Manning v. Commissioner

Ashley Manning, Petitioner, v. Commissioner of Internal Revenue, Respondent Manning v. Commissioner Docket No. 5472 United States Tax Court 8 T.C. 537; 1947 U.S. Tax Ct. LEXIS 258; March 12, 1947, Promulgated *258 Decision will be entered under Rule 50. Petitioner married on June 30, 1939, and since that date has resided with his wife in California. On that date he had an established business, which he continued to operate through the taxable year 1941, and he had an ascertained separate property capital invested therein. The business was successful and profitable; the earnings and profits thereof being due in part to the capital invested, but primarily due to the efforts, ability, and skill of the petitioner. Held, that the income from the business should be apportioned between the capital invested and the petitioner's services, that the apportionment to capital should be in an amount equal to 8 per cent of the capital and is the separate property of petitioner to the extent of 8 per cent on his separate capital in the business, and the remainder of the income over and above 8 per cent of the capital should be apportioned to petitioner's services and is the community income of petitioner and his wife. Lawrence Oliver, 4 T. C. 684, followed. A. Calder Mackay, Esq., and Adam Y. Bennion, Esq., for the petitioner. Byron M. Coon, Esq., for the respondent. Black, Judge. BLACK *538 This proceeding involves a deficiency in income tax for the calendar year 1941 in the amount of $ 12,514.01. In determining this deficiency the respondent made two adjustments to the net income as disclosed by petitioner's return for the year 1941, only one of which adjustments, namely, "(a) Income from business*260 $ 22,113.09," is contested. In a statement attached to the deficiency notice the respondent explained this adjustment as follows: (a) Net income from business, in the adjusted amount of $ 94,930.01, has been apportioned as follows: Your separate income $ 60,797.12 Your half of community income 17,066.45 Total amount taxable to you $ 77,863.57 Half of community income taxable to your wife 17,066.44 Total $ 94,930.01 Since you reported the amount of $ 55,750.48 as the portion taxable to you, the amount of $ 22,113.09 is added to your income. By appropriate assignments of error, the petitioner contests the foregoing adjustment. FINDINGS OF FACT. Petitioner is an individual, with his principal place of business at 2251 Venice Boulevard, Los Angeles, California, where he is engaged in the piano business. The business consists principally of buying and selling, repairing, reconstructing, and renting pianos and the selling of piano repair parts. Petitioner's return for the year 1941 was filed with the collector for the sixth district of California. Petitioner married on June 30, 1939, and since that time he and his wife have resided together as husband*261 and wife in the State of California and have filed separate income tax returns. Petitioner has devoted himself exclusively to the piano business. His wife has taken no active part in the conduct of the business. Petitioner settled in Los Angeles in 1922 and went into the business of tuning and repairing pianos, which business he had learned from the ground up. He began his business with approximately $ 300 in cash. He also bought used pianos and repaired and sold them. He rented space from a musical instrument manufacturer who had been operating in Los Angeles since about 1910. Prior to 1925 petitioner purchased what equipment and business the latter had in this line for $ 100. *539 In 1925 he moved to his present location on Venice Boulevard, where he rented an old residence with a two-car garage. He used the garage for a repair shop, the first floor of the house for his salesrooms, and the upstairs as his living quarters, until his marriage in 1939. At first the business was mainly repairing and tuning pianos, but later the sale of used and new pianos became of paramount importance. As business grew, petitioner expanded his facilities. He worked long hours, keeping*262 his store open from 8 a. m. to 9 p. m. He rented additional properties and enlarged his establishment. In or about 1930 he built on the corner of his property an entrance to his establishment in the shape of a huge grand piano. He painted the piano red and from that time his business has been known as "Manning's Big Red Piano Shop." In 1937 he purchased, for $ 20,000, the properties which he had rented and in 1938 built a large modern show window at a cost of $ 11,000. His establishment was customarily known as Manning's Big Red Piano Shop, or the California Piano Supply Co., although the business was a single proprietorship. Petitioner also accumulated a large stock of piano repair parts and supplies, and he supplied other dealers. The mending of piano strings is a highly specialized job that is done by only a comparatively few concerns in the United States. Petitioner is one of them and has been the only one in Los Angeles for many years. He advertised for damaged and broken pianos and, since he was better equipped to repair them than anyone else in the city, he acquired pianos which other dealers did not want. Petitioner in about 1935 conceived and designed a small inexpensive*263 