Ach, Pauline W., et al. v. Comm.

Decisions will be entered under Rule 50.

William R. Seaman and Ronald E. Heinlen, for the petitioners. Gerald W. Fuller, for the respondent.

PAGE 113

--

PAGE 114

Respondent determined deficiencies in income tax in these consolidated proceedings as follows:

                                  Estate of Ernest

--

PAGE 115

The principal issues for decision are (1) whether income reflected in the corporation's returns from the operation of a dress business during the taxable years may be ascribed to petitioner Pauline W. Ach; and (2) whether net operating losses incurred prior to 1954 in the operation of a dairy business may be carried forward as deductions against corporate earnings realized in the conduct of a dress and apparel business. FINDINGS OF FACT

Some of the facts have been stipulated; the stipulation of facts and all exhibits identified therein are incorporated by this reference.

Pauline W. Ach and her husband, Ernest M. Ach, resided in Hamilton, Ohio. He died on February 14, 1956. Pauline timely filed joint income tax returns with her husband, or his estate, for the years 1954, 1955, and 1956. She filed separate individual returns for 1957 and 1958. The Ach Corp., an Ohio corporation with its principal place of business in Cincinnati, Ohio, timely filed its corporate income tax returns for the years 1955-58. All of the foregoing returns were filed with the district director of internal revenue at Cincinnati. Pauline was the executrix of Ernest's will and his sole beneficiary.

Roger W. Ach is the son of Pauline and Ernest. During 1945 or early 1946 Roger and his father purchased the assets of a dairy business in Indiana and conducted a dairy business with those assets as a partnership in Rising Sun, Ind. The business was incorporated under the laws of Ohio in December 1946 as "Indiana Ideal Creamery Company," but shortly thereafter, in January 1947, its name was changed to "Rising Sun Creamery Company." The statement of purpose or purposes for which the corporation was formed reads in its entirety as follows:

To buy, sell, manufacture, purchase, distribute and deal in milk, cream, butter, cheese, eggs, and all other products and derivatives of milk, cream and other dairy products of any kind, and the doing of all things incidental and necessary to carry out the purposes of this corporation.

The only shares of stock issued were 300 shares of common to Roger and 200 shares of 4-percent noncumulative preferred to his father. The shares of preferred stock were transferred to someone else on December 31, 1951, and were surrendered for cancellation during the following year. All of the common stock was held continuously by Roger until July 14, 1953, when changes occurred, as hereinafter set forth.

Throughout the years 1947 through 1952 the Rising Sun Creamery Co.'s principal business was the operation of a creamery plant in Rising Sun, Ind. Roger was its president and chief executive officer in charge of its daily operations. Neither of his parents participated

PAGE 115

--

PAGE 116

in the management of the corporation. The business was unsuccessful, and the corporation's net operating losses during the years 1950-53 were as follows:

 Year  Net operating loss

 Year  Amount

 Assets

--

PAGE 117

During the latter part of 1952, Roger went to his father and told him that it was time to give up the dairy and creamery business; Roger felt his father was too old to have to worry about continued losses and the continued backing of a losing cause. It was at approximately this time that it was decided to quit this business. The corporation ceased operating the dairy and creamery business at some undisclosed time prior to August 1, 1953, and sold its dairy and creamery equipment. Its principal remaining assets consisted of land and buildings in Rising Sun, Ind., which were being rented to persons not connected with the corporation.

On April 23, 1953, the corporation changed its name to the Ach Corp. and changed its stated corporate purposes from the operation of a creamery plant and related dairy business to broad, general purposes which would permit it to conduct a wide range of businesses authorized under the statutes in the State of Ohio. On or about July 14, 1953, Roger, pursuant to his parents' suggestion, transferred to his brother, S. Laurence Ach, 149 shares of the corporation's common stock; there was no consideration for this transfer.

For approximately 29 years prior to August 1, 1953, Pauline had owned and operated a sole proprietorship known as "Vogues and Vanities," a successful retail dress and apparel business located in Cincinnati, Ohio. During this period there was never a year when the business lost money, even during the depression. Prior to August 1, 1953, the profits approximated 25,000-30,000 per year; the trend of these profits was upward. Vogues and Vanities employed approximately 9 to 12 persons. On August 1, 1953, the net book value of its assets was 30,705.57.

