Docket No. 12986.
Tim G. Lowry, Esq., for the petitioner. Charles D. Leist, Esq., for the respondent.
1. Petitioner's basis for gain or loss on certain securities purchased in January and October 1937 and sold in 1941, held to be the original cost of such securities and not their fair market value on December 31, 1937, where the securities were intended to be purchased for petitioner's account with funds which its parent corporation owed it, but the securities were erroneously recorded on the parent's books, and the error was not discovered and corrected until December 31, 1937, by a transfer to petitioner at cost.
2. Petitioner is engaged in the pharmaceutical manufacturing and distributing business. It began research in hormones in 1936, and in 1937 it acquired a ranch in Arizona and stocked it with horses. The raw material source of such hormones was the urine of pregnant mares, and one of the purposes in acquiring the ranch was to obtain a source of supply in commercial quantities. The principal stockholder of petitioner's parent corporation, who actively managed the affairs of both companies, lived at the ranch with his family. Petitioner constructed a large residence and other buildings for his use, did extensive landscaping, built a golf course, and made other similar investments at the ranch. Held that some of the petitioner's expenses in operating the ranch in 1941 and 1942 were for the primary personal benefit of that individual and are not deductible; the amounts of expenses deductible as ordinary and necessary business expenses are determined from the evidence. Tim G. Lowry, Esq., for the petitioner. Charles D. Leist, Esq., for the respondent.
The respondent determined deficiencies in petitioner's income tax liability for 1941 and 1942 in the respective amounts of $12,266.27 and $15,577.67. Certain adjustments made by the respondent are not contested. The questions for decision are, first, the basis to petitioner of certain securities acquired by it in 1937 and sold in 1941 and, second, whether the net operating expenses of an Arizona ranch property for 1941 and 1942 are deductible by petitioner either as ordinary and necessary business expenses under section 23(a) or as losses under section 23(f) of the Internal Revenue Code.
FINDINGS OF FACT.
The petitioner, Lanteen Medical Laboratories, Inc., is a corporation organized in 1934 under the laws of Delaware, with principal office in Chicago, Illinois. Its tax returns for 1941 and 1942 were filed with the collector of internal revenue for the first district of Illinois.
Petitioner is a subsidiary of Lanteen Laboratories, Inc. (hereinafter referred to as the parent company). The parent company was organized in 1928 under the laws of Illinois, for the primary purpose of manufacturing pharmaceutical products. Rufus Riddlesbarger was the principal shareholder in the parent company. He invested ten or twelve thousand dollars in the business and actively participated in its operations.
Petitioner was organized in 1934, upon advice of counsel, for the purpose of dividing operations along state lines. It merchandises its products in all states except Illinois. The parent company does not manufacturing, but purchases its merchandise from the petitioner and conducts merchandising operations only within Illinois.
From 1934 to November 1, 1942, the parent company had issued and outstanding 25,942 shares of class B and 645 shares of class A common stock, both classes being entitled to vote. During that period Riddlesbarger at all times owned not less than 22,671 shares of class B and none of class A. He was also president of the parent company and drew a salary from it during these years.
From the date of its organization in 1934 through 1942 petitioner had issued and outstanding 7,440 voting common shares and 200 nonvoting preferred shares. The parent company owned at all times 7,400 of the voting common shares and none of the nonvoting preferred shares. Except for keeping separate books and records and dividing operations along state lines, little if any change in business methods resulted from the incorporation of petitioner. Riddlesbarger, as controlling stockholder of the parent company, selected the officers and directors of both companies, determined whether a new product was to be added to the line of items manufactured, and selected the auditors and attorneys for the companies. The directors of the petitioner were salaried employees, who ordinarily followed the directions and instructions of Riddlesbarger in performing their duties, although he was not an officer or director of petitioner and did not directly own any of petitioner's stock.
Since its incorporation petitioner has engaged in the manufacture and sale of various pharmaceutical and biological products and apparatus and devices dispensed through drug stores, physicians, and others. It has also engaged in continuous research to improve its present products and to develop new products. Among the products which it has from time to time manufactured or sold are contraceptive preparations and devices, antiseptic mouth washes, douche powders, physicians' lubricating jelly, physicians' fitting sets for diaphragms, pain tablets, hormone preparations, pectin pastes, vitamin tablets, vitamin capsules, vitamin solutions, and vitamin and iron preparations.