piano, fashioned after a toy Japanese piano which he had manufactured and imported under the name "Monochord." He sold them for retail prices ranging from $ 49 to $ 189 each. Their harp-like tone won immediate acceptance from purchasers. Petitioner in about 1938 was appointed the exclusive dealer in Los Angeles for Wurlitzer and Lester pianos, and in 1939, 1940, and 1941 he was the largest distributor of Wurlitzer pianos in the United States. In 1941 petitioner sold approximately 2,000 pianos of all types. At first petitioner did all the work himself, and he acquired assistance only as his expanding business demanded. He acted as salesman, office manager, credit manager, and shop manager. By 1938 he had organized his business into 4 departments and had approximately 30 employees. The 4 departments were sales, credit, repair, and office management and bookkeeping. Petitioner, however, closely supervised the entire business and the work of his employees. Petitioner did all the purchasing, established prices, approved sales, directed repairs to be made on pianos, and did some of the more difficult repair work himself, did all the hiring and firing of employees, wrote the advertising, *264 and established all policies of the business. The principal employees during 1941 were paid approximately as follows: sales manager, $ 6,200; shop *540 manager, $ 2,700; credit manager, $ 2,000; and bookkeeper, $ 1,500. Petitioner included as an administrative expense on the accounting records a salary allowance to himself in the amount of $ 535 a month, or $ 6,420 a year, in each of the years 1939 through 1941. This amount has remained unchanged since 1932. It was never intended as compensation for personal services, but only as an amount suggested by petitioner's accountants to cover his bare living expenses. The pianos are sold on the installment plan, and interest of approximately 8 per cent is earned by petitioner on the unpaid balances. Petitioner carries his own contracts, differing from most piano dealers, who sell their contracts receivable to finance companies. Petitioner has been approached by a finance company with reference to taking over his installment papers, but it has not been necessary for him to convert them into cash. The amounts thus invested in contracts receivable constitute the greater part of petitioner's capital, as is shown in the following *265 statement of the net worth of the business as of the date of petitioner's marriage and at the close of 1939, 1940, and 1941: 6/30/39 12/31/39 12/31/40 12/31/41 Cash on hand $ 12,508.26 $ 7,850.82 $ 26,741.54 ($ 889.14) Accounts receivable 845.88 956.86 938.43 622.76 Inventory pianos 31,641.45 24,933.41 23,820.12 91,692.51 Inventory piano parts, etc 8,095.66 5,637.34 6,355.97 5,753.05 Prepaid values 1,478.04 2,180.75 1,716.48 2,369.96 Fixed assets (less depr.) 34,556.69 34,149.62 33,973.58 61,422.18 Total assets (other than contracts receivable) 89,125.98 75,708.80 93,546.12 160,971.32 Less liabilities 26,281.52 34,579.01 36,663.78 74,983.48 Net assets (other than contracts receivable) 62,844.46 41,129.79 56,882.34 85,987.84 Contracts receivable (less reserve for unearned interest) 117,153.76 152,516.12 189,488.00 247,836.08 Net worth 179,998.22 193,645.91 * 246,370.34 * 333,823.92 *266 The net income from the business, as reported for tax purposes and as adjusted for changes made by the respondent and acquiesced in by the petitioner and his wife, was as follows: Income as Income as Period reported adjusted 1939 (July to Dec. 31, 1939) $ 27,465.99 $ 27,465.99 [1940] 66,217.16 69,384.96 [1941] 97,724.08 94,930.01 Petitioner and his wife filed separate income tax returns for the years 1939, 1940, and 1941, in which they divided the taxable net income from the business upon the basis that the capital earned a return from the business of 8 per cent and the balance of the income after June 30, *541 1939, was attributable to personal service. Their return of the income was as follows: Taxable to Taxable to petitioner wife Total [1939] (July 1 to Dec. 31) 8% return on capital of $ 179,998.22 for 6 mos $ 7,199.93 $ 7,199.93 Income attributable to personal services 10,133.03 10,133.03 20,266.06 17,332.96 10,133.03 27,465.99 [1940] 8% return on capital of $ 193,645.91 15,491.67 15,491.67 Income attributable to personal services 25,362.75 25,362.74 50,725.49 40,854.42 25,362.74 66,217.16 [1941] 8% return on petitioner's capital of $ 207,706.77 16,616.54 16,616.54 8% return on Mrs. Manning's capital of $ 35,495.77 2,839.66 2,839.66 Income attributable to personal services 39,133.94 39,133.94 78,267.88 Total 55,750.48 41,973.60 97,724.08 *267 In determining the deficiency herein the respondent employed the formula set forth in G. C. M. 9825, C. B. X-2, p. 146 and determined that 8 per cent was a fair return on capital and $ 10,000 per annum was the fair value of petitioner's services during the years 1939, 1940, and 1941. He allocated income and withdrawals as follows: Petitioner's Community capital capital Capital at 6/30/39 $ 179,998.22 Income for last 6 months of 1939 attributable to capital ($ 7,199.93/$ 12,199.93 x $ 27,465.99) 16,209.37 Income attributable to personal services ($ 5,000/$ 12,199.93 x $ 27,465.99) $ 11,256.62 196,207.59 11,256.62 