Docket No. 5665–76.
Charles R. Breyer and Jeffry A. Bernstein , for the petitioner. Vernon R. Balmes and Edward B. Simpson , for the respondent.
Petitioner was a wholesale liquor dealer. In violation of State law, petitioner made sales to selected customers at posted prices with the understanding that such customers would be entitled to credit to be used for the purchase of additional liquors, or to an additional bottle for each case purchased. When deliveries were made of the additional liquors, the cost thereof was charged to the cost of sales and deducted in arriving at petitioner's gross income: Held, the cost of such additional liquors is deductible from gross income as part of the cost of goods sold and is not, therefore, a deduction which may be disallowed under sec. 162(c)(2). Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956), followed. Charles R. Breyer and Jeffry A. Bernstein, for the petitioner. Vernon R. Balmes and Edward B. Simpson, for the respondent. QUEALY, Judge:
This proceeding involves the redetermination of deficiencies in income taxes of petitioner as follows:
+------------------------------+ ¦FYE Jan. 31— ¦Deficiency ¦ +-----------------+------------¦ ¦ ¦ ¦ +-----------------+------------¦ ¦1973 ¦$72,468 ¦ +-----------------+------------¦ ¦1974 ¦59,487 ¦ +-----------------+------------¦ ¦1975 ¦42,410 ¦ +------------------------------+
As a result of concessions by the parties, the sole question for decision is whether the petitioner is precluded from charging as a cost or deducting under section 162(c)(2) the cost of liquor and wine transferred to selected customers in violation of the laws of the State of California.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
Max Sobel Wholesale Liquors (hereinafter referred to as petitioner) is a California corporation with its principal place of business in San Francisco, Calif. At all times material herein, petitioner was engaged in the distribution and sale, at wholesale, of liquor, wine, and other alcoholic beverages in and around the Bay area of San Francisco. Its Federal income tax returns for the fiscal years ended January 31, 1973 to 1975, inclusive, were filed with the Internal Revenue Service, Fresno, Calif.
The petitioner's books and records were maintained on the accrual basis of accounting, and petitioner reported its income for Federal income tax purposes on that basis. In computing its costs of sales, purchases of liquor and wine were carried in inventory at petitioner's cost. Delivery of liquor and wine to its customers were made out of such inventory, thereby reflecting the cost of such deliveries as a part of the cost of sales.
The business of distributing and selling liquor at wholesale was regulated under California law. The enforcement of such laws was delegated to the Department of Alcoholic Beverage Control of the State of California (hereinafter referred to as ABC). Section 24756 of the California Business & Professions Code (West 1964), in force during the years involved in this proceeding, provided as follows:
Price lists; filing; contents; compliance. Every distilled spirits manufacturer, brandy manufacturer, rectifier, and wholesaler shall file and maintain with the department a price list showing the prices at which distilled spirits are sold to retailers by the licensee. Sales of distilled spirits to retailers by each distilled spirits manufacturer, brandy manufacturer, rectifier, and wholesaler shall be made in compliance with the price list of the licensee on file with the department. Section 24862 of the California Business & Professions Code provides for a similar procedure with respect to wine manufacturers and wholesalers.
As a wholesaler of liquor and wine, the petitioner was required to file or to post each month the selling prices for the liquor and wine to be sold by it in accordance with sections 24756 and 24862 of the California Business & Professions Code. Such price list became effective for sales made during the ensuing month. The prices posted by petitioner and its competitors, in most cases, were determined in the first instance by the producers or importers of such spirits. The producers or importers of liquor and wine supplied ‘suggested’ monthly price lists to the petitioner in order that such prices might be posted with the ABC. If the petitioner did not conform to the suggested prices, there was a risk that the supplier would terminate petitioner's right to distribute the brands of liquor and wine which the petitioner obtained from that source.
During the period involved in this proceeding, the petitioner evolved a procedure whereby certain selected customers might purchase liquor and wine from the petitioner on a basis more favorable than the selling prices for such liquor and wine posted by the petitioner with the ABC. An agreement was entered into with such customers pursuant to which, with each purchase of liquor or wine, the customer would be entitled to a credit of a stated percent of the total purchase, which amount would be available to be used by such customer in the purchase of additional quantities of liquor or wine. In other instances, the agreement provided that with the purchase of a case of certain liquors or wines, the purchaser would be entitled to receive an additional bottle of that liquor or wine.
