Holmes & Janes, Inc. v. Commissioner

HOLMES & JANES, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Holmes & Janes, Inc. v. Commissioner Docket No. 58436. United States Board of Tax Appeals 30 B.T.A. 74; 1934 BTA LEXIS 1379; March 13, 1934, Promulgated *1379 1. The petitioner made certain payments to its officers designated as bonus or additional compensation for services rendered. After the receipt of such payments the recipients thereof, by private arrangement not reflected in the books or on the income tax returns of petitioner, redistributed the same among themselves so that each retained for his own use an amount exactly in proportion to his stockholdings. Held, the alleged bonuses were in fact distributions of earnings and so not deductible from petitioner's gross income as and when made. Held, further, that the redistribution of such payments by private arrangement among the officers which was not disclosed to the respondent and the deduction of all the amounts so distributed as ordinary and necessary expenses are convincing evidence of a willful understatement of income for the purpose of evading tax. 2. The petitioner and the Commissioner duly executed a closing agreement for the year 1928 as authorized by section 606 of the Revenue Act of that year. Thereafter, alleging a showing of fraud, the Commissioner, with the approval of the Secretary, abrogated such agreement and directed that it be eliminated. Held,*1380 that the Board has jurisdiction to review such order of elimination. Held, further, that if the Commissioner adduces convincing evidence in support of his allegation of a showing of fraud, his action must be affirmed and the tax liability covered by the eliminated agreement may then be redetermined by the Board on merits. Henry Jacobs, Esq., and J. E. Hammond, C.P.A., for the petitioner. E. A. Tonjes, Esq., for the respondent. LANSDON *74 The respondent has determined deficiencies in income tax for the years 1927, 1928, and 1929 in the respective amounts of $956.25, $2,418, and $870.75, to which he has added 50 percent penalties for the first two years in the respective amounts of $478.13 and $1,216.97. Three issues are involved - (1) whether the respondent erroneously disallowed certain deductions from petitioner's gross income in each of the taxable years as additional compensation for officers in the *75 nature of bonuses; (2) whether the petitioner's returns for each of the years 1927 and 1928 were false and fraudulent, as affirmatively pleaded in the answer of the respondent; and (3) whether a closing agreement under*1381 section 606 of the Revenue Act of 1928 may be set aside by the Commissioner on a showing of fraud. FINDINGS OF FACT. The petitioner is a California corporation, with its principal office in San Francisco, where it is engaged in the business of dealing in pelts and furs. It was organized in 1926 and from the date of its incorporation until April 1, 1927, all its capital stock of the par value of $25,000 was owned by D. A. Holmes. On April 1, 1927, W. H. Janes acquired a 40 percent stock interest in the petitioner. At the close of such year all outstanding stock was held by D. A. Holmes, president, W. H. Janes, vice president, and D. V. Skovsky, secretary, in the respective amounts of 149 shares, 100 shares, and 1 share. In the year 1928 the authorized capital was increased to 500 shares and on December 31 was held as follows: D. A. Holmes, 279 shares; William H. Janes, 200 shares; D. V. Skovsky, 11 shares; and M. Downes, 10 shares. During the period from April 1 to December 31, 1927, the petitioner paid Holmes, Janes, and Skovsky the respective amounts of $6,300, $6,300, and $2,610. One half of each of such payments was for salary and the remainder was accounted for*1382 on the books of the petitioner as bonuses or additional compensation for officers and charged to profit and loss. In the year 1928 petitioner paid salaries to Holmes, Janes, and Skovsky in the respective amounts of $4,200, $4,200, and $2,070, and other amounts in addition thereto accounted for on its books as bonuses or additional compensation of $10,000, $5,000, and $2,500, respectively. In the same year it also paid M. Downes and C. E. Van Dane the respective amounts of $1,000 and $75 as additional compensation. Such salaries and other payments were authorized by proper corporate action, paid by check within the year, and duly charged to profit and loss. After Holmes, Janes, and Skovsky received the alleged bonus payments in each of the years 1927 and 1928, as above set out, they made adjustments among themselves with the effect that each received for his own share of the total payments an amount exactly in proportion to his ownership of petitioner's stock. Such adjustments were not accounted for in any way on the books of the petitioner or disclosed to the Commissioner on its tax returns or otherwise. In the year 1929 the petitioner paid Holmes the respective amounts*1383 of $5,775 and $6,340, which it accounted for on its books as salary *76 and bonus or additional compensation. No other bonus payment was made in that year and no part of the alleged bonus received by Holmes was transferred by him to any other officer. The payment to Holmes in addition to his salary was 2 1/2 percent of the amount of the gross sales of the petitioner in that year. In the years 1927, 1928, and 1929 petitioner's gross sales were in the respective amounts of $111,150.19, $212,343.37, and $253.637.03, and in the same years its net profits, after the payment of all expenses, salaries, and bonuses, were in the amounts of $2,984.08, $3,955.55, and $4,154.36. In each of those years it made and timely filed income tax returns which reflected tax liabilities in the several amounts of $200.35, $114.67, and $126.98. In each return the amounts paid as bonuses were deducted from gross income