Cooke v. COMMISSIONER OF INTERNAL REVENUE, 4496.

• Decision Date: 14 April 1953
• Docket Number: No. 4496.,4496.
• Citation: 203 F.2d 258
• Parties: COOKE v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Tenth Circuit

203 F.2d 258 (1953)

COOKE v. COMMISSIONER OF INTERNAL REVENUE.

No. 4496.

United States Court of Appeals Tenth Circuit.

January 3, 1953.

Rehearing Denied April 14, 1953.

COPYRIGHT MATERIAL OMITTED

John H. Cantrell, Oklahoma City, Okl. (Edward M. Box, Oklahoma City, Okl., on the brief), for petitioner.

Carlton Fox, Special Asst. to the Atty. Gen. (Charles S. Lyon, Ass't Atty. Gen., and Ellis N. Slack, Special Ass't to the Atty. Gen., on the brief), for respondent.

Before HUXMAN, MURRAH and PICKETT, Circuit Judges.

PICKETT, Circuit Judge.

This is a proceeding to review a decision of the Tax Court which fixed deficiencies in petitioner's (herein referred to as taxpayer or Cooke) income tax for the years 1941 and 1943, at $46,239.86 and $70,995.51 respectively. The appeal presents two primary issues: 1, whether, within the meaning of the statute,¹ credits on the taxpayer's books for the purpose of sharing 1941 business profits with key employees constituted "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business"; and 2, whether the taxpayer had, for income tax purposes, entered into a partnership with his key employees as of January 1, 1943.

Since 1908 the taxpayer had been engaged as an individual in roofing and sheet metal work, doing business under the firm name of C. C. Cooke, Company. Through the years the taxpayer had acquired key employees. These were highly entrusted individuals who supervised work and assisted in managerial duties. They were paid whether or not there was work to be done. From 1930 on, work was scarce but the company made a profit through 1940 except for the years 1932 and 1933. In 1941 these key employees included J. C. Leister, manager of the branch office in Texas, who received a salary and a share of the profits; L. E. Hodges, a mechanic and roofer who supervised certain construction projects; J. P. Ground, a laborer who supervised the fabrication of materials to be erected on jobs; Clint C. Cooke, Jr., taxpayer's son, who supervised the work of different contracts; and Charles H. DeLaughter, bookkeeper. Prior to 1941, all of these employees were paid salaries and bonuses comparable to those paid by other organizations similar to that of the taxpayer. For a considerable time prior to 1941, Cooke had induced these employees to stay with his organization upon his promise that when the profits of the business were adequate, there would be a division among them. There was a profit in the 1940 business but due to pressing obligations the taxpayer prevailed upon the employees to waive any claim for participation in them.

It was apparent that there would be a substantial profit in 1941 from war contracts in which Cooke was associated. In July of that year taxpayer requested DeLaughter to determine whether the revenue laws would allow amounts paid out to employees on a profit sharing arrangement to be deducted as ordinary and necessary business expenses in computing income tax. DeLaughter reported that he found nothing which would prohibit the allowance of such amounts. The business profits for 1941 were $126,456.66. On February 24, 1942, DeLaughter was directed by the taxpayer to credit on the books of the company 20% of the total profits to the accounts of Cooke, Jr., 20% to Ground, 5% to Hodges and 5% to DeLaughter. Prior to this time there had been no definite agreement or understanding as to what the division would be. The following day DeLaughter was advised by the taxpayer that he had not been with the organization long enough to warrant his sharing in the profits and he was directed to credit Hodges with 10% instead of 5%, and DeLaughter was not to participate until the following year.² When these credits were made on the books, an entry was then made charging salary expenses with the amount of the credits. The explanation of the entry classified the amounts as distributions of profit in accordance with an agreement of January 1, 1941, without any statement that it was additional compensation for services rendered during prior years. In computing the amounts, no deductions were made for salaries already paid during any of the previous years. Income tax returns were prepared by DeLaughter for each of the employees on a cash basis, and checks were drawn on the company to pay the taxes, both state and federal, and charged against the account of each employee. These returns included the amounts credited to the employees and they were treated as income for personal services for the year 1941. The taxpayer was on an accrual basis and reported his gross income for the year 1941 as $168,209.14 and deducted for salaries $78,330.91, which included the division of profits. The Commissioner disallowed the item of $63,228.34 upon the grounds that payment was not an ordinary and necessary expense of the business or a reasonable allowance for salaries or other compensation for personal services actually rendered, and that the allowances "were made solely for the purpose of avoiding income tax and not for the purpose of setting up bona fide credits" to the employees. The Commissioner also assessed the usual fraud penalty. The Tax Court was of the view that there was no enforceable agreement for the payment of the amounts in question in addition to the regular salaries, and further that if there were such an agreement, the amounts paid were unreasonable and excessive. The Tax Court did not assess a fraud penalty. Otherwise, there was no substantial difference between the Commissioner's action and the finding of the Tax Court.

