Docket No. 9270.
Guy C. Heater, Esq., and John M. McEvoy, Esq., for the petitioner. William A. Schmitt, Esq., for the respondent.
Petitioner, a business corporation, was organized by 100 wholesale druggists, each of whom owned 10 shares of its capital stock. Petitioner entered into contracts with certain selected manufacturers to furnish them specified services, for which it received a fee from each manufacturer based on the purchases made by the wholesaler. Certain of the services petitioner agreed to furnish required the cooperative assistance of the wholesaler. Petitioner had a ‘membership‘ agreement with each of the wholesalers under which the latter agreed to assist petitioner in connection with the contract with the manufacturer. Under the membership agreement petitioner, after deducting its operating expenses and such reserves as its directors deemed expedient, was to distribute to the wholesaler the balance of such service fee, based upon the amount of purchases made from the manufacturer, as ‘patronage dividends,‘ the wholesaler waiving any rights to dividends on the shares of petitioner's capital stock held by such wholesaler. Petitioner neither purchased for nor sold to the wholesaler. In the taxable year, the respondent added to petitioner's income the total amount so distributed as ‘patronage dividends.‘ Held:
(1) Petitioner functioned as a business and not as a cooperative corporation. The fees collected under the service contracts with the manufacturers were its property.
(2) The so-called patronage dividends were not true patronage distributions exempt from tax liability, nor were they paid pursuant to a fixed legal liability and deductible as ordinary and necessary expenses of petitioner.
(3) Under the circumstances presented, the imposition of a penalty for failure to file an excess profits tax return in the taxable year is not justified. Guy C. Heater, Esq., and John M. McEvoy, Esq., for the petitioner. William A. Schmitt, Esq., for the respondent.
This proceeding involves deficiencies in income tax of $38,359.11, declared value excess profits tax of $22,404.96, and excess profits tax of $34,270.24, and penalty for failure to file an excess profits tax return for the year 1940 of $8,567.56. The issues are: (1) Whether the respondent properly added to petitioner's gross income the amount of $182,249.58, and (2) whether petitioner is subject to the 25 per cent penalty for failure to file an excess profits tax return. The case was submitted on a stipulation of facts, oral testimony, and exhibits. The facts stipulated are adopted as our findings of fact. Facts found other than those stipulated are found from the evidence.
FINDINGS OF FACT.
Petitioner is a corporation, organized under the laws of the State of New York in 1913. It has its principal and only place of business at 25 East 26th Street, New York City. Petitioner filed its Federal income tax return for the taxable period with the collector of internal revenue for the third district of New York. Petitioner kept its books and filed its income tax returns on the accrual basis of accounting. Its charter authorized it to do business either within or without the State of New York. It never procured a license to do business in any other state. The authorized capital stock is $200,000, composed of 2,000 shares of the par value of $100 each. In the taxable year 1940 there were issued and outstanding 1,000 shares. The charter provided for a board of directors consisting of 15 members, who were not required to be stockholders. In the taxable year all of the directors were stockholders. The bylaws, inter alia, provide that a stockholder shall have no right to sell, assign, or transfer his stock without first offering to sell the same to the corporation at not more than par value, and the corporation shall have the exclusive right to buy for a period of 30 days. This provision was endorsed on the stock certificates. Article VI, section 3, provides:
SECTION 3. Dividends. The directors may declare dividends not exceeding six per centum per annum in any one year, from the surplus or net profits arising from the business of the corporation as an (sic) when they deem expedient. Before declaring any dividend there may be reserved out of the accumulated profit such sum or sums as the directors from time to time in their discretion think proper for working capital or as a reserve fund to meet contingencies, or for equalizing dividends, or for any such other purposes as the directors shall think conducive to the interests of the company. * * *
Except for these provisions, petitioner's bylaws are the usual type used by a business corporation of the State of New York.
The stockholders in 1940 consisted of 100 full line independent service wholesale druggists located throughout the entire United States. Each stockholder owned 10 shares and was limited to such amount. A full line wholesale druggist is a wholesaler who maintains a full line of stock of patent medicines or proprietaries, sundries, chemicals, drugs, and pharmaceuticals so as to meet all the needs and service all the requirements of a retail druggist; such stock generally comprises 40,000 to 60,000 items, depending upon the size of the wholesaler and the territory served. The 100 wholesale druggists, stockholders of the petitioner, formed a membership committee of 15 to select independent full line service drug wholesalers acceptable as stockholders of the petitioner and a merchandise committee to select manufacturers. These committees were not provided for in either the charter or the bylaws of the petitioner. The membership committee was composed entirely of directors and the merchandise committee was composed entirely of stockholders of the petitioner. These committees held no meetings other than the regular directors' and stockholders' meetings.
