Lorraine Corp. v. Commissioner

THE LORRAINE CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Lorraine Corp. v. Commissioner Docket No. 61329. United States Board of Tax Appeals 33 B.T.A. 1158; 1936 BTA LEXIS 775; February 20, 1936, Promulgated *775 1. During the taxable years the petitioner charged to profit and loss and credited to its president as royalties paid the amount of profits realized from a certain device manufactured by petitioner under a certain license agreement it had with a third party. Held, that the profits, having been income of the petitioner, were taxable to it and were not deductible by it in determining its taxable net income. 2. During the taxable years the petitioner made expenditures for purchases of whiskey from bootleggers. The greater portion of the whiskey was used in entertaining petitioner's customers and prospective customers. The remainder was used by its employees. Held, that such expenditures did not constitute ordinary and necessary expenses in carrying on a trade or business and therefore were not allowable deductions. 3. Held, that the petitioner's returns for the taxable years were fraudulent and made with an intent to evade tax. George Bouchard, esq., for the petitioner. Dewitt M. Evans, Esq., for the respondent. TRAMMELL *1158 This proceeding is for the redetermination of deficiencies in income taxes, penalties, and interest*776 determined and assessed by the respondent as follows: Year Deficiency Penalty Interest [1926] $4,754.22 $2,377.11 $1,288.31 [1927] 4,921.22 2,460.61 1,038.31 [1928] 3,786.63 1,893.31 571.73 Issues presented by the pleadings are whether the respondent erred: (1) In not determining that the period of limitations had run against assessment and collection of the deficiencies in tax for each of the years; (2) in asserting a 50 percent penalty for each of the years; (3) in assessing the amounts as interest for each of the years; (4) by reducing the deductions taken for depreciation by the amounts of $1,155.74, $15,671.92, and $1,457.34 for 1926, 1927, and 1928, spectively; (5) in reducing the deductions taken for royalties paid by the amounts of $16,837.20, $26,152.83, and $24,272.03 for 1926. 1927, and 1928, respectively; (6) in reducing the deductions taken for traveling and entertainment expenses by the amounts of $2,870, $5,272.93, and $3,618.90 for 1926, 1927, and 1928, respectively; (7) in reducing the deductions taken for commissions by the amounts of $445 and $650 for 1926 and 1927, respectively; (8) in disallowing as *1159 deductions the*777 amounts of $592.36 and $514.68 as automobile maintenance for 1927 and 1928, respectively; (9) in reducing by $200 the deduction taken in 1926 for material and supplies; (10) in reducing the deduction taken for taxes paid by the amount of $2,607.86 for 1926; (11) in disallowing as a deduction for 1926 the amount of $9,100.64 as a statutory net loss brought forward from 1924; (12) in reducing by $212.52 the amount of a deduction taken for insurance for 1927; and (13) in including in income for 1928 the amount of $1,517.29 as the profit realized by the petitioner on the sale of a capital asset. FINDINGS OF FACT. The petitioner is a Nevada corporation organized in 1923 and has its principal office in Los Angeles, California. It is engaged in the business of manufacturing gas traps and accessories. During the years in controversy David G. Lorraine was its president and W. B. Summers was its secretary and treasurer. During the years in controversy the petitioner's books were kept and its income tax returns were filed on the accrual basis. On December 8, 1924, the petitioner entered into a license agreement with Erd V. Crowell, to whom had been issued certain patents by the United*778 States Patent Office on an oil well device known as an oil well cementing barrel. Under this agreement Crowell among other things agreed to assign to the petitioner a one-half interest in the patents and granted to petitioner the sole and exclusive right to manufacture, use, and sell the device within the United States and foreign countries for and during the term of the patents or any other patents that might be issued thereon and for the full term of any reissue or extensions thereof. In the agreement the petitioner agreed to manufacture the devices in a good and workmanlike manner and to use its best efforts to promote the use and sale of the inventions in all the oil fields of the United States and foreign countries. The petitioner further agreed that it would not become financially interested in or promote the use and sale of any other cementing barrel or device for its purpose than the one covered in the agreement, without the written consent of Crowell. The agreement further provided that the petitioner would not assign its interest therein or in the patents without the written consent of Crowell except under certain situations not present here. The agreement also provided*779 for the payment by the petitioner to Crowell of certain stipulated royalties on each device or part thereof manufactured by the petitioner and sold. Subsequently certain amendments, not here material, were made to the agreement by the petitioner and Crowell. *1160 During the period from July 9 to August 29, 1927, there was certain correspondence between Crowell, the petitioner, and Lorraine relative to a demand made upon Crowell by Lorraine that he assign to him (Lorraine) personally a one-half interest in an application for a patent to which the agreement of December 8, 1924, related. On July 9, 1927, Lorraine wrote Crowell advising him that unless Crowell made an assignment to him (Lorraine) personally within 20 days of a one-half interest in the application he (Lorraine) would file an application and cause an interference. He also advised Crowell that all royalties would be withheld until the matter was taken care of satisfactorily. He further advised Crowell that he (Lorraine) was instructing Summers (the secretary and treasurer of the