Christman Co. v. Commissioner

The Christman Company, a Michigan Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent Christman Co. v. Commissioner Docket No. 9284 United States Tax Court 8 T.C. 679; 1947 U.S. Tax Ct. LEXIS 239; March 31, 1947, Promulgated *239 Decision will be entered under Rule 50. 1. Excess Profits Tax -- Equity Invested Capital -- Section 718 (a) (2), I. R. C. -- Amounts of cash and property paid in for shares must be reduced in computing equity invested capital by corresponding amounts of capital later paid out by the petitioner in reacquiring its own shares. 2. Deductions -- Officers' Salaries. -- The total amount paid to three officers, held deductible under section 23 (a) (1) (A) as reasonable compensation for services rendered. Clayton F. Jennings, Esq., and Clarence A. Bradford, Esq., for the petitioner. Clarence E. Price, Esq., for the respondent. Murdock, Judge. MURDOCK *680 The Commissioner determined the following deficiencies: Declared value Year Income tax excess profits Excess profits tax tax [1941] $ 3,247.57 $ 1,564.28 $ 607.87 [1942] 209.38 10,264.71 The petitioner assigns as error the action of the Commissioner (1) in excluding from equity invested capital under section 718 of the Internal Revenue Code the amount paid in for 14,096 shares of the petitioner's stock which it later reacquired; (2) in disallowing as excessive a part of the deduction*240 claimed for compensation of officers. FINDINGS OF FACT. The petitioner, a Michigan corporation, filed its returns for the taxable years with the collector of internal revenue at Detroit, Michigan. The H. G. Christman Co. of Indiana (hereinafter referred to as Indiana) had been engaged in the building and construction business in the area around Lansing, Michigan, and elsewhere. The Lansing business was managed by four of its employees, H. L. Conrad, E. J. Ketterman, H. R. Robert, and M. Lechlitner. Those employees decided to go into business for themselves and, together with some of the shareholders of Indiana, they incorporated the petitioner as a Michigan corporation on May 12, 1927, under the name of "H. G. Christman-Lansing Company." The authorized capital of the petitioner consisted of 35,000 shares of no par value common stock. It was divided into two classes: 34,000 shares were designated class A shares and had no voting rights, and 1,000 shares were designated class B shares and had exclusive voting rights. The two classes were the same in all other respects. 3,100 shares were issued on May 12, 1927, to each of the four persons named above. The Indiana company paid $ *241 124,000 in cash to the petitioner for the shares thus issued. It partially discharged in that manner an obligation of $ 133,000 for back compensation which it owed to them. The balance was paid to them by check. The petitioner issued 12,400 additional shares on the same day to certain shareholders of the Indiana company in exchange for machinery and equipment then being used in the Lansing business. The value of that property at that time was $ 124,000 and the value of the stock issued for it was $ 124,000. H. L. Conrad and H. R. Robert later became indebted to the petitioner. Each transferred 550 shares of the petitioner's stock to the petitioner at $ 10 per share on March 8, 1932, in liquidation of his indebtedness. *681 Each received in cash the excess in the value of his shares over the amount of his canceled debt. Ketterman transferred 550 shares to the petitioner for cash at $ 10 per share at that time in order to maintain stock equality between Conrad, Robert, and Ketterman (Lechlitner having died). A certificate numbered 34, dated December 31, 1932, for 1,650 shares of class A stock was issued by the petitioner in its own name. Another of the petitioner's shareholders, *242 H. G. Christman & Brothers Co., became indebted to the petitioner in the amount of $ 41,218.52. It transferred 4,000 shares of the petitioner's class A stock to the petitioner on March 8, 1932, at $ 10 per share in return for the cancellation of a part of that indebtedness. That left a balance due of $ 1,218.52. A certificate of stock numbered 35, dated February 1, 1932, for 4,000 shares of Class A stock was issued by the petitioner in its own name. That date was over a month prior to the date of the resolution by which the shares were acquired by the petitioner. A receipt on the stub for certificate number 35 is dated January 26, 1933. Indiana became indebted to the petitioner in the amount of $ 60,760.56. Certain Indiana shareholders transferred 8,446 shares of the petitioner's stock to the petitioner on or about July 31, 1939, in return for the cancellation of that indebtedness and $ 21,115 in cash. 8,046 of the shares thus transferred were class A shares and 400 were class B shares. Certificate No. 51 for 8,046 shares of class A stock was issued in the name of the petitioner. It bore the date July 31, 1939. The articles of incorporation of the petitioner were amended *243 on April 30, 1940, changing its name to "The Christman Company" and changing all of its stock to voting stock having a par value of $ 5 per