supervision. A few months after he took charge of petitioner's distribution Geeslin discussed with Little the necessity of a medium through which the petitioner could exercise more control over, and could work closer with, the independent bottlers for the purpose of expanding their sales and distribution. Subsequent events further convinced Geeslin of the merits of his idea and he continued to urge upon the officers and the directors the necessity and desirability of setting up some form of organization which would improve petitioner's advertising and merchandising services and at the same time would work more closely with the bottlers. Two of petitioner's directors opposed the idea; two were interested but not entirely convinced. Early in 1937 Geeslin obtained permission from Little to move his office, and the offices of about five other employees, from the manufacturing building to the Hamilton National Bank Building. Lack of space at the factory, the availability of space at the bank building, better accommodations, and a nicer atmosphere in which to meet representatives of the bottlers, prompted this move. Geeslin was in complete charge of the office and the salesmen.
At the annual meeting of petitioner's stockholders on April 29, 1938, their concern over the company's situation is recorded in the following minutes:
The President submitted a statement of the operation of the company during 1937, and also a comparative statement of the operation of the company during the first three months of 1938 as compared with the first three months of 1937.
The question of whether or not the company would surrender its charter and reincorporate, or would create or take over another company and use one as a manufacturing company and the other as a sales company was discussed at length, and the directors were authorized to make investigation as to what would be the most feasible plan, if there should be any change at all.
Many other things with reference to the operation of the business were discussed at length.
There was extensive discussion as to whether or not the company should adopt a six ounce or seven ounce bottle to be used along with the twelve ounce bottle, but do definite action was taken on this.
During 1938 and 1939 petitioner's officers and directors continued to discuss whether petitioner should change its method of sales promotion and distribution and the merits of the various plans suggested. They recognized that petitioner had more bottling plants to service than its facilities or organization could handle and that complaints of the bottlers about inadequate service were merited. Petitioner had been paying a nationally known advertising firm a monthly retainer of $500 for its services and, in addition, paid the cost of making up any art work, employing the artist, and other costs that entered into its advertising material, plus its own costs in connection with its advertising program. In or about July 1938 petitioner was advised by the advertising agency that it was unprofitable to continue the account. In response thereto and in an effort to improve the advertising services rendered to its bottlers, petitioner dispensed with the services of the agency and employed its own advertising expert, L. B. Krick, who had had years of experience in advertising and merchandising bottled beverages. Despite changes thereafter made in its advertising services and additions to its personnel, petitioner's relations with its bottlers continued to be unsatisfactory.
By the latter part of 1938 or early in 1939 petitioner had lost approximately 50 percent of its bottling accounts, principally because petitioner did not assist the bottlers sufficiently in merchandising and advertising the product. Little, who had been in the bottled beverage business since 1914, realized that unless something was done to correct existing conditions petitioner might be forced out of business. He had seen his own bottling plants, the bottling plants of others, and the manufacturers that supplied the bottlers forced out of business because of the manufacturers' failure or inability to remedy conditions similar to those confronting the petitioner. Little realized that more drastic changes in the services rendered to bottlers were necessary, as the bottlers were even then discussing among themselves the organization of an association for advertising and merchandising their products.
