Bentley v. Commissioner

Elwin S. Bentley, Petitioner, v. Commissioner of Internal Revenue, Respondent. E. Merritt Ashworth, Petitioner, v. Commissioner of Internal Revenue, Respondent. LeRoy P. Brownell, Petitioner, v. Commissioner of Internal Revenue, Respondent Bentley v. Commissioner Docket Nos. 19783, 19784, 19785 United States Tax Court 14 T.C. 228; 1950 U.S. Tax Ct. LEXIS 275; February 15, 1950, Promulgated *275 Decisions will be entered for the respondent. Petitioners for some years had been carrying on a business in corporate form. They were dissatisfied with the small amount of profits left to them after taxes and wanted to sell or liquidate the corporation. At the suggestion of their tax counsel, the corporation was liquidated and the wives of petitioners formed a partnership and entered into an agreement with their husbands, the petitioners, to continue to operate the business on a salary. The assets of the former corporation were rented from its stockholders. The transaction resulted in no change in policy or interruption in the operation of the business. Held, that the business earnings for the years 1945 and 1946 are properly taxable to the petitioners rather than to the petitioners' wives. *276 Howe P. Cochran, Esq., for the petitioners. William F. Evans, Esq., for the respondent. Arundell, Judge. ARUNDELL *229 This proceeding involves three cases which were consolidated for purposes of trial. They include the following deficiencies in income tax for the taxable years 1945 and 1946: Elwin S. Bentley, in the respective amounts of $ 2,498.38 and $ 5,330.92; E. Merritt Ashworth, in the respective amounts of $ 13,972.22 and $ 28,701.12; and LeRoy P. Brownell, in the respective amounts of $ 13,401.29 and $ 28,369.27. The principal issue is whether petitioners Bentley, Ashworth, and Brownell may be taxed on the profits of the Hoosick Engineering Co., or are taxable only on their respective salaries and bonuses from that company and, secondly, whether in computing the net income of Hoosick Engineering Co. for the fiscal periods ended August 31, 1945 and 1946, deductions may be allowed in the respective amounts of $ 9,250 and $ 16,161.76 representing contributions made by the company to its pension and profit-sharing plans during such periods. No testimony having been adduced at the hearing in respect to various other allegations of error contained*277 in the petitions, they are deemed to have been abandoned by the petitioners. These cases have been submitted upon oral and documentary evidence. FINDINGS OF FACT. The petitioners, all residents of Hoosick Falls, New York, filed their returns with the collector of internal revenue for the fourteenth district of New York. The petitioners have been engaged in the automobile spare parts and engineering business since the early 1920's and have been associated with each other since the late 1920's. "Hoosick Engineering Company, Inc.," a corporation doing business in Hoosick Falls, New York, manufactured and sold plastic distributor heads and rotors for automobiles to automobile manufacturers and repairmen. In 1939 the petitioners and the wife of petitioner Brownell bought the inventory, accounts receivable, and machinery of Hoosick Engineering Co. for approximately $ 17,000, which property was turned in to a new corporation with the same name which was then formed to operate the business. The corporation listed as "Cash Capital" $ 420. The shareholders and the number of shares held in the new Hoosick Engineering Co. were as follows: LeRoy P. Brownell 262 shares Marion A. Brownell 100 shares E. Merritt Ashworth 362 shares Elwin S. Bentley 105 shares *278 In the first year of operation, the new corporation showed a loss of $ 106, but thereafter the income of the corporation increased until 1943, when profits of $ 41,000 were reached. In 1944, after 11 months, although times were good, Hoosick showed a loss of $ 2,840.24. Profit and loss statements for the period 1939 through 1946 were as follows: *230 — 1939 — — 1940 — Sales $ 28,677.47 $ 63,377.70 Cost of goods sold 18,762.27 30,645.32 Gross profit 9,915.20 32,732.38 Other expenses 10,022.11 31,432.70 Net income (106.91) 1,299.68 Fed. taxes accrued 193.01 Fed. tax deficiencies, 1941-42, accrued Net after taxes (106.91) 1,106.67 — 1941 — — 1942 — Sales $ 117,573.20 $ 35.01 150,015.87 Cost of goods sold 46,610.28 39,174.25 Gross profit 70,962.92 35.01 110,841.62 Other expenses 59,176.08 77,240.35 Net income 11,786.84 5 