United Control Corp. v. Comm'r of Internal Revenue, Docket No. 77477.
| Decision Date | 27 September 1962 |
| Docket Number | Docket No. 77477. |
| Citation | 38 T.C. 957 |
| Parties | UNITED CONTROL CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Merle D. Cohn, Esq., for the petitioner.
Norman H. McNeil, Esq., for the respondent.
During the fiscal years ended August 31, 1954, 1955, and 1956, petitioner authorized officers' a salaries in excess of the amounts allowed to be paid to the officers each year under credit agreements then in force between petitioner and a bank. The excess of the authorized salaries over the allowable salaries each year were subordinated to the bank loan and were accrued on petitioner's books and records as a liability to its officers. All authorized salaries during these years, whether paid or accrued on its books as a liability, were deducted as an ordinary and necessary business expense, the latter being disallowed by respondent. Held, the unpaid and accrued salaries as of the end of each year represented an enforcible indebtedness of petitioner and petitioner at these times was reasonably justified in believing that it would discharge such liability in due course.
Respondent determined deficiencies in income tax against petitioner as follows:
+-----------------------------------------+
¦Fiscal year ended Aug. 31— ¦Amount ¦
+------------------------------+----------¦
¦1954 ¦$50,854.36¦
+------------------------------+----------¦
¦1955 ¦50,415.03 ¦
+------------------------------+----------¦
¦1956 ¦25,107.43 ¦
+-----------------------------------------+
Some of the issues have been stipulated. The only issue remaining for our consideration is whether petitioner may deduct the excess of authorized salaries over the amount it actually paid to its four officers during each of the fiscal years in issue.
Most of the facts have been stipulated and are incorporated herein by this reference.
The United Control Corporation, hereinafter referred to as petitioner, was incorporated under the laws of the State of Washington On September 25, 1948. Its principal office and manufacturing facilities have been located in Seattle, Washington, until March 1961 when it moved to a new plant facility in Redmond, Washington. Petitioner is engaged primarily in the design, manufacture, and sale of electronic control systems, electronic equipment, and accessory devices for military and commercial aircraft, missiles, and industrial uses.
During all times material herein, the outstanding and issued shares of stock of the petitioner were held as follows:
+--------------------------------------+
¦ ¦Shares ¦Percent ¦
+-------------------+--------+---------¦
¦Louis P. Hanson ¦180 ¦34 ¦
+-------------------+--------+---------¦
¦Howard H. Suskin ¦180 ¦34 ¦
+-------------------+--------+---------¦
¦Martin K. Lilleberg¦88 ¦16 ¦
+-------------------+--------+---------¦
¦Jake Graybeal ¦88 ¦16 ¦
+-------------------+--------+---------¦
¦Total ¦536 ¦100 ¦
+--------------------------------------+
During all times in issue herein, the above four stockholders were directors and the principal executive officer of petitioner. All four men were unrelated to one another and none were engaged in any partnership with any of the others.
Beginning with the fiscal year ended August 31, 1951, petitioner and the Pacific National Bank of Seattle (hereinafter referred to as the bank) began entering into yearly recurring credit agreements whereby petitioner was enabled to borrow substantial amounts of cash for its business from the bank. Such credit agreements, substantially similar in their provisions, were in effect continually until December 31, 1960.
The credit agreements in effect during the fiscal years ended August 31, 1951, 1952, and 1953, as did the subsequent agreements provided, inter alia, for the limits which petitioner could pay out each year as officers' salaries.
As of August 31, 1953, petitioner's books reflected accrued liabilities to its four officers in the amount of $117,735.38, which amount represented the total amount of authorized officers' salaries for the previous 3 fiscal years which remained unpaid because of the cash outlay restrictions in the credit agreements then in force.
