Ace Tool & Eng., Inc. v. Commissioner

Ace Tool & Eng., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Ace Tool & Eng., Inc. v. Commissioner Docket No. 37932 United States Tax Court 22 T.C. 833; 1954 U.S. Tax Ct. LEXIS 160; June 30, 1954, Filed. June 30, 1954, Filed *160 Decision will be entered for the respondent. In 1942, petitioner's three stockholders, who were also its officers and directors and who owned equal amounts of stock, agreed upon a plan to conceal part of petitioner's earnings. It was agreed that one of the stockholders, the president, would receive the proceeds of sales and keep them, and that such proceeds would be equally divided among the stockholders. Accordingly, substantial amounts of petitioner's sales in 1942 and 1943 were not entered on its books, were not deposited in its bank account, and were not reported in its tax returns. Some of the expenses of petitioner and parts of the officers' salaries in 1942 and 1943 were paid with the concealed funds. The net amount of the concealed funds was not divided equally among the three stockholders but each received some part thereof. Held: 1. Under the facts and circumstances of this case, petitioner has failed to prove that income improperly omitted from its books and returns in each of the taxable years was offset by a deductible embezzlement loss. 2 The scheme was entered into by all of the stockholders to evade payment of petitioner's taxes. 3. Respondent's determination*161 of fraud sustained. B. W. Minsky, Esq., for the petitioner. Francis B. Campbell, Esq., for the respondent. Harron, Judge. HARRON *833 The Commissioner determined deficiencies*162 in the petitioner's income tax, declared value excess-profits tax, and excess profits tax for the years 1942 and 1943, and additions to the deficiencies for fraud, under section 293 (b), Internal Revenue Code, and additions to the tax for negligence, under section 291 (a), as follows: 50 per cent 25 per cent Year Deficiency addition addition under under 293 (b) 291 (a) Income tax [1942] $ 2,157.71 $ 1,078.86 [1943] 2,083.24 1,041.62 Declared value excess-profits tax [1942] 3,566.92 1,783.46 [1943] 6,980.41 3,490.21 Excess profits tax [1942] 13,484.36 6,742.18 $ 3,371.09 [1943] 33,312.09 16,656.05 8,328.02 The deficiencies result from the determination by respondent that petitioner's gross income, as reported, in each of the years 1942 and 1943 was understated in the amounts of $ 51,178.75 and $ 78,493.68, respectively. The petitioner concedes that its gross income, as reported, in each of the years involved was understated in the amount determined by the respondent. It contends however that it is entitled to a deduction in each year of a corresponding amount for embezzlement losses. Petitioner *834 has stipulated that the understatements*163 of gross income were due to fraud, and that, if it is determined that petitioner is not entitled to the claimed deduction for embezzlement losses in each of the years 1942 and 1943, the fraud penalty has been properly determined. Also, petitioner does not contest the respondent's determination that its failure to file an excess profits tax return in each of the years 1942 and 1943 was due to willful neglect and not to reasonable cause, so as to make petitioner liable for the 25 per cent addition to the tax, if any is found to be due, provided for under section 291 (a) of the Code. Petitioner has abandoned an issue raised in the petition relating to its claim for a net operating loss carry-back. The only issue to be decided is whether the petitioner is entitled to deductions in 1942 and 1943 for alleged embezzlement losses in the amounts of $ 51,178.75 and $ 78,493.68, respectively, under section 23 (f) of the Code. FINDINGS OF FACT. The stipulated facts are found as facts, and the stipulation is incorporated herein by this reference. Petitioner is a California corporation with its principal place of business located in Los Angeles, California. It was incorporated on January 13, *164 1941, with an authorized capital of $ 25,000, represented by 25,000 shares of common stock, par value $ 1. The petitioner kept its books and reported its income on the calendar year, accrual basis. It filed corporate income tax returns for each of the years 1942 and 1943 with the collector for the sixth district of California. Petitioner did not file a corporate excess profits tax return for either of the years 1942 or 1943. During the years 1942 and 1943, all of the outstanding shares of stock of petitioner were held by three individuals, in the following proportions: Name Per cent Harry D. Fidler [33] Lorrin A. Smith [33] Steven F. Petyus [34] During the years involved, the officers of the petitioner were Harry D. Fidler, president; Steven F. Petyus, vice president; Lorrin A. Smith, secretary-treasurer. Each of the officers was a director of the