as additional compensation of officers. In 1927, and at a time when Holmes was the sole stockholder of the petitioner, a sublease was taken on a certain business property which the petitioner used and for which it paid rent until the sale of the sublease in 1928 for $3,500, which*1384 was credited and paid to Holmes, who included the amount thereof in his gross income on his income tax return for 1928. The respondent has determined that the entire amount of $3,500 was income to the corporation in the year in which the lease was sold. The income tax return of the petitioner for the year 1928 disclosed tax liability in the amount of $114.67. Upon audit the respondent determined a deficiency of $15.94. On January 23, 1930, the Commissioner signed a closing agreement as to petitioner's tax liability for the year 1928 under the provisions of section 606 of the Revenue Act of 1928. 1 On May 7, 1931, by memorandum approved by the Secretary, he directed that such closing agreement should be disregarded on account of a showing that petitioner had fraudulently understated its income for the year 1928. *1385 *77 OPINION. LANSDON: The respondent has determined that the bonuses paid to the officers of the petitioner in the years 1927, 1928, and 1929 in the guise of additional compensation for services rendered in such years were, in fact, distributions of profit. The petitioner contends that the bonuses were authorized by proper corporate action, that the full amounts were actually paid in the respective years in which authorized, and that, added to stated salaries paid to its several officers, such bonuses were reasonable compensation for services rendered. The record supports petitioner's contention as to the form of the bonus payments. It also discloses that the amount thereof when included in petitioner's ordinary expenses reduced tax liability for each year to a nominal sum and left a very small surplus available for distribution as dividends and that no dividends as such were paid in 1928 or 1929. Petitioner admits that after the bonuses were paid in 1927 and 1928 the recipients redistributed the amounts thereof among themselves ratably as to their stockholdings. Its counsel argues, however, that such adjustments were wholly outside the corporation and without any*1386 bearing on the issues here. He bases this argument on an understanding between Holmes and Janes at the time of the purchase of stock by the latter in April 1927. The alleged understanding was that such principal stockholders, so long as they remained associated in the business, should share in the property and profits in proportions of 60 and 40 percent. This agreement supports the determination of the respondent. If the payments in question were in fact compensation for services rendered, they were without the terms of the agreement and not subject to any adjustment. If they represented profits they were within such terms and adjustments were necessary. The fact that adjustments were made to conform the amounts received to the terms of the agreement indicates very clearly that Holmes and Janes regarded the alleged compensation payments as distributions of profit. We are of the opinion that the bonus payments in 1927, 1928, and 1929 were in fact distributions of profits and therefore not deductible from petitioner's gross income in each of the respective years. *1387 Universal Milking Machine Co.,4 B.T.A. 506; Heflin, Inc. v. United States, 58 Fed.(2d) 482; certiorari denied, 287 U.S. 631; L. Schepp Co.,25 B.T.A. 419. On this issue the determinations of the respondent are affirmed. Respondent has added to petitioner's gross income for 1928 the amount of $3,500 as profit realized from the sale of a lease on certain business premises in San Francisco. Such amount was not accounted *78 for as received by the petitioner but was paid over to Holmes, who included it in his gross income in his personal income tax return for that year. Petitioner contends that the lease was never assigned to it and so was the property of Holmes when sold. The only proof in support of petitioner's contention is the testimony of Holmes that he personally acquired the lease, always considered it as his individual property, and regarded and reported the profit from the sale thereof as his own income. The contrary evidence is that the petitioner used the premises for the purposes of its business and paid the rents thereon. Neither the lease nor any assignment thereof is in the record. In our*1388 opinion the evidence is not sufficient to overcome the presumption of correctness that attaches to the determination of the respondent. Petitioner also contends that its tax liability for 1928 has been finally determined and settled under a closing agreement in conformity with section 606 of the Revenue Act of 1928. Subsequent to the execution of the closing agreement the respondent transmitted to the petitioner the following memorandum: Reference is made to the agreement executed by Holmes and Janes, Incorporated, San Francisco, California, under the provisions of Section 606 of the Revenue Act of 1928 with respect to its income tax liability for the year 1928, which was listed on Schedule #3793 and approved by the Secretary of the Treasury on February 1, 1930. The net income disclosed on the return for this year was $3,955.55. The Revenue Agent who made the original investigation determined a deficiency in the amount of $15.94. The deficiency was assessed and the return closed in accordance with the provisions of Section 606 of the Revenue Act of 1928. Subsequently information was received to the effect that the taxpayer fraudulently understated income for this year. *1389 Consequently a reinvestigation was conducted of the taxpayer's books of account and records, which investigation disclosed understatements of income for the years 1927 to 