The stated object of organizing the petitioner was to reduce prices for stockholders by volume buying. Its officers consist of an executive vice president and general manager and a secretary and treasurer who operate under the direction of the board of directors. It has but eight paid employees. The officers and employees are not stockholders. Petitioner enters into contracts with various manufacturers of drug supplies. In the taxable year it started off with contracts with 169 manufacturers. With various additional contracts and cancellations, it ended the year with 188 contracts. The contract which petitioner made with the manufacturers varied somewhat over the years. A specimen contract in use in the taxable year is set forth in the stipulation. After certain preambles setting forth the character of petitioner's services, it reads as follows:
WHEREAS, the MANUFACTURER desires to gain all the advantages possible from the aforesaid services furnished by D.S.C.;
NOW THEREFORE, D.S.C. and said MANUFACTURER, in consideration of their respective reciprocal promises and agreements hereinafter set forth, promise and agree as follows:
1. D.S.C. agrees to render to the MANUFACTURER the following services:
(a) Sales bulletin service;
(b) Sales representation in the field by D.S.C.'s officials;
(c) Merchandising counsel;
(d) Advertising counsel;
(e) Distribution of advertising materials;
(f) Trade surveys;
(g) Specific sales promotion drives;
(h) Checking of placement of window and counter displays;
(i) Privilege, at the discretion of D.S.C., of showing at the annual D.C.S. exhibit;
(j) To use its best endeavors in every legitimate way to further the interests of the manufacturer and to get the help and assistance of the member wholesalers with which it is in contact.
2. The MANUFACTURER promises and agrees to contract for the aforesaid services of D.S.C. for the period of one year from the date hereof and thereafter shall be continued and automatically renewed for like periods, and to pay for such services by the 15th of every April, July, October and January from the date hereof, an amount equal to . . . per centum of the net purchases by the member wholesalers of D.S.C. of the products of the MANUFACTURER during such previous period, such percentage being arrived at merely for the purpose of evaluating in dollars and cents the amount to be paid to D.S.C. for such services.
The MANUFACTURER further agrees to all the terms and conditions set forth in the schedule attached hereto.
IT IS RECIPROCALLY AGREED:
3. That such payment to D.S.C. for the services aforesaid has no relation to any purchases or to the price at which the manufacturer's product is sold to the several D.S.C. member wholesalers.
4. This agreement may be cancelled by either party on thirty days' written notice.
IN WITNESS WHEREOF, both parties have signed and accepted this agreement on the day and year first above written.
DRUGGISTS' SUPPLY CORPORATION
(Corporate Seal) By: . . .
Executive Vice-President . . .
(Corporate Seal if a corporation). By: . . .
The petitioner in the taxable year had written agreements with its 100 stockholder members. A specimen of this agreement reads as follows:
AGREEMENT made the 16th day of October, 1937 by and between DRUGGISTS' SUPPLY CORPORATION, located at New York, New York (hereinafter referred to as ‘D.S.C. ‘) and . . . , a member of D.S.C., located at . . . (hereinafter referred to as ‘MEMBER‘);
WHEREAS D.S.C., among its services, is furnishing sales, promotion and advertising services to various selected manufacturers, (hereinafter referred to as ‘MANUFACTURERS‘) supplying the drug trade;
NOW, THEREFORE, D.S.C. and the MEMBER, in consideration of their respective reciprocal promises and agreements hereinafter set forth, promise and agree as follows:
FIRST: The MEMBER engages to and will perform the following services for D.S.C. along the following broad lines:
(a) To assist ‘D.S.C.‘ in every legitimate manner possible in the performance of the services contracted for, all in keeping with the spirit and intent of such organization.
SECOND: D.S.C. agrees to pay to the MEMBER for the aforesaid services, as soon after the close of each calendar year's business as may be, after the payment of all expenses of the operation of D.S.C. and the replenishing of any impairment of its capital and after the deduction from its receipts of such an amount for addition to its surplus account as its Board of Directors may determine, the balance then remaining from its operations in proportion to the purchases or sales from, to or through, D.S.C. and its MANUFACTURERS, by said MEMBER for each calendar year as closed; not as a dividend upon the shares of stock of D.S.C. owned by said MEMBER (which right to the payment of a dividend, if any, upon said shares of stock is hereby waived) but as a ‘participation distribution.‘ This agreement may be cancelled at any time by reciprocal consent of the respective parties hereto.
