Drybrough v. Commissioner of Internal Revenue

• Decision Date: 03 December 1956
• Docket Number: 12748.,No. 12747,12747
• Parties: F. W. DRYBROUGH, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. L. N. SIMPSON, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Sixth Circuit

238 F.2d 735 (1956)

F. W. DRYBROUGH, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

L. N. SIMPSON, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 12747, 12748.

United States Court of Appeals Sixth Circuit.

December 3, 1956.

Donald V. Hunter, Washington, D. C., Miller & Chevalier, Washington, D. C., of counsel, for petitioners.

S. Dee Hanson, Washington, D. C., Charles K. Rice, Lee A. Jackson, Robert N. Anderson, Dept. of Justice, Washington, D. C., on the brief, for respondent.

Before SIMONS, Chief Judge, and MARTIN and STEWART, Circuit Judges.

STEWART, Circuit Judge.

These are petitions to review decisions of the Tax Court in consolidated proceedings. The facts are set out in detail in that court's findings and opinion. 1955, 23 T.C. 1105 (sub nom. United Mercantile Agencies, Inc.).

Stripped of details, the facts are appallingly simple. The petitioners owned or controlled all the stock of a corporation engaged in the business of conducting a collection and mercantile agency. The corporation and both petitioners kept their books and filed their tax returns on the cash basis. During the years 1942 through 1946 the petitioners systematically removed from the corporation's incoming mail basket checks payable to the corporation, cashed them and divided the proceeds. These secretly diverted funds, amounting to more than $200,000 over the five year period, were not reflected upon the corporation's records or tax returns and were not reported by the petitioners on their individual returns.

Since the appropriated checks represented either fees for collection services or final payments on purchased accounts, the costs of which had been recovered, they constituted income to the corporation and were subject to a ninety-five per cent excess profits tax. The petitioners took the checks in order to evade the payment of this corporate tax.

Their defalcations were brought to light by an internal revenue agent in 1946. The corporation and each of the petitioners were subsequently indicted in the United States District Court for the Western District of Kentucky and jointly charged with knowingly and willfully attempting to defeat the corporation's federal taxes for the years involved. Pleas of nolo contendere were entered, and all three defendants were fined. In addition, both of the petitioners were sentenced to prison. After their release from prison they restored to the corporation the full amount they had taken.

The Commissioner asserted deficiencies and civil fraud penalties of approximately $300,000 against the corporation for failure to report receipt of the diverted funds in its income and excess profits tax returns for the years in which the diversions occurred. The Commissioner further determined that the abstracted funds constituted taxable dividends to the petitioners, and accordingly asserted deficiencies and fraud penalties of more than $300,000 against them individually. The Tax Court upheld the Commissioner's determinations against the corporation, and no petition for review of that decision has been filed by the corporation. The Tax Court also sustained the Commissioner's determinations of deficiencies and fraud penalties against the petitioners personally, deciding that the funds diverted were taxable as dividends to them (except to the extent that one of the petitioners received such funds attributable to stock belonging to his wife), and that at least part of the deficiencies was due to fraud with intent to evade tax.

On this review the petitioners attack the Tax Court's decisions upon several alternative grounds. They argue that in diverting the corporate funds they were acting merely as officers and agents of the corporation in furthering its criminal purpose of evading its taxes. But if the conclusion be reached that they were acting for their own benefit, they say that they were embezzlers and that the purloined checks were therefore not taxable to them. Commissioner v. Wilcox, 1946, 327 U.S. 404, 66 S.Ct. 546, 90 L.Ed. 752. In any event, they contend that funds which from the beginning were owed to the United States cannot be taxed both as income to the corporation and as dividends to them, particularly where, as here, the amounts were returned in full to the corporation, the deficiencies and penalties assessed against the corporation more than exhausted those funds, and the corporation was thereby rendered insolvent. As to the fraud penalties, the petitioners concede that they were guilty of fraud with respect to the corporation's returns, but maintain that there was no proof of fraud in their personal returns because there was no evidence that they knew they had personally received taxable income when they secretly abstracted checks payable to the corporation.

