Desmond's, Inc. v. Commissioner

DESMOND'S, INCORPORATED, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Desmond's, Inc. v. Commissioner Docket No. 14465. United States Board of Tax Appeals 15 B.T.A. 738; 1929 BTA LEXIS 2799; March 8, 1929, Promulgated *2799 1. The respondent's action sustained in disallowing as deductions from gross income for the years 1919, 1920, and 1921, amounts paid by the petitioner as salary to its former president, and amounts alleged to have been given as bonuses to employees of the petitioner. 2. Deductions taken by petitioner on account of amounts of money paid to one of its officers for the purpose of conducting investigations of its employees approved. 3. Adjustments made by the respondent in the petitioner's closing inventories for 1920 and 1921 approved. 4. The petitioner's income and profits-tax returns for the years 1919, 1920, and 1921, were not false and fraudulent with intent to evade tax, and the understatements were not due to negligence. A. Calder Mackay, Esq., and Thomas A. Dempsey, Esq., for the petitioner. C. H. Curl, Esq., for the respondent. MARQUETTE *739 This proceeding is for the redetermination of deficiencies in income and profits taxes and penalties which the respondent has asserted for the years 1919, 1920, and 1921, as follows: Tax Penalty [1919] $9,077.32 $4,538.66 [1920] 1,836.97 918.49 [1921] 27,272.61 13,636.31 *2800 The deficiencies in tax arise from the disallowance by the respondent of deductions claimed by the petitioner on account of salaries paid to its former president; amounts alleged to have been expended in carrying on secret investigations of its employees and in efforts to sell its business; amounts of certain merchandise orders alleged to have been given to employees as additional compensation, and from adjustments made by the respondent in the petitioner's inventories for 1919 and 1920. The respondent also asserted a penalty of 50 per cent of the additional tax for each of the years 1919, 1920, and 1921, on the ground that the petitioner made false and fraudulent returns of income with intent to evade tax. FINDINGS OF FACT. The petitioner was organized in the year 1913 under the laws of California, with a capital stock of $150,000, all of which was issued to C. C. Desmond in exchange for the assets and business of a clothing store which he had conducted for many years at Los Angeles. During the year 1913 and until June 15, 1914, Desmond was president of the petitioner and received an annual salary of $12,000. In the year 1914 Desmond developed arthritis deformans, and*2801 thereafter until his death in December, 1920, he was confined to his bed or to a wheel chair. About June, 1914, in order to compel *740 Desmond to submit to medical treatment and to obtain such legal control over him as to prevent his interfering with and disturbing the business of the petitioner, which he then manifested a disposition to do, his wife and others instituted proceedings to have him declared mentally incompetent. He was adjudged insane and was paroled in the custody of his family, but he was never committed to an institution for the insane. At or about the time the lunacy proceedings were had, the shares of the petitioner's capital stock which Desmond owned were transferred to one W. E. Hampton as trustee. On June 15, 1914, Hampton was elected president of the petitioner and served each succeeding year up to and including 1921. Hampton received no salary as president. On June 15, 1914, Agnes E. Desmond, wife of C. C. Desmond, who had been secretary of the petitioner, was elected vice president and was reelected to that office each succeeding year up to and including 1921. On June 15, 1914, the petitioner's board of directors adopted the following resolutions: *2802 WHEREAS, C. C. Desmond has retired from the Presidency and active management of the corporation, and Agnes E. Desmond as Secretary; RESOLVED: That the salary voted C. C. Desmond and Agnes E. Desmond, on January 7, 1913, is discontinued. WHEREAS, The salary voted C. C. Desmond and Agnes E. Desmond has been discontinued by the above resolution, and as Agnes E. Desmond and C. C. Desmond, through his Trustee, control the majority of the stock of the corporation, RESOLVED: That instead of the salary as voted them on January 7, 1913, that C. C. Desmond and Agnes E. Desmond be allowed to draw on their personal account in sums to suit their convenience at any time during the year, an amount not to exceed Fifteen Thousand ($15,000) Dollars per annum. On January 17, 1917, the board of directors by resolution duly adopted, authorized the payment of a salary of $8,000 for the year 1917 to Agnes E. Desmond as vice president of the corporation, and a salary of $8,000 to C. C. Desmond for that year. No duties were specified for Desmond nor was any office indicated for him. The board of directors also authorized a salary of $2,000 per year to Mary E. Desmond, daughter of C. C. Desmond, *2803 as secretary of the corporation. Salaries of $8,000 to Agnes E. Desmond as vice president, $8,000 to C. C. Desmond, and $2,000 to Mary E. Desmond were also voted for the years 1919 and 1920 at regular meetings of the board of directors held in those years. In 1921, after the death of C. C. Desmond, the petitioner's board of directors voted a salary of $15,000 per year to Agnes E. Desmond as vice president of the corporation. *741 After Desmond had been adjudged mentally incompetent, he submitted to medical treatment and became somewhat improved in both his physical and his mental