Wooster Rubber Co. v. Commissioner

The Wooster Rubber Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Wooster Rubber Co. v. Commissioner Docket No. 21767 United States Tax Court 14 T.C. 1192; 1950 U.S. Tax Ct. LEXIS 166; June 20, 1950, Promulgated *166 Decision will be entered for the respondent. Where petitioner made payments to a profit-sharing plan which had been approved as an exempt trust under section 165 (a), and the contributions were in excess of the amounts required to be contributed by the terms of the plan, held, only the payments required by the terms of the plan may be deducted under section 23 (p) (1) (C), Internal Revenue Code. F. E. Gleach, Esq., and Robert Critchfield, Esq., for the petitioner. William R. Bagby, Esq., for the respondent. Harron, Judge. HARRON *1193 The Commissioner determined a deficiency in income tax for the fiscal year ended September 30, 1944, in the amount of $ 18.37, and deficiencies in petitioner's excess profits tax for the fiscal years ended on September 30, 1944 and 1945, in the amounts of $ 19,201.96 and $ 21,117.62, respectively. The issue to be decided is whether the entire amounts of contributions made by petitioner during the fiscal years involved to a profit-sharing plan approved by the Commissioner under section 165 (a) of the Internal Revenue Code are deductible under section 23 (p); or whether the deductions are limited to the amounts actually required to be contributed under the terms of the plan. The amounts of the annual contributions required by the plan are also in dispute. Petitioner does not contest several adjustments*168 which increase its net income for both of the taxable years. Petitioner filed its returns for the taxable years with the collector for the eighteenth district of Ohio. The record in this proceeding consists of a stipulation of facts, testimony, and various exhibits, from which we make the following findings of fact. FINDINGS OF FACT. The stipulated facts are found as stipulated, and the stipulation is incorporated herein by this reference. Petitioner is a corporation, organized under the laws of Ohio, with its principal place of business at Wooster, Ohio. It is engaged in the manufacture of molded rubber products and rubber household ware. Petitioner keeps its books and makes its returns on the accrual basis of accounting. Its fiscal year ends on the thirtieth of September. On September 28, 1944, the board of directors of petitioner, by a duly adopted resolution, created a profit-sharing plan called "The Wooster Rubber Company Profit Sharing Plan," and authorized its officers to execute an agreement and declaration of trust and any other instruments necessary to place the plan in effect. Petitioner and the National City Bank of Cleveland, on September 30, 1944, executed the agreement*169 and declaration of trust which established the plan. The agreement and declaration of trust, in so far as here material, is as follows: Article II The Plan * * * * Section (4) -- Contributions to Plan -- Employee Shares -- (a) Each year on, or within sixty (60) days after, each anniversary date, (including the initial anniversary date), the Company will contribute to the Trustee hereunder for the purposes of this Plan and Trust a sum *1194 (1) Equal to fifteen (15%) per cent of the compensation otherwise paid or accrued during the Company's fiscal year to the Participants and employees eligible to become Participants as of the anniversary date of the contribution. (2) In no event, however, shall the amount of the annual contribution by the Company a. be in excess of the amount allowable as a deduction from the gross income of the Company under Section 23 (p) of the Internal Revenue Code, or other applicable statute; or b. be in such an amount as to result in disqualifying this Trust (or in its not qualifying) under Section 165 (a) of the Internal Revenue Code; or c. be in such amount as to constitute a violation of any law or regulation now or hereafter in *170 force; or d. be in such an amount as to reduce by more than twenty-five (25%) per cent the net profits (as defined under sub-Paragraph (d) of Section (4) of this Article II) after deducting therefrom an annual dividend commitment equal to six (6%) per cent per share on the preferred stock, and Six ($ 6.00) Dollars per share on the common stock outstanding as of the beginning of the last taxable year prior to the anniversary date as to which the contribution is to be made. * * * * (c) The words "basic compensation" as used in this Agreement shall be the actual earnings of each Participant for the fiscal year ending as of the particular anniversary date, including the earnings for a forty-eight (48) hour week but excluding the over-time premium, commissions, bonuses, and other like additions to earnings. (d) For the purposes of