THIRD: It is reciprocally agreed that the compensation received by D.S.C. for sales, promotion and advertising services furnished to MANUFACTURERS and the ‘participation distribution‘ agreed to be paid by D.S.C. to the MEMBER hereunder, has no relation to or bearing upon the price which the MEMBER pays or agrees to pay to the MANUFACTURER for merchandise purchased; but that it is merely an endeavor on the part of the respective parties hereto to reach a fair value in money for the payment for the services rendered by D.S.C., and that of the MEMBER to be rendered hereunder, and shall, so far as legitimately may be, never be taken into consideration by the MEMBER in fixing the resale price of merchandise dealt in by the parties hereto.
FOURTH: It is further reciprocally agreed that this agreement is not assignable or transferable by operation of law or otherwise, and shall be binding upon, and inure to the benefit of, the successors, assigns, executors, administrators and representatives of the respective parties hereto.
IN WITNESS WHEREOF, the parties hereto have caused this agreement to be duly executed the day and year first above written.
DRUGGISTS' SUPPLY CORPORATION,
(Corporate Seal) By: . . . Executive Vice President
. . . (NAME OF MEMBER)
(Corporate Seal) By: . . .
Petitioner maintained no sales force. It was impossible for it to perform the sales promotional and advertising services it agreed to furnish under its contract with the manufacturers without the cooperation of the wholesale druggists, stockholders of the petitioner, who agreed to so cooperate in their individual contracts with the petitioner.
Among the services which petitioner agreed to furnish under its contract with the manufacturers was to arrange an annual exhibition, which is generally held in March at New York City, at which the manufacturers exhibit their products. The exhibition runs for one week. The purpose of the exhibition is to bring the manufacturers and the wholesale druggists, stockholders of petitioner, together. Substantial orders are placed at this annual exhibition. With the idea of getting the wholesale druggists to attend the exhibition, the annual meeting of petitioner's stockholders is generally held on the Saturday preceding the opening of the exhibition. At this meeting of the stockholders' checks representing the ‘patronage dividend‘ or ‘reciprocal distribution‘ are delivered.
Petitioner sends out a form to the manufacturers and the wholesalers and at each quarter they return the form, reporting sales and purchases. With each quarterly report the manufacturer sends a check covering the agreed percentage of the amount of the respective purchases of its wholesalers. This check is deposited in the petitioner's bank account and placed in a reserve called ‘reserve for reciprocal dividends on purchases.‘ The amounts received by petitioner from the manufacturer under its contract were not entered currently to the credit of the wholesaler's account, but are merely listed in the book in tabulated form. The auditor makes the quarterly entries and later renders an annual report to the board of directors and the stockholders at the annual meeting held after the close of the current year. While the gross sales of the wholesalers, stockholders of petitioner, run around $300,000,000 annually, their total purchases from the manufacturers under the contracts with petitioner in the taxable year 1940 were less than $6,000,000.
The balance sheet of the petitioner as of December 31, 1940, shows that, in addition to its cash and accounts receivable, it held a certificate of the Lawyers Mortgage Co., valued at $18,163.08, and a $5,000 investment in the capital stock of the Druggists' Importing Co. In 1936 the board of directors placed in surplus the sum of $10,000 to cover anticipated costs of an investigation by the Federal Trade Commission. The amount was not needed for such purpose and it now remains in the surplus of the petitioner.
Petitioner had nothing to do with the purchases made by the wholesalers, nor were there any sales or purchases by or between it and its stockholders.
In 1940 petitioner had contracts with four manufacturers designated ‘Class B Manufacturers,‘ whose products and contracts were approved by the merchandise committee. These manufacturers made lump sum payments for the privilege of exhibiting their products at the annual exhibition arranged by the petitioner. The total amount received from these four manufacturers in 1940 was $7,980, which was applied by petitioner toward defraying its operating expenses.
The total amount of fees received by petitioner in 1940 from the other manufacturers with which it had contracts was $235,164.56. Of this amount, $182,249.58 was distributed to the petitioner's stockholders as ‘participation distributions,‘ so called in the membership agreement, or, as designated on petitioner's books, ‘reciprocal dividends on purchases.‘
The income of petitioner also included direct charges from stockholders of $15,000; volume charges of $37,914.98; class B Manufacturers, $7,980; other revenue of $4,017.39, aggregating $64,912.37. In the taxable year petitioner reported gross income of $64,912.37 and claimed deductions of a like amount, showing no tax due.
The excess profits tax return for the taxable year has never been filed. Petitioner has always filed corporation income tax returns. It has never claimed it was an exempt corporation, and has never filed an affidavit or questionnaire under Regulations 103, section 19.101-1.