Withdrawals last six months of 1939 2,561.68 11,256.62 Capital at 12/31/39 193,645.91 Income for 1940 attributable to capital ($ 15,491.67/$ 25,491.67 x $ 69,384.96) 42,166.28 Income attributable to services ($ 10,000/$ 25,491.67 x $ 69,384.96) 27,218.68 235,812.19 27,218.68 Withdrawals for 1940 19,828.33 Capital 12/31/40 235,812.19 7,390.35 Income for 1941 attributable to capital: ($ 18,864.98/$ 29,456.21 x $ 94,930.01) 60,797.12 ($ 591.23/$ 29,456.21 x $ 94,930.01) 1,905.39 Income attributable to services ($ 10,000/$ 29,456.21 x $ 94,930.01) 32,227.50 296,609.31 41,523.24 *268 During the period July 1, 1939, to December 31, 1941, withdrawals from the business were made as follows: Income taxes Personal Year withdrawals, Total A. Manning A. Manning V. Manning 1939 (6 mos.) $ 17,056.30 None None $ 17,056.30 [1940] 15,281.40 $ 6,600.28 $ 896.62 22,738.30 [1941] 848.75 11,777.37 5,407.62 18,033.74 *542 There was an increase of 5 or 6 per cent in the retail price of Spinette model pianos from 1939 to 1941, which coincided with a similar increase in the cost of these models to petitioner. The percentage of gross profits on sales was 48.7 per cent in 1939, 50.4 per cent in 1940 and 50.1 per cent in 1941. The prevailing rate of return upon long term, well secured investments in the Los Angeles area during 1939, 1940, and 1941 was between 4 1/2 and 5 per cent. The prevailing rate of return on capital invested in general business comparable to the risk involved in petitioner's business in the Los Angeles area during 1941 was approximately 7 per cent, with a maximum return of 8 per cent. Of the net income of petitioner's business in each of the years from and after June 30, 1939 through 1941, 8 per cent on the capital*269 invested is attributable to the use of capital. The remainder of such income is attributable to the personal services of petitioner. Any of the stipulated facts which are not embodied in the foregoing findings are incorporated herein by reference. OPINION. The method and manner of taxing income and the rates at which it is taxed are determined by the Federal income tax law. The ownership of the income which is to be taxed is, however, determined under state law. Poe v. Seaborn, 282 U.S. 101. The applicable California statutes which determine the ownership of the income involved in this proceeding are printed in the margin. 1 *270 The parties are agreed as to the applicable statutes and they are also agreed as to the amount of net income of the business known as "Manning's Big Red Piano Shop," which was conducted as a sole proprietorship by the petitioner, Ashley Manning. They are disagreed as to the amounts of such income which were the separate income of petitioner and those which were the community income of petitioner and his wife. Petitioner contends that his separate capital did not earn and should not be credited with a return in excess of 8 per cent and that the balance *543 of the income from the business constituted community income because it was due primarily to petitioner's personal services. He contends that the evidence shows clearly that the earnings from petitioner's business were primarily due to his activities, skill, ability, and business acumen and not to the capital invested therein, that 8 per cent on the capital invested therein is all that should be attributed to capital, that the balance of the income should be attributed to personal services of petitioner and is community income, and that there is no occasion to apply G. C. M. 9825. In support of *271 these contentions petitioner strongly relies on Lawrence Oliver, 4 T. C. 684. He contends, in the alternative, that the respondent's formula set out in G. C. M. 9825, if applied here, should be applied only to the income derived from the merchandising phase of the business and not to the part used in carrying installment paper, because in no event did the capital invested in installment paper earn more than 8 per cent; also, that if the formula is to be used the income should be apportioned in the ratio that an 8 per cent return upon such capital bears to a reasonable value for the services rendered by petitioner, which should be not less than $ 40,000. Petitioner also maintains that his withdrawals in 1940 to pay income taxes on his separate income for 1939 in the sum of $ 5,743.66 should be charged to his separate capital. It is agreed that the taxable net income in 1941 of petitioner's business was $ 94,930.01. Respondent contends that, of the taxable net income for 1941 in the amount of $ 94,930.01, the amount of $ 60,797.12 is attributable to capital and is separate income and the remainder of $ 34,132.89 is community*272 income. He arrived at these amounts by the use of G. C. M. 9825 and, in so doing, he determined that 8 per cent was a fair return on capital and $ 10,000 per annum was the fair value of petitioner's services during the years 1939, 1940, and 1941. The California rule of property law is that, where a husband has a capital investment in a business at the time of his marriage which he continues to conduct during marriage, such capital investment continues to be his separate property. Where the subsequent profits from the business are partly attributable to the husband's separate capital and in part