Decisions in docket Nos. 80949, 80954, 80955, 80957, 80958, 80959, 95427, 95428, 95429 and 95431 will be entered under Rule 50.
Decisions in docket Nos. 95425 and 95426 will be entered for the petitioners.
Decisions in docket Nos. 80950, 80951, 80952, 80953, 95430, 95432 and 95433 will be entered for the respondent.
In 1955, the five individual petitioners, engaged as partners in the business of processing and selling sausage products, decided to incorporate the business. It was determined that the four petitioner corporations would be organized, each to take over a portion of the partnership business. Articles of incorporation for the four corporations were filed on July 29, 1955, but it was not until 1956 that most of the steps were taken to transfer the business to the corporations. The stock of each of the four corporations was issued to the five individual petitioners in equal amounts. The business conducted by the four petitioner corporations in 1956 and thereafter was the same business as that previously conducted by the partnership. Held:
1. The income of the business was taxable to the individual petitioners as partners throughout 1955, the corporations not having taken *138 over the business until 1956.
2. The principal purpose for the organization of the four corporations, rather than a single corporation, was to avoid income taxes by securing the benefit of additional surtax exemptions, and three of the surtax exemptions were properly disallowed by the respondent under section 269 of the Internal Revenue Code of 1954.
3. Determination made of amounts representing reasonable compensation paid to officers and employees of petitioner Made Rite Investment Co. during 1956 and 1957.
4. Respondent's determination of reasonable compensation paid to petitioner Dillier by petitioner Made Rite Transportation Co. during 1956 and 1957 was proper.
*763 The respondent determined deficiencies in income tax against the petitioners as follows:
| Docket | Petitioner | Year | Deficiency |
| No. | |||
| 80949 | Joe (Joseph) Dillier and Anna Dillier | 1955 | $ 30,472.33 |
| 95427 | Joseph Dillier and Anna Dillier | 1956 | 20,829.79 |
| 1957 | 2,295.70 | ||
| 1958 | 3,610.48 | ||
| 1959 | 36,592.73 | ||
| 80950 | Fred Kaelin and Bertha Kaelin | 1955 | 27,472.12 |
| 95428 | Fred Kaelin and Bertha Kaelin | 1956 | 21,272.92 |
| 1957 | 5,960.62 | ||
| 1958 | 14,464.41 | ||
| 1959 | 33,185.12 | ||
| 80951 | Clarence W. Curnow and Inez Curnow | 1955 | 29,398.02 |
| 95431 | Clarence W. Curnow and Martha Inez Curnow | 1956 | 23,605.04 |
| 1957 | 6,278.60 | ||
| 1958 | 14,543.53 | ||
| 1959 | 36,052.74 | ||
| 80952 | Thores Johnson and Dorothy Johnson | 1955 | 26,302.11 |
| 95425 | Thores Johnson and Dorothy Johnson | 1956 | 19,189.73 |
| 1957 | 5,956.84 | ||
| 1958 | 14,106.27 | ||
| 1959 | 33,198.94 | ||
| 80953 | Frank Halter and Hedy Halter | 1955 | 26,621.95 |
| 95426 | Frank Halter and Hedy Halter | 1956 | 19,313.98 |
| 1957 | 6,049.49 | ||
| 1958 | 13,973.78 | ||
| 1959 | 33,599.35 | ||
| 80954 | Made Rite Manufacturing Co | 1955 | 5,500.00 |
| 95433 | Made Rite Manufacturing Co | 1956 | 6,053.64 |
| 1958 | 4,479.05 | ||
| 1959 | 6,053.66 | ||
| 80955 | Made Rite Investment Co | 1955 | 4,783.78 |
| 95429 | Made Rite Investment Co | 1956 | 20,844.20 |
| 1957 | 7,911.55 | ||
| 1958 | 5,675.55 | ||
| 1959 | 5,675.56 | ||
| 80957 | Made Rite Sausage Co. 1 | 1955 | 2,802.95 |
| 95430 | Made Rite Sausage Co | 1956 | 5,653.40 |
| 1957 | 5,653.40 | ||
| 80958 | Made Rite Transportation Co | 1955 | 5,500.00 |
| 95432 | Made Rite Transportation Co | 1956 | 17,780.94 |
| 1957 | 8,732.94 | ||
| 1958 | 5,664.95 | ||
| 1959 | 6,879.52 | ||
| 80959 | Made Rite Sales Co.1 | 1955 | 2,802.95 |
*764 Petitioners in some of the dockets also claim certain overpayments. The questions presented for determination are: (1) Whether the income reported on corporate income tax returns filed by the petitioner corporations for 1955 was actually reportable by Made Rite Sausage Co., a partnership, and thus taxable to the individual petitioners, who were the partners; (2) whether the petitioner corporations are precluded by section 269 of the Internal Revenue Code of 1954 from obtaining the surtax exemption provided by section 11(c) of the Code; (3) whether the compensation paid to officers and employees by Made Rite Investment Co. in 1956 and 1957 was unreasonable; and (4) whether the compensation paid to Joseph Dillier by Made Rite Transportation Co. in 1956 and 1957 was unreasonable.
