Hales-Mullaly, Inc. v. Commissioner

HALES-MULLALY, INC., A CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Hales-Mullaly, Inc. v. Commissioner Docket No. 100853. United States Board of Tax Appeals 46 B.T.A. 25; 1942 BTA LEXIS 920; January 6, 1942, Promulgated *920 Petitioner, after acquiring by purchase part of the assets and business of another corporation, was made a party defendant to an action brought by the vendor against some of its former stockholders and employees, in which it was alleged that it had been damaged by certain overt acts performed by them prior to petitioner's incorporation in furtherance of a conspiracy entered into for the purpose of procuring its wholesale business. This action and five suits which had been brought by former salesmen against the vendor for commissions were settled by having the petitioner pay the salesmen a portion of the commissions claimed by them and attorney fees and other expenses incurred in connection with the litigation. Held, the payments made by petitioner are not deductible by it as ordinary and necessary expenses incurred in carrying on its trade or business. Charles H. Garnett, Esq., for the petitioner. Frank B. Schlosser, Esq., for the respondent. MELLOTT *26 This proceeding involves a deficiency in income tax for the fiscal year ended August 31, 1937, in the amount of $15,858.62. The sole error charged in the petition is the disallowance*921 by the respondent of the deduction of $51,788.08 paid by petitioner in settlement of a lawsuit, for attorneys' fees, and for expenses in connection with such suit. FINDINGS OF FACT. Petitioner is a corporation organized and existing under the laws of the State of Oklahoma. Its books are kept and its returns of income are filed on the accrual basis. Its income tax return for the fiscal year ended August 31, 1937, was duly filed with the collector of internal revenue for the district of Oklahoma and the tax shown to be due was paid. Petitioner was incorporated on September 9, 1935, for the purpose of conducting a wholesale and retail merchandise business particularly for dealing generally in all kinds of office and household furniture, instruments, appliances, utilities, and equipment, either as owner or as agent, consignee, or factor for others. Its incorporators and first board of directors were W. T. Hales, George A. Hales, W. T. Hales, Jr., J. R. McBrayer, and Carter Mullaly. Harbour-Longmire Co. was a corporation having its principal office and place of business at Oklahoma City. For many years it had been engaged in the business of merchandising and dealing in office*922 and household furniture, furnishings, equipment, and appliances of all kinds at wholesale and retail. McBrayer entered its employ in 1917, later became a stockholder, and was its secretary from January 1, 1923, until September 1935. W. T. Hales was a large stockholder in, and president of, the corporation prior to 1935. Hales and McBrayer, in 1934, became dissatisfied with the conduct of the business by the corporation and about May or June of 1935, sold their stock in the corporation to it. George A. Hales and Carter Muallaly were employees of the corporation until about August 1935. George A. Hales and W. T. Hales, Jr., were sons of W. T. Hales and Mullaly was his son-in-law. On September 12, 1935, Mullaly and George A. Hales entered into a written agreement with Harbour-Longmire Co. for the purchase of all of the stock of household appliances in the wholesale division of that corporation such as refrigerators, radios, and ranges, together with all parts and accessories of such appliances, including the merchandise then in warehouses and on order but not delivered and the good will of the wholesale business. *27 On the same date $30,000 was paid on the purchase*923 price of the merchandise included in the foregoing contract by check of petitioner. On September 14th Harbour-Longmire Co. executed a bill of sale of the merchandise purchased under the above contract in accordance with an inventory made and approved by the seller and purchasers. On the same date it gave Mullaly and George A. Hales a receipt for the $30,000, which it applied on the consideration for the bill of sale of the merchandise and good will, the receipt also containing a recital that the balance of the consideration was to be paid according to the amounts shown by adjusted inventories of the merchandise. On September 21, 1935, Mullaly and George A. Hales made a further payment on the purchase price of the merchandise and good will by check of petitioner in the sum of $10,140.39. On September 23d Harbour-Longmire Co. gave its receipt for the above sum, the receipt stating it was understood and agreed the balance of the consideration was to be paid according to the amount