petitioner. In 1942 and 1943, the petitioner, sometimes referred to hereinafter as Ace Tool, made machine tools, chiefly permanent molds. Petyus and Smith were experienced tool and die makers. Petyus had conducted a machine tool business in Los Angeles as a sole proprietor *835 for several years prior to organizing Ace Tool. *165 Before Fidler acquired an interest in Ace Tool, Petyus, Smith, and Edward Beckwell each held one-third of the stock of the corporation. Petyus contributed to the corporation his equity in a small shop building and machinery. The building cost $ 1,250; the machinery was entered on the corporation's books at a value of $ 31,287.50. It cost Petyus about $ 10,000. Smith contributed about $ 1,200 in cash, and Beckwell about $ 300. In the fall of 1941, petitioner was in financial distress. It was unable to pay its creditors and was in need of working capital. At this time, Fidler, who had been introduced to Petyus by a business acquaintance, promised to secure financing and new business for the corporation, and to make a capital contribution of $ 5,000, in exchange for an equal interest in the business. He also insisted that he be made president and general manager of Ace Tool. This was agreed to by the three stockholders, and, in October 1941, Fidler acquired one-fourth of petitioner's stock and was made president, a director, and general manager of the company. Fidler did secure loans for the company but he never made any capital contribution. Beckwell withdrew from the company*166 in December 1941, and his one-fourth interest in the stock was divided equally among Petyus, Smith, and Fidler. During 1942 and 1943, Fidler had charge of petitioner's finances and sales, all office work, and the books and records of the corporation. Petyus and Smith worked in the shop and supervised the work of the shop employees. At all times material hereto, a commercial bank account was maintained in the name of Ace Tool at a branch of the Bank of America in Los Angeles. Fidler was authorized to draw checks on this account. Also, pursuant to a resolution of the board of directors of Ace Tool, adopted on June 24, 1942, and signed by Fidler and Smith, Fidler was authorized to cash checks made payable to Ace Tool. The resolution authorizing Fidler to cash checks was filed with the Bank of America. In 1942 and 1943, the petitioner's chief customer was the Century Metalcraft Company which was located in Los Angeles. Petitioner also did work for the Zinsmeyer Co. in 1942, and for O'Neal & Company and the Southern California Foundry in 1943. The petitioner's income tax returns for each of the years 1942 and 1943 disclosed a net loss. The petitioner's gross receipts and the amount*167 of the net loss reported for each year were as follows: [1943] Gross receipts $ 41,206.34 $ 32,415.00 Net loss 4,577.33 1,340.83 The petitioner's gross receipts and net loss, as reported, corresponded with the figures appearing in the petitioner's books. *836 Petitioner's income tax return for 1942 was signed by Fidler and Smith; the 1943 return was signed by Fidler. In 1942 sales totaling $ 51,178.15 were not entered in the petitioner's books and were not reported in its income tax return. The sales were made to the following companies: Century Metalcraft Company $ 50,462.87 Zinsmeyer Co 715.88 Total $ 51,178.75 The petitioner's gross income as reported for 1942 was understated in the amount of $ 51,178.75. In 1943 sales totaling $ 78,493.68 were not entered in the petitioner's books and were not reported in its income tax return. The sales were made to the following companies: Century Metalcraft Company $ 74,434.68 O'Neal & Company 1,425.00 Southern California Foundry 2,634.00 Total $ 78,493.68 The petitioner's gross income as reported for 1943 was understated in the amount of $ 78,493.68. Early in 1942, when petitioner*168 began to receive a large volume of business from the Century Metalcraft Company, Fidler, Smith, and Petyus, each, agreed that a substantial part of the petitioner's sales should not be entered in the books of the company and that the proceeds of the unrecorded sales were to be divided equally among Fidler, Smith, and Petyus. The purposes of this scheme were to evade the payment of petitioner's taxes and to place the proceeds of the unrecorded sales out of the reach of creditors of the corporation. During the years 1942 and 1943, all of the petitioner's officers, who were also its directors and stockholders, knew that sales in substantial amounts were not being entered in the books and records of the company. The failure on the part of the officers to cause a record to be made of all sales by the petitioner was deliberate and willful. The proceeds of the unrecorded sales were not deposited in the petitioner's bank account or in any other bank account. Fidler held the proceeds. In his capacity as