PAGE 117

--

PAGE 118

The balance sheet of Vogues and Vanities, as of July 31, 1953, reflected the following:

 Assets

At a "Special Meeting of the Board of Directors" of the corporation, on August 1, 1953, at which Pauline presided, she made the following written offer to the corporation:

As sole proprietor of Vogues and Vanities, a shop engaged in selling women's apparel at retail and presently located at 27 Garfield Place, Cincinnati, Ohio,

PAGE 118

--

PAGE 119

I hereby offer to sell to you all the business, merchandise and other assets thereof, less the liabilities, at the book value of 30,705.57 as shown by balance sheet of Vogues and Vanities of July 31, 1953, prepared by J. D. Cloud & Co., Certified Public Accountants, payment to be made by the corporation's demand note payable to me, without interest, in the sum of 30,705.57.

The minutes reveal that the offer was accepted. No formal contract or other written instrument reflecting an agreement between Pauline and the corporation, other than the foregoing, is available.

During the period August 1, 1953, to December 31, 1962, inclusive, Pauline continued to manage Vogues and Vanities and did not engage, either as a sole proprietor or otherwise, in any other business endeavor. During the period commencing August 1, 1953, and ending December 31, 1958, Pauline received no payments from the corporation which were designated as compensation for her services as manager of Vogues and Vanities. The name of the apparel business, as displayed to the public by a sign hanging outside the door, continued to be Vogues and Vanities and this business continued to be listed in the telephone book under that name. Pauline signed most of the checks of the corporation; another person, Edna Rowan, an assistant treasurer of the corporation, was also authorized to sign checks. Roger and Laurence did not participate in the day-to-day management of Vogues and Vanities; they did, however, attend and participate in shareholders' and directors' meetings of the corporation. Pauline did not take any steps to teach either of her sons the women's apparel business and they had no prior knowledge of it. Each of the sons was engaged in a business venture of his own entirely unrelated to any activity of the corporation or Vogues and Vanities.

Subsequent to August 1, 1953, the only other activity the corporation engaged in was the rental of its former creamery property; this activity was unprofitable.

On February 14, 1956, Ernest died testate, leaving Pauline as sole beneficiary of his estate. The corporation was indebted to Ernest in the amount of 232,390 at the date of his death in respect of the notes hereinabove described. Ernest's estate reported these notes, for Federal estate taxes, at a value of 95,000; this amount was later increased to 190,000 by agreement of the estate and respondent. The estate and respondent also agreed upon an additional estate tax based upon this and other adjustments, which additional estate tax was paid. After 1953, payments were made upon these notes out of the profits of Vogues and Vanities, and after Ernest's death such payments were made to or for the benefit of Pauline, who succeeded to the notes as Ernest's sole beneficiary. The corporation's books reflected the following

PAGE 119

--

PAGE 120

amounts due on the notes as of the end of each of the years indicated:

 Year  Amount due

                                        1954          1955          1956

The following expenses, which were reflected on the corporate income tax returns, were not determined by respondent to be expenses incurred in the operation of Vogues and Vanities:

                1954       1955         1956         1957         1958

--

PAGE 121

The corporation reported taxable income from current operations for the years 1954 through 1958 as follows:

        Taxable

By August 12, 1954, the corporation had paid Pauline 30,705.57. Payments of this amount were designated by the corporation, its shareholders of record, and its officers as the payment of indebtedness for the transfer on August 1, 1953, of the sole proprietorship, Vogues and Vanities.

The corporation made payments in at least the following amounts during the years indicated on account of the notes payable to Ernest:

 Year         Payments

During the period July 14, 1953, through December 31, 1958, the shareholders of record of the issued and outstanding shares of common stock of the corporation were Roger and his brother, Laurence, who owned 151 shares and 149 shares, respectively.