On or before August 5, 1939, Little and the other stockholders and directors decided that a partnership would afford the most feasible and flexible arrangement for promoting the sale and distribution of petitioner's products. Accordingly, petitioner's five stockholders executed a partnership agreement on August 5, 1939, for the purpose of forming a limited partnership under the Uniform Partnership Act of Tennessee. The general partners were C. D. Little and J. S. Foster; the limited partners were Mae S. Little, wife of C. D. Little, F. L. Underwood, and J. Lon Foust. The partnership was to continue for five years unless sooner terminated by agreement, or by the death, retirement, or insanity or one of the general partners. The general and limited partners paid $10,000 cash into the partnership and acquired thereby interests in the partnership. The interests of the several partners, as reflected by the amendment to the partnership agreement of August 15, 1939, were almost identical with their stock interests in petitioner, as shown by the following table:
+------------------------------------------+ ¦ ¦ ¦Stock interest¦ +---------------+-----------+--------------¦ ¦ ¦Partnership¦_ ¦ +---------------+-----------+--------------¦ ¦ ¦interest ¦ ¦ ¦ +---------------+-----------+------+-------¦ ¦ ¦ ¦Shares¦Percent¦ +---------------+-----------+------+-------¦ ¦ ¦Percent ¦ ¦ ¦ +---------------+-----------+------+-------¦ ¦C. D. Little ¦43.2 ¦324 ¦43.2 ¦ +---------------+-----------+------+-------¦ ¦Mae S. Little ¦42.4 ¦318 ¦42.4 ¦ +---------------+-----------+------+-------¦ ¦J. S. Foster ¦9.34 ¦70 ¦9.33 ¦ +---------------+-----------+------+-------¦ ¦F. L. Underwood¦4.8 ¦36 ¦4.8 ¦ +---------------+-----------+------+-------¦ ¦J. L. Foust ¦0.26 ¦2 ¦0.27 ¦ +---------------+-----------+------+-------¦ ¦Total ¦100.00 ¦750 ¦100.00 ¦ +------------------------------------------+
The name adopted by the partnership was Seminole Flavor Co., Ltd., and the purpose for which the partnership was created was stated by the agreement to be as follows:
2. The business of the partnership shall be commercial, and shall consist of services to be rendered in connection with the promotion, advertisement, sale and distribution of the products and merchandise of SEMINOLE FLAVOR COMPANY of Chattanooga, Tennessee, used for bottling soft drinks.
Management of the partnership's affairs was vested in the general partners, who were entitled to be paid a salary for their services in addition to their share of the profits. The managing partners were empowered to employ suitable persons to assist in the performance and discharge of the duties of the partnership and to carry on the business for which it was formed.
Under date of August 14, 1939, the partnership submitted a written proposal to petitioner to take over the sales, advertising, and distributing end of its business, purchase the furniture and fixtures used by petitioner in connection therewith, and render specified services in promoting the sale and distribution of petitioner's products, paying all costs and expenses incurred, in consideration of a commission measured by gross sales less prepaid freight.
On August 15, 1939, petitioner's directors, Little, Foster, Geeslin, Underwood and Foust, met and considered the above proposal. The minutes of this meeting recite that the directors unanimously approved the partnerhship's proposal, provided that an agreement should be entered into specificially fixing the compensation to be paid the partnership for services rendered, and directed its officers to prepare a contract to carry out the proposal and submit the contract to them for consideration before it was executed. The minutes also recite that, after a short adjournment for the officers to consider the form of the contract, the meeting was reconvened, the contract was submitted for the consideration of the directors, and, after full discussion thereof, the proper officers of the petitioner were authorized to execute the agreement and to sell and transfer to the partnership the office equipment and furniture used in the sales, distribution, and advertisement department for the price of $3,530.22.
The agreement between the petitioner and the partnership was executed on the same day, Geeslin and Foust executing the instrument for petitioner, as vice president and secretary, respectively, and Little and Foster, as general partners, executing the instrument for the partnership. Pertinent paragraphs from the agreement read as follows, the petitioner being referred to as the first party and the partnership as the second party:
WHEREAS from the time of the organization of the party of the first part, and up to the present time, it has endeavored to carry on the business of manufacturing ‘DOUBLE-COLA‘ concentrate and sundry flavors, and at the same time maintain a department for the advertisement and distribution of such products, and the sale of same to persons, firms and corporations engaged in the business of bottling soft drinks; and
WHEREAS, the party of the second part proposes to take over, manage and control the features of the business of the party of the first part that have to do with the advertisement, distribution, sale and consumption of the products of the party of the first part; and to increase the sale and consumption of such products in the use of bottling soft drinks.
NOW, THEREFORE, it is agreed between the parties hereto as follows:
1. That the party of the first part will sell and transfer to the party of the second part all of its office equipment and furniture located in its distribution office in the Main Street Branch of the Hamilton National Bank Building, in Chattanooga, Tennessee, situated at the corner of Main and Market Streets, Chattanooga, Tennessee, at the price of $3,530.22.