share. Certificate No. 69 for 5,650 shares was issued in lieu of canceled certificates 34 and 35. Certificate 69 bears the date January 1, 1941. Certificate No. 70 for 400 shares bears the date July 31, 1939. Certificate No. 3 for 400 shares was issued in lieu of canceled certificate No. 70. It bears the date July 31, 1939. The date July 31, 1939, was written on the stub for certificate No. 3 and was then crossed off and the date June 6, 1945, was written in on the same line to show the date of issuance of the certificate. Certificate No. 71 for 8,046 shares was issued in lieu of canceled certificate No. 51. It bears the date July 31, 1939. Certificate No. 4 for 8,046 shares was issued in lieu of canceled certificate No. 71. It bears the date July 31, 1939. The date July 31, 1939, was written on the stub for certificate No. 4 and was then crossed off and the date June 6, 1945, was written on the same line to show the date of issuance of the certificate. Certificates 69, 70, and 71 were on a printed form on which the name of the petitioner*244 appears throughout as "The Christman Co." *682 and on which the stock is described as "without par value." The form used in making out certificates 3 and 4 was similar to that used in making out certificates 69, 70, and 71, except that on certificates 3 and 4 the name of the petitioner appears throughout as "The Christman Company" and the stock is described as "Par Value $ 5.00 Per Share." The petitioner reacquired a total of 14,096 shares of its stock at $ 10 per share as a result of the foregoing transactions. The petitioner's books of account during the taxable years did not record any treasury stock. The petitioner, on its return for 1941, claimed an excess profits credit of $ 7,287.23, and used in the computation thereof equity invested capital in the amount of $ 85,943.52. The petitioner, on its return for 1942, claimed an excess profits credit of $ 8,980.06 and used in the computation thereof equity invested capital in the amount of $ 117,599.84. The Commissioner, in determining the deficiencies, allowed an excess profits credit of $ 9,294.23 for 1941 and $ 9,678.89 for 1942, each based upon invested capital. The record does not show the amount of equity invested capital*245 which the Commissioner used in computing those credits. The three officers whose compensation is in question are H. L. Conrad, president; E. J. Ketterman, vice president; and H. R. Robert secretary-treasurer. These three men, a man representing the petitioner's employees, and an attorney constituted the petitioner's board of directors. The following table shows the number of shares of the petitioner's stock owned by each of the men in question, the aggregate owned by them, and the total number of the petitioner's shares outstanding: Year H. L. Conrad E. J. Ketterman H. R. Robert Aggregate Outstanding [1941] 2,250 2,550 2,550 7,350 10,859 [1942] 2,116 2,416 2,416 6,948 9,359 The following table shows the salaries received by these persons from Indiana and thereafter from the petitioner: Year H. L. Conrad E. J. Ketterman H. R. Robert [1920] $ 9,200.00 $ 8,840.00 [1921] 9,200.00 8,800.00 [1922] 12,585.00 10,200.00 $ 8,437.23 [1923] 17,500.00 15,200.00 14,420.00 [1924] 17,500.00 15,200.00 14,420.00 [1925] 25,859.29 28,374.54 [1926] 17,031.00 10,070.90 [1928] 9,561.50 8,561.50 7,061.50 [1929] 10,000.00 8,000.00 8,000.00 [1930] 10,000.00 8,000.00 8,000.00 [1931] 10,000.00 8,000.00 8,000.00 [1932] $ 7,500.00 $ 5,500.00 $ 5,500.00 [1933] 7,500.00 5,500.00 5,500.00 [1934] 7,500.00 5,500.00 5,500.00 [1935] 7,500.00 5,500.00 5,500.00 [1936] 8,500.00 6,500.00 6,500.00 [1937] 8,500.00 6,500.00 6,500.00 [1938] 8,500.00 6,500.00 6,500.00 [1939] 8,000.00 6,250.00 6,250.00 [1940] 7,000.00 5,500.00 5,500.00 [1941] 16,090.72 14,090.73 14,090.73 [1942] 18,322.00 16,321.99 16,321.99 *246 *683 All employees of the petitioner accepted voluntary reductions in their salaries in 1940, with the understanding that when conditions got better an employees' participation bonus program would be instituted as an incentive. Such a program was put into effect in 1941, whereby 40 per cent of the net earnings of the petitioner were divided equally among 16 of the petitioner's employees. This group included Conrad, Robert, and Ketterman. The amount received by each pursuant to that part of the plan is hereinafter referred to as "participating fund bonus." Another 10 per cent of the net earnings was divided equally among those three employees. The amount received by each pursuant to that part of the plan is hereinafter referred to as "management bonus." The following table shows the basic salary, the amounts paid under each of the "bonuses," the total amount claimed by the petitioner as a deduction for each year for compensation of these employees, and the amount thereof disallowed: [1941] Participating Management Salary fund bonus bonus Total Disallowance Conrad $ 10,000 $ 2,250 $ 3,840.72 $ 16,090.72 $ 3,840.72 Ketterman 8,000 2,250 3,840.73 14,090.73 3,840.73 Robert 8,000 2,250 3,840.73 14,090.73 3,840.73 Total 26,000 6,750 11,522.18 44,272.18 11,522.18 [1942] Conrad 12,000 