The petitioner has never treated as income the net amount received from manufacturers and distributed to its members, but at all times has shown it on its books as accounts payable to the various members as due for services rendered. On at least two occasions prior to the taxable year revenue agents questioned this treatment of these amounts and on each occasion were advised as to the facts. The question of petitioner's treatment of these items was on each occasion referred by the revenue agents to higher authority. Petitioner was later advised that such treatment was correct. In failing to file an excess profits tax return for the taxable year 1940 petitioner relied on this action of the revenue agents as constituting an approval of that treatment.
The respondent added to the income of the petitioner in the taxable year the amount of $182,249.58. The correctness of his action gives rise to the only issue in controversy. Petitioner contends the amount represents ‘patronage dividends‘ and is the property of 100 wholesale druggists who operate petitioner as a cooperative agency, or constitutes payments made pursuant to a definite liability and deductible as an ordinary business expense. Petitioner, organized under the Business Corporation Law of New York State, has, since its incorporation, filed Federal corporate income tax returns. No claim is made that petitioner is an exempt corporation within the meaning of section 101 of the Internal Revenue Code. The gist of petitioner's contention appears to be that, although petitioner is a business corporation, it functions as a cooperative corporation and is merely a collection agency for a voluntary unincorporated association comprising the 100 wholesale druggists who hold the shares of its capital stock in equal proportions. Does the record warrant such a conclusion? We think not.
Petitioner holds regular meetings of its stockholders and directors. The board of directors appoints the officers, prescribes and supervises their duties, fixes their salaries, and controls the distribution of its funds. Petitioner enters into contracts with manufacturers to furnish certain services for an agreed fee. That a part of the services which, under the contract, petitioner agrees to furnish, requires the cooperative effort of the 100 wholesalers, does not, we think, alter the situation. The contract is that of petitioner. It alone is entitled to enforce payment for the services contracted for. The payments made by the manufacturers to petitioner, although computed on the basis of the voluntary purchases by the 100 wholesalers, belong to petitioner. Petitioner has income from other sources. It has investments and reserves. The board of directors fixes the amounts to be deducted for operating expenses and the amount of reserves to be retained for emergencies. The functions we have above outlined are clearly beyond the ordinary powers and duties of a mere collection agency. Petitioner neither buys for nor sells anything to the 100 wholesale druggists who constitute its stockholders. Its principal function is to furnish to the manufacturer the services specified in its contract. The payments the manufacturer makes under the contract are the property of the petitioner. The wholesale druggist is under no obligation to the manufacturer. Purchases are not compulsory. If no purchases are made, no benefit is received. Under the membership agreement, the wholesaler agrees to ‘assist‘ petitioner ‘in every legitimate manner possible in the performance of the services contracted for, all in keeping with the spirit and intent of such organization.‘ Just what that embraces by way of a legal obligation on the part of the member is difficult to surmise. This indefinite and general provision makes it doubtful whether the ‘Membership‘ contract serves a purpose other than as a vehicle for the wholesaler waiving his rights to dividends on his shares of the capital stock in the petitioner, and in lieu thereof to receive these so-called ‘participation distributions.‘ We perceive in the membership contract no enforceable legal liability on the part of petitioner to make any definite and specific payments so as to entitle it to a deduction of the amounts distributed as ordinary and necessary expenses of the business. The circuitous method adopted for distributing what is in fact taxable income of the petitioner does not permit it to escape its Federal tax liability.
We think it clear from this record that petitioner was functioning as a business corporation and not as a mere collection agency operating as a cooperative corporation. Our conclusion is based on the particular facts here presented. It will serve no useful purpose to review other authorities. We sustain the respondent's action in adding to petitioner's income, for the taxable year involved, the sum of $182,249.58.
There remains for consideration the propriety of respondent's action in assessing a penalty of $8,567.56 for failure to file an excess profits tax return for the taxable year 1940. It is conceded that no such return was filed. Under section 291 of the Internal Revenue Code, the penalty is to be imposed ‘unless it is shown that such failure is due to reasonable cause and not due to willful neglect.‘ For 30 years petitioner has been filing its Federal income tax returns showing no income and showing these service fees credited to members as a liability for accounts payable. On at least two previous occasions the revenue agents have inquired of the petitioner about such treatment of these service fees. Upon being informed of the facts, those agents referred the question of the proper treatment of these fees to higher authority. Later, the revenue agents advised petitioner that its treatment was approved. Relying on this approval, petitioner filed no excess profits tax return for 1940, because such treatment resulted in no taxable income. We think such facts are even more favorable to the taxpayer than those revealed in Hugh Smith, Inc., 8 T.C. 660, in which we struck the penalty. Under such circumstances, we hold that the failure to file such return was based upon a reasonable belief that it was not required and that the imposition of the penalty is not justified.
Decision will be entered under Rule 50.