condition. During the years 1918 to 1920, inclusive, he appeared to his friends and close acquaintances to be rational. He was much interested in the welfare of Desmond's, Inc., and carefully examined each day the newspaper advertisements and made suggestions regarding them. He discussed business affairs with Mrs. Desmond and advised her as to the conduct of the business. This was the only service he rendered to the petitioner during the years 1918 to 1920, inclusive. The petitioner in its income and profits-tax returns for each of the years 1919 and 1920 deducted from gross income the*2804 amount of $8,000 as salary paid to C. C. Desmond. In the return Desmond was named as president and it was stated that he devoted "all necessary" time to the business of the petitioner and was the owner of 1,480 shares of its capital stock. He was in fact neither the president of the petitioner nor the holder of any of the shares of its capital stock. W. E. Hampton held 1,480 shares of the petitioner's capital stock as trustee for C. C. Desmond and he was president of the corporation. Ten shares of the petitioner's capital stock were owned and held by Agnes E. Desmond, and four shares were owned and held by Mary E. Desmond. The remaining six shares were held by other directors of the corporation as qualifying shares. During the years 1919, 1920, and 1921 Agnes E. Desmond, as vicepresident, withdrew from the petitioner with the approval of the board of directors and for the purpose of making secret investigations of certain employees of the petitioner, including buyers in the eastern part of the United States, the following amounts of money: $9,726 in 1919; $5,957.11 in 1920; and $1,004.11 in 1921. The company had suffered losses from time to time because of embezzlement or*2805 thefts by certain employees, and in making these investigations Agnes E. Desmond was carrying out a policy which had been pursued by the petitioner and by C. C. Desmond prior to the organization of the petitioner. Mrs. Desmond did not keep a record of the persons to whom she paid the money so withdrawn, and only one item of such expense, has been shown herein, $600 paid to a firm of accountants. The amounts so withdrawn were charged on the petitioner's books to "Miscellaneous Expenses," and were deducted from gross income in the petitioner's returns for the years 1919, 1920, and 1921. In its income and profits-tax returns for the years 1920 and 1921 the petitioner deducted from gross income the amounts of $972 and $1,174, respectively, as Christmas bonuses given to certain employees. *742 The inventory method employed by the petitioner during 1912 to 1915 did not meet the purposes of petitioner's business and was entirely unsatisfactory. Each year it was found necessary to make a large adjustment in the book value of the inventory to bring it into conformity with a value based upon a physical count of goods on hand which were priced at actual cost. In the settlement*2806 of its insurance claims, following a loss from fire in 1915, the insurance adjusters reduced the claimed value of petitioner's inventory by $13,000, on the ground that it was overstated through failure to give proper recognition to mark-downs. For these reasons, petitioner instructed its comptroller to make an investigation of what other like business organizations were doing in the way of accounting for and valuing their inventories, with a view of determining upon a method better suited to its purposes and which would yield more substantially correct results. Visits were made by the comptroller to several stores in and around San Francisco to ascertain how they were accounting for their inventories, and the matter was taken up by him with several accountants and economists. Following, and as a result of, these investigations by its comptroller, petitioner adopted in 1916 the so-called retail method of accounting for inventories. A new record of merchandise was opened, showing cost, retail selling prices, mark-downs from retail selling prices, and sales, of each department, for each calendar month, the purpose of which was to determine the percentage of mark-ups in the retail*2807 selling prices over cost, and to maintain a running book inventory at both cost and retail prices. From 1916 to 1919, inclusive, the book inventories were verified annually by a physical count of goods on hand valued at cost and at retail price. The expense of taking the annual inventory at both cost and retail value was considerable. As the results obtained by the use of the retail method during the four years mentioned closely paralleled actual costs, petitioner's officers were convinced that that method was a proper and correct one for accounting for inventories. The taking of inventory on the dual basis of cost and retail value was discontinued in 1920, and thereafter the inventories, including that of December 31, 1920, were accounted for according to the retail method only. Ever since it adopted the retail inventory method in 1916, petitioner has determined its inventories on a monthly basis. At the close of each year from 1916 to 1919, inclusive, the book inventories were adjusted to conform with a physical count of goods on hand valued at actual cost. No such adjustments were made for 1920 and 1921. The following illustrates the manner in which the inventory for July, *2808 1916, was accounted for on the books of account: (1) (2) At cost At retail prices (a) Inventory, Jan. 1, 1916, plus purchases to July 31, 1916 $114,740.86 $180,176.69 (b) Deduct: Accumulated mark- downs