Package Mach. Co. v. Commissioner

PACKAGE MACHINERY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Package Mach. Co. v. Commissioner Docket No. 54334. United States Board of Tax Appeals 28 B.T.A. 980; 1933 BTA LEXIS 1065; August 8, 1933, Promulgated *1065 In addition to the regular salaries paid in cash to its officers, who were rendering valuable services of a specialized nature, petitioner, prior to the tax year, provided that, after setting aside out of net profits certain amounts for sinking fund and dividend purposes, "25% of the balance of the net earnings shall be paid to the officers aforesaid in the proportion hereinafter set forth, said payment to be made in common stock of the company at par." Held, the liability of petitioner to its officers under the agreement was not for a specific sum in terms of dollars and cents, but for a number of shares of stock of an aggregate par value equal to the amount of profits in which the officers were entitled to participate, that amount being merely the measure of the number of shares to be issued to them. Held, further, the basis for the deduction for the stock issued as compensation for services is the fair market value of the stock as of the date issued. Held, further, the total compensation so paid did not exceed a reasonable amount for the services rendered during the tax year. Virgil Y. Moore, Esq., and W. W. Johnston, C.P.A., for the petitioner. *1066 O. W. Swecker, Esq., for the respondent. ARUNDELL *981 The respondent determined a deficiency in income tax for 1927 in the amount of $873.31. The sole issue raised by the pleadings is whether the petitioner is entitled to deduct $53,067 for compensation for personal services actually rendered, in addition to the amount allowed by the respondent in the deficiency notice. FINDINGS OF FACT. The petitioner, a Massachusetts corporation, was incorporated on August 18, 1919, and succeeded to the business of a predecessor corporation organized in 1913. Between July 1, 1921, and December 31, 1928, its authorized capital stock consisted of 40,000 shares of common of the par value of $50 each, and 9,217 to 10,000 shares of preferred of the par value of $100 each. Between the same dates, various amounts of common, ranging from 29,739 to 35,479 shares, and of preferred, ranging from 3,728 to 4,511 shares, were outstanding and in the treasury. The preferred stock bore a cumulative dividend at the rate of 7 percent per annum. Under the terms of its issuance, petitioner was required to set apart each year a sum equal to 2 percent of the par value of outstanding*1067 preferred stock, including that in the sinking fund, as a sinking fund with which to purchase or call said preferred stock. Petitioner is, and has been for its entire life, in the business of making specialized machinery for the automatic wrapping of packages. It makes the machines which wrap Ivory Soap, Uneeda Biscuit, Hershey's Chocolate, Chesterfield Cigarettes, Sunshine Candy, Liggett's Chocolate, Nabisco Wafers, Dromedary Golden Dates, Ungentine, Baby Ruth Gum, Lucky Strike Cigarettes and many other *982 package products. No other concern in the country manufactures exclusively automatice package-wrapping machines, but the petitioner has competition in its various lines from other machinery manufacturing concerns. Petitioner has no established line of customers and no established year-to-year business. To sustain its business it must develop new machines and persuade customers to adopt them as it did in the case of introducing cellophane wrappings for cigars and cigarettes. With small exception each order received by petitioner necessitates a new machinery design, sometimes a modification of an existing machine, sometimes an entirely new invention. A development*1068 and invention department is maintained, to make new designs and develop new ideas, and on these designs and development it subsists. Very few repeat orders are received, on account of the small amount of depreciation usually suffered by the machines. The petitioner could not subsist on repeat orders alone. The machines as a rule become obsolete before they wear out; and this obsolescence is due in a large measure to the progress which the petitioner itself makes in producing new and better machines. During 1927 and theretofore the business was conducted by the officers somewhat as the business of a partnership would be conducted. They consulted each other as to the various details of the business, each having his special field, but all consulting together on all matters. The business was dependent largely on the specific efforts of these men. If the capital of the business were wiped out, the same group could start over again; but if the group were wiped out, the business would be severely handicapped. In 1921, petitioner's vice president and general manager, Jefferson, and its superintendent, Langhammer, became restive and dissatisfied with the compensation they were receiving*1069 from the petitioner. Jefferson complained to petitioner's president that he should have a larger salary and members of