PAGE 121

--

PAGE 122

The corporation's balance sheet, as of December 31, 1958, reflected the following:

 Assets

In May 1959 Roger and Laurence transferred their shares of stock in the corporation to Pauline at her request and without consideration. OPINION

1. Taxability of Vogues and Vanities Profits to Petitioner Pauline W. Ach. -- During the years 1954-58, profits in the amounts of 36,569.24, 40,663.64, 44,538.90, 41,777.51, and 45,297.28, respectively, were realized from Pauline's operation of the dress business known as Vogues and Vanities in Cincinnati, Ohio. These amounts were reflected in the returns for these years filed by the Ach Corp., but no taxes were paid thereon by reason of net operating loss carryovers from earlier years when Roger conducted a dairy business in Rising Sun, Ind., under the same corporation, then known by another name and with drastically limited charter powers that did not include the operation of a dress business. The Commissioner allocated the foregoing profits to Pauline under sections 482 and 61 of the 1954 Code. Subject to an adjustment, hereinafter noted, we think he was correct.

PAGE 122

--

PAGE 123

At the outset it is important that the factual background be clearly understood. For some 6 years Pauline's son Roger had owned all of the common stock in and was the principal officer of the Rising Sun Creamery Co. His father, Ernest, had bought the business for him in 1946, but its annual losses were heavy and it was kept alive only by a series of loans which Ernest made to the corporation. In late 1952 or early 1953 it was decided to give up that business, which in fact was terminated at some undisclosed time prior to August 1, 1953. Meanwhile, it was decided to make an entirely different use of the corporation. Pauline, as a sole proprietor, had been operating a successful dress business, known as Vogues and Vanities, in Cincinnati for 29 years. Its earnings were approximately 30,000 a year and rising. The name of Roger's corporation was changed to "The Ach Corporation," Pauline became its president, treasurer, and chairman of the board, and the assets of Vogues and Vanities were "sold" to the corporation for its non-interest-bearing note in the amount of 30,705.57, the net book value of such assets as of July 31, 1953. There was no "commitment" that Pauline continue to manage the enterprise, nor does there appear to have been any covenant not to compete. However, Pauline's management was essential to the success of the dress business, and it was obviously contemplated that she would continue to run it.

Plainly, this was not an arm's-length transaction. The corporation was hopelessly insolvent, and it is utterly beyond belief that any unrelated third party would have sold a prosperous business for a non-interest-bearing 30,705.57 note of such an insolvent maker where the level of earnings of that business was about 30,000 a year and rising, and where the seller contemplated continued full-time management of the business without compensation. Notwithstanding testimony indicating otherwise, it is all too clear to us on this record that Pauline was acquiring control of this moribund corporation for the purpose of attempting to utilize the net operating loss carryover of the dairy business, to offset the resulting deductions against earnings of her successful dress business, and to obtain the actual benefits of those tax-free earnings by having the corporation pay off, first, her 30,705.57 note, and then the notes of some 280,000 held by her husband which were otherwise uncollectable -- all of which would be received free of tax!

It has been suggested by the Government that we look through the corporate fiction and tax the earnings of Vogues and Vanities directly to Pauline as though she had never transferred any part of that business to the corporation. However, we think that this would not be proper. The corporation was actually in existence, and there was a genuine transfer of assets to it that were actually used in the conduct of the dress business. It had salaried employees and discharged its

PAGE 123

--

PAGE 124

obligations to the State and Federal Governments in respect of workmen's compensation, social security, and the like. While there are situations in which the corporate fiction may be ignored, cf. Haberman Farms, Inc. v. United States, 305 F. 2d 787 (C.A. 8), we think that this is not one of them. Nevertheless, it does not follow that all of the income from Vogues and Vanities is properly to be charged to the corporation rather than to Pauline. And this brings us to section 482, upon which the Commissioner strongly relies. It provides that:

SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

In our judgment these provisions justify an allocation here.

