Gemological Institute of America v. Riddell

• Citation: 149 F. Supp. 128
• Decision Date: 20 February 1957
• Docket Number: No. 19795.,19795.
• Parties: GEMOLOGICAL INSTITUTE OF AMERICA, Inc., an Ohio corporation, Plaintiff, v. Robert A. RIDDELL, Director of Internal Revenue at Los Angeles, California, Defendant.
• Court: U.S. District Court — Southern District of California

149 F. Supp. 128

GEMOLOGICAL INSTITUTE OF AMERICA, Inc., an Ohio corporation, Plaintiff, v. Robert A. RIDDELL, Director of Internal Revenue at Los Angeles, California, Defendant.

No. 19795.

United States District Court S. D. California, Central Division.

February 20, 1957.

Lillie & Bryant, by George M. Bryant, Los Angeles, Cal., and Anthony Bradisse, for plaintiff.

Laughlin E. Waters, U. S. Atty., Edward R. McHale, Asst. U. S. Atty., Chief, Tax Div., Los Angeles, Cal., by Robert H. Wyshak, Los Angeles, Cal., for defendant.

YANKWICH, Chief Judge.

The above-entitled cause heretofore tried, argued and submitted, is now decided as follows:

Upon the grounds stated in the comments to follow, Judgment will be for the defendant that plaintiff take nothing.

Formal Findings and Judgment to be prepared by counsel for the Government under Local Rule 7. West's Ann.Cal. Code.

Comment.

1. Relating To All Cases: Liability For Tax

Separate actions have been brought by the plaintiff to recover alleged overpayment of income tax for the years from 1948 to 1954 as follows:

                    1948      $ 9,880.01
                    1949       26,719.81
                    1950       16,003.64
                    1951       53,863.72
                    1953       20,314.31
                    1954        2,603.42
                

Some special issues are raised as to some of the years. These will be specifically referred to in Part III of each memorandum to be filed in the separate cases. See Appendix A, at end, for full findings in which the facts are set out more specifically.

The object of this memorandum, to be filed in this case and referred to in all others, is to determine whether the plaintiff is exempt from taxation for the year 1954 under Section 501(c) (3) of the 1954 Internal Revenue Code, 26 U.S. C.A. § 501(c) (3), and for the prior years under Section 101(6) of the 1939 Code, 26 U.S.C.A. § 101(6).

The basis for exemption is the claim that the institution was exempt as a non-profit institution "organized and operated exclusively for * * * educational purposes" under Section 101(6) of the 1939 Internal Revenue Code, and the similar provision of Section 501(c) (3) of the 1954 Internal Revenue Code. For the years 1944, 1945 and 1946, its character as such an institution was denied by the Tax Court, See, Gemological Institute of America v. Commissioner, 1952, 17 T.C. 1604 the decision being affirmed in a per curiam memorandum by the Court of Appeals for the Ninth Circuit. See, Gemological Institute of America v. Commissioner of Internal Revenue, 9 Cir., 1954, 212 F.2d 205.

Without considering this decision as determinative of the issue as to the years before us, it is well to start with it in order to determine whether the character of the institution was changed in subsequent years. Before doing so, we advert to the fact that the Court of Appeals for the Ninth Circuit has declined to follow what is known as "the ultimate destination" of the taxpayer's profits as the test in these cases, as that test was laid down by the Court of Appeals for the Second Circuit in Roche's Beach, Inc., v. Commissioner of Internal Revenue, 2 Cir., 1938, 96 F.2d 776. To the contrary, they have held repeatedly and consistently that the existence of exemption is to be determined by the nature of the particular institution with the view to ascertain whether the institution was organized exclusively for educational purposes. Squire v. Students' Book Corp., 1951, 9 Cir., 191 F.2d 1018, 1020-1021; Ralph H. Eaton Foundation v. Commissioner of Internal Revenue, 9 Cir., 1955, 219 F.2d 527, 528-529; John Danz Charitable Trust v. Commissioner of Internal Revenue, 9 Cir., 1955, 231 F.2d 673, 676; Randall Foundation, Inc., v. Riddell, 9 Cir., ___ F.2d ___. And see, United States v. Community Services, 4 Cir., 1951, 189 F.2d 421, the reasoning of which is approved in Ralph H. Eaton Foundation v. Commissioner of Internal Revenue, supra, 219 F.2d at page 529. See also, Wm. L. Powell Foundation v. Commissioner of Internal Revenue, 1953, 21 T.C. 279; Smyth v. California State Automobile Association, 9 Cir., 1949, 175 F.2d 752; Le Savoy Foundation v. Commissioner, 1956, 25 T.C. 924.

