Docket Nos. 2703 2780.
F. L. Van Haaften, Esq., for the respondent. W. H. Albritton, Esq., and R. B. Albritton, Esq., for the petitioners.
Partnership between petitioners and their children for carrying on a manufacturing business not recognized for Federal income tax purposes where the capital contributions of the children originated with the petitioners, the children took no part in the management or control of the business, and the services performed by them were not of vital importance. F. L. Van Haaften, Esq., for the respondent. W. H. Albritton, Esq., and R. B. Albritton, Esq., for the petitioners.
The Commissioner determined deficiencies in income tax for 1940 of $4,498.75 against John G. Scherf and $4,125 against George H. Barnes and Ada E. Barnes. The sole issue presented is whether, for Federal income tax purposes, recognition should be accorded a partnership consisting of petitioner John G. Scherf and his two sons and petitioner George H. Barnes and his two daughters. The proceedings were consolidated.
FINDINGS OF FACT.
In 1940 and at all times material hereto the petitioners, John G. Scherf and George H. Barnes and his wife Ada E. Barnes, were residents of Andalusia, Alabama. John G. Scherf filed a separate return and George H. Barnes and his wife filed a joint return for the year 1940. The returns were filed with the collector for the district of Alabama.
Petitioners John G. Scherf and George H. Barnes were partners engaged in the manufacture and sale of work plants at Andalusia, Alabama, under the firm name of S & B Manufacturing Co. The partnership was formed in November 1938 and they each owned a one-half interest therein. At the beginning of 1940 they were operating factories at Andalusia and Brantley, Alabama, in buildings occupied under lease, and they employed about 200 workers, including machine operators, examiners, pressers, and foremen. Scherf ran the office and looked after the financial matters and Barnes operated the factories. Scherf and Barnes also were officers and stockholders of the Andala Co. and the Alabama Textile Products Co., Scherf and Barnes being vice presidents of the Andala Co. and Scherf being president of the Alabama Textile Products Co., in which he also owned a controlling interest. The former manufactured work shirts and the latter dress shirts and underwear. These two companies, and the Southern Textile Commission Co., a partnership composed of Scherf and Barnes which acted as selling agent for the Alabama Textile Products Co., occupied a single office in Andalusia, together with the S & B Manufacturing Co., and the office work of all 4 organizations was performed by one set of bookkeepers and office employees.
The S & B Manufacturing Co. had assets at the close of the year 1939 of the total amount of $47,163.15, and its net worth as shown by its balance sheet was $32,321.30. The assets included about $25,000 worth of machinery and equipment and $20,000 of cash accounts receivable.
John G. Scherf had two sons, Paul W. Scherf and John G. Scherf, Jr. In the latter part of 1939 he proposed to Barnes that they be taken into the S & B Manufacturing Co. as partners. Barnes stated that he would also like to bring his daughters, Mildred E. Barnes and Ruth E. Barnes, into the business. They agreed that all this should be done and instructed their attorney to prepare papers necessary to effect the change as of January 1, 1940. Due to other engagements, the attorney was unable to prepare the papers until May 16, 1940.
On May 16, 1940, Scherf and Barnes executed instruments of assignment transferring to their respective children a one-sixth interest each in the business and assets of the S & B Manufacturing Co. The assignment to Paul, which is identical with that to each of the others except as to the assignee and assignor, reads as follows:
IN CONSIDERATION of love and affection the undersigned J. G. Scherf, owner of an undivided one-half (1/2) interest in the partnership business and assets of S & B Manufacturing Company, a partnership composed of J. G. Scherf and George H. Barnes, does hereby give, assign, transfer and convey unto Paul W. Scherf as a gift, an undivided one-sixth (1/6) interest in the business of said partnership * * * , including all the stock, raw material and finished products, machinery, equipment, fixtures, accounts and all other assets of said partnership of every nature and kind whatsoever, including the leasehold interest on the premises in which said business is now conducted.
On May 16, 1940, Scherf and Barnes and Paul W. Scherf signed an agreement of partnership, and John G. Scherf, Jr. Mildred E. Barnes, and Ruth E. Barnes signed it shortly thereafter. The pertinent provisions of the agreement are as follows:
AGREEMENT made this 1st day of January, 1940, at Andalusia, Alabama, between J. G. SCHERF, GEORGE H. BARNES, JOHN G. SCHERF, JR., MILDRED E. BARNES, PAUL W. SCHERF and RUTH E. BARNES, all of Andalusia, Alabama.