Considering all the evidence, we agree that there was no enforceable agreement between the employees and the taxpayer prior to 1942 which would require the division of the profits of 1941. It is true that there had been considerable discussion in prior years concerning the participation of certain employees in the profits of the business. For the purpose of inducing the employees to remain with the company, they were told that at some time in the future a profit sharing arrangement would be devised. When this was to be done and how it was to be done were never determined. This is evidenced by what happened in February of 1942 when the division of the 1941 profits was decided upon. The division was not the result of an agreement or even a discussion with the employees but was fixed as the taxpayer thought best. Even after he had determined a division which he thought proper, he made a change without consulting anyone and increased the percentage of one employee and eliminated the share of another. This division was not made until after the taxpayer had assured himself that he would be able to deduct the amounts from his gross income in 1941. It was also a condition that the employees who were receiving the profits should include them in their income tax return for 1941 in order to correspond with the deductions as shown by the company books. The employees were on a cash basis and they should have included the amounts in their 1942 returns, as they constructively received the allowances when the credits were made to their accounts. Eckhard v. Commissioner of Internal Revenue, 10 Cir., 182 F.2d 547, 551; Treasury Regulations 111, Sec. 29.42-2.

The taxpayer and the employees testified as to an alleged agreement or understanding for the division of profits, but it is well settled that the trial court is not bound by the declaration of a purpose made by interested parties and is free to conclude from all the facts what the real situation was. Helvering v. Chicago Stock Yards Co., 318 U.S. 693, 701, 63 S.Ct. 843, 87 L.Ed. 1086; Helvering v. National Grocery Co., 304 U.S. 282, 295, 58 S.Ct. 932, 82 L.Ed. 1346; United States v. Washington Dehydrated Food Co., 8 Cir., 89 F.2d 606, 609; Treasury Regulations 103, Sec. 19.23(a)-6.³ Without attempting to further detail the evidence, we think it sufficient to say that the record discloses ample evidence to sustain the findings of the Tax Court. From what has been said, it is clear that the relationship between the parties was that of employer and employee and there is no merit to the contention that the parties were engaged in a joint adventure during the years 1941 and 1942.

The Commissioner makes some contention that the credits to the accounts of the employees were not real and that the money which they represented was never actually owned or controlled by the employees. The record does not support this contention. The undisputed evidence is that the credits were made on the books of the company and that the employees could have made withdrawals if they desired. The fact that the money was not withdrawn and remained in the company and was later used to purchase an outright interest therein did not change the reality of the accounts.

This leaves for consideration the question of whether the credits together with the fixed salaries and bonuses received by the employees constituted reasonable compensation.⁴ The question of reasonableness is one of fact to be determined in the first instance by the trial court. In re Rae's Estate, 3 Cir., 147 F.2d 204, 208; Burford-Toothaker Tractor Co. v. Commissioner of Internal Revenue, 5 Cir., 192 F.2d 633, certiorari denied 343 U.S. 941, 72 S.Ct. 1033; American Pitch Pine Export Co. v. Commissioner of Internal Revenue, 5 Cir., 188 F.2d 721, 723. The Tax Court found that the amounts credited to the employees were unreasonable and disproportionate to compensation generally paid to like employees for similar services. These findings should not be set aside unless they are clearly erroneous. Burford-Toothaker Tractor Co. v. Commissioner of Internal Revenue, supra; Davis v. Commissioner of Internal Revenue, 3 Cir., 161 F.2d 361. The fact that the petitioner fixed the compensation or agreed upon it with his key employees, does not bind the Tax Court. Helvering v....