24 T.C. 75 (1955), 44927, Southwest Hardware Co. v. C.I.R.

Docket Nº:44927.
Citation:24 T.C. 75
Opinion Judge:HARRON, Judge:
Attorney:Harrison Harkins, Esq., and John B. Milliken, Esq., for the petitioner. Francis B. Campbell, Jr., Esq., for the respondent.
Judge Panel:KERN and WITHEY, JJ., dissent.
Case Date:April 26, 1955
Court:United States Tax Court

Page 75

24 T.C. 75 (1955)




No. 44927.

United States Tax Court.

April 26, 1955

Page 76

Harrison Harkins, Esq., and John B. Milliken, Esq., for the petitioner.

Francis B. Campbell, Jr., Esq., for the respondent.

Petitioner, organized in 1912 under the general corporation law of California, always has carried on its business as a co-operative wholesale dealer in hardware selling only to its stockholder-members who own equal amounts of stock. No dividends have ever been paid on petitioner's stock. It was understood and agreed between petitioner and each prospective stockholder at the time stock was purchased that all of petitioner's annual net earnings would be distributed to the stockholder-members in proportion to the purchases of each. In each year, patronage refunds were paid to the members in certificates representing their shares of annual profits over costs and operating expenses, which shares were credited on petitioner's books to each member. The certificates were redeemed by petitioner in cash during 5 years after issuance. Held, that the patronage refunds so paid, in certificates, were paid under legal obligation to and contracts with petitioner's members, and that the amount thereof is subject to exclusion in computing the net income of petitioner subject to tax.

The Commissioner determined deficiencies in income tax for the fiscal years ended on August 31, 1946, 1947, 1948, and 1949, and a deficiency in excess profits tax for the fiscal year ended August 31, 1946, in the following amounts:

Year ended August 31 Income tax Excess profits tax

1946 $40,585.18 $31,046.07

1947 36,666.42

1948 31,927.63

1949 23,029.41

Total $132,208.64 $31,046.07

The sole issue is whether petitioner properly can exclude from income for each taxable year the entire amount of its net income after all expenses, which represents its profit in each year upon business done with its members, which was credited each year to its members and petitioner asserts belonged to its members as commissions or patronage refunds. The petitioner contends that determinations of deficiencies for the fiscal years ended August 31, 1946 and 1947, are barred by the statute of limitations and that the provisions of section 275(c) of the 1939 Code do not apply. FINDINGS OF FACT. The stipulated facts are found as stipulated; the stipulation and annexed exhibits are incorporated herein by reference. The petitioner was incorporated on September 17, 1912, under the general corporation laws of California under the name, Hardware Merchants Syndicate, which name was changed to Southwest Hardware Company in 1925. Its place of business is located in Los Angeles, California. It keeps its books and files its returns on an accrual basis for a fiscal year ending on August 31. Petitioner filed income tax returns for the taxable years with the collector of internal revenue for the sixth district of California. No excess profits tax return was filed for the year ended August 31, 1946. The income tax returns for the taxable years were filed on November 15, 1946, October 28, 1947, November 15, 1948, and November 9, 1949, respectively. The statutory notice of deficiencies was mailed on July 29, 1952. The petitioners did not consent to waive the provisions of section 275(a) of the 1939 Code before or after the time prescribed Page 77 therein with respect to its returns for the years ended August 31, 1946 and 1947. During the taxable years the petitioner was engaged in the business of wholesaling hardware and like products in competition with other wholesalers. However, at all times it has sold merchandise only to its member dealers who are its stockholders. Petitioner's members are selected retail hardware dealers in southwest California. Petitioner describes itself on its income tax returns as a co-operative wholesale hardware company. During the taxable years, petitioner's outstanding stock consisted of one class of common stock, only, having a par value of 80 cents per share. Each stockholder owned 1,250 shares having a total par value of $1,000. Each of petitioner's directors was the record owner of 1 share. The number of stockholders and directors, and the total pay value of all of the outstanding stock at the end of each of the taxable years were as follows:

Year ended August 31 Directors Stockholders Issued stock

1946 7 93 $93,005.60

1947 7 95 95,005.60

1948 9 102 102,007.20

1949 9 102 102,007.20

Petitioner was organized to operate as a hardware buying syndicate without profit to itself. Although petitioner's articles of incorporation and bylaws do not provide for payment of patronage refunds to members, petitioner has at all time treated earnings above costs and operating expenses as belonging to its members, and it has never paid any dividends on its stock. During the taxable years, and in prior years, the patronage refund, or commission, of each member has been computed on the basis of the ratio of net profit derived from the purchases of each member to total net profit derived from the purchases of all members in a year. Petitioner's method of making patronage refunds has always been based upon resolutions of its member-stockholders which were duly adopted. A method of making patronage refunds was followed before 1930 which proved to be unsatisfactory because it did not work out so that sufficient provision was made to cover petitioner's operating expenses. Therefore in 1930 a new method of allowing patronage refunds, or commissions, was adopted, pursuant to a resolution of the stockholder-members which has been followed ever since. The resolution was adopted by the stockholder-members on October 20, 1930. It is tantamount to a bylaw provision. It provided, in part, as follows: Page 78 the member's commission on the gross profits on their purchases (shall) be limited to an amount not to exceed the net income after deducting all expenses not including members' commissions, and * * * members' commission in such profit to be equal to the gross profit on the purchases of all participating members. * * * Since 1930, at least, records and accounts in petitioner's books have been maintained by which each member's share of annual net profit above expenses and costs has been computed according to the ratio which the profit on each member's purchases during the year bears to the total profit on total sales to all members. The gross profit, or gross commission, on every purchase of a member dealer was stated on the retained copy of each invoice of sales to a member and was entered in the member's account on petitioner's books. At the end of the year, the percentage which petitioner's net earnings bears to the total gross profit on all members' purchases is applied to each member's commission. The total of these commissions, which equals the petitioner's net earnings, is entered in an accounts payable control account, ‘ Commissions Due Members.’ Petitioner's books do not contain any profit and loss account. Its accounting records for each year show gross sales, net sales after returns and allowances, cost of goods sold to member dealers, operating expenses, miscellaneous expenses, and net profit. All of the net profit of each year's operations is credited at the end of each year to the ‘ Members' Commissions' account. For the taxable years, petitioner's net profit before commissions and the credits to members' commissions were as follows:

Net profit Credit to

Year ended August 31 before members'

commissions commissions

1946 $144,279.75 $144,279.75

1947 96,630.75 96,630.75

1948 84,153.94 84,153.94

1949 60,603.71 60,603.71

In its income tax returns for the taxable years, the petitioner excluded from ‘ taxable income’ the above amounts of the credits to members' commissions, i.e., all of its net profits after all expenses. The Commissioner restored the above amounts to petitioner's taxable income, determining that all of the net profit for each year is taxable to petitioner. Each member dealer was advised of the amount of its commission for the year and advised that it must be reported in the member's income tax return. Page 79 Because petitioner's sales are not made for cash but are made on account, whereas most of its purchases are paid for in cash on delivery, petitioner requires a large fund to carry on buying operations. Its paid-in capital represents a small percentage of its inventory and receivables. In order to avoid borrowing from banks, petitioner's members voted after each of the taxable years, and prior years, to loan their patronage refunds to petitioner at 2 per cent interest so that petitioner could build a fund for operations. Accordingly, in the taxable years, and before, petitioner distributed the patronage refunds to members by means of certificates or receipts,[1] issued serially, in lieu of cash. It has paid the certificates in cash within 5 years from the year of issuance. The receipts are numbered serially; they are signed by petitioner's president and secretary; they bear interest payable semiannually; they are printed; they acknowledge the receipt from the member of a stated sum of money; and they set forth petitioner's agreement with the member-lender to make repayment of the amount stated. The receipts are transferable without...

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