In the years from 1934 to 1937 substantial open account indebtednesses existed from the parent company to the petitioner for services and merchandise furnished by petitioner. The parent company from time to time made payments on account. On December 31, 1936, the books of both corporations reflected an indebtedness from the parent company to the petitioner in the amount of $72,921.76. This amount included a cash transfer of $30,000 from petitioner to the parent company on November 30, 1936, made at the direction of Riddlesbarger after petitioner's bookkeeper, M. A. Tarrach, had called his attention to the fact that petitioner had a rather substantial cash balance for which no use was being made. This surplus was acquired by petitioner as deposits by wholesalers pursuant to contracts under which they were del credere agents. Riddlesbarger decided that these surplus funds of the petitioner should be invested in securities in order to earn income. As president of the parent company, Riddlesbarger had on file with brokers authority to purchase securities in the name of that company, but not in the name of the petitioner.
In January 1937 Riddlesbarger purchased through the brokers securities at a cost of $48,518.43, and in October 1937 securities costing $12,995.75— a total cost of $61,514.18. He intended the purchases to be for the account of petitioner, although the securities were actually taken in the name of the parent company. He gave no instructions to anyone at that time concerning the recording of the securities on the books of either company because he was in Los Angeles when they were delivered.
The books of petitioner and those of the parent company were kept in the same office by the same persons. When the securities were purchased, the bookkeeper entered on the parent company's books a credit to cash for the cost of the purchase and debited in a similar amount its account for the brokerage firm. When the securities were delivered by the brokers (delivery being accomplished in the same month within which the purchases were made) there were entered on the parent company's books a credit to the brokers' account in the amount of the cost of the securities and a debit to its securities account in a similar amount.
Riddlesbarger was not aware that the securities were thus recorded on the books of the parent company until the matter was brought to his attention in December 1937. In that month petitioner's bookkeeper, then H. A. Scofield, noticed that the book indebtedness of the parent company to the petitioner was larger than it had been in previous years, and he mentioned this to Riddlesbarger. The two of them made an analysis and review of the intercompany account and determined that some erroneous entries had been made on the books in connection with the purchase of the securities. Riddlesbarger then instructed Scofield to transfer the securities to the books of the petitioner at the original cost.
On December 31, 1937, the securities were transferred from the parent company to petitioner at the original cost of $61,514.18. Entries were made upon the parent company's books crediting its securities account and debiting its account to the petitioner in the amount of $61,514.18, and corresponding entries were made upon petitioner's books debiting its securities account and crediting its parent's account in like amount. The market value of the securities had declined to $39,759.38 on December 31, 1937, and a reserve account for decline in market value in the amount of $21,754.80 was then set up on petitioner's books and its surplus debited in the same amount. Prior to the transfer of the securities, the books of the two corporations showed the indebtedness of the parent company to petitioner to be in the amount of $103,195.96. The transfer reduced the indebtedness on the books to $41,681.78.
In the course of an audit of the books of petitioner and of the parent company in February and March of 1938, John D. Filson, of the accounting firm of George Rossiter & Co., questioned the book entries of December 31, 1937, reflecting the transfer of the securities from the parent company to petitioner, inasmuch as the market value was less than cost. Scofield communicated with Riddlesbarger, then in Denver, and the latter wired Filson on March 2, 1938, explaining that he had actually purchased the securities for the petitioner with funds which the parent company owed petitioner. With this explanation, Filson regarded the book entries merely as correcting an erroneous recording of the ownership of the securities and approved them, with the suggestion, however, that the corporate records should fully support the transfer.
No minutes of any directors' meeting with respect to the transfer of the securities had been recorded at the time; but, after the correspondence with Filson, Riddlesbarger directed R. T. Badger, who was employed by petitioner as treasurer, to prepare minutes relating to the transfer. Accordingly, several months after December 31, 1937, minutes of purported special meetings of the directors of petitioner and of the parent company held on December 31, 1937, were prepared and inserted in the minute books of the respective companies. These minutes erroneously described the transfer of the securities as a sale. Actually no such meetings were held, and the details of the erroneous minutes did not come to Riddlesbarger's attention until after a revenue agent checked the petitioner's tax returns for 1941 and 1942.
