OPINION.
Raum, Judge:1. Although Anaheim was at one time an exempt corporation, it had ceased to be such for a number of years because of the substantial income which it had been receiving from oil royalties and other sources.1 There is no dispute between the parties that Anaheim is a taxable corporation, and this case must be decided upon that assumption. The Commissioner determined that Anaheim’s water costs or expenses incurred in the distribution of water to its shareholders were not deductible as ordinary and necessary business expenses to the extent that they exceeded the revenue received by it from the sale of such water.
It is plain from the record before us that the directors deliberately fixed the water rates at such level that when the amounts paid by the shareholders for the water are added to the corporation’s income from oil and other sources the sum will be such that after subtracting the cost of supplying the water no net taxable income remains. In substance the corporation distributed its oil royalties and other income to its shareholders through the medium of charging them less than cost for water. Although the question for decision has been variously stated by the parties from time to time — and subtle differences may perhaps be thought to turn upon the form of the statement — we think that the real issue before us is whether the water costs or expenses incurred by Anaheim are ordinary and necessary expenses on this record to the extent that they exceeded the amounts which Anaheim obtained for such water from its shareholders. We hold that to the extent of such excess they do not qualify as “ordinary and necessary” expenses.
The question is not whether such expenses might be “ordinary and necessary” in other situations. The question rather is whether such expenditures in this case, known in advance to be in excess of what the corporation would obtain for the water sold to its shareholders, can fairly be classified as “ordinary and necessary.” We think that they are neither “ordinary” nor “necessary.” Indeed, it appears to ns to be “in a high degree extraordinary,” cf. Welch v. Helvering, 290 U.S. 111, 114, for a corporation to incur business expenses in connection with goods or services in an amount greatly in excess of what it knows it will obtain for such goods or services. To be sure, exceptional circumstances may exist in other situations that would justify the deduction where expenses exceed anticipated income. For example, extraordinarily large outlays may be made by a business when introducing a new product where the reasonable expectation exists that sales in later years will more than compensate for losses in the early years. But no such exceptional circumstances exist here. In essence, the entire setup is merely a device to distribute the oil and other unrelated income to the shareholders. Although Anaheim was clearly not incorporated for that purpose in 1884, the fact nevertheless remains that it has been used for that purpose in recent years.2 Cf. United States v. Joliet da Chicago Railroad Co., 315 U.S. 44, where the controlling indenture was executed in 1864. And we are of the opinion that the water expenses incurred herein in excess of the amounts which the directors reasonably expected to obtain for the water were not “ordinary and necessary” expenses, but were merely part of a plan to distribute otherwise taxable income to the shareholders.
We have not been directed to any decisions squarely in point. However, there are cases which, although perhaps distinguishable, nevertheless point the way to the proper disposition of this controversy. In International Trading Co. v. Commissioner, 275 F. 2d 578 (C.A. 7), affirming a Memorandum Opinion of this Court, a corporation was not allowed to deduct expenses in excess of rent received on certain lakeside property leased to its principal shareholders. It was held that the difference between expenses incurred and rents received was not an ordinary and necessary expense of the corporation, since (p. 585) “the property was purchased and improved with the knowledge that it would not earn a profit, and was not expected to earn a profit, but was maintained primarily for the personal benefit of the families of the corporation’s stockholders, without a corresponding benefit to tbe corporation * * Deduction for that portion of the expenses which did not exceed the rent was not contested.
Our own decision in Pomeroy Cooperative Grain Co., 31 T.C. 674, is also instructive. There a nonexempt cooperative carried on business with nonmembers as well as members. It was allowed to exclude from its gross income the amount of patronage dividends paid to its members that was based upon receipts from such members; but it was not permitted to eliminate from its gross income a similar amount equal to that portion of patronage dividends paid to its members that was based upon receipts obtained from nonmembers. In short, income obtained from nonmembers that was otherwise taxable could not in effect be distributed to the members through the medium of patronage dividends so as to render it tax free. Anaheim’s operations are similar in many respects to those of a cooperative and the question presented in Pomeroy of properly reflecting the taxable income obtained from transactions with nonmembers (though raised in the context of an income rather than expense problem) is not unlike the issue of properly reflecting Anaheim’s non-shareholder income from oil royalties and other sources. We think it no more appropriate to bury such income for tax purposes in Anaheim’s designedly insufficient water rates than in Pomeroy's so-called patronage dividends. Just as the Court in Pomeroy refused to treat the contested distributions as true patronage dividends, we similarly refuse to be misled by form in this case; for what might in other circumstances be an “ordinary and necessary” expense is here merely a device for distributing unrelated taxable income and is in fact not an “ordinary and necessary” expense on the record before us.
