Wickens Co. v. Commissioner

THE WICKENS CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Wickens Co. v. Commissioner Docket No. 16476. United States Board of Tax Appeals 16 B.T.A. 968; 1929 BTA LEXIS 2479; June 10, 1929, Promulgated *2479 1. The amount of salaries of officers of a corporation deductible from gross income determined. 2. The petitioner took its inventory at December 31, 1917, at market, which was in excess of the cost; it took its inventory at December 31, 1918, at cost and reduced the amount thereof by 10 per centum to bring it to market value. The Commissioner restored the inventory to cost at December 31, 1918, for the purpose of determining the tax liability for 1918. Held, the petitioner properly reduced its inventory. L. B. Fauver, Esq., for the petitioner. T. M. Mather, Esq., for the respondent. SMITH *968 This is a proceeding for the redetermination of deficiencies in income and profits tax for the years 1918 and 1919 of $24,902.88 and $16,686.89, respectively. The errors alleged in the petition are: (1) The disallowance of a deduction of an amount of $6,801.27 for the year 1918, and $10,331 for the year 1919 as compensation of officers of such company. (2) The disallowance of a deduction for the year 1918 of $11,086.28 as an adjustment of inventory to cost or market. (3) The refusal of the Commissioner to assess excess-profits tax*2480 under section 328 of the Revenue Act of 1918. FINDINGS OF FACT. The petitioner was engaged in the retail furniture business at Lorain, Ohio. The business was established in 1881 and was incorporated in 1905, shortly after the death of the founder. The founder bequeathed the business to his two children, E. M. Wickens and Elizabeth Lewis, nee Wickens. Under the will of their father the share belonging to Elizabeth Lewis was to be held by Chloe E. Wickens as trustee for her. During the taxable years most of the stock of the corporation was held by E. M. Wickens, his wife, Maude C. Wickens, and by Elizabeth Lewis, and Chloe E. Wickens, as trustee for Elizabeth Lewis. Of the 435 shares outstanding at the close of 1918, 62 shares were held E. M. Wickens, 182 shares by Maude C. Wickens, 30 shares by Elizabeth Lewis and 130 shares by Chloe E. Wickens, as trustee for Elizabeth Lewis. Of the 498 shares outstanding at the close of 1919, 70 shares were held by E. M. Wickens, 182 shares by Maude C. Wickens, 37 shares by Elizabeth Lewis, and 130 shares by Chloe E. Wickens, as trustee for Elizabeth Lewis. Most of the remaining shares were held by the members of *969 the Wickens*2481 family. For many years prior to the taxable years, E. M. Wickens, president of the corporation, had received a slary of $25 per week and his sister, Elizabeth Lewis, who was secretary and treasurer, a salary of $22 per week. The key employees were paid salaries from $37.50 to $45 per week. It was the understanding of the stockholders that the salaries paid them weekly were not to constitute their entire compensation but that they should receive additional compensation out of a fund specially set aside for the payment of bonuses to officers and certain employees of the corporation. This fund was made up of 6 per cent of the receipts from sales of merchandise. The fund was kept in the savings department of the Cleveland Trust Co., separate from the other funds of the petitioner. The corporation was a close corporation and its officers were not familiar with corporate procedure or transactions. Corporate procedure was not followed. The additional compensation to E. M. Wickens and Elizabeth Lewis was paid as dividends. Dividends were paid on the stock as follows: Per cent April 1, 1918 [4] June 28, 1918 [4] Sept. 14, 1918 [6] Dec. 28, 1918 [2] Mch. 22, 1918 [5] June 7, 1919 [7] Sept. 13, 1919 [5] Dec. 13, 1919 [7] *2482 All of the distributions made upon the stock of Maude C. Wickens from the special savings bank fund were received by E. M. Wickens in accordance with the arrangement had with respect to additional compensation for services and all of the distributions made to Chloe E. Wickens out of the special fund were received by Elizabeth Wickens as additional compensation. The additional compensation thus received by E. M. Wickens was $3,806.24 for 1918 and $6,008 for 1919, and the additional compensation thus paid Elizabeth Lewis was $2,729.83 for 1918 and $4,238 for 1919. Additional compensation was paid to another office employee from the special fund of $265.20 for 1918 and $85 for 1919. In its income-tax returns for 1918 and 1919, the petitioner deducted from gross income as salaries of officers the amounts paid to E. M. Wickens and Elizabeth Lewis weekly, plus the additional compensation shown upon the books of account as dividends paid to or for these individuals and also the additional compensation paid to a third office employee in the amounts above stated, $265.20 for 1918 and $85 for 1919. The Commissioner in determining deficiencies for 1918 and 1919 disallowed the deduction*2483 of the additional compensation from the special fund of $6,801.27 for 1918 and $10,331 for 1919. In his income-tax return for 1919, E. M. Wickens reported the receipt of a salary of $5,000 from petitioner, and Elizabeth Lewis in *970 her income-tax return for 1919 reported the receipt of $2,800 as her salary from the petitioner. The amount of the weekly salary plus the dividends claimed as compensation in the case of E. M. Wickens was $7,308 and in that of Elizabeth Lewis, $5,382. For many years prior to the taxable years the petitioner had taken its inventories upon the basis of the market; if the market was higher than cost the inventory reflected the appreciation over cost, and if the market was lower, the inventory reflected the markdown from cost. The market was above cost at December 31, 1917, and the inventory reported at the close of 1917 on the 1917 return was in excess of cost. The same inventory was used as the opening inventory of 1918. The officers of the petitioner knew the market with respect to its goods on hand at the close of each year and after the inventory was taken in each instance at cost prices the total inventory was adjusted to the market. *2484 The inventory at cost on December 31, 1918, was $110,862,83. There was a decline in prices of petitioner's merchandise at the close of 1918 which fact was known by the