Time Oil Co. v. Commissioner

Time Oil Co., Petitioner, v. Commissioner of Internal Revenue, Respondent Time Oil Co. v. Commissioner Docket No. 50122 United States Tax Court 26 T.C. 1061; 1956 U.S. Tax Ct. LEXIS 89; September 19, 1956, Filed *89 Decision will be entered under Rule 50. Petitioner held not entitled to deduct contributions made to a profit-sharing trust during 1949 and 1950. A. R. Kehoe, Esq., for the petitioner. John H. Welch, Esq., and Wilford H. Payne, Esq., for the respondent. Withey, Judge. WITHEY *1061 The respondent determined deficiencies in the income tax of petitioner as follows: Year Deficiency [1949] $ 63,105.48 [1950] 50,046.05 The sole issue presented for our decision is the correctness of the respondent's action in determining that petitioner is not entitled to deduct amounts contributed to an employees' profit-sharing trust during 1949 and 1950. *1062 All other issues presented by the pleadings have been disposed of by stipulation. FINDINGS OF FACT. Petitioner*90 is a corporation organized under the laws of the State of Washington with its principal place of business at Seattle, Washington. Petitioner filed its income tax returns for 1949 and 1950 with the collector of internal revenue for the district of Washington at Tacoma, Washington. The returns were prepared on an accrual basis. On May 14, 1945, petitioner executed an instrument designated as a stock bonus plan and profit-sharing trust, made effective as of November 25, 1944. The plan was submitted to the respondent, and on May 28, 1945, the respondent issued a letter advising petitioner that the plan met the requirements of section 165 (a) of the Internal Revenue Code of 1939, that the income of the trust was exempt from Federal income taxation, and that contributions to the trust by the petitioner would be deductible under section 23 (p) of the 1939 Code. The plan provides for an administrative committee of 3 to be appointed by the company to administer the plan and requires the appointment of 3 trustees to hold and distribute the trust assets. Every employee of the company who has earned at least $ 250 during the company's fiscal year is eligible to participate in the plan. The*91 company is required to make a contribution to the trust each year of an amount equal to 25 per cent of its net income for each taxable year with the limitation that such contribution shall not exceed 15 per cent of the aggregate compensation of all participating employees. The amounts allocated to participants who hold more than 10 per cent of the voting stock of the company are not to exceed 30 per cent of the total contributions for all participants. The trustees are given power to invest the corpus in bonds, preferred stock, or such other securities as they in their sole discretion may select. The trustees are not restricted to investments in securities commonly known as legal investments for trust funds. The trustees are required, however, to invest at least 80 per cent of the trust funds in first mortgage bonds of the company and 3 1/2 per cent cumulative preferred stock of the company if such securities are available. The trustees are required to keep accurate and detailed records of the administration of the trust and such records are to be open for inspection at all reasonable times by any person designated in writing by the committee or the company. Within 60 days following*92 the close of each company fiscal year (or such other time as may be agreed upon by the trustees and *1063 the company), the trustees are required to file with the company and committee a written statement disclosing all investments, receipts, disbursements, and other transactions consummated during the year. The plan provides that the company's contributions should be either in cumulative preferred stock of the company or cash. The company's contribution is to be held in a suspense account by the trustees for allocation as of the end of the fiscal year of the company. Each eligible employee is to have credited to his account at the end of each fiscal year the fractional portion of the entire suspense account which his total annual compensation bears to the total compensation of all eligible employees for that year. The plan provides for the vesting of 20 per cent of the amount credited to a participating employee's account after 1 year of participation with an additional vesting of 20 per cent per year for 5 years, so that after 5 full years of participation the employee is entitled to the full amount credited to his account. In the event of retirement at any time prior to*93 the expiration of the 5-year period, each participating employee is entitled to the entire amount credited to his account as of the date of retirement. In the event of severance of employment, the participating employee's undistributed vested interest is to be paid to him over a period of 5 consecutive years in annual installments of 20 per cent each year. The plan provides for the distribution of the participating employee's interest upon completion of 10 years of participation under the plan. Such distribution is to be made in 10 equal annual installments. The plan provides for distributions in the event of death and provides for accelerated distributions in the event of the sickness or disability of a participant or a member of his immediate family. The trust instrument expressly states that it is the intention of petitioner that the trust and profit-sharing plan should qualify under section 165 (a) of the 1939 Code, and provides that in the event the trust and plan are held by the Commissioner or other competent authority