33,636.31 Fed. taxes accrued 4,106.81 1 25,192.49 Fed. tax deficiencies, 1941-42, accrued 1 4,994.23 Net after taxes 7,680.03 3,449.59 — 1943 — 11 mos. 1944 Sales $ 190,055.10 $ 142,838.01 Cost of goods sold 44,244.80 39,542.99 Gross profit 145,810.30 103,295.02 Other expenses 103,951.40 106,135.26 Net income 41,858.90 (2,840.24) Fed. taxes accrued 31,104.52 Fed. tax deficiencies, 1941-42, accrued Net after taxes 10,754.38 (2,840.24) *279 9 mos. 1945 2 1946 2 Sales 3 $ 169,265.17 3 $ 329,401.90 Cost of goods sold 39,394.18 85,125.11 Gross profit 129,870.99 244,276.79 Other expenses 4 78,862.59 4 165,948.50 Net income 51,008.40 78,328.29 Fed. taxes accrued Fed. tax deficiencies, 1941-42, accrued Net after taxes *231 Confronted with an operating loss in one year and dissatisfied with the profits left to them after taxes in other years, petitioners decided to sell or liquidate the corporation. Their tax counsel asked some of his clients in Washington, D. C., if they would be interested in buying the business, but they were not. Thereafter, petitioners' tax counsel suggested a plan whereby the wives of petitioners should form a partnership and employ their husbands to operate the business. This plan was accepted. Thereafter, at a meeting held on November 28, 1944, the corporation, by a vote of its directors confirmed by the stockholders, effectively took the necessary*280 steps to dissolve the corporation. A committee, consisting of Ashworth and Marion A. Brownell, both shareholders in the corporation, was selected and appointed to receive the assets of the corporation "on behalf of the stockholders" and to administer all duties in respect thereto and thereafter the assets were transferred to this committee, which called itself "The Agency." Contemporaneously with the dissolution of the "Hoosick Engineering Company, Inc.," a partnership of the wives was formed under the name of Hoosick Engineering Co., and the operation of the business was to be continued in the same manner as theretofore, with the husbands in actual charge of its activities. A letter dated November 28, 1944, which was signed by the three wives and addressed to the stockholders of the corporation, read as follows: We have formed a partnership and we make you the following offer: 1. We will rent from you the use of your good name, and good will, and your leasehold rights (subject to the rents payable thereunder) for an annual rental beginning November 1, 1944 of Three Dollars ($ 3.00), being One Dollar ($ 1.00) per annum for each of the above named assets. 2. We will rent your equipment*281 from you at an annual rate of six (6%) per cent of the cost thereof to you in the liquidation of the Hoosick Engineering Co. Inc., and we will agree in addition thereto, to maintain it in good condition, and to make at our expense all necessary, proper, and reasonable repairs and replacements to the end that we will deliver back to you this plant in as good condition as received from you, less depreciation, which we shall describe as ordinary wear and tear. When we say "plant" we mean all of the equipment that you took over on the liquidation of the Hoosick Engineering Co. Inc. 3. We agree to pay the rent upon the property which you have under lease. 4. We will take over your accounts receivable, inventories and work-in-process at the price at which those assets came over to you from the Hoosick Engineering Co. Inc. in its liquidation and agree to pay you for the same. 5. We will take over all orders on the books, and all the business that the Hoosick Engineering Co. Inc. distributed to you, if any there be. 6. We agree to continue the Hoosick Engineering Co. Inc. Pension and Profit-Sharing Plan as our own. In consideration of the foregoing we agree to pay you, in return for services*282 rendered, annual salaries during the life of this agreement as follows: to Mr. *232 LeRoy P. Brownell of $ 7500.00, to Mr. E. Merritt Ashworth $ 7500.00, and to Mr. Elwin S. Bentley $ 3500.00, and we promise to pay you as agreed in Paragraphs 1, 2 and 4 above. The terms outlined in the above letter were accepted. There was no change in the policy of the business and no shutdown of the factory during the transition period. The salaries as fixed were approximately the same as those theretofore paid by the corporation. These salaries were generally in proportion to the husbands' stock interests in the corporation and in proportion to the wives' participation in the partnership profits. The