United Draperies, Inc. v. Commissioner

United Draperies, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent; United Draperies, Inc. (Formerly United Slip Cover and Interiors Co.), Petitioner, v. Commissioner of Internal Revenue, Respondent United Draperies, Inc. v. Commissioner Docket Nos. 94171, 3952-62 United States Tax Court 41 T.C. 457; 1964 U.S. Tax Ct. LEXIS 167; January 6, 1964, Filed *167 Decisions will be entered under Rule 50. 1. Held, rebates paid by petitioner to certain employees of its customers are not deductible under section 162, I.R.C. 1954. 2. Held, further, the amounts of these rebates are includable in gross income under section 61(a), I.R.C. 1954. 3. Held, further, amounts paid by petitioner primarily for property transfers to employees of its customers are not deductible under section 162, I.R.C. 1954. Julian L. Berman, Arthur S. Freeman, Leo J. Schwartz, and George Brode, for the petitioner. Theodore W. Hirsh, for the respondent. Bruce, Judge. BRUCE *457 Respondent determined deficiencies in the income taxes of petitioner as follows: Docket No. Year ended or period Deficiency 94171 Mar. 31, 1957 $ 21,561.24 Mar. 31, 1958 28,804.37 Mar. 31, 1959 17,065.88 3952-62 Apr. 1, 1959, to Dec. 31, 1959 9,682.06 Dec. 31, 1960 2,053.16 The issues are: (1) Whether amounts paid by petitioner to certain employees of its customers are deductible under section 162 of the *458 Internal Revenue Code of 1954; (2) whether the amounts so paid are includable in gross income under section 61(a) of the Internal Revenue Code of 1954; and (3) whether amounts which, with the exception of $ 1,150 in *168 cash paid directly, were paid for property transfers to or for benefit of employees of its customers are deductible under section 162 of the Internal Revenue Code of 1954. FINDINGS OF FACT The stipulated facts and exhibits attached thereto are incorporated herein by this reference. Petitioner is a corporation incorporated under the laws of Illinois and has its principal place of business at 320 West Ohio Street, Chicago, Ill. On June 23, 1961, by amendment of its articles of incorporation, petitioner's corporate name was changed from United Slip Cover & Interiors Co. to United Draperies, Inc. Petitioner's Federal income tax returns for the periods here involved were filed with the district director of internal revenue at Chicago, Ill. During the years in issue, petitioner was engaged primarily in the manufacture and sale of draperies to manufacturers of mobile homes. Petitioner presently is the largest supplier of draperies to mobile home manufacturers in the United States. At all times material to this case, Max Rosenberg (hereinafter referred to as Rosenberg) was petitioner's president. During the years involved, Mid-States Corp. (hereinafter referred to as Mid-States) was an Illinois *169 corporation engaged in the manufacture of mobile homes and had its principal office at 831 South Wabash Avenue, Chicago, Ill. William B. MacDonald (hereinafter referred to as MacDonald) was Mid-States' president. Mid-States' manufacturing operations were conducted by controlled subsidiary corporations, including Elcar Mobile Homes, Inc. (hereinafter referred to as Elcar), located at Bourbon, Ind., M. Systems, Inc. (hereinafter referred to as M. Systems), located at Texarkana, Tex., and Kozy Coach Co., Inc. (hereinafter referred to as Kozy), located at Kalamazoo, Mich. During the years in question Dominic Conte (hereinafter referred to as Conte), was vice president and general manager of Elcar, Henry Eckstein (hereinafter referred to as Eckstein) was vice president and general manager of M. Systems, and Donald Bergner (hereinafter referred to as Bergner) was vice president and general manager of Kozy. Prior to 1953 petitioner was engaged in manufacturing custom-made draperies and slipcovers for retail consumers. Its principal office was located at 831 South Wabash Avenue, Chicago, Ill., in the same building *459 in which Mid-States' principal office was located. In 1953 Conte was assistant *170 purchasing manager for Mid-States. Bergner and Eckstein were also Mid-States' employees. At this time, Venetian blinds were the principal covering used for windows in mobile homes. Sometime in 1953 Conte and Bergner approached Rosenberg with an order for 500 draperies for mobile homes. This order was accepted by Rosenberg on petitioner's behalf. Petitioner paid 10 percent of the amount collected on this order to Conte and Bergner. A second order