to his personal services, that part of the profits attributable to the capital investment is his separate income and that part attributable to his personal services is community income. The question of what part of the profits arises from the use of capital and what part from the personal services of the husband depends upon the facts and circumstances of each case. The income attributable to the capital would amount at least to the usual interest on a long term, well secured investment, unless the facts show otherwise. Pereira v. Pereira, 156 Cal. 1;*273 103 Pac. 12; Estate of Gold, 170 Cal. 621; 151 Pac. 12; In re *544 , 127 Cal. App. 80; 15 Pac. (2d) 223; Todd v. Commissioner, 153 Fed. (2d) 553; George W. Van Vorst, 7 T. C. 826. In support of his contention that only 8 per cent should be apportioned to capital and that the balance of the income should be apportioned to petitioner's services, he relies largely upon our decision in Lawrence Oliver, supra. In that case our decision in favor of the taxpayer was based on the fact that "the business was profitable, the earnings and profits thereof being due in part to the capital invested, but mainly due to the activities, management, and skill of the taxpayer, whose full time was devoted to its operation." In the Oliver case, among other things, we said: We hold that the income from petitioner's business from and after July 29, 1927, through 1939 should be apportioned between the capital invested and his services; that the*274 apportionment to capital should be an amount equal to 7 percent of such capital, and that the remainder of the business income should be apportioned to petitioner's services in conducting such business. The latter is community income and the former is separate and community income in the proportions that the capital comprises separate and community property. Although the business in which Oliver was engaged was very different from that in which the petitioner was engaged, we find many similarities in the two cases, particularly that, as Lawrence Oliver furnished the main part of the business acumen and driving power in the business conducted by him as a sole proprietor, so did Manning furnish the business acumen and driving power of the business conducted by him as a sole proprietor. Concerning the unique character of services which petitioner furnished the business which he was carrying on, Everett J. Rothschild, district sales manager for the Wurlitzer Piano Co. on the Pacific Coast, testified, among other things, as follows: Well, I find him very unusual. Anyone that does the volume of business he does ordinarily has a larger sales organization, and certainly assistance along*275 the line. I know of no one with whom I deal that reaches his scope and does so single-handed, so to speak. He is definitely unusual from that standpoint, because in my observations of his operation, why, it is strictly a one-man setup, with no reflection on the other folks there whom I am personally acquainted with. In my dealings with him since 1938 I have found strictly he is the man behind everything and the man responsible for everything that takes place with regard to purchasing, as well as sales. I find his method of advertising very unusual; no one else practices in the same way. In a general way, why, I don't know of anyone with whom I have ever dealt that does the volume of business he does and does it on the basis he does, in such a restricted way. There is much other testimony in the record along the same lines as the above, but it would make this opinion too long to recite it in detail. On the strength of this evidence, we have found in our findings of fact that 8 per cent on the capital invested in the business from June 30, 1939, when petitioner married, through the taxable year 1941, should be attributed to capital and the balance of the earnings of the *545 *276 business should be attributed to personal services of petitioner and should be apportioned accordingly. This we understood to be in harmony with our decision in Lawrence Oliver, supra.Since some of the profits were kept in the business after petitioner's marriage in 1939 and it appears that these figures are not in dispute, the portions of separate and community capital can be determined in the recomputation under Rule 50. Respondent relies strongly upon Clara B. Parker, Executrix, 31 B. T. A. 644, and J. Z. Todd, 3 T. C. 643, which approved the formula set out in G. C. M. 9825. In the Parker case the evidence did not establish that the income for the years in question was primarily due to the husband's efforts, ability, and skill. In the Todd case, in our original opinion, we pointed out that there was no evidence to indicate that the allocations made by the respondent were unreasonable. The taxpayers argued that under the California law the burden was upon the respondent to establish that a greater amount that the legal rate of interest constituted *277 separate property of the taxpayers. We held that the burden of proof was upon the taxpayers to prove that the respondent's allocation was in error, and sustained the respondent's determination in view of taxpayers' neglect of their duty of going forward with the proof. On appeal, the Ninth Circuit said that the "Commissioner's