president and general manager of the petitioner, he received the checks of customers in payment of sales which were drawn to the order of Ace Tool & Eng., Inc. Fidler, under the authorization*169 given to him, endorsed and cashed the checks, receiving in exchange either cash or cashiers checks made payable to himself. The funds in Fidler's possession, representing the proceeds of the unrecorded sales, were used, in part, by Fidler to pay operating expenses of the corporation. Out of these funds Fidler paid operating *837 expenses of the corporation in 1942 and 1943 totaling $ 14,984.51, and $ 18,690, respectively, as follows: Item [1943] Interest $ 694.51 $ 240 Officers salaries and payroll bonuses 9,090.00 12,375 Bookkeeper's bonus [875] Entertainment and miscellaneous expenses 5,200.00 5,200 Totals $ 14,984.51 $ 18,690 The above items of expense were not entered in the petitioner's books, and they were not claimed as deductions in the petitioner's income tax returns. The respondent in determining the deficiencies has allowed these items of expense as deductions. The books and records of the petitioner corporation disclosed that the salary paid to each of its three officers, Fidler, Smith, and Petyus, for the period from May through December 1944 was $ 50 a week. Each of the petitioner's three officers actually received a salary of*170 at least $ 125 a week during the same period, $ 75 more than the books showed. They received the additional salary payments from Fidler out of the concealed earnings of petitioner. Fidler, Smith, and Petyus each agreed, at the suggestion of Fidler, to falsify the records of the corporation to show the payment of officers' salaries in amounts less than were actually paid in order to evade the payment of withholding tax by the corporation and income tax by each of the officers on the full amount of their salaries. During 1942 and 1943 Fidler made payments to Smith and Petyus out of the concealed earnings of petitioner, in addition to the extra sums which each received as salary payments. Smith received from Fidler at least $ 7,000 in 1942 and at least $ 11,750 in 1943, or a total of at least $ 18,750. Petyus received at least $ 500 in 1942. In 1943, Petyus received about $ 11,000 for work which he did for O'Neal & Company, assisted by Smith, of which Petyus paid Smith about one-half. Neither Petyus nor Smith reported any of the $ 11,000 in his individual return, and the $ 11,000 was not reported in petitioner's return for 1943. Petyus did work for O'Neal & Company and received*171 payment therefor pursuant to another agreement with Fidler and Smith (which was made in the latter part of 1942) that Petyus could use petitioner's machinery and equipment to do work on his own account and could keep the payments for such work rather than turn such payments in to the petitioner corporation. The Commissioner's agents began an investigation of petitioner's tax liability in May 1944. Their investigation uncovered the fact that a substantial part of petitioner's sales in 1942 and 1943 were not entered on petitioner's books or reported in its returns, and the extent of petitioner's unreported and concealed income. No action was taken *838 by Petyus or the other stockholders on behalf of petitioner until petitioner was confronted with the extent of its tax liability and of the deficiencies. After the agents made known the extent of petitioner's liability for taxes, Fidler resigned from the office of president of petitioner in November of 1944. Also, the petitioner corporation on January 5, 1945, filed suit in the Superior Court of Los Angeles County against Fidler, Smith, and others for money due and for an accounting. Fidler entered a general denial, and Smith*172 admitted that he had received $ 18,500 "in trust for petitioner." And, on February 26, 1945, Fidler for himself and other stockholders filed a suit in the Superior Court against Petyus and the petitioner corporation for damages, wherein he alleged that Petyus had collected and received for the account of the corporation $ 21,000, which sum he had not repaid to the corporation, and that, in addition, Petyus was retaining in his possession certain machinery belonging to the corporation which he refused to return to the corporation. The relief asked for in the complaint was that judgment be entered against Petyus for $ 21,000 plus interest and costs, together with damages for the wrongful taking of the machinery. An answer was filed by Petyus denying the allegations contained in the complaint. The litigation was settled by an agreement entered into on March 13, 1947, by the petitioner corporation, Fidler, and Petyus. The settlement agreement contained, inter alia, the following provisions: (1) Fidler agreed to pay Petyus $ 4,000, and to assign to Petyus all of his stock in the petitioner corporation. (2) Fidler