petitioner) accordingly so that further royalties would not be paid. Crowell resisted the demand, refused to make the assignment*780 to Lorraine personally, but expressed a willingness to make an assignment to the petitioner of an undivided one-half interest in the application, subject to the terms of the license agreement then existing between him and the petitioner. He also notified the petitioner that he was dealing with it and not with Lorraine personally, that if it carried out the threats contained in Lorraine's letter of July 9, 1927, it would breach the license agreement, and that he (Crowell) would consider the agreement terminated in accordance with the terms contained therein. The controversy was finally ended in August 1929 by the petitioner making payment of all royalties then due and continuing to pay royalties just as before the controversy arose. The license agreement was in effect during the years in controversy and under it the petitioner paid Crowell royalties ranging from $5,000 to $7,000 a year. Such amounts were treated as expenses of the petitioner and were taken as deductions in the petitioner's income tax returns. For the years in controversy the petitioner determined the total selling price of the articles manufactured and sold during such years under the license agreement. From*781 that amount was subtracted all cost or expenses connected with the manufacture and sale of the articles, and the amount of the remainder, or the net profit thus computed for each year, was charged to profit and loss on the books of the petitioner as royalties paid to Lorraine, and his personal account on the petitioner's books was credited accordingly The amounts thus charged to profit and loss on the petitioner's books and credited to Lorraine were $16,837.20 for 1926, $26,152.83 for 1927, and $24,272.03 for 1928. In determining the deficiencies in controversy the respondent disallowed as deductions for royalties paid for the respective years the foregoing amounts charged to profit and loss by the petitioner and credited to Lorraine. *1161 The petitioner kept a supply of whiskey at its place of business and throughout the years in controversy purchased whiskey from half a dozen or more different bootleggers. Purchases were paid for by checks. In some instances checks were drawn payable to the party from whom the whiskey was purchased. In other instances a fictitious name was established on the pay roll as a commissioned agent of the petitioner, a check was drawn payable*782 to such fictitious name for the amount of the purchase, the fictitious name was endorsed on the check by the petitioner's secretary and treasurer and then delivered to the bootlegger from whom the purchase had been made. Checks thus issued were charged on the petitioner's books to the account of commissions paid. The reason for this procedure was that there was a doubt as to the deductibility for tax purposes of payments made for such purpose. By handling them in this manner no record would appear in the petitioner's books of these purchases as being purchases of whiskey, and it was though that by charging them to commissions paid they would be sure to be allowed. Before the total amount of the checks drawn payable to any one fictitious name amounted to $1500 a new fictitious name was established and used, on the theory that the petitioner would not be required to file information returns showing the payment of such amounts to such fictitious name, and also for the reason that there would be no person having such name to file an income tax return his operations under an assumed or fictitious name. In a his operations under an assumed or fictitious name. In a case of that kind*783 checks for purchases from him would be drawn payable to such name notwithstanding that his real name was known. At certain times some of the bootleggers who only recently had been pursued by the law enforcement authorities did not want to handle any checks for awhile. In these cases the checks drawn for whiskey purchased from them would either be cashed at the bank by the petitioner's secretary and treasurer or deposited in his personal account at the bank. The petitioner carried on its books a traveling and entertainment account to which was charged various items given away to the trade, such as novelties and cigars. In the later years checks drawn payable to the persons from whom whiskey was purchased were also charged to this account. The whiskey was purchased by the petitioner primarily for the purpose of entertaining its customers and prospective customers. This was the customary practice in the type of business conducted by the petitioner. About three fourths of the whiskey purchased by the petitioner was used for the foregoing purpose while the balance was consumed by persons in the employ of the petitioner. *1162 In determining the deficiencies the respondent*784 disallowed as deductions for 1926 the amount of $445 as commissions paid and $2,870 as traveling and entertainment expenses, for 1927 the amount of $650 as commissions paid and $5,272.93 as traveling and entertainment expenses, and for 1928 the amount of $3,618.90 as traveling and entertainment expenses. In determining the deficiencies the respondent, in addition to disallowing as deductions for royalties the amounts heretofore set out and the foregoing amounts for commissions paid and for entertainment and traveling expenses, disallowed the following amounts as deductions for the years indicated: [1928] Depreciation $1,155.74 $15,671.92 $1,457.34 Material and supplies 200.00 Taxes 2,607.86 Statutory net loss 9,100.64 Automobile maintenance 592.36 514.68 Insurance 212.52 In addition to the foregoing adjustments the respondent increased the petitioner's taxable income for 1928 by the amount of $1,517.29, as representing the profit realized from the sale of a capital asset. In 1931 Lorraine as president of the petitioner was tried, convicted and sentenced to pay fines totaling $15,000 for attempting