The parent company claimed no loss on the transfer of the securities, either on its books or on any income tax return. In its return for 1937 that company claimed and was allowed a capital loss of $2,000 with respect to other transactions.
Petitioner sold the securities in question in 1941 for $36,834.03 and in its return for that year claimed a long term capital loss of $24,680.15. In the same year the parent company had taxable net income of $38,685.97. In the deficiency notice the respondent determined that petitioner's basis for the securities was not the original cost of $61,514.18, but the fair market value of $39,759.38 on December 31, 1937, and he accordingly allowed a deductible loss of only $2,925.35.
In November 1937 petitioner purchased 2,400 acres of improved ranch property in Cochise County, Arizona, for $24,025. Riddlesbarger conducted the negotiations with respect to the purchase. The improvements at that time consisted of a stone house (hereafter considered the horse trainer's quarters), with nearby garage, 2 corrals, 17 miles of fence, 2 water wells, and 1 1/2 miles of pipe line. Petitioner allocated $13,525 of the purchase price to the land and the rest to the improvements. On July 31, 1938, petitioner purchased 160 additional acres for $525 and on April 30, 1939, another 20 acres for $150, both tracts being located in Cochise County.
In about 1936 petitioner began experiments and research in the properties of hormones, with a view ultimately to manufacturing as one of its products a hormone preparation embodying natural hormones. While the estrogenic hormones are present to some extent in the urine of almost any animal, for practical reasons the urine of pregnant mares is the most feasible source. One of the purposes in the acquisition of the ranch property in Arizona was the development of a source of supply of the hormone raw material in commercial quantities.
At the beginning of its hormone research, petitioner was able to obtain raw material in experimental quantities from stockyards. However, petitioner knew of no one source that was able to supply the raw material in commercial or production quantities, and it was highly impractical to obtain the necessary quantities from numerous or widely scattered sources. Some of petitioner's competitors had their own farms, from which they derived their raw materials.
Beginning about the middle of 1938, petitioner began to make extensive improvements on the ranch property and to acquire equipment and livestock. Its investment in improvements and equipment increased from about $24,000 in 1937 to approximately $150,000 in 1941 and $168,000 in 1942. A 60-acre plot in one corner of the ranch was developed as a homesite and was improved with several buildings of adobe brick and stucco, among them a lodge house at an investment of over $5,000, a guest house at an investment of about $7,000, and a main house at an investment of about $32,000. Riddlesbarger supervised the construction of the buildings and the operation of the ranch. He lived in the lodge house while the guest house was under construction and in the latter while the main house was being built. In 1941 and 1942 he and his family lived in the main house.
Landscaping of the property cost over $5,000, roadways were constructed at a cost of over $4,000, and a golf course was built at a cost of more than $5,000, together with several hundred dollars of golf course equipment. An airport runway was graded at a cost of about $270 to accommodate an airplane which cost the petitioner about $16,000. The airplane was used by Riddlesbarger primarily on business trips. Electric, gas, and water utilities were installed at an investment which totaled a little more than $19,000 in 1941 and about $27,000 in 1942.
Stables, barns, and power house were constructed at a cost of between $17,000 and $18,000. Additional fences, corrals, etc., were built at a total investment of between $9,000 and $10,000.
In addition to the improvements made and the equipment acquired, petitioner invested substantial amounts in livestock. Its investment in this respect grew from about $2,500 at the end of 1937 to approximately $47,000 at the end of 1941. At the latter date its investment represented Arabian horses of a value of $26,845.61, palomino horses of the value of $13,900, pinto horses of the value of $2,675, chestnut and other horses of the value of $3,425, and cattle and dairy cows of the value of $449.37. Its horse herd in 1941 comprised a little more than 100 horses. The Arabian and palomino horses represented a substantial investment. While these horses were probably no better than ordinary horses as a source of supply for hormone raw material, their offspring brought a very high price in the market; and it was hoped that sales of the natural increase in inventory of the better types of horses would pay or help to pay the operating expenses of the ranch.
There were many practical difficulties in collecting the hormone raw material, and work was done at the ranch toward solving these problems. Petitioner devised a satisfactory method by constructing box stalls with concrete floors and collector troughs running to a storage tank. In these stalls the animals were confined during the profitable stages of pregnancy.
