Docket No. 8294.
H. A. Dancer, Esq., for the petitioner. Edward C. Adams, Esq., for the respondent.
Petitioner from 1930 until the taxable year was one of the administrators of an estate consisting in large part of the stock in a corporation formed after decedent's death to incorporate decedent's retail department store business. He was asked by several of the heirs to serve as administrator, and he accepted with the expectation of being paid for his services. In 1939 some of the heirs became dissatisfied with the administration and later filed suit against the petitioner and the other administrators, alleging mismanagement and asking damages of $300,000. After the controversy arose, petitioner agreed to forego his fees and commissions to promote settlement. In 1941 the suit was compromised by petitioner's payment of $10,000, and he also paid attorneys' fees of $1,500 in connection with the matter. Held, the payments totaling $11,500 are deductible as nontrade or nonbusiness expenses under section 23(a)(2), Internal Revenue Code. H. A. Dancer, Esq., for the petitioner. Edward C. Adams, Esq., for the respondent.
The Commissioner determined a deficiency in Federal income taxes against the petitioner for the year 1941 in the amount of $6,887.23. Certain adjustments made by the Commissioner are not in dispute. The only issue presented is whether petitioner may deduct from gross income in 1941, under either section 23(a)(1)(A) or section 23(a)(2), Internal Revenue Code, the sum of $11,500, composed of $10,000 paid in settlement of litigation and $1,500 attorneys' fees connection therewith.
From evidence both documentary and oral we make the following findings of fact.
FINDINGS OF FACT.
The petitioner, Hyman Y. Josephs, a resident of Duluth, Minnesota, filed his income tax return for the year 1941 with the collector of internal revenue for the district of Minnesota, at St. Paul.
Ignatz Freimuth, the decedent whose estate petitioner administered, died intestate on March 31, 1930, leaving as his heirs nine surviving children.
The decedent's estate consisted largely of a retail department store in the city of Duluth, but included also real estate, stocks, bonds, and cash, the entire estate amounting to $436,831.09, according to accepted appraisal, subject to debts of $131,371.82.
On April 2, 1930, eight of decedent's children filed in probate court their petition praying that David C. Freimuth, a son of the decedent, be appointed special administrator of decedent's estate; that he be authorized to continue the department store business as a going concern until the further order of the court or until the special administration of the estate should terminate; and that the general administrators of the estate, when appointed, also be given like authority to conduct the business. By the petition they agreed that the representative of the estate or the special administrator or general administrators should not be liable to them or any of them for any loss arising in the conduct of the business except such as might result from the willful and intentional misconduct of such representative or representatives in the conduct of the business. The petition was granted.
For many years Hyman Y. Josephs, the petitioner, has been a prominent businessman of Duluth. He has long been engaged in the scrap iron business, first in partnership and later in corporate form. He has also been a director of a bank in Duluth and has always been financially sound. He was a friend of the decedent, but was not related to him in any way and had no interest in the decedent's business, nor did the decedent have any interest in petitioner's business.
Within a few days after the death of Ignatz Freimuth the family gathered at the Duluth home, and it was the unanimous decision to request the petitioner to act as administrator, along with David C. Freimuth and Victor Kohn, a son-in-law of the decedent.
Letters of administration were granted by the probate court of St. Louis County, Minnesota, May 26, 1930, naming as administrators David C. Freimuth, Victor Kohn, and Hyman Y. Josephs.
Victor Kohn, a resident of Chicago, Illinois, was engaged in the liquor business there. During his tenure as coadministrator he complained of incurring personal financial loss in coming from Chicago to Duluth to attend to affairs of the Ignatz Freimuth estate, and he was told by David C. Freimuth that allowance had been made for paying the administrators. Kohn died within four or five years after his appointment, and no successor was named to take his place.
At the time of decedent's death, David C. Freimuth and three of his brothers were working in decedent's store. David was educated as a lawyer, passed the Minnesota bar examination, and practiced law a short time before entering his father's store in 1906, in which business he has occupied himself to the present time. He was the only one of the administrators who had had experience in the dry goods or department store business.