on retail prices to July 31, 1916 2,776.19 (c) Inventory and purchases at actual cost and net retail prices 114,740.86 177,400.50 (d) Net mark-up in retail prices 62,659.64 Totals 177,400.50 177,400.50 (e) Percentage of mark-up ($62,659.64 (d) divided by $177,400.50) 35.32 (f) Complement of mark-up percentage and percentage of retail price representing cost 64.68 (g) Sales for July $17,175.35 (h) Add: Mark-downs for July 1,504.50 (i) Total sales and mark-downs for July 18,679.85 (j) Cost of sales for July [$18,679.85(i) multiplied by 64,68 per cent (f)] 11,982.12 (k) Inventory June 30, 1916 47,120.54 73,821.67 (l) Add: Purchases for July 4,199.29 6,446.00 (m) Total inventory and purchases for July 1,319.83 80,267.67 (n) Deduct: Cost of sales for July [see (j) and (i)] 11,982.12 18.679.85 (o) Inventory at July 31, 1916 39,337.71 61.587.82 *743 The inventories*2809 at the close of each month of the taxable years on appeal, have been determined in the manner shown above. The petitioner's books of account, for 1920 and 1921, show the following pertinent data in the determination of its inventories: [1921] Inventory and purchases, at retail value $2,299,423.22 $2,408,220.50 Inventory and purchases, at cost value 1,547,912.45 1,367,915.31 Net mark-downs 103,735.17 86,295.39 Sales 1,591,668.56 1,725,408.59 Cost of sales 1,155,776.39 1,233,244.37 Inventory adjustments, at retail value 25,914.33 10,812.33 Inventory adjustments, at cost value 18,024.19 6,960.11 Closing inventory, at retail value 578,105.16 585,704.19 Closing inventory, at cost value 374,111.87 327,710.83 The books of account show total mark-downs, and total retail value of merchandise stock, for 1916 to 1919, inclusive, as follows: Year Mark-downs Retail value of merchandise [1916] $9,566.92 $760,322.05 [1917] 4,458.00 1,025,854.49 [1918] 5,442.47 1,170,035.83 [1919] 13,205.64 1,842,855.82 Except for a slight carry-over, approximating 5 per cent of the total inventories, the merchandise on hand at the*2810 close of 1920 had been purchased in the spring of that year and in the fall of 1919, and that on hand at the close of 1921 had been purchased in the spring of that year and in the fall of 1920. *744 Early in the summer of 1920, a decline set in in market prices of merchandise dealt in by petitioner, and by the close of that year the decline approximated 33 1/3 per cent to 35 per cent of 1919 fall and 1920 spring prices. A further decline took place in 1921, though much smaller and less precipitous than that of 1920. The replacement costs of merchandise in the inventories of 1920 and 1921 were, at the close of those years, approximately 33 1/3 and 5 per cent, respectively, less than the costs shown by the books of account computed according to the retail method. Because of the belief of petitioner's officers, at the time, that the decline in market prices was of a temporary nature, mark-downs of merchandise made in 1920 were relatively less than the decline in market prices for the same goods. The continued decline in market prices in 1921, and the trend to stabilization of those prices at lower levels than existed in 1920, necessitated further substantial mark-downs*2811 in retail prices to relatively lower levels. The petitioner's books of account, for the years on appeal, were examined in 1924 by a revenue agent, who, in his report to the respondent, commented upon the method employed by the petitioner in accounting for inventories, and made adjustments of inventories, as follows: The Company has for some time prior to the opening date of the period covered by this investigation, kept a record of merchandise showing "cost" "Retail Price" "Sales" "Mark Downs" segregated by departments and entered each month. This record has been used to determine the percentage of "mark-ups" and to carry a running book inventory at both cost and retail selling price and was up to, and including Jan. 1, 1920, verified by taking an actual physical inventory at both cost and retail. As this method checked the book inventory and showed it to be fairly accurate, the cost price was omitted from purchases subsequent to Jan. 1, 1920, and the inventory taken on Dec. 31, 1920 and again on Dec. 31, 1921 was priced at Retail only and on the basis of the monthly percentages, the inventory at cost was computed without being checked by actual cost inventory. In prior*2812 years, in which few mark-downs had been made, the method followed undoubtedly arrived at a figure which was fairly accurate, but in 1920, in which there were mark downs of over $100,000, and in 1921, with mark downs of over $85,000 the method followed appears to have been in error, this error occurring through the consideration of mark downs as part of cost in determining the average per cent of mark ups thus increasing the cost of goods sold as deducted from the "cost inventory plus purchases" and reflecting a like understatement of the closing inventories. The result of this erroneous attempt to apply the "Retail Method" of determining inventory is shown by a comparison of figures applying to the Clothing Dept in the year 1921 the minimum average mark up for any month was 30.15%, and the maximum average was 37.58%. On Dec. 31, 1921 the inventory was taken at retail price and found to be $204,406.00 which amount was the result of a careful listing of stock, and the book inventory at cost showed that this $204,406.00 worth of merchandise had a cost value of only $98,665.40 or only 48% of retail whereas if this stock all had the maximum mark up it would be worth, at cost, at