Opinion
Docket Nos. 2407 2408.
1944-04-18
J. Z. TODD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.J. L. TODD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
R. E. Brotherton, Esq., and Aaron Turner, Esq., for the petitioners. Harold D. Thomas, Esq., for the respondent.
1. Partnership earnings allocated between separate and community income.
2. A presumption of California law casting the burden of proof upon one claiming a greater return on separate capital than the legal rate of interest is overcome by the determination of the respondent and the petitioner continues to have the burdens of proof. R. E. Brotherton, Esq., and Aaron Turner, Esq., for the petitioners. Harold D. Thomas, Esq., for the respondent.
These consolidated proceedings involve determined deficiencies in income tax for the years 1940 and 1941 in amounts as follows:
+-------------------------------+ ¦ ¦1940 ¦1941 ¦ +-----------+---------+---------¦ ¦J. Z. Todd ¦$2,618.84¦$4,996.57¦ +-----------+---------+---------¦ ¦J. L. Todd ¦2,450.94 ¦4,702.27 ¦ +-------------------------------+
The only error now urged by the petitioners is the respondent's allocation of each petitioner's distributive share of the partnership profits between separate income and community income.
FINDINGS OF FACT.
The petitioners, J. Z. Todd and his father, J. L. Todd, are individuals, both married and residing with their wives in the State of California. For the years here involved each filed separate returns with the collector for the first district of California.
In 1914 the petitioners formed a partnership, Western Door & Sash Co., with total capital of approximately $1,500, to engage in the business of jobber and wholesaler of doors, sash, panels, and glass. They have made no further capital contributions to the business other than the accumulated earnings of the partnership. The two petitioners have been the only members of the partnership at all times, each owning an equal interest therein. Each was married prior to 1927 and has since that time continuously resided in California with his wife.
Both men have been actively engaged in the management and operation of the business since the time of its organization. Their work has consisted of financing, buying and selling, and contacting customers. During the last few years a rough division of work has been effected, with J. L. Todd, who was 87 years of age in 1941, looking after the sales activities, particularly in the outlying districts, and J. Z. Todd supervising purchasing, credit, and local sales.
The business is highly competitive. The partnership employed several salesmen, who in recent years have worked on the basis of a 5 percent commission on sales originating in their territory. In the years 1940 and 1941 the highest paid salesman received approximately $7,840 and $9,310. The salesmen were assigned certain territories, calling more or less upon the same group of customers. In the development of new territories and outlets, the initial contacts would first be made by the petitioners, after which the salesmen would make their calls.
In 1940 the business of the partnership expanded into war work, and ordinary commercial business dwindled. In 1940 approximately 15 percent and in 1941 approximately 60 percent of the total sales represented war contract sales. The partnership acted in some instances as prime contractor, but more frequently as subcontractor. It has engaged in some manufacturing in connection with the war contracts, but the business consists primarily in buying and selling. Orders were sometimes filled from the warehouses and sometimes directly from the source of supply, depending upon the size of the contract and the destination of the shipment.
The sales for the years 1936 to 1941, inclusive, were as follows:
+---------------------------------+ ¦1936¦$359,923.84¦1939¦$490,430.10¦ +----+-----------+----+-----------¦ ¦1937¦396,417.68 ¦1940¦600,825.60 ¦ +----+-----------+----+-----------¦ ¦1938¦381,134.59 ¦1941¦952,919.82 ¦ +---------------------------------+
Merchandise bought for sale amounted to $380,957.65 in 1940 and $670,551.26 in 1941. The partnership carried a substantial inventory because it was thought to be a good investment in view of the ascending prices. The same volume of business could have been transacted with a smaller inventory.
The aggregate net book profits for the period beginning in 1927 and ending in 1935 amounted to $67,862.28. Due to withdrawals in those years in excess of that amount, the capital balance decreased from $165,194.88, as of the beginning of 1927, to $144,366.81, as of the close of 1935. The capital balance at the close of 1935 represented separate property of the two partners.
The book profits, withdrawals, and capital balances for the years 1936 to 1941, were as follows:
+------------------------------------------------------------------------------+ ¦Year ended ¦Net book ¦Partners' ¦Balance to ¦Capital ¦Average capital¦ ¦Dec. 31 ¦profits ¦withdrawals ¦capital ¦balances ¦balances ¦ +------------+----------+-------------+------------+-----------+---------------¦ ¦1936 ¦$26,990.82¦$11,763.02 ¦$15,227.80 ¦$159,594.61¦$151,980.71 ¦ +------------+----------+-------------+------------+-----------+---------------¦ ¦1937 ¦39,445.09 ¦12,312.20 ¦27,132.89 ¦186,727.50 ¦173,161.05 ¦ +------------+----------+-------------+------------+-----------+---------------¦ ¦1938 ¦39,701.88 ¦20,883.72 ¦18,818.16 ¦205,545.66 ¦196,136.58 ¦ +------------+----------+-------------+------------+-----------+---------------¦ ¦1939 ¦36,118.03 ¦14,772.92 ¦21,345.11 ¦226,890.77 ¦216,218.22 ¦ +------------+----------+-------------+------------+-----------+---------------¦ ¦1940 ¦81,777.20 ¦22,988.99 ¦58,788.21 ¦285,678.98 ¦256,284.87 ¦ +------------+----------+-------------+------------+-----------+---------------¦ ¦1941 ¦87,254.49 ¦17,836.76 ¦69,417.73 ¦355,096.71 ¦320,387.85 ¦ +------------------------------------------------------------------------------+
From time to time prior to the years here involved the partnership had borrowed from banks amounts up to $75,000. In the year 1941 a loan of that amount, at 6 percent interest, was negotiated to finance a rather large Government job for a short period of time.