this Agreement, the words "net profits" shall mean the net earnings of the Company for each fiscal year ending September 30, as determined by the Company's independent accountants. "Net earnings" shall be determined by said accountants on an accrual basis by deducting from the Company's gross earnings all current operating expenses, insurance, all state and local*171 taxes and assessments, all Federal Taxes (including income, excess profits, declared value excess profits, and taxes on undistributed earnings, if any, and any Federal taxes levied or measured by income, now in effect or hereafter enacted), current repairs and maintenance, depreciation, inventory losses, together with such items as in a similar line of business and in accordance with proper accounting practice would be charged to expenses; provided, however, that for the purposes of determining the amount of the contribution to this Trust for any year, the amount of the contribution itself for such year shall not be included among the expenses. (e) In the event that through error in computing the said net profits after taxes for any year, the amount contributed to this Trust in such year shall upon later final computation be found to exceed the limitation set out in Paragraph d of Paragraph (a) (2) of this Section (4), the Trustee shall promptly refund to the Company the amount of such excess. (f) If any part, or all, of the contributions made by the Company under this Trust for any year should be disallowed by the Bureau of Internal Revenue as deductions in computing the Federal *172 income or excess profits and other similar Federal income taxes of the Company, then, and to the extent that such contributions shall be so disallowed, the same, or the securities or property in which said contributions shall have been invested by the Trustee, shall be repaid or distributed, as the case may be, to the Company by the Trustee upon the written request of the President of the Company accompanied by evidence of such disallowance. The Trustee shall be fully protected in relying upon a copy of a letter or report from the Bureau of Internal Revenue of the Treasury Department of the United States advising of such disallowance. * * * * *1195 Section (5) -- Distributions Under the Plan -- * * * * (c) On Termination of Employment: If a Participant shall cease to be an employee of the Company otherwise than by reason of death or retirement, he shall thereupon cease to be a Participant. If any such employee shall have been a Participant under this Plan for at least five (5) full years prior to the date he leaves the employment of the Company as above provided, the Trustee shall set aside an amount equal to twenty-five (25%) per cent of such former Participant's*173 beneficial interest in the Trust determined as provided by Section (2) of Article III hereof. For each additional full year such Participant was under the Plan, an additional five (5%) per cent shall be set aside for him up to one hundred (100%) per cent, which percentage shall be the maximum. * * * * Prior to December 29, 1944, petitioner's original profit-sharing plan was submitted to the Bureau of Internal Revenue for approval. Thereupon, a conference was held, attended by petitioner's attorney who had prepared the original plan and by representatives of the Bureau. At that conference the Bureau's representatives submitted to petitioner's attorney certain proposed changes and amendments to the plan and required that such changes and amendments be made as a prerequisite to the Bureau's approval. On December 29, 1944, the board of directors of petitioner, by resolution, amended the agreement and declaration of trust. The material amendments were as follows: Article II. * * * * Section (4) (a) (1) -- Amended by substituting a comma for the period now appearing and adding thereto the following: "less the amount of forfeitures occurring [sic] since the last*174 anniversary date by reason of terminations of employment." Section (4) (a) (2)-a -- Amended by striking in its entirety. Section (4) (d) -- Amended by striking and substituting in lieu thereof the following: "For the purposes of this Agreement, the words 'net profits' shall mean the net earnings of the Company for each fiscal year ending September 30 as determined by the Company's independent accountants. 