Under date of July 8, 1930, an order was signed by the judge of the probate court authorizing the transfer of the store business of the deceased, which until the time of his death had been operated as a sole proprietorship, to a corporation organized under the laws of Delaware, known as I. Freimuth, Inc. Pursuant to the petition, preceding the order, the court authorized and directed the administrators to transfer the assets of the store to the corporation in exchange for corporate stock. The three administrators were directors of that corporation. David C. Freimuth was elected manager of the corporation and acted as such at all times here material.
Late in 1933 or early in 1934, a Minnesota corporation was formed under the same name of I. Freimuth, Inc. The assets of the Delaware corporation were turned over to the Minnesota corporation, and the stock of the Delaware corporation was surrendered. This reorganization was accomplished without intervention of the probate court and was pursuant to a ‘CONSENT AND WAIVER‘ signed by all the heirs at law of the decedent, as the sole parties in interest. Petitioner was neither a director nor an officer in this, the Minnesota corporation.
The Minnesota corporation stock consisted of 207 shares of no par common stock, which was issued to the administrators, who at that time were David C. Freimuth and petitioner, and class A and B preferred stock, both held by certain members of the Freimuth family to compensate for loans they made to the corporation.
Details of the operation of the incorporated store business were left to David C. Freimuth. Petitioner was frequently consulted on financial matters concerning the store and was particularly instrumental in securing a reduction of the rent the corporation was paying for the store building. Also, he was often consulted by the heirs with respect to the estate affairs.
Under date of March 26, 1931, a Minnesota inheritance tax report was filed and an amount of $2,500 was allowed for fees of administrator. The same amount was allowed in the Federal estate tax return. Counsel for the estate agreed upon and inserted the amount of $2,500, this being an amount they thought would be allowed by the court.
On or about December 30, 1939, certain heirs of the estate of Ignatz Freimuth filed a petition with the probate court objecting to the manner in which the estate was being managed and asking for an order requiring an accounting and other relief. Several days thereafter the petitioner stated to an attorney with whom D. C. Freimuth had arranged to close up the estate that any fees or expenses he might be entitled to could be waived or forgotten or entirely eliminated, and that if it would accomplish or contribute anything to a settlement of the controversy which was arising between the heirs in closing the estate he was glad to forego any fees or expenses. On March 18, 1940, an account and petition was filed with the probate court under the names of D. C. Freimuth and H. Y. Josephs, by D. C. Freimuth, which contained an account of their administration up to January 25, 1940. Under the heading ‘RECEIPTS‘ the administrators stated that they received $421,713.86 worth of personal property, according to a schedule attached to the account and petition. The assets of the store were included in that amount. Under the heading ‘DISBURSEMENTS‘ appears an item of $319,971.18 described as ‘Assets to corporation— July 25, 1930.‘ The account and petition also contained the appraised value of the personal property on hand January 25, 1940. Therein were included, among other personal property, 207 shares of no par value common stock of I. Freimuth, Inc., a Minnesota corporation— value undetermined.
Objections to the last mentioned administrators' account were filed by the disgruntled heirs on April 30, 1940, which alleged, in substance, misconduct and waste on the part of the administrators. The document also alleged as follows:
That the said D. C. Freimuth assumed exclusive control of this entire estate for his personal gain and advantage without regard to the rights of the heirs, other than himself, or the rights of the co-administrators and contrary to the laws of the State of Minnesota, but to the contrary treated said administration and said assets as his individual property.
On August 22, 1940, there were filed by the disgruntled heirs objections to the administrators' final account. This instrument contained language similar to the one filed by the same heirs on April 30, 1940. The final account as filed by the administrators was approved, with minor exceptions, by the judge of the probate court on February 1, 1941. Accompanying the order was a memorandum of the Court's reasons for approval.