Petitioners earnestly contend that section 482 is inapplicable because "two or more" organizations, etc., are not involved in this case. We hold otherwise. The statutory provisions are broad and sweeping. They refer to "two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated)." Pauline certainly conducted Vogues and Vanities as an individual prior to August 1, 1953, and, as such, she was a taxpayer of the character referred to in section 482. Similarly, the corporation is a separate taxpayer covered by this statute. And Pauline did not cease to be a separate taxpayer or "organization," "trade," or "business," within the purview of these provisions by reason of her "sale" of the naked assets of the dress business to the corporation. The balance sheet of Vogues and Vanities, as of July 31, 1953, is set forth in our findings, and it shows precisely what Pauline "sold" to the corporation.

The assets appearing on the balance sheet consist of (1) "current" assets (primarily accounts receivable, a comparatively small amount of inventory, and several other items), (2) "fixed" assets (furniture, fixtures, and leasehold improvements, having a total depreciated cost of 2,568.11), and (3) "deferred charges" (unexpired insurance in the amount of 161.43). No intangible assets appear on the balance sheet, and we cannot find that Pauline in fact transferred any intangible assets to the corporation. Moreover, what was probably the most important aspect of the business, Pauline's active participation as manager and guiding spirit, was not transferred to it. Cf. Frederic R. Harris, Inc., 40 T.C. 744, 750. The corporation did not receive the

PAGE 124

--

PAGE 125

right to Pauline's services; there was no contract of employment between them; and she in fact rendered her services to the corporation voluntarily without compensation. Nor did the corporation receive a covenant not to compete from Pauline. For aught that appears, in the absence of a covenant not to compete, she could readily have established a competing business that might well have rendered Vogues and Vanities worthless, apart from the balance sheet assets "sold" to the corporation. Indeed, in view of the balance sheet, it is not clear that there was even a transfer of the right to use the name Vogues and Vanities. In any event, sufficient aspects of the business remained with Pauline so as not to deprive her of the status of a separate "organization," "trade," or "business," within the meaning of section 482.

Section 482 is remedial in character. It is couched in broad, comprehensive terms, and we should be slow to give it a narrow, inhospitable reading that fails to achieve the end that the legislature plainly had in view. We think that the statute is not made inapplicable by its reference to "two or more organizations, trades, or businesses."

Another ground for the alleged inapplicability of section 482 is petitioners' contention that Pauline was not in "control" of the corporation during the tax years, since she did not become a stockholder of record until 1959. Section 482 speaks of two or more organizations, etc., "owned or controlled directly or indirectly by the same interests." Here, again, the language is broad and sweeping, and is ample to cover the present case.

Pauline was chairman of the board of directors and was the president and treasurer of the corporation. She was in full charge of its affairs. To be sure, the stock was formally owned by Roger and his brother, Laurence, but when Pauline wanted it in 1959 they transferred it all to her without consideration. The conclusion is irresistible that the corporation in fact belonged to her, and that she was actually the beneficial owner of the stock even prior to the formal transfer in 1959. In any event, it is not record ownership, but actual control, which counts in the application of the statute. Grenada Industries, Inc., 17 T.C. 231, 254, affirmed 202 F. 2d 873 (C.A. 5), certiorari denied 346 U.S. 819. And it is difficult to imagine how anyone could have had more control over the corporation than was in fact exercised by Pauline.

Respondent may allocate income under section 482 in order to prevent "evasion of taxes or clearly to reflect the income." The legislative history of section 482 indicates that it was designed to prevent evasion of taxes by the arbitrary shifting of profits, the making of fictitious sales, and other such methods used to "milk" a taxable entity. Ballentine Motor Co., Inc., 39 T.C. 348, affirmed 321 F. 2d 796 (C.A. 4); Seminole Flavor Co., 4 T.C. 1215, 1228. The