agreed to pay to the petitioner corporation $ 6,000. (3) The agreement*173 was not to be construed as releasing or discharging any of the parties from any tax liability. (4) The agreement was to constitute a full and final settlement of all claims of the parties against each other. (5) The actions commenced by the parties in the Superior Court of Los Angeles County were to be dismissed with prejudice. On June 27, 1945, Fidler was indicted in Los Angeles County for falsifying the records of Ace Tool & Eng., Inc., with intent to defraud the corporation, in violation of section 563 of the Penal Code of California, and for grand theft of the corporation's funds. Both crimes are felonies. The indictment charged the offenses occurred in 1943 and 1944. On November 5, 1945, Fidler entered a plea of guilty to two counts, admitting that he falsified the records of the petitioner corporation in January 1943 with intent to defraud the corporation of the sums of $ 534.10, and $ 857, respectively. Fidler did not plead guilty to charges of grand theft of the corporation's funds and he has never been convicted of embezzlement of the corporation's funds. On December 14, 1945, he was sentenced in the Superior Court of Los Angeles County*839 to a term of 6 months' *174 imprisonment and fined $ 500 on each of the two counts. All the other counts in the indictment were dismissed. In the spring of 1949, Fidler and Smith, each, were convicted of the crime of attempting to evade or defeat the payment of petitioner's income tax liability for 1942 and 1943, under section 145 (b) of the Internal Revenue Code; and each was sentenced to imprisonment in a Federal penitentiary. Smith kept $ 18,750, which he received from Fidler, in a safe-deposit box. He returned this fund to petitioner in 1944. On December 1, 1944, petitioner made a payment of $ 20,000 to the collector of internal revenue for the sixth district of California. Petitioner, in making this payment, used $ 15,000 of the sum which Smith returned in 1944, and $ 5,000 which Fidler returned. The $ 20,000 is being held in a suspense account to be applied to deficiencies in petitioner's liability for taxes in 1942 and 1943, if any. The Commissioner determined an income tax deficiency, plus the fraud penalty, against Petyus for 1943 which he agreed to and paid. Fidler, Smith, and Petyus controlled the petitioner corporation in 1942 and 1943. Petitioner did not formally declare any dividends at any*175 time up to and including December 31, 1943. The withholding of the net amounts of $ 36,194.24, in 1942, and $ 59,803.68, in 1943, of petitioner's concealed earnings in each of those years constituted a withholding of earnings by and for petitioner's stockholders. The petitioner did not sustain a loss of $ 51,178.75, or of $ 78,493.68, in 1942 and 1943, respectively, not compensated for by insurance or otherwise. The above amounts were not stolen or embezzled from petitioner in 1942 and 1943, respectively. Petitioner knowingly and willfully omitted from its income and declared value excess-profits tax returns for 1942 and 1943 gross earnings in the amounts of $ 51,178.75 and $ 78,493.68, respectively, with intent to evade taxes; and it knowingly and willfully omitted from deductions for 1942 and 1943 in its returns $ 14,984.51 and $ 18,690, respectively, with intent to evade taxes. The petitioner filed false and fraudulent returns for 1942 and 1943 with intent to evade tax. The petitioner willfully failed to file an excess profits tax return for each of the years 1942 and 1943. Part of the deficiency in petitioner's income tax, declared value excess-profits tax, and excess profits*176 tax for each of the years 1942 and 1943 is due to fraud with intent to evade tax. OPINION. The petitioner corporation admits that gross income of $ 51,178.75 for 1942 and of $ 78,493.68 for 1943 was not reported *840 in its returns for those years. But petitioner claims that there are no deficiencies in taxes because even if it should have reported such income, it is entitled to a loss deduction in each year in an identical amount because, it alleges, the amounts in question were embezzled by its president, Fidler. Petitioner claims a loss in each year under section 23 (f) of the Code which allows deduction for a loss not compensated for by insurance, or otherwise. The petitioner corporation has the burden of proving that it sustained a loss in each year, the amount of the loss, and that it was not compensated for by insurance, or otherwise. Upon consideration of the entire record, we find and conclude that early in 1942, the three officer-stockholders, who were also petitioner's directors, agreed, for the purpose of evading petitioner's taxes, that a substantial part of petitioner's sales should not be recorded in its books, or reported in its tax returns, and should be divided*177 equally