shown by an adjusted inventory of the merchandise. This instrument was executed in duplicate and was signed by Mullaly and George A. Hales as well as by Harbour-Longmire Co. On September 27, 1935, Mullaly*924 and Hales made a final payment of $7,426.12 on the purchase of the merchandise and good will by check of petitioner. A receipt for this sum was given by Harbour-Longmire Co. in which it was recited that it was in payment of merchandise not included in the inventory but described in the agreement as in transit or as thereafter to be received from shippers and that it had now been received by the seller and delivered to the purchasers. By assignment and bill of sale dated October 12, 1935, Mullaly and George A. Hales assigned and transferred to petitioner all of the merchandise and business good will which had been purchased under the preceding instruments from Harbour-Longmire Co. This assignment and bill of sale recited that petitioner had paid the full consideration for the purchase of the described merchandise from Harbour-Longmire and that Mullaly and Hales * * * in the making of said agreement and taking of said bill of sale were acting for the use and benefit of said Hales-Mullaly, Inc., with the understanding and agreement that the consideration of said agreement and bill of sale was to be paid by the said Hales-Mullaly, Inc., a corporation, and that Hales-Mullaly, Inc.*925 , should have all benefits and assume all obligations of said agreement and bill of sale between the said Harbour-Longmire Company and Carter Mullaly and George A. Hales. Endorsed on the assignment and bill of sale referred to in the preceding paragraph is an acceptance by petitioner, "together with the benefits and obligations therein contained pursuant to approval and acceptance by the board of directors of said corporation." At a special meeting of petitioner's board of directors held on the same date *28 that the assignment and bill of sale was accepted - Mullaly and George A. Hales not voting - a resolution was adopted reciting that Mullaly and Hales were acting on behalf of, and for the use and benefit of, the corporation in entering into the agreement with Harbour-Longmire Co. and that it had paid the purchase price of the merchandise and good will purchased from such company. It was therefore resolved that the assignment be accepted "and that the obligations, agreements and promises therein contained be assumed by this corporation * * *." In December 1935 five former employees of Harbour-Longmire Co. instituted separate suits against it in the District Court of*926 Oklahoma County, each plaintiff alleging that he was formerly a salesman in the employ of Harbour-Longmire Co. and that he was entitled to unpaid commissions earned as compensation for services in that employment. The amounts sued for ranged from $1,527.28 to $7,389.66, the total amount claimed being $27,634.24. On March 5, 1936, Harbour-Longmire Co. commenced a suit in the District Court of Oklahoma County against W. T. Hales, George A. Hales, Mullaly, McBrayer, petitioner herein, and the five former employees referred to in the preceding paragraph. The petition filed in this case is lengthy and is incorporated herein by reference. Briefly summarized, it charges that the four individuals named above performed certain overt acts, in furtherance of a conspiracy which had been entered into for the purpose of procuring the wholesale business, franchises, and good will of the plaintiff. The acts and conduct relied upon are set out in considerable detail and include: threats to institute an action charging corporate mismanagement of the plaintiff and asking for appointment of a receiver; acts deliberately performed for the purpose of embarrassing the plaintiff with its bankers; misrepresentations*927 to manufacturers who had previously granted plaintiff franchises to distribute their products; interference with, misrepresentation to, and the ultimate withdrawal from its employment by, certain of its employees; profiting from contracts of sale made by the employees while in plaintiff's employ but withheld by them for the purpose of enabling the conspirators to obtain the benefits; ransacking of private files; cheating in connection with the preparation of inventories after a contract of sale was executed; and other oppressive, fraudulent, and malicious acts, all of which injured and damaged it in the amount of $596,739.53. In the petition referred to in the preceding paragraph it is alleged that McBrayer, when the sale and purchase agreement between plaintiff and George A. Hales and Mullaly was executed, had become secretary of Hales-Mullaly, Inc., a "Corporation organized by the defendants W. T. Hales, Carter Mullaly, J. R. McBrayer, George A. Hales and one