*264 Decision will be entered under Rule 50.
1. Petitioner has failed to show that there was a change in the capacity for production or operation of its business consummated subsequent to December 31, 1939, as a result of a course of action to which it was committed prior to January 1, 1940. It has not established the existence of a qualifying factor under section 722 (b) (4), I. R. C. 1939, and is not entitled to excess profits tax relief under section 722 of the 1939 Code.
2. Respondent disallowed certain alleged selling commission expenses paid or incurred during the fiscal years 1944 and 1945 as ordinary and necessary business expenses. The amounts were paid to two partnerships composed of petitioner's stockholder-president and stockholder-general manager in one instance, and composed of a stockholder and a third party in the other instance. Held, that the partnerships did perform services for petitioner, that the commissions did not represent distributions of earnings to shareholders, and that they were ordinary and necessary business expenses deductible under section 23 (a) (1) (A), I. R. C. 1939.
3. The State of North Carolina assessed additional income taxes because *265 of the increase in petitioner's income due to the disallowance of the selling commissions in Issue 2, supra. However, it withheld collection until Issue 2, supra, is finally determined by the Federal Government. Respondent originally allowed these additional taxes as deductions for years imposed but now contends that since petitioner, an accrual basis taxpayer, is contesting the adjustments in Issue 2, supra, the liability for the taxes is contingent and has not yet accrued. Held, that, since increases in income due to adjustments in Issue 2 are improper, see Issue 2, supra, additional taxes based on those improper increases are also improper deductions.
4. Pursuant to a consent decree in a stockholders' suit petitioner paid fees for its attorney of record in that suit and also paid fees for plaintiffs' (minority stockholders') attorney of record. Respondent has allowed these as deductions. As a result of the consent decree, minority stockholders and another group of interests acquired control of petitioner. Petitioner then paid fees to a law firm, of which a minority stockholder was a member, and to a member of the other group in control of petitioner, allegedly*266 for services rendered in stockholders' suit. Petitioner also paid legal fees for petitioner's president's attorneys in connection with the withholding of his salary in the same suit. Held, that the services for which the fees were paid were not for the benefit of petitioner and not deductible as ordinary and necessary business expenses.
*762 The Commissioner determined deficiencies as follows:
| Declared | |||
| Fiscal year ended August 31 | Income tax | value | Excess profits |
| excess-profits | tax | ||
| tax | |||
| 1942 | $ 5,694.57 | $ 5,491.98 | |
| 1943 | 13,190.64 | ||
| 1944 | 1,861.37 | $ 915.25 | 53,004.53 |
| 1945 | 53,478.06 | ||
| 1946 | 13,489.95 | ||
| Total | 7,555.94 | 915.25 | 138,655.16 |
*267 In the same notice, the Commissioner disallowed the petitioner's claims for relief under section 722, I. R. C. 1939, 1 for the fiscal years ended August 31, 1942 to 1946, inclusive. Petitioner's claims for relief under section 722 are as follows:
| Fiscal year ended | Refund claimed under section |
| August 31 | 722 per Form 991 |
| 1942 | $ 12,565.37 |
| 1943 | 42,861.94 |
| 1944 | 8,964.34 |
| 1945 | 20,484.66 |
| 1946 | 7,160.48 |
| 92,036.79 |
In an amended answer filed prior to the hearing the respondent claims increased deficiencies in declared value excess-profits tax for *763 the fiscal year ended August 31, 1944, in the amount of $ 214.78, and in excess profits tax for the fiscal years ended August 31, 1944 and 1945, in the respective amounts of $ 2,553.12 and $ 21,615.29.
The questions involved are:
1. Did the petitioner change the character of its business during the base period, specifically was there a change in the capacity *268 for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940? If so, is petitioner's average base period net income, hereinafter sometimes referred to as ABPNI, an inadequate standard of normal earnings because of the change, and, if so, has it established what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income, hereinafter sometimes referred to as CABPNI? Petitioner contends that it would have earned $ 70,852.61 in 1939 had the changeover been made during the base period, to which it was allegedly committed at December 31, 1939. By backcasting this claimed $ 70,852.61 constructive income for 1939 to the other 3 base period years with a general index of 91.2 per cent, petitioner claims a CABPNI of $ 64,617.58.
2. Are certain alleged selling commission expenses for the fiscal years 1944 and 1945 paid by petitioner to a partnership composed of petitioner's president-stockholder and general manager in one instance and to a partnership composed of a stockholder and another, *269 who owned no stock, deductible as ordinary and necessary expenses incurred in trade or business?
3. Is the petitioner entitled to accrue and deduct in the fiscal years 1944 and 1945 additional State income taxes due to the State of North Carolina for the fiscal years 1944 and 1945 which result from the respondent's disallowance of the items referred to in Issue 2, supra, where the petitioner contests the disallowance (Issue 2, supra) and where the taxes have been assessed by the State but will not be collected until Issue 2, supra, is finally determined by the Federal Government?
4. Were certain parts of the payments by petitioner for litigation expenses alleged to be incident to a stockholders' suit deductible by petitioner as ordinary and necessary expenses incurred in trade or business?
Issues 3 and 4 were raised by the respondent in an amended answer and he has the burden of proof respecting them.
FINDINGS OF FACT.
Some of the facts were stipulated and the stipulation is incorporated herein by reference.
*764 The petitioner, a North Carolina corporation with its principal business address at Saxaphaw, North Carolina, kept its books and prepared its returns on *270 an accrual basis of accounting. Its returns for the periods involved herein were filed with the collector of internal revenue for the district of North Carolina.
Issue 1. Section 722 Relief.
Petitioner was organized November 15, 1933. Upon its organization it purchased all the properties of Royall Cotton Mills, Inc., Wake Forest, North Carolina (hereinafter sometimes called the old company), which had started business about the year 1900, and which had passed into receivership in 1931. The purchase of its properties by petitioner was made under court approval to terminate the receivership. The purchase price was $ 60,000, which was the amount of the unpaid balance on the old company's first mortgage bonds, assumed by petitioner, with the further requirement that the first $ 20,000 of said bonds be personally guaranteed and that not less than $ 25,000 be subscribed in stock of petitioner. The guaranty was furnished by Harvey Seward, hereinafter referred to as Seward, who became petitioner's first president, and by Don P. Johnston, hereinafter referred to as Johnston, Seward's brother-in-law, who had been a director, the last president, and receiver of the old company and who*271 became general manager of petitioner. Johnston replaced Seward as president of petitioner in 1937.
When petitioner acquired the property of the old company it received the mill building with all machinery and appurtenances, all inventories including goods in process, supplies of every nature, 5 warehouses, 68 acres of land, and a mill village of 92 houses. The property was neglected for some time and was in poor condition. The original machinery was still in use; it had been installed about 1900, with additions made in 1913.
The old company was manufacturing carded cotton yarn, principally 20-count, 2-ply (20/2), which was about the only product the mill could make with its existing equipment. The petitioner continued to manufacture the same yarn. The classification of yarn by count and ply refers to the number of hanks of 840 yards each which is required to make a pound, and the number of strands in the yarn. Thus, a 20/2 yarn would be composed of 2 strands of yarn twisted together, each of which weighed 16,800 yards to the pound. This type yarn, 20/2, was principally used in the drape and upholstery fields. There was a seasonal market, depending largely upon automobile upholstery*272 manufacturers. The market was also highly competitive.
Johnston, the petitioner's manager, although familiar with the mill operation did not have a technical knowledge of cotton spinning. *765 George Greason, who had been the superintendent for the old company and the petitioner, retired in 1936. Petitioner, after a careful search for the right man, employed Lewis D. Smart, hereinafter sometimes referred to as Smart, as superintendent. Smart had a technical background and had practical experience in many phases of cotton manufacturing. Petitioner was not able to offer Smart a salary comparable to a salary that he could get elsewhere, but Smart was employed with the understanding that with his technical knowledge he would help put the petitioner in a competitive position whereby profitable products would be manufactured and that he would then be compensated for his efforts by some profit-sharing or stock-ownership plan.