In 1940 a chemist who had been doing hormone research for petitioner at its Chicago laboratories left its employ and took his notes with him. In 1941 petitioner employed another chemist, Chester C. Fowler, to conduct research in that field. Fowler discovered that patents to others created a difficult situation and hampered the development by petitioner of processes and methods for extracting and purifying the hormone from the mares' urine which would not infringe. He was successful, however, in working out a process for producing at the ranch a concentrate which would make it unnecessary to ship large quantities of urine to petitioner's plant in Chicago. His complete instructions and equipment for gathering the urine and preparing the concentrate were sent to the ranch, and the procedure was set up early in 1942.
Some difficulty was experienced in obtaining competent veterinary help at the ranch. A principal obstacle to the success of the hormone program, however, was the appearance on the market in the fall of 1941 of a synthetic product named Stilbestrol. While not quite as satisfactory for all purposes as the natural product, it had a similar therapeutic effect and its cost of manufacture was much lower.
The financial records relating to the ranch and its operations were kept in the same books of account and by the same persons as the financial records of the other operations of petitioner. During 1941 petitioner started the practice of crediting the income account of the ranch with the market value of the hormone raw material which the ranch supplied to petitioner. This account shows two shipments of the hormone raw material to petitioner in 1941, one being valued at $25 and the other at $50. The petitioner's corporate charter, as amended in April 1940 and in effect in the taxable years, covered its operations at the ranch.
In view of the difficulties encountered in the development of hormone products, it was decided that petitioner should abandon the ranch project in 1942. A buyer's market in horses developed in 1942, and petitioner sold a considerable part of its herd at a loss. On or about November 1, 1942, the ranch was transferred in a reorganization to a new corporation, Lanteen Realty Co., and immediately after the transfer Riddlesbarger was the owner of more than 94 per cent of the voting shares of Lanteen Realty Co. The ranch was sold in the summer of 1947, and Riddlesbarger now has no interest in it. Since the spring of 1946 petitioner has been engaged in the commercial manufacture and sale of a natural hormone product, but it obtains the refined hormones from others.
While Riddlesbarger lived with his family in the main house during the taxable years, the entire ranch activities were under his supervision and control and he was free to use any part of the ranch property. He made use of the golf course and occasionally rode the horses about the ranch. He paid the wages of his domestic help at the main dwelling. His housekeeper and his secretary lived in the lodge house, and when he had more than two guests at a time they stayed in the guest house. Occasional meetings of sales representatives of the petitioner in the west were held at the ranch. Riddlesbarger also carried on his duties relating to the active direction of the affairs of the petitioner and the parent company, and from time to time he made use of the airplane to make business trips to Chicago and elsewhere.
Riddlesbarger paid the petitioner $300 a month rent for the main house, $8 a month for a garage for his automobile, and $500 a year for the use of the golf course. His rental payments for 1941 totaled $4,196 and for the first 10 months of 1942, $3,496.67. There was no written lease between petitioner and Riddlesbarger. Riddlesbarger told petitioner's bookkeeper to compute what would be a proper rental in view of the investment, depreciation, and similar items.
Exhibit 7-G, in which the parties have stipulated the total cost of the ranch property, the improvements made, and the equipment acquired, and the total market value of the livestock as of December 31 of each year from 1937 through 1941 and as of October 31, 1942, is incorporated herein by reference. In Exhibit 8-H the parties have stipulated the income and expenses in connection with the operation of the ranch from 1938 to October 31, 1942. The income and expenses therein shown for the years 1941 and 1942 were reported by petitioner in various items of its income tax returns filed for those years. Exhibit 8-H is also incorporated herein by reference. The exhibit shows that the operations of the ranch resulted in a net loss for each of the years, as follows:
+----------------+ ¦1938¦$13,863.26 ¦ +----+-----------¦ ¦1939¦13,109.82 ¦ +----+-----------¦ ¦1940¦7,800.56 ¦ +----+-----------¦ ¦1941¦14,281.65 ¦ +----+-----------¦ ¦1942¦37,722.76 ¦ +----------------+
The $14,281.65 figure for 1941 is the difference between gross income of $10,980.30 (profit from horse and cattle sales, sales of dairy and other products, increase in value of inventory, and rent paid by Riddlesbarger) and expenses of $25,269.02, plus a net loss of $16,453.74 on sales of livestock and decrease in value of inventory, as offset by a small amount of dairy and other product sales and the rental income.