least*2813 62.50% of retail price. *745 Because of this comparison, the inventories have been revised on the basis shown on the following sheets in the column headed "At Cost per Retail Basis" and for further comparison the minimum and maximum average monthly mark ups for both 1920 and 1921 are shown. In the consideration of this inventory schedule it is important to bear in mind the fact that the inventory of Dec. 31, 1919 was taken at both "cost" and "retail" and that no mark ups which may have occurred prior to that time could in any way affect the relation between "cost" and "retail" at either Dec. 31, 1920, or December 31, 1921. Also that mark-downs were not segregated between those amounts applying to goods sold and to goods on hand. As a result, it has been necessary to consider all mark downs as applicable to merchandise sold thus giving the taxpayer the advantage of even a lower inventory than would be shown had all data been available. To illustrate this point, consider that one half of the mark-downs totaling $52,358.63, which were taken in the Clothing Dept. in 1920 were mark-downs applying to goods still on hand, then the December 31, 1920 inventory, which was taken at the marked down retail price would be $198,185.50 Plus one half of $52,358.63 26,179.30 Or a total of 224,364.80 and 67.76 per cent of this amount would be 152,029.59 *2814 However, as a division of the mark downs is impossible, the total was considered, as previously stated as applying entirely to the goods sold. Monthly percentage of mark-ups [1921] Minimum Maximum Minimum Maximum A. Clothing department 27.82 36.89 30.15 37.58 Required, 35 per cent. B. Boys' 15.12 35.97 21.60 43.10 C. Hats 31.99 40.62 30.10 41.00 D. Cadet 19.00 31.46 25.40 39.50 E. Women's 31.06 39.43 36.15 48.00 F. Men's furnishings 30.13 37.26 33.31 40.30 G. Subway 28.45 39.06 32.90 36.32 H. Uniforms 19.72 29.90 17.08 31.37 Showing inventory computation and revision 1920 PERCENTAGE At retail Cost At cost per At cost per [1920] to retail basis books increase retail (actual A. Clothing department: Opening inventory $155,620.37 $105,542.87 $105,542.87 Purchases 883,350.77 598,488.29 598,488.29 Total 1,038,971.14 67.76% 704,031.16 704,031.16 Sales 777,743.67 571,951.46 Mark downs 52,358.63 Inventory adjustment 10,683.34 7,621.49 Total deductions 840,785.64 579,572.95 Closing inventory 198,185.50 134,290.49 124,458.21 $9,832.28 B. Boys' department: Opening inventory $33,030.94 $22,220.16 $22,220.16 Purchases 125,616.28 89,236.52 89,236.52 Total 158,647.22 70.25% 111,456.68 111,456.68 Sales 86,183.33 67,477.36 Mark downs 8,859.87 Inventory adjustment (1,866.81) (1,388.90) Total deductions 93,176.39 66,088.46 Closing inventory 65,470.83 45,993.25 45,368.22 $625.03 C. Hats: Opening inventory 48,527.90 29,607.95 29,607.95 Purchases 127,641.50 80,485.24 80,485.24 Total 176,169.40 62.49% 110,093.19 110,093.19 Sales 128,741.85 86,095.91 Mark downs 8,722.24 Inventory adjustment (880.49) (578.92) Total deductions 136,585.60 85,516.99 Closing inventory 39,585.80 24,737.17 24,576.20 160.97 D. Cadet: Opening inventory 12,193.95 9,120.47 9,120.47 Purchases 96,724.14 70,805.06 70,805.06 Total 108,918.09 73.38% 79,925.53 79,925.53 Sales 81,092.34 60,776.16 Mark downs 200.14 Inventory adjustment 2,912.01 2,140.61 Total deductions 84,204.49 62,916.77 Closing inventory 24,713.60 18,134.84 17,008.76 1,126.08 E. Women's: Opening inventory 42,083.52 27,431.05 27,431.05 Purchases 88,449.63 57,939.84 57,939.84 Total 130,533.15 65.40% 85,370.89 85,370.89 Sales 77,589.21 59,430.75 Mark downs 13,496.53 Inventory adjustment 6,546.56 4,775.06 Total deductions 97,632.30 64,205.81 Closing inventory 32,900.85 21,517.16 21,165.08 352.08 F. Men's furnishings: Opening inventory 171,015.55 107,295.87 107,295.87 Purchases 326,451.76 218,653.86 218,653.86 Total 497,467.31 65.52% 325,949.73 325,949.73 Sales 319,171.92 220,936.36 Mark downs 16,149.75 Inventory adjustment 2,857.41 1,935.03 Total deductions 338,179.08 222,871.39 Closing inventory 159,288.23 104,365.65 103,078.34 1,287.31 G. Subway: Opening inventory 41,543.39 25,878.38 25,878.38 Purchases 68,981.50 45,906.46 45,906.46 Total 110,524.89 64.95% 71,784.84 71,784.84 Sales 62,386.86 41,559.03 Mark downs 1,626.51 Inventory adjustment 1,680.27 1,107.46 Total deductions 65,693.64 42,666.49 Closing inventory 44,831.25 29,117.90 29,118.35 [1] H. Uniforms: Opening inventory 19,160.40 15,360.31 15,360.31 Purchases 59,131.62 43,940.12 43,940.12 Total 78,192.02 75.84% 59,300.43 59,300.43 Sales 58,759.38 47,549.36 Mark downs 2,321.50 Inventory adjustment 3,982.04 2,412.36 Total deductions 65,062.92 49,961.72 Closing inventory 13,129.10 9,957.11 9,338.71 618.40 Total amounts inventories should be increased 14,002.15 *2815 1921 PERCENTAGE At retail Cost to At cost per At cost per 1921 increase retail retail basis books (actual inventory) A. Clothing: Opening inventory 198,185.50 134,290.49 124,458.21 Purchases 966,292.09 632,919.90 632,919.90 Total 1,164,477.59 65.88% 767,210.39 757,378.11 Sales 908,924.48 654,611.90 Mark downs 45,086.20 Inventory adjustment 6,060.91 4,100.81 Tota deductions 960,071.59 658,712.71 Closing inventory 204,406.00 134,662.67 98,665.40 35,997.27 B. Boys' department: Opening inventory 65,470.83 45,993.25 45,368.22 Purchases 58,849.78 38,161.17 38,161.77 Total 124,320.61 67.69% 84,154.42 83,529.99 Sales 69,635.02 52,928.01 Mark downs 5,679.78 Inventory adjustment (1,258.24) (881.40) Total deductions 74,056.56 52,046.61 Closing inventory 50,264.05 34,023.74 31,483.38 2,540.36 C. Hats: Opening