Schultz v. CIR, 17914.

• Decision Date: 30 May 1960
• Docket Number: No. 17914.,17914.
• Citation: 278 F.2d 927
• Parties: David H. SCHULTZ and Bessie Schultz, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

278 F.2d 927 (1960)

David H. SCHULTZ and Bessie Schultz, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 17914.

United States Court of Appeals Fifth Circuit.

May 30, 1960.

Bert B. Rand, Washington, D. C., Seymour Lieberman, Houston, Tex., for petitioners, Trammell, Rand & Nathan, Washington, D. C., of counsel.

Arthur I. Gould, Fred Youngman, Robert N. Anderson, Lee A. Jackson, Dept. of Justice, Washington, D. C., Rollin A. Transue, Sp. Atty., IRS., Arch M. Cantrall, Chief Counsel, IRS., Washington, D. C., Charles K. Rice, Asst. Atty. Gen., for respondent.

Before RIVES, Chief Judge, and HUTCHESON and BROWN, Circuit Judges.

JOHN R. BROWN, Circuit Judge.

This case presents problems arising under the net worth plus nondeductible expenses method of reconstructing income. On the basis of it, the Commissioner asserted substantial deficiencies against Taxpayer (and his wife), together with penalties for fraud, 26 U.S. C.A. § 293(b), and under 26 U.S.C.A. § 294(d) (1) (B) & § 294(d) (2) 1939 I.R.C. for the years 1946, 1947, 1948 and 1949. The Tax Court approved in principle, though its findings resulted in totals considerably less than those imposed by the Commissioner. The principal attack by Taxpayer is fourfold. First, upon the death of Tax Court Judge Rice, all should have started over again so it was error for Judge Raum to determine the case on the basis of the record heard before Judge Rice. Second, the net worth method was not usable since the Taxpayer in his various enterprises kept a full set of books. Third, under the net worth method, deductions from net worth within the reconstructed tax year should be determined by economic realities, not technical tax deductibility. Fourth, assuming application of the net worth method, as to various items proper treatment was not given. And, of course, to the extent that there was any deficiency remaining, Taxpayer challenged the fraud penalty.

As we are of the view that with respect to several specific items there was an inadequate treatment requiring a remand for further consideration, we find it unnecessary to discuss the facts in any detail. Moreover, since we conclude that the nature of the net worth method with its dovetailing of many seemingly unrelated items calls for a rehearing of the whole, not just specific items, it would be unwise to discuss those details. To the extent that we do, it is largely illustrative for we disavow any purpose here to direct what the Tax Court shall or may do on any one or more or all of the items or issues on remand. At the same time, in the interest of orderly administration and the advancement of a cause now eleven to fourteen years old and destined by the nature of the things to be two or three years older if it makes its way back to this Court, we deem it essential to set forth some controlling principles as to which the parties are at loggerheads.

I.

As there will be a rehearing, we need not pass upon the contention that Judge Raum could not determine the case on the basis of the record before Judge Rice. We mention only that to the many cases urged pro and con¹ should be added MacCrowe's Estate v. Commissioner, 4 Cir., 1959, 264 F.2d 621; 4 Cir., 1958, 252 F.2d 293; 1956, 240 F.2d 841, in which the Fourth Circuit, after three appeals, expressly directed a complete rehearing.

II.

On the question of the use of the net worth method, we have no doubt of two things. First, the Taxpayer while stipulating to many of the factors in the Revenue Agent's net worth statement, clearly preserved his objections to the use of the method. He urges them here and may properly reurge them below on the remand order. Second, the Taxpayer has a basic misconception about the circumstances in which it may be used.

The Taxpayer insists that under § 41² the net income is to be computed in accordance with the method of accounting regularly employed by a taxpayer. Consequently, where a taxpayer keeps books and records, the Commission has the burden of first establishing that the records are faulty or either negligently or fraudulently fail to reflect items of income or disbursements. But this is clearly not so. This Court, with many others, is conscious of the dangers in the use of the net worth method³ and will require that there be adequate evidence⁴ to support a determination that the true income is represented by the process of reconstruction. But once that is satisfied, neither the method nor the evidence undergoes an added scrutiny because the taxpayer's books are to this extent disregarded. Indeed, the determination that the trier of fact had requisite basis for concluding that income was truly that shown by the reconstruction process is a simultaneous determination that no matter how neatly or diligently or consistently or conscientiously kept, the books and records were inadequate. Whatever doubts may have existed prior to Holland v. United States, 1954, 348 U.S. 121, 75 S.Ct. 127, 99 L.Ed. 150, this is what we have now so held, Dupree v. United States, 5 Cir., 1955, 218 F.2d 781, and so have others. Davis v. Commissioner, 7 Cir., 1956, 239 F.2d 187.⁵