among the stockholders. We find and conclude, also, that the three stockholders were aware, during 1942 and 1943, of this concealment of the receipt of a large part of petitioner's income, and that such concealment was fraudulent, willful, and deliberate. The evidence establishes beyond any doubt that petitioner's president, Fidler, and its secretary and treasurer, Smith, intended to omit from petitioner's books and tax returns a substantial part of its gross income for 1942 and 1943 for the purpose of evading petitioner's taxes, and that their intent was fraudulent. The petitioner corporation endeavors to escape from the consequences, in this case, of the deliberate acts of its president and secretary-treasurer by ascribing to both of them, or to its president, alone, a plan of embezzling petitioner's funds, and of cheating a minority stockholder, Petyus. Petyus, in petitioner's behalf in this proceeding, disclaims knowledge of and participation in the scheme. We are not impressed by petitioner's theory, and upon the entire record it is rejected. We are satisfied from all of the evidence that Petyus, in the early part of 1942, agreed with Fidler and Smith to pursue the*178 scheme to omit the recording, the banking, and the reporting in petitioner's tax returns of a substantial part of petitioner's receipts. We are convinced, also, that he agreed with Fidler and Smith to falsification of petitioner's records to show payment of salaries to them in lesser amounts than they received, for the purpose of tax evasion. That Petyus had an interest in evading tax is demonstrated by his failure to report in his individual return for 1943, the share of the payment of O'Neal & Company which he retained. Furthermore, he admits that he received at least $ 500 from Fidler in 1942 as his share of a "split-up" of some of petitioner's receipts. He admits, also, that he agreed to have petitioner's books and records show the payment of *841 salaries of officers in 1943 in amounts less than the amounts actually paid in order to evade payment of withholding tax by the corporation and of income tax by the officers on the full amounts of their salaries. Fidler and Smith admit that there were such agreements. Each of them, either in testimony or in sworn statements given to respondent's agents during their investigation of petitioner's income tax returns, has implicated*179 Petyus. We are unable to believe Petyus' denial of knowledge of and participation in the scheme to understate petitioner's true income in the taxable years. During the years in question, Petyus worked in the shop and supervised the shop employees. He had firsthand knowledge of the volume of work being done by the petitioner. He knew from experience, approximately, the profit realized on each job. He admits that he checked the books of the company, at least during most of 1942. The books reflected sales of $ 41,206 for 1942; it is now stipulated that petitioner's sales for 1942 were $ 92,384. In view of these facts, the testimony of Petyus that he had only a suspicion that all sales were not being recorded in the books and that the corporation was making more money than was indicated by the books strains credulity. The question before us is whether petitioner sustained losses from alleged embezzlements in 1942 and 1943. We should first consider that question. It will then be in order to comment upon the relevancy and materiality of the allegation of Petyus that he was cheated out of his share of petitioner's net earnings in 1942 and 1943 by Fidler and Smith. In order for petitioner*180 to succeed in its contention that someone embezzled some of its earnings in the taxable years, it must show that there was no consent to or condoning of the appropriation of funds and that the person or persons who appropriated funds were liable to return the full amount to the corporation. Commissioner v. Wilcox, 327 U.S. 404. In this case, Fidler, Smith, and Petyus were in complete control of the petitioner corporation. Fidler was authorized by a corporate resolution, which was adopted on June 24, 1942, to endorse and cash checks made payable to petitioner. Smith and Petyus joined with him in the scheme to omit the recording of receipts on petitioner's books. They received from Fidler, out of the sums which he held, the proceeds of checks made payable to petitioner, payments of salary in excess of the recorded amounts of their salaries. They agreed, the three stockholders, that they would share in the proceeds. Their intent was to receive the unrecorded, net income of petitioner as constructive dividends. Under these circumstances, it cannot be said that the withholding of part of petitioner's net income in 1942 and 1943 was not condoned*181 or consented to, or that there was an obligation *842 to return the funds to petitioner. See Currier v. United States, 