inventory 39,585.80 24,737.17 24,576.20 Purchases 116,302.65 72,951.51 72,951.51 Total 155,888.45 [*] 97,688.68 97,527.71 Sales 119,908.06 79,417.28 Mark downs 4,790.94 Inventory adjustment 1,818.55 1,172.96 Total deductions 126,517.55 80,590.24 Closing inventory 29,370.90 18,406.74 16,937.47 1,467.27 D. Cadet: Opening inventory 24,713.60 18,134.84 17,008.75 Purchases 158,788.67 106,661.27 106,661.27 Total 183,502.27 68.01% 124,796.11 123,670.03 Sales 114,370.76 79,112.68 Mark downs 1,997.91 Inventory adjustment 5,236.62 3,560.90 Total deductions 121,605.29 82,673.58 Closing inventory 61,896.98 42,096.14 40,996.45 1,099.69 E. Women's: Opening inventory 32,900.85 21,517.16 21,165.08 Purchases 119,978.94 70,980.02 70,980.02 Total 152,879.79 60.50% 92,497.18 92,145.10 Sales 92,455.61 65,440.73 Mark downs 8,186.06 Inventory adjustment 4,076.52 2,600.82 Total deductions 104,718.19 68,041.55 Closing inventory 48,161.60 29,137.77 24,103.55 5,034.22 F. Men's furnishings: Opening inventory 159,288.23 104,365.65 103,078.34 Purchases 325,686.35 205,555.21 205,555.21 Total 484,974.58 63.90% 309,920.86 308,633.55 Sales 304,141.05 215,259.09 Mark downs 18,940.05 Inventory adjustment (2,946.61) (1,951.54) Total deductions 320,134.49 213,307.55 Closing inventory 164,840.09 105,332.82 95,326.00 10,006.82 G. Subway: Opening inventory 44,831.25 29,118.35 Purchases (28,437.14) (18,168.10) Total 16,394.11 10,950.25 Sales 15,118.76 10,950.25 Mark downs 1,275.35 Inventory adjustment Total deductions 16,394.11 10,950.25 Closing inventory H. Uniforms: Opening inventory 13,129.10 9,957.11 9,338.71 Purchases 112,654.00 84,741.86 84,741.86 Total 125,783.10 75.29% 94,698.97 94,080.57 Sales 100,854.85 75,524.43 Mark downs 339.10 Inventory adjustment (2,175.42) (1,642.44) Total deductions [*] 73,881.99 Closing inventory 26,764.57 20,151.04 20,198.58 (47.52) Total amounts inventories should be increased 56,100.11 *2816 *749 The adjustments made by the revenue agent resulted in increasing the inventories of 1920 and 1921 by the amounts of $14,002.15 and $56,100.11, respectively. These adjustments were approved by the respondent, and a portion of the deficiency determined for each of these years is attributable to that action. The respondent, upon audit of the petitioner's income and profits-tax returns for the years 1919, 1920 and 1921, disallowed the deductions taken for 1919 and 1920 on account of salary paid to C. C. Desmond; the deductions taken in the years 1919, 1920 and 1921, on account of the payments made to Mrs. Desmond for the investigation of employees, and the deductions taken in 1920 and 1921 on account of the amounts alleged to have been given as Christmas bonuses to employees, and also increased the petitioner's closing inventory for 1920 and 1921 by the amounts of $14,002.15 and $56,100.11, respectively, thereby increasing the petitioner's income for those years by the same amounts. The respondent also determined that the returns were false and fraudulent with intent to evade tax and he asserted as to each year a penalty of 50% of the additional tax. OPINION. *2817 MARQUETTE: The first question raised by the record herein is whether the petitioner, in computing its net income for the years 1919 and 1920, is entitled to deduct in each year the amount of $8,000 paid to C. C. Desmond as salary. The petitioner contends that the salary so paid was reasonable in amount and constituted an ordinary and necessary business expense and is therefore deductible. This the respondent denies. In our opinion the salary paid to Desmond was neither reasonable in amount nor was it an ordinary and necessary business expense. During the years involved he was clearly physically incapacitated, and had also been adjudged mentally incompetent, although there is evidence that his mental condition had improved. He did not visit the petitioner's place of business and his only services to the petitioner consisted of advice to his wife on how to run the business, and some occasional suggestions concerning the advertisements made by the petitioner. A "necessary business expense," as we understand it, is one which is fairly and properly connected with the sound conduct of a business. Furthermore, assuming for the moment, that in 1919 and 1920 Desmond had recovered*2818 from his mental disability, the salary paid to him seems entirely out of proportion to the services rendered, and does not constitute "ordinary and necessary expense" within the meaning of the statute. Botany Worsted Mills v. United States,278 U.S. 282; 49 Sup.Ct. 129. *750 The petitioner introduced evidence to show that Mrs. Desmond's services were worth at least $15,000 per year, whereas she was paid a salary of only $8,000 per year. Conceding this to be true, it does not alter the situation. The fact that Mrs. Desmond accepted a salary which was lower than the value of her services does not render reasonable the salary paid to her husband. On this issue we approve the action of the respondent. The second question is whether the petitioner is entitled to deduct, in computing its net income for the years 1919 to 1921, inclusive, the amounts paid to Mrs. Desmond for the purpose of carrying on investigations of certain of the petitioner's employees. The evidence shows that the amounts claimed were actually paid to Mrs. Desmond with the approval and consent of the board of directors, on her representation that she intended to use the*2819 money in investigation of certain employees, including buyers of the petitioner, and that the making of such investigations was