Tulia Feedlot, Inc. v. U.S.

• Decision Date: 02 June 1975
• Docket Number: No. 74-1928,74-1928
• Citation: 513 F.2d 800
• Parties: 75-2 USTC P 9522 TULIA FEEDLOT, INC., Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 800

513 F.2d 800

75-2 USTC P 9522

TULIA FEEDLOT, INC., Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 74-1928.

United States Court of Appeals Fifth Circuit.

June 2, 1975.

Frank D. McCown, U. S. Atty., Ft. Worth, Tex., Robert B. Wilson, Asst. U. S. Atty., Lubbock, Tex., Louis A. Bradbury, Scott P. Crampton, Asst. Atty. Gen., Ernest J. Brown, Meyer Rothwacks, Chief, App. Sec., U. S. Dept. of Justice, Tax Div., Washington, D. C., Lawrence R. Jones, Jr., William W. Guild, Dept. of Justice, Tax Div., Dallas, Tex., for defendant-appellant.

Clarence P. Brazill, Jr., Lubbock, Tex., for plaintiff-appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before WISDOM and DYER, Circuit Judges, and KRAFT ^*, District Judge.

WISDOM, Circuit Judge:

Tulia Feedlot, a closely-held Texas business corporation, brought this tax refund suit to recover income taxes and interest totalling $23,798.81, which it paid under protest when the Commissioner of Internal Revenue disallowed its deduction of $54,000 for alleged guarantors' fees that it had paid, pro rata, to its director-shareholders during its tax year ending August 31, 1970. The question this case presents is whether the taxpayer may deduct as ordinary and necessary business expenses amounts paid its shareholders ostensibly as guarantors' fees. The district court, sitting without a jury, found that the amounts paid were ordinary and necessary business expenses under Int.Rev.Code of 1954, § 162(a), ¹ and that they were reasonable in amount. We reverse.

I

Tulia Feedlot, the plaintiff-appellee, was organized in 1962 for the purpose of conducting a cattle feedlot in Tulia, Texas. The feedlot grew rapidly from an initial capacity of 5,000 head in 1962 to a capacity of 28,000 head in 1970. Although the corporation had both profitable and unprofitable years during that period, it began the tax year in question with retained earnings of $318,395.27. The corporation declared no dividends until 1972, but it customarily paid a director's fee, in the amount of $2400 per year, to its directors, who are virtually the only shareholders of the corporation.

During the tax year in dispute, the stock of the corporation was principally owned by thirteen individuals. Eleven of these thirteen shareholders held equal amounts of the stock, 280 shares. Two other shareholders, a father and his son, each owned one-half of the number of shares owned by the other eleven shareholders or 140 shares each. In addition to these 3,360 shares, the corporation also had outstanding 22 shares of stock that were owned by employees of the corporation. At least some of the director-shareholders, including the President and Chairman of the Board, are also customers of the feedlot and use its facilities to feed cattle which they own individually or in partnership with others.

Tulia's business has two distinct aspects. Principally, it feeds cattle owned by its customers. When insufficient business is generated by its regular customers, however, Tulia must purchase cattle on its own account to keep the pens full and thereby minimize the feedlot's losses. This second aspect of Tulia's business requires large amounts of credit in order to purchase cattle and feed in anticipation of future sale. Financial institutions generally require that the feedlot pay 30 percent of the purchase price of the cattle. They may also require that the loans be secured by mortgages on the feedlot's cattle, feed, and real estate, and that personal guaranties be given by the feedlot's shareholders.

Since 1964, Tulia's principal shareholders have routinely guarantied loans to the corporation in proportion to their stock holdings. In 1964, each shareholder guarantied a pro rata share amounting to $5,000. This amount gradually increased over the following years so that, on January 20, 1970, each shareholder guarantied $91,000. On March 10, 1970, the amount was increased to $125,000. On July 28, 1970, each shareholder increased his guaranty to $150,000. Until July 1970, the guaranties were routinely made without any compensation to the shareholders. At a regular meeting of the board of directors on July 14, 1970, however, the board voted to increase the amount of the guaranty from $125,000 to $150,000, and to pay to each of the shareholder-guarantors an annual fee equal to 3 percent of the amount guarantied by him. Because the corporation operated on an accrual method of accounting, it paid to each shareholder the sum of $4,500 for the fiscal year that ended August 31, 1970. This fee, of course, represents 3 percent of the loan guaranty of July 28, 1970, whereas the amounts actually guarantied by the shareholders during the first eleven months of the fiscal year were considerably less. As a result of these calculations, Tulia paid a total of $54,000 in guarantors' fees for the tax year in question. Interest payments during the same period amounted to $87,991.07.

