Leonhart v. Commissioner, Docket No. 6743-65.

• Decision Date: 27 May 1968
• Docket Number: Docket No. 6743-65.
• Parties: William H. and Martha C. Leonhart v. Commissioner.
• Court: U.S. Tax Court

27 T.C.M. (CCH) 443 (1968)

T.C. Memo. 1968-98.

William H. and Martha C. Leonhart v. Commissioner.

Docket No. 6743-65.

United States Tax Court.

Filed May 27, 1968.

Chapman H. Belew, Jr., for the petitioners. Charles F. T. Carroll, for the respondent.

Memorandum Findings of Fact and Opinion

KERN, Judge:

Respondent determined deficiencies in petitioners' income tax and additions to tax in the following amounts for the following years:

                                              Income tax  Additions to tax
                  Year                        deficiency   Sec. 6653(a)
                  1960....................    $24,611.16    $1,230.56
                  1961....................     19,884.64       994.23
                

The hearing of this case occupied six days. Over 200 exhibits were introduced by the parties. A very large number of relatively small factual questions of a type usually settled by counsel before or during the trial of a case remain unresolved.

Petitioner William H. Leonhart is the sole shareholder of Leonhart and Co., Inc., sometimes hereinafter referred to as Leonhart, Inc., which was in the years in question a qualifying small business corporation under Subchapter S of the Internal Revenue Code of 1954. The deficiencies in petitioners' tax relate both to adjustments made with respect to income of Leonhart, Inc., attributable to these petitioners and to disallowed deductions claimed on account of expenditures made by petitioners in their individual capacities.

Concessions have been made by both sides. The many issues remaining for our determination may be stated or classified as follows:

1. Whether the statute of limitations precludes the respondent from adjusting petitioners' income in 1960 and 1961 by reason of adjustments in the income of Leonhart, Inc., in those years.

2. Whether petitioners are entitled to certain charitable deductions for the years 1960 and 1961 in addition to those allowed by the Commissioner.

3. Whether Leonhart, Inc.'s change in its method of accounting with respect to its reporting of certain commission income from the American Fire and Casualty Company in 1960 and continuing in 1961 without the consent of the Commissioner requires its income to be recomputed under its prior method of accounting for this item for 1960 and 1961.

4. Whether Leonhart, Inc., is entitled to deductions in addition to those allowed by the Commissioner for amounts paid to Harold's sons Bill and Jay in 1960 and 1961 as salary and for employment taxes paid by it with respect thereto.

5. Whether Leonhart, Inc., is entitled to deduct in 1960 as part of its advertising expenses payments incident to publishing the biography of the founder of the Civitan Club International.

6. Whether Leonhart, Inc., is entitled to deduct any amounts for depreciation and expenses relating to the "Leonhart Music Club" for 1960 and 1961.

7. Whether Leonhart, Inc., is entitled to deductions claimed for automobile expense and depreciation in 1960 and 1961 in addition to those allowed by the Commissioner, and for the loss on a sale of an automobile.

8. Whether Leonhart, Inc., is entitled to a deduction for legal expenses paid in 1961 in addition to that allowed by the Commissioner.

9. Whether petitioners or Leonhart, Inc., are entitled to deductions for various items claimed to be travel and entertainment expenses for 1960 and 1961 in addition to those allowed by the Commissioner.

10. Whether certain alleged deductions are claimed for the first time on brief and are therefore not to be allowed in this proceeding.

11. Whether Leonhart, Inc., may properly deduct as a business expense a part of the cost of maintaining petitioners' summer house in 1960.

12. Whether petitioners are subject to additions to tax in 1960 and 1961 under section 6653(a), I. R. C. 1954.

General Findings of Fact

Some of the facts have been stipulated, and they, together with attached exhibits, are found to be as stipulated.