method of allocation between the separate capital income and the managerial community earnings is a rational one," and "the burden of showing error in computing in its application is upon the taxpayers." In our decision on remand (7 T. C. 399), we again pointed out that the taxpayer did not offer proof as to what amounts were properly attributable to capital and what amounts to personal services. We said: * * * Petitioners have not attempted to demonstrate what final amounts, if different from those determined by respondent, should properly result from the application of the method. Their sole purpose is to avoid the use of the method altogether, and to shift to respondent the burden of sustaining his determination and proving that a greater proportion of the distributive net income of the partnership than a 7 per cent return on*278 invested capital is separate property of the petitioners. Their efforts on remand had, in large part, been directed to an attempt to demonstrate that respondent's determination is "erroneous upon its face," by reason whereof they contend that no presumption of correctness attaches thereto. We are not convinced, however, of error in respondent's determination; and, as we said in our original opinion, we do not think the burden has thus been shifted to the Commissioner. We think that the evidence adduced by petitioner in this proceeding has affirmatively shown that the respondent's allocation was in error. We think that petitioner has proved by competent evidence that no more than 8 per cent on the capital invested should be attributed to the earnings of capital and that the remainder of the earnings of the business should be attributed to the personal services of petitioner. *546 Moreover, the evidence established in J. Z. Todd, supra, that the partnership had a large capital investment in inventory because it was thought to be a good investment in view of ascending prices. The Ninth Circuit pointed out that in 1940 the war in Europe and the*279 war preparations in this country caused a constant increase in demand for lumber, and with it an increase in prices and in value of the inventory, and that the Commissioner and the Tax Court were warranted in inferring that there was a substantial gain in the capital value of the inventory as distinguished from earnings from new business obtained. In our decision on remand we thought that under all the circumstances the amounts of income attributed by the respondent to invested capital in the years 1940 and 1941 were reasonable amounts to be expected as a return on the large capital investments in those years. In the instant proceeding the evidence satisfactorily establishes that the profits of the business were not due to increases in price or increases in the value of the inventory. Having decided petitioner's main contention in his favor, it becomes unnecessary to discuss petitioner's alternative contention, that the respondent's formula if employed at all should be applied only to the income derived from the merchandising phase of the business and not to that which was kept invested in installment paper. Petitioner also maintains that withdrawals during 1940 to pay income taxes*280 on his separate income for the period prior to June 30, 1939, in the amount of $ 5,743.66 should be charged to his separate capital. The evidence shows that petitioner made withdrawals in 1940 for income taxes in the amount of $ 6,600.28. However, there is no showing that such withdrawals were from petitioner's separate property. Such withdrawals, therefore, are chargeable to the community earnings. Lawrence Oliver, supra;Hugh B. Tinling, 7 T. C. 1393. Cf. Van Camp v. Van Camp, 53 Cal. App. 17; 199 Pac. 885. On this issue we sustain respondent. Decision will be entered under Rule 50. Footnotes *. The net worth at December 31, 1940, is $ 3,167.80 higher than shown on the book balance sheets (Exhibit 5-E, $ 243,202.54), reflecting the decrease in reserve for unearned interest in that amount determined by a revenue agent. The net worth at December 31, 1941, should be increased to $ 334,197.65 to reflect the tw minor disallowances in the notice of deficiency, aggregating $ 373.73.↩ 1. Civil Code of California (1937): "Sec. 161a. Interests in community property. The respective interests of the husband and wife in community property during continuance of the marriage relation are present, existing and equal interests under the management and control of the husband as is provided in sections 172 and 172a of the Civil Code. This section shall be construed as defining the respective interests and rights of husband and wife in community property. * * *" "Sec. 163. Separate property of the husband. All property owned by the husband before marriage, and that acquired afterwards by gift, bequest, devise, or descent, with the rents, issues, and profits thereof, is his separate property. * * *" "Sec. 164. All other property acquired after marriage by either husband or wife, or both, including real property situated in this State and personal property wherever situated, heretofore or hereafter acquired while domiciled elsewhere, which would not have been the separate property of either if acquired while domiciled in this State, is community property * * *"↩