'Net earnings' shall be determined by said accountants on an accrual basis by deducting from the Company's gross earnings all current operating expenses, insurance, all state and local taxes and assessments, all Federal taxes (including the amount shown on the original income tax return for the year in question of all income, excess profits, declared value excess profits, and taxes on undistributed earnings, if any, and any Federal taxes levied or measured by income not in effect or hereafter enacted), current repairs and maintenance, interest, depreciation and amortization, inventory losses, and other losses sustained during such fiscal year, together with such items as in a similar line of business and in accordance with proper accounting practice*175 would be charged to expense; provided, however, that gains realized upon the disposition of any property other than the stock in trade of the Company, or property held by the Company primarily for sale to customers in the ordinary course of its business, shall not be included in the gross earnings of the Company for such fiscal year; and, provided further, that for the purposes *1196 of determining the amount of the contribution to this Trust for any year, the amount of the contribution itself for such year shall not be included among the expenses, but the amount of the contribution to the Pension Trust Plan shall be included among the expenses." Section (4) (f) -- Amended by striking in its entirety. Under the resolution of the board of directors the amendments were made retroactive to September 30, 1944. The agreement and declaration of trust, as amended, was submitted to the Bureau of Internal Revenue for approval on December 30, 1944. On or about March 1, 1945, petitioner's profit-sharing plan was approved by the Commissioner of Internal Revenue as an exempt trust under the provisions of section 165 (a) of the Internal Revenue Code. On May 28, 1945, the board*176 of directors, by resolution, amended the agreement and declaration of trust. The material amendment was as follows: The first paragraph of Article II, section (5) (c) is hereby amended to read as follows: "(c) On Termination of Employment: If a Participant shall cease to be an employee of the Company otherwise than by reason of death or retirement, he shall thereupon cease to be a Participant. If any such employee shall have been a Participant under this Plan for at least five (5) full years prior to the date he leaves the employment of the Company he shall have a vested interest in an amount equal to twenty-five per cent (25%) of his beneficial interest in the Trust determined as provided by section (1) of Article III hereof, plus an additional five per cent (5%) for each additional full year such Participant is under the Plan, up to one hundred per cent (100%), which shall be the maximum. The balance of the beneficial interest of the terminating Participant in the Trust Fund shall be forfeited and shall be reallocated as provided in Section (2) of Article III." On August 29, 1945, the board of directors of petitioner, by resolution, amended the agreement and declaration of*177 trust to delete in its entirety section (4) (e) of article II. Petitioner's profit-sharing plan, as thus amended, was approved by the Commissioner of Internal Revenue as an exempt trust under the provisions of section 165 of the Internal Revenue Code. This plan constitutes the profit-sharing plan in effect for the fiscal years ended September 30, 1944, and September 30, 1945. The taxable year of the trust established under the profit-sharing plan is the same as the taxable year of petitioner. Within 60 days after the close of the taxable year ended September 30, 1944, petitioner paid $ 40,082.22 to the trustee of the plan for the taxable year ended September 30, 1944. This amount of $ 40,082.22 is exactly 15 per cent of the compensation otherwise paid or accrued during that year to all employees under the profit-sharing plan. Petitioner's net profits for the taxable year 1944, as defined in article II, section (4) (d), of the profit-sharing plan, were $ 281,413.18 before *1197 taxes and not including the contribution to the profit-sharing plan as an expense. The dividend requirement referred to in article II, section (4) (a) (2) (d), of the plan was $ 18,720 in 1944. In*178 its return for the fiscal year ended September 30, 1944, petitioner claimed a deduction for contributions paid to the trustee of the plan in the amount of $ 40,082.22. In determining the amount deductible for contributions under section 23 (p) (1) of the Internal Revenue Code, the Commissioner determined such contributions to be limited by article II, section (4) (a) (2) (d), of the profit-sharing plan to the amount of $ 17,717.95 for the fiscal year ended September 30, 1944; $ 22,364.27 was disallowed. Within 60 days after the close of the taxable year ended September 30, 1945, petitioner paid $ 39,854.67 to the trustee of the plan as the contribution for that year. This amount of $ 39,854.67 is exactly 15 per cent of the compensation otherwise paid or accrued during that year to all employees under the profit-sharing plan. Petitioner's net profits for the taxable year 1945 were $ 281,681.43 before taxes and before the deduction of the contribution to the profit-sharing