Without anticipating what the Tax Court may hold on the record to be made on the rehearing after remand, we think it appropriate to point out that on this record now before us, there was adequate basis for the use of the net worth method. There was, first, the admitted "under the table" payments to the Mexican banana sellers to get bananas then in short supply. There was also the "over the ceiling" (OPA) receipts from American buyers to whom the bananas were sold. On one side of the border at least, these transactions were beyond the border of the law and merited the closest scrutiny since these excess payments and receipts were nowhere recorded. Similarly, one of Taxpayer's banana enterprises computed its distributable income to Taxpayer and his partners on an arbitrary 5% of the sales price received. This is what the books showed and on them, the tax returns were prepared. The sale and purchase records showing detailed delivery shipments by specific vessels from Mexico and the like sales of the same bananas to American buyers showed, however, that the price paid by Taxpayer's group to the Mexican vendors exceeded the price received from American buyers by $256,961.54. As it was uncontradicted that Taxpayer never sold to American buyers for a price less than that paid to Mexican vendors, the books understated income by at least 5% on this excess. More important, the net worth statements for at least two of the years established without doubt substantial income in excess of that shown by the books.⁶

III.

To afford a more tangible basis on which to discuss the Taxpayer's third contention, it is helpful to refer briefly to a few of the items as to which, under ground four, Taxpayer makes specific complaint.

One may be described as the Haitian banana deal which turned out to be less of a banana bonanza than all thought. In 1947 Taxpayer with another American was importuned to acquire a 50% interest in an exclusive franchise for the purchase and shipment of 120,000 stems of bananas a month from the southern peninsula of Haiti. The other 50% was to go to persons high in or close to those in the Haitian Government. Taxpayer's share of the payment for the franchise was $67,500. The franchise was assigned to a Haitian corporation formed for that purpose. The stock was thereafter issued 50% to Taxpayer and his ally and 50% to the Haitian promoters. It is a brief, but fair, summary to say that the Haitians took off for Paris with all of the funds, and after a few months' operations at not more than 40,000 stems per month, the enterprise collapsed. One thing the banana investors learned about Haitian banana promotional schemes was that apparently the franchise was not very exclusive. If it was not virtually worthless by the end of 1947, the year of the investment, it seems assuredly so at the beginning or during the next year, 1948. In the net worth statement, this $67,500 was shown as an addition to assets in the year 1947. It was carried throughout each succeeding year, 1948 and 1949.

Another item was the Schalker indebtedness. This represented genuine indebtedness of Schalker to Taxpayer incurred from moneys advanced by Taxpayer as he undertook in 1944 his new and brief business of lending as a factor. This was included as an opening asset for $18,117.01 in the January 1, 1946 opening statement. It was singled out for special treatment by Taxpayer because in 1947 Schalker filed a petition in bankruptcy. He was adjudged a bankrupt and discharged in 1947. It took a number of years to wind up the estate, but it seems quite clear that within the year of bankruptcy (or at least 1948), the maximum probable recovery by unsecured creditors was known or ascertainable to be substantially that ultimately recovered (6%) in 1953. Nevertheless it was carried as an asset at the full original value ($18,117.01) through the three net worth years, 1947, 1948, 1949.

Before the Tax Court and represented then by different counsel, Taxpayer urged that each of these items was deductible in the traditional income tax sense. The Haitian banana deal was urged as a loss by theft or fraud under § 23(e) (3). 26 U.S.C.A. § 23(e) (3) 1939 I.R.C.. This was rejected by the Tax Court largely because Taxpayer had failed to show a requisite criminal act under Haitian law albeit the Tax Court, all counsel and this Court, labor with the vague expert testimony on what that law is. Likewise, looking at it in terms of the last act giving rise to the payment of the $67,500 the Tax Court treated it as an investment in corporate stock not shown to have become worthless. The Schalker factor loan was urged as an inclusion in 1946 opening net worth and a deduction in 1947, the year of bankruptcy, as a business bad debt under § 23(k) (1). 26 U.S.C.A. § 23(k) (1) 1939 I.R.C.. The Tax Court held that since...