not to qualify under section 165 (a) of the Code, the contributions made to the trust and held to be nondeductible shall be refunded to the petitioner, insofar*94 as the trust fund is sufficient to permit such repayment. The company is entitled to amend or terminate the foregoing plan at any time but in the event of such termination no part of either the corpus or income of the trust is to revert to the company or is to be diverted to any use other than for the exclusive benefit of the participants, their beneficiaries, or estates. The net amounts contributed by petitioner to the trust, the form of payment, and the dates of payment from May 14, 1945, through December 31, 1950, are as follows: *1064 Date of payment Promissory Cash For year note ended Sept. 17, 1945 $ 33,859.84 Nov. 30, 1944 Nov. 30, 1945 Sept. 5, 1947 1,485.57 Nov. 30, 1946 May 1948 $ 30,466.86 Nov. 30, 1947 Feb. 28, 1949 66,342.82 Dec. 31, 1948 Apr. 20, 1949 1 30,466.86 Feb. 15, 1950 84,568.49 Dec. 31, 1949 Apr. 17, 1950 25,067.96 Dec. 31, 1949 Aug. 8, 1950 2 66,342.82 Aug. 8, 1950 3 21,926.45 The amounts*95 equal to 25 per cent of the net income of petitioner and 15 per cent of the total compensation of all its eligible employees for the fiscal year ended November 30, 1947, and the calendar years 1948 through 1950 were as follows: 15 per cent of 25 per cent of aggregate Year net income compensation of eligible employees [1947] $ 30,466.86 $ 34,475.51 [1948] 66,342.82 42,347.54 [1949] 109,636.45 51,562.31 1950 1 n1 100,000.00 60,000.00 Petitioner initially contributed $ 62,148.13 to the trust for the fiscal year ended November 30, 1944. Thereafter, it was determined that the 15 per cent limitation prescribed by the trust instrument restricted the contribution for the fiscal year 1944 to only $ 33,859.84. The balance, or $ 28,288.29, was refunded to the petitioner. Of the $ 33,859.84 contributed for 1944, 80 per cent, or $ 27,090, was invested in 3 1/2 per cent cumulative preferred stock of the company. Inasmuch as the petitioner experienced an operating loss during the fiscal year ended November 30, 1945, no contribution was made to the trust for that year. As indicated above, petitioner made no cash contributions to the profit-sharing*96 trust for the years ended November 30, 1947, and December 31, 1948, but, instead, gave its negotiable promissory note, payable on demand, to the trustees in the amount of $ 30,466.86 by way of contribution to the trust for 1947, and its note in the amount of $ 66,342.82 as payment of its contribution for 1948. On April 20, 1949, the company paid the trustees $ 30,466.86 in cash, discharging the note for that amount issued in 1948. On February 15, 1950, petitioner issued to the trust its demand note in the amount of $ 84,568.49 and on April 17, 1950, it gave the trust *1065 its note in the amount of $ 25,067.96, making a total amount of $ 109,636.45 intended as a contribution to the trust for 1949. On August 8, 1950, petitioner paid the trustees under the profit-sharing trust the sum of $ 175,979.27 in cash, of which $ 66,342.82 was in payment of the note given the trustees during 1949 and the balance, or $ 109,636.45, was intended as payment of the 2 notes issued during 1950. The trustees of the profit-sharing trust on August 8, 1950, issued a check in the amount of $ 87,710 (approximately 80 per cent of the value of the 2 notes totaling $ 109,636.45) to the petitioner for *97 the purchase of 8,771 shares of 3 1/2 per cent cumulative preferred stock of the company. The petitioner advised the trustees that the aforementioned stock was not available and the $ 87,710 stock purchase payment was retained by petitioner. The net payment acquired by the trust in the amount of $ 21,926.45 was endorsed on the note in the amount of $ 84,568.49 issued by petitioner on February 15, 1950. On April 21, 1949, $ 25,560, or approximately 80 per cent of petitioner's contribution in the amount of $ 30,466.86, was invested in 2,556 shares of 3 1/2 per cent cumulative preferred stock of the petitioner. Approximately 80 per cent of the company's contribution in the amount of $ 66,342.82, or $ 53,080, was invested in 5,308 shares of 3 1/2 per cent cumulative preferred stock of petitioner. The original trustees included R. D. Abendroth, president of petitioner, and E. A. Peyser, petitioner's counsel. John Parker Holden, vice president and assistant secretary of petitioner, has served as a trustee since August 1945. The present trustees are Abendroth, Holden, and C. E. Miller, chairman of petitioner's board of directors. During the course of the administration of the profit-sharing*98 trust, no accounting work was done within the first 2 years, after which time the accounting firm of Ernst & Ernst was engaged to bring the records up to date. Since its employment by the trustees, the firm of Ernst & Ernst has maintained the ledger account showing the interests of the beneficiaries, and has been in complete control of all bookkeeping. The trustees maintained no accounts of their own. The accounting firm of Ernst & Ernst prepared a list of terminated employees and the amount of each such employee's interest in the trust fund. In a letter to the trustees dated November 18, 1950, the firm of Ernst & Ernst informed the trustees of the existence of several hundred accounts of terminated employees totaling over $ 7,500, part of which had become fully payable on December 31, 1949, and the remainder of which would become payable on December 31, 1950. The terminated employees were not paid the respective amounts thus determined to be due and payable under the terms of the