2. The party of the second part agrees to take over, manage, handle and control all of the business of the party of the first part that pertains to the advertisement, sale and distribution of its products, and in connection with the sale and distribution of such products, render to the party of the first part the following services, viz:
(a) To perform all work and services incident to maintaining and developing markets for the sale and distribution of the products of the party of the first part.
(b) Supervise and service all contracts and franchises with persons, firms or corporations for the purchase of the products of the party of the first part which are used in bottling soft drinks; and do all things that are necessary and expedient to increase the sale and consumption of the products of the party of the first part to persons, firms or corporations engaged in the business of bottling soft drinks.
(c) Do all things necessary and expedient to enlarge and extend the territory and markets in which the products of the party of the first part are sold, or may hereafter be sold, by selecting new locations for bottling plants and entering into agreements with responsible persons, firms or corporations, to engage in the business of bottling soft drinks with the use of the products of the party of the first part; and to render to such distributors and bottlers such financial aid and assistance as may be necessary and expedient under circumstances where new bottling plants are to be established.
(d) Design, execute and manage all plans for the advertisement and sale and consumption of the products of the party of the first part in an efficient and artistic manner.
(e) To keep a careful watch over the credit rating and standing of persons, firms or corporations who purchase the products of the party of the first part, perform all services incident to sending out statements for merchandise shipped and sold from the manufacturing plant of the party of the first part, make all collections of accounts receivable for merchandise shipped and sold by and for the party of the first part.
3. In addition to the foregoing services to be rendered by the party of the second part to the party of the first part, the party of the second part agrees to bear and pay all expenses and costs incident to and incurred in connection with rendering such services; keep an accurate record of all statements sent out for merchandise shipped by the party of the first part, also an accurate record of all collections made on account of such shipments, and make settlement therefor to the party of the first part.
4. IT IS AGREED between the parties hereto that for the services to be rendered by the party of the second part to the party of the first part, that the party of the second part shall be paid a commission on the gross sales of all the products and merchandise shipped and sold by the party of the first part at the rate of 50% of the invoice price of such products and merchandise, less prepaid freight charges where freight is to be prepaid on shipment.
5. It is further agreed between the parties hereto that in connection with services to be rendered by the party of the second part in promoting, advertising, distribution and sale of the products of the party of the first part, the party of the second part shall pay and bear all expenses incurred by it out of the commission to be paid it for such services as provided in paragraph 4 of this agreement. That inasmuch as the party of the second part is responsible to the party of the first part for the invoice price of all merchandise and products shipped and sold; and is to make collections for all such merchandise, the amount of the commission to be paid the party of the second part, as aforesaid, shall be retained by it in remitting to the party of the first part.
6. The party of the second part shall furnish to the party of the first part, on or before the 10th day of each calendar month, a statement of the invoice price of all merchandise and products of the party of the first part shipped and sold during the previous calendar month, and shall at intervals of quarterly periods of three calendar months each make full and complete remittance to the party of the first part of 50% of the invoice price of all merchandise and products of the party of the first part shipped and sold during such previous quarter of three calendar months.
The agreement was to run for five years, but petitioner expressly retained the right, power, and authority to change the basis of compensation within the first 30 days of any calendar year by giving written notice of the change in the rate of commissions to be paid. Either party could terminate the agreement by giving written notice of 6 months.
On December 12, 1940, the parties to the above contract amended paragraph 4 of the agreement so that the rate of compensation, viz., 50 percent of the invoice price, was to be reduced by ‘manufacturing cost‘ and by ‘prepaid freight charges where freight is to be prepaid on shipments.‘ This amendment was made effective as of the date of the original agreement ‘so as to clarify the meaning of‘ paragraph 4. Proper adjustments were authorized to be made in the accounts of the respective parties giving due effect to such change. The adjustment made in accordance with this agreement reduced the partnership income for the period August 16 to December 31, 1939, inclusive, by $56,316.71 and increased the petitioner's 1939 profits by a like amount. This sum was ratified as a dividend to stockholders by petitioner's directors at a meeting on July 1, 1941, the stockholders having reported this amount in their 1939 income tax returns as profits received from the partnership.