Although Tulia did not declare a dividend until 1972, the possibility of a dividend had been discussed every year. Evidence adduced at trial demonstrates that some of Tulia's principal shareholders, dissatisfied with the $2400 annual directors' fees, were impatient with the corporation's dividend policy and wished to have a more substantial return on their investments. The lack of any evidence to show how the 3 percent figure was determined is particularly significant in this light. That figure was simply the lowest amount that the dissatisfied, pro-dividend directors would agree to accept. It did not, in any way, reflect a rational calculation of the risks involved in the guaranties. Indeed, at least two of the guarantors made guaranties in excess of their respective net worths. Moreover, in 1972, when the corporation declared its first dividend, the director-guarantors increased the rate of return on their guaranties from 3 percent to 6 percent.

As a result of deducting the full $54,000 paid in guarantors' fees from its income in the tax year in question, the corporation had a net loss of $6,309.07. It paid no dividend. At the same time, each of the corporation's principal shareholders received income from the corporation in the nature of a $2400 director's fee and a $4500 guarantor's fee. In these circumstances, we think that the $4500 guarantor's fee was a distribution of property made by a corporation to its shareholders under 26 U.S.C. § 316, ² and not an ordinary and necessary business expense within the meaning of 26 U.S.C. § 162(a). See Giles Industries, Inc. v. United States, Ct.Cl.1974, 496 F.2d 556, 563.

II

In order for payments to qualify as ordinary and necessary business expenses under Int.Rev.Code of 1954, § 162(a), they must be appropriate, helpful, and of a common or frequent occurrence in the type of business carried on by the taxpayer. Lilly v. Commissioner of Internal Revenue, 1952, 343 U.S. 90, 72 S.Ct. 497, 96 L.Ed. 769; Deputy v. Du Pont, 1940, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416; Welch v. Helvering, 1933,290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212. The payments must be ordinary, not in the sense that they are habitually or normally made by a single taxpayer, but in the sense that they are of a known type and commonly made, in some circumstances, by persons in the type of business carried on by the taxpayer. The expenses of a lawsuit to safeguard a taxpayer's business, for instance, may be "unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part". Welch v. Helvering, 1933, 290 U.S. 111, 114, 54 S.Ct. 8, 9, 78 L.Ed. 212. The payments must also be ordinary in the sense that they represent expenses that are currently deductible, and not capital expenditures which, if deductible at all, must be amortized over the useful life of the asset. Commissioner of Internal Revenue v. Tellier, 1966, 383 U.S. 687, 689-90, 86 S.Ct. 1118, 16 L.Ed.2d 185. They must be reasonable in amount. Limericks, Inc. v. Commissioner of Internal Revenue, 5 Cir. 1948, 165 F.2d 483.

Expenses must be necessary in the sense that they are, at least, appropriate and helpful for the development of the taxpayer's business. Commissioner of Internal Revenue v. Tellier, 1966, 383 U.S. 687, 689, 86 S.Ct. 1118, 16 L.Ed.2d 185. Section 162(a) does not require that expenses be necessary in a philosophic or logical sense. As one commentator has suggested, a reading of Section 162(a) based on the logical meaning of " necessary" would "place the courts and the Commissioner in the position of business efficiency experts reviewing the commercial decisions of the taxpayer, a function which they are ill-fitted to perform." Comment, Business Expenses, Disallowance And Public Policy: Some Problems of Sanctioning With The Internal Revenue Code, 72 Yale L.J. 108, 113, n. 20 (1962). Because courts are reluctant to review commercial decisions made by a taxpayer, they have generally looked to the actual practices of businessmen to determine the standard. In determining whether expenses are ordinary and necessary under Section 162, the test is whether a hard-headed businessman, under the circumstances, would have incurred the expense. Cole v. Commissioner of Internal Revenue, 2 Cir. 1973, 481 F.2d 872, 876. This rule is, of course, subject to numerous limitations. First, it is only the business practices of a hard-headed businessman, and not his tax avoidance schemes, that are subject to judicial deference. Second, the practices of an entire trade or profession may be infirm from the standpoint of the administration of the revenue laws. Third, special relationships between the contracting parties may, as here, limit the utility of the hard-headed businessman principle.

The law presumes, for instance, that corporate officers make expenditures of corporate funds only when they consider them to be in the interest of the corporation and its shareholders. Armour & Company v....