Atzingen-Whitehouse Dairy, Inc. v. Commissioner

Atzingen-Whitehouse Dairy, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Atzingen-Whitehouse Dairy, Inc. v. Commissioner Docket No. 83717 United States Tax Court 36 T.C. 173; 1961 U.S. Tax Ct. LEXIS 164; April 27, 1961, Filed *164 Decision will be entered under Rule 50. 1. In computing milk company's gross income there must be excluded from its receipts amounts of rebates which it made to its customers pursuant to oral arrangements with them, notwithstanding that such rebates were in violation of State law. Pittsburgh Milk Co., 26 T.C. 707, followed. 2. Amount of disputed cash rebates for 1955 and 1956 determined. 3. A payment of $ 7,000 to the Office of Milk Industry of New Jersey as an "adjustment" for willful violation of minimum price law held not deductible as "ordinary and necessary" business expense. 4. Legal fee of $ 6,000 paid for services culminating in petitioner's purchase of its own stock from dissident stockholders held capital expenditure to be added to the cost of acquiring the stock and not a deductible expense. 5. Amount of deductible entertainment expenses determined. Martin D. Cohen, Esq., for the petitioner. Sheldon Seevak, Esq., for the respondent. Raum, Judge. RAUM *174 Respondent determined deficiencies in the income tax of petitioner in the amounts of $ 13,441.49 for the calendar year 1954, $ 5,105.44 for the calendar year 1955, and $ 12,671.60 for the calendar year 1956. The issues are: (1) Is the petitioner entitled to exclude from its gross income for the taxable years amounts equal to certain payments which it made to customers who purchased milk and dairy products from it? (2) Did the respondent err in determining that payments claimed to have been made by petitioner to its *166 customers were unsubstantiated to the extent of $ 940.65 and $ 2,998.52 for the years 1955 and 1956, respectively? (3) Is the amount of $ 7,000 which petitioner paid to the Office of Milk Industry in 1955 deductible as an ordinary and necessary business expense? (4) Is the amount of $ 6,000 which petitioner paid to its attorney for legal services in 1956 deductible as an ordinary and necessary business expense? (5) Did the respondent err in disallowing a deduction of $ 1,500 claimed by petitioner in its return for 1956? FINDINGS OF FACT. Some of the facts have been stipulated, and, as stipulated, they are incorporated herein by reference. Petitioner is a corporation organized under the laws of the State of New Jersey. Its principal office is located in Jersey City, New Jersey. It filed United States corporation income tax returns for the years 1954, 1955, and 1956 with the district director of internal revenue at Newark, New Jersey. It maintains its books of account and files its income tax returns on a calendar year basis using an accrual method of accounting. During the years 1954, 1955, and 1956, petitioner was engaged in the business of selling milk and related dairy products*167 to both wholesale and retail customers. The major portion of its annual sales volume during those years consisted of sales to wholesale customers, which included grocery stores, moderate-sized supermarkets, delicatessen stores, luncheonettes, and restaurants. Under the laws of the State of New Jersey only milk dealers, processors, subdealers, and stores, duly licensed as provided by those laws, are permitted to sell, transport, import, dispose of, store, or distribute milk or otherwise engage in the milk business within that State. During the period involved herein, petitioner was duly licensed to sell milk in the State of New Jersey. *175 The Office of Milk Industry (hereinafter referred to as OMI) is a legally constituted agency of the State of New Jersey. The director of OMI is empowered by statute to fix the price at which milk is to be bought, sold, or distributed; regulate conditions and terms of sale; establish and require observance of fair trade practices; and supervise, regulate, and control the entire milk industry of the State of New Jersey. During the year 1954 and the periods January 1, 1955, to February 15, 1955, and June 30, 1956, to December 31, 1956, various*168 orders and regulations of the director of OMI were in full force and effect which established minimum prices for the sale of milk, cream, and milk products in the State of New Jersey. Sales made for less than those prices violated the milk control laws of the State of New Jersey. 