for draperies for 50 mobile homes was refused by petitioner, but approximately 6 months later petitioner accepted and filled a similar order. Again, petitioner paid Conte and Bergner 10 percent of the amount collected on the order from Mid-States. In 1955 Conte, Bergner, and Eckstein were made vice president and general manager of Elcar, Kozy, and M. Systems, respectively. As vice president and general manager of Elcar, Conte's duties consisted of the overall operation of the corporation, including overseeing the company's production, design, sales, purchases, collections, and payments. He devoted substantial time to improving the design of Elcar mobile homes. Sometime in 1955, after he became in charge of Elcar, Conte again asked Rosenberg *171 to manufacture draperies for Mid-States mobile homes. Rosenberg on behalf of petitioner agreed to supply draperies to Elcar, M. Systems, and Kozy and to pay Conte 10 percent of all collections from sales by petitioner to Elcar and 5 percent of all collections from sales to M. Systems and Kozy. Rosenberg further agreed to pay Eckstein 5 percent of all collections by petitioner from M. Systems and Bergner 5 percent of all collections from Kozy. Subsequent to this agreement, the orders received by petitioner from Elcar, M. Systems, and Kozy specified the measurement, material, and design to be used in the draperies for their mobile homes. Conte often went to petitioner's office on Saturday and accompanied Rosenberg on several trips to New York to buy material. In addition, Rosenberg went with Conte to several mobile home shows where Conte introduced him to other mobile home manufacturers. Bergner and Eckstein occasionally also were in petitioner's office on Saturday. In 1959 Conte executed a written guaranty of prompt payment of all bills rendered by petitioner to Elcar and M. Systems to the extent of $ 50,000. The agreement stated that Conte had assured petitioner orally since February *172 1956 that amounts due it from Elcar and M. Systems would be paid promptly. Sometime in 1958 or 1959 the amount paid by petitioner to Conte was increased to 13 percent of collections from Elcar. *460 Petitioner's total sales for the years 1950 through 1960 were as follows: Year ended or period Sales Mar. 31, 1950 $ 150,378.16 Mar. 31, 1951 137,562.40 Mar. 31, 1952 171,884.00 Mar. 31, 1953 142,433.02 Mar. 31, 1954 123,239.41 Mar. 31, 1955 191,784.80 Mar. 31, 1956 344,441.51 Mar. 31, 1957 483,218.11 Mar. 31, 1958 505,720.53 Mar. 31, 1959 638,115.22 Apr. 1, 1959, to Dec. 31, 1959 464,325.88 Dec. 31, 1960 437,761.93 During the years 1957 through 1960 petitioner made the following amounts of sales to Elcar, M. Systems, and Kozy: Year ended or period Elcar M. Systems Kozy Total Mar. 31, 1957 $ 221,000.25 $ 86,258.00 $ 82,026.61 $ 389,284.86 Mar. 31, 1958 239,721.56 63,214.94 83,817.55 386,754.05 Mar. 31, 1959 159,996.18 95,627.43 38,771.48 294,395.09 Apr. 1, 1959-Dec. 31, 1959 80,097.68 54,064.87 [1] 134,162.55 Dec. 31, 1960 69,541.81 53,165.39 122,707.20 Petitioner's sales to mobile home *173 manufacturers outside the Mid-States group during the years in issue were as follows: Year ended or period Non-Mid-States sales Mar. 31, 1959 $ 283,221.67 Apr. 1, 1959, to Dec. 31, 1959 251,314.86 Dec. 31, 1960 294,097.21 The following amounts were paid by petitioner to Conte, Eckstein, and Bergner during the years involved in accordance with its agreement to pay them a percentage of its collections from Elcar, M. Systems, and Kozy: Year ended or period Conte Eckstein Bergner Total Mar. 31, 1957 $ 28,305.78 $ 1,184.59 $ 7,229.60 1 $ 36,719.97 Mar. 31, 1958 31,089.48 6,486.37 6,373.07 43,948.92 Mar. 31, 1959 18,314.63 8,385.40 3,958.57 30,658.60 Apr. 1, 1959-Dec. 31, [1959] 2 14,617.87 2 6,185.09 126.25 20,929.21 Dec. 31, 1960 4,909.15 1,257.76 6,166.91 These amounts were delivered to Conte at petitioner's office and to Bergner and Eckstein either at petitioner's office or by mail at their respective offices in Kalamazoo and Texarkana. *461 On its Federal income tax returns for the taxable periods in issue petitioner reported the full payment received *174 from Elcar, M. Systems, and Kozy for the sale of its draperies but deducted the above-stated amounts paid to Conte, Bergner, and Eckstein as commission expense. Petitioner deducted as sales promotion expense on its Federal income tax returns for the years in issue the following amounts which, with the exception of $ 1,150 paid in cash to Conte and Eckstein, were paid