wives, Mrs. Brownell and Mrs. Ashworth, were credited with a contribution to the partnership of $ 2,000 each, and Mrs. Bentley with $ 580. This was their own money. The amounts paid in by the wives were arbitrarily fixed in accordance with the holdings of stock originally owned by the three families in the corporation that was dissolved. The wives knew nothing about the business or the corporation's past operations except what their husbands told them. Mrs. Bentley was a supervisor of music*283 in the schools. Mrs. Ashworth had been a trained nurse before she married Ashworth. The operation of the business required particular ability, because it involved tool-designing, selling, and purchasing skills. The petitioners possessed the skills necessary to carry on the business successfully. The wives were completely lacking in the skills and abilities necessary to operate the business. At the time of the dissolution of the corporation in November, 1944, its balance sheet showed gross assets of $ 68,975.65 and a net worth of $ 42,264.85, a depreciation reserve of $ 17,162.65, and miscellaneous liabilities of $ 9,548.15. Accounts receivable and inventory, totaling $ 36,764.08, were taken over by the wives from the agency and in "something less than two years" they were collected and liquidated, and the former stockholders, via the agency, were paid. The partnership papers were filed with the State of New York and with the counties in which the business was situated, as required by law. The Commissioner of Internal Revenue was notified of all of the contemplated steps incident to the liquidation of the corporation and the organizing of a partnership composed of the wives. As*284 a result of the operation of the business for the year ended August 31, 1945, there were distributed to the three wives the entire earnings in the amount of $ 51,008.40. In the second year the entire earnings of the business in the amount of $ 78,328.29 were likewise distributed to them. Helen Ashworth used her share to make investments and also made deposits in a saving account in her own name. The wives did not turn the money over to the husbands. *233 The company had no borrowed funds. The capital requirements of the business were small. During the second fiscal year of the partnership, i. e., in March, 1946, the partnership increased the compensation of Brownell and Ashworth by $ 4,500 each, without increasing the pay of Bentley. In addition, it agreed to pay all three of them further compensation out of the profits of the business, after all charges of every kind, as follows: 20% of the profits, if the profits are $ 100,000 or less; 30% of the profits, if the profits exceed $ 100,000 and do not reach $ 200,000, and 40% of the profits, if the profits exceed $ 200,000. The profits were to be divided among petitioners "in proportion to their salaries." Petitioners*285 paid their income taxes on the salaries and extra compensation which the company paid them. For the year ended August 31, 1946, E. Merritt Ashworth received from the partnership compensation of $ 11,000 as "salary" and an additional amount of $ 13,593.86 under the "management contract." LeRoy P. Brownell received as compensation $ 11,000 as "salary" and an additional amount under the "management contract" in the sum of $ 13,593.86, and Elwin S. Bentley received as compensation $ 3,550.04 and an additional amount under the "management contract" in the sum of $ 3,965. Under the arrangement made for the operation of Hoosick Engineering Co., the wives had nothing to do with the management of the business other than to sign checks. Petitioners had no power to draw any money from the firm on their own signatures. The signing of checks constituted the only service rendered by the wives. The checks were made out at the office and two of the wives were required to sign them, which they did either at the plant or at their homes. They signed whatever checks were presented to them without exception. The wives received no compensation for this service. After the new arrangement was made, *286 petitioners continued to perform the identical duties they had theretofore performed as officers of the corporation. The termination of the business of Hoosick Engineering Co. and the formation of the partnership occurred at or about the same time. The major motive for the change in the form of the business from a corporation to a partnership was to secure more favorable tax treatment. The change was carried out under