WHEREAS, by an agreement dated the 3rd day of February, 1939, J. G. Scherf and George H. Barnes became partners in the business of manufacturing pants, play suits, shirts, underwear and other apparel of whatsoever kind or character, for the term of ten years, and have continued to be partners from the day of the date of said agreement to the present time, each of said partners owning an undivided one-half (1/2) interest in said partnership business, and
WHEREAS, J. G. Scherf has conveyed an undivided one-sixth (1/6) interest in and to said partnership business and assets to the undersigned John G. Scherf, Jr., and also an undivided one-sixth (1/6) interest to the undersigned Paul W. Scherf, and George H. Barnes has conveyed an undivided one-sixth (1/6) interest each to the undersigned Mildred E. Barnes and Ruth E. Barnes, and
WHEREAS, the parties have agreed to continue the operation of the partnership business and be and become partners therein.
NOW, THEREFORE, in consideration of the mutual covenants and agreement herein contained and in consideration of the premises the parties hereto do make this partnership agreement on the following terms and conditions, viz:
1. The partnership shall be for the purpose of carrying on the business of manufacturing and selling, of factoring the manufacture and sale of pants, play suit, shirts, underwear, and other apparel and textile products of whatsoever kind or character.
2. The partnership shall continue until dissolved by mutual agreement.
3. Said partnership shall be conducted and carried on under the partnership name, style and firm of ‘S & B Manufacturing Company.‘
4. The place of business of said partnership shall be in the City of Andalusia, in Covington County, Alabama, or at such other place or places as the partners shall hereafter determine.
5. The capital of said partnership shall consist of the net capital account and assets of said partnership of J. G. Scherf and George H. Barnes doing business under the name of S & B Manufacturing Company as of December 30, 1939 and in the amount of Thirty Two Thousand Three Hundred Twenty One and 30/100 ($32,321.30) Dollars, said capital account and assets being made up of cash, machinery and equipment and other property, supplies, etc., provided, however, the items composing said net capital account may be changed or altered in varying proportions as may be deemed advisable so long as the aggregate amount shall remain the sum of Thirty Two Thousand Three Hundred Twenty One and 30/100 ($32,321.30) Dollars.
6. It is agreed that each partner shall share equally in all the profits and losses that may arise out of or occur in the prosecution of the said partnership operations from and after January 1, 1940, subject only to the limitations herein contained. None of the partners shall be entitled to draw any compensation or any part of the profits or principal of said business so long as the partnership is indebted to any corporation other than a bank, in which either of the partners is a stockholder. In the event the partnership is not indebted to any such corporation, then upon the first day of each year hereafter, if the books of the said partnership disclose a balance of funds over and above all outstanding claims and charges, the accrued profits of said business as shall appear by the books shall be equally divided between the said parties and withdrawn from said business, leaving however, the original capital intact; or, such accrued profits or any portions thereof may be added to the original capital by agreement between the parties.
7. J. G. Scherf and George H. Barnes shall be the managing partners and the other parties hereto shall be investing partners. Said J. G. Scherf and George H. Barnes shall diligently employ themselves in the business of the said partnership and be faithful to all parties hereto in all transactions relating to the firm and give, whenever required, a true account of all business transactions arising out of or connected with the operation of the partnership business. None of the partners shall at any time, without the written consent of the other partners, employ either the capital or the credit of the partnership in any manner other than in the regular conduct and operation of the partnership business.
8. J. G. Scherf shall have charge of the office, shall see that the books of the partnership are properly kept, shall have exclusive charge of all the financial details of the partnership, including the receiving and collecting of all monies due the partnership and the payments due from said partnership to others, whether in the general conduct of said business or otherwise, with full and complete rights and powers to borrow such money or funds and at such times as may be needed for use in operation and conduct of the partnership business and evidence said loans by executing promissory notes for and in the name of the partnership and secure said notes and loans by mortgages on any or all of the partnership property, said notes and mortgages to be binding on the partnership and partnership property without the signatures of the other partners. George H. Barnes shall have the actual outside work and management of the business and shall be the general manager in all things that pertain to the manufacture, production and general operation of the manufacturing plant.
In March 1941 Scherf and Barnes filed gift tax returns covering the assignments of an undivided one-sixth interest in the business to each of the four children. The one-sixth interests were valued at $7,635.64 each in those returns, which value was computed on the basis of the net capital account of $32,321.30 as of January 1, 1940, plus the net income of the business from that date up to May 16, 1940. Paul Scherf and John G. Scherf each filed a donee's information return of the gifts covered by the assignments to them.
In assigning the undivided interests in the assets of the S & B Manufacturing Co. to their children Scherf and Barnes intended that the assets should remain in the business, and the children so understood when they received the assignments. The children made no contribution of capital to the business other than that of their respective interests in the assets which they acquired from their fathers.