plan. The dividend requirement referred to in article II, section (4) (a) (2) (d), of the profit-sharing plan was $ 18,720 for that year. In its return for the year ended September 30, 1945, petitioner claimed*179 a deduction in the amount of $ 39,854.67 for contributions paid to the trustee of the profit-sharing plan. In determining the amount deductible for contributions under section 23 (p) (1) of the Internal Revenue Code, the Commissioner determined such contributions to be limited by article II, section (4) (a) (2) (d), of the profit-sharing plan to the amount of $ 17,718.53 for the taxable year ended September 30, 1945; $ 22,136.14 was disallowed. The agreement and declaration of trust under which petitioner made contributions to its profit-sharing plan required that $ 17,717.95 be contributed by petitioner for the taxable year ended September 30, 1944, and $ 17,718.53 be contributed by petitioner for the taxable year ended September 30, 1945. OPINION. During the taxable years 1944 and 1945 petitioner contributed the amounts of $ 40,082.22 and $ 39,854.67, respectively, to an employees' trust, which was set up pursuant to a profit-sharing plan and approved by the Commissioner as exempt from tax under section 165 (a) of the Internal Revenue Code. The amounts contributed were exactly 15 per cent of the compensation otherwise paid or accrued during the taxable year to the employees covered*180 by the plan. Petitioner contends that the amounts so contributed are all deductible *1198 under section 23 (p) (1) (C) of the Internal Revenue Code, 1 and that the contributions were made pursuant to the requirements of the plan and the trust thereunder. Respondent admits that some part of the contributions is properly deductible, but argues that only the amounts required by the plan may be deducted under section 23 (p). He has computed the amounts called for during the years 1944 and 1945 as $ 17,717.95 and $ 17,718.53, respectively, and has disallowed as deductions the differences between those amounts and the funds actually contributed. Respondent does not contend that the payments made to or under the plan for the years involved herein were not reasonable compensation to the employees, or, in so far as they were properly deductible under section 23 (p) (1) (C), that they were not ordinary and necessary business expenses. The first question to be decided in this proceeding, therefore, is the amounts of the contributions required by the profit-sharing plan as approved by the Commissioner. *181 The plan called for an annual contribution by petitioner of "fifteen per cent of the compensation otherwise paid or accrued during the Company's fiscal year to the Participants and employees eligible to *1199 become participants as of the anniversary date of the contribution, less the amount of forfeitures occuring [sic] since the last anniversary date by reason of terminations of employment." The annual contribution, however, could not "be in such amount as to reduce by more than twenty-five per cent the net profits" after deducting an annual dividend requirement, stipulated to be $ 18,720 for the years in question. "Net profits" were defined by the agreement as follows: For the purposes of this Agreement, the words "net profits" shall mean the net earnings of the Company for each fiscal year ending September 30 as determined by the Company's independent accountants. The conflict between the computations by petitioner and respondent of the maximum contributions allowed by the plan arises from the fact that, in computing the "net profits" as defined by the plan, which can not be reduced by the contribution by more than 25 per cent after deducting the dividend requirement, *182 petitioner has included as Federal tax expense a hypothetical figure arrived at by determining what the Federal taxes would be if there were no deduction for the contribution to the plan; respondent, on the other hand, has arrived at the "net profit" figure by deducting as an expense the actual Federal taxes due if a contribution is made. 2 *183 *1200 It is obvious from a reading of the plan's definition of "net profits" that respondent's determination of the amount of "net profits" for purposes of computing the maximum allowable contribution is the correct one. This definition expressly states that in the determination of "net profits" there shall be deducted from gross earnings "all Federal taxes (including the amount shown on the original income tax return for the year in question of all income, excess profits, declared value excess profits, and taxes on undistributed earnings, if any)." (Emphasis added.) The only possible interpretation of this wording is that the actual Federal taxes paid, rather than a hypothetical figure, must be included as an expense. Before he would grant approval to