The minutes of the annual meeting of petitioner's board of directors held on August 20, 1953, state, in part, as follows:
A discussion of salaries for the officers and department superintendents of the corporation was had, and it was moved, seconded and passed that for the year commencing September 1, 1953, and ending August 31, 1954, salaries will be the following sums:
President and general manager, $27,500.00
Treasurer and business manager $25,000.00
Superintendent, engineering $22,000.00
Superintendent, material $22,000.00.
and that said salaries are hereby declared approved and authorized, and that payment of the same should be made by this company as soon as approval for the payment of the same can be had from the Pacific National Bank, pursuant to the credit agreement in force by and between the said Pacific National Bank and this corporation; it was noted that said credit agreement referred to restricts the payment of salaries to the officers of this company to the sum of $10,000.00 per year. It was moved, seconded and passed that overtime work by the officers and superintendents should be accounted for as in the past, and accrued on the books at one and one-half the straight time rate based on this $10,000.00 limitation per year. At the end of the fiscal year authority to pay the aforementioned salaries in full should be requested from the Pacific National Bank. If this authority be denied by said Pacific National Bank, as it has been denied for the past fiscal year, then authority will be requested to pay the overtime accrual in addition to the $10,000.00 annual withdrawals now permitted; it being the intent that any payment so authorized will be applied against the annual salaries set forth above. It was noted that the company is in a good financial condition to presently pay the aforementioned annual salaries, but is restricted from so doing by the aforementioned credit agreement.
Pursuant to such meeting, petitioner on October 30, 1953, wrote two letters to the bank requesting authority to pay the accrued salaries of $117,735.38 as of August 31, 1953.
A letter from the bank to petitioner dated November 3, 1953, stated, in part, as follows:
THE PACIFIC NATIONAL BANK OF SEATTLE Second Avenue and Marion Street Seattle 11, Washington, November 3, 1953.
Under the terms of the loan agreement, the salaries for the four officers in question, namely: Louis P. Hanson, Howard H. Suskin, Martin K. Lilleberg and Jake Graybeal, are limited to $10,000 each, or a total of $40,000.
First of all, we would be the first to admit that a salary of $10,000 presently allowed to each of the above officer is very nominal, considering the perplexity of the work, the amount of the time involved and the volume of work being done by the company, which is a direct result of the initiative and intelligence of the four individuals involved. We do not question that the salaries, as authorized by the Board of Directors, would be fair compensation and more in line with what could be obtained by these individuals were they to apply their talents in the employ of some other corporation.
In view of these requests, we have reviewed the year and figures of United Control Corporation as of August 31, 1953, and in our opinion, if the total amount involved in your letters, which would namely be $117,735.38, were to be paid in cash, it would place severe burden on the working capital of your company, particularly when the size of your backlog of orders is considered.
An analysis of the net profit shows that after all expenses, including the authorized salaries, the company was able to achieve approximately 2% on their sales. The United Control Corporation is a prime example of the difficulties encountered by a small corporation, under the present tax laws, in building up a sufficient net worth out of profits to adequately provide facilities, equip the plant with machinery, and have sufficient working capital to take care of expanding volume of business. To accomplish this goal, it will be necessary for the four officers to forego the payment of these salaries, at perhaps a personal sacrifice, and therefore your request for the payment of these funds is denied.
Preliminary discussions have already been held with you regarding the amount of bank credit which will be required by United Control Corporation for the coming year, and you have informed us that our present limit of $150,000 will have to be raised to $200,000 in order to adequately finance the company' contracts. In order to obtain this amount of credit from this bank with a capital of $53,800 and a surplus of $74,466, we will insist on the entire amount of $117,735.38 being subordinated to our loans.
On January 22, 1954, petitioner and the bank entered into another credit agreement which was substantially similar to the previous agreements (except for the amount of the subordinated debts to the officers) which became effective as of August 31, 1953. This agreement provided, in part, as follows:
Section C. Subordination of Indebtedness to Officers.
Contemporaneously herewith the payment of certain indebtedness of Borrower to certain of its officers, the total principal amount of which was $117,735.38 as of the effective date hereof, has been subordinated to all indebtedness of Borrower incurred under this agreement. Each such indebtedness is evidenced by an account payable in appropriate form on Borrower's books in principal amounts as...
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