FINDINGS OF FACT
Some of the facts have been stipulated and are found *140 as stipulated.
Petitioners Joseph Dillier and Anna Dillier, Fred Kaelin and Bertha Kaelin, Clarence W. Curnow and Inez Curnow, Thores Johnson and Dorothy Johnson, and Frank Halter and Hedy Halter, husbands and wives respectively, all residing in Sacramento, Calif., filed joint income tax returns for the years 1955 through 1959 with the district director of internal revenue at San Francisco, Calif. The husbands are hereinafter sometimes referred to individually as Dillier, Kaelin, Curnow, Johnson, and Halter, respectively, and collectively as the partners or stockholders.
Petitioners Made Rite Sausage Co. (hereinafter called Sausage), Made Rite Manufacturing Co. (hereinafter called Manufacturing), Made Rite Investment Co. (hereinafter called Investment), and Made Rite Transportation Co. (hereinafter called Transportation) are corporations organized under the laws of the State of California. The four petitioner corporations are hereinafter sometimes referred to collectively as the Made Rite corporations.
Manufacturing, Investment, and Transportation each filed corporation income tax returns, prepared on an accrual method of accounting, for the period July 18, 1955, through December 31, *141 1955, and for the calendar years 1956 through 1959, with the district director of internal revenue at San Francisco.
Sausage filed corporation income tax returns, prepared on an accrual method of accounting, for the period July 18, 1955, through December 31, 1955, 2 and for the calendar years 1956 and 1957 with the district director at San Francisco. By a timely election, Sausage elected to report its income as a "small business corporation" under subchapter S of chapter 1 (sections 1371- 1377) of the Internal Revenue Code of 1954, and filed small business corporation returns of income, *765 Form 1120-S, for the calendar years 1958 and 1959 with the district director at San Francisco.
Commencing about 1930, Dillier and others were engaged in the business of manufacturing, processing, and selling frankfurters, luncheon meats, and other sausage products, as well as hams and bacon, as a partnership under the name of Made Rite Sausage Co. (hereinafter sometimes called the partnership). Between 1930 and 1955 there was a substantial growth in the business of the partnership. The number of employees increased from approximately *142 8 in 1930 to approximately 200 in 1955.
Johnson was employed by the partnership as a bookkeeper in 1930, at which time he was 24 years of age. He later became office manager. In 1942 he acquired an interest in the partnership.
Either at the same time that Johnson acquired his interest or at some other undisclosed time prior to 1949, Curnow, Halter, and Kaelin each acquired an interest in the partnership equal to that of Johnson. In 1949, Johnson, Curnow, Halter, and Kaelin purchased additional interests in the partnership from Dillier, so that thereafter each of the five partners owned an equal one-fifth interest. The partnership was operated under written "Articles of Copartnership" dated February 26, 1949.
After the five individuals became equal partners, their respective duties were as follows: Curnow was in charge of sales; Halter was in charge of production; Kaelin was the meat buyer, and also was in charge of the fresh meat operations and the maintenance of the plant and refrigeration equipment; Johnson was in charge of office and clerical functions, credit and collections, advertising, bookkeeping, purchasing of packaging supplies, and labor relations; and Dillier was the general *143 manager of the entire operation. Commencing about 1955, Dillier took a less active role in the partnership business, his duties becoming advisory in nature, while Johnson assumed more of the general managerial duties.
During 1954 or 1955, the approximate ages of the partners were as follows: Dillier, 63; Halter, 56; Curnow, 56; Kaelin, 55; and Johnson, 49.
The main plant and offices of the partnership were located in a building or buildings owned by it at 3353 Second Avenue, Sacramento, Calif. The city block in which the property was located consisted of 14 or 15 lots. By 1955, the partnership owned nine of the lots and portions of two others.
The meat products processed by the partnership were sold under the name "Made Rite Camellia Brand." Sales were made to grocery stores and other retail outlets in the northern two-thirds of California by driver-salesmen employed by the partnership covering regularly assigned routes. The driver-salesmen made sales to their customers *766 directly from the trucks. Small quantities of certain other products, such as cheese, purchased by the partnership from other producers, were also sold by the driver-salesmen. In addition, small amounts of fresh *144 meats were sold directly from the plant.