The nature of the corporation is described in the opinion in the Tax Court case. It has not been changed. It evidently conducts classes, sells books, of most of which the founder of the institution, Robert M. Shipley, is the author, has acquired patents to instruments which it sells to students and those interested in the science of gemmology. The only change which has occurred since the year 1946, is that an agreement was entered into by the plaintiff and Shipley on June 30, 1948, whereby, in lieu of the salary and of the 50 per cent of the profits provided in the previous agreement, he agreed to receive $19,000 per year. On March 29, 1952, this agreement was terminated and he was voted a special severance pay of $10,000 per year until a total of $60,000 was paid to him, the first payment on the execution of this agreement. In addition to this, he was to receive royalties upon the books published by him and on the instruments to which he had patents. He was to render no services in exchange for this severance pay, but he was not to engage in similar activities with others for five years. While the agreement recites that differences have arisen as to compensation, it is quite evident that the attempted change in relationship was motivated by the decision of the Tax Court dated two days before, March 27, 1952, declaring the corporation not to be an educational institution because of the diversion of a large percentage of its profits to an individual.

Granted that the institution has graduated students who seek to maintain the high ethical standards of the gemmology profession, I am of the view that it cannot qualify as a non-profit institution exclusively engaged in educational purposes as those words are construed by the Court of Appeals for the Ninth Circuit in the decisions already cited. See also, Commissioner of Internal Revenue v. Orton, 6 Cir., 1949, 173 F. 2d 483. A good portion of its profits has always been, and were in the taxable years, devoted to the remuneration of Mr. Shipley. And, even considering the fact that, as of today, business executives are compensated in a munificent manner, the contracts entered into in 1948 and 1952, the first providing for the compensation at the rate of $19,000 a year plus royalties, and the other awarding him a retirement pay of $60,000 to be paid over a period of six years, were not mere contracts for excessive compensation, but were characteristic of an enterprise that is conducted as a commercial enterprise for the greater benefit of one person. The fact that well-meaning persons engaged in the jewelry trade like James G. Donavan and others who testified at the trial, served on the directorate without compensation does not deter from the fact that the educational activities were incidental to purely commercial objects, — the sale of books and instruments, ownership of property, patents, etc., — and which included the fostering of better ethics in the jewelry profession. See, Better Business Bureau v. United States, 1949, 326 U.S. 279, 284, 66 S.Ct. 112, 90 L.Ed. 67. Concededly a taxpayer may change the nature of his operation in order to receive the benefit of tax exemptions. And it was within the power of the corporation to change its articles of organization and conform, both in their declaration of corporate aims and activities, exclusively to educational purposes henceforth. They did not choose to do so. And I am of the view that the change in the contracts between them and Shipley were not sufficient to amount to a repudiation of the purposes set forth in the articles of incorporation and in the activities engaged in these long years. See, Helvering v. Coleman-Gilbert Associates, 1935, 296 U.S. 369, 374, 56 S.Ct. 285, 80 L.Ed. 278; Buckley v. Commissioner of Internal Revenue, 2 Cir., 1956, 231 F.2d 204. This rule of interpretation in tax cases has the approval of our Court of Appeals. See, Title Ins. & Trust Co. v. Commissioner of Internal Revenue, 9 Cir., 1938, 100 F.2d 482, 485.

II. Relating To All Cases Except 19795-Y (1954): Liability For Penalty

Section 291(a) of the Internal Revenue Code of 1939 provided:

"In case of any failure to make and file return required by this chapter, within the time prescribed by law or prescribed by the Commissioner in pursuance of law, unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the tax: 5 per centum if the failure is for not more than thirty days with an additional 5 per centum for each additional thirty days or fraction thereof during which such failure continues, not exceeding 25 per centum in the aggregate. The amount so added to any tax shall be collected at the same time and in the same manner and as a part of the tax unless the tax has been paid before the discovery of the neglect, in which case the amount so added shall be collected in the same manner as the tax. The amount added to the tax under this section shall be in lieu of the 25 per centum addition to the tax provided in section 3612(d) (1)." 26 U.S.C. 1952 Ed., § 291.

Assessment of the maximum of 25 per cent penalty was made as to all the years involved except the year 1954. All the tax returns for the years prior to 1955 were filed in 1954 with simultaneous claims for refund. Ordinarily, the finding of neglect under provisions of this character under this and other tax Acts is considered purely an administrative act which will not be disturbed. Bothwell v. Commissioner of Internal Revenue, 10 Cir., 1935, 77 F.2d 35, 39; Gouldman v. Commissioner of Internal Revenue, 4 Cir., 1948, 165 F.2d 686, 690.

However, I am of the view that in the cases before us, the failure to file was not due to "willful neglect" but rather was due to "reasonable cause". See, Hatfried, Inc., v. Commissioner of Internal Revenue, 3 Cir., 1947, 162 F.2d 628, 635; ...