PAGE 125

--

PAGE 126

Commissioner has considerable discretion in applying this section and his determinations must be sustained unless he has abused his discretion. We may reverse his determinations only where the taxpayer proves them to be unreasonable, arbitrary, or capricious. See, e.g., G.U.R. Co. v. Commissioner, 117 F. 2d 187, 189 (C.A. 7); National Securities Corp., 46 B.T.A. 562, 564, affirmed 137 F. 2d 600, 602 (C.A. 3), certiorari denied 320 U.S. 794; Grenada Industries, Inc., 17 T.C. 231, 255, affirmed 202 F. 2d 873 (C.A. 5), certiorari denied 346 U.S. 819. In the instant case Pauline made the transfer of assets in order to defeat taxes; prior losses could be used to offset income from Vogues and Vanities, and this income, which would not be reduced by taxes, could then be distributed to her and her husband as payments on account of their notes. During the years in question, 1954-58, the corporation reported taxable income (before net operating loss deductions based on pre-1954 carryovers) in the amount of 194,145.23; this income was earned largely through Pauline's efforts. And during this period the corporation made payments in the amount of 192,015.57, 30,705.57 directly to Pauline and the remainder on account of her husband's notes. There was a distortion in income of the kind condemned by section 482, and an allocation by the Commissioner was fully warranted under section 482 in order "clearly to reflect the income" involved.

Nor is there basis for disapproving an allocation under section 482 because the Commissioner's allocation of "profits" of Vogues and Vanities was allegedly an allocation of "net income." The matter was recently considered in Ballentine Motor Co., 39 T.C. 348, affirmed 321 F. 2d 796 (C.A. 4), which we regard as dispositive of this contention.

Although we approve an allocation under section 482 for the reasons set forth above, we do not approve the Commissioner's allocation of all of the profits of the Vogues and Vanities dress business to Pauline. The mere existence of common control is not itself sufficient to warrant the application of the statute; there must be in addition a distortion of income, and the Commissioner's power under the statute is limited to correct that distortion. Grenada Industries, Inc., 17 T.C. at 254, 255.

To be sure, there was substantial distortion of income in this case, as shown above; but some of the income from the dress business was properly attributable to the corporation, and should not have been allocated to Pauline. The corporation did own assets that were used in the business, and it had paid employees who performed services. Some portion of the profits of Vogues and Vanities was attributableto these factors. However, the most important factor in the earning process was Pauline's management. Although there

PAGE 126

--

PAGE 127

were 9 to 12 employees, their total compensation, according to the returns in evidence, ranged from 15,609.67 in 1954 to 20,012.90 in 1958. Plainly, their contribution to the enterprise was largely of a routine nature. And while capital was a factor, the rapid turnover of inventory, at least several times a year, as is indicated in the returns, makes this a matter of lesser importance. Using our best judgment on the entire record, we have concluded and hereby find as a fact that 70 percent of the profit of Vogues and Vanities was attributable to Pauline's services, cf. Cohan v. Commissioner, 39 F. 2d 540, 544 (C.A. 2), and was properly allocated to her. ² We hold that the Commissioner erred in allocating the remaining 30 percent to her.

2. Carryover of the Corporation's Net Operating Losses From the Dairy Business. -- The Commissioner determined that the corporation could not carry forward the net operating losses incurred in a period prior to August 1, 1953, in operating a creamery and dairy business in Rising Sun, Ind., and apply them against income earned in a period subsequent to August 1, 1953, from the operations of Vogues and Vanities, a dress and apparel shop, located in Cincinnati, Ohio, because of the application of section 129 of the Internal Revenue Code of 1939, and section 269, the corresponding provision in the Internal Revenue Code of 1954 and, alternatively, because of what is sometimes referred to as the doctrine of Libson Shops, Inc. v. Koehler, 353 U.S. 382. Section 269 provides in part as follows: (a) In General. -- If --

(1) any person or persons acquire, or acquired * * * control of a corporation * * * and the principal purpose for which such acquisition was made is evasion or avoidance of Federal income tax by securing the benefit of a deduction, credit, or other allowance which such person or corporation would not otherwise enjoy, then such deduction, credit, or other allowance shall not be allowed. For purposes of paragraphs (1) and (2), control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock of the corporation. ³

The first issue thus presented is whether Pauline's "principal purpose" upon transferring the Vogues and Vanities' assets was to acquire "control" of the corporation in order to avoid taxes by obtaining the benefit of its net operating losses as a deduction against income

