Turner v. Commissioner, Docket No. 82122.

• Decision Date: 31 March 1961
• Docket Number: Docket No. 82122.
• Citation: 1961 TC Memo 101,20 TCM (CCH) 468
• Parties: Rufus F. Turner and Marguerite H. Turner v. Commissioner.
• Court: U.S. Tax Court

20 T.C.M. (CCH) 468 (1961)

T. C. Memo. 1961-101.

Rufus F. Turner and Marguerite H. Turner v. Commissioner.

Docket No. 82122.

United States Tax Court.

Filed March 31, 1961.

Fortescue W. Hopkins, Esq., and William N. Pierce, Esq., Mountain Trust Bank Bldg., Roanoke, Va., for the petitioners. Richard C. Forman, Esq., for the respondent.

Memorandum Findings of Fact and Opinion

TIETJENS, Judge:

The Commissioner determined a deficiency in petitioners' income tax for 1957 in the amount of $11,670.36. The issues presented are (1) whether there was a recognized gain upon the incorporation of a sole proprietorship; and (2) whether a bonus received in 1957 was properly reported in that year for income tax purposes.

Findings of Fact

Some of the facts have been stipulated and are incorporated herein by reference.

Petitioners are husband and wife and reside in Martinsville, Virginia. For the calendar year 1957 they filed a joint income tax return with the director of internal revenue for the district of Virginia.

Rufus F. Turner, hereinafter referred to as petitioner, as a sole proprietor, had engaged in the operation of a fresh produce wholesale grocery business for 36 years in Martinsville under the name of Cash Produce Company. Also associated with the business were petitioner's wife, Marguerite H. Turner, who had been employed for 26 years as a bookkeeper, and James R. Ingram, petitioner's son-in-law, who had been employed for 7 years and was petitioner's principal assistant.

On November 14, 1956, petitioner incorporated the sole proprietorship under the name of Cash Produce Company, Inc., hereinafter referred to as Cash Produce. The corporation transacted no business until January 1, 1957. A stock statement was filed with the Virginia State Corporation Commission on December 6, 1956, advising it of a plan to issue 135 shares of common stock for $6,750 in cash. Also in December 1956, petitioner conferred with his attorney and his certified public accountant with respect to the manner in which to accomplish the proposed transfer of the proprietorship assets to the new corporation. At that time the accountant made the following computation of the proprietorship goodwill:

                Net earnings (before income taxes)—
                  1952 ........................  $ 29,887.34
                  1953 ........................    18,468.80
                  1954 ........................    19,536.61
                  1955 ........................    24,830.86
                  1956 ........................    21,535.87
                                                 ___________
                  Total .......................  $114,259.48
                Less income taxes — 25%
                 average ......................    28,564.87
                                                 ___________
                Total net earnings.............  $ 85,694.61
                5 year average.................  $ 17,138.92
                Net earnings capitalized at 10% ............  $171,389.20
                Less net invested capital at 12-31-56
                 excluding goodwill (75,534.48 +
                 21,535.87) ................................    97,070.35
                                                              ___________
                Goodwill at date of incorporation...........  $ 74,318.85
                   Rounding off ...............  $ 74,300.00
                

On January 1, 1957, with the exception of real estate and certain other fixed assets, all of the assets of the sole proprietorship together with certain liabilities were transferred to Cash Produce in exchange for 1,365 shares of common stock. These assets had a cost basis of $49,593.46. A summary of the balance sheet of the proprietorship as of December 31, 1956 was as follows:

                Current Assets ...........................  $ 47,077.44
                Fixed Assets ................  $ 91,455.07
                Less Depreciation ...........    36,490.09    54,964.98
                                               ___________
                Other Asset ..............................       230.10
                                                            ___________
                TOTAL ASSETS .............................  $102,272.52
                Current Liabilities ......................  $  5,202.17
                R. F. Turner, Capital
                    Balance 1-1-56...........  $116,013.78
                    Earnings for year
                     1956 ...................    21,535.87
                                               ___________
                                               $137,549.65
                    Drawings for 1956 .......    40,479.30    97,070.35
                                               ___________  ___________
                TOTAL LIABILITIES ........................  $102,272.52
                

The following is the opening journal entry as of January 1, 1957 on the books of Cash Produce prepared by its attorney:

                                 Debit
                  Cash ..........................   $ 9,092.61
                  Accounts receivable ...........    12,339.46
                  Inventory .....................    25,645.37
                  Store fixtures ................       996.30
                  Cars and trucks ...............    20,273.91
                  Office equipment ..............     3,111.87
                  Frigidaire air conditioners ...       620.21
                  Incorporation expense .........       230.10
                Goodwill ........................    74,300.00
                

                                Credit
                  Reserve for depreciation —
                     Store fixtures ...............  $    481.53
                     Cars and trucks ..............    15,449.23
                     Office equipment .............     1,433.56
                     Air conditioners .............       149.88
                  Accounts payable—trade ......     2,312.01
                  Reserve for withholding tax .....       625.02
                  Accrued salaries ................     2,024.58
                  Accrued social security taxes....       240.56
                  Note payable—R. F. Turner........    48,893.46
                  Capital stock subscribed ........    68,250.00
                  Capital stock issued ............     6,750.00
                

To record acquisition of business assets from R. F. Turner in exchange for capital stock of the corporation and account due R. F. Turner.

A financial statement for Cash Produce as of January 1, 1957 was prepared by the accountant on January 19, 1957, and transmitted to the Produce Reporter Company, Wheaton, Illinois which publishes a credit rating reference book of produce firms. The following is the balance sheet from that financial statement:

                  CURRENT ASSETS
                            Cash ..........................................................   $  9,092.61
                            Accounts receivable—customers..................................     12,339.46
                            Merchandise inventory—at the lower of cost (determined by the
                             first-in-first-out method) or market .........................     25,645.37  $ 47,077.44
                                                                                               __________  ___________
                  FIXED ASSETS
                            Store fixtures, furniture, equipment and vehicles—at cost ......  $ 25,002.29
                               Less accumulated depreciation ...............................    17,514.20     7,488.09
                                                                                               __________  ___________
                  INTANGIBLE ASSETS
                            Good Will ......................................................  $ 74,300.00
                            Incorporation expense ..........................................       230.10    74,530.10
                                                                                              ___________  ___________
                  TOTAL ASSETS ..........................................................................  $129,095.63
                  CURRENT LIABILITIES
                            Accounts payable
                               Trade .............................................. $2,312.01
                               Other ..............................................    625.02 $  2,937.03
                                                                                    _________
                            Accrued liabilities
                               Salaries and wages ................................. $2,024.58
                               Taxes (other than taxes on income) .................    240.56    2,265.14  $  5,202.17
                                                                                    _________ ___________  ___________
                  NONCURRENT LIABILITY
                            Note payable to officer—unsecured and without interest ......................  $ 48,893.46
                  CAPITAL
                            Common stock—authorized, 3,000 shares of $50 par value; issued
                             and outstanding, 135 shares ...................................  $ 6,750.00
                            Subscriptions to common stock, 1,365 shares ....................   68,250.00     75,000.00
                                                                                              __________   ___________
                  TOTAL LIABILITIES ....................................................................   $129,095.63
                

Thereafter petitioner received the following reply from the Produce Reporter Company in regard to the financial statement submitted:

The statement of Cash Produce Company, Inc., does present several problems from a rating standpoint.

The item of "good will" is very correctly listed as a "intangible asset", it is the type asset which is eliminated from credit consideration in arriving at Blue Book financial ratings.

When your good will and incorporation expenses of $74,530.10 are eliminated from your statement, that January 1, 1957 Corporation financial statement then shows a net worth of less than $500.

We believe we have a feel of what your accountant and tax attornies sic have attempted to accomplish in handling your incorporation on a basis which provides for a corporation note payable "to officer" of $48,893.46. Such an arrangement does, however, deplete completely the corporation's financial responsibility for credit rating purposes.

Your accountant can, of course, advise you on the advisability of issuing corporate stock for that indebtedness to officers.

Frankly, Mr. Turner, we hesitate very much to recommend a subordination agreement covering the notes payable to officers and do so only as a last resort.

In the event your accountants or attornies sic would want to prepare a subordination agreement which would clearly set forth that no payments are to be made on indebtedness to officers as long as there are any trade obligations and indicate clearly that you will notify Produce Reporter Company prior to the time any payment is made on that indebtedness, then such a subordination agreement could be accepted.

It is

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