Soon after its organization the petitioner initiated a policy of continuous improvement of plant and equipment. Pursuant to that policy, petitioner made substantial expenditures on plant improvement. In the 5-year period, 1934 through 1938, it added about*273 $ 11,000 to its building account and about $ 66,000 to machinery and fixtures account. It expended an additional $ 53,000, which was charged to expense, on maintenance and repairs in excess of normal expenditures for these items.
As a result of these expenditures the property was in the best condition that it had been for many years. However, the equipment was mainly obsolescent and the operation was inefficient.
Smart, from the time when he became employed by petitioner, was constantly devising plans to improve the petitioner's operations and profits. About 1938, however, Smart realized that petitioner's present operation could not be made profitable. Also, about that time he made a survey which showed that there was an increasing demand for coarse yarn (such as 10-count) which is used for a variety of things, such as cotton duck, wire insulation, chenille goods, carpets, sweaters, ladies' nightgowns, and tape.
In October 1938, petitioner considered consolidating with certain other cotton mills to form a vertical combination. Smart, in a memorandum to Johnston dated October 21, 1938, stated that he believed that petitioner "should be thoroughly modernized as a prerequisite to*274 any expansion." He stated further that he had other attractive business offers but believed "that the possibilities here at Royal should be very profitable to me if provision can be made which would reflect in earnings, my full abilities."
Johnston, in a memorandum dated January 30, 1939, informed Smart that he (Johnston), Willis Smith, hereafter sometimes referred to as Smith, a shareholder and general counsel of petitioner, and Seward agreed that Johnston "should work out some basis of compensation based on our ability to pay plus some future mutual protection. This could be some form of profit sharing or volume and *766 cost determination." Johnston added that Smart should reduce to writing his (Smart's) ideas on proposed mechanical changes in order to plan the financing. In a memorandum dated February 2, 1939, Smart replied to Johnston's memorandum of January 30, 1939. Therein Smart stated:
The following is a list of definite proposals and cost which make up the program for modernization which I believe we should follow:
| (1) Rebuilt Opening and Picking | $ 35,000.00 |
| (2) New Drawing | 7,500.00 |
| (3) New Stripping Equipment | 4,000.00 |
| (4) New Roving | 20,000.00 |
| (5) New Spinning | 100,000.00 |
| (6) New Twisting | 80,000.00 |
| (7) New Winding | 10,000.00 |
| $ 256,500.00 |
*275 This proposal contemplates the change of our product from 20/2 to 10/2.
Instead of a labor cost of about .09 cents per pound a labor cost of about .05 cents per pound could be had, or an annual saving of about $ 120,000.00 on 3,000,000 pounds production.
Under this program and with some definite assurance that in the successful execution of it there would be adequate remuneration accruing to me in the form of stock or on a fair share of the profits I could of course, assure you of my continual cooperation. Especially in view of the fact that I believe we would then be in a position to really expand on a very sound basis.
Smart's proposal for modernization was not financially feasible. The petitioner was greatly handicapped during 1939, as it had been since its organization, by the lack of adequate funds to finance its operation and production even with its then present machinery. In 1939, and even in 1940, it was forced to turn down profitable yarn contracts because of insufficient funds to finance increased production. During 1939, petitioner was not able to meet the payments which were due on the mortgage covering its plant. The bondholders and Seward, the guarantor of petitioner's*276 mortgage, were pressing petitioner for payment. Johnston, in a letter to Smith dated October 13, 1939, stated that he thought the petitioner's present operation could be profitable if its finances could be straightened out.
Petitioner sought to remedy its financial problem by attempting to secure a loan from the Reconstruction Finance Corporation, hereinafter referred to as R. F. C. It prepared a preliminary application dated July 28, 1939, for an R. F. C. loan in the amount of $ 230,000. Of this amount, petitioner stated in its application that it would use $ 150,000 to purchase 200 high-speed looms with which to manufacture finished products of terry cloth and other goods. The remaining amount of the loan was to be used to pay bonds and notes of the petitioner. This application was not filed.
*767 Petitioner filed a preliminary application dated September 6, 1939, with the R. F. C. at Charlotte, North Carolina, for a loan in the amount of $ 150,000. No mention was made on this application of the possible purchase of new machinery. Shortly thereafter this application was rejected. Petitioner again filed a preliminary application dated September 18, 1939, for a loan in*277 the amount of $ 95,000. The R. F. C. again refused to recommend the filing of a final application. The petitioner prepared another preliminary application dated October 10, 1939, for an $ 80,000 loan but it was apparently never filed.
In a memorandum to Smart dated October 2, 1939, Johnston stated as follows:
Mr. Smith suggests that if we get our sights down that maybe we can get a reconsideration by R. F. C. Your proposal for modernization seems to be flexible and it looks as though we will have to go at this thing piecemeal as Mr. Seward will not subordinate his position. But maybe he will release the engines and village if proceeds are applied on bonds.
So again please get your plans on paper and in detail so I can understand it. As I look back at Charlotte, I think we failed on account of lack of a definite plan. As I understand your talk, I believe you have a very definite idea of a worthwhile plan. What I need is to get it onto paper so I can understand it and plan to execute it.
Smart replied to Johnston with a memorandum dated October 13, 1939, which stated in part as follows:
I have discussed with you at some length the reduction of my original program to about*278 half of the original figure of about $ 250,000.00. I do appreciate the necessity of staying within whatever limitation which conditions of finance make necessary. The following represents the bare minimum.
| 1 -- Opening | ||
| 4 to 6 second hand hoppers | ||
| 1 -- 4 or 5 Opening machine | ||
| 2 Vertical openers | ||
| Drives | $ 1,000.00 | |
| Out of the machinery to be junked some of it can be traded for this | ||
| equipment. | ||
| 2 -- Pickers | ||
| Modernizing the picker room can wait until the end of the change-over in | ||
| order to determine if the $ 22,000.00 necessary to buy 3 new pickers will be | ||
| available. | ||
| 3 -- Cards | ||
| Complete new stripping system | 5,000.00 | |
| The present system is worn out and obsolete. | ||
| 4 -- Drawing | ||
| 2 Lap winders | 3,000.00 | |
| 32 Deliveries drawing | 7,500.00 | |
| Some return can be had from the old drawings 3 to $ 4,000.00. | ||
| 5 -- Roving | ||
| 6-88 or 92 Sp. 11 x 5 1/2 or 12 x 6 slubbers | ||
| These can be had by trading some of present old equipment. | ||
| Drives | 2,000.00 | |
| 6 -- Spinning | ||
| 20 frames 4,800 spindles, new long draft large package | ||
| spinning | 90,000.00 | |
| The old frames are only junk and about $ 5,000.00 is all that can be | ||
| recovered from them. | ||
| 7 -- Winding | ||
| 2 -- 100 Sp. Roto Coners | 8,500.00 | |
| 100 to 200 Sp. Precise Winding | 10,000.00 | |
| 8 -- Warping | ||
| Present warping to be retained | ||
| 9 -- Twisting |
*279 *768 To be left until balance of program is completed (12 frames 2,400 Sp. -- $ 60,000.00).
The total cost should be about $ 130,000.00 if any worthwhile recovery is made from the old equipment.
As I have discussed with you I have this week opened discussions with the 3 big machinery companies leading to definite proposals for the purchase of this equipment by us as early as possible.
I believe that we should arrive at something definite in regard to where I stand in this. Since from time to time I am placed in a position which might be embarrassing to both of us if I should find it advantageous to change my employment. There is nothing of this nature which is specific at this time, however, I am sure you will understand that my salary alone is not the sole reason for my being here at this time.
Johnston replied with a memorandum dated November 10, 1939, as follows:
Last night I told you that Mr. Seward's attorney will cooperate.
Mr. Smith did not refile with R. F. C. but I have other plans.
With your assurances to see me through on a modernization program I have decided definitely to go ahead on your plan of October 13th as a basis.
Go ahead with your negotiations with the*280 machinery people and I will handle the minute book when the time comes.