Before turning to these arguments, it is appropriate to observe that there is not before us in this case any issue as to the petitioners' criminal culpability. It is abundantly clear that the petitioners carried out a deliberate and calculated scheme to cheat their government out of substantial tax revenues at a time when honest taxpayers were called upon to pay levies of unprecedented magnitude; and many citizens were making far greater sacrifices in the waging of a world war. For their criminal conduct they have been punished by fines and imprisonment. Moreover, much more than the full amount abstracted has already been assessed in favor of the government by way of the deficiencies, penalties and interest determined against the corporation. The sole question here is the extent of the petitioners' individual civil liability for taxes and penalties, and the correct resolution of that question will not be promoted by the importation of punitive concepts. The decisions in criminal cases relied on by the respondent are consequently of little assistance in deciding the issue before us. See e. g., Davis v. United States, 6 Cir., 1955, 226 F.2d 331, certiorari denied 1956, 350 U. S. 965, 76 S.Ct. 432; Currier v. United States, 1 Cir., 1948, 166 F.2d 346; Jolly v. United States, 6 Cir., 1956, 229 F.2d 180, certiorari denied 1956, 351 U.S. 963, 76 S.Ct. 1024.

The petitioners contend that since their purpose in taking the corporation's checks was to evade the payment of the corporation's tax, as the Tax Court found, they were merely acting as agents in promoting the fraud of the corporation, owing at all times a duty to hold the funds subject to the demands and needs of the corporation, and that therefore they cannot be charged with the receipt of income. Cf. Lashells' Estate v. Commissioner, 6 Cir., 1953, 208 F.2d 430. This argument is completely specious. Whatever their initial motives may have been, it clearly appears that through the fraudulent transactions in which they were engaged the petitioners received money over which they had complete and unrestricted control, which they took and treated as their own, and for which they doubtless never would have been required to account had it not been for the discovery of their fraud.

Alternatively, the petitioners argue that the funds they received were embezzled by them and therefore did not constitute taxable income under the rule of Commissioner v. Wilcox, 1946, 327 U.S. 404, 66 S.Ct. 546, 90 L.Ed. 752. The petitioners point out that twenty per cent of the common stock of the corporation was owned by the wife of one of them, who did not even learn of the withdrawals until 1947 after their discovery by the internal revenue agent. They further argue that their actions constituted embezzlement under the law of the state where they took place. Reinicke v. Bailey, 1908, 112 S.W. 569, 33 Ky.Law Rep. 977.

How much vitality continues to reside in the Wilcox rule since the Supreme Court's decision in Rutkin v. United States, 1952, 343 U.S. 130, 72 S.Ct. 571, 96 L.Ed. 833, is a question not easy to answer. Compare Kann v. Commissioner, 3 Cir., 1954, 210 F.2d 247, certiorari denied 1954, 347 U.S. 967, 74 S.Ct. 778, 98 L.Ed. 1109, with J. J. Dix, Inc. v. Commissioner, 2 Cir., 1955, 223 F.2d 436, certiorari denied 1955, 350 U.S. 894, 76 S.Ct. 150.¹ We are convinced in any event that whatever authority the Wilcox rule retains is too narrow to encompass the facts of the present case. The petitioners were not employees who embezzled from an unwitting employer, but officers, directors and stockholders in complete domination and control of their corporation. We think the Tax Court was clearly correct in concluding that the petitioners took the corporation's funds under a claim of right and with the implied consent of the corporation. North American Oil Consolidated v. Burnet, 1932, 286 U.S. 417, 52 S.Ct. 613, 76 L.Ed. 1197; United States v. Lewis, 1951, 340 U.S. 590, 71 S.Ct. 522, 95 L.Ed. 560; Rutkin v. United States, 1952, 343 U.S. 130, 72 S.Ct. 571, 96 L.Ed. 833; Healy v. Commissioner, 1953, 345 U.S. 278, 73 S.Ct. 671, 97 L.Ed. 1007.²

Yet, even though received by petitioners under a claim of right, the funds are taxable as dividends only to the extent that the corporation had earnings and profits for the years in which they were withdrawn. Section 115(a) Internal Revenue Code of 1939, 26 U.S. C.A. § 115(a); Commissioner v. Timkin, 6 Cir., 1944, 141 F.2d 625, 630; United States v. Lesoine, 9 Cir., 1953, 203 F.2d 123, 125; Charles G. Duffy, 1943, 2 T.C. 568, 569.

The Tax Court held that in determining the earnings and profits available for dividends the corporation's tax liabilities could not be considered, because the corporation kept its books on the cash basis. We are not convinced that the corporation's accounting method requires such a conclusion.

Whether a corporation keeps its accounts and makes its returns on the cash or accrual basis is a question generally relevant only in determining its own income and deductions as a taxpayer. Section 41, Internal Revenue Code of 1939, 26 U.S.C.A. § 41; United States v. Anderson, 1926, 269 U.S. 422, 46 S.Ct. 131, 70...