W. T. Hales, Jr., for the purpose of taking over the franchises *29 and plaintiff's wholesale business when the same should be procured by the defendants pursuant to said conspiracy; that said corporation did acquire*928 and take over and now owns and operates all of the same, and was, and is, merely an instrument and means designed by the defendants to operate the said wholesale business and hold the franchises, good will and merchandise, the incorporators, directors and officers of said corporation and the persons having the management and control thereof being the defendants and conspirators, W. T. Hales, Carter Mullaly, J. R. McBrayer and George A. Hales." It is also alleged that the acts and conduct of the defendants were oppressive and fraudulent, were done with malicious intent to injure and damage the plaintiff, and that by reason thereof plaintiff was entitled to exemplary damages in the sum of $500,000. W. T. Hales was a wealthy man and was the only individual defendant named in the above suit able to respond in damages in any substantial amount. Defendants filed a general denial and plea of estoppel, plaintiff filed a reply, and the case was set for trial on June 1, 1937. On that date the parties to all six of the lawsuits settled them by stipulation, the suits instituted by the former employees being dismissed with prejudice by the plaintiffs and by the defendant upon its crosspetitions. *929 The consideration for the settlement of the six cases was the settlement and satisfaction by petitioner herein of the amounts claimed by the former employees of Harbour-Longmire Co., each of whom was paid 60 percent of the amount claimed by him in the suit, the total sum thus paid by petitioner being $16,585.33. A firm of attorneys had been employed to represent the defendants in the suit for damages, the fee agreed upon being $35,000. The employment agreement was between W. T. Hales and the senior member of the law firm. Hales died September 15, 1938. Fifty percent of the agreed fee was paid by petitioner on December 30, 1936, and the balance on June 3, 1937. Other expenses incident to the suit were paid by petitioner during its fiscal year ending August 31, 1937, aggregating $202.75 [$203.90]. Recapitulating, the total payments made for attorney fees, expenses, and in settlement of the litigation were: Attorney fees $35,000.00 Expenses 202.75 Settlement 16,585.33 51,788.08 The formation of petitioner was planned by those interested in August 1935, and their purpose in the subsequent dealings with Harbour-Longmire Co. was to obtain the distributors*930 or dealers' franchises which it held and the merchandise on hand for the corporation which they proposed to form. The facts alleged in the petition *30 in the suit for damages instituted by Harbour-Longmire with respect to the incorporation of Hales-Mullaly and its officers, the previous employment of the salesmen and other employees, and the acquisition of the property are not denied by the defendants. They always denied, however, that they had unlawfully conspired against Harbour-Longmire Co. and insisted that they were simply organizing a competitive business and acquiring, as best they could, the contracts and franchises. The net income disclosed by the return filed by the petitioner for the fiscal year ending August 31, 1937, was $25,775.91. In computing it petitioner deducted from gross income $51,788.08, the aggregate of the payments made in settlement of, and for expenses in connection with, the lawsuit referred to above. Respondent restored this amount to income, made other adjustments not now in issue, and determined a deficiency of $15,858.62. This amount, together with $2,933.84 representing interest, was paid to the collector of internal revenue for the*931 district of Oklahoma on December 16, 1940, and is held in his "unidentified account awiting the assessment." The notice of deficiency was mailed on November 16, 1939, and the petition was filed on December 15, 1939. OPINION. MELLOTT: The applicable statute is section 23(a) of the Revenue Act of 1936. 1 Respondent also cites section 24(a)(2) of the same act and the corresponding article of Regulations 94. 