On February 24, 1941, the probate court entered an order requiring the representatives to use all reasonable effort to dispose of all the assets of the estate of the decedent and to report the results of their efforts on March 17, 1941.
The dissatisfied heirs appealed from the order of the probate court to the District Court for the Eleventh Judicial District, St. Louis County, Minnesota. On March 25, 1941, defendants David C. Freimuth and H. Y. Josephs filed their answer to this action.
On February 17, 1941, certain of the objectors commenced another suit in the same district court against the administrators, the corporation, the Northern National Bank of Duluth, and other individuals. The substance of the complaint was the mismanagement of the estate and prayer for damages in the amount of $300,000. The defendant administrators demurred to the complaint and on May 9, 1941, the judge of the district court sustained the demurrer.
The heirs appealed the order of the district court sustaining the demurrer to the Supreme Court of Minnesota, serving notice of appeal on counsel for petitioner and others under date of May 23, 1941.
On July 21, 1941, all parties to the litigation reached an agreement whereby, inter alia, petitioner H. Y. Josephs was to pay $10,000 in full release of all liability from any source, which amount, together with $1,500 attorneys' fees incurred in the case, was paid. David C. Freimuth was to pay $5,000 in full release of his liability. Finally, it was agreed that the estate of decedent would be closed, the final decree of dissolution filed, and the appeal pending before the Supreme Court of Minnesota dismissed— all of which was done.
Petitioner knew at the time he was appointed administrator that administrators were ordinarily paid for their services, and be expected to be paid for his services. He would not have accepted the office if he had not expected to receive compensation.
We need not decide whether the petitioner, acting as administrator, was engaged in carrying on a trade or business so as to make the payment of $10,000 in settlement of the suit and the $1,500 attorneys' fees deductible under section 23(a)(1)(A), because we have reached the conclusion that the expenses are deductible under section 23(a)(2) of the Internal Revenue Code.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(a) EXPENSES.—(2) NON-TRADE OR NON-BUSINESS EXPENSES.— In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.
Prior to the adoption of section 23(a)(2) the statute made provision for deduction of expenses only if the taxpayer was engaged in carrying on a trade or business. In earlier years, under a broad and liberal interpretation of the term ‘trade or business,‘ expense deductions were allowed both administratively and judicially to taxpayers who incurred the expenses in connection with the production of taxable income or in connection with income-producing property. Later, conflict developed in the matter; and in 1941 the Supreme Court resolved the conflict in its decision in Higgins v. Commissioner, 312 U.S. 212, strictly limiting the scope of the term ‘trade or business.‘ The enactment by Congress in 1942 of section 23(a)(2) followed shortly upon the heels of the Higgins case and provided for deduction of nontrade or nonbusiness expenses.
While it is true that the new statute was interpreted rather strictly in the first two or three years following its enactment (see, for example, Estate of Edward W. Clark, III, 2 T.C. 676, and Stoddard v. Commissioner, 141 Fed. (2d) 76), in 1945 the Supreme Court decided Bingham's Trust v. Commissioner, 325 U.S. 365, pointing out that section 23(a)(2) is comparable and in pari materia with section 23(a)(1); that section 23(a)(2) provides for a class of nonbusiness deductions coextensive with the business deductions allowed by section 23(a)(1), except that the taxpayer need not be engaged in trade or business; and that the principle of Kornhauser v. United States, 276 U.S. 135, applicable to section 23(a)(1)— i.e., that the expense be directly connected with or proximately result from the conduct of the business— is likewise applicable to those activities which fall within section 23(a)(2). Following the Bingham case, this and other courts have taken a noticeably broader view of section 23(a)(2). See, for example, Howard E. Cammack, 5 T.C. 467; Philip D. Armour, 6 T.C. 359; Julius A. Heide, 8 T.C. 314; Stoddard v. Commissioner, 152 Fed.(2d) 445.