In May 1942 a further adjustment of $56,040.53 was made with respect to petitioner's 1939 profits and the partnership income was reduced in a like amount. As a result of these two adjustments the partnership books for the period August 16 to December 31, 1939, inclusive, showed a net profit of $11,148.88, of which approximately $500 represented compensation paid the partnership under the agreement of August 15, 1939, and the remainder represented profit realized from the sale of crowns. This adjustment was made soon after the tax liabilities of the petitioner for 1939 were adjusted with the Commissioner in Docket No. 108965, decision entered, April 4, 1942.
On December 15, 1942, the parties to the contract of August 15, 1939, mutually agreed to the termination thereof as of January 1, 1943, and that thereafter the relations between them, if any, should be that of seller and buyer of petitioner's products at prices to be agreed upon. On January 1, 1943, the parties entered into an agreement providing for the purchase and sale of minimum and maximum gallonage, per annum, of Double-Cola concentrate, at an agreed price, subject to change in proportion to any increase in the cost of production. The agreement continued in effect for one year and after such year from year to year in the absence of written notice of intention to terminate.
After August 15, 1939, petitioner's business activities were devoted entirely to manufacturing. Its accounts receivable, sales and advertising accounts and records, and the employees who kept these records were transferred to the partnership, which thereafter maintained a separate and distinct system of accounting from that maintained by petitioner. Geeslin became the manager of the partnership and Krick was placed in charge of advertising, although final authority in all partnership matters was vested in Little and Foster. Little devoted between 80 and 90 percent of his time to supervising the partnership. Foster was production manager and treasurer of the petitioner in full charge of all the help, the factory, and the manufacture of all flavors; his services to the partnership were mostly advisory. Claude A. Findley, who served as comptroller for the petitioner and the partnership, received his salary from the petitioner. J. L. Foust, judge of the Chancery Court, and F. L. Underwood, vice president and trust officer of the Hamilton National Bank in Chattanooga, served as directors, but otherwise took no active part in petitioner's business.
The partnership changed the entire set-up with reference to sales promotions, advertising, and merchandising services previously rendered bottlers. Instead of having a selling organization with high pressure salesmen operating in large territories, it employed men experienced in the bottling industry who were capable of making decisions and advising bottlers. These men visited each bottler in their district five or six times a year, worked with the bottler at his plant, analyzed the problems confronting each bottler, and helped in the solution thereof. Bottlers who were losing money were placed on a profitable basis. A system of cost accounting was approved for the use of the bottlers. An operations chart or yardstick was furnished the bottler against which he could check the results of his own operations. As advertising catalog was furnished the bottler which displayed in detail the various pieces of advertising adopted by the partnership, most of which was furnished the bottler without cost. Some of the advertising listed was not furnished, but could be procured for the bottler by the partnership at cost. The partnership, in conjunction with its bottlers, instituted motion picture, radio, billboard, newspaper and other advertising campaigns to promote the sale of its Double-Cola and other flavors. A bulletin service was maintained by the partnership by means of which new ideas, changes in the industry, or any information of value was circularized to and for the use of its bottlers. The partnership also provided technical and laboratory services for controlling and bottling operations. It acted as purchasing agent for machinery and supplies for the bottlers, generally without profit to itself. Bottlers at one time or another sought and received the advice and services of the partnership on all phases of the operation of a bottling plant.
The services rendered by the partnership to all bottlers alike would have been too expensive for any individual bottler to have maintained. The continued increase in sales volume during and after the taxable periods was due in part to the adequacy and sufficiency of the services rendered to the bottlers, some of whom testified that without such services they would have to close their plants.