2 *932 The facts are not seriously in dispute. The findings show the circumstances under which the payments were made. Respondent determined that they were not ordinary and necessary expenses of carrying on petitioner's business. He does not seriously contend they were not necessary, directing his argument upon brief chiefly *31 to the question whether they were ordinary. Without abandoning the theory upon which he disallowed the deduction, he advances an alternative one - that the payments were in the nature of capital expenditures. The decided cases establish certain general principles: Expenses incurred in connection with a suit or action against a taxpayer directly connected with or approximately resulting from his business, whether to secure payment of the earnings of the business or to retain them after receipt, are deductible as ordinary and necessary business expenses. Kornhauser v. United States,276 U.S. 145. Expenses incurred in the settlement of a criminal liability or to avoid criminal prosecution, are not deductible, *933 B. E. Levinstein,19 B.T.A. 99; Sanitary Earthenware Specialty Co.,19 B.T.A. 641; Estate of John W. Thompson,21 B.T.A. 568; Burroughs Building Material Co. v. Commissioner, 47 Fed.(2d) 178; nor are those paid in connection with lobbying or propaganda, Textile Mills Securities Corporation v. Commissioner,314 U.S. 326; those which are "beyond the norm of general and accepted business practice" and "so extraordinary as to occur in the lives of ordinary business men not at all", Deputy v. du Pont,308 U.S. 488; capital expenditures, including those made in defending or perfecting title to property, Aluminum Products Co.,24 B.T.A. 420; Morgan Jones, Estate,43 B.T.A. 691 (on appeal, C.C.A., 5th Cir.); amounts paid by a corporation in settlement of a suit brought against its officers on account of their alleged wrongdoing, Blackwell Oil & Gas Co. v. Commissioner, 60 Fed.(2d) 257; or payments which are made to discharge the liabilities of others, even though they are made for the purpose of insuring future*934 profits, Welch v. Helvering,290 U.S. 111; A. Giurlani & Bros. v. Commissioner, 119 Fed.(2d) 852, affirming 41 B.T.A. 403. Expenditures made in securing an acquittal on a criminal charge, Commissioner v. Peoples-Pittsburgh Trust Co., 60 Fed.(2d) 187, affirming 21 B.T.A. 588; in successfully defending against a complaint before the Federal Trade Commission, Continental Screen Co.,19 B.T.A. 1095; affd., 58 Fed.(2d) 625; to compromise a tax or abate a proposed penalty, H. E. Bullock,16 B.T.A. 451; in prosecuting a claim for refund of taxes, Florence Grandin,16 B.T.A. 515; to settle a dispute arising from "business dealings between the parties", H. M. Howard,22 B.T.A. 375; in compromise of a civil suit for damages even though the suit was also against others, International Shoe Co.,38 B.T.A. 81; in resisting an assessment for widening a street or an illegal attempt by a city to condemn property, *935 Commissioner v. Chicago Dock Canal Co., 84 Fed.(2d) 288; L. B. Reakirt,29 B.T.A. 1296; affd., 84 Fed.(2d) 996; in defending against litigation which was an outgrowth of a taxpayer's connection with the business of a corporation, Foss v. Commissioner, 75 Fed.(2d) 326; *32 to recover, in a proceeding before the Mixed Claims Commission, balances in the taxpayer's accounts with German banks, Commissioner v. Speyer, 77 Fed.(2d) 824; and in making restitution for a wrong committed in a business transaction, Helvering v. Hampton, 79 Fed.(2d) 358; W. R. Hervey,25 B.T.A. 1282, have been held to be ordinary and necessary business expenses paid or incurred in carrying on a trade or business. The cited cases are but a few of the legion in which the courts or this Board have been called upon to determine the difficult and vexing question. Collectively, they "fail to provide 'any verbal formula that will supply a ready touchstone'. Welch v. Helvering * * *." *936 A. Giurlani & Bros. v. Commissioner, supra."To attempt to harmonize [the cases] would be a futile task. They involve the application of particular situations, at times with borderline conclusions." Welch v. Helvering, supra."Review of the many decided cases is of little aid since each turns on its own special facts." Deputy v. du Pont, supra."The words 'ordinary and necessary' are not so clear and unambiguous in their meaning and application as to leave no room for an interpretative regulation." Textile Mills Security Corporation v. Commissioner, supra.No interpretative regulation, other than article 24-2 is cited and, while it has some pertinency, the question whether the expenditures were ordinary is primarily a question of fact. The facts will be briefly summarized. In 1934 a number of the officers and employees of Harbour-Longmire Co., including W. T. Hales, its president, became dissatisfied with the way the business was being conducted. Those who were stockholders sold their stock to the company in May or June of 1935. In August of that year they left the company with the idea of forming*937 a corporation to engage in business in competition with Harbour-Longmire Co. The necessary funds were to be advanced by W. T. Hales, who was possessed of considerable means. By letter dated September 5 or 6, 1935, Harbour-Longmire Co. agreed to sell its wholesale division, good will and certain franchises to George A. Hales and Mullaly, son and