Petitioner's financial difficulties continued. The $ 60,000 in mortgage bonds was a first lien upon petitioner's property. In addition, its poor operating record combined to restrict its credit at lending institutions. Johnston was continually lending his own funds to the petitioner. In 1941, after negotiations which lasted over a year, petitioner sold its two diesel engines which had been used to generate the power for the mill in earlier days for $ 30,000, of which $ 27,500 was used to reduce the bonded indebtedness. It also, in 1941, sold its mill *769 village for $ 55,795, $ 17,400 being paid in cash and the balance being payable on an installment plan.
On April 24, 1941, petitioner's board of directors discussed plans for the modernization of the plant. Johnston stated that he had consulted Smith and Allen, petitioner's auditor, and that they had agreed "that the program should be undertaken as fast as credit and financing permit."
Smart prepared five different and alternative plans dated April 30, 1941, regarding the petitioner's operations. They had all been devised and discussed prior to that*281 time; some of them prior to January 1, 1940. He also prepared a summary schedule comparing the five plans. Plan A was a study of the then present operations of the mill. Plan B was a plan to install $ 367,444 of new equipment which would enable petitioner to produce competitively 40,000 pounds weekly of 20/2 cotton yarn. Plan C was a study of completely liquidating all the mill's holdings for cash. Plan D was a plan to install $ 141,614 of new machinery which would enable petitioner to produce 57,000 pounds weekly of 12/2 cotton yarn. Plan E was a plan to use the then present equipment for some phases of the operation and to purchase: (a) Drawing -- 32 deliveries of controlled draft drawing; (b) spinning -- 4,800 spindles, new 4 1/2-inch gauge-type drive long draft spinning; and (c) winders -- new precision winders. Under plan E the petitioner would produce 60,000 pounds of 10/1 yarn weekly. Plan E was substantially the same as Smart's plan of October 13, 1939, supra, which Johnston assured Smart would be followed. Johnson instructed Smart at that time to "[go] ahead with your negotiations with the machinery people and I will handle the minute book when the time comes."
*282 On May 16, 1941, petitioner placed an order with the Saco-Lowell Shops of Biddeford, Maine, for the purchase of $ 79,699.64 of new machinery, upon terms of 25 per cent net cash and the balance payable in 18 equal monthly installments with interest at 5 per cent per year. Plan E was the basis of the order. On May 30, 1941, petitioner's board of directors approved the contract to purchase the above-mentioned machinery from the Saco-Lowell Shops. The machinery was shipped and completely installed in petitioner's plant by July 1942. The following is a list of the machinery ordered and installed:
| 20 -- Ring spinning frames, 240 spindles each | $ 66,192.00 |
| 2 -- Lap winders | 3,000.00 |
| 32 -- Controlled draft drawing | 8,320.00 |
| Miscellaneous equipment and charges | 2,187.64 |
| Total 1 | 79,699.64 |
*770 The amount of the downpayment required to be made for the purchase of this machinery was guaranteed by Turner, Halsey & Co., hereinafter sometimes referred to as Turner-Halsey, selling agents, of New York City. In order to purchase the machinery*283 it was necessary for petitioner to obtain a guarantee of the downpayment. George C. Busher, an official of Turner-Halsey, in a letter to petitioner stated they were assisting petitioner in financing the purchase of this machinery because of the war demand for the yarn which could be manufactured by such machinery.
The petitioner also, during the fiscal year 1942, expended about $ 46,000 for improvements to its building, for wiring its plant and the addition of electrical fixtures, new office furniture, and for other miscellaneous items of machinery and equipment. It expended an additional $ 60,000 for three new pickers as contemplated by Smart's plan of October 13, 1939, for electric motors for winding, and for a card stripper. These items did not affect the capacity of the new machinery purchased from Saco-Lowell.
The machinery purchased from Saco-Lowell was included by petitioner in an application, executed under oath, which it made for a certificate of necessity for accelerated amortization. In that application petitioner, in part, stated:
About 90% of taxpayer's production goes directly into the war effort. Its product is sold to other concerns whose individual productive*284 capacity is sufficient to supply their demands in normal times. Therefore, when the present emergency is over taxpayer will have no outlet for its product and it will be extremely hard to convert this machinery to other purposes; and it can not be done without the expenditure of considerable money. * * *
Petitioner also stated that it equipped its mill to meet the war emergency. Based on such application, the petitioner was granted a certificate of necessity which permitted it to amortize the cost of such machinery over a short period of time.
The additions and improvements to the petitioner's plant made it completely modern. Its new operation was efficient and many cost savings were effected.
Petitioner's production in pounds for the calendar years 1935 to 1940, inclusive, the 8 months ended August 31, 1941, and for the fiscal years ended August 31, 1942 to 1946, inclusive, is as follows:
| Year | Production |
| (in pounds) | |
| 1935 | 1,779,110 |
| 1936 | 1,996,549 |
| 1937 | 1,762,343 |
| 1938 | 1,171,504 |
| 1939 | 1,107,191 |
| 1940 | 1,579,729 |
| 1941 1 | 1,947,312 |
| 1942 | 4,583,106 |
| 1943 | 5,134,689 |
| 1944 | 5,717,465 |
| 1945 | 5,513,972 |
| 1946 | 4,325,470 |
*771 The yarn manufactured during*285 all periods up to and including the period ended August 31, 1941, was principally 20/2; the yarn manufactured during the fiscal year ended August 31, 1942, was both 20/2 and 10/1; 10/1 yarn was principally manufactured during the periods after the fiscal year ended August 31, 1942. During some weeks in the latter part of 1941 and the early part of 1942 when 20/2 yarn was being manufactured, the petitioner's production reached a rate of about 5,000,000 pounds per year. The petitioner operated on a round-the-clock 7-day basis at that time. During the war period, with the new machinery, petitioner operated its mill for a substantial portion of the time on schedules of 144 or 168 hours per week.
The following schedule shows the petitioner's net sales, net income (or loss), and excess profits net income (or loss):
| Net income | Excess profits | ||
| Year ended or period | Net sales | (or loss) | net income |
| (or loss) | |||
| Dec. 31, 1936 | $ 509,781.16 | $ 1,418.49 | $ 1,418.49 |
| Dec. 31, 1937 | 496,794.57 | 235.33 | 235.33 |
| Dec. 31, 1938 | 268,306.20 | (2,251.40) | (2,251.40) |
| Dec. 31, 1939 | 259,577.39 | 5,734.54 | 5,734.54 |
| Dec. 31, 1940 | 385,038.85 | 532.10 | 532.10 |
| Jan. 1, 1941, to Aug. 31, 1941 | 500,754.53 | 14,926.86 | (9,077.43) |
| Aug. 31, 1942 | 1,539,749.47 | 67,489.83 | 51,527.83 |
| Aug. 31, 1943 | 1,707,802.70 | 80,613.77 | 75,824.88 |
| Aug. 31, 1944 | 1,903,795.29 | 1 112,952.21 | 1 107,455.43 |
| Aug. 31, 1945 | 1,951,836.11 | 1 94,496.66 | 1 86,621.75 |
| Aug. 31, 1946 | 1,851,929.27 | 207,733.95 | 202,083.06 |
Petitioner's excess profits credit, based on invested capital, for each of the fiscal years ended August 31, 1942 to 1946, inclusive, was as follows:
| Fiscal year ended | Invested |
| August 31 | capital credit |
| 1942 | $ 6,967.46 |
| 1943 | 10,489.02 |
| 1944 | 13,237.60 |
| 1945 | 11,230.82 |
| 1946 | 22,309.59 |
The petitioner was not committed to a course of action prior to January 1, 1940, which resulted in a change (increase) in the capacity for production or operation of its business consummated subsequent to December 31, 1939.
Issue 2. Selling Commissions.