1929, inclusive. For the year 1928 the taxpayer deducted a bonus as having been paid to officers in the amount of $16,650 which, in fact, was a distribution of profits and should not have been deducted from gross income and failed to report the profit on the sale of a lease in the amount of $3,500.00. At the time of the original investigation, this information was not disclosed to the Revenue Agents. It was not known that the principal stockholder received the benefit of almost the entire amount of the bonus. The information was only discovered after a suit had been filed by one of the stockholders for an accounting. The General Counsel for the Bureau of Internal Revenue has reviewed the evidence and in a memorandum of February 28, 1931, indicates that there is a sufficient showing of fraud or misrepresentation of a material fact to warrant the setting aside of the agreement. In view of the fact that the failure of the Bureau to assess and collect the correct amount of tax for the year 1928 was evidently*1390 caused by the taxpayer's fraud or misrepresentation of a material fact, the closing agreement above referred to will be disregarded and you are accordingly authorized and directed to eliminate from Schedule #3793 approved by the Secretary of the Treasury on February 1, 1930, the agreement listed thereon in the name of *79 Holmes and Janes, Incorporated, covering the year 1928 and to take such further action to adjust the tax liability for this year as may be in order. [Signed] DAVID BURNET, Commissioner. Approved: Mar. 7, 1931. OGDEN L. MILLS, Secretary of the Treasury. Counsel for respondent argues at length that the act of the Commissioner, approved by the Secretary, abrogating the closing agreement was an exercise of discretionary authority that is not subject to review by the Board, and that such a conclusion is necessary in order to establish our jurisdiction over the tax controversy herein for the year 1928. We are unable to accept this view. If the Commissioner, upon a mere showing that in his opinion indicates fraud, has authority to eliminate a closing agreement, it is obvious that section 606 provides no protection for a taxpayer who has signed*1391 such an agreement in good faith. The memorandum abrogating the closing agreement is no more than an allegation of fraud which must be proved before the respondent can recover any additional taxes for the year 1928. The deficiency notice establishes the jurisdiction of the Board to hear and determine all the issues joined in an appeal therefrom. The respondent has asserted a deficiency for the year 1928. As an affirmative defense the petitioner has produced the closing agreement which automatically establishes on its face that there is no tax liability. The respondent contends that such agreement has been abrogated on a showing of fraud. In our opinion this is not enough. He must prove by convincing evidence that fraud was actually committed. If he successfully carries his burden it then follows that the closing agreement must be set aside and the petitioner's tax liability for the year covered thereby must be redetermined on merits by the Board. The respondent alleges fraud as to petitioner's return for 1928 in two particulars - (1) that petitioner with intent to evade taxes deducted certain amounts from its income as ordinary and necessary expenses that were in fact distributions*1392 of profits and that its book entries relating thereto were intended to cover up the real nature of the payments to the officers; and (2) in failing to include in its gross income on its income tax return the profit of $3,500 realized from the sale of a leasehold. In our opinion the petitioner's attempt to secure deductions from taxable income in the guise of payments for services rendered, where in fact the amounts thereof were distributions of profit, was a willful understatement of income, deliberately made for the purpose of evading taxes. On the allegation of fraud the respondent has sustained the burden of proof. We therefore affirm his action in eliminating the closing agreement from the tax *80 controversy. The deficiency for 1928 will be determined in the amount asserted by the respondent, and the fraud penalties added to the deficiencies for 1927 and 1928 are affirmed. See Cooper v. United States, 9 Fed.(2d) 216; D. C. Clarke,22 B.T.A. 314; E. A. Wickham Estate,22 B.T.A. 1393; L. Schepp & Son, supra. Reviewed by the Board. Decision will be entered for the respondent. Footnotes 1. SEC. 606. CLOSING AGREEMENTS. (a) Authorization. - The Commissioner (or any officer or employee of the Bureau of Internal Revenue, including the field service, authorized in writing by the Commissioner) is authorized to enter into an agreement in writing with any person relating to the liability of such person (or of the person or estate for whom he acts) in respect of any internal revenue tax for any taxable period ending prior to the date of the agreement. (b) Finality of agreements. - If such agreement is approved by the Secretary, or the Undersecretary, within such time as may be stated in such agreement, or later agreed to, such agreement shall be final and conclusive, and, except upon a showing of fraud or malfeasance, or misrepresentation of a material fact - (1) the case shall not be reopened as to the matters agreed upon or the agreement modified, by any officer, employee, or agent of the United States, and (2) in any suit, action, or proceeding, such agreement, or any determination, assessment, collection, payment, abatement, refund, or credit made in accordance therewith, shall not be annulled, modified, set aside, or disregarded. (c) Section 1106(b) of the Revenue Act of 1926 is repealed, effective on the expiration of 30 days after the enactment of this Act, but such repeal shall not affect any agreements made before such repeal takes effect. ↩