son-in-law, respectively, of W. T. Hales. In pursuance of this agreement a contract of sale was entered into by the parties on September 12, 1935. Between those dates petitioner was organized and on October 12, 1935, Hales and Mullaly executed an assignment to petitioner as set out in our findings, drawing its checks payable to the order of Harbour-Longmire Co. in payment for the properties. On December 16, 1935, five salesmen formerly in the employ of Harbour-Longmire Co. but then in petitioner's employ, filed suits against Harbour-Longmire Co. for commissions. It countered by filing a suit against W. T. Hales, his son, son-in-law, McBrayer, the five salesmen, and petitioner, charging that the individual defendants *33 had conspired to ruin its business and, through fraudulent means, had acquired its wholesale department, good*938 will and franchises. It alleged that because of the false and fraudulent representations of the individuals it had been forced to enter into a contract for the sale of its properties in order to avoid further losses, all to its damage in a sum, including exemplary damages, totaling $1,096,739.53. The sole allegation of the petition pertaining to petitioner herein is in paragraph 37, 3 which recites that petitioner was organized for the purpose of taking over the property and that it acquired it merely as an instrument or means designed by the individual defendants to operate and hold it. W. T. Hales was the only defendant in a position to respond in damages. *939 The genesis of the litigation was schism or dissension between two groups of stockholders of Harbour-Longmire Co. and the major portion, if not all, of the acts relied upon in the petition for damages took place prior to the organization of petitioner. All of the suits were settled by petitioner paying the five salesmen 60 percent of the amounts which they were claiming as commissions due from Harbour-Longmire Co. and petitioner paid what appears to be, so far as this record shows, the total attorney fees and costs in connection with the conspiracy action. Petitioner insists that the kind of action it is required to defend is immaterial unless the transaction out of which it arose is of a class in which deductions may not be allowed as a matter of public policy (e.g., crimes, lobbying, and propaganda); that it makes no difference whether it participated in the conspiracy or, if it did participate, whether its action was, or was not, in the ordinary course of its business; that the extent of petitioner's culpability, liability, or unethical and unmoral conduct may not be inquired into in this collateral proceeding; that the petition stated a cause of action against it for more*940 than a million dollars and its officers deemed it wise to settle it rather than hazard a trial; that "lawsuits are of common or frequent occurrence in the type of business in which the taxpayer was engaged"; that the expenditures in question were ordinary in the sense that they were normal and usual; and that the respondent erred in denying the claimed deduction. Its contentions are more or less summarized in its reply brief in the following sentence: The question here is whether, when a merchandising business corporation is sued for damages on account of any kind of a transaction, it is the ordinary and *34 necessary thing to defend against such lawsuit and to incur expense for attorney's fees in such defense, and, if its directors and officers in good faith believe it for the best interest of the corporation to settle such lawsuit, even though it be regarded as having only a nuisance value, such attorney's fees and the settlement sum are ordinary and necessary expenses of such corporation's business. It is unnecessary to pass upon each of petitioner's contentions. Suffice it to point out "the fact an obligation to pay has arisen is not sufficient." Deputy v. duPont,*941 supra. The transaction which gives rise to it must be of common or frequent occurrence in the type of business involved, Welch v. Helvering, supra - "normal, usual or customary" - "and its normalcy in the particular business" is "crucial and controlling." Deputy v. du Pont, supra.If petitioner had been sued upon an account, or for damages sustained through the negligent operation of one of its delivery trucks, for example, there would be but slight question of normalcy; but it is far from "normal, usual or customary" for a mercantile corporation to be sued for acts committed by its incorporators prior to its organization. Moreover, we think it is also material, and incumbent upon petitioner to show, that the suit resulted, at least in part, from some action of the corporation either in, or incidental to, its ordinary business. Cf. Wolf Manufacturing Co.,10 B.T.A. 1161; W. S. Dickason,20 B.T.A. 