2,250 4,072.00 18,322.00 4,072.00 Ketterman 10,000 2,250 4,071.99 16,321.99 4,071.99 Robert 10,000 2,250 4,071.99 16,321.99 4,071.99 Total 32,000 6,750 12,215.98 50,965.98 12,215.98 *247 The salaries and additional compensation of these employees for each of the taxable years were fixed by resolutions of the board of directors. The amounts were not based upon the amounts of stock owned by these employees. The following table shows the gross income, net profits, and dividends paid by the petitioner in 1940, 1941, and 1942: [1942] Gross income $ 1,221,469.05 $ 1,885,926.88 $ 2,125,435.09 Net profits (16,521.86) 53,063.96 74,152.30 Dividends paid 5,429.50 2,714.75 The three employees whose salaries are here in question were the key employees of the petitioner. They were largely responsible for *684 its organization in 1927. Together they assumed all of the executive responsibilities of the business. Although Conrad is the president and manager of the business, the three of them actually conduct it together. Almost all of the petitioner's contracts were obtained in strict competition, either by preparing plans and submitting competitive bids or by taking architect's plans and submitting estimates upon them. These three men had to go out and get business, had to design a great part of the structures, and had to negotiate the *248 purchase of materials. They had to expedite delivery, build the structures, collect on them, and account for the money. The petitioner completed 140 separate and distinct building and construction operations in 1941, involving residential work, industrial work, and institutional work, and 272 jobs were completed in 1942. The three employees have had personal contact with every important job performed by the petitioner since 1927. The three men worked 10 to 12 hours a day, sometimes 7 days a week. They were subject to call at any time of the day or night. Conrad and Robert traveled between 25,000 and 30,000 miles a year on behalf of the petitioner. The petitioner's activities covered all the lower peninsula of Michigan. Conrad is a graduate civil engineer who began to do engineering work in 1907. He has been constantly engaged in building and construction work since that time. He is experienced in supervision, drafting, designing, and estimating, and has worked on many big building projects, some involving as much as $ 5,000,000. He is the chief engineer, sales manager, expediter, and purchasing agent of the petitioner. It is his duty to do the buying, subletting, awarding*249 of subcontracts and the negotiating and liaison work between the engineers, architects, and others for the purpose of interpreting plans and specifications so that the work will progress smoothly. This work requires him to make inspection trips to all the jobs carried on by the petitioner. Conrad has received for many years a salary $ 2,000 in excess of that received by Robert and Ketterman to take care of the additional expenses which he incurs in connection with his travel and dealing with customers. Robert is a graduate civil engineer who started in the construction business in 1903. He began as a carpenter and later became, and still is, a general superintendent in charge of jobs. His duties as a general superintendent consist, first, of organizing the job in the field. He hires a job superintendent for the specific operation, then the two select foremen to work on the job. He must see that the necessary machinery is obtained. He goes to the next project and organizes it after seeing that the first job is properly organized. He also maintains contact with each job after it is organized. The petitioner always had a great *685 number of jobs going at the same time *250 and it was necessary for Robert to be in constant touch with many of them. This necessitated a lot of traveling. Ketterman, aged 66, started in the construction business as a mason at the age of 12. He began to take charge of work at about the age of 25 and since that time he has been in charge of jobs as a general superintendent. His duties for the petitioner are similar to those of Robert. He and Robert work together closely and are personally responsible for the successful conduct of the work carried on in the field. The compensation received by each of the employees in question for the years 1941 and 1942 was reasonable compensation for services actually rendered to the petitioner. OPINION. The issue in regard to equity invested capital requires a brief explanation. The Commissioner allowed a larger excess profits credit for each of the years here involved than the petitioner claimed on its returns. He recognized that the petitioner had made an error in considering that outstanding stock went into equity invested capital at $ 5 per share instead of at $ 10, the amount originally paid for each share. The question here is, what was the amount of the petitioner's equity invested*251 capital under section 718, of the Internal Revenue Code. 1 The respondent contends that his determination was correct. The petitioner contends that $ 124,000 was paid in cash for shares and $ 124,000 was paid