petitioner. The market prices of merchandise carried were from 10 to 25 per cent below cost. The petitioner therefore in an attempt to bring its inventory at December 31, 1918, to the basis of the market prices reduced the total inventory 10 per cent or in an aggregate amount of $11,086.28 and reported its inventory at December 31, 1918, in its income-tax return for 1918, at $99,776.55. The inventory at December 31, 1919, was taken at cost which was the same as the market. All inventory records were accidentally destroyed in 1924. In the audit of the petitioner's tax return for 1918 the Commissioner has restored the inventory at December 31, 1918, to $110,862.83 thereby increasing the reported net income for 1918 by the amount of $11,086.28. OPINION. SMITH: The first point made by the petitioner is that the respondent has erroneously disallowed the deduction of $6,801.27 for the year 1918 and $10,331 for 1919 as compensation of its officers. These amounts represent items shown on the taxpayer's books of*2485 account as dividends to E. M. Wickens and Elizabeth Lewis. The amounts were drawn from a special fund maintained by the petitioner for the purpose of paying this additional compensation. The record indicates that from this special fund additional compensation was paid to some other individuals than the two above mentioned. The evidence also indicates that in some instances dividends were paid upon all the shares of stock outstanding and in other instances on only a portion of the stock outstanding and that other individuals than the stockholders received some of the distributions. The Revenue Act of 1918 permits a corporation to deduct from gross income, among other items, "a reasonable allowance for salaries *971 or other compensation for personal services actually rendered." Section 234(a)(1). It is immaterial in what form or manner the compensation is paid. The mere fact that it is distributed to officers in accordance with their stockholdings will not render it nondeductible, provided it is paid as compensation and the amount is reasonable. The bookkeeping of the transaction is not controlling. *2486 Mitchell Brothers Co. v. Doyle,247 U.S. 179. In the instant case it is difficult to determine the amount that was actually distributed as additional compensation to E. M. Wickens and Elizabeth Lewis from the amounts paid to them as dividends upon their stock. The respondent has introduced in evidence the individual income-tax returns of E. M. Wickens and Elizabeth Lewis for 1919. The return of the former shows that he received a salary from the petitioner for 1919 of $5,000 and the return of the latter shows that she received a salary of $2,800. E. m. Wickens shows the receipt of $5,000 as dividends although it is not certain that these dividends were upon the stock of the petitioner owned by him. In this state of the record we are of the opinion that reasonable compensation for E. M. Wickens constitutes $5,000 per year for each of the years 1918 and 1919, and that reasonable compensation for Elizabeth Lewis was $2,800 for each of the taxable years and that these amounts were paid by the corporation as compensation. The petitioner is therefore entitled to deduct from gross income in determining tax liability a total of $7,800 for each of the taxable years*2487 for compensation of E. M. Wickens and Elizabeth Lewis. The second question presented is the correctness of the disallowance by the respondent of $11,086.28 as a reduction in the inventory at December 31, 1918. Section 203 of the Revenue Act of 1918 provides: That whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income. The first regulation of the Commissioner, with the approval of the Secretary, authorizing the use of inventories upon other bases than cost appears to have been Treasury Decision 2609, which was promulgated December 19, 1917. This was under the Revenue Act of 1917. Treasury Decision 2649, promulgated January 30, 1918, and Treasury Decision 2744, promulgated July 3, 1918, likewise authorized the taking of an inventory upon the basis of either (a) cost, or (b) cost or market, whichever is lower. The same regulations were*2488 continued in effect under the Revenue Act of 1918. See *972 articles 1582, 1583, and 1584 of Regulations 45 (1920 Edition). In all of these regulations it is provided that corporations filing income-tax returns may elect to take inventories upon either of the above bases, but that after a return has been made upon one basis a change can not be made for subsequent years until "after permission is secured from the Commissioner." For the purpose of inventories any income-tax return is to enable the taxpayer correctly to determine his income. The only inventory about which any question is raised in the instant proceeding is that of December 31, 1918. Under the Commissioner's regulations petitioner was entitled to take this on the basis of cost or market, whichever is lower. The market was lower than cost. We are satisfied from the evidence that the markdown of the inventory made by the petitioner at December 31, 1918, was in an honest effort to bring the inventory to the basis of cost or market, whichever was lower. It effected that result. We are therefore of the opinion that it was error of the respondent to disallow the reduction made. The inventory at December 31, 1919, was*2489 taken at cost. It is in evidence, however, that the inventory had always been taken on the basis of the market. It is found therefore that the inventory at December 31, 1919, taken on the basis of cost was in effect on the basis of cost or market, whichever is lower, since the cost and the market were the same. We therefore think that the inventories at the close of 1918 and 1919 were consistently on the basis of cost or market, whichever is lower. It is apparent that inasmuch as the respondent has increased inventory at December 31, 1918, and has increased taxable income for 1918 in the amount of the increase, namely, $11,086.28, the inventory at January 1, 1919, which formed the basis for the respondent's computation of deficiency for 1919, was overstated in a like amount, namely, $11,086.28. The deficiencies for 1918 and 1919 should be computed upon the basis that the correct inventory at both December 31, 1918, and January 1, 1919, was $99,776.55. Judgment will be entered under Rule 50.