Thus, under the principles of the Bingham case, we are to determine here whether the expenses in question are directly connected with or proximately result from an income-producing activity or from an activity consisting of the management of income-producing property so as to make them deductible under section 23(a)(2). And, we see no reason why the term ‘production or collection of income‘ should be construed any more narrowly or strictly than the term ‘management, conservation, or maintenance of property held for the production of income.‘ That is to say, there is no reason why the connection between the expense and the activity need be any more direct or proximate in the one case than in the other. Any expense which would be deductible under section 23(a)(1) if the taxpayer's activities amounted to the carrying on of a trade or business is deductible under section 23(a)(2) where the activities do not quite measure up to a trade or business but nevertheless were embarked upon by the taxpayer with the expectation of realizing income or profit. The corollary, of course, is that any expense, such as strictly personal, living or family expenses, which would not be deductible under section 23(a)(1) is likewise not deductible under section 23(a)(2).
In the instant case it cannot be gainsaid that the expenses in question would be deductible under section 23(a)(1) if the taxpayer's activities as administrator amounted to the carrying on of a trade or business. John Abbott, 38 B.T.A. 1290. The evidence establishes positively that petitioner entered upon his duties as administrator with the expectation of being paid for his services. We have found as a fact that he would not have accepted the office if he had not expected to receive compensation. Indeed, no reason appears on this record why he should otherwise have accepted the office or why the heirs should have expected him to serve without compensation. He was not a relative of the decedent, and he had no interest in the decedent's business.
This being so, we think it immaterial that several years later, i.e., after the controversy with some of the heirs arose in 1939 or 1940 and petitioner was threatened with suit, he agreed to forego the compensation and fees to which he was entitled in order to promote a settlement. Cf. Julius A. Heide, supra. Certain it is that petitioner entered upon his office as administrator with the expectation of realizing income and that the expense payments in question were a direct result of his activity as administrator. We therefore hold that the expenses are deductible under section 23(a)(2).
Reviewed by the Court.
Decision will be entered under Rule 50.
KERN, J., dissents.
DISNEY, J., dissenting: The majority opinion appears to state the basis therefor in the following:
Thus, under the principles of the Bingham case, we are to determine here whether the expenses in question are directly connected with or proximately result from an income-producing activity or from an activity consisting of the management of income-producing property so as to make them deductible under section 23(a)(2). And, we see no reason why the term ‘production or collection of income‘ should be construed any more narrowly or strictly than the term ‘management, conservation, or maintenance of property held for the production of income.‘ * * *
This, despite the fact that the petitioner in this case did not rely upon the first part of section 23(a)(2), but upon the fact of expense paid ‘for the production or collection of income.‘ No argument is made that there was expense ‘for the management, conservation, or maintenance of property held for production of income.‘ The Bingham case (325 U.S. 365) is nowhere cited or relied upon by the petitioner. The reason is obvious. That case was rested on the fact that the expenses involved had to do, not with the first part of section 23(a)(2) herein relied upon, but with the second part, as to reasonable and proximate relation to the management of property held for the production of income, and I think that we should be careful not to give the case undue weight when we are considering, not the second part of section 23(a)(2), but the first part, having to do with expenses ‘for the production or the collection of income.‘ That the case is so limited is shown early therein in the following statement:
* * * The questions whether, on the facts found, the expenses in question are nondeductible, either because they were not to produce income or because they were related to the management of property which was not held for the production of income, turn in this case on the meaning of the words of Sec. 23(a)(2), ‘property held for the production of income.‘
After so stating, the Court then proceeds to approve the conclusions of the Tax Court that ‘the trust property was held for the production of income during the stated term of the trust,‘ and to hold that such holding for the production of income did not cease until distribution of the trust property, and points out that the Tax Court had held the expenses to be expenses of management of the trust. The Government had contended that under section 23(a)(2) as a whole there could be no deduction unless the expenses were not only for management, conservation, or maintenance of property held for the production of income, but were also ‘for the production or collection of income.‘ This the Court denies, pointing out that section 23(a)(2) provides for two classes of deductions, that is, expenses for the production of income, and expenses of management, conservation, etc., of property held for the production of income, and that ‘There is no warrant for such a construction‘— that is, the Government's view or construction. Then follows immediately:
* * * Section 23(a)(2) is comparable and in pari materia with Sec. 23(a)(1), authorizing the deduction of business or trade expenses. Such expenses need not relate directly to the production of income for the business. It is enough that the expense, if ‘ordinary and necessary,‘ is directly connected with or proximately results from the conduct of the business. Kornhauser v. United States, supra, 276 U.S. 152, 153; Commissioner v. Heininger, supra, 320 U.S. 470, 471. The effect of Sec. 23(a)(2) was to provide for a class of non-business deductions coextensive with the business deductions allowed by Sec. 23(a)(1), except for the fact that, since they were not incurred in connection with a business, the section made it necessary that they be incurred for the production of income or in the management or conservation of property held for the production of income. * * *
In short, the quoted language is merely argument that expenses do not need to come under both parts of section 23(a)(2), as is shown by the fact that the Court (after citing authorities) proceeds:
Since there is no requirement that business expenses be for the production of income, there is no reason for that requirement in the case of like expenses of managing a trust, so long as they are in connection with the management of property which is held for the production of income. Section 23(a)(2) thus treats the trust as an entity for producing income comparable to a business enterprise, and like Sec. 23(a)(1) permits deductions of management expenses of the trust, even though the particular expense was not an expense directly producing income. It follows that all of the items of expense here in question are deductible, as the Tax Court has held, they are expenses of management or conservation of the trust fund, whether their expenditure did or did not result in the production of income.
That the Supreme Court bases its conclusion in the Bingham case on the fact of management of property cannot be gain said, and we will do well, I think, to hesitate about applying it to ‘expenses paid or incurred * * * for the production or collection of income,‘ under the first part of section 23(a)(2). It does not, in terms or by inference, hold that such expenses need have only some kind of proximate connection with such collection or production. Its reference to proximity of connection is definitely to ‘conduct of business‘ and to ‘litigation expenses when they are directly connected with or proximately result from the enterprise— the management of property held for production of income.‘ I find in the Bingham case neither mandate nor reason to deviate from the text of the statute requiring expenses, in order to be deductible under the first grounds, to be ‘paid or incurred * * * for the production or collection of income‘ and to say that such expenses need only have some proximate relation to such collection or production. It is much easier to see how the ‘management, conservation, or maintenance of property held for the production of income‘ is in the nature of a business, ‘comparable to a business enterprise,‘ in the words of the Bingham case, and so analogous thereto that expenses thereof come within the very broad expression ‘carrying on any trade or business,‘ in section 23(a)(1). ‘Carrying on any trade or business‘ easily involves almost anything having any proximate or incidental relation thereto, but it seems to me that the expression ‘paid or incurred * * * for the production or collection of income ‘ requires not merely connection between expense and collection or production of income, but a causal connection, that is, that the expenses are caused by such production or collection. The Bingham case, in any event, is bottomed on the second part of section 23(a)(2), the management, etc., of property held for the production of income, as is shown by the repeated use of the word ‘management‘ throughout the opinion; and it is no basis, in my view, for reasoning, good or bad, as to the first portion of the statute concerning expense of collection or production of income. If it were true that we should stretch the words ‘paid or incurred * * * for the production or collection of income‘ to encompass broadly expenses not caused by production or collection of income, or attempts so to do, the Bingham case is no authority for so doing; it neither requires nor allows us to go entirely beyond the words of the statute and to allow deductions which, though they may be seen to have some kind of connection with production or collection of income— such as expenses paid in settling a case, not brought to collect income, but involving some relationship, such as trust, where fees or income might have been involved—are equally clearly seen not to be caused by collection or production of income, or attempts so to do. Congress intended, undoubtedly, to broaden old concepts, and if there was expense of management, etc., of property held for income-producing purposes, something like ‘carrying on‘ a trade or business, a broad concept appears— ‘co-extensive with the business deductions allowed by Sec. 23(a)(1),‘ in the words of the Bingham case. But when it comes to expense paid for collecting income, or producing it, it seems to me that the new idea necessarily much more limited and that Congress did not intend that we permit deductions having casual, but not causal, connection with such production or collection of income— unless, as in the Bingham case, on the facts the expense may broadly be seen as within management, etc., of property, something akin to the generality ‘carrying on any trade or business,‘ found in section 23(a)(1).