Prior to the assignments and the formation of the partnership, the Scherf and Barnes children were not employed by, nor did they render any service to, the partnership. When the partnership agreement was signed Paul W. Scherf was 28 years of age and married; John G. Scherf, Jr., and Mildred E. Barnes were each 20 years of age and were attending college outside of Andalusia; and Ruth E. Barnes was 18 years of age and attending a preparatory school. Paul W. Scherf was working for the Alabama Textile Products Co. at a salary.
After the partnership was formed, the business was continued in the same manner as before, and Scherf continued to manage the office and financial affairs and Barnes continued to supervise the operation of the factories. Scherf was the only member authorized to draw checks against the partnership funds, except that one of the clerks in the office had authority to draw checks to pay ordinary business expenses. Paul W. Scherf continued in the employ of the Alabama Textile Products Co. throughout 1940 and received a salary of $3,400 from it for that year. He knew nothing about the manufacturing operations of the S & B Manufacturing Co. and up to the latter part of the year 1940 his activities were limited to learning about the business and keeping some personnel files. There is no evidence that he took an active part in the manufacturing operations of the S & B Manufacturing Co. during 1940 or that he devoted much of his time thereto. His activities in 1941 and subsequent years were directed to keeping personnel records and doing welfare work for employees. He also after 1940 supervised the keeping of production records and operated a ‘suggestions‘ system for employees.
John G. Scherf, Jr., left college in September 1940 and began to work in the office of the four companies. He was employed by the Alabama Textile Products Co. and received a salary from it of $312.97 during 1940. He learned to operate a billing machine and did some billing for S & B Manufacturing Co. in 1940. Mildred and Ruth Barnes remained in school until 1943. They did some clerical work in the office during the summer vacation of 1940.
The net income of the S & B Manufacturing Co. for the year 1940 was $36,213.42. On the partnership income tax return for 1940 one-sixth of that amount, or $6,035.57, was allocated to each of the six partners.
The following statement was attached to the partnership return:
A partnership under this trade name was originally organized November 8, 1938. J. G. Scherf and George H. Barnes were the partners. A new partnership was subsequently formed, effective between the partners as of January 1, 1940, with J. G. Scherf, John G. Scherf, Jr., Paul W. Scherf, George H. Barnes, Mildred E. Barnes and Ruth E. Barnes as partners. However, the actual conveyance of property interest and execution of new partnership agreement was not completed until May 16, 1940. Since the partnership business was to continue, effective between the partners as of January 1, 1940, the books of the partnership were not closed and this return shows operation for entire year. However, for tax purposes allocations have been made to old partnership and new partnership and will be reported in returns of individual partners, as follows:
+--------------------------------------------------------------------+ ¦Total net income ¦ ¦ ¦$36,213.42¦ +------------------------------------+---------+----------+----------¦ ¦136/365 allocated to old partnership¦ ¦$13,492.56¦ ¦ +------------------------------------+---------+----------+----------¦ ¦J.G. Scherf ¦$6,746.28¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦G.H. Barnes ¦6,746.28 ¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦229/365 allocated to new partnership¦ ¦22,720.86 ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦J.G. Scherf ¦3,786.81 ¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦John G. Scherf ¦3,786.81 ¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦Paul W. Scherf ¦3,786.81 ¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦G.H. Barnes ¦3,786.81 ¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦Mildred E. Barnes ¦3,786.81 ¦ ¦ ¦ +------------------------------------+---------+----------+----------¦ ¦Ruth E. Barnes ¦3,786.81 ¦ ¦ ¦ +--------------------------------------------------------------------+
On their several income tax returns the petitioners and their children reported income from the partnership in accordance with the allocation set out in the statement attached to the partnership return and paid taxes thereon.
The books of the partnership of Scherf and Barnes were not closed when the new partnership was formed on May 16, 1940, but were continued in use. Each of the six members of the new partnership withdrew $2,467.76 during 1940. Mildred and Ruth Barnes each withdrew $200 in July 1940, $800 in September 1940, and $1,467.67 on December 14, 1940. The other members each withdrew $2,467.67 on December 14, 1940. Capital accounts were set up on the books for each of the four children at the time when each made his or her first withdrawals. In closing the partnership books for 1940, in January 1941, an accountant credited the capital accounts of each of the children as of January 1, 1940, with one-sixth of the net worth of the old partnership, or $5,386.88, and credited each of the partners with one-sixth of the 1940 net income of the partnership of $36,213.42, or $6,035.57.