Petitioners, husband and wife, are residents of Baltimore, Maryland. For the taxable years 1960 and 1961 they timely filed joint income tax returns with the district director of internal revenue at Baltimore, in which they reported for 1960 adjusted gross income in the amount of $58,903.05 and taxable income in the amount of $40,870.95 and for 1961 adjusted gross income in the amount of $67,893.38 and taxable income in the amount of $49,175.95. The notice of deficiency sent to petitioners under date of August 27, 1965, stated deficiencies based upon respondent's determination that petitioners' corrected taxable income for 1960 was $80,190.30 and for 1961 was $81,191.31, resulting from the following adjustments:

                ---------------------------------------------------------------------------------------
                                                                                  1960          1961
                  Taxable income as disclosed by return....................    $40,870.95    $49,175.95
                  Unallowable deductions and additional income
                     (a) Subchapter S Corporation income understated.......     38,506.26     32,212.22
                     (b) Contributions ....................................        419.60        265.00
                     (c) Exemption ........................................        600.00     
                                                                               __________    __________
                            Total .........................................    $80,396.21    $81,653.17
                  Nontaxable income and additional deductions
                     Dividends ............................................        205.91        202.26
                     Casualty loss ........................................     .........        259.60
                  Corrected taxable income ................................    $80,190.30    $81,191.31
                ---------------------------------------------------------------------------------------
                

Petitioner William H. Leonhart, sometimes hereinafter referred to as Harold, is and was during the period in question the sole shareholder of Leonhart, Inc. On January 30, 1960, Leonhart, Inc., elected to be taxed as a small business corporation under section 1372 of the Internal Revenue Code of 1954, which election remained effective for 1960 and 1961. In those years Leonhart, Inc., filed timely tax returns required of electing small business corporations. While Leonhart, Inc., had a board of directors and officers (such as Vice Presidents,¹ Treasurer and Secretary), Harold had not only the ultimate control over it by reason of his ownership of all of its stock but also complete operational control over all phases of its business.

Leonhart, Inc., was incorporated under the laws of Maryland in 1953. During 1960 and 1961 the primary business of Leonhart, Inc., was that of reinsurance brokerage. Reinsurance is, broadly speaking, a method by which an insurance company can reduce its potential liability on an insurance policy or group of policies it has issued by itself contracting with a reinsurance company so that the latter assumes a portion of the risk initially assumed by the former.

Leonhart, Inc., filed its federal income tax returns for its calendar years 1960 and 1961 and kept its books on a cash basis with the exception of one item of income hereinafter described in some detail.

Two basic types of reinsurance contracts, sometimes known as treaties, are "excess of loss" and "quota share" contracts. On an "excess of loss" contract the reinsured assumes all the risk up to a certain amount and the reinsurer agrees to assume all liability in excess of that figure. Under a "quota share" contract the reinsurer assumes a percentage of the risk from "the ground up."

The role of Leonhart, Inc., as a reinsurance broker was to bring together insurance companies desiring reinsurance (buyers) and reinsurance companies (sellers) who would be willing to assume a part of the risk of the primary insurer in return for the payment to them of a part of the premiums paid by the insured to the primary insurer. Leonhart, Inc., placed a large proportion of its business with syndicates of insurance underwriters associated with Lloyd's of London although it dealt also with American and other European reinsurers. Leonhart, Inc., placed reinsurance with them through any one of four or five brokers authorized "to go on the floor at Lloyd's and place business." At various times Leonhart, Inc., has dealt with reinsurance companies located in the United States, England, Germany, France, Belgium, the Netherlands, Italy, the Scandinavian countries and Switzerland.

Generally, American reinsurance companies require the reinsured to remit the reinsurance premiums directly to them, out of which the broker is paid, whereas European reinsurance companies rely on the broker to collect the reinsurance premiums and, after deducting the commission due, to pay the premiums over to them. The commissions Leonhart, Inc., receives run about 2 or 2½% of the premiums paid by the reinsured on a "quota share" contract and from 5 to 10% on an "excess of loss" contract since the premiums payable to the reinsurer under the latter would be a lower percentage of the premiums paid to the primary insurer than those under a "quota share" contract. Leonhart, Inc., reported commission income for 1960 of $186,442.93 and for 1961 of $210,990.95, derived from reinsurance contracts obtained by it for domestic insurers located in many parts of the United States. Leonhart, Inc., ranks about tenth in volume of reinsurance placed by the approximately 100 reinsurance intermediaries in this country.

Harold, in addition to being the sole shareholder of Leonhart, Inc., was also the sole shareholder of Leonhart and Company of Maryland, hereinafter sometimes referred to as Leonhart of Maryland, which was incorporated under the laws of that state in 1951. Leonhart of Maryland was formed in order to conduct the insurance brokerage business formerly handled by Leonhart, Inc., which from that time dealt almost exclusively in reinsurance brokerage.

Southern Underwriters, Inc., hereinafter sometimes referred to as...