for the transfer of property, such as furniture, suits, and automobiles, to or for the benefit of Conte, Eckstein, and Bergner: Year ended or period Conte Eckstein Bergner Total Mar. 31, 1957 $ 6,349.00 $ 687.47 1 $ 7,036.47 Mar. 31, 1958 2 7,652.48 3 $ 1,330.00 2,461.60 11,444.08 Mar. 31, 1959 2,160.39 2,160.39 Apr. 1, 1959-Dec. 31, 1959 791.61 791.61 No payments were made by petitioner to any employees of its customers *175 other than to Conte, Eckstein, and Bergner. Conte received payments from other suppliers of Elcar similar to those paid to him by petitioner. Petitioner's employee, Lindy Thomas, serviced petitioner's non-Mid-States accounts, including measuring windows and selecting the material and design of the draperies, and was paid a commission amounting to 7 percent of sales to these customers. The amounts paid by petitioner to Conte, Eckstein, and Bergner were not ordinary and necessary business expenses of petitioner. The amounts paid by petitioner for property transferred to Conte, Eckstein, and Bergner were not ordinary and necessary business expenses of petitioner. OPINION The first issue is whether the amounts paid by petitioner to Conte, Eckstein, and Bergner pursuant to its agreement to pay them a fixed percentage of its collections from their respective employers are deductible as ordinary and necessary business expenses under section 162 of the Internal Revenue Code of 1954. 1 Section 162(a) provides: SEC. 162. TRADE OR BUSINESS EXPENSES. (a) In General. -- There shall be *176 allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including -- *462 (1) a reasonable allowance for salaries or other compensation for personal services actually rendered; The Income Tax Regulations, section 1.162-7(b)(1), provide that an amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible under this section as compensation for personal services. Petitioner contends that its percentage payments to Conte, Eckstein, and Bergner were compensation for personal services actually rendered in the course of its trade or business and therefore are deductible under section 162(a)(1). Respondent on the other hand has determined that these payments were made in order to secure the business of the payees' employers and thus were common kickbacks within the purview of Rev. Rul. 62-194, 1962-2 C.B. 57. We think that petitioner has failed to prove that these payments were made in return for the personal services of the recipients. The services which petitioner claims were the consideration for the payments to Conte, Eckstein, and Bergner were services which *177 they were obligated to perform for their employers. Conte was responsible to his employer for the overall management of its operations, including designing its products and promptly paying its bills. Eckstein and Bergner held positions with their employers similar to that of Conte at Elcar, and their duties were presumably the same as were his to his employer. Although the orders received by petitioner from Elcar, M. Systems, and Kozy specified the measurements, material, and design of the draperies desired, petitioner has failed to prove that these specifications were made in return for its paying Conte, Eckstein, and Bergner a percentage of collections on the orders. Rather, it appears from Conte's testimony that the prime reason for his interest in designing the draperies for Elcar mobile homes was to improve the appearance, and thereby the marketability, of his product. Likewise, petitioner has failed to establish that any purported guaranty of prompt payment of amounts due from Elcar, M. Systems, and Kozy prior to 1959 or Conte's written guaranty executed in 1959 were related to its agreement to make the percentage payments involved. Although Conte did introduce Rosenberg *178 to other mobile home manufacturers at mobile home shows, petitioner has not shown that this was in exchange for its payments to Conte. Thus, respondent's determination that petitioner's percentage payments to Conte, Eckstein, and Bergner were rebates paid in consideration for their giving their employer's business to petitioner is sustained. Although not deductible under section 162(a)(1) as compensation for personal services rendered, these amounts paid by petitioner to Conte, Eckstein, and Bergner for the purpose of obtaining their employers' business may nonetheless be deductible under section 162 if *463 they are both ordinary and necessary business expenses. Lilly v. Commissioner, 343 U.S. 