Commissioner of Int. Rev. v. RJ Reynolds Tobacco Co., 7659.

• Decision Date: 06 October 1958
• Docket Number: No. 7659.,7659.
• Citation: 260 F.2d 9
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. R. J. REYNOLDS TOBACCO COMPANY, Respondent.
• Court: U.S. Court of Appeals — Fourth Circuit

260 F.2d 9 (1958)

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. R. J. REYNOLDS TOBACCO COMPANY, Respondent.

No. 7659.

United States Court of Appeals Fourth Circuit.

Argued June 12, 1958.

Decided October 6, 1958.

Thomas N. Chambers, Atty., Dept. of Justice, Washington, D. C. (Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson and A. F. Prescott, Attys., Dept. of Justice, Washington, D.C., on the brief), for petitioner.

Marion N. Fisher, New York City, and Leon L. Rice, Jr., Winston-Salem, N. C. (Philip C. Potter, Jr., Davis, Polk, Wardwell, Sunderland & Kiendl, New York City, and Womble, Carlyle, Sandridge & Rice, Winston-Salem, N. C., on the brief), for respondent.

Before SOBELOFF, Chief Judge, and SOPER and HAYNSWORTH, Circuit Judges.

SOBELOFF, Chief Judge.

In the years 1949 and 1950, the R. J. Reynolds Tobacco Company claimed deductions in its income tax returns for amounts distributed to its employees pursuant to one of its by-laws. Although the employees shared in the fund in proportion to their stockholdings in the company, it claimed that the payments were compensation for services and for that reason deductible as an ordinary and necessary expense. The Commissioner of Internal Revenue disallowed the claims and the taxpayer sought review in the Tax Court. From the judgment of that court allowing deductions for part of the payments, the Commissioner appeals.

The by-law was originally adopted in August, 1912, before the adoption of the Sixteenth Amendment and the advent of income tax laws. It provided for an annual payment, in the discretion of the board of directors, to those Reynolds officers and employees who had been in the company's employ and had owned its stock for at least twelve months. The total payments were not to exceed ten percent of the company's profits in excess of those earned in 1910 and were to be apportioned among the officers and employees according to their respective holdings of shares of the company's stock. The payments were in addition to their regular salaries, and in addition also to the regular dividends paid to all stockholders including employees.

In proposing the by-law, the Reynolds' management stated:

"After full consideration, the Board of Directors have determined that the interest of the Company and all of its stockholders will be materially advanced by encouraging its officers and employees, a number of whom are not stockholders, to invest in its stock and to be thus more closely identified with its affairs."

Following the passage of the by-law, the company began acquiring stock for sale to its employees. The management's aim was to place stock with employees who were doing a good job, showed promise of becoming more valuable to the company, filled more important positions, and had the interest of the company "at heart." In 1935, however, Reynolds was forced to discontinue the sale of its stock to employees because of certain restrictive regulations of the Securities and Exchange Commission. Thereafter, although the management was unable directly to supervise employee stock acquisitions, it continued to check on the amount of stock employees were acquiring, and to make known its displeasure with those employees who purchased too much. Even this general supervision was relaxed when it became known in 1949 that the by-law was gradually passing out of existence, although as late as 1950 employees understood that they were not to purchase stock without consulting a superior.

Despite supervision by management, some employees came through the years to own amounts of stock which, it cannot be denied, failed to represent a fair and reasonable relation to their value to the company. Such cases resulted in the main from inheritances, gifts, purchases without management approval, failure of some employees to fulfill their original promise, and stock dividends and splits in the earlier years.

Nevertheless, management felt that the instances of excessive holdings did not affect the general satisfactory operation of the by-law. By looking to the by-law payments to provide additional income for such personnel, Reynolds was able to employ and retain competent supervisory and executive personnel, despite the fact that it paid relatively low fixed salaries.

The by-law remained substantially unchanged until June 29, 1949, when it was amended to provide for the gradual elimination of the special payments. The amendment called for the special participation in profits to be reduced from ten percent to zero, at the rate of one percent per year, so that after 1958 such payments would be terminated. As a result of the impending reduction in the by-law payments, the company began in 1949 to liberalize its basic salary scales.