The petitioner maintained a ‘black book’ setting forth the name of the customer, the purchases by such customer, and the credit to which the customer was entitled. Periodically, such credits would be availed of by the customer to purchase additional liquor or wine or the customer would be supplied with the additional bottles to which the customer became entitled under the agreement of purchase.
When the petitioner received a regular order from its customers, the order was filled and delivered by the petitioner out of inventory. As a part of petitioner's accounting and billing system, a sales invoice was prepared with respect to each sales transaction which listed thereon the brand and quantity of the spirits sold and the sales price, along with any posted discount. The billing price for liquor and wine listed on such sales invoice conformed to the prices posted with the ABC as required by California law.
When the petitioner received an order for use of the ‘credit’ from one of the selected customers to whom the petitioner had agreed to give such credit, a document was prepared identifying the retailer, the type of spirits, brand name, quantity, and amount. A copy of this document, referred to as a ‘drop tag,’ was transmitted to the employee in charge of maintaining the inventory records in order that he might remove the designated quantity from inventory. Another copy of the ‘drop tag’ was sent to the warehouse in order that the goods would be released for pickup by the retailer or for delivery. The additional goods supplied to the customer were thus removed from inventory and automatically charged as a part of the cost of sales. The credits and deliveries made on account thereof were recorded in the ‘black book’ but did not otherwise appear in the petitioner's accounting records.
The practice whereby the petitioner gave rebates, credits, or additional merchandise to selected customers, without reflecting such in the prices posted by petitioner with the ABC, was in violation of the laws of the State of California.
An ‘Accusation’ was filed by the State of California against the petitioner alleging violations of sections 24756, 24862, 25503(b), 25503(d), 25503(e), and 25600 of the California Business & Professions Code. The dates of particular violations for which petitioner is cited in the ‘Accusation’ are—on or about—March 28, 1972; April 24, 1972; July 13, 1972; January 5, 9, 1973; March 8, 15, 23, 1973; and April 3, 1975. Petitioner stipulated to having violated California law. As a result of such stipulation, petitioner's license to do business was suspended for 15 days.
During the fiscal year ended January 31, 1973, petitioner delivered to the selected customers at no additional charge, in satisfaction of the credits recorded in the ‘black book,’ liquor and wine from its inventory having a cost to petitioner in the amount of $121,218. During the fiscal year ended January 31, 1974, similar deliveries were made out of inventory having a cost to petitioner of $13,757. The practice was discontinued in April 1973 due to a Federal grand jury investigation.
In his notice of deficiency, respondent increased petitioner's income as reported for the years ending January 31, 1973 and 1974, in the amounts of $121,218 and $13,757, on account of the additional spirits charged to the cost of goods sold.
The petitioner was a wholesale liquor dealer in the San Francisco Bay area. Under California law, the business was subject to regulation by the Alcoholic Beverage Control Board. Petitioner was required to file monthly price lists with the ABC and was prohibited from selling below the posted prices. The prices at which the petitioner was supposed to sell spirits were ‘suggested’ by its suppliers. If the petitioner posted prices different from those suggested by the suppliers, petitioner ran the risk of having its distributorship terminated by the supplier.
Notwithstanding the posted prices, wholesale liquor dealers in the San Francisco Bay area offered credits, discounts, or rebates to selected customers in order to keep their business. In the case of the petitioner, selected customers were advised that the purchase of stated quantities of designated brands of spirits would entitle the purchaser to a credit, either stated in dollars or in kind, whereby the purchaser could acquire additional spirits up to the amount credited in a secret account maintained for each of such purchasers. The practice constituted a violation of the California law regulating the pricing of alcoholic beverages and could be interpreted as a violation of Federal law prohibiting the distribution of ‘free goods' as an inducement to the sale of such beverages.