Petitioner's growth is reflected in the following comparative statement of its total net profits, dividends paid, and surplus for the years and period listed, taken from petitioner's books:
+--------------------------------------------------+ ¦ ¦Total net ¦Dividends ¦ ¦ +--------+----------+--------------+---------------¦ ¦Year ¦profits ¦paid ¦Surplus ¦ +--------+----------+--------------+---------------¦ ¦1931 ¦$2,773.89 ¦$7,500.00 ¦$18,193.36 ¦ +--------+----------+--------------+---------------¦ ¦1932 ¦11,186.60 ¦4,500.00 ¦2,506.76 ¦ +--------+----------+--------------+---------------¦ ¦1933 ¦2,003.42 ¦none ¦4,701.40 ¦ +--------+----------+--------------+---------------¦ ¦1934 ¦4,498.30 ¦7,500.00 ¦1,410.10 ¦ +--------+----------+--------------+---------------¦ ¦1935 ¦10,295.03 ¦11,250.00 ¦64.21 ¦ +--------+----------+--------------+---------------¦ ¦1936 ¦92,646.68 ¦90,000.00 ¦1 (11,462.67)¦ +--------+----------+--------------+---------------¦ ¦1937 ¦186,524.58¦86,250.00 ¦47,323.96 ¦ +--------+----------+--------------+---------------¦ ¦1938 ¦217,432.37¦108,750.00 ¦115,753.73 ¦ +--------+----------+--------------+---------------¦ ¦1939 ¦241,889.16¦2 172,355.24¦253,497.65 ¦ +--------+----------+--------------+---------------¦ ¦1940 ¦303,583.32¦60,000.00 ¦411,384.35 ¦ +--------+----------+--------------+---------------¦ ¦1941 3 ¦296,194.08¦105,000.00 ¦538,194.05 ¦ +--------------------------------------------------+
Included in petitioner's annual net profits shown by the above table is the profit it realized from the sale of crowns for each of the years 1934 to 1939, inclusive, as follows:
+-------------------------------+ ¦1934¦$16.38 ¦1937¦$15,503.76 ¦ +----+---------+----+-----------¦ ¦1935¦115.85 ¦1938¦16,457.49 ¦ +----+---------+----+-----------¦ ¦1936¦11,173.00¦1939¦17,949.69 ¦ +-------------------------------+
Petitioner's plant cost of sales, its total selling expenses, including net advertising expenses and salesmen's salaries and traveling expenses, from 1931 to September 30, 1941, inclusive, are shown by its books to be as follows:
+-----------------------------------------------------+ ¦ ¦ ¦Selling expenses ¦ +--------+----------+---------------------------------¦ ¦Year ¦Plant cost¦ ¦ +--------+----------+---------------------------------¦ ¦ ¦ ¦Advertising¦Salesmen ¦Total ¦ +--------+----------+-----------+----------+----------¦ ¦1931 ¦$23,047.36¦$13,586.42 ¦$11,772.31¦$29,551.31¦ +--------+----------+-----------+----------+----------¦ ¦1932 ¦23,555.41 ¦7,408.35 ¦10,016.04 ¦20,291.48 ¦ +--------+----------+-----------+----------+----------¦ ¦1933 ¦22,064.65 ¦6,317.04 ¦5,754.56 ¦14,319.92 ¦ +--------+----------+-----------+----------+----------¦ ¦1934 ¦44,425.30 ¦30,539.68 ¦12,673.80 ¦47,378.60 ¦ +--------+----------+-----------+----------+----------¦ ¦1935 ¦54,950.42 ¦29,884.93 ¦19,966.81 ¦53,006.47 ¦ +--------+----------+-----------+----------+----------¦ ¦1936 ¦112,707.09¦40,170.91 ¦26,021.82 ¦74,391.95 ¦ +--------+----------+-----------+----------+----------¦ ¦1937 ¦186,589.07¦90,423.69 ¦37,789.09 ¦136,163.69¦ +--------+----------+-----------+----------+----------¦ ¦1938 ¦222,451.05¦146,258.07 ¦55,645.20 ¦212,880.72¦ +--------+----------+-----------+----------+----------¦ ¦1939 ¦274,290.13¦85,448.74 ¦31,838.49 ¦291,750.00¦ +--------+----------+-----------+----------+----------¦ ¦1940 ¦322,747.12¦35.72 ¦160.02 ¦346,129.63¦ +--------+----------+-----------+----------+----------¦ ¦1941 1 ¦356,073.04¦ ¦ ¦353,411.23¦ +-----------------------------------------------------+ Fiscal year ended Sept. 30, 1941.