trust instrument. The trustees were not aware of the amounts due the terminated employees until they were so advised by Ernst & Ernst on November 21, *1066 1950, upon completion of an audit of *99 the trust records. Distributions to terminated employees were not begun until June 16, 1955, approximately 60 days prior to the hearing herein. Petitioner on that date commenced distribution of its preferred stock in payment of the interests of the employees in the profit-sharing trust. At no time was cash distributed to the employees of petitioner. The trust funds were invested exclusively in the stock of petitioner. Apart from petitioner's contributions to the trust, the trust income resulted solely from dividends on petitioner's stock. Dividends earned on the aforementioned stock for 1945, 1946, and 1947 were paid to the trust on April 12, 1948. The dividend earned during 1948 was paid on April 28, 1949. Petitioner claimed deductions for contributions to the profit-sharing trust in the amounts of $ 30,466.86 and $ 66,342.82 in its income tax returns for the years 1947 and 1948, respectively. The intended contribution, in each instance, was represented by a promissory note. Fifteen per cent of the total compensation of all eligible employees of petitioner for 1948 is $ 42,347.54. Respondent proposed the assessment of a deficiency in petitioner's income tax for 1947 and 1948, *100 based in part on the disallowance of the foregoing deductions. Petitioner executed a waiver of restrictions on assessment and collection of deficiency in tax (Form 870) and paid the deficiency assessed for each of the foregoing years. Petitioner claimed a deduction in its income tax return for 1949 in the amount of $ 109,636.45, representing the total face amount of 2 demand notes contributed to the employees' trust for that year. The foregoing amount is equal to 25 per cent of petitioner's net income for 1949. Fifteen per cent of the total compensation of all eligible employees of petitioner for 1949 is $ 51,562.31. Petitioner deducted $ 88,269.27 on its return for 1950 for payments made to the trust during that year. Fifteen per cent of the total compensation of all eligible employees of petitioner for 1950 is approximately $ 60,000. On April 2, 1951, respondent notified petitioner by letter of the revocation of the ruling letter issued May 28, 1945, and advised petitioner that its employees' profit-sharing plan did not meet the requirements of section 165 (a) of the 1939 Code because the plan had not been operated for the exclusive benefit of its employees. OPINION. Respondent*101 has determined that the trust and profit-sharing plan of petitioner were neither formed nor operated for the exclusive benefit of its employees within the meaning of section *1067 165 (a) of the 1939 Code, 1*102 and therefore that amounts contributed by petitioner to the trust during 1949 and 1950 are not deductible under section 23 (p) of the 1939 Code. 2 Petitioner contends that its employees' trust and profit-sharing plan were formed for the exclusive benefit of its employees and that it is entitled to deduct its cash contributions to the trust in the amounts of $ 30,466.86 and $ 88,269.27 for 1949 and 1950, respectively. Petitioner contends in the alternative that it is entitled to deduct the face amounts of the promissory notes contributed to the trust during 1949 and 1950. In support of its position, petitioner relies on the decision of the United States Court of Appeals for the Sixth*103 Circuit in H. S. D. Co. v. Kavanagh, 191 F. 2d 831. There, as here, the taxpayer established a profit-sharing plan for its employees, submitted the plan to the Commissioner, and obtained a ruling approving the plan as exempt within the provisions of section 165 (a) of the 1939 Code. Subsequently, a succeeding Commissioner reexamined the plan and, on the same facts as originally presented, ruled that the plan discriminated in favor of officers and higher-paid employees of the company, was not operated for the exclusive benefit of the employees, and did not qualify under section 165 (a). Consequently, the Commissioner determined that the amounts contributed by the taxpayer to the plan were not deductible from its gross income in the computation of its income tax liability. The Court of Appeals first found that the plan was not *1068 discriminatory in its operation as the Commissioner had determined and further held, at page 846: Under the foregoing circumstances, and especially because of the fact that the Commissioner was given the unusual power by Congress to approve the plan and trusts and did so at various times during the course of the*104 years, with full knowledge of all details relating to them and their operations, we are of the opinion that the Commissioner, in this case, was bound by the prior decisions of his predecessor that the plan complied with Section 165 (a) of the Internal Revenue Code, as amended, and that the trusts were exempt. Inasmuch as the Commissioner's decision in H. S. D. Co., supra, to revoke the earlier ruling of his predecessor in office was not based on an examination of newly discovered evidence relating to the actual operation of the taxpayer's profit-sharing plan, but represented simply a reconsideration of the identical facts originally furnished by the taxpayer, we are of the opinion that the decision of the Court of Appeals for the Sixth Circuit in H. S. D. Co., supra, is distinguishable from the situation here in issue. That a stock bonus and profit-sharing plan must qualify in its operation as well as in its formation in order to be exempt under section 165 (a) of the 1939 Code is clear from the House Committee Report accompanying the amendment of that section by the Revenue Act of 1942. 3 Accordingly, it is incumbent*105 upon petitioner herein to demonstrate that the trust and profit-sharing plan here in question were operated exclusively for the benefit of its employees. The facts, that petitioner's plan requires the investment of 80 per cent of the trust assets in the securities of petitioner, if available, that the trust is controlled and administered by petitioner's officials, and that from the face of the trust instrument it appears that the creation of the plan was motivated by tax considerations, were known to the respondent prior to the issuance of his ruling on May 28, 1945, approving the plan. However, a trust which is so formed must be administered with scrupulous care and with the utmost good*106 faith toward the employees if it is to continue to qualify as a trust operated exclusively for the benefit of petitioner's employees. The record discloses that the administration of petitioner's trust and profit-sharing plan was deficient in several particulars and that the terms of the plan, as set forth in the instrument executed on May 14, 1945, were violated in a number of instances. The trustees were required by the plan to keep accurate and detailed records of the administration of the trust and to make such records available for inspection at all reasonable times. However, the trustees *1069 failed to keep books and accounts during the first 2 years after the commencement of the plan. Moreover, they were not aware of the benefits which had become payable to terminated employees as of December 31, 1949, until they were so notified by their public accountant on November 18, 1950. Further, no distributions were made to such employees until June 16, 1955, approximately 60 days prior to the hearing herein. Petitioner was required by the plan to contribute to the trust each year an amount equal to 25 per cent of its net income for that year but not to exceed 15 per cent of*107 the aggregate compensation of all participating employees. Such contributions were to be either in the form of preferred stock of petitioner or cash. However, for the years ended November 30, 1947, and December 31, 1948, no cash or preferred stock contributions were made to the trust. Instead, petitioner delivered to the trust 2 promissory notes payable on demand, in the amounts of $ 30,466.86 and $ 66,342.82, for 1947 and 1948, respectively. The contribution of such notes to petitioner's profit-sharing plan, in violation of the terms of the plan, does not constitute a payment to the employees' trust, deductible under section 23 (p) of the 1939 Code. Logan Engineering Co., 12 T. C. 860; Slaymaker Lock Co., 18 T. C. 1001, revd. 208 F. 2d 313. On August 8, 1950, when it became apparent to the trustees that it would be impossible to invest $ 87,710 (approximately 80 per cent of the value of the 2 notes previously delivered to the trust during that year) in cumulative preferred stock of petitioner, that amount was retained by petitioner, thus diverting for the use of petitioner a portion of the*108 corpus of the trust. The trust investments consisted entirely of petitioner's securities. Dividends earned by the trust on its investment in petitioner's stock for 1945, 1946, and 1947 were not paid to the trust until April 12, 1948. The deductions claimed by petitioner as payments to the employees' trust in the amounts of $ 109,636.45 and $ 88,269.27 for 1949 and 1950, respectively, are substantially in excess of 15 per cent of the aggregate compensation of all participating employees during those years. None of the aforementioned facts relating to the operation of petitioner's profit-sharing plan were known to the respondent at the time of the issuance on May 28, 1945, of the ruling approving the plan. In view of the foregoing developments in the administration of the plan, we are of the opinion that it was not operated exclusively for the benefit of petitioner's employees. We therefore hold that none of the payments made by petitioner to the employees' trust during 1949 and 1950 are deductible from gross income under section 23 (p) of the 1939 Code. Decision will be entered under Rule 50. Footnotes 1. In payment of note in that amount issued in May 1948.↩ 2. In payment of note in that amount issued Feb. 28, 1949.↩ 3. In partial payment of note for $ 84,568.49 issued Feb. 15, 1950.↩ 1. Approximately.↩ 1. SEC. 165. EMPLOYEES' TRUSTS. (a) Exemption From Tax. -- A trust forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall not be taxable under this supplement and no other provision of this supplement shall apply with respect to such trust or to its beneficiary -- (1) if contributions are made to the trust by such employer, or employees, or both, for the purpose of distributing to such employees or their beneficiaries the corpus and income of the fund accumulated by the trust in accordance with such plan; (2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries;↩ 2. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: * * * * (p) Contribution 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, * * * such contributions or compensation * * * 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. 3. H. Rept. No. 2333, 77th Cong., 2d Sess. (1942), pp. 103, 104: In order to insure that stock bonus, pension, or profit-sharing plans are operated↩ for the welfare of employees in general, and to prevent the trust device from being used for the benefit of shareholders, officials, or highly paid employees, * * * [Emphasis added.]