a practice which the petitioner and Desmond had theretofore pursued. The evidence also shows that in past years the petitioner had suffered pecuniary losses due to the dishonesty of employees. There is no question but that the money was actually appropriated by the petitioner and paid to Mrs. Desmond for the purpose mentioned, and it seems under the circumstances, a necessary purpose, and the petitioner definitely parted with its money for that purpose. As to these items the petitioner's contention is sustained. The third question relates to certain alleged bonuses which the petitioner seeks to deduct in computing its net income for 1920 and 1922. In the petition herein it is alleged that at the end of the years 1920 and 1921 the petitioner gave its employees Christmas bonuses in the form of merchandise orders amounting to $972 and $1,074, respectively, which amounts represented additional compensation to the employees for services rendered. The respondent in his answer denies these allegations and the petitioner has produced no evidence to support*2820 them. On the record as to this point we must affirm the action of the respondent. The fourth question relates to the respondent's action in increasing the petitioner's closing inventories for 1920 and 1921, and thereby increasing the petitioner's income for those years. In its returns for 1920 and 1921, petitioner reported inventories of $374,111.87 and $327,710.83, respectively, which were determined, in accordance with a practice adopted in 1916 under the retail inventory method. Respondent, acting upon the basis of his examining agent's report, has increased the inventory of 1920 by $14,002.15 and that of 1921 by $56,100.11, resulting in an increase of $14,002.15 in the net income of 1920 and an increase of $42,097.96 in the net income *751 of 1921. The respondent's determination as to the inventories also was made under the retail inventory method. The formula used by the petitioner for determining its inventories is set out in the findings of fact by way of an illustration of its application in the determination of the inventory for July, 1916. It may be stated thus: (a) (Opening inventory + purchases, at retail prices) - mark-downs = retail value of goods*2821 on hand at beginning and purchases during year. (b) Retail value of goods on hand at beginning and purchased during year - cost of goods on hand at beginning and purchased during year = net mark-up. (c) Net mark-up / retail value of goods on hand at beginning and purchased during year = percentage of net mark-up. (d) (Sales + mark-downs) X percentage of net mark-up = cost of sales and mark-downs. (e) Cost of goods on hand at beginning and purchased during year - cost of sales and mark-downs = cost of goods in closing inventory. The respondent used the following formula: (a) (Opening inventory + purchases, at retail prices) - (opening inventory + purchases, at cost) = mark-up. (b) Mark-up / (opening inventory + purchases, at retail prices) = percentage of mark-up. (c) Closing inventory at retail price X (100% - percentage of mark-up) = cost of goods in closing inventory. Petitioner contends that the formula adopted in 1916 is a correct one for determining the value of inventories at cost, and that its inventories have been consistently determined by this formula in all subsequent years to 1924. It asks, therefore, that we set aside the respondent's determinations, *2822 which it terms as arbitrary and unjust, in favor of its own, which it alleges were made in accordance with a consistent and correct inventory practice. The respondent contends that the formula which the petitioner used to determine the inventories of 1920 and 1921 is not in accordance with the regulations, and he denies the correctness of that formula and of the inventory values determined by it. Respondent also denies that petitioner has followed a consistent inventory practice, pointing out that in 1920 petitioner abandoned the practice of verifying the inventory values determined according to its formula, by a physical count of the goods in the inventory priced at cost. Taking up first the question as to whether the petitioner has followed a consistent inventory practice since 1916, we find that the petitioner's contention in this respect is not supported by the evidence. It was not until 1920, one of the years under consideration, that the petitioner entirely adopted the retail inventory method for income-tax purposes. It is true that in 1916 petitioner instituted the practice of maintaining a running book inventory determined according to the retail inventory method, but*2823 at the close of each *752 year, to and including 1919, the book inventory was adjusted to bring it into conformity with a physical count of the goods on hand valued on the basis of actual cost. No such adjustment was made in 1920, so that the inventory of that year was the first to have been determined under the retail inventory method. It is true also, that the inventories of 1920 and 1921 were computed by the same formula that petitioner had used in maintaining the running book inventory from 1916 to 1919, inclusive, but as has already been pointed out, the final determinations as to inventories from 1916 to 1919 were based upon actual cost of the goods on hand, whereas in 1920 and 1921 such determinations were made on the basis of the retail inventory method, and, as to the latter determinations, they certainly are not representative of cost. The underlying principle of the retail inventory method is the determination