the board of directors believed that he could get a larger salary elsewhere. He demanded additional salary. Langhammer made known the fact that he had been made an offer for his services from another concern, which he was inclined to accept. The directors entertained the thought that the chief engineer, Smith, in charge of invention and design, would likely follow the lead of Jefferson and Langhammer, and believed that in fairness to him he should be included in any salary raises. The petitioner's prospects, at the time, were not good. During the war it had placed with its largest customers all the machines they were likely to need. It did not know where to turn to get business. Its common stock had declined in value to approximately $30 per share. *983 On July 21, 1921, the executive committee of petitioner's board of directors passed a resolution which, so far as material here, reads as follows: On motion duly made and seconded, it was VOTED: That, out of the net profits of the Company, there shall be set aside enough to pay the dividend and*1070 sinking fund on First Preferred Stock, and also a sum equal to twice as much as is needed to pay a 4% dividend on the Common Stock at the usual dates, and 25% of the balance of the net earnings shall be paid to the officers aforesaid in the proportion hereinafter set forth, said payment to be made in Common Stock of the Company at par. In determining the net earnings of the Company for the purpose of ascertaining the amount of Common Stock to be paid to the officers, this payment of Common Stock shall not be deducted. But this payment of Common Stock is paid to the officers in part compensation for their services and should be deducted in ascertaining the earnings of the Corporation for the purposes of taxation. On November 7, 1923, the executive committee voted to amend the foregoing resolution so that, for the purpose of figuring the compensation of the officers, dividends received on preferred stock of the company held in the treasury and not in the sinking fund would be treated as profits. Beginning in 1921, and continuing through 1927, the trend of petitioner's sales was upward, due to the development and sale of new machines, notably a new machine for wrapping biscuit*1071 containers, which was sold to National Biscuit Co., a new gum-wrapping machine, which made obsolete the old machines used for the purpose; and a new toffee-wrapping machine, a great many of which were sold in England. On January 18, 1928, petitioner's board of directors voted that common stock to be issued to officers for 1927 and 1928, under the resolution of July 21, 1921, as amended, should be distributed as follows: Roger L. Putnam 1/4 Paul Langhammer 1/4 E. Lovell Smith 1/4 Roe S. Clark 1/8 George A. Mohlman 1/8 Of the 33,548 shares of petitioner's common stock outstanding during 1927, 12,690 shares were owned and held by petitioner's officers and their wives as follows: Shares Roger L. Putnam and wife 9,400 Paul Langhammer and wife 1,600 E. Lovell Smith and wife 1,230 Roe S. Clark and wife [360] George A. Mohlman [100] *984 The net profit for 1927, before deductions for additional salaries authorized by the resolution of July 21, 1921, estimated accrued Federal income tax, sinking fund, and dividend requirements, amounted to $408,522.25. The balance of net profits after making the specified deductions, in which*1072 the officers were entitled to participate under the resolution of July 21, 1921, amounted to $186,460.68, 25 percent of which is $46,615.17. The latter amount was paid to the officers, pursuant to the aforesaid resolution, by the issuance of common stock of a total par value of $46,550, and payments in cash, for fractional shares, amounting to $65.17. The fair market value of the common stock so issued, as of the date of issue, was $99,617. Salaries paid to officers for personal services rendered during 1927, were as follows: Common stock Name Cash Par value Market value Roger L. Putnam $15,003.79 $11,650 $24,931 Paul Langhammer 12,003.79 11,650 24,931 E. Lovell Smith 10,003.79 11,650 24,931 Roe S. Clark 8,526.90 5,800 12,412 George A. Mohlman 16,526.90 5,800 12,412 George W. Kyburg 9,000.00 Total 71,065.17 1 46,550 2 99,617 The following is a statement of salaries paid to officers, for each of the years 1921 to 1928, inclusive: Common stock Year Par value Market value Cash Total cash and market value of stock [1921] None. None. $71,500.00 $71,500.00 [1922] $10,250 $9,430 74,738.93 84,168.93 [1923] 34,050 58,566 70,263.07 128,829.07 [1924] 12,300 23,124 70,261.60 93,385.60 [1925] 18,000 35,640 46,235.85 81,875.85 [1926] 32,000 64,640 62,713.80 127,353.80 [1927] 46,550 99,617 71,065.17 170,682.17 [1928] 19,350 43,344 81,581.09 124,925.09 *1073 Roger L. Putnam was president of the petitioner in 1927. He became associated with petitioner in 1919, became vice president in 1921, commenced acting as president in 1924, and assumed the latter title and office in 1927. He has had charge of the export trade of petitioner since 1923, and developed a large export business in England and in small amounts