Here, the petitioner's contention is that the expenditure in question was incurred for the production or the collection of income, and he bases his argument primarily on the theory that petitioner had, some eleven years before, entered into a fiduciary relationship, expecting to receive a fee, and, since the expenditure of the sum in question was incurred in settling a lawsuit that arose because of that fiduciary relationship, the amount expended was for the production or the collection of income. This does not follow. The statute requires the expense, itself, to be for the production or collection of income. The case of Estate of Edward W. Clark, III, 2 T.C. 676, was based on facts substantially the same as those in the instant case. There the petitioner served as executor and trustee and actually received a fee for the services rendered (under the law of that state, Pennsylvania, a person who under a will fulfills the duties of both executor and trustee is entitled to one fee) and paid as an expense a sum for attorney fees for defending a suit for mismanaging the trust. The Court disallowed the payment of the attorney fees, first, on the ground of lack of proof, stating in part, ‘on this scant record we might justly disallow the item for paucity of proof‘; and then the Court said:
* * * There is, however, a further reason for the disallowance. Petitioner relies on section 23(a)(2) of the Internal Revenue Code, as amended by section 121 of the Revenue Act of 1942. Obviously the expense was not paid or incurred ‘for the production or collection of income.‘ * * *
In considering the cited case, we observe that there were sufficient facts to reveal what the payment was for and there could be no doubt but that the expense arose in connection with the petitioner's fiduciary relationship. However, we disallowed the deduction.
The expense in the instant case is not for the production or collection of income; rather, it is for settling a lawsuit in which there could have been no possibility of producing or collecting any income. No action was instituted by the petitioner, no attempt was made by him to collect income or produce it for himself or the estate, either by action or cross-action in the case filed by the heirs. He was altogether on the defensive, not intending or trying to collect anything. On the contrary, he had, a few days after the petition for accounting was filed in the probate Court, said that any fees or expenses he might be entitled to could be waived or forgotten, or entirely eliminated, and that, if it would accomplish or contribute anything to a settlement of the controversy which was arising among the heirs in closing the estate, he was glad to forego any fees or expenses. It is noticeable that this was apparently at least two months before the filing of the account by the administrators, nearly four months before objections were filed, and more than a year before the suit was filed in which the $300,000 damages were asked and which several months later was settled by the payment of $10,000 by the petitioner.
In Julius A. Heide, 8 T.C. 314, in sustaining a deduction under the first part of section 23(a)(2), we pointed out that the petitioner had, in asking settlement of trustees' accounts, asserted claim for the commissions due him—precisely the element not only absent here, but waived by the petitioner. It is apparent, I think, that, even assuming that proximate connection between expense incurred and production or collection of income is a sufficient basis for the deduction, there was no such proximate connection under the facts here. The administrators' account asked neither for fees nor commissions. The majority opinion is based upon a part of section 23(a)(2) not relied on, and upon facts occurring long before the case which was settled and in which the petitioner definitely did not seek production or collection of income. There was no causal connection between collection or production, or attempt at collection or production of income (for there was none), and the expenses paid by petitioner. ‘For,‘ in the phrase ‘for the production or collection of income,‘ can connote nothing less than causal connection. John H. Wilmott, 2 T.C. 321.
Since the expense is not for the ‘production or collection of income‘ and there is no contention that the expense comes under the provision of the statute as to ‘management, conservation or maintenance of property held for the production of income,‘ we should hold that petitioner should be denied this deduction as claimed under section 23(a)(2). I respectfully dissent.