of the inventory value by applying the complement of the percentage of mark-up to the retail value of the inventory. The petitioner and the respondent have attempted by this method to determine the inventories of 1920 and 1921 on the basis of cost, though*2824 each by a different formula, and their results differ by the amounts in dispute. An analysis of the inventory data set out in the findings of fact, which is taken from petitioner's books of account, discloses that there is something fundamentally wrong with the book inventories, for they represent a lesser percentage of the retail values of the inventories than that percentage which is the complement of the percentage of mark-up. According to the petitioner's procedure for determining the percentage of mark-up, that percentage for all departments for 1920 is 29.50 and its complement is 70.50, but the book inventory for that year, $374,111.87, is only 64.71 per cent of the retail value of the inventory, $578,105.16. For 1921 the percentage of mark-up for all departments, computed according to the petitioner's procedure, is 32.47 and its complement is 67.53, but the book inventory of $327,710.83 is only 55.95 per cent of the retail value of the inventory, $585,704.79. Examination of the formula by which petitioner determined the book inventories, readily discloses the error accountable for these discrepancies. Under this formula the cost value of the inventory is determined by*2825 deducting the cost of sales from the total cost of opening inventory and purchases. The error is in computing the cost of sales, which is done by applying to the sales figure, which includes the gross mark-up, a percentage which is complementary to the percentage of net mark-up. Manifestly, when cost of sales is computed by applying to the sales figure, which includes the gross mark-up, a percentage which is complementary to the percentage of net mark-up, cost of sales is overstated, and, in that circumstance, the *753 result of cost of opening inventory plus cost of purchases minus cost of sales is less than the cost value of the closing inventory. We can readily appreciate the reason for the agreement of the parties that petitioner's formula produced fairly accurate results during 1916, 1917, 1918, and 1919, when compared with physical inventories priced at cost, since the mark-downs of those years were but 1.25, .43, .47, and .72 per cent, respectively, of the retail values of the merchandise stock; but it is obvious, from what already has been said, that as appreciable increases in mark-downs are made, as is the case in 1920 and 1921, when they amounted*2826 to 4.50 and 3.58 per cent, respectively, there will be a proportionately greater discrepancy due to the error in the formula. Were it not for this error in the petitioner's formula, the resulting inventory valuations would have been $407,564.14 for 1920, and $403,960.18 for 1921, which amounts are equal to those percentages of the retail value of the inventories of those years which are complementary to the respective percentages of mark-up, and there would have been no conflict, in that respect, with any principle of the retail inventory method. Respondent points out that the formula used by the petitioner for determining the inventories, under the retail inventory method, does not conform with article 1588 of Regulations 62, and that is undoubtedly true. At least, the immediate results of that formula are not what are contemplated by those regulations, and this is due to the error in computing the cost of sales which we have pointed out. On the other hand, it is equally clear that the formula used by the respondent does not conform with the regulations. Article 1588 of Regulations 62 provides: Inventories of retail merchants. - Retail merchants who employ what is known*2827 as the "retail method" of pricing inventories may make their returns upon that basis, provided that the use of such method is designated upon the return, that accurate accounts are kept, and that such method is consistently adhered to unless a change is authorized by the Commissioner. Under this method the goods in the inventory are ordinarily priced at the selling prices, and the total retail value of the goods in each department or of each class of goods is reduced to approximate cost by deducting the percentage which represents the difference between the retail selling value and the purchase price. This percentage is determined by departments of a store or by classes of goods, and should represent as accurately as may be the amounts added to the cost prices of the goods to cover selling and other expenses of doing business and for the margin or profit. In computing the percentage above mentioned, proper adjustment should be made for all mark-ups and mark-downs. A taxpayer maintaining more than one department in his store or dealing in classes of goods carrying different percentages of gross profit should not use a percentage of profit based upon an average of his entire business, *2828 but should compute and use in valuing his inventory the proper percentages for the respective departments or classes of goods. *754 The regulations require that the percentage of mark-up shall be computed upon the basis of the net mark-up. That is the only construction which can be placed on the provision which requires that "In computing the percentage above mentioned, proper adjustment should be made for all mark-ups and mark-downs," for the only way of carrying this provision into effect is to offset the mark-downs against the