PAGE 127

--

PAGE 128

of Vogues and Vanities. The fact that the deduction is claimed by the acquired corporation is no bar to the application of this section. Thomas E. Snyder Sons Co., 34 T.C. 400, 406, affirmed 288 F. 2d 36 (C.A. 7); Frank Spingolo Warehouse Co., 37 T.C. 1, 5; Mill Ridge Coal Co. v. Patterson, 264 F. 2d 713, 716, 717 (C.A. 5), certiorari denied 361 U.S. 816. The corporation contends that Pauline did not acquire control over it because section 269(a) defines control to be the acquisition of 50 percent of the total voting stock or 50 percent of the total value of shares of all classes of stock and Pauline owned no stock prior to 1959. We disagree. Although Pauline did not have record ownership of the shares of stock, we are satisfied on this record that she was the beneficial owner and hence was the owner of the stock within section 269. Pauline had transferred assets of a prosperous business to a hopelessly insolvent corporation, she became its president, treasurer, and chairman of the board. When these circumstances are viewed together with her sons' transfer of their shares to her without consideration at her request in 1959, we are convinced that she was the true beneficial owner of the stock from the time that she took charge of its operations. We heard proffered explanations for the delayed transfer of the shares to Pauline but did not find them credible. She was in reality the owner of 100 percent of the stock and exercised control over the corporation commensurate with that of a sole shareholder. To construe "control" in section 269 to mean record ownership would be to provide a readymade tax-avoidance escape hatch for taxpayers in a provision which has as its purpose the prevention of tax avoidance. Such a construction is untenable.

Although there was some testimony by Pauline tending to indicate that there were business reasons for incorporating, the question is not whether there were reasons for incorporating her proprietorship, but rather whether her acquisition of control of this corporation had as its principal purpose tax avoidance. The oral testimony which suggested to the contrary is sharply contradicted by other facts of record. We do not find such testimony convincing and, to the extent that it attributed to Pauline a purpose other than tax avoidance in acquiring the corporation, we do not believe it. Frank Spingolo Warehouse Co., supra at 6; Thomas E. Snyder Sons Co., supra at 406. Our decision on this issue is similar to Frank Spingolo Warehouse Co., supra; Mill Ridge Coal Co. v. Patterson, supra; Thomas E. Snyder Sons Co., supra; and J. G. Dudley Co., 36 T.C. 1122, affirmed 298 F. 2d 750 (C.A. 4).

In view of our conclusion reached above, we do not find it necessary to decide whether the so-called doctrine of Libson Shops, Inc. v. Koehler, 353 U.S. 382, is also fatal to the corporation's contention. There is, however, strong support for respondent's position in such

PAGE 128

--

decisions as: J. G. Dudley Co., supra; Norden-Ketay Corporation v. Commissioner, 319 F. 2d 902 (C.A. 2), affirming a Memorandum Opinion of this Court; Commissioner v. Virginia Metal Products, Inc., 290 F. 2d 675 (C.A. 3), reversing 33 T.C. 788, certiorari denied 368 U.S. 889; Julius Garfinckel & Co., 40 T.C. 870; Huyler's, 38 T.C. 773; Arthur T. Beckett, 41 T.C. 386; Frederick Steel Co., 42 T.C. 13.

Decisions will be entered under Rule 50.

¹ Proceedings of the following petitioners are consolidated herewith: Estate of Ernest M. Ach, Deceased, Pauline W. Ach, Sole Legatee and Pauline W. Ach, Surviving Wife, docket No. 94163; and The Ach Corporation, docket No. 94164.

² This determination automatically disposes of petitioner's contention that the deficiencies for 1954 and 1955 are barred by limitations. Sec. 6501(e) (1) provides for a 6-year period of limitations where there is an omission in excess of 25 percent of the gross income stated in the return. As a result of the foregoing conclusion, the 25-percent requirement has been met here, and there is no dispute that this proceeding is timely if that requirement is satisfied.

³ The language in sec. 129(a) of the Internal Revenue Code of 1939 is substantially identical to the language in sec. 269(a).