1 *169 More milk is consumed in New Jersey than is produced there, necessitating a daily importation of milk into the State. Milk imported into New Jersey could be bought for less than the price of New Jersey produced milk as fixed by OMI. During the period in question certain New Jersey dealers buying from out-of-State producing dairies paid lower prices than those prevailing in New Jersey. During the period here involved, the method used by petitioner for billing sales to its customers, collecting from its customers, and recording such sales and receipts (without taking into account certain rebates hereinafter more fully referred to) was as follows: (a) Petitioner had in its employ approximately six drivers or routemen. To each driver was assigned a group of petitioner's customers who were located in a particular geographical area. Each day of the week, except Sunday, the drivers would pick up milk and other dairy products at petitioner's main office and then proceed to make deliveries to their assigned customers. *176 (b) Each driver maintained his own record of sales to and collections from customers. A daily ticket was made out showing products sold to each customer, priced*170 at the minimum legal prices which had been fixed by OMI and which were in effect on the date of the sale. In most instances the driver would present to the customer a daily bill or invoice showing sales for that day billed at OMI minimum prices. The driver would then collect from the customer the amount of the day's bill. In some cases collections were made from customers on a monthly basis. In a very few cases collections were made on a weekly basis. Otherwise, the method of billing and pricing was the same as described above. (c) All moneys collected by petitioner's drivers from customers located within their route area were turned in to petitioner. Petitioner did not record sales or receipts from sales according to individual customers; instead, petitioner recorded its sales according to drivers or routemen. Thus, petitioner's sales were listed as having been received from its several drivers. Sales of dairy products as thus recorded on petitioner's books were based on OMI minimum prices. Competition between petitioner and the other members of its industry serving the New Jersey area was keen and neither petitioner nor its competitors adhered to the minimum prices which*171 OMI had prescribed during the years involved herein. Petitioner continually received demands from its wholesale customers for downward adjustments in prices. These customers threatened to discontinue buying from petitioner unless it complied with their demands. In many instances petitioner did not do so and as a consequence lost customers. At all material times prior to January 4, 1956, the officers and directors of petitioner and the owners of the petitioner's 600 outstanding shares of stock were as follows: Office held Director Number of shares held Ernest Zima President Yes 199 (class B) Walter Von Atzingen Vice president Yes 200 (class A) William Von Atzingen Secretary-treasurer Yes 200 (class A) Henry Zima None Yes 1 (class B) As petitioner's president, the duties of Ernest Zima (hereinafter referred to as Zima) included general supervision of the business, personnel matters, and servicing of roughly one-half of petitioner's approximately 200 wholesale accounts. The balance of such accounts was looked after by William Von Atzingen (hereinafter referred to as William). Petitioner entered into oral agreements with certain customers agreeing to make payments*172 (sometimes hereinafter referred to as *177 rebates, discounts, or allowances) to them based upon a percentage of sales or a specific amount per quart of milk. The agreements varied from 1/2 cent to 2 cents per quart and from 3 percent to 10 percent of gross sales. The amount of the rebate was arrived at through bargaining, with the petitioner making the best deal with each individual customer that it could negotiate. It was petitioner's practice to keep certain working sheets showing the name and address of each customer with whom an agreement was in effect, the terms of such agreement, and, for each month, the amounts of milk and dairy products sold and the discount payable to each such customer. Such discounts were computed by applying the agreed rate of discount to total monthly sales as shown in the drivers' route books. Between 60 and 85 percent of the customers with whom petitioner had agreements received a cash rebate from petitioner once a month; a small number received cash rebates only once a year; and the remainder received cash rebates every 3 months. The majority of the agreements as to rebates remained constant. However, from time to time petitioner did agree*173 to pay discounts to certain customers at an increased rate. On some occasions, customers who received a rebate only once a year were given rebates in round sums rather than in the precise amount of dollars and cents which would result from applying the agreed discount rate to the actual amount of the year's sales. Payment of such round sums resulted from petitioner's willingness to give such customers their rebate a month or two before it otherwise would have been paid. Each month, during the years involved, petitioner drew from its general funds an amount which it estimated would be needed for payment of rebates to customers. Such amounts were credited to cash and debited to an account regularly maintained by petitioner entitled "Selling Expense-Sales Promotion." During the years 1954, 1955, and 1956 the following amounts were withdrawn by petitioner