in all industrial countries in the world. In 1927, his duties included settling the general policies of *985 the business, doing some selling, helping the treasurer with financial matters, consulting with Langhammer as to production, and, in general, performing all the duties ordinarily assumed by the executive head of a business. He gave all his time to petitioner, worked long hours, took a vacation of only two weeks and transacted some business for petitioner during that period. In 1928, the board of directors raised his cash salary, leaving his stock distribution as it had been theretofore. Paul Langhammer, petitioner's superintendent, in charge of all its production, became associated with petitioner's predecessor in 1913. During 1927 and theretofore he was in charge of building machines and perfecting minor ideas*1074 in connection with them. He was especially good in making the machines work and in overcoming difficulties of operation. In 1927, he had about 300 men working under his direction, who had to do highly complicated and skillful labor; they "tended to be geniuses", were temperamental, jealous of each other, and difficult to handle. He had a special talent for keeping them harmonious and happy. He had been sought after by other concerns. There is probably no one else in this country with his specialized knowledge of the details of handling paper and glue. If his services should be lost to petitioner, they could not readily be replaced. He gave all of his time to petitioner. E. Lovell Smith, petitioner's chief engineer, in 1927, had charge of all designing, development, and invention work. He did original designing and inventive work of his own and directed subordinates who did work of the same type. He has been associated with the business since 1913. He is a highly capable inventor. The men under him, all inventors, even more than those in the shops, are temperamental and jealous of their own ideas. He handles them smoothly. There is no man in the country with his background*1075 of training and ability in this line. He gave all of his time to the petitioner. Roe S. Clark became associated with the business in 1916. Since 1924 he has performed the duties of treasurer, but did not receive the title until 1930. In 1927, he was assistant treasurer and secretary. He was responsible for all bookkeeping and cost accounting. He worked with petitioner's cost accounting system in 1917, and has modernized and developed it since. He had charge of all petitioner's collections, the extension of all its credit, and all its financial operations, and had supervision of all its office work. He devoted his entire time to petitioner. George A. Mohlman was vice president of petitioner in 1927, in charge of sales. He became associated with the business as a salesman in 1918. In 1924, he commenced handling most of petitioner's large sales; by 1927, he was definitely in charge of sales and handled *986 personally all petitioner's large accounts. In addition to his personal selling efforts, he directed the activities of five salesmen. His selling was difficult, since it consisted in interesting the executives of large manufacturing concerns in new ideas, not*1076 in selling a known commodity; every sale he made involved opening a new field; his task at all times was the selling of new ideas. He devoted all of his time to petitioner's business. George W. Kyburg held the title of treasurer in 1927, but his duties were those of a chairman of the board. He was of an older generation than the other officers, who consulted with him on policy matters and to whom he was extremely helpful. He usually spent every week day morning in petitioner's offices, leaving in the afternoon. The petitioner kept its books of account on an accrual basis, and the net income was computed in its return on the same basis. The compensation paid to the six aforesaid individuals for personal services rendered in 1927 was reasonable in amount. In its 1927 return, petitioner deducted from income the cash paid to its officers and the par value of the stock issued to them for services for such year. The deduction so claimed by petitioner, and no more, has been allowed by the respondent. The officers in their 1927 returns, reported income from salaries received from the petitioner in an aggregate amount equal to the amount of the deduction claimed by the petitioner*1077 in its return. OPINION. ARUNDELL: The deduction claimed by the petitioner in its return and allowed by the respondent for compensation for personal services actually rendered amounted to $117,615.17, which is the total of cash paid, $71,065.17, plus the par value, $46,550, of stock issued under the resolution of July 21, 1921. The petitioner contends it is entitled to a deduction of $170,682.17, this being the total of cash paid, plus the fair market value, $99,617, of the stock so issued, and represents an increase of $53,067 over the amount deducted and allowed. This increase of $53,067, it will be noted, is the amount by which the fair market value of the stock issued exceeds its par value. The