mark-ups before computing the percentage of mark-up. The respondent has computed the percentage of mark-up upon the basis of the gross mark-up, which procedure, for the reasons stated, does not conform with the regulations. Had he computed the inventories in the manner seemingly required by the regulations, he would have determined their values to be $407,564.14 for 1920, and $403,960.18 for 1921, which are the same as would have resulted under the petitioner's formula were it not for the error in computing cost of sales. However, there is this irony in respondent's action - that, if his assumption that all mark-downs have been actually taken*2829 on goods sold and there have been no mark-downs on the goods in the inventories is well founded, he has come closer to an actual cost valuation of the inventories by his formula than he would have had he followed the procedure contemplated by the regulations. As a usual rule the formula used by respondent is not suitable for determining the cost valuation of the inventory, because when there have been mark-downs it is seldom that the inventory does not include some of the marked-down goods; and where there are mark-down goods in the inventory it is obvious that the inventory does not contain the percentage of gross mark-up the complement of which is to be applied to the retail value of the inventory to determine its value. If the unusual circumstances in the respondent's assumption exist, and there is no evidence to the contrary, the formula he has used will result in a cost valuation as closely approximating actual cost as is possible under the retail inventory method. The effect of the procedure outlined in the regulations is to spread the mark-downs ratably over every dollar of sales and every dollar of retail value in the inventory. This procedure might be justified when the*2830 inventory is known to contain marked-down goods and the mark-downs can not be segregated as to goods sold and goods in the inventory; but in the actual or assumed circumstances that no mark-downs were made on the goods in the inventory, the procedure is obviously improper in the determination of the cost value of the inventory. There is no proof in the record which challenges the correctness of the cost values of the inventories determined by the respondent. *755 Petitioner has rested its entire case on the grounds that the formula adopted in 1916 is a proper one for determining the cost valuations of the inventories and that its inventory practice has been consistent, in the use of that formula, since 1916. These grounds we have found to be erroneous; and lacking proof of error in the inventory values determined by respondent, those values must stand. The last question is whether the petitioner made false and fraudulent returns for the years 1919, 1920, and 1921, with intent to evade tax. The respondent has asserted the fraud penalty as to each of those years, and the hearing herein having been had prior to the enactment of the Revenue Act of 1928, the burden is upon*2831 the petitioner to show the returns were not false and fraudulent. The facts concerning the several transactions at issue, and on which the respondent's determination of fraud is apparently predicated, are fully set forth in the findings of fact herein, and we do not deem it necessary to restate them. It is sufficient to say that in our opinion the petitioner has sustained the burden of proof as to this issue. It is true that the evidence shows that its returns for the years involved contained statements which were untrue, and that it claimed deductions to which it is not entitled. However, the petitioner has shown that these statements were not made with intent to mislead or defraud, and that it believed, and still believes, that it is entitled to the deductions claimed. We are satisfied that the returns were not false or fraudulent with intent to evade tax, and we so hold. At the hearing the respondent, by an amendment to his answer, prayed that in the event we should hold that the petitioner's returns for any of the years involved were not false and fraudulent with intent to evade tax, we should also hold that the petitioner was negligent in the preparation and filing of*2832 such returns, and that the negligence penalty should be asserted. We have carefully considered this phase of the case and we are of opinion that on the record the assertion of the negligence penalty is not warranted. Reviewed by the Board. Judgment will be entered under Rule 50. VAN FOSSAN concurs in the result. SMITH dissents on the fourth point, regarding inventories. MURDOCK MURDOCK, dissenting: In my opinion the deduction claimed by the petitioner on account of money paid to one of its officers, for the alleged purpose of conducting investigations of its employees, should be disallowed for lack of evidence showing this amount to have been an ordinary and necessary expense. Furthermore, I do not agree *756 with the prevailing opinion in its decision on the last point. From the facts and the opinion it is clear that the petitioner made false statements in its returns for the years involved and claimed deductions based on those false statements. There are no facts found from which I could reach the conclusion, stated in the opinion, that the petitioner "believed and still believes that it is not entitled to the deductions claimed." But in any*2833 event does a taxpayer's belief that it is entitled to a certain deduction justify a false statement under oath to support the deduction? Footnotes 1. Not changed. ↩