The expense items incurred in the taxable years were:
+-----------------------------------------------------------------+ ¦Item ¦1941 ¦1942 ¦ +---------------------------------------------+---------+---------¦ ¦Pasture and range expense ¦$760.27 ¦$695.34 ¦ +---------------------------------------------+---------+---------¦ ¦Horse and cattle camp expense ¦5,547.91 ¦6,057.61 ¦ +---------------------------------------------+---------+---------¦ ¦Truck and automobile expense ¦2,889.44 ¦1,556.63 ¦ +---------------------------------------------+---------+---------¦ ¦Buildings and grounds expense and maintenance¦1,617.73 ¦2,079.38 ¦ +---------------------------------------------+---------+---------¦ ¦Administrative expense ¦3,160.81 ¦691.44 ¦ +---------------------------------------------+---------+---------¦ ¦Miscellaneous operating expense ¦4,667.20 ¦4,946.98 ¦ +---------------------------------------------+---------+---------¦ ¦Depreciation, buildings and equipment ¦6,618.59 ¦5,241.64 ¦ +---------------------------------------------+---------+---------¦ ¦Total ¦25,261.95¦21,269.02¦ +-----------------------------------------------------------------+
Of the above expenditures, approximately $12,000 in 1941 and approximately $9,500 in 1942 were of a personal nature, inuring primarily to the benefit of Riddlesbarger. The rentals which he paid petitioner served to reimburse it only in part for such expenditures. The net amount of petitioner's unreimbursed expenses of this personal nature was $7,800 in 1941 and $6,000 in 1942, and these do not constitute ordinary and necessary expenses of the petitioner's business.
In determining the deficiencies the respondent disallowed, and restored to income, all the net operating expenses of the ranch in the amount of $14,281.65 for 1941 and in the amount of $37,722.76 for 1942. In lieu of these claimed amounts of net expenses, petitioner is entitled to deductions of $6,481.65 for 1941 and $31,722.76 for 1942, and the net income as determined in the deficiency notice should be reduced accordingly.
Presumably because of the close relationship between the petitioner and the parent company, the respondent has determined that petitioner's basis for gain or loss on the securities in question should be their fair market value of $39,759.38 on December 31, 1937, rather than the $61,514.18 which petitioner actually paid. He cites Majestic Securities Corporation v. Commissioner, 120 Fed.(2d) 12, and New Hampshire Fire Insurance Co., 2 T.C. 708, in support of his position. The facts here present, however, are quite different from the facts in the cited cases, and they do not call for application of the rule of those cases.
The instant question would probably not have arisen had it not been for the erroneous bookkeeping entries and description of the transaction in the corporate minute books. It is well settled, however, that, where book entries are found to be at variance with the facts, decision must rest on the facts. Doyle v. Mitchell Bros. Co., 247 U.S. 179. Riddlesbarger was the dominant and controlling personality in the affairs of both the parent company and the petitioner. The directors were only salaried employees, who ordinarily followed his directions in exercising their functions. He testified that he intended to purchase the securities in the first instance for the account of the petitioner, using funds which the parent company owed the petitioner. We see no reason to disbelieve his testimony, particularly when it is supported by other evidence more or less contemporaneous with the transaction and before the taxing authorities raised any question with respect thereto.
Being away at the time the securities were delivered, Riddlesbarger gave no instructions to the bookkeeper or others with respect to recording the ownership of the securities; and the book entries did not come to his attention until some time in December 1937. The book entries of December 31, 1937, do not amount to a sale of the securities from the parent company to the petitioner at that time. They were made for the purpose of correcting the erroneous recording of the ownership of the securities at the time of their original acquisition. There is nothing in the record to suggest any purpose to shift deductions from one corporation to another closely related corporation so as to gain a tax advantage. As a matter of fact, it is stipulated that the parent company in the taxable year had taxable net income of over $38,000—more than enough to cover the entire loss on the securities.
We hold that petitioner's basis on the securities was the original cost of $61,514.18, and petitioner is accordingly entitled to the full deduction claimed.