Before 1949, Reynolds never claimed any income tax deductions for the bylaw payments and it did not withhold and remit to the Commissioner any part of the by-law payments as withholding taxes or employment taxes. In 1949 and 1950, the company made such withholdings and filed appropriate information returns, reporting such payments as part of the employees' compensation. On the same theory it simultaneously filed claims for refund of income or excess profits taxes for past years, 1940 through 1948. The Commissioner disallowed both the deductions for 1949 and 1950 and the claimed refunds for the earlier period. The Court of Claims was asked to review the denial of refunds in the earlier years, and the Commissioner's disallowance of deductions for 1949 and 1950 was brought in due course to the Tax Court for review.

The Tax Court was convinced that part of the 1949 and 1950 payments were reasonable compensation. Because Reynolds was unable to prove the exact portions of each employee's payments which were reasonable, the Tax Court, "having in mind the principle of Cohan v. Commissioner, 2 Cir., 1930, 39 F. 2d 540, and in the exercise of our best judgment," devised a formula by which it determined what amounts were reasonable compensation. For 1949 the Commissioner had determined deficiencies of $1,063,555.43, and for 1950 $1,275,510.88. These deficiencies were reduced by the Tax Court to $657,618.28 and $727,134.48 respectively for the two years.

After the Tax Court's decision as to the 1949 and 1950 payments, the Court of Claims, taking a somewhat divergent view, affirmed the Commissioner's disallowance of the refund claims for the years 1940 through 1948. R. J. Reynolds Tobacco Co. v. United States, Ct. Cl., 149 F.Supp. 889, 897. In an effort to minimize the conflict between the decisions of the two courts, the Court of Claims, speaking of the Tax Court's decision, said:

"We think it would be proper to note at this time that we are not unmindful of the tax court decision in R. J. Reynolds Tobacco Company v. Commissioner, T. C. Memo 1956-161, decided July 6, 1956, in which that court decided that part of the bylaw payments for the years 1949 and 1950 were reasonable compensation and devised a formula to determine just what part of the payments represented reasonable compensation. However, the court in that case was deciding the nature of the payments made pursuant to a different bylaw, on a different record, and for different years than the ones in question here."

In this appeal, to fortify his arguments that the payments in the latter years were not deductible, the Commissioner uses in large measure reasons which the Court of Claims gave for finding Reynolds not entitled to a refund for the earlier years.

1. The Commissioner's initial contention here is that the Tax Court committed error in holding part of the bylaw payments to be compensation and part dividends. While it is certain that the Tax Court held only part of the payments deductible as reasonable compensation, its opinion does not make it completely clear whether the excess was designated as dividends or merely as unreasonable compensation. We will assume, however, in accordance with the Commissioner's contention, that the Tax Court did regard the non-deductible part of the payments as dividends.

The Commissioner earnestly submits that such a division cannot be made because all the payments were necessarily of the same nature, and hence either all dividends or all compensation. To fortify this contention, he relies upon the following language from page 895 of the Court of Claims opinion in the Reynolds case in 149 F.Supp.:

"* * * However, conceding that the plan was designed for incentive purposes, the payments must have been reasonable compensation and not dividends in order to be deductible under section 23(a) (1) (A) of the Internal Revenue Code of 1939 because the two were mutually exclusive."

We agree that compensation and dividends are different things, but that is not to say that for income tax purposes the payor is to get no deduction at all if an employee stockholder, is given compensation and dividends in a single payment. There is precedent for the view that a lump sum may be partly compensation for services and partly dividends; and that in such a case the compensatory part should be allowed as a deduction while only the excess should be disallowed. Botany Worsted Mills v. United States, 278 U.S. 282, 49 S.Ct. 129, 73 L.Ed. 379; United States v. Philadelphia Knitting Mills Co., 3 Cir., 273 F. 657; Becker Bros. v. United States, 2 Cir., 7 F.2d 3.

If there is a reasonable basis in the record for isolating that part of the payment which is reasonable compensation for services, we think that a deduction for that part should be allowed. This is true whether the excess is classified as unreasonable compensation or as dividends. There is no basis in reason, the Tax Code, or administrative practice for the insistence that the part which is not deductible fatally infects the part which clearly is.

2. Next, the Commissioner argues that the Tax Court failed to apply the proper legal test of compensation. Section 23 of the Internal Revenue Code of 1939, 26 U.S.C.A. § 23, which is here...