amount of stock so issued and the fair market value thereof are agreed upon and have been stipulated by the parties. The respondent makes no contention, on the brief, as to the reasonableness of the deduction for which the petitioner contends, but asserts that petitioner's liability under the aforesaid resolution was a matter of dollars and cents and amounted to only $46,615.17, this being 25 percent of the profits after making the deductions specified in the *987 resolution, *1078 for which shares of the par value of $46,550 were issued and cash of $65.17, in lieu of fractional shares, was paid, and that, irrespective of the fair market value of those shares, petitioner is not entitled to deduct more than its liability. Thus, the controversy is centered on the additional compensation authorized and paid in stock under the resolution of July 21, 1921 - whether petitioner was liable in dollars and cents for 25 percent of the profits computed under the terms of the resolution, or for shares of stock of an aggregate par value equal to a similar amount of the profits. The respondent's position, we think, is premised upon an erroneous interpretation of the resolution authorizing the additional compensation. The resolution provided that 25 percent of the profits, after certain specified deductions had been made, should be set aside to pay the officers, in certain proportions, additional compensation, payment to be made in petitioner's common stock at par. Its effect was to create a liability on the part of the petitioner to its officers, not for a specific sum in terms of dollars and cents, but for a number of shares of stock of an aggregate par value equal to*1079 the profits in which the officers were entitled to participate. In other words the amount set aside was not the petitioner's absolute liability, but merely the measure of the number of shares to be issued. Thus the petitioner's liability for additional compensation to officers for the taxable year involved was 931 shares of its common stock, plus fractional shares for which cash was paid. This liability must, of course, for the purposes of the tax, be translated into dollars and cents; and we have consistently held that the translation must be based upon the fair market value of the stock as of the date of issue. ; ; and . See also ; and . So translated, the petitioner's liability for additional compensation, under the resolution of July 21, 1921, amounted to $99,617, disregarding fractional shares for which cash was paid, that being the stipulated fair market value*1080 of the stock issued, and not $46,550, the par value thereof. Though, as hereinbefore stated, the point is not raised in respondent's brief, the question of the reasonableness of the entire deduction claimed is inherent in the issue, and the petitioner has adequately assumed its burden in that respect. The compensation paid was determined, seven years previously, after open bargaining in arm's length transactions; and the amounts paid to the several individuals concerned bear no relationship to their stockholdings. The evidence discloses a subsequent expansion in business *988 and increased earnings, with an attending rise in the value of petitioner's common stock of $30from per share in 1921 to $107 per share in 1927, that has fully vindicated and justified the directors' action in authorizing the additional compensation. The findings of fact reflect the reasonableness of the compensation paid, and nothing would be gained by belaboring this report with further discussion of a point that does not appear to be seriously contested. The respondent argues, on brief, that petitioner is estopped from claiming the greater deduction, because respondent was misled by the information*1081 contained in its return anent the amounts of compensation paid to officers and, therefore, withheld, until after the statutory period of limitation had expired, adjustment of the officers' individual returns in which they had reported compensation based upon the par value, instead of market value, of the stock issued to them by the petitioner. But aside from the fact that estoppels, in order to be available on the trial must be pleaded and proved, , a matter which respondent apparently has overlooked, there is, so far as we can ascertain from the facts before us, no ground for invoking the doctrine of estoppel here. The "misleading" information in the petitioner's return, to which respondent refers, is merely the claimed deduction for compensation based upon the par value, rather than market value, of the stock issued. The respondent's position implies that petitioner deliberately refrained from claiming the larger and more advantageous deduction based upon market value of the stock. But even assuming the implication to be correct, we can find no connection between the petitioner's action and that of its officers in*1082 their individual returns. Decision will be entered under Rule 50. Footnotes 1. Total based upon cash and par value of stock, $117,615.17. ↩ 2. Total based upon cash and fair market value of stock, $170,682.17. ↩