496. No such showing, however, has been made. Petitioner's contention that expenditures made by a mercantile business in defending a suit for damages on account of any kind of a transaction is clearly contrary*942 to the decisions, especially Deputy v. du Pont. This case is controlling and, since, in our judgment, petitioner has failed to prove that the expenditures were "ordinary", respondent's determination must be upheld. While decision may be rested wholly upon the ground set out above, it is not amiss to refer to the fact that the record does not disclose why all of the expenses were borne by petitioner while the gravamen of the action was an unlawful conspiracy by the individual defendants. This Board has allowed the deduction by a corporation of its share of the legal expenses where it was a codefendant with some of its stockholders, Matson Navigation Co.,24 B.T.A. 14, and has allowed the deduction of the amount paid in settlement by a corporation which had been charged as a coconspirator with its officers in a transaction arising out of and in connection with its business subsequent to its organization. International Shoe Co., supra.No case has been cited, and we know of none, in which deduction has been allowed for the full amount of a fee paid by one defendant for the benefit of several, and the general rule, certainly in the absence*943 of an agreement to the contrary, would seem to be that deduction should be allowed only for an aliquot portion of the total fee. Cf. Blackwell Oil & Gas Co., supra;Walter S. Dickey,14 B.T.A. 1295; *35 affirmed on another issue, 56 Fed.(2d) 917; certiorari denied, 287 U.S. 606. Respondent's alternative contention, though not indicated in his original determination, is properly before us (Standard Oil Co.,43 B.T.A. 973 (on appeal, C.C.A., 7th Cir.), and cases cited) and, if necessary, could be considered. Briefly it is, that the expenditures were made in connection with the acquisition of the property, franchises, and good will of Harbour-Longmire Co. and represented a capital investment. Sec. 24(a)(2) and art. 24-2, Regulations 94, supra.This contention seems to be sound; but in view of the conclusion reached upon the main issue it may be passed without decision or further discussion. The parties cite and discuss at considerable length an opinion by the Supreme Court of Oklahoma, *944 Hales-Mullaly, Inc. v. Oklahoma Tax Commission,100 Pac.(2d) 274, handed down January 23, 1940, and involving the identical expenditures in controversy here. The majority of the court held that the expenditures were ordinary and necessary expenses of carrying on the taxpayer's business, under a state statute almost identical with section 23(a) of the revenue act, supra.Neither party contends that the cited case is binding upon us, though of course it is entitled to considerable weight because of the high standing of the court. The fact that the decision was not unanimous and that we find ourselves more nearly in accord with the views expressed by the dissenting judges, indicates that the question is not an easy one to answer. As Mr. Justice Cardozo remarked, in Welch v. Helvering, supra: "The standard set up by the statute is not a rule of law; it is rather a way of life. Life in all its fullness must supply the answer to the riddle." Decision will be entered for the respondent. Footnotes 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME. In computing net income there shall be allowed as deductions: (a) EXPENSES. - All the ordinary and necesssary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. ↩ 2. SEC. 24. ITEMS NOT DEDUCTIBLE. (a) GENERAL RULE. - In computing net income no deduction shall in any case be allowed in respect of - * * * (2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. ART. 24 - 2. Capital expenditures. - * * * * * * The cost of defending or perfecting title to property constitutes a part of the cost of the property and is not a deductible expense. * * * * * * ↩ 3. That Hales-Mullaly, Inc. is an Oklahoma Corporation organized by the defendants W. T. Hales, Carter Mullaly, J. R. McBrayer, George A. Hales and one W. T. Hales, Jr., for the purpose of taking over the franchises and plaintiff's wholesale business when the same should be procured by the defendants pursuant to said conspiracy; that said corporation did acquire and take over and now owns and operates all of the same, and was, and is, merely an instrument and means designed by the defendants to operate the said wholesale business and hold the franchises, good-will and merchandise, the incorporators. directors and officers of said corporation and the persons having the management and control thereof being the defendants and conspirators, W. T. Hales, Carter Mullaly, J. R. McBrayer and George A. Hales. ↩