90; Deputy v. du Pont, 308 U.S. 488. Whether or not an expenditure is ordinary and necessary is a question of fact to be decided from the circumstances in each case. Welch v. Helvering, 290 U.S. 111. To be ordinary within the meaning of section 162, expenditures must be common in the taxpayer's dealings or of frequent occurrence in the type of business in which the taxpayer is engaged. Deputy v. du Pont, supra;Welch v. Helvering, supra. Petitioner has failed to show that it normally made payments *179 of the type in issue or that such payments were commonly made in the kind of business in which it was engaged. On the contrary, petitioner's president testified that petitioner made no payments to employees of its customers other than to Conte, Eckstein, and Bergner. Petitioner has offered no evidence of payments by drapery manufacturers to employees of their mobile home customers and the fact that Conte was paid amounts by other Elcar suppliers is insufficient to establish that the practice was common among suppliers of mobile home manufacturers. Petitioner's deduction of its percentage payments to Conte, Eckstein, and Bergner therefore must be denied because petitioner has failed to establish that these payments were ordinary expenses. Deputy v. du Pont, supra. The deduction of these amounts must also be disallowed because petitioner has failed to establish that these expenses were necessary. There is no question that petitioner's arrangement with Conte, Eckstein, and Bergner was advantageous to its enterprise. Subsequent to this arrangement, petitioner developed from a small supplier of custom-made draperies for retail buyers with gross sales in 1954 of $ 123,239.41 to the largest *180 supplier of draperies to the mobile home industry with gross sales in 1960 of $ 437,761.93. Assuming that petitioner would not have received the business of Elcar, M. Systems, and Kozy had it not agreed to pay Conte, Eckstein, and Bergner a percentage of its collections from their respective employers, these payments were necessary in the sense that they were helpful in establishing petitioner's business. Welch v. Helvering, supra;Lilly v. Commissioner, supra.The record is not sufficient, however, to find as a fact that petitioner would not have received the business of Elcar, M. Systems, and Kozy but for such payments. Petitioner's work was apparently satisfactory and there is no evidence Elcar, M. Systems, and Kozy considered making their purchases elsewhere. Moreover, a finding of necessity cannot be made if the allowance of the deduction would frustrate sharply defined national or State policy evidenced by some governmental declaration. Tank Truck Rentals v. Commissioner, 356 U.S. 30, 33. See also, Lilly v. Commissioner, supra;Commissioner v. Heininger, 320 U.S. 467. A statute in the jurisdiction involved, Tank Truck Rentals v. Commissioner, supra;Hoover *464 v. United States, 356 U.S. 38, *181 and a Treasury regulation having the force of law, Cammarano v. United States, 358 U.S. 498, have been held to evidence sharply defined public policy. In the instant case, respondent, citing Rev. Rul. 62-194, 1962-2 C.B. 57, relies upon a long-standing policy of the Federal Trade Commission developed in the implementation of section 45, 15 U.S.C., prohibiting unfair competition. Although Rev. Rul. 62-194 was published subsequent to the taxable years involved, Federal Trade Commission regulations effective during these years provide: Section 3.310To influence employers. Secretly giving or offering to give to employees of customers or prospective customers, without knowledge or consent of their employers, as inducement to purchase products of respondent, money or anything of value, is prohibited. [16 C.F.R. sec. 3.310 (1949 ed.).] Petitioner has failed to establish that Conte, Eckstein, and Bergner's employers knew of petitioner's practice of paying rebates to their employees. The only evidence offered by petitioner of the knowledge and consent of the payees' employers is Rosenberg's testimony referring to a statement of MacDonald that he would be better off "to let the other boys *182 make $ 5 or $ 10 on a trailer" than to have trouble with a fourth Mid-States subsidiary manufacturing its own draperies. MacDonald was not called as a witness and this evidence, if otherwise competent, is insufficient to establish the extent of his knowledge or consent. Thus, the rebates paid by petitioner were payments proscribed by the Federal Trade Commission regulation. And