the plan under section 165 (a), the Commissioner required that the definition of "net profits" be modified by the inclusion, among other changes, of the italicized clause. The clear language of the agreement and declaration of trust setting up petitioner's profit-sharing plan can only mean that the Federal tax expense to be deducted from gross earnings in determining "net profits" is the actual tax expense which will be *184 paid. Under petitioner's computation (see footnote 2), the Federal tax expense deducted is a hypothetical figure which differs from "the amount shown on the original income tax return." Respondent's computation conforms to the stricture in the agreement that the amount of the contribution to the plan shall not be deducted as an expense in determining "net profits." And he is correct in his determination that the agreement and declaration of trust requires that the actual Federal tax expense be deducted from gross earnings in determining the profit figure which the employees' share of the profits can not reduce by more than 25 per cent after dividend requirements are met. Petitioner also contends that, even if the payments made are in excess of those required by the profit-sharing plan, section 23 (p) (1) (C) does not circumscribe the allowable deduction by the amount of contribution called for by the terms of the agreement. Petitioner takes the position that the only limitation contained in section 23 (p) (1) (C) is that the allowable deduction for such a contribution is restricted to 15 per cent of the compensation otherwise paid or accrued during the taxable year to the plan's *185 participants. But the purpose of the 15 per cent limitation is only to set the maximum amount which may be deductible; it does not mean that, even though a plan requires a certain contribution to be made, any payment in excess of that requirement may be deducted if it does not result in a total deduction greater than 15 per cent of the compensation of the plan's participants. The profit-sharing plan under which the payments in question were made was approved by the Commissioner under section 165 (a), resulting in the exemption from tax of the trust. Section 23 (p) (1)*1201 (C), under which the deduction in issue is claimed, expressly refers to contributions to a profit-sharing trust which may be deducted in the taxable year when paid "if such taxable year ends within or with a taxable year of the trust with respect to which the trust is exempt under section 165 (a)." Thus, approval of an employees' trust as tax exempt under section 165 (a) is a prerequisite to allowance as a deduction under section 23 (p) (1) (C) of an employer's contributions to such a trust. To qualify as tax exempt under section 165 (a), the employees' trust must be part of a plan designed and applied to*186 enable the employees or their beneficiaries to share in the profits of their employer's trade or business according to a predetermined formula. Regulations 111, sec. 29.165-1; Lincoln Electric Co. Employees' Profit-Sharing Trust, 14 T. C. 598. If the provisions of the plan are approved, the trust set up under it is exempt from tax, and under section 165 (b) the contributions made to the trust are taxable to the employees benefited only when distributed or made available to them. The profit-sharing plan to which petitioner made payments was exempt under section 165 (a), but we have held that only part of the payments made by petitioner were to or under a plan as envisaged by sections 165 (a) and 23 (p) (1) (C) and approved by the Commissioner. Only such payments as were actually called for by the predetermined formula contained in the agreement and declaration of trust are deductible under section 23 (p) (1) (C). As is said in Mertens, Law of Federal Income Taxation (Supp. 1949), sec. 25.71, pp. 251-2: [The employer] is not entitled to a deduction under amended I. R. C., Sec. 23 (p), however, unless the plan is either one qualifying under amended *187 Section 165 (a) or the employees' rights in the plan are nonforfeitable. This is brought out by a converse provision [section 23 (p) (1) (D)] making the employer's contribution deductible in the taxable year in which paid if the employees' rights are nonforfeitable. Respondent does not question the deductibility of such contributions as were called for by the plan. But he correctly disallows the excess payments made, which can not be said to be a part of the plan as it was approved, with its accompanying tax benefits, by the Commissioner. (Compare the interrelated effect of sections 165, 23 (p) (1), and 22 (b) (2) (B), all added to the Internal Revenue Code by section 162 of the Revenue Act of 1942.) Petitioner makes no argument that the excess contributions were deductible under subparagraph (D) of section 23 (p) (1), since it