in property for shares when it was organized, its equity invested capital includes both amounts, and no adjustment is to be made for stock later reacquired and held as treasury stock. The respondent concedes that $ 124,000 in cash was paid in for 12,400 shares at the incorporation of the petitioner, but he argues that the property paid in for another 12,400 shares was not worth $ 124,000 at that time but was worth only $ 63,239.44. *252 Some property was paid in for 12,400 shares. It is to be included in equity invested capital at its basis for loss, regardless of its value. Cf. Ralphs-Pugh Co., 7 T. C. 325. Its basis was its cost. It was acquired by issuing shares and its cost was the then value of those shares. The evidence indicates that the shares were worth $ 10 each. That *686 was the amount paid in cash for 12,400 shares and the property paid in was worth $ 124,000. The figure of $ 60,760.56, by which the Commissioner would reduce the $ 124,000 claimed on account of property paid in for shares, was an amount later owed the petitioner by Indiana, representing profits of the petitioner for 1927 improperly accounted for as belonging to Indiana. It did not serve to reduce the cost of the property paid in for shares. Thus, the computation of equity invested capital begins with $ 248,000. The only remaining question on the first issue is whether the $ 248,000 should be reduced by $ 140,960, the amount later paid out by the petitioner in reacquiring 14,096 shares of the 24,800 originally issued. The statute is silent on this point. Regulations 112 provide in section 35.718-5*253 in part as follows: Sec. 35.718-5 Determination of Daily Equity Invested Capital -- Reductions by Distributions. -- * * * * * * * The purchase by a corporation of its own stock for investment does not of itself result in a reduction of invested capital. But see section 35.720-1 relative to inadmissible assets. If, however, the corporation subsequently cancels such stock, invested capital is reduced, beginning with the day following such cancellation, by so much of the adjusted basis of such stock in the hands of the corporation as is not properly chargeable to earnings and profits of the taxable year. If stock is purchased for retirement, there is a distribution on the date of purchase of the amount paid therefor and the invested capital is reduced by the amount thereof not properly chargeable to earnings and profits of the taxable year. Neither party questions the propriety of that regulation or its application here. We shall assume, for the purpose of this case, that it is a proper regulation and that the remaining question is the one which the parties have argued, i. e., Was the stock reacquired for investment, or was it canceled or purchased for retirement, so that there*254 was a distribution of a part of the capital theretofore invested in the business? The first reacquisition of shares took place on March 8, 1932. Conrad and Robert, two of the three managing stockholders, had become indebted to the petitioner and desired to cancel that debt by surrendering stock to the petitioner. Ketterman, the only other managing stockholder, surrendered a like number of shares for cash in order to maintain equality among the three. Another stockholder was also indebted to the petitioner and it surrendered shares at that same time in cancellation of all but a small part of its debt. These shares represented almost one-fourth of the outstanding shares. The remaining 8,446 shares were apparently reacquired in the summer of 1939. The books of the petitioner had been kept for a while with those of Indiana, and profits of the petitioner for 1927 were recorded, falsely, as if they belonged to Indiana. The reacquisition of the 8,446 shares was partly for the purpose of canceling the debt which originated in that falsification of accounts. It may have terminated *687 the stockholdings of the Indiana group, since that group originally acquired only 12,400 shares*255 and thereafter surrendered 12,446 shares (4,000 on March 8, 1932, and 8,446 on July 31, 1939). Over one-half of the original issue had thus far been surrendered. There is no evidence of an intention on the part of the petitioner at March 8, 1932, or at July 31, 1939, to reissue or resell any of the reacquired shares immediately at any future time, or under any plan then in existence. The number of shares involved and the circumstances of the reacquisitions indicate, rather, that there was no intention to reissue or resell any of those shares. Certainly none of the three managing stockholders were to acquire any shares which would disturb the carefully preserved equality of their holdings. The capital represented by the retired shares was apparently not needed. That represented by the 8,446 shares had never been used and that represented by the 5,650 had not been used in the business at least since 1932. Reference to the cancellations of the old certificates and the purported issuance of new certificates in the name of the petitioner has been avoided intentionally thus far in this discussion. The record on this point is unsatisfactory