advice of tax counsel. At the time the arrangement was made to have petitioners manage the business of the partnership, they were already employed in similar capacities by the Lovejoy Patent Specialty Co., for which Ashworth, Brownell, and Bentley received salaries of $ 8,700, $ 8,700 and $ 5,250, respectively. Prior to November, 1944, petitioners had owned, along with Mrs. Brownell, the Lovejoy Patent Specialty Co. Betty Stockvis, *234 daughter of petitioners' tax counsel, purchased the Lovejoy Co., with the understanding that the petitioners would run the business for her until each of them reached the age of 65. She would only buy the Lovejoy business in the event that petitioners would run it for her. Under date of December 30, 1943, the Hoosick Engineering*287 Co. set up, under the provisions of section 165 of the Internal Revenue Code, a pension trust for the benefit of all employees who had been with the company for a period of three months or more and on the same date also established a profit-sharing trust for the same employees. Upon the dissolution of the corporation, the partnership agreed to continue the pension and profit-sharing plans as theretofore established. Contributions were made to the two trusts for the period December 1, 1944, to August 31, 1945, and the fiscal year ended August 31, 1946, as follows: Period Fiscal year ended ended Aug. 31, 1945 Aug. 31, 1946 Pension plan $ 3,500 $ 5,661.76 Profit-sharing plan 5,750 10,500.00 Total 9,250 16,161.76 Petitioners' interests in the two trusts for the period ended August 31, 1945, and for the fiscal year ended August 31, 1946, were as follows: Period Fiscal year ended ended Aug. 31, 1945 Aug. 31, 1946 LeRoy P. Brownell 16.59% 17.898% Elwin S. Bentley 8.24% 6.871% E. Merritt Ashworth 16.59% 17.898% Total 41.42% 42.667% The Commissioner has disallowed these contributions as deductions on the partnership returns, claiming*288 that the pension and profit-sharing plans did not meet the requirements of section 165 (a) of the Internal Revenue Code, as amended. There were 17 persons, including Brownell, Bentley, and Ashworth, employed by the Hoosick Engineering Co. throughout the entire year 1944. In 1945 there were 20 employees, including petitioners, who were engaged for the entire year. The profits of the business known as the Hoosick Engineering Co. in the taxable years were the profits of petitioners and resulted from their services and from the use of property over which they had complete control. *235 OPINION. The principal issue in this case is whether petitioners may be taxed on the profits of the Hoosick Engineering Co. or whether they are taxable only on their respective salaries and bonuses from that company. The petitioners have been engaged in the automobile spare parts and engineering business since the early 1920's, and have been associated with each other since the late 1920's. They have been together in the Hoosick Engineering Co. itself, which they have operated since 1939. Over the course of the years they acquired considerable knowledge of and skill in the industry and in this particular*289 company. The business itself showed fair earning power under petitioners' management. From a loss of $ 106.91 in its first year of operation it went on to earn $ 41,858 in 1943. However, the petitioners, after considering the results of their operations and the small amount of net profits left to them after the payment of an excess profits tax, decided to sell or liquidate their business. It was at this point that their tax counsel suggested the formation of a partnership by petitioners' wives and the employment of the husbands to operate the business. The terms of the partnership arrangement provided for an allocation of interests and benefits in accordance with original family stock holdings in the corporation. The petitioners were to continue the control of the company, with no change in or interruption of policy or operations. The profits to be distributed to the wives were to be in accordance with their cash contributions to the partnership, which in turn were to be in the same proportion as the stock interest formerly held by their husbands, * the petitioners. The petitioners' salaries as originally set were to be in the same amount as formerly received from the corporation. *290 As the business prospered, the husbands received a larger participation in the profits of the company, which generally was in proportion to the interests formerly held by