to defeat and evade income*785 taxes of the petitioner in the amounts of $4,921.22 and $3,786.63 (the same amounts here in controversy) for 1927 and 1928, respectively, by reason of his having executed and filed income tax returns for the petitioner for those years, in which certain items of gross income of the petitioner were either understated or omitted and in which certain deductions, including those for royalties paid, commissions paid, and traveling and entertainment expenses, were overstated. No appeal was taken and thereafter Lorraine began making payment of the fines in installments. Summers was indicted by the grand jury of Los Angeles County, California, for forgery of the petitioner's records, grand theft, and violation of the corporation securities act. He pleaded guilty to the charge of forgery. He, however, obtained no benefit personally by any forgery. The petitioner's returns for the years in controversy were fraudulent and made with an intent to evade tax, and a portion of the deficiency was due to fraud with intent to evade tax. The petitioner's income tax return for 1926 was filed on March 10, 1927, that for 1927 was filed on March 15, 1928, and that for 1928 was filed on April 15, 1929. *786 The deficiencies in controversy were assessed on September 21, 1931, and the notice of the respondent's determination was mailed to the petitioner on November 16, 1931. *1163 OPINION TRAMMELL: 1 With respect to the issue involving limitations, the respondent concedes in his brief that unless we find for him on the question of fraud the deficiencies are barred. On the question of fraud, the respondent, who has the burden of proof, now relies on only two classes of items, namely, royalties from the Crowell license agreement and deductions for the expenditures for whiskey. The testimony of Summers, who was the secretary and treasurer of the petitioner during the years in controversy, shows that all the net profit realized by the petitioner for each year from the manufacture and sale of the device covered by the license agreement entered into between the petitioner and Crowell was charged to profit and loss on the books of the petitioner as royalties paid to Lorraine, its president, and his personal account on the petitioner's books was credited accordingly. The amounts of such charges and credits*787 were stipulated by the parties and are not in controversy. The controversy is as to the deductibility of the amounts by the petitioner. The respondent contends that, since the license to manufacture and sell granted under the agreement with Crowell was granted to the petitioner, the profit realized by the petitioner from operations thereunder was profit belonging to the petitioner and was taxable to it. The petitioner contends that, after it entered into the agreement with Crowell and before any profit was realized from operations thereunder, it entered into an agreement with Lorraine whereby it was to manufacture the device covered by the Crowell patents, receiving therefor the cost of materials used plus $3 per hour for the time each of its employees was engaged in the manufacture of it, and that whatever profits were derived from the sale of the device were to belong to Lorraine and losses that resulted were to be borne by him. In support of this contention the petitioner relies on certain testimony of Lorraine which was substantially to this effect. Lorraine, however, further testified that the manufacture of the device by the petitioner, under these conditions, was taken*788 up by him with the other stockholders of the petitioner, including William Lacy, and was agreed to by them, that such agreement was made at a meeting of the stockholders of the petitioner at which William Lacy among others was present, that such action of the stockholders was recorded in the minute book, that the directors of the petitioner authorized an assignment to him of the license agreement with Crowell, and that this action was also recorded in their minute book. Neither the minutes of the meeting of the petitioner's stockholders respecting their action as testified to by Lorraine were offered in evidence nor was there offered *1164 in evidence the minutes of a meeting of its board of directors showing their authorization of the assignment to Lorraine of the license agreement, as he testified. William Lacy was a stockholder in the petitioner during 1926, 1927, and until some time in 1928 when he sold his stock to Lorraine. His holdings amounted to about 12 1/2 percent of the petitioner's outstanding stock. Lacy was called as a witness by the respondent and testified that he knew nothing about the license agreement between Crowell and the petitioner, that he knew*789 nothing about the manufacture of the device thereunder or that Lorraine was taking the profit therefrom for himself, that he never entered into any agreement with Lorraine respecting the profits and losses from the device, and that he had no recollection of ever discussing the license agreement with Lorraine or of ever being present at a meeting of the stockholders of the petitioner at which they agreed that Lorraine would receive the profit from the device and not the petitioner. The license agreement, an executed copy of which was placed in evidence, clearly shows that it was one between the petitioner and Crowell and not one between Lorraine personally and Crowell. The agreement specifically provided against the petitioner's assignment of its interest therein without the consent of Crowell. There is nothing in the record to indicate that Crowell was ever asked to or did give his consent to the petitioner's assignment of it to Lorraine. While Lorraine testified that the petitioner's board of directors authorized the assignment of the license agreement to him by the petitioner, his testimony is not supported by any minutes of the meeting of the directors substantiating his testimony, *790 nor is there any showing that such assignment, if authorized by action