Among cotton mills it has been common practice to sell the mill's product through outside selling agents. The arrangements between mills and their outside selling agents vary in detail, but in general *772 the arrangements fall into three groups: (1) Mills which use the same agents both as sales agents and as factors, (2) mills which employ different firms as sales agents and factors, and (3) mills*287 which employ their own salesmen but use outside factors. Smaller mills, such as petitioner, customarily have both selling and factoring done by independent outside firms. The function of the sales agent is to call upon the trade, sell the mill's product, handle complaints, and keep the mill supplied with orders and the customer supplied with the product. The factor's principal function is to guarantee the credit of the mill's customers and to pay invoices immediately, before the factor receives payment from the customer. The advantages to the mill in factoring are that it has no credit problems or risks; to investigate the credit of its customers all over the country would be expensive and would involve losses. Also, by being paid upon its invoices immediately, the mill quickly frees for use working capital which would otherwise be tied up in accounts receivable or inventory. The advantage of employing outside sales agents is that such commission houses, employing their own staff and paying their own expenses, can handle the products of many mills simultaneously and can thus do as good a selling job for the mill as though the mill had sent out its own salesmen to all parts of*288 the country.
Petitioner has never had its own sales force but has always used both factors and outside sales agents. Prior to August 31, 1942, petitioner employed a number of firms as factors and sales agents at various times. Petitioner, with one exception, paid these firms 5 per cent on sales for factoring and selling, which rate was in accord with rates generally paid by carded yarn mills for these services. Petitioner never sold direct to customers, and always protected its brokers even when orders from customers came direct to the mill.
In 1941, petitioner entered into an exclusive selling and factoring arrangement with Turner-Halsey at a rate of 5 per cent. This contract was part of the arrangement under which Turner-Halsey agreed to lend its credit to petitioner and guarantee petitioner's payment of the deferred portion of the purchase price of the new machinery ordered from Saco-Lowell Shops in the spring of 1941. (See Findings of Fact, Issue 1, supra.)
Due to the great increase in the demand for yarn during the war it became increasingly easy to sell the petitioner's product. Most of petitioner's production was going into the war effort. All customers with Government-issued*289 priorities were clamoring for cotton. Petitioner, in the main, was not directed to sell to any particular customers with a priority but could choose among those holding priorities. Many companies during this war period released their sales agents and did their own selling. George C. Buscher, the official of Turner-Halsey who handled the petitioner's sales, did most of his selling *773 during this period of great demand by telephone. He was channeling the petitioner's output to a few large customers rather than distributing the yarn to a larger number of small customers. Petitioner was especially concerned in regard to the postwar period because most of the mills which were purchasing the yarn from petitioner could, under normal conditions, spin a sufficient quantity to meet their own needs. Petitioner wanted to distribute its product to a greater number of small customers so it would not be dependent on the purchases of these few large customers when the war ceased. Buscher, however, was reluctant to change his policies.
At a meeting of petitioner's board of directors on August 28, 1942, Johnston reported that the Turner-Halsey contract had been terminated and that he *290 discussed selling arrangements with a few other factors and brokers. However, he reported that he had negotiated a new contract for a 4 per cent commission with Turner-Halsey and recommended that in view of the fact that Turner-Halsey "had our merchandising to war contracts of the duck program so well in hand" and that they offered to handle the business on a 4 per cent commission instead of the standard 5 per cent, the new contract be approved. The board of directors duly approved the contract.
As of August 2, 1943, petitioner terminated its exclusive sales and factoring arrangement at 4 per cent with Turner-Halsey and entered into a new tripartite arrangement whereby Wm. Iselin & Co., Inc., hereinafter sometimes referred to as Iselin, of New York City was to act as factor and Johnston & Smart, a copartnership composed of Johnston, the petitioner's salaried president, and Smart, the petitioner's general manager, was to act as exclusive sales agent. Petitioner was to pay a total commission of 4 per cent to Iselin, of which Iselin was to retain 1 per cent for its factoring services and was to remit 3 per cent to the copartnership of Johnston & Smart for its services. Johnston, who*291 with members of his family owned 480 of petitioner's 660 common shares, and Smart were equal partners of the selling agency.
Prior to the formation of the partnership, Johnston, as president of petitioner, like executives of most carded yarn manufacturers, frequently visited customers with salesmen. Smart's experience was principally in the technical end of the business. During the course of the Johnston & Smart partnership, Johnston did most of the traveling as sales agent; Smart made some calls on technical matters. The mill's old customers and certain prospective new customers were notified that Johnston & Smart had become exclusive sales agent for petitioner. In the first few months it held petitioner's account, the partnership succeeded in substantially increasing the number of petitioner's customers and in attaining wider geographical distribution. The number of customers remained fairly constant thereafter, but *774 the partnership was able to increase the amounts sold to each customer. The partnership contacted other mills in hope of securing other accounts but none were ever secured. Johnston & Smart acted as petitioner's exclusive sales agent from August 2, 1943, *292 to July 5, 1944.
On March 9, 1944, certain transfers of petitioner's common stock took place. The following schedule shows the ownership of petitioner's common stock during the periods indicated:
| Common Shares Held | ||
| Aug. 3, 1942 | Mar. 9, 1944 | |
| to | to | |
| Mar. 9, 1944 | May 31, 1945 | |
| Don P. Johnston | 211 | 11 |
| Petrona P. Johnston (Johnston's wife) | 268 | 1 |
| Jessie P. Powers (Johnston's sister-in-law) | 1 | 9 |
| Don Johnston, Jr. (Johnston's son) | 100 | |
| Lewis D. Smart | 349 | |
| H. H. Harris | 9 | |
| I. Beverly Lake | 1 | |
| Willis Smith | 60 | 60 |
| Mary Creecy Smith (Smith's mother) | 90 | 90 |
| Anna Lee Smith (Smith's wife) | 30 | 30 |
| Total | 660 | 660 |
Smart purchased his shares from Johnston and his (Johnston's) wife, some for $ 25 per share and the others for $ 50 per share.
During the period that Johnston & Smart was acting as sales agent for petitioner, Johnston was approached by I. Beverly Lake, an attorney at law, who had drawn the Johnston & Smart partnership agreement. Lake stated that he had been contacted by an attorney for certain minority stockholders, who apparently disliked the existing sales arrangement because they felt there was some impropriety in Johnston's acting both as president*293 of petitioner and as a partner in petitioner's sales agent. Lake advised that Johnston confine himself to the sales end of the business and that Smart should take over the mill operation exclusively. Accordingly, on July 3, 1944, Johnston resigned as president, treasurer, and director of petitioner; his wife, Petrona P. Johnston, resigned as director, assistant treasurer, and assistant secretary; and his sister-in-law, Jessie P. Powers, resigned as director and vice president of petitioner. To fill these vacancies Smart was elected president, treasurer, and director; H. H. Harris was elected director and vice president; Lake was elected director and assistant treasurer; and Jessie P. Powers was elected assistant secretary. Two days thereafter, the tripartite arrangement between petitioner, Iselin, as factor, and Johnston & Smart, as sales agent, was terminated. On the same day, a new tripartite agreement was executed upon the same terms, except that the Johnston & Smart partnership was replaced as sales agent by Johnston & Co., a new partnership composed of Johnston and L. C. Milliken, hereinafter sometimes referred to as *775 Milliken, vice president of Iselin. A separate*294 agreement was executed between petitioner and Johnston & Co., as sales agent. The shares of the partners in Johnston & Co. were as follows: Johnston, 85 per cent, and Milliken, 15 per cent. Smart had no interest in Johnston & Co.
The partnership of Johnston & Co. acted as exclusive sales agent of petitioner from July 5, 1944, to May 31, 1945. All commissions on sales billed or shipped after July 3, 1944, were paid to Johnston & Co. During this period, as during the period when Johnston & Smart was sales agent, petitioner paid a commission of 4 per cent to the factor, Iselin, in New York City. The factor in turn remitted 3 per cent to the sales agent. The partnerships were paid the 3 per cent commission on all sales, regardless of who the customer was. Both partnerships reported the commissions earned by them on Federal partnership information returns.