Section 19.45-1 of Regulations 103 defines the terms used in section 45, its scope and purpose, and the application thereof. Section 45 is not a new provision in the code. Much of the language found therein can be traced back through prior acts to section 240(d) of the Revenue Act of 1921. It first appeared in its present form as section 45 in the Revenue Act of 1928. Despite its long history as an integral part of the revenue statutes, the section has been sparingly applied. However, where section 45 has been at issue, it has been held that it confers broad discretionary power upon the Commissioner to allocate income or deductions ‘if he determines‘ that such allocation ‘is necessary in order to prevent evasion of taxes or clearly to reflect the income * * * .‘ Briggs-Killian Co., 40 B.T.A. 895; Asiatic Petroleum Co. (Delaware), Ltd., 31 B.T.A. 1152; affd. (C.C.A., 2d Cir.), 79 Fed.(2d) 234; certiorari denied, 296 U.S. 645; National Securities Corporation v. Commissioner (C.C.A., 3d Cir.), 137 Fed.(2d) 600, affirming 46 B.T.A. 562. The congressional committee reports show that Congress in enacting this section had particularly in mind the evasion of taxes by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of ‘milking.‘ See Asiatic Petroleum, supra, 31 B.T.A.,at pp. 1155-56. If the Commissioner determines that an allocation is necessary, the taxpayer has the burden of proving that the Commissioner's determination was arbitrary and that its situation is not one to which the statute applies. Essex Broadcasters, Inc., 2 T.C. 523, 529; Glenmore Distilleries Co., 47 B.T.A. 213, 224; G.U.R. Co. v. Commissioner (C.C.A., 7th Cir.) 117 Fed.(2d) 187, affirming 41 B.T.A. 223; Welworth Realty Co., 40 B.T.A. 97, 100. Application of section 45 has been denied where the Commissioner attempted to set up income where none existed, Tennessee-Arkansas Gravel Co. v. Commissioner (C.C.A., 6th Cir.), 112 Fed.(2d) 508, reversing Board of Tax Appeals memorandum opinion; E. C. Laster, 43 B.T.A. 159, 176; affirmed on another point, 128 Fed.(2d) 4, or to use the section for the disallowance of a deduction. General Industries Corporation, 35 B.T.A. 615.
The basic facts here are that prior to August 16, 1939, petitioner manufactured, advertised, sold, and supervised the bottling of its flavor extracts; thereafter it only manufactured the flavor extracts. After August 15, 1939, advertising, merchandising, and supervisory services were handled under contract by a partnership composed of petitioner's stockholders, whose interests in the partnership were identical with their stock interests in the petitioner. In view of these facts respondent has determined under section 45 that it is necessary to allocate to petitioner for each taxable year a stated portion of the gross income of the partnership ‘in order that your income and the income of Seminole Flavor Co., Ltd., may be clearly reflected, ‘ and he contends that the existence of the partnership should be ignored for tax purposes. Under the statute and the decided cases petitioner must prove Commissioner's determination was arbitrary in order to prevail.
Petitioner's proof can be summarized under three main contentions. In the first place it is contended that the books and records of the petitioner and the partnership, separately kept and maintained, clearly reflect the income of each. Secondly, it is contended, at least in effect, that petitioner and the partnership were separate and distinct business enterprises, each organized and operated for a definite business purpose and each actively engaged during the taxable years in carrying on a trade or business, so that there was no compelling reason to ignore the existence of the partnership. Thirdly, it is contended that section 45 seeks only to adjust and correct improper bookkeeping entries between separate businesses, that application of the section should be strictly confined to this purpose, and that the Commissioner should not be permitted to use the section to justify his arbitrary consolidation of the net incomes of two separate businesses.