of the directors, was ever made. The only evidence in the record to support the existence of an agreement between the petitioner and Lorraine whereby the latter was to have the profits and bear the losses from the device is the testimony of Lorraine. Much of his testimony was contradicted by a stockholder of the petitioner who owned a substantial amount of its stock. In view of this and of the fact that Lorraine stated that the agreement was recorded in the minutes of a meeting of the petitioner's stockholders, the question arises as to why such minutes were not offered in evidence. No explanation is offered by the petitioner for its failure in this respect. We think under the circumstances here presented the only logical conclusion to be reached from the petitioner's failure in this respect is that there were not any minutes containing such an agreement. The revenue agent who made an examination of the petitioner's books for the years in controversy testified that he was unable to find any basis for the petitioner's *1165 action in charging the amounts here in question to royalties paid and crediting*791 them to Lorraine's personal account. From the record before us we are unable to find that the alleged agreement was ever entered into between the petitioner and Lorraine and therefore conclude that such agreement never existed. The profits realized by the petitioner from the device, therefore, were income taxable to it and were improperly taken as deductions. The next question is whether the deduction of the amounts by the petitioner was due to fraud with intent to evade tax. Summers, who was secretary and treasurer of the petitioner during the years in question, testified that the amounts were entered on the petitioner's books as royalties paid to Lorraine, pursuant to instructions given by Lorraine. Nowhere in the record is the correctness of this statement disputed or denied. To justify the deduction of the amounts the petitioner has relied on an alleged agreement between it and Lorraine. The evidence not only fails to establish the making of such agreement but tends to indicate that the allegation as to its having been made is a fabrication. The amount of $16,837.20 deducted for 1926 is approximately two and one-half times the amount of net income reported by the petitioner*792 for that year. The amount of $26,152.83 deducted for 1927 is more than nine times the amount of net income reported by the petitioner for that year. The deduction of $24,272.03 taken for 1928 is approximately one third of the amount of the net income reported for that year. In extenuation of this situation the petitioner relies on the testimony of Lorraine that he reported the amounts as income in his individual returns for the respective years, hence the Government has not been deprived of the tax thereon. This does not greatly help the petitioner's position. In the hands of the corporation the amounts were subject to a normal tax at the rate of 13 1/2 percent for 1926 and 1927 and at 12 percent for 1928. If they had been the income of Lorraine as a result of the alleged agreement the highest rate of normal tax on them would have been only 5 percent for each of the years. Irrespective of whether the amounts came into Lorraine's hands either by way of dividends from the petitioner or as a result of the alleged agreement they would have been subject to the same graduated rates of surtax. By the amounts having been treated as they were by the petitioner the Government was deprived*793 of normal tax on them by at least the difference between the rates of 5 percent and 13 1/2 percent for the years 1926 and 1927, and by the difference between the rates of 5 percent and 12 percent for 1928. No agreement having existed between the petitioner and Lorraine during the years in controversy which warranted the deduction of the amounts by the petitioner, we think under the circumstances presented *1166 the action of the petitioner was fraudulent and with an intent to evade tax. The action of the respondent in determining the 50 percent penalties is accordingly sustained. The pertinent portions of the applicable revenue revenue acts provide that if any part of the deficiency is due to fraud with intent to evade tax then 50 percent of the total amount of the deficiency shall be assessed as a penalty. While our opinion as to fraud with respect to the issue above discussed would be sufficient on which to base the fraud penalty, there is in addition thereto the question of the deduction claimed as an ordinary and necessary expense of expenditures made for whiskey for beverage purposes. These expenditures for this purpose were disguised in the form of commissions and*794 traveling and entertainment expenses. We do not think that such expenditures are allowable deductions even though the purpose was entertainment. The expenditures were for an illegal purpose, that is, to acquire possession of alcoholic liquor for beverage purposes contrary to Federal statute. It appears that a portion of the liquor was consumed by employees. While we think that the entire expenditures for illegal liquor are not allowable deductions as ordinary and necessary expenses of carrying on a trade or business, at least that portion of the expenditures for liquor which was consumed by employees and for which a deduction was claimed in the disguised form of commissions and traveling and entertainment expenses constituted fraud with intent to evade the tax. Since we have found that the petitioner's returns were fraudulent with intent to evade tax, the question of limitations is decided adversely to the petitioner. The petitioner offered no evidence respecting the remaining assignments of error and makes no contention relative to them in its brief. The action of the respondent with respect to them is sustained for lack of evidence. Reviewed by the Board. Decision*795 will be entered under Rule 50. Footnotes 1. This decision was prepared during Mr. Trammell's term of office. ↩