and the fault lies squarely upon the petitioner. *256 The matter was brought to the attention of its counsel during the course of the hearing and full opportunity to clarify it was available. The petitioner must stand the consequences of any deficiency in the proof. The 1,650 shares surrendered by Conrad, Robert, and Ketterman on March 8, 1932, were reissued in the name of the petitioner by means of certificate 34, dated December 31, 1932. The 4,000 shares also surrendered on March 8, 1932, were reissued in the name of the petitioner by means of certificate 35, dated February 1, 1932. That date was more than a month prior to the date upon which the resolution was adopted and the 4,000 shares were surrendered. Those two certificates were destroyed by perforation at some time not disclosed by this record. 8,446 shares were surrendered on or about July 31, 1939. Certificate No. 51, for 8,046 shares, was issued in the name of the petitioner. It was dated July 31, 1939, and was for class A stock. Another, No. 70, also dated July 31, 1939, for 400 shares "without par value," was issued in the name of "The Christman Co." although that did not become the name of the petitioner until April 30, 1940. Certificate 71, for 8,046 shares "without*257 par value," was issued in the name of "The Christman Co." It bears the date July 31, 1939, although the name was not changed until April 30, 1940. Certificates 70 and 71 were perforated and certificate 3 was issued for 400 shares and certificate 4 for 8,046, each in the new name of the petitioner. The stubs for 3 and 4 bear the date of July 31, 1939, crossed off with an ink line *688 and the date of June 6, 1945, written above the earlier date. These irregularities may not be overlooked. They must justify the suspicion that the stock records are not genuine, but were prepared to supply evidence for this case. However, it is not necessary to reach that conclusion in deciding this issue. Suffice to say that the certificates and the stock book do not satisfactorily prove when the certificates in the name of the petitioner were issued. Furthermore, the books of account do not show the existence of any treasury stock at any time up through the taxable years. The petitioner has failed to prove that it reacquired the 14,096 shares for investment and to negative the Commissioner's determination. It has failed to show that any of the reacquired shares were still a part of equity*258 invested capital within Regulations 112, section 35.718-5. The reacquisition of each share had the effect of distributing $ 10 of capital, the payment-out of what had originally been paid in, and there would be no sound reason for regarding that money, no longer at risk in the business, as a part of equity invested capital. Cf. West Construction Co., 7 T. C. 974; David Bruckheimer, 46 B. T. A. 234, 239. The source of the funds used to retire the shares is immaterial for present purposes. The effect of such a retirement could not be affected by any bookkeeping or "earmarking" of the funds (as between earnings and capital) used to retire the shares. These retirements are chargeable against capital and not to earnings. However, the use of accumulated earnings would likewise reduce equity invested capital. See section 718 (a) (4). The provisions of section 720 and of Regulations 112, section 35.720-1, relating to inadmissible assets, have been considered, but they do not complicate the present issue. The stock presently under consideration was not an asset of the petitioner during the taxable years (Borg v. International Silver Co., 11 Fed. (2d) 147;*259 David Bruckheimer, supra), and is not within section 720. The second issue is decided for the petitioner upon the evidence. The three officers, parts of whose salaries have been disallowed, were the managers and operators of the business. They were responsible for its success. They, with other employees, had taken cuts in 1940, with the understanding that increases would follow if earnings permitted. They had earned larger amounts in prior years than their salaries for 1941 and 1942, except that Robert's salary for 1942 was somewhat larger than that for his best prior year. The salaries were not dividends in disguise, but were earned by the services performed. They were duly authorized. The evidence on this point fairly preponderates in favor of the petitioner. Decision will be entered under Rule 50. Footnotes 1. SEC. 718. EQUITY INVESTED CAPITAL. (a) Definition. -- The equity invested capital for any day of any taxable year shall be determined as of the beginning of such day and shall be the sum of the following amounts, reduced as provided in subsection (b) -- (1) Money Paid In. -- Money previously paid in for stock, * * * (2) Property Paid In. -- Property (other than money) previously paid in (regardless of the time paid in) for stock * * *. Such property shall be included in an amount equal to its basis (unadjusted) for determining loss upon sale or exchange. * * * * * * * (4) Earnings and Profits at Beginning of Year. -- The accumulated earnings and profits as of the beginning of such taxable year.↩