After the books had been closed and the partnership tax return had been prepared with the memorandum allocating the income for tax purposes, the bookkeeper adjusted the credits to the capital accounts by debiting the accounts of Paul W. Scherf and John G. Scherf, Jr., in the amount of $2,248.16 each and crediting the account of John G. Scherf in the amount of $4,497.52; and by making identical debits and credits in the accounts of Mildred and Ruth Barnes and George H. Barnes. The amount of $4,497.52 so credited to John G. Scherf and George H. Barnes is the difference between their distributive shares of $6,035.57 (appearing on the partnership income tax return) and the $10,533.09 allocated to each of them in the memorandum attached to the partnership return, set forth above. Later, upon learning that these adjustments were erroneous, the bookkeeper made correcting entries, debiting the accounts of Paul W. Scherf, John G. Scherf, Jr., Mildred E. Barnes, and Ruth E. Barnes in the amount of $2,248.76 each, and crediting the accounts of John G. Scherf and George H. Barnes in the amount of $4,497.52 each.
During 1941, 1942, and 1943 the capital accounts of each of the six parties to the partnership agreement dated January 1, 1940, were credited with one-sixth of the profits. Each of the parties withdrew the same amount of cash in each of those years, and the net credit balance in each of the capital accounts as of October 1, 1944, was $16,141.49.
In determining the deficiencies, the respondent held that petitioners John G. Scherf and George H. Barnes were each taxable on the amount of $18,106.71, representing one-half of the 1940 net income of the business of the S & B Manufacturing Co. and he increased the net income of $10,533.09 reported by each of them by the amount of $7,573.62.
The sole issue presented is whether all of the 1940 net income of the S & B Manufacturing Co. is taxable to petitioners John G. Scherf and George H. Barnes, as partners each having a one-half interest in the business, or whether the partnership formed by them and Paul W. Scherf, John G. Scherf, Jr., Mildred E. Barnes, and Ruth E. Barnes on May 16, 1940, should be recognized so that, with respect to as much of the 1940 net income as is allocable to the period May 16 to December 31, 1940, the petitioners are each taxable only on one-sixth thereof.
In cases like the present one we are not concerned with whether the Scherf and Barnes children were the legal owners under the laws of Alabama of a one-sixth interest each in the capital of the business, for the issue for Federal income tax purposes is, Who earned the income? The answer to that question depends upon whether the petitioners and their children really intended to carry on business as a partnership. Commissioner v. Tower, 327 U.S. 280. Where a husband and his wife, or a husband and his wife and children, have entered into a partnership arrangement and it appears from the facts that the wife and children made no investment of capital originating with them, that they have no voice in the management or control of the business, and that they contribute no vital services, those circumstances will justify this Court in concluding that a real partnership between them and the husband and father does not exist in so far as the Federal income tax law is concerned. Commissioner v. Tower, supra; Lusthaus v. Commissioner, 327 U.S. 293; Ed. Dubinsky Durwood, 6 T.C. 682; Floyd D. Akers, 6 T.C. 693; Abe Schreiber, 6 T.C. 707; Lewis Coleman Benson, 6 T.C. 748; John Lang, 7 T.C. 6; and W. A. Belcher, 7 T.C. 182.
The evidence shows quite plainly that the children contributed no capital originating with them and contributed nothing to the management or control of the business. Their investment in the business was the one-sixth undivided interest in the assets which they each received from their respective fathers by way of gift contemporaneously with the formation of the partnership. The partnership agreement excluded the children from any voice in the management of the business. It provided that Scherf and Barnes should be managing partners and the children should be investing partners, and it gave Scherf complete control of the office and financial matters, while it placed Barnes in charge of all things pertaining to the manufacture of goods and the operation of the factories; and Scherf and Barnes testified that, in the separate spheres thus allotted to them, they exercised the powers of management exclusively. Nor does the evidence disclose any services by the children which can be said to be ‘vital‘ to the business. John G. Scherf, Jr., and the Barnes girls were inexperienced minors and devoted a small part of their time to the performance for the S & B Manufacturing Co. of simple clerical service. Paul W. Scherf received a substantial salary from the Alabama Textile Products Co. in 1940, and what little time he devoted to the S & B Manufacturing Co. was utilized in learning about the business. In our opinion he was not an active partner in 1940. His services were negligible in so far as they tended to produce income. It is true that he became more active in 1941 and later years, but the evidence indicates that those activities were along the line of welfare work among the employees. As to all four children, we think their services contributed little, if anything, to the earning of the income.
We conclude that in 1940 there was no real partnership between the petitioners and their children for Federal income tax purposes, and, upon the authority of the cases cited above, we hold that the respondent did not err in taxing the petitioners on their respective one-half shares in the net income of the S & B Manufacturing Co.
Decision will be entered for the respondent.