After carefully weighing and scrutinizing the entire record herein, and limiting our conclusion solely to the particular facts and circumstances before us, it is our opinion that petitioner has sustained its burden of proof. Our findings show that petitioner and the partnership kept and maintained separate books of account. The accuracy of the books of account and record is emphasized by the Commissioner's use of the partnership net profits, per its books, as the exact amount of gross income to be allocated for each taxable year to the petitioner. The Commissioner directs our attention to no single entry or account which he contends is improper or inaccurate or which he now seeks to correct. His contention is that the entire arrangement was devised so that all of the partnership profits would be diverted from the petitioner for the purpose of reducing and evading its income tax liabilities.
The Commissioner supports his determination by pointing out that it was immaterial to Geeslin what form of organization was adopted, so long as he had control of it, and that Little and the other directors only became interested in Geeslin's plan in April 1938, after the realized that 1937 taxes amounted to $41,487.95
Petitioner's total selling expenses for 1939, 1940, and 1941, set forth in the foregoing table, included ‘Compensation Paid to Seminole Flavor Co., Ltd.‘ in the respective amounts of $170,622.64, $342,468.24, and $352,919.18. These amounts were reflected upon the books of the partnership as ‘Income per Agreement‘ for the period August 16 to December 31, 1939, the calendar year 1940, and the fiscal year ended September 30, 1941, respectively.
A condensed comparative statement of the partnership's operations, as shown by its books, reflects the following items of income and expenses for the period August 16 to December 31, 1939, the calendar year 1940, and the fiscal year ended September 30, 1941:
+--------------------------------------------------------------------+ ¦Receipts ¦1939 ¦1940 ¦1941 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Income per agreement of 8/15/39 ¦$170,622.64¦$342,468.24¦$352,919.18¦ +--------------------------------+-----------+-----------+-----------¦ ¦Profit from sale of crowns ¦10,615.02 ¦27,765.10 ¦40,926.45 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Advertising paid by bottler ¦11,950.46 ¦73,899.93 ¦42,788.93 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Total gross income ¦193,188.12 ¦444,133.27 ¦436,634.56 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Disbursements ¦ ¦ ¦ ¦ +--------------------------------+-----------+-----------+-----------¦ ¦ ¦ ¦ ¦ ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Advertising ¦36,861.35 ¦133,146.26 ¦121,161.65 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Salesman's salaries, commissions¦ ¦ ¦ ¦ +--------------------------------+-----------+-----------+-----------¦ ¦and traveling expenses ¦18,759.20 ¦56,043.35 ¦39,058.63 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Other selling expenses ¦3,141.56 ¦46,557.74 ¦7,977.14 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Total selling expenses ¦58,762.11 ¦235,747.35 ¦168,197.42 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Selling profit ¦134,426.01 ¦208,385.92 ¦265,437.14 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Total adminstrative expenses ¦10,919.89 ¦30,944.67 ¦26,188.99 ¦ +--------------------------------+-----------+-----------+-----------¦ ¦Net profit ¦123,506.12 ¦177,441.25 ¦242,248.15 ¦ +--------------------------------------------------------------------+
The partnership's returns of income on Form 1065 reported ordinary income for the period in 1939, the calendar year 1940, and the period January 1 to September 30, 1941, in the amounts hereinabove shown as net profits for 1939, 1940, and 1941, and showed the distributive share of each partner therein.