During the periods when Johnston & Smart and Johnston & Co. were petitioner's sales agents many other mills which retained sales agents were paying a 2 per cent sales commission, and some others were paying a higher percentage.
Petitioner was listed in Davison's Blue Book, a standard textile trade directory, for the year 1943 *295 as selling through Turner-Halsey. When Davison's Blue Book sought information for the 1944 publication Johnston & Smart had not yet been perfected. Petitioner informed Davison's that it was selling direct and it was listed as selling direct in the 1944 and 1945 issues of that publication.
Johnston & Co., during the month of November 1944, advertised itself in a style trade journal as sales agent for petitioner as follows:
Royal is almost entirely on war work, so we haven't much to sell. But we would like to know you -- talk over plans for peace-time production. Just tell us when . . . and we'll be glad to ring your doorbell.
Johnston & Smart had their offices in a room in the upstairs of petitioner's old storehouse building in the small village of Wake Forest, North Carolina. Other selling agencies are usually located in large cities and some have offices in many cities.
Petitioner received a lengthy protest dated July 28, 1944, in writing, from Smith on behalf of himself and certain members of his family, who also were stockholders. Smith alleged various acts of improper conduct on the part of petitioner and its officers, and Smart and Johnston in particular, and alleged that*296 the selling arrangements between petitioner on the one hand, and the partnerships of Johnston & Smart and Johnston & Co. on the other hand, were improper. He demanded, among other things, that such selling arrangements be terminated at once and that any commissions paid thereunder be refunded in full to petitioner, and that petitioner thereafter sell its products *776 only through its own salaried employees. He further demanded that Smart's salary as president, which was $ 20,000, be reduced so as not to exceed $ 10,000 per year.
Smith's demands were considered at a meeting of the board of directors but final action was postponed until after the receipt of a report of Barnes Textile Associates of Boston, Massachusetts (that firm was apparently a managerial and sales consultant firm), regarding its study of the management and sales policy of petitioner. That study was authorized by petitioner's board of directors prior to the receipt of Smith's protest.
At a meeting of petitioner's stockholders on October 25, 1944, Smart instructed the secretary to read the report of Barnes Textile Associates. The secretary read the report. The full report was included in the minute book *297 and the conclusion which was included in the body of the minutes of the meeting was as follows:
V. Conclusion.In the foregoing a professional opinion has been presented treating with the subjects of Chief Executive's Salary, Selling Commission, and Comparable Qualifications of Selling Agency currently related to the subject company.
A. -- The present salary of $ 20,000.00 per year for the president and treasurer has been found not to exceed salaries paid by comparable mills.
B. -- The current arrangements for payment of 3% commission for selling and 1% commission for factoring has been indicated as directly in line with standard practice by comparable mills in the industry.
C. -- The rating of the present selling agency has been shown as comparable to the best agencies tied in with other similar mills from the standpoint of planning foresight and achievement.
Discussion of plans for the future administrative protection with the president-treasurer and the selling agent further indicates a high degree of qualification. In both instances steps have either already been taken or are in the process of development, for training understudies and successors to their respective positions.
*298 Smith's demands were then considered and in October 1944, prior to the rejection, Smith and others (members of his family) brought suit against petitioner, Johnston and Smart, individually, and the partnerships of Johnston & Smart and Johnston & Co. in the Superior Court of Wake County, North Carolina. The alleged grounds of the suit were the same as those stated in Smith's demands made directly to petitioner. Plaintiffs asked, among other things, that the company be placed in receivership, that the selling arrangements between petitioner and the two partnerships be terminated, and that all commissions paid under such arrangements be restored to petitioner. Acting upon the allegations of plaintiffs' complaint, the Wake County Superior Court promptly entered a temporary restraining order, pending an adjudication upon the merits, which withheld payment of future commissions to Johnston & Co. and future salary payments to Smart.
*777 Although this suit was at issue and pending for several months, no trial was ever had and the Superior Court never rendered a decision on the merits. The suit was settled by agreement of the parties on May 31, 1945. Pursuant to this agreement, *299 a consent judgment was entered in the Superior Court which dismissed the suit and provided, inter alia, that the temporary restraining order was dissolved and that all sums withheld by petitioner from Smart and Johnston & Co. should be paid. The judgment further provided that plaintiffs recover nothing from any of the defendants and that petitioner, as defendant, recover nothing from the other defendants. The judgment terminated the sales agreement between Johnston & Co. and petitioner as of May 31, 1945, but provided that Johnston & Co. was entitled to its stated commission on goods shipped by petitioner up to that date. This consent judgment was carried out according to its terms and no refunds to petitioner were made either by Johnston & Smart or Johnston & Co. on account of commissions as petitioner's sales agents.
An integral part of the settlement, although not included in the specific terms of the consent judgment, was an agreement between the minority shareholders (Smith and members of his family owned 180 shares) and the majority shareholders (Smart, Johnston and members of his family, and other holders of a small number of shares, who apparently were aligned with the*300 majority, owned 480 shares) whereby the minority group had the option of buying out the majority or selling out to the majority. The agreement contemplated the sale of either block of the petitioner's common stock at $ 500 per share.
Smith induced B. E. Jordan, hereinafter sometimes referred to as Jordan, to join him in the purchase of the majority's 480 shares. Smart handled the transaction, which took the form of a pooling arrangement, for the majority. He collected all of their shares, including his own, and deposited them with a bank. Jordan deposited $ 165,000 (330 shares at $ 500) with the bank covering the price for one-half of petitioner's 660 shares which he was purchasing for himself, his wife, and Sellers Mfg. Co. Willis Smith, Jr., Smith's son, purchased 25 shares; Smith purchased 125 shares. These purchases, added to the 180 shares already held, brought the holding of Smith and members of his family up to 330 shares, or one-half of petitioner's outstanding common shares. Smith did not pay $ 500 per share for the 125 shares which he purchased. Smart and Smith worked out a plan whereby Smith would receive a concession of $ 32,500 on the 125 shares he purchased. *301 Smart directly absorbed $ 25,000 of this amount by reduction of his share of the sale proceeds. A memorandum prepared by Johnston at the time of the sale containing his understanding of the transaction shows that Johnston & Co. was to absorb the remaining $ 7,500. Johnston agreed to this reduction in settlement *778 of Smart's share of certain profits which had accrued to Johnston & Smart but which Smart had not yet received. Therefore Smart, in effect, absorbed the entire $ 32,500 reduction in selling price to Smith.
During the fiscal years ended August 31, 1944 and 1945, the partnerships of Johnston & Smart and Johnston & Co. were paid selling commissions in the amounts of $ 54,236.90 and $ 54,111.96, respectively.
Petitioner, for the fiscal years ended August 31, 1944 and 1945, after payment of the above-mentioned selling commissions to Johnston & Smart and Johnston & Co., had the amounts of $ 33,110.49 and $ 49,028.31, respectively, in its surplus account.
During the following years petitioner's total gross sales and total commissions (selling and factoring) paid or incurred were as follows:
| Fiscal year ended August 31 | Sales | Commissions |
| 1944 | $ 2,081,651.86 | $ 79,403.75 |
| 1945 | 2,118,830.14 | 68,771.99 |
| 1946 | 1,952,828.72 | 33,352.42 |
*302 Respondent, in his notice of deficiency, disallowed as deductions the amounts of $ 54,236.90 and $ 54,111.96 paid to the partnerships of Johnston & Smart and Johnston & Co. during the fiscal years ended August 31, 1944 and 1945, respectively, and explained the disallowance as follows:
(b) It has been determined that * * * the deduction claimed in your return as commissions actually represented payments made directly or indirectly to your stockholders; these so-called commissions are disallowed as not representing ordinary and necessary business expenses under the provisions of the Internal Revenue Code.
The above-mentioned amounts were actually paid by petitioner to Johnston & Smart and Johnston & Co. for services performed. None of these amounts were ever refunded to petitioner. They were ordinary and necessary expenses paid or incurred in carrying on its business during the fiscal years ended August 31, 1944 and 1945, respectively.
Issue 3. Accrual of State Income Taxes.