Glendirming, McLeish & Co., 24 B.T.A. 518, affirmed 61 F. 2d 950 (C.A. 2), and Horace E. Podems, 24 T.C. 21,. are also helpful in arriving at the correct answer in the present case. They dealt with the question whether deductions for “ordinary and necessary” expenses are allowable where the taxpayer might have obtained but in fact took no steps to receive reimbursement for the expenditures in issue. Anaheim’s purposeful arrangement of not seeking full reimbursement of its water costs from its shareholders makes the denial of deductions in those cases especially significant. Since Anaheim’s amended articles of incorporation provided that water was to be supplied to the shareholders “at cost,” it appears that there was ample authority for the directors to fix the rates so that the company would be fully reimbursed for its water expenses without regard to other income. Moreover, even if it be assumed that the directors had no such power by reason of changes in bylaws or otherwise, such lack of power would merely be a consequence of arrangements voluntarily accepted by Anaheim and would therefore be irrelevant here. Not only were Anaheim and its shareholders fully able to control the content of the bylaws and other possible documents affecting their relations inter sese, but Anaheim in any event could have assured itself of full reimbursement for its water expenses by segregating or divesting itself of its profitable non-water business (in such manner that its shareholders would continue to benefit therefrom) and thereby have remained a bona fide nonprofit mutual irrigation company selling its water at cost. However, the fact that it deliberately chose not to do so, thereby blending its profitable non-water operations with its water business, does not entitle it to claim successfully under the Federal statute3 that its directors were required to fix the rates so as to operate the water business at a loss.
2. A similar issue is presented in SARD’S case, since it appears from the record that SARD charged its shareholders, Anaheim and SAYI, less than cost for the water services it furnished them during the tax years in question because it, too, applied non-shareholder income to the payment of its expenses. We think a like decision is called for in respect of the Commissioner’s adjustments relating thereto. Unlike Anaheim, SARD by agreement with its shareholders in 1944 was specifically required to apply its “rents, issue, and profits” from its land to its water service expenses before billing its shareholders for them. However, we do not consider this difference crucial. It is no more “ordinary and necessary” for a corporation by agreement to expend more for its services than it is paid than it is to do the same thing without an agreement. The agreement merely tends to make explicit in SARD’s case what was apparent in the absence of an agreement in Anaheim’s, namely, that a corporation which charges its shareholders less than cost for its goods or services and uses otherwise taxable income to pay for the expense differential is, in effect, merely making a distribution of such taxable income to the shareholders without a formal declaration of dividends.
3. There remains finally the issue whether rental income in 1952 and 1953 and rental expenses in 1952, 1953, and 1954 reported by SARD should have been allocated to Anaheim as cotenant of the rental property as determined by the respondent. The respondent contends that SARD is a separate entity and that its rental income and expenses should have been allocated to the parties, Anaheim and SAYI, to whom such income and expenses are attributable. Anaheim, on the other hand, claims that SARD is merely an agent created to carry on upstream water conservation activities on behalf of the two downstream water companies, Anaheim and SAYI.
SABD, Anaheim, and SAYI are each separate corporate entities. The fact that SABD may have performed functions as an agent for Anaheim and SAVI in no way permits SABD to report on its own returns the entire rental income and expense from those lands in which it was a cotenant with Anaheim and SAVI. The aggregate rental income derived from these properties should have been allocated together with the corresponding rental expenses to each of the three corporations and so reported by them. National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949); Rev. Rul. 59-247, 1959-2 C.B. 14.
The respondent’s determination that the rental income reported by SABD in 1952 and 1953 and the rental expense deducted by SABD in 1952, 1953, and 1954 should have been allocated to the parties to whom such rental income and expense is attributable, is sustained. There is nothing in the record which would demonstrate that the allocation made by the respondent of the income and expenses was arbitrary or unreasonable and we approve the allocation as made.
Beviewed by the Court.
Decisions will be entered for the respondent.
The exemption was based upon section 101(10) of tbe Revenue Act of 1934 (and cognate provisions of other revenue acts) which included among exempt corporations “mutual ditch or irrigation companies, * * * or like organizations; but only If 85 per centum or more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses.” The administrative ruling that Anaheim was exempt was withdrawn in 1939, since its oil and other income was of such magnitude as to render it incapable of complying with the 85 percent requirement.
In 1943, the one year In which Anaheim’s directors accidentally set a water rate which together with the non-water income yielded a net profit, the following revealing item appeared in the minutes of Anaheim’s board of directors under date of December 20, 1943 :
“The Secretary reported that he had prepared estimates on income and expense for the year 1943, this estimate included the actual income and expense for eleven months plus an estimate for December, 1943. The result was that we would show a net profit from operations of approximately $22,500.00. He stated that he had consulted Mr. Diehl of the firm of Diehl and Company, Accountants, and that the income tax on this amount would amount to approximately $5,000.00. The Secretary further stated that he had discussed with Mr. Diehl a refund to water users. Water deliveries would be approximately $97,700.00, and a refund of 25% would amount to approximately $24,400.00. Whereupon * * * [motion was made and unanimously carried for a refund].”
Compare Pomeroy Cooperative Grain Co., 31 T.C. 674, 685, where the Court pointed out that in determining what patronage dividends were to be excluded from gross income, the problem “is controlled by Federal law” and not by State law (in that ease Iowa) which provided how and to whom the earnings of the cooperative might be distributed.