Birmingham Business College, Inc. v. CIR

• Decision Date: 04 April 1960
• Docket Number: No. 17937.,17937.
• Parties: BIRMINGHAM BUSINESS COLLEGE, INC.; John Ike Griffith; Hulon A. Spears and Audrey Spears; Carl B. Carter and Jewell Carter, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

276 F.2d 476 (1960)

BIRMINGHAM BUSINESS COLLEGE, INC.; John Ike Griffith; Hulon A. Spears and Audrey Spears; Carl B. Carter and Jewell Carter, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 17937.

United States Court of Appeals Fifth Circuit.

April 4, 1960.

John Ike Griffith, Birmingham, Ala., for appellant.

Helen A. Buckley, Melva M. Graney, Lee A. Jackson, Dept. of Justice, Washington, D. C., Charles Owen Johnson, Sp. Atty., I.R.S., Herman T. Reiling, Acting Chief Counsel, I.R.S., Washington, D. C., Charles K. Rice, Asst. Atty. Gen., for appellee.

Before HUTCHESON, TUTTLE and BROWN, Circuit Judges.

JOHN R. BROWN, Circuit Judge.

The principal question is whether Birmingham Business College (BBC) qualifies as a tax exempt entity under § 101(6), 26 U.S.C.A. § 101. The Tax Court held it was not. Related to that are subsidiary issues on the statute of limitations, computation of gross and net income, and the propriety of asserted penalties. Similar questions arise with respect to additional taxes and penalties imposed on the stockholder-owner-employees of BBC who are also petitioners here.

The Tax Court, after an extended trial on a lengthy record, held that BBC did not satisfy two of the three statutory prerequisites that the institution (1) be organized and operated exclusively for educational purposes, and that (2) no part of the net earnings inure to the benefit of any individual or shareholder.¹

Consideration of this took the Tax Court back through the life history of BBC. Quite properly the distillation process of the trial permits us to briefly summarize the facts upon which, we determine, the Tax Court was authorized to draw these conclusions.

About 1940 John Ike Griffith, one of the individual taxpayer petitioners, then employed as a principal of a small public school with a part time law practice, was assisting two others in the financing of the small business college in Birmingham bearing its present name. With increased financial difficulties, he ended up with the school on his hands. He persuaded his two sisters, Audrey and Jewell, to leave their teaching positions in the public school in Jackson County and come to Birmingham and run the school. He decided then to incorporate. He had heard that the federal taxing authorities had ruled that such an institution would be tax exempt if no salary exceeded $10,000. From his vantage as a school teacher, he could not conceive of ever paying himself more than $10,000. His objective was to obtain tax benefits of which he had vaguely heard. Consequently, he drew and filed the charter for an Alabama corporation. It called for a capital structure of $2,000 to be owned in equal one-third shares by him (at first through his mother who loaned him the money) and his two sisters, Audrey and Jewell. The charter² did declare the corporate purposes to be "operating a non-profit, eleemosynary institution of learning" with the incorporators "claiming * * * exemptions * * * from * * * taxation * * * under" Alabama law. But of decisive importance to Tax Court and us, the charter was to be a binding irrevocable perpetual contract "between the incorporators that they shall not pay themselves salaries except in * * * proportion to the amount of * * * stock held by each * * *."

For the years 1941-1945, no income tax returns whatever were filed. In 1946 Griffith as President filed application on the official form for income tax exemption. The information given was in many material respects completely erroneous, though no one has suggested that these three school teachers were consciously making representations known to be false with a purpose to defraud. This erroneous information covered such vital matters as the absence of capital stock, authority of the school to issue it, distribution of property or cash to stockholders, payments to stockholders for services rendered, the organization and the general statement that no part of the net income of the organization inured to the benefit of shareholders or individuals.³ On July 16, 1946, the Commissioner granted the exemption "based upon the evidence presented" and stated that the school would "not be required to file returns of income unless you change the character of your organization, the purpose for which you were organized, or your method of operation."

Following the Revenue Agent's examination in 1952, which precipitated these taxes and penalties, the Commissioner on October 31, 1952, revoked the 1946 exemption ruling.