The petitioners have never received a salary or other fixed compensation for their services, but have withdrawn each year varying amounts as needed by them for living expenses. Withdrawals for the five-year period from 1935 to 1939, inclusive, averaged $14,155.21.
The net distributive income for the partnership for the years 1940 and 1941 amounted to $92,409.91 and $110,729.60. Each partner's share was thus $46,204.96 and $55,364.80. As this amount included return on investment and compensation for services, the latter of which is community property, reportable one-half by each spouse it was necessary to determine the amount of each.
In determining a deficiency for 1940 and 1941 for each of the petitioners, the Commissioner made the following allocation:
+------------------------------------------------------------+ ¦ ¦1940 ¦1941 ¦ +--------------------------------------+----------+----------¦ ¦Income from husband's separate capital¦$25,237.14¦$31,840.30¦ +--------------------------------------+----------+----------¦ ¦Income from community capital ¦1,446.22 ¦3,083.82 ¦ +--------------------------------------+----------+----------¦ ¦Income from services ¦19,521.60 ¦20,440.68 ¦ +--------------------------------------+----------+----------¦ ¦Total ¦46,204.96 ¦55,364.80 ¦ +------------------------------------------------------------+
This allocation was based upon the principles outlines in G.C.M. 9825 (1931). For each of the years 1936 to 1941 the Commissioner allocated net book profits between income from capital and income from services in the ratio which an 8 percent return on annual average invested capital bore to an assumed reasonable salary allowance. The excess of the income from services, so determined, over withdrawals, was carried over to capital as a community contribution. The aggregate of such community contributions provided the basis for the allocation of income from capital between the husband's separate capital and the community capital, as above shown, in the ratio each bore to the total of the two. It is the correctness of the allocation between income from capital and income from services which the petitioners contest.
OPINION.
ARUNDELL, Judge:
Section 161(a) of the California Civil Code, effective July 29, 1927, conferred upon the wife such an interest in community property as to make community income thereafter received taxable one-half to each spouse. United States v. Malcolm, 282 U.S.. 792.
Where income arises in part from separate capital and in part from personal services, an allocation is necessary. Julius Shafer, 2 B.T.A. 640; Pereira v. Pereira, 103 Pac. 488. The Commissioner has made such an allocation in this case based upon the principles laid down in G.C.M. 9825, C.B. X-2, p. 146, approved in Clara B. Parker, 31 B.T.A. 644. Briefly, he has determined that of the profits distributable to each petitioner for the years involved, in the approximate amount of $46,000 and $55,000, approximately $19,500 and $20,400 represented income from services, taxable to the husband and wife in equal shares.
The petitioners attack this allocation, seeking to increase the amounts representing income from services. There is no evidence in the record to indicate that the amounts determined by the respondent are unreasonable compensation for the services tendered the partnership, nor is this contention made. The sole argument is that the law of California demands a different determination.
The petitioners argue that only such part of the net distributive profits as would be equal to a fair return on the investment as it existed at the close of 1935 was the separate property of the petitioners. In making this argument they rely upon a group of California cases dealing with the respective rights of husband and wife upon the termination of the community. In Pereira v. Pereira, supra, it was held, upon appeal from an interlocutory decree of divorce, that the husband was entitled to some return on his separate capital. The court said: ‘The probable contribution of the capital to the income should have been determined from all the circumstances of the case, and, as the business was profitable, it would amount at least to the usual interest on a long investment well secured.‘ In re McCarthy's Estate, 15 Pac.(2d) 223, stated the rule as follows:
It is the rule that, where at the time of his marriage the husband has a definite amount of his separate property invested as capital in his business, which he continues to conduct, the entire profits therefrom are not necessarily his separate property, but may be the result of his energy and ability. Estate of Gold, 170 Cal. 621, 151 P. 12. In determining what portion of such profits is community property, while it must be presumed, in the absence of evidence, that some thereof were due to the capital invested, and would equal at least the usual interest on a long-term investment well secured, yet, if the husband claims that his capital was entitled to a greater return than legal interest, the burden of showing the fact rests upon him. * * *
From this the petitioners contend that the burden is upon the respondent to establish that a greater amount than the legal rate of interest constituted separate property of the petitioners; failing which, all amounts in excess of 7 percent of the investment as it existed at the close of 1935 represented compensation for services. Aside from the fact that this contention urged an unusual way of computing a reasonable salary allowance, we think that the burden can not be so shifted to the Commissioner. His determination effectually overcomes the ordinary presumptions of law, and the petitioners continue to have the duty of going forward with their proof. Shea v. Commissioner, 81 Fed.(2d) 937. This duty the petitioners have completely neglected, by reason of which the determination of the Commissioner must stand.
Decisions will be entered under Rule 50.