petitioners in the corporation. Under the plan as proposed and carried out, title to the assets formerly owned by petitioners remained with them, subject to a nominal rental for the good will and going business, and a rental of the equipment at a figure equal to 6 per cent of its cost. The agreement was to run for no set time and presumably could be revoked at will. The plan was not one that people dealing at arm's length would enter into. After the plan had been effected, the only substantial change which had been brought about was that the wives and the petitioners should share the income from the company. The income of the business was still produced mainly through the efforts of the petitioners. It was a *236 business which admittedly required a high*291 degree of technical skill and specialized knowledge such as the petitioners had always furnished and continued to furnish. The company's major assets were never relinquished to any substantial degree, either with respect to formal title or to the use of the assets. Petitioners' arrangement with their wives could be terminated at will. In our opinion, the purpose of the wives' partnership was not the creation or operation of a joint enterprise. They furnished no services other than the formal signing of checks. The record discloses no purposes for a partnership by the wives other than that of minimizing income taxes. As the court said in Earp v. Jones, 131 Fed (2d) 292; certiorari denied, 318 U.S. 764: The apparent purpose of the partnership was not the creation and carrying on of a new joint enterprise or uniting their joint efforts or substance in a new undertaking. The real purpose of the partnership was to minimize income taxes. It is well settled that it is not unlawful to avoid the attachment of taxes. When a new tax comes into existence one is free to arrange or change his method or mode of operation to avoid*292 the attachment of the tax or minimize the effect thereof. The change must, however, be real and substantial. One may not merely change the form but do business in substantially the same way. An essentially new and different economic unit must be formed. [Emphasis supplied.] We do not think that the effect of the plan was to form a new and different economic unit. The income was earned, as in the past, by the use of Hoosick's assets, title to which remained with petitioners (even though there was a rental agreement), in conjunction with their talents, skill, and experience, and the business continued to be operated by petititioners as formerly. We are completely impressed with the lack of reality in the transaction. It was a scheme devised by tax counsel solely to avoid the incidence of the taxing statutes. The earnings of the business are properly taxable to the petitioners. Robert E. Werner, 7 T. C. 39; Louis Visintainer, 13 T. C. 805; cf. Burnet v. Leininger, 285 U.S. 136. Petitioners rely on Clifford R. Allen, Jr., 12 T. C. 227, but in that*293 case the facts show that the husband, after the transfer of his partnership interest to his wife, had no interest in and in no way participated in the operation of the business, directly or indirectly, as an employee or otherwise. In Simmons v. Commissioner, 164 Fed. (2d) 220, also cited by the petitioners, the husbands' interests in the partnership were completely disposed of to their respective wives and the husbands no longer had any connection with the partnership. The second issue is whether the Hoosick Engineering Co. was entitled to deductions for contributions to its pension and profit-sharing plans for the fiscal periods ended August 31, 1945 and 1946, in the respective amounts of $ 9,250 and $ 16,161.76. We think not. The petitioners herein retained all the essentials of ownership of this company -- both in form and in substance. Petitioners were not employees *237 within the meaning of section 165 of the Internal Revenue Code, as amended. The language of that section is clear in that it states that the exemption from tax will be granted for payments to such trusts if they are set up by the employer "for the exclusive benefit *294 of his employees or their beneficiaries." Decisions will be entered for the respondent. Footnotes 5. It appears that the correct figure should be $ 33,636.28.↩ 1. Accrued in November, 1944.↩ 2. Partnership return, fiscal years 1945, 1946.↩ 3. Gross receipts.↩ 4. Deductions and expenses.↩ *. In the case of the Brownells, stock in the corporations was held by husband and wife.↩