Petitioner in all years relevant has filed its tax returns and kept its books on an accrual method of accounting.
Respondent, in his statutory notice, increased petitioner's net income by disallowing certain*303 selling commission deductions (see Findings of Fact, Issue 2, supra) claimed by petitioner in its Federal income tax returns for the fiscal years ended August 31, 1944 and 1945, in the amounts of $ 54,236.90 and $ 54,111.96, respectively. By reason of such disallowance, respondent increased the amounts of State *779 income tax deductible by petitioner in the amount of $ 3,254.21 for the fiscal year ended August 31, 1944, and in the amount of $ 3,246.72 for the fiscal year ended August 31, 1945. The above amounts of additional State income tax were arrived at by applying the North Carolina income tax rate of 6 per cent to the amount of selling commission deductions disallowed for each of the years ended August 31, 1944 and 1945.
The State of North Carolina on December 8, 1954, gave notice to petitioner that it had assessed the above amounts of additional State income tax. However, on December 30, 1954, it notified petitioner that it would take no step to collect such tax pending a final determination by the Federal Government of whether the amounts of selling commission deductions disallowed by respondent are properly disallowable.
Petitioner contested and is contesting*304 respondent's disallowance of the selling commission deductions. It has not paid the State of North Carolina the above amounts of additional State income tax. It, however, has admitted liability for the tax if the selling commission items are determined contrary to its contention.
Issue 4. Litigation Expenses.
The petitioner, as one of the defendants in the stockholders' suit (see Findings of Fact, Issue 2, supra) brought by the minority stockholders, Smith and members of his family, was represented by counsel. Its counsel of record were I. Beverly Lake, the firm of Bailey, Holding, Wyatt & Lassiter, and W. H. Hofler. Such attorneys were paid the following amounts by petitioner in connection with the service rendered with respect to the minority stockholders' suit:
| I. Beverly Lake | $ 2,000.00 |
| Bailey, Holding, Wyatt & Lassiter | 4,188.48 |
| W. H. Hofler | 2,000.00 |
These amounts were deducted by petitioner on its Federal income and excess profits tax return for the fiscal year ended August 31, 1945, and these deductions are not questioned by respondent.
Smith and members of his family, the plaintiffs in the above-mentioned suit, were represented by counsel. Such counsel*305 were W. T. Joyner and the firm of Douglass & Douglass. The consent judgment entered by the court in the minority stockholders' suit provided, "[that] in compensation for services rendered in this litigation for its benefit, defendant Royal Cotton Mill Company is directed to pay out of its funds fees to counsel for the plaintiff, Messrs. Douglass & Douglass and Mr. W. T. Joyner, the total sum of $ 12,500." Petitioner, during the fiscal year ended August 31, 1945, paid to such attorneys for the plaintiffs an amount of $ 12,617.85 for services rendered by *780 them in connection with the minority stockholders' suit. This amount was deducted by petitioner on its Federal income and excess profits tax return for the fiscal year ended August 31, 1945, and this deduction is not questioned by respondent.
The consent judgment provided that the petitioner was to be relieved of any further obligation to compensate its counsel who had appeared for it in the case.
Prior to the commencement of the stockholders' suit, Jordan was approached by Smith, whom Jordan had known for some years. Smith had been a stockholder of petitioner since its organization. Smith had also been general counsel*306 of petitioner from the time of its organization until sometime prior to the time when he approached Jordan. Jordan did not know whether Smith was an officer of petitioner at that time. Smith referred to a dispute among petitioner's stockholders and asked Jordan to come to Wake Forest and make an appraisal of petitioner's mill for him. Jordan refused, saying that he did not want to become involved gratuitously in someone else's fight and that it would only create ill will for him in the industry. He finally told Smith that he would consent to make an appraisal of petitioner's plant only on the basis of a professional engagement, and for a fee, which Jordan specified. Jordan was not in the business of making appraisals; however, he had been associated with the cotton textile industry most of his adult life and was familiar with many phases of the industry. At the time of the appraisal his salary from the cotton manufacturing firms in which he was interested was between $ 35,000 and $ 40,000 per year. After several days, Smith contacted Jordan and told him to make the appraisal upon Jordan's terms. Jordan later went to the plant with Smith and was introduced to Smart, petitioner's*307 president and director who was aligned with the stockholders opposed by Smith. Smart conducted Jordan around the plant and offered to help Jordan in any way he could in making the appraisal. Jordan made other visits to the mill in connection with his appraisal. Jordan, in making his appraisal, also consulted a previous appraisal of petitioner's plant and equipment which had been made on December 28, 1942, by J. E. Sirrine & Company. Jordan, on November 8, 1944, submitted his appraisal to Smith.
Other than the submission of two affidavits, Jordan was in no other way connected with the minority stockholders' suit. One of the above-mentioned affidavits submitted by Jordan dealt in part with the appraisal which he had made of petitioner's plant.
Smith was a member of the law firm of Smith, Leach & Anderson.
As a result of the settlement of the above-mentioned lawsuit, Smith and members of his family acquired additional shares to bring their holdings to 50 per cent of the common shares. Jordan, his wife, and Sellers Mfg. Co., in which company Jordan was interested, acquired *781 the other 50 per cent of petitioner's common shares. After these stock acquisitions, on May 31, *308 1945, a meeting of petitioner's stockholders was held. At that meeting, Smith, who presided at the meeting, stated that his law firm, Smith, Leach & Anderson, and Jordan had, in connection with the stockholders' suit, rendered valuable services to the petitioner and that in view of the results obtained for the benefit of the petitioner they should be substantially compensated for those services. The stockholders unanimously approved a resolution that both the firm of Smith, Leach & Anderson and Jordan should be paid a substantial amount to cover their services in connection with the minority stockholders' suit. The directors named that day were Smith, Smith's son, Jordan, and Jordan's wife. Also, Jordan was elected president and Smith, vice president.
Pursuant to the resolution of the stockholders, petitioner, during the fiscal year ended August 31, 1945, paid $ 10,000 to Smith, Leach & Anderson, as attorney fees for the plaintiffs in the minority stockholders' suit, and $ 10,000 to Jordan. These amounts were deducted by petitioner on its Federal income and excess profits tax return for the fiscal year ended August 31, 1945.
Pursuant to a restraining order which had been entered*309 by the court in the minority stockholders' suit, the sum of $ 9,600 was withheld from the salary of Smart. Pending a determination of whether his salary was excessive, such amount was deposited with a bank under the jurisdiction of the court. The law firm of Fuller, Reade, Umstead & Fuller represented Smart in his capacity as an individual defendant in the above-referred-to minority stockholders' suit. By the terms of the consent judgment entered on the conclusion of the lawsuit, the amount withheld from the salary of Smart was paid over to him.
During the fiscal year ended August 31, 1945, petitioner paid to the firm of Fuller, Reade, Umstead & Fuller, as attorneys for the defendant Smart, the sum of $ 2,000. This amount was deducted by petitioner on its Federal income and excess profits tax return for the fiscal year ended August 31, 1945.
Petitioner, on its return for the fiscal year ended August 31, 1945, deducted $ 42,982.08 as litigation expenses incurred in connection with the stockholders' suit. Of that amount, $ 22,000 ($ 10,000 to Smith, Leach & Anderson, $ 10,000 to Jordan, and $ 2,000 to Fuller, Reade, Umstead & Fuller) is in controversy here. It is in controversy*310 because respondent, in an amendment to his answer, alleges that in his determination of the deficiency for the fiscal year ended August 31, 1945, he erred in allowing petitioner a deduction as ordinary and necessary business expenses of the following amounts:
| $ 10,000 | to Smith, Leach & Anderson |
| 10,000 | to Jordan |
| 2,000 | to Fuller, Reade, Umstead & Fuller |
*782 Respondent affirmatively alleges that these amounts should be disallowed and the deficiency for 1945 should be increased accordingly.