allowance of the deduction of the amounts of these payments would frustrate the policy pronounced in this regulation, since deductibility of such payments would provide an inducement to violate the Federal Trade Commission's prohibition against this type of unfair competition. Deduction of the payments to Bergner which were mailed to his office in Michigan would frustrate also the policy of that State declared in section 28.320, Mich. Stat. Ann., 2*183 which declares unlawful the giving of any commission, gift, or gratuity to an employee of another with intent to influence the action of such employee in relation to his employer's business. The second issue is whether the rebates paid to Conte, Eckstein, and Bergner are includable in petitioner's gross income under section 61(a). *465 Rebates paid pursuant to a preexisting arrangement with the purchaser have been held to be excludable from gross income under the theory that only the actual consideration paid for the purchase is income. Pittsburgh Milk Co., 26 T.C. 707. In the instant case, petitioner's agreement to pay rebates was *184 made with employees of its customers and was independent of its agreement with its purchasers fixing the selling price of the products sold. The fact that the amounts it agreed to pay these employees was measured by a fixed percentage of its collections from their employers is immaterial. These amounts were paid for a consideration separate from the selling price of its products, namely these employees sending the business of their employers to petitioner, and the amounts received from these employers in consideration for its products sold is properly includable in petitioner's gross income. The third issue is whether the amounts petitioner paid to cause certain items of personal property to be transferred to Conte, Eckstein, and Bergner, plus $ 1,150 in cash transferred to Conte and Eckstein, are deductible as ordinary and necessary business expenses under section 162. The only evidence offered by petitioner in regard to these payments are statements by Rosenberg and Conte that these payments were made and Conte's testimony that they were made in consideration of what he had done for petitioner. This evidence is insufficient to establish that these expenditures were either ordinary *185 or necessary. Respondent's determination that these amounts are not deductible under section 162 therefore is sustained. Because petitioner claimed as sales promotion expense and respondent disallowed certain expenditures in years other than those in which the payments were actually made, Decisions will be entered under Rule 50. Footnotes 1. Sometime prior to Apr. 1, 1959, Kozy's manufacturing operations were moved to the Elcar location and petitioner's subsequent sales to Kozy were made through Elcar.↩ 1. Petitioner only claimed a deduction of $ 36,717.27 due to a transposition error.↩ 2. For this year the total payments to Conte and Eckstein exceed the amounts disallowed by respondent.↩ 1. Respondent disallowed $ 7,034.46 of the $ 7,036.47.↩ 2. This amount includes a check for $ 929 issued on Jan. 7, 1957, which was also disallowed in the year ended Mar. 31, 1957, and a check for $ 250 issued on July 28, 1958, which should have been disallowed in the fiscal year ended Mar. 31, 1959.↩ 3. This amount includes a check for $ 150 issued on Dec. 4, 1958, which should have been disallowed in the fiscal year ended Mar. 31, 1959.↩ 1. Except as otherwise indicated, all section references hereinafter will refer to the Internal Revenue Code of 1954.↩ 2. Sec. 28.320 Bribery of agents, servants, and deception of their principals; evidence; immunity.] Sec. 125. It shall be unlawful for any person to give, offer or promise to an agent, employe or servant of another or any other person, any commission, gift or gratuity whatever, or to do an act beneficial to such agent, employe or servant or another with intent to influence the action of such agent, employe or servant in relation to his principal's, employer's or master's business; or for an agent, employe or servant to request or accept for himself or another any commission, gift or gratuity or promise to make any commission, gift, or gratuity to himself or another or the doing of an act beneficial to himself or another, according to any agreement or understanding between him and any other person to the effect that he shall act in any particular manner in relation to his principal's, employer's or master's business. * * *