S. Naitove & Co. v. Commissioner of Internal Revenue

• Decision Date: 06 May 1929
• Docket Number: No. 4768.,4768.
• Parties: S. NAITOVE & CO., Inc., v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — District of Columbia Circuit

32 F.2d 949 (1929)

S. NAITOVE & CO., Inc., v. COMMISSIONER OF INTERNAL REVENUE.

No. 4768.

Court of Appeals of District of Columbia.

Submitted April 4, 1929.

Decided May 6, 1929.

R. Kemp Slaughter and Hugh C. Bickford, both of Washington, D. C., and Robert E. Coulson, of New York City, for appellant.

Mabel W. Willebrandt, Asst. Atty. Gen., and C. M. Charest, L. W. Scott, Sewall Key, and Millar E. McGilchrist, all of Washington, D. C., for appellee.

Before MARTIN, Chief Justice, and ROBB and VAN ORSDEL, Associate Justices.

VAN ORSDEL, Associate Justice.

Appellant, a New York corporation engaged in buying and selling woolen, silk, and cotton goods, had five employees who constituted the entire buying and selling staff of the business. These employees, dissatisfied with their compensation, threatened to go into business for themselves. To retain them, an agreement was entered into by the appellant and the employees under which they were to participate in the profits of the business. The agreement was expressed in a resolution passed by the board of directors on February 10, 1919, as follows:

"Resolved, That additional compensation for the year 1919 be paid to the following officers and employees of the company in accordance with the practice of the company on the following basis:

"Mr. Moe Naitove, 10% of the net profits for the year 1919;

"Mr. Nat Naitove, 10% of the net profits for the year 1919;

"Mr. Jack Naitove, 10% of the net profits for the year 1919;

"Mr. Moe Turnan, 5% of the net profits for the year 1919;

"Mr. George Naitove, 5% of the net profits for the year 1919.

"Provided, however, that any and all sums to which the above named officers and employees may become entitled under the terms of this resolution shall remain in the business at the risk of the business for a period of five years, and that prior to the expiration of such period said officers and employees shall be entitled to demand and receive payment of the sums to which they may become entitled only to the extent that drawings against such sum may be authorized by the president of the company, it being the intention of this resolution that any and all contingent compensation to which said officers and employees may become entitled under the terms of this resolution, be at the risk of the business in the sense that it shall be subject to pro rata deductions in the event that losses are incurred by the business during the period within which such sums are to remain at the risk of the business; and provided, further, that no officer or employee shall at any time be entitled to withdraw any sums credited to him under the terms of this resolution, except as hereinabove provided, unless he shall remain in the employ of S. Naitove Co., Inc., during the entire period during which the credits mentioned are to remain at the risk of the business, and in the event of the discharge of any such officer or employee or withdrawal during such period, all right, title or interest of such officer or employee in or to any sums credited to said officer or employee under the terms of this resolution shall revert to this corporation."

Appellant kept its books on an accrual basis of accounting, and, in closing the books of December 31, 1919, the entry as to these five employees was computed as follows:

                  Charge, selling and commission ......... $116,548 44
                                                           ===========
                  Credit Moe Naitove ..................... $ 29,137 11
                         Nat Naitove .....................   29,137 11
                         Jack Naitove ....................   29,137 11
                         George Naitove ..................   14,568 56
                         Moe Turnan ......................   14,568 55
                  additional compensation as per agreement
                

The resolution was continued in force during the year 1920 on the same basis as in the year 1919, but in 1920 appellant suffered a loss of approximately $90,000; and pursuant to the resolution the books as of December 31, 1920, showed as to the participation by the five employees the following accruals:

                  Charge Moe Naitove 10% .................. $10,441 42
                  Nat Naitove 10% .........................  10,441 42
                  Jack Naitove 10% ........................  10,441 42
                  George Naitove 5% .......................   5,220 71
                  Moe Turnan 5% ...........................   5,220 71
                                                            __________
                     Credit surplus account ............... $41,765 68
                

Appellant in its return for the year 1919 deducted as expenses from its income the sum of $116,548.44, which represented the portion of the earnings which accrued to said employees pursuant to the terms and conditions of the agreement set forth in the resolution by the board of directors. The Commissioner disallowed this deduction, and on August 19, 1925, notified appellant corporation of a deficiency in its income and profits taxes for the calendar year 1919 of $59,049.33.

From the ruling of the Board of Tax Appeals sustaining the Commissioner, the case comes here on appeal.

The tax in controversy was imposed under the provisions of the Revenue Act of 1918, 40 Stats. 1057.

"Sec. 212. (b) The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income."

"Sec. 232. That in the case of a corporation subject to the tax imposed by section 230 the term `net income' means the gross income as defined in section 233 less the deductions allowed by section 234, and the net income shall be computed on the same basis as is provided in subdivision (b) of section 212 or in section 226."

"Sec. 234. That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions: (1) All the ordinary and necessary 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, and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity."

The accounts under the agreement were kept on the books of appellant on an accrual basis, under which system these items of expense could not accrue until all the events occurred from which liability could be determined and become fixed. In pursuance of this system appellant credited on its books as of December 31, 1919, to its five employees $116,548.44. This represented the portion of appellant's earnings for that year to which the employees would be entitled, in the event the credits equaled or exceeded that amount during the remaining four years. But in 1920 the credits to the employees dropped to $41,765.68, thus demonstrating the total impossibility of determining until the expiration of the five-year period the amount of expense appellant would be entitled to deduct for compensation paid these employees.

Construing the provisions of the income tax law here involved, we are of the opinion that under the accrual system of accounting income may be said to be accrued when it is definitely received, and that likewise liabilities or expenses will be considered to have accrued only when the events...