The services rendered by Smith, Leach & Anderson, by Jordan, and by Fuller, Reade, Umstead & Fuller, were not primarily for the benefit of the petitioner. The fee of $ 10,000 to Smith, Leach & Anderson, the fee of $ 10,000 to Jordan, and the fee of $ 2,000 to Fuller, Reade, Umstead & Fuller, for those services paid by petitioner are not ordinary and necessary expenses paid or incurred in carrying on petitioner's trade or business.
OPINION.
The issues will be discussed in the same order as the findings of fact relating to them.
Issue 1. Section 722 Relief.
Petitioner seeks excess profits tax relief, relying on section 722 (a) and (b) (4). The first question is whether the petitioner*311 has established the existence of a qualifying factor. It relies on a change in character of its business, specifically a commitment. The qualifying factor relied upon is defined in section 722 (b) (4), as follows:
Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940 * * *
Such change, if it occurred, is deemed to have been made on December 31, 1939.
Regulations 112, section 35.722-3 (d), provide, in part, as follows:
Such a commitment may be proved by a contract for the construction, purchase, or other acquisition of facilities resulting in such change, by the expenditure of money in the commencement of the desired change, by the institution of legal action looking toward such change, or by any other change in position unequivocally establishing the intent to make the change and commitment to a course of action leading to such change. * * *
Petitioner contends that soon after its inception it realized that it could not hope to operate successfully with the same equipment and manufacturing the same*312 products; that it made investigations to determine what sort of changes were necessary in order to put it on a profitable basis, employing an experienced man specifically for that purpose; that in 1939 it adopted a specific plan involving the purchase of a substantial amount of new machinery, the discarding of certain old machinery, the manufacturing of a different product, and the doubling of its productive capacity; that because of financial difficulties it could not carry out the plan in 1939; and that in 1941-1942 when its financial problems were solved it carried out the plan.
*783 For the reasons hereinafter stated, we do not think the record sustains the petitioner's position. The conclusion that early in the base period petitioner realized that its present operations could not be successful is not supported. Soon after it commenced operations it initiated a policy of continuous improvement of its physical plant. During the period 1934 to 1938, it added $ 66,000 to its machinery account, $ 11,000 to its building account, and expended $ 53,000 on maintenance repairs in excess of normal expenditures on these items. The expenditures contemplated the improvement of the*313 then existing operations; not a change in operation as was consummated in 1942.
It is true that petitioner hired Smart with an eye toward making its operation profitable and if he was successful, to compensate him in the future with some sort of profit-sharing plan. Smart, who was not a witness at the hearing, appears to have been thoroughly qualified for his work and a person who was continually devising plans to make petitioner's operation successful. There is nothing, however, that indicates that he was hired in conjunction with the alleged realization that a complete change of operation was necessary.
Smart's memorandum dated October 13, 1939, and Johnston's reply dated November 10, 1939, which, judging from petitioner's argument in its brief, purportedly embrace the "plan" and its adoption by petitioner, if considered in vacuo might be considered to be a course of action to which the taxpayer was committed prior to January 1, 1940. However, when viewed in relation to other circumstances it seems clear that petitioner made no change in position and was not committed to that plan within the meaning of section 722 (b) (4) and the Treasury regulations quoted above. *314 In 1941, shortly before the order for the new machinery was placed with Saco-Lowell, Smart prepared five separate and distinct plans concerning petitioner's operation. Undoubtedly some of them were originally devised and discussed during the base period and did not constitute new plans. It is significant, however, that Smart brought the information in these plans up to date. If petitioner was committed to the October 13, 1939, plan there would have been, it seems to us, no need to relate the other plans to 1941 conditions.
The petitioner relies heavily on Studio Theatre Inc., 18 T. C. 548 (1952). We think that case is distinguishable on its facts and is not controlling here.
The record as a whole, we think, does not show that the petitioner made any "change in position unequivocally establishing the intent to make the change and commitment to a course of action leading to such change." Accordingly, we hold that petitioner has failed to establish the existence of a qualifying factor. The lack of a qualifying factor makes it unnecessary to decide whether the petitioner's ABPNI is an inadequate standard of normal earnings and whether the petitioner*315 has *784 established what would be a fair and just amount representing normal earnings to be used as a CABPNI.
We sustain the Commissioner in his denial of petitioner's claim for relief under section 722.
Issue 2. Selling Commissions.
This issue involves the question of whether certain selling commissions in the amounts of $ 54,236.90 and $ 59,111.96 which were paid or incurred in the fiscal years 1944 and 1945, respectively, are deductible under section 23 (a) (1) (A) as ordinary and necessary expenses of carrying on petitioner's business.
Prior to the years in question petitioner, in accord with the industry's custom, had always sold its product through a sales agent and also factored its accounts receivable. The rate for both services combined was usually 5 per cent of sales. During the war there was a great demand for cotton products; customers with Government priorities were clamoring for yarn; and it became increasingly easy for mills to sell their products and, in some instances, they could do so without the services of a sales agent. Some mills disposed of their sales agent. Many mills which retained their sales agents paid a 2 per cent commission while others*316 paid 3 per cent or more.
Petitioner became dissatisfied with its agent, Turner-Halsey, to which it was paying 4 per cent for selling and factoring because Turner-Halsey was selling petitioner's production to a few large customers. Petitioner was especially concerned in regard to the postwar period. Most of the mills which were purchasing yarn from petitioner could, under normal circumstances, spin a sufficient quantity to meet their own needs. Petitioner was seeking to distribute its products to a greater number of small customers so it would not be dependent on the purchases of a few large customers when the war ceased.
In August 1943, petitioner terminated its contract with Turner-Halsey and entered into a contract with a partnership composed of Johnston, petitioner's salaried president who with other members of his family owned 480 of the petitioner's 660 shares of common stock, and Smart, petitioner's general manager, which provided that the partnership would be petitioner's exclusive selling agent for a 3 per cent commission. Johnston and Smart were equal partners. The partnership operated out of office space in petitioner's old storehouse in Wake Forest and had no branch*317 offices. In the first few months, however, the partnership substantially increased the number of petitioner's customers.
In March 1944, Johnston and other members of his family sold 349 of their shares of petitioner's common stock to Smart and 10 shares *785 to two other persons. Johnston was advised that certain minority shareholders did not regard Johnston's acting as both president of petitioner and its sales agent as proper. Thereafter, in July 1944, Johnston and other members of his family resigned their positions as officers and directors of petitioner and Smart was elected president; the contract with Johnston & Smart was terminated; and a new contract, with the same terms, was entered into with Johnston & Co., a partnership composed of Johnston, who with other members of his family now owned 121 shares of petitioner, and Milliken, who owned no stock in petitioner. Johnston had an 85 per cent interest and Milliken had a 15 per cent interest in the partnership. This partnership acted as petitioner's exclusive sales agent from July 5, 1944, to May 31, 1945.
About August 1, 1944, petitioner received a lengthy protest from Smith and certain members of his family alleging*318 improper conduct on the part of petitioner and its officers, Johnston and Smart particularly, regarding the petitioner's selling arrangements. Petitioner considered the objections in light of a survey made by a third party of petitioner's management and sales policies. The demands of the protesters were rejected. In the meantime, Smith and the other members of his family who were stockholders brought suit against petitioner, Johnston, Smart, and the two selling partnerships. The suit was settled on May 31, 1945. A consent decree was entered providing that no party should recover from any other party. As part of the settlement the majority shareholders (Johnston and members of his family, Smart, and others) sold their 480 shares of petitioner's common stock to the minority shareholders (Smith and members of his family) and to those whom the minority brought in (Jordan interests). The stock was sold for $ 500 per share; however, Smith received a discount of $ 32,500 on the shares which he purchased. The discount was absorbed by Smart.
The respondent does not contend that selling commissions during the war period are objectionable per se. He does contend they are not deductible*319 in the instant case because they were paid to selling agents who were connected with the petitioner in other ways. During the periods when they acted as selling agents and shared in the commissions, Smart was general manager for 11 months and majority shareholder for 4 months; Johnston was president for 11 months and a continuous shareholder; and Milliken, the other partner in Johnston & Co., never had any direct connection with petitioner.