The second issue is whether petitioner is entitled to deduct the net operating expenses of the Arizona ranch property in 1941 and 1942. In support of his disallowance of such expenses, respondent takes the position that the ranch was operated for the personal convenience or accomodation of Riddlesbarger. In our opinion that is only partially the case. The evidence convinces us that one of the purposes in the acquisition of the ranch was to obtain a source of supply for the hormone raw material, with the expectation of eventually engaging in the manufacture and sale of hormone preparations.
Petitioner had already begun research and experiments in the hormone field before the ranch was bought, and it was difficult at that time to obtain the raw material in commercial quantities. The hormone product was a logical addition to the petitioner's line of merchandise, and the endeavor to develop a source of raw material supply was a legitimate object of the petitioner's business. The investment in the better types of horses would also seem to be justifiable on the petitioner's part by reason of the fact that their offspring brought much higher prices than the ordinary types, with the resultant possibility that profits from the sale of the natural increase in the inventory of horses might help defray the operating expenses of the ranch. So, we think that whatever expenses were proximately or directly related to the hormone project should be deductible as ordinary and necessary business expenses.
It is true, of course, that the petitioner's hormone project did not meet with the anticipated success. But the failure to realize the hopes therefor is sufficiently explained by the difficulties which petitioner met in the course of the project— among them the patent complications and particularly the advent on the market of a synthetic product which was much cheaper.
On the other hand, we can not agree with the petitioner's contention that Riddlesbarger did not live on the ranch for pleasure, but only because it was necessary for someone to be there and supervise the operations. It can hardly be thought ordinary and necessary for petitioner to go to the extent it did in landscaping and in constructing imposing dwellings and other buildings, a golf course, extensive utilities, and the like, in order to develop its source of supply for hormones. We do not think other corporations having a similar business purpose, but not so subservient to the will of one man, would have made such elaborate investments to provide an overseer with sumptuous living accomodations. In the circumstances of this case, where Riddlesbarger undeniably was the dominant figure in the affairs of both the parent company and the petitioner, little if any weight should be given to the rental he paid the petitioner. Certainly the mere fact that rent was paid should not be taken here as conclusively establishing that expenditures which primarily inured to Riddlesbarger's benefit did not exceed the amount of the rental.
We have not overlooked, but we are not greatly impressed with, the testimony as to other motives of the petitioner in acquiring the ranch, such, for example, as the hope of acquiring additional adjoining land in Arizona and the development of a resort area, and the purpose of holding meetings of the petitioner's employees at the ranch; nor can we see the particular relevancy of such alleged purposes to the petitioner's ordinary business.
We are satisfied that not all of the petitioner's expenditures at the ranch in the taxable years had that proximate or direct relation to its business which would justify their deduction as ordinary and necessary expenses. But it clearly appears to us that some of the expenses incurred had a legitimate connection with petitioner's business and should be allowed.
While the state of the record is such that an exact allocation of the total expenditures as between personal and business is hardly possible, it does provide the basis for a reasonable approximation. The stipulated facts show a partial breakdown of the various items of expense incurred. They also show a partial breakdown of the total investments of petitioner in the ranch assets, from which it appears, in conjunction with other evidence of record, that the relative investment in physical assets of the kind inuring primarily to Riddlesbarger's benefit and enjoyment was larger than that in the physical assets more directly connected with the business.
As best we could in the circumstances, we have determined and set out in our findings the amounts of expenses which we consider as primarily of a personal or nonbusiness nature and, therefore, not allowable deductions as ordinary or necessary business expenses. We have likewise made findings of the amounts which we think petitioner is entitled to deduct because of their direct or proximate relation to its business. In making such determination, we have in general treated the pasture and range expense and horse and cattle camp expense as being mainly of a business nature, and the buildings and grounds expense and maintenance as largely personal. The other items of expense we have apportioned or allocated between the two categories, having in mind the relative investments of the petitioner in nonbusiness and business assets at the ranch. We have also taken account of the fact that petitioner was in part reimbursed for the nonbusiness expenses by the rentals which Riddlesbarger paid and which it took into its income; and we have accordingly made appropriate adjustments therefor, the net effect of which is to take the rentals out of the income account and equal amounts of expenses out of the expense accounts. After such adjustments, the net amounts of petitioner's unreimbursed personal or nonbusiness expenses are disallowed as deductions.
Decision will be entered under Rule 50.