The Agent's examination revealed that BBC had few books or records. What there were had been loosely kept with glaring errors and omissions. It took a public accountant — a faculty member teaching accounting in the school — some 250 hours to reconstruct records for these eleven years. Covering much the same ground with an effort to verify subsidiary details, the Revenue Agent spent over 66 days in the same process. Both arrived at the conclusion that the school had had substantial income and net earnings, all of which, except for capital investments, had been distributed in one form or another to the stockholders, or to the husbands of Audrey and Jewell. Both Audrey and Jewell's husbands were, for most of this time, employed doing important work for the school.

It was these "drawings" by stockholders (or spouses) which caused so much difficulty in the determination of net earnings and its treatment by the Commissioner in the hands of the individual petitioners. Most of this was washed out by the Tax Court. But the details demonstrated a relationship similar to that existing between a commercial profit corporation and its shareholders. There was a constant commingling of the funds of the shareholders and BBC. On occasion receipts of BBC were deposited in the bank accounts of the individual shareholders without being recorded on BBC's books. Numerous personal expenses of the individuals were paid directly by BBC. The record reflects many instances where the shareholders treated the assets of BBC as their own to do with as they might desire. Money for cars they drove, for example, came from BBC. Again, this is not to suggest immoral or illegal conduct. Quite to the contrary, this represented a pooling of resources, but with a like expectation that what was there or what was left belonged equally to the three shareholder groups. For it is certainly clear that during many years the school had great difficulty in meeting its obligations for operating expenses. Frequently Griffith, Jewell and Audrey would borrow money pesonally to pay its obligations. Funds were inadequate to pay salaries or salaries adequate for services rendered. There was, without a doubt, a mutual sharing and sacrifice to keep the institution alive.

One incident treated as highly significant by the Commissioner and Tax Court was the use of some $17,000 by Audrey and her husband in the financing of the construction of their home. The Commissioner treated this as a dividend but the Tax Court concluded, properly we think, that it was a loan. But we agree that it is of substantial relevance for at least two reasons. First, it reflected the assumption that the shareholders were entitled to use the money available as might be needed. Second, a significant part of that sum was represented by a check paid by the Security Bank from BBC's account to Audrey. This was done under an express written direction⁴ signed by Griffith as President certifying that it was "an advance payment against her one-third interest in the earnings of the college" and for which she would subsequently have to account to maintain the integrity of the one-third distribution called for in the charter, see note 2, supra.

We are, of course, required to look at this as it actually was, not as it might have been. So viewed, we agree with the Tax Court that in the way BBC was brought into being as a corporation and as it was operated, two things came about. First, it was operated as a business producing, or ultimately producing, substantial revenues for its operators. Second, the net earnings, or substantial portions, were to be, and were in fact, distributed to these shareholders for their own personal benefit.

Several things stand out. The school was established as a corporation under a form which sought carefully to preserve an equality among the stockholders. Consequently, while the payment of reasonable compensation, or even the anticipated expectation of such payment, does not constitute earnings inuring to the benefit of those who create a tax exempt organization, this corporation put an additional condition on such payments. Compensation was not merely to be limited to that which was reasonable for such services. It could under no circumstances exceed a ratable distribution based on stock ownership. It was, and was intended to be, a means by which to assure an equal distribution of the earnings.⁵ It was treated this way throughout the continued operation of the school as the commingling of funds reflected, and as the certificate to the bank in 1950, see note 4, supra, so plainly attested. However reluctant we might be to reach this conclusion merely on the basis of the inartful corporate charter, note 2, supra, we have, with the Tax Court, undertaken to apply the tax law upon the practical operation which these taxpayers gave to the organization and their relation to it. In the current use of funds, in the use of available surplus cash, in the accumulation of capital investments available for distribution in the event of liquidation, what was left over after deducting expenses was to be shared equally. Net earnings were, therefore, to be for the benefit of the three as shareholders. An essential ingredient for the statutory exemption was lacking.

The tax impact of this basic conclusion cannot be overcome by the further subsidiary contentions of BBC. No returns were ever filed. Consequently, the statute of limitations offers no...