Sales of spirits were reflected on the books of the petitioner at invoice prices in conformity with the schedule of prices filed with the ABC. The additional spirits which the customers obtained by credits earned on such purchases were delivered out of inventory and the cost thereof was automatically reflected in the cost of sales. While respondent seeks to distinguish between the granting of a rebate payable in merchandise and a rebate payable in cash, the result is the same. In fact, the case of one of petitioner's competitors who granted cash rebates ‘under the table’ is also before this Court. The basic question is whether such rebates, regardless of form, come within the scope of section 162(c).
Insofar as applicable hereto, section 162(c) provides:
(c) ILLEGAL BRIBES, KICKBACKS, AND OTHER PAYMENTS.
* * *
(2) OTHER ILLEGAL PAYMENTS.—No deduction shall be allowed under subsection (a) for any payment (other than a payment described in paragraph (1)) made, directly or indirectly, to any person, if the payment constitutes an illegal bribe, illegal kickback, or other illegal payment under any law of the United States, or under any law of a State (but only if such State law is generally enforced), which subjects the payor to a criminal penalty or the loss of license or privilege to engage in a trade or business. For purposes of this paragraph, a kickback includes a payment in consideration of the referral of a client, patient, or customer. The burden of proof in respect of the issue, for purposes of this paragraph, as to whether a payment constitutes an illegal bribe, illegal kickback, or other illegal payment shall be upon the Secretary to the same extent as he bears the burden of proof under section 7454 (concerning the burden of proof when the issue relates to fraud).
Section 162(c)(2) thus denies the deduction of certain payments, which might otherwise be deductible under section 162(a), on account of the illegality of such payments. The Court must first decide whether the agreement between petitioner and its selected customers, whereby the stated invoice price of the spirits was subject to a credit for the purchase of additional merchandise, constituted an ‘illegal bribe, illegal kickback, or other illegal payment’ otherwise deductible under section 162(a).
The practice of illegally rebating did not originate with these San Francisco wholesale liquor dealers. This practice first came before the Tax Court in the case of rebates granted contrary to State law in the sale of milk. Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956). The Pittsburgh Milk case was then invoked by the respondent to deny to the taxpayer, an Illinois liquor dealer, an adjustment in computing the World War II excess profit tax credit for an abnormal deduction for illegal rebates to its customers. Tri-State Beverage Distributors, Inc. v. Commissioner, 27 T.C. 1026 (1957).
In the Pittsburgh Milk case (and the cases which followed that decision), this Court distinguished between a discount or rebate to which the customers became entitled at the time of sale and costs incurred in the form of illegal payments, or payments to the third parties, which were not made pursuant to agreement between the buyer and the seller. Where the rebate was a part of the transaction of sale, this Court held that the deductibility of such payment was not the question. The rebate was a reduction in gross income. This principle was reaffirmed in Atzingen-Whitehouse Dairy, Inc. v. Commissioner, 36 T.C. 173 (1961), wherein this Court said:
RAUM, Judge: (1) We have concluded on the evidence that the actual prices at which petitioner sold its products were the invoice prices minus the discounts agreed upon between petitioner and its customers. Accordingly, the problem before us is not whether such discounts are deductible as ‘ordinary and necessary’ business expenses from gross income in arriving at net income, cf. Tank Truck Rentals v. Commissioner, 356 U.S. 30; rather it is whether the discounts must be taken into account in determining the amount of gross income chargeable to petitioner in the first instance. Cf. Lela Sullenger, 11 T.C. 1076 acq. 1952–2 C.B. 3. We hold, following Pittsburgh Milk Co., 26 T.C. 707, which involved a virtually identical situation, that in computing gross income the amount of petitioner's sales must be based upon its actual prices and not upon the theoretical legal minimum prices. The present case is closer to the Pittsburgh Milk Co. case than to Boyle, Flagg & Seaman, Inc., 25 T.C. 43, relied upon by respondent.
Respondent urges that the decision in the Pittsburgh Milk Co. case be reconsidered. He made a similar contention in two other cases, in which the holding in the Pittsburgh Milk Co. case was reaffirmed and followed in memorandum opinions by this Court. Moreover, the theory of the Pittsburgh Milk Co. case has been applied, at the respondent's urging, in Tri-State Beverage Distributors, Inc., 27 T.C. 1026, 1030–1031. We are not disposed to reopen the question. [Fn. ref. omitted]