During the calendar years 1948 through 1954, the net income of the partnership and each partner's share of such income were as follows:
| Partnership net | Johnson, Halter, | ||
| Year | income | Dillier | Curnow, and |
| Kaelin, each | |||
| 1948 | $ 244,248.69 | $ 135,693.73 | $ 27,138.74 |
| 1949 | 221,584.00 | 44,316.80 | 44,316.80 |
| 1950 | 191,904.00 | 38,380.80 | 38,380.80 |
| 1951 | 226,049.46 | 45,209.89 | 45,209.89 |
| 1952 | 275,341.90 | 55,068.38 | 55,068.38 |
| 1953 | 260,091.05 | 52,018.21 | 52,018.21 |
| 1954 | 231,453.96 | 46,290.79 | 46,290.79 |
In March 1954, Johnson had conversations and correspondence with representatives of the Equitable Life Assurance Society regarding the possibility of a "sale and lease-back" transaction with that company concerning the partnership real estate. In July 1954, Equitable rejected the proposal.
Sometime in 1954 or 1955, Johnson developed the idea of incorporating the business conducted by the partnership. He discussed some of the problems involved with various business people with whom the partnership dealt, including a banker, an insurance agent, and the firm's outside public accountant. In May or June 1955, the decision was made by the partners to incorporate the business. It was decided that four corporations would *145 be formed: Manufacturing, the function of which would be to purchase meats and process them into sausage products; Sausage, to sell the products; Investment, to hold title to the real estate used in the business; and Transportation, to hold title to the delivery trucks, refrigerator trucks, and other motor vehicles used in the business.
The legal work of incorporation was performed by a San Francisco attorney. Articles of incorporation for the four Made Rite corporations, prepared by the attorney, were each signed by the five partners as incorporators on July 13, 1955. The respective articles were filed with the secretary of state of California on July 29, 1955, and with the county clerk of Sacramento County on August 11, 1955. In the respective articles of incorporation, the five partners were designated to act as the first directors of each corporation.
At the time of the incorporations, it was Johnson's understanding that three additional surtax exemptions would be available if four corporations, rather than a single corporation, were formed to take over the partnership business.
*767 No stock in any of the Made Rite corporations was issued during 1955. Under California law, a permit *146 from the California commissioner of corporations was a prerequisite to the issuance of stock by a corporation, 3 but no application for such a permit was made on behalf of any of the Made Rite corporations during 1955.
The accounting records of the *147 partnership had for many years been kept on the basis of thirteen 4-week accounting periods per year. The partnership, beginning at least as early as 1949, had taken a complete physical inventory of its meats and packaging supplies regularly at the end of every 4-week period. The regular inventory taken in the normal manner on July 15, 16, and 17, 1955, showed a figure of $ 299,382.98 for the goods then on hand. This figure was used in subsequently prepared financial statements and tax returns as the closing inventory of the partnership and the opening inventory of Manufacturing.
During the first half of 1955, the partners had each withdrawn $ 250 per week from the partnership by checks drawn on a partnership general checking account at the Anglo California National Bank. After the filing of the articles of incorporation of the four corporations, and throughout the third quarter of 1955, they continued this practice, each receiving $ 250 per week, with no payroll taxes withheld, by checks drawn on the partnership account. The amounts paid to them during the third quarter were subsequently shown as accounts receivable in the accounting records of Sausage.
An employer's quarterly *148 Federal tax return, Form 941, was timely filed by the partnership for the third quarter of 1955, listing all of the employees of the business, but not listing any of the partners as employees. No returns were filed for any of the Made Rite corporations for that quarter.
In September 1955, the partnership purchased from unrelated parties one of the remaining properties in the block where its main plant and offices were located. The property, known as lot 4, was deeded to the partnership by a deed executed September 15, 1955, and recorded September 27, 1955.
On or about October 18, 1955, an application for an average rate for fire insurance on the partnership buildings, fixtures, and equipment was submitted to the Pacific Fire Rating Bureau on behalf of *768 the partnership. An insurance policy was subsequently issued to the partnership by Aetna Insurance Co. as a result of the application.
Accounting ledgers for the four Made Rite corporations were opened by the accountant in October or November 1955. Accounting entries for the corporations for the prior portion of 1955 were contained in working papers prepared by the accountant. Sales of meat products from Manufacturing to Sausage were *149 recorded solely by journal entries throughout 1955, with no money passing between the corporations.
Title to the real estate used in the business remained in the partnership throughout 1955. However, rent was accrued by the accountant as payable by Manufacturing to Investment for the plant, using July 17, 1955, as the starting date. The amounts accrued were based solely upon oral information received by the accountant from Johnson. None of the amounts so accrued as rent were actually paid by Manufacturing to Investment during 1955.
At some undisclosed time, two leases, running from Investment to Transportation and Manufacturing, respectively, were prepared and backdated to July 17, 1955. One of these instruments purported to lease the garage and parking lot adjoining the main plant to Transportation for a 5-year term beginning