We think the respondent's disallowance of these commissions was in error. It should be pointed out at this juncture that our task is not to decide whether the payments in question were ethical in character. Our function is to decide whether they are deductible as ordinary and necessary business expenses under section 23 (a) (1) (A). See *786 Lilly v. Commissioner, 343 U.S. 90">343 U.S. 90 (1952). There is no question but that the partnerships were separate and distinct entities. The fact that Johnston visited customers in his capacity as president does not mean that he did not perform other services as a salesman which he did not customarily perform in his capacity as president. If this were not so there would be*320 no justification for paying commissions to other sales agents such as Turner-Halsey, which the respondent concedes are proper. Also, Johnston acted in the dual capacity as president of the corporation and salesman of the partnership for only 11 months. Although the partnerships did not have service facilities comparable to some of the other larger sales agents, the record shows that the partnerships did act as petitioner's exclusive sales agent and they performed their functions in a manner which so far as the record shows was satisfactory. Considering these circumstances, respondent's reliance on Gregory v. Helvering, 293 U.S. 465">293 U.S. 465 (1935), is misplaced.
The 3 per cent rate paid, although in excess of the 2 per cent rate paid by some mills during this period, was the same as or less than the rate paid by other mills and cannot be considered, in the light of the evidence, unreasonable in amount. See J. T. Flagg Knitting Co., 12 T. C. 394 (1949).
Also, it seems clear that these commissions were not disbursements of dividends to stockholders as respondent contends. They were not paid to stockholders in proportion to*321 their stockholdings. The facts, we think, establish that they were not intended as dividends but were intended to be what they purported to be, namely, the payment of commissions for services performed.
Upon consideration of all the evidence, it is our conclusion that respondent erred in disallowing the sales commissions in the fiscal years 1944 and 1945. We think the record establishes that the commissions were actually incurred and paid for services performed for petitioner and were ordinary and necessary expenses paid or incurred in carrying on the petitioner's business.
Issue 3. Accrual of State Income Taxes.
Petitioner is an accrual basis taxpayer.
Respondent, in his notice of deficiency, increased petitioner's net income for the fiscal years 1944 and 1945 by disallowing certain claimed deductions for selling commissions. (See Issue 2, supra.) As a result of this increase in net income respondent allowed additional State income taxes for the fiscal years 1944 and 1945 as proper accruals and deductions. Based on the Commissioner's determination the State of North Carolina has assessed these additional taxes but has withheld collection until a final determination by*322 the Federal Government. Respondent, *787 in an amended answer, asserts that he erred in allowing the additional State income taxes. He contends that they did not accrue in the years involved (fiscal years 1944 and 1945) since petitioner is contesting the selling commissions disallowance and in effect is contesting the additional State income taxes. In other words, the taxes in question were and still are contingent.
Obviously, the respondent is correct in asserting that he erred in allowing the additional State income taxes that were based on improper increases in income, such as the disallowance of the selling commissions. See opinion, Issue 2, supra. Curran Realty Co., 15 T. C. 341, 344 (1950). We do not understand that the petitioner objects to our holding for the respondent on this issue in the event he prevailed on Issue 2, supra.
Accordingly, we hold for the respondent on this issue.
Issue 4. Litigation Expenses.
Petitioner, on its 1945 return, deducted $ 42,982.08 as litigation expenses incurred in connection with the stockholders' suit. (See Issue 2, supra.) The respondent, in an amended answer, asserts that items representing*323 $ 22,000 of that amount, comprising payments of $ 10,000 to the law firm of Smith, Leach & Anderson, $ 10,000 to Jordan, and $ 2,000 to the law firm of Fuller, Reade, Umstead & Fuller, are not ordinary and necessary business expenses incurred in trade or business under section 23 (a) (1) (A) and not deductible by petitioner. Respondent further alleges that he erred in allowing this $ 22,000 as a deduction in his determination of the deficiency for the fiscal year 1945 and prays for an increased deficiency for that year.
The petitioner paid its attorneys of record in the suit $ 8,188.48 and paid other incidental expenses connected with the litigation. It paid the attorneys of record for the plaintiffs (Smith and members of his family) $ 12,617.85 pursuant to the mandate of the consent judgment which recited that plaintiffs' attorneys of record rendered valuable services for the benefit of petitioner. The consent judgment provided that petitioner was to be relieved of any further obligation to compensate its counsel who had appeared for it in the case. The above-mentioned amounts described in this paragraph were deducted by the petitioner and are not questioned by respondent.
Prior*324 to the commencement of the lawsuit Smith, who at this time was not an officer or director of petitioner, requested Jordan to appraise petitioner's property. Jordan, who was qualified to make such appraisal, did so. Jordan's only connection with the lawsuit was the submission of two affidavits, one of which dealt with the appraisal.
After the settlement of the lawsuit Smith and members of his family acquired additional shares of petitioner's common stock to bring *788 their holdings to 50 per cent of such shares. Jordan, his wife, and a company with which he was connected acquired the other 50 per cent. Smith and Jordan were elected officers and directors of petitioner. At a meeting of petitioner's shareholders Smith stated that his law firm, Smith, Leach & Anderson, and Jordan had rendered valuable services for petitioner in connection with the lawsuit. The stockholders voted to substantially compensate them for those services. Petitioner paid Smith, Leach & Anderson $ 10,000 and Jordan $ 10,000.
Petitioner also paid $ 2,000 to Fuller, Reade, Umstead & Fuller, as attorneys of record for defendant Smart, petitioner's president at the time of the suit.
The determination *325 of whether the items involved are ordinary and necessary business expenses is essentially one of fact and the principal question here is whether the services, if any, performed by the recipient of the fees were for the benefit of the petitioner or for the individual stockholder. Cf. Charles Kay Bishop, 25 T. C. 969, 972-973 (1956).
The respondent, who admittedly has the burden of proof on this issue, see Rule 32, Tax Court Rules of Practice (Jan. 15, 1957), takes the position that --
Inasmuch as the benefits to petitioner in connection with the litigation were secured by its own counsel and according to the consent judgment by Messrs. Douglass and Douglass and Mr. W. T. Joyner, [plaintiffs' counsel of record] the only possible conclusion is that the remaining legal expenses at issue herein, were incurred strictly for the benefit of the individual stockholders concerned, and are therefore not deductible.
Petitioner contends that the respondent has not shown, with the exception of Jordan's services, what services were or were not rendered; that he has failed to show that the Jordan fee was unreasonable; that there is no showing that the services were*326 not for the benefit of petitioner; and that therefore the respondent has not maintained his burden of proof.
We think the inference reasonably to be drawn from all the facts and circumstances supports the respondent's position. The recitations in the consent judgment that petitioner should pay the fees of plaintiffs' attorneys of record for valuable services rendered to petitioner and that petitioner should be relieved of any further obligation to compensate its counsel in the case indicate the extent of the services of the various counsel which were of benefit to petitioner. On the other hand, Smith's statement at the stockholders' meeting, after he and Jordan had obtained control, that his own law firm and Jordon performed valuable services for petitioner is made questionable by the close relation between those in control of petitioner and those who were the recipients of the fees. Also, it is difficult to see how Smart's attorney, who apparently represented him in regard to the withholding *789 of his salary, could have performed any service for the benefit of petitioner.
Under these circumstances we think that respondent has at least established a prima facie case. In*327 our view petitioner has not rebutted it. Accordingly, we hold that the fees in question are not ordinary and necessary expenses incurred in petitioner's trade or business.
Reviewed by the Special Division as to the section 722 issue.
Decision will be entered under Rule 50.
Footnotes
1. All section references are to the Internal Revenue Code of 1939, as amended.↩
1. There were a few other items of small amount that were subsequently ordered and there were other minor adjustments of price.↩
1. Eight months.↩
1. Petitioner is contesting in this proceeding the disallowance of certain selling commission deductions made by the revenue agent. Also, these amounts do not reflect the adjustments asserted by respondent in his amended answer.↩