The following comparative statement shows the salaries paid the principal officers of the petitioner and the partnership for the calendar years 1939, 1940, and 1941:
+-----------------------------------------------------------+ ¦1939 ¦ +-----------------------------------------------------------¦ ¦ ¦Petitioner ¦Partnership ¦ +-------------+----------------------+----------------------¦ ¦ ¦Title ¦Salary ¦Title ¦Salary¦ +-------------+--------------+-------+---------------+------¦ ¦C. D. Little ¦President ¦$40,000¦General partner¦ ¦ +-------------+--------------+-------+---------------+------¦ ¦J. M. Geeslin¦Vice president¦4,300 ¦Manager ¦$2,500¦ +-------------+--------------+-------+---------------+------¦ ¦L. B. Krick ¦Vice president¦8,600 ¦Advertising ¦5,000 ¦ +-------------+--------------+-------+---------------+------¦ ¦J. S. Foster ¦Treasurer ¦10,880 ¦General partner¦ ¦ +-------------+--------------+-------+---------------+------¦ ¦Total ¦ ¦64,580 ¦ ¦7,500 ¦ +-----------------------------------------------------------+
1940 C. D. Little President 40,000 General partner J. M. Geeslin Manager 6,800 L. B. Krick Advertising 16,750 J. S. Foster Treasurer 10,800 General partner Total 51,600 23,550
1941 C. D. Little President 40,800 General partner J. M. Geeslin Vice president 3,000 Manager 6,800 L. B. Krick Advertising 15,850 J. S. Foster Treasurer 15,380 General partner Total 59,180 22,650
Little and Foster, as general partners, fixed the amounts of net profits that should be added to the partners' capital accounts and the amounts that should be distributed. Such additions and distributions were always pro rata. Withdrawals authorized by the general partners prior to and during the taxable periods were: $90,000 for the period August 16 to December 31, 1939; $168,750 for the calendar year 1940; and $37,500 for the fiscal period ended September 30, 1941, or a total for the 25 1/2 months of $296,250. During this same period additions to the capital accounts of the partners increased their capital investment from the original $10,000 to $256,945.52 on September 30, 1941. The distributive share of partnership net profits was reported on the individual income tax returns of each partner, whether distributed or not, and the tax due thereon was paid.
Federal taxes paid by the petitioner in 1935 in the amount of $1,708.58 were the largest in its history. Federal taxes paid thereafter, and prior to the formation of the partnership, were: $12,913.04 in 1936; $41,669.56 in 1937; and $38,594.18 in 1938. Petitioner's income tax returns for the taxable periods herein reported tax liabilities of $63,944.97 for 1940 and $105,771.45 for the fiscal period January 1 to September 30, 1941. Respondent determined petitioner's Federal tax liability for 1940 and the fiscal period 1941 to be $118,879.94 and $259,789.66, respectively. His principal adjustment for each taxable period carries the same explanation, which, except for a difference in amount, is as follows:
Under the authority of Section 45 of the Internal Revenue Code $177,441.25 (or $242,248.15) of the gross income of Seminole Flavor Co., Ltd., a partnership which is owned or controlled by your officers and stockholders, has been allocated to you and the income reported on your return is increased accordingly. It has been determined that this allocation is necessary in order that your income and the income of Seminole Flavor Co., Ltd. may be clearly reflected.
For the calendar years 1940 and 1941 the aggregate tax liability reported and paid by the individual partners and stockholders (Little, Mrs. Little, Foster, Underwood and Foust) was $142,850.97 and $272,113.62, respectively. The aggregate tax liability of the same individuals for the same periods computed after deducting all partnership income from their respective returns would be $42,130.47 and $110,370.52, respectively. The aggregate tax liability of the same individuals for the same periods computed by including in income only that portion of partnership profits actually distributed to them would be $137,275.51 and $134,275.20, respectively. It is stipulated that the above stated tax liabilities ignore any adjustments that the Commissioner has made in auditing the several returns.
Petitioner's books of account clearly reflect its income. The partnership's income is clearly reflected by its separate books of account and no part thereof constituted income of the petitioner. The partnership, organized and operated by petitioner's stockholders, was a business enterprise separate and distinct from the manufacturing business conducted by the petitioner. The predominant purpose of petitioner's stockholders in creating and operating the partnership was to solve the merchandising difficulties confronting the petitioner.
OPINION.
ARNOLD, Judge:
The issue herein involves an interpretation, construction, and application of section 45 of the Internal Revenue Code, set forth in the margin.