is clear that the employees' rights were forfeitable to varying extents if their employment was terminated otherwise than by reason of death or retirement. See H. S. D. Co. v. Kavanagh, 88 Fed. Supp. 64 (Dist. Mich. 1949). *1202 It is held, therefore, that respondent was correct in his determination that only the amounts*188 of $ 17,717.95 and $ 17,718.53 were deductible by petitioner as contributions under section 23 (p) (1) for the taxable years 1944 and 1945, respectively. Decision will be entered for the respondent. Footnotes 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. * * * * (p) Contributions of an Employer to an Employees' Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan. -- (1) General rule. -- If contributions are paid by an employer to or under a stock bonus, pension, profit-sharing, or annuity plan, or if compensation is paid or accrued on account of any employee under a plan deferring the receipt of such compensation, such contributions or compensation shall not be deductible under subsection (a) but shall be deductible, if deductible under subsection (a) without regard to this subsection, under this subsection but only to the following extent: * * * * (C) In the taxable year when paid, if the contributions are paid into a stock bonus or profit-sharing trust, and if such taxable year ends within or with a taxable year of the trust with respect to which the trust is exempt under section 165 (a), in an amount not in excess of 15 per centum of the compensation otherwise paid or accrued during the taxable year to all employees under the stock bonus or profit-sharing plan. If in any taxable year beginning after December 31, 1941, there is paid into the trust, or a similar trust then in effect, amounts less than the amounts deductible under the preceding sentence, the excess, or if no amount is paid, the amounts deductible, shall be carried forward and be deductible when paid in the succeeding taxable years in order of time, but the amount so deductible under this sentence in any such succeeding taxable year shall not exceed 15 per centum of the compensation otherwise paid or accrued during such succeeding taxable year to the beneficiaries under the plan. In addition, any amount paid into the trust in a taxable year beginning after December 31, 1941, in excess of the amount allowable with respect to such year under the preceding provisions of this subparagraph shall be deductible in the succeeding taxable years in order of time, but the amount so deductible under this sentence in any one such succeeding taxable year together with the amount allowable under the first sentence of this subparagraph shall not exceed 15 per centum of the compensation otherwise paid or accrued during such taxable year to the beneficiaries under the plan. The term "stock bonus or profit-sharing trust," as used in this subparagraph, shall not include any trust designed to provide benefits upon retirement and covering a period of years, if under the plan the amounts to be contributed by the employer can be determined actuarially as provided in subparagraph (A). If the contributions are made to two or more stock bonus or profit-sharing trusts, such trusts shall be considered a single trust for the purposes of applying the limitations in this subparagraph. (D) In the taxable year when paid, if the plan is not one included in paragraphs (A), (B), or (C), if the employees' rights to or derived from such employer's contribution or such compensation are nonforfeitable at the time the contribution or compensation is paid.↩ 2. The actual computations made by petitioner and respondent for the taxable year ended September 30, 1945, of the maximum amount required to be contributed by the terms of the agreement and declaration of trust are as follows: (a) Petitioner's computation: Net income before taxes and contribution $ 281,681.43 Less: Taxes on $ 281,681.43 * $ 204,846.45 Dividend commitment 18,720.00 223,566.45 $ 58,144.98 Less 25% 14,528.74 Amount to be retained by company after contributions are determined $ 43,586.24 Maximum contribution which will leave the company $ 43,586.24: 14,528.74 X 100/28 (since the tax rate would be 72%) $ 51,888.29 * The actual Federal tax expense would be $ 167,486.90, based on taxable income of $ 281,681.43 less deductible contribution of $ 51,888.29. (b) Respondent's computation: Formula for contribution "C": C = .25 (281,681.43 -- T -- 18,720) Formula for excess profits tax "T": T = [(281,681.43 -- C) 80% -- 20,340.37] 90% C = $ 17,718.53 T = 171,746.96 ↩ Net income before taxes and contribution $ 281,681.43 Less: Net excess profits tax $ 171,746.96 Income tax 20,340.37 Dividend commitment 18,720.00 210,807.33 Net profit for limitation under profit-sharing plan $ 70,874.10 Maximum contribution under 25% limitation $ 17,718.53