166 F. 2d 346, where the contention that the chief, if not sole, stockholder of a corporation embezzled its funds was rejected. See also, Kann v. Commissioner, 210 F. 2d 247, affirming 18 T. C. 1032, where under similar facts, it was said that stockholders "were to a large extent taking their own money." We think it is clear that petitioner's president, Fidler, with the consent of the other two stockholders, in the first instance, during 1942 and 1943, held the funds in question for petitioner's use and benefit. This is borne out by his having used part of the funds, in each year, to pay some of petitioner's operating expenses, namely, $ 14,984.51 in 1942, and $ 18,690 in 1943. The balance, $ 36,194.24, and $ 59,803.68, represented net earnings available to the stockholders. It is concluded that the above net amounts were withheld for distribution to stockholders as informal or constructive dividends. Neither Fidler nor Smith has been convicted of embezzling *182 petitioner's funds. Such external evidence of embezzlement, which was present in the Wilcox case, is lacking in this case. On the other hand, there is clear evidence here of fraudulent intent on the part of petitioner's three stockholders to evade petitioner's tax. The distinction between "embezzlement" in the Wilcox case, and the "fraud" in Rutkin v. United States, 343 U.S. 130, is again illustrated here. See W. L. Kann, 18 T. C. 1032, 1044. Furthermore, in deciding the question in this case, we should not approve a "local law concept of embezzlement * * * useful to deter those in control of a corporation from defrauding * * * minority stockholders" to be used "as a vehicle for tax avoidance, absent a clear mandate to the contrary." Kann v. Commissioner, supra.The intent of the president is to be imputed to the corporation. Auerbach Shoe Co., infra. With respect to the contention that Fidler and Smith conspired to defraud Petyus of his share of part of the net earnings of petitioner for 1942 and 1943, after the scheme was in operation, we make the following observations. *183 There is no clear proof that Fidler and Smith in fact cheated Petyus of his shares. For example, there is a suggestion that Petyus was making use of petitioner's machinery and equipment for his own personal profit by taking payments for jobs rather than turning the payments over to petitioner. It is true that counter suits were filed in 1945 by petitioner against Fidler and Smith, and by Fidler against petitioner, which were settled out of court in 1947. But this litigation is not relevant nor material to the question in this proceeding in view of the facts found from the entire record. We think it is significant that the litigation was instituted after revenue agents had discovered that petitioner's income was understated in its returns for 1942 and 1943. It is entirely possible that when revenue agents discovered the facts relating to petitioner's tax liability, petitioner's *843 stockholders desired to disavow their tax evasion scheme. Furthermore, since the evidence establishes, in our opinion, that all of the stockholders agreed and consented to the plan of concealing petitioner's true income, it is not material to a decision of the issue before us that a minority*184 stockholder may have believed that he was getting the "short-end" of the bargain. If that was true, it happened after the scheme was in operation; and if Petyus, in fact, was cheated out of his full share of all of petitioner's net earnings in 1942 and 1943, in the operation of a scheme to which he consented, his grievance was a personal one, and his remedy was to be found in making claim against Fidler and Smith, as individuals, for wrongfully taking his share of petitioner's earnings. Whatever the real situation may have been, petitioner cannot successfully make use, in this case, of such dispute between Petyus and the other two individuals. That dispute is not material. What we said in W. L. Kann, supra, p. 1044, is appropriately paraphrased here. The evidence satisfies us that the whole project was a false front erected to deceive the Commissioner of Internal Revenue rather than the petitioner corporation. A corporation acts only through its officers and we must conclude that the scheme before us resulted from the fraud of the petitioner corporation (see Auerbach Shoe Co., 21 T. C. 191, 194), and that under these*185 circumstances no support can be found for a contention of the petitioner corporation that it was a victim of any embezzlement. It is held that petitioner did not sustain losses in 1942 and 1943, respectively, of $ 51,178.75 and $ 78,493.68, respectively, or of any part thereof. The petitioner does not contest the penalties imposed under section 291 (a) of the Code. The cases cited by petitioner are distinguishable on their facts. Decision will be entered for the respondent.