from its general funds, debited to petitioner's account "Selling Expense-Sales Promotion" and claimed by petitioner on its Federal income tax returns as a deduction for "Commissions and Promotion": [1954] $ 25,849.01 [1955] 32,318.17 [1956] 39,550.08 Respondent determined that, for the taxable year 1954, petitioner's deduction*174 for commissions and promotion expense in the amount of *178 $ 25,849.01 was not allowable "inasmuch as it consists of rebates to customers in violation of regulations issued by the Director of the New Jersey Office of Milk Industry." For the year 1955, respondent determined that the deduction of $ 32,318.17 claimed by the petitioner for commissions and promotion expense was not allowable to the extent of $ 2,818.17 on the grounds that $ 1,877.52 of this amount represented rebates made to customers in violation of the minimum price regulations and orders issued by the director of OMI in effect during the period from January 1, 1955, to February 15, 1955; and that the remaining $ 940.65 represented cash withdrawals charged to the "Selling Expense-Sales Promotion" account, the ultimate use of which was not substantiated by petitioner. Rebates were made by petitioner to some of its customers by check. Most of its customers, however, received cash and signed a voucher evidencing the receipt of such cash. Some would neither accept a check nor give petitioner a receipt for the cash discounts they received. In 1955, petitioner pursuant to preexisting agreements paid $ 575 in cash *175 rebates to customers who gave no receipts therefor. For the year 1956, respondent determined that the deduction of $ 39,550.08 claimed by the petitioner for commissions and promotion expense was not allowable to the extent of $ 20,279.55 on the grounds that $ 17,281.03 of that amount represented rebates made to customers in violation of the minimum price regulations and orders issued by the director of OMI in effect during the period from June 30, 1956, to December 31, 1956; and that $ 2,998.52 represented cash withdrawals charged to the "Selling Expense-Sales Promotion" account the ultimate use of which was not substantiated by petitioner. In 1956 petitioner pursuant to preexisting agreements made cash rebates of $ 2,750 to customers who refused to give it any receipts therefor. The prices for which petitioner sold its milk and dairy products were the net prices arrived at by reducing invoiced prices by the amounts of rebates made pursuant to agreements between it and its customers. The amounts of rebates paid by petitioner to its customers in 1954, 1955, and 1956 (including those for which customers refused to give receipts) are properly to be deducted from its gross sales in computing*176 its gross income. Payment of $ 7,000 to OMI. The records of OMI, maintained on the basis of a fiscal year ending June 30, show that over a 7-year period (1954 through 1960) the director has held informal hearings relating to violations of minimum prices for the resale of milk in New Jersey, that each hearing resulted *179 in an adjustment under N.J. Stat. Ann., sec. 4:12A-43, 2 and that the number of such informal hearings and the amounts of adjustments resulting therefrom were as follows: Fiscal year ended June Number of Adjustments 30 -- informal hearings [230] $ 15,105 [823] 81,270 [151] 32,180 [106] 26,385 [198] 14,315 [147] 11,249 [442] 19,810 The smallest adjustment imposed by the director of OMI during the period from 1954 through 1960 was $ 10; the largest adjustment was $ 10,000. *177 Between May 1, 1953, and the present, there have been periods when prices for resale of milk in New Jersey were fixed and periods when they were not fixed. OMI experience shows that respect for minimum resale prices varies from time to time depending on conditions which cause price cutting. In the early part of 1955, petitioner was served by OMI with an order to show cause why its license to sell milk in the State of New Jersey should not be suspended or revoked on the ground that it had been guilty of violating minimum price regulations issued by OMI pursuant to law. After the service of the aforementioned order to show cause, petitioner, through its counsel, conducted negotiations with the director of OMI in an effort to adjust the matter under N.J. Stat. Ann., sec. 4:12A-43. The director of OMI initially suggested that the payment in adjustment be in the amount of $ 10,000. At the time petitioner was aware that it was guilty of violating the milk control laws of the State of New Jersey and that if it were not able to adjust the matter under N.J. Stat. Ann., sec. 4:12A-43 its license would be suspended or revoked. The negotiations finally resulted in an agreement that petitioner*178 make a payment in adjustment of the violations in the amount of $ 7,000, and this amount was paid to OMI during the year 1955. In its 1955 return, petitioner claimed as a deductible business expense the amount of $ 7,000 paid to OMI during that year. The claimed deduction was disallowed by respondent. *180 $ 6,000 Legal Fee. As already noted Zima, Walter Von Atzingen, and William Von Atzingen at all material times prior to January 4, 1956, each owned approximately one-third of the outstanding stock of petitioner. The stockholders had a written agreement that provided that no stockholder could dispose of his stock without offering it to the others. In the summer of 1955 friction developed between Zima and the two Von Atzingens, and the latter gave Zima notice that they desired either to sell their stock or to buy his stock. Conferences were thereafter held between the stockholders which ultimately resulted in an agreement that petitioner would purchase the stock owned by the two Von Atzingens. Michael Z. Szadkowski, attorney for petitioner, attended these conferences and prepared the agreements and handled other details necessary to consummate the transaction. Effective*179 January 4, 1956, Walter Von Atzingen resigned as an officer and director of petitioner, and on or about that date petitioner purchased the 200 shares of its stock owned by him for $ 72,000. On February 9, 1956, William Von Atzingen resigned as an officer and director of petitioner and petitioner purchased the 200 shares of its stock owned by him for $ 72,000. Following the redemption of their stock, Walter and William became employees of petitioner. Walter died on December 31, 1956. On or about April 1, 1956, petitioner paid $ 6,000 to Szadkowski for legal services rendered. In its 1956 return, petitioner claimed the $ 6,000 paid to Szadkowski as a deductible business expense. On July 23, 1957, Internal Revenue Agent Jessie Krellenstein started an audit of petitioner's returns for the years 1954, 1955, and 1956. In the course of her audit she questioned the payment of the $ 6,000 legal fee and asked for substantiation. The petitioner's representative gave her two bills, one for $ 3,500 and the other for $ 2,500, and told her they were photo copies of the original bills presented by Szadkowski to petitioner for his services. In these bills the legal services rendered by Szadkowski*180 were described in detail. All of the services so described related solely to services rendered by Szadkowski in connection with the sale of the Von Atzingens' stock to petitioner. Respondent disallowed the deduction of $ 6,000 claimed by petitioner in its 1956 return on the ground that legal expenses incurred for services rendered in connection with the purchase of stock by a corporation from its stockholders were not deductible as ordinary and necessary business expenses. Deduction of $ 1,500 in 1956 Return. After petitioner redeemed the stock owned by William Von Atzingen on February 9, 1956, substantially all of its stock was owned by *181 Ernest Zima. During 1956, after Labor Day, petitioner made three payments to Zima which totaled $ 1,500. In its 1956 return petitioner claimed a deduction of $ 1,500 for miscellaneous expenses which was disallowed by the respondent. $ 150 of the $ 1,500 paid by petitioner to Zima during 1956 represented reimbursement for amounts which he expended during that year to entertain petitioner's customers. OPINION. (1) We have concluded on the evidence that the actual prices at which petitioner sold its products were the invoice prices *181 minus the discounts agreed upon between petitioner and its customers. Accordingly, the problem before us is not whether such discounts are deductible as "ordinary and necessary" business expenses from gross income in arriving at net income, cf. Tank Truck Rentals v. Commissioner, 356 U.S. 30; rather it is whether the discounts must be taken into account in determining the amount of gross income chargeable to petitioner in the first instance. Cf. Lela Sullenger, 11 T.C. 1076, acq. 1952-2 C.B. 3. We hold, following Pittsburgh Milk Co., 26 T.C. 707, which involved a virtually identical situation, that in computing gross income the amount of petitioner's sales must be based upon its actual prices and not upon the theoretical legal minimum prices. The present case is closer to the Pittsburgh Milk Co. case than to Boyle, Flagg & Seaman, Inc., 25 T.C. 43, relied upon by respondent. Respondent urges that the decision in the Pittsburgh Milk Co. case be reconsidered. He made a similar contention in two other cases, in which the*182 holding in the Pittsburgh Milk Co. case was reaffirmed and followed in memorandum opinions by this Court. 3 Moreover, the theory of the Pittsburgh Milk Co. case has been applied, at the respondent's urging, in Tri-State Beverage Distributors, Inc., 27 T.C. 1026, 1030-1031. We are not disposed to reopen the question. (2) In connection with the first issue decided above, the Commissioner made adjustments in the amounts of $ 940.65 and $ 2,998.52 for the years 1955 and 1956, respectively, on the ground that there was no substantiation for rebates to that extent. In general petitioner obtained receipts from its customers for cash rebates which had been made, and the Commissioner's determination treated petitioner as having made cash rebates only in the amounts supported by such receipts. However, there was evidence that some customers*183 refused to sign receipts, and on the basis of such evidence as we have before us we have found as a fact that petitioner made cash rebates of $ 575 in 1955 and $ 2,750 in 1956 to customers who refused to give it any receipts. Our holding with respect to these cash rebates is the same as *182 that heretofore made with respect to rebates which respondent was able to substantiate from petitioner's records. (3) Payment of $ 7,000 to OMI. -- Petitioner contends that its payment of $ 7,000 to OMI in 1955 was not a fine or penalty the allowance of which would frustrate public policy, and that it is deductible as an ordinary and necessary business expense. It urges that the ordinary nature of the payment is established by OMI statistics showing that OMI held 823 informal hearings respecting minimum milk price violations all of which resulted in adjustments under N.J. Stat. Ann., sec. 4:12A-43, and that the payment was necessary because, if it had not been made, petitioner would have been subjected to a more severe sanction, the revocation of its license, without which it could not carry on its business. In O'Dowd's Dairy v. Hoffman, 52 N.J. Super. 135, 145 A. 2d 40,*184 the Superior Court of New Jersey, Appellate Division, held that the director of OMI had no power to impose a penalty under N.J. Stat. Ann., sec. 4:12A-39, 4 a section which is not involved in the instant proceeding. In the course of its opinion in that case, the court pointed out that the director did have the following powers to enforce the milk control laws (145 A. 2d at 43-44): He has drastic powers with which to enforce the law -- far more compelling than penalties under section 39. He may suspend or revoke a license. N.J.S.A. 4:12A-35. He may seize products produced or handled in violation of the law (N.J.S.A. 4:12A-39), and he may proceed in the Superior Court against chronic violators by injunction. N.J.S.A. 4:12A-44. On the other hand, he may informally adjust violations (N.J.S.A. 4:12A-43), in which case he may collect the sum the violator agrees to pay. * * * *185 It is apparent that the milk control laws of New Jersey gave the director several means of enforcing them and discouraging violations. In N.J. Stat. Ann., sec. 4:12A-43, he was given the power to hold informal hearings and "adjust" violations with the person accused thereof, as was done in this case, "for such amounts as may in his discretion, be proper under the circumstances." The adjustment of $ 7,000 which he determined and petitioner paid in 1955 was for willful violations and is not comparable to the innocent violations of the Emergency Price Control Act considered in Jerry Rossman Corporation *183 v. Commissioner, 175 F. 2d 711 (C.A. 2), relied upon by petitioner. Petitioner's right to the deduction claimed for the $ 7,000 payment depends upon whether the allowance of such a deduction would frustrate the enforcement of the milk control laws by reducing the "sting" of the adjustment made for violating them. Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 35. We think that it would and, in the circumstances, respondent's disallowance of the claimed deduction should be sustained. No useful purpose*186 would be served by a verbal inquiry into whether the adjustment may be called a "fine" or "penalty." The label is immaterial. Plainly, it was intended as a sanction calculated to induce compliance with New Jersey law and was punitive in character. The payment of the amount in controversy was not an "ordinary and necessary" business expense. (4) $ 6,000 legal fee. -- In 1956 petitioner paid $ 6,000 to an attorney for legal services. In its return for that year petitioner claimed a deduction for this payment as an ordinary and necessary business expense. Respondent disallowed the claimed deduction on the ground that the payment was for legal expenses for services rendered in connection with the purchase by petitioner of the shares of its stock owned by William and Walter Von Atzingen. Petitioner has not proved that respondent erred in this determination. On the contrary, the evidence produced convinces us that the respondent correctly determined that the $ 6,000 payment was for legal services rendered in connection with the purchase by petitioner of shares of its stock. That payment is a capital expenditure which should have been treated as part of the cost of the stock *187 purchased. It is not deductible as an ordinary and necessary business expense. The fact that the purchase of the stock was motivated by a desire to eliminate friction between the Von Atzingens and Zima is immaterial. Certainly, the cost of the stock itself was a capital expenditure rather than a deductible expense, and the accompanying legal fee must be similarly classified. (5) Entertainment expenses. -- In its 1956 return petitioner claimed a deduction of $ 1,500 for miscellaneous expenses, which was disallowed by the respondent. During 1956, after Labor Day, petitioner made three payments to Ernest Zima which totaled $ 1,500. At that time Zima owned substantially all the stock of petitioner. He testified that he made expenditures from his own funds for entertainment of petitioner's customers and that the $ 1,500 received from petitioner was to reimburse him therefor. He kept no records showing such expenditures and had no receipts to evidence them. Although he testified that he entertained many of petitioner's customers, he identified only one by name. According to his testimony, the entertainment consisted of buying customers drinks, taking them out to dinner, and*188 spending money at customers' establishments in order to promote business. His testimony as to the nature and amount of these expenditures was *184 vague and unsatisfactory. However, we think that some part of the amount in controversy may have been spent for entertaining customers in circumstances that were proximately related to petitioner's business. Applying the familiar rule of Cohan v. Commissioner, 39 F. 2d 540, 544 (C.A. 2), and "bearing heavily" upon petitioner for its failure to furnish adequate proof, we have found as a fact, and hold, that $ 150 of the $ 1,500 paid to Zima during 1956 represented reimbursement for deductible amounts which he expended during that year to entertain petitioner's customers. Decision will be entered under Rule 50. Footnotes 1. The Act provides, in part, as follows: 4:12A-29. Milk purchased for less than minimum price; prohibition against sale and distribution No milk dealer, processor, subdealer or store shall distribute, sell or handle milk in this State which is obtained from any producer, other milk dealer, processor, subdealer or store where the milk has been purchased either directly or indirectly for a price less than the minimum price fixed by the director to be paid for such milk to be distributed in a given market. L. 1941, c. 274, p. 725, § 29. 4:12A-30. Secret agreement for price reduction prohibited; exception No licensee or other person, association or corporation shall hereafter contrary to the public interest operate in any municipality under any mutual or secret agreement, arrangement, combination, contract or common understanding, with any other licensee or person, firm, association or corporation, whereby the price for milk to be paid to producers in this State is reduced or the price to be paid by dealers, processors, subdealers, stores or consumers for such milk is decreased in pursuance of such mutual or secret agreement, arrangement, combination, contract or common understanding, and each such contract, arrangement, agreement or understanding is hereby prohibited and declared to be contrary to the public interest and in restraint of trade and commerce, and shall subject the violator or violators to the penalty in this act prescribed; provided, however↩, that the right may be granted to deduct a check-off to be paid as association or corporation with consent of producer and approval of the director. L. 1941, c. 274, p. 725, § 30. 2. 4:12A-43. Informal hearings on violations; adjustments Upon receiving evidence of a violation of any of the provisions of this act or of any of the rules, regulations or orders of the director, any employee designated by the director is hereby empowered to hold informal hearings upon said violation or violations at such place or places as the director may fix and upon finding the violations to have been committed, to adjust same with any person accused of violating any provisions of this act or the rules, regulations or orders of the director, for such amounts as may in the discretion of the director, be proper under the circumstances. In the event of the violator making payment of the sum set in adjustment, no further prosecution shall be had upon any violation so adjusted. L. 1941, e. 274, p. 735, § 43.↩ 3. Rosedale Dairy Co., T.C. Memo. 1957-243; Harmony Dairy Co., T.C. Memo. 1960-109↩. 4. 4:12A-39. Violations of act; penalty; seizure and sale Any person who shall violate any of the provisions of this act or the orders, rules and regulations of the director as adopted from time to time shall be deemed guilty of a violation of the provisions of this act and shall pay a penalty of not more than fifty dollars ($ 50.00) for the first offense and not more than two hundred dollars ($ 200.00) for the second, or each subsequent offense, and such penalty when collected shall be paid to the Treasurer of the State of New Jersey and become a part of the general fund of the State of New Jersey. Any milk as herein defined which is the subject of the violation of this act or the orders, rules and regulations of the director, may be seized, and any part thereof may be sold as the director or court may direct; the proceeds from such sale to be paid to the Treasurer of the State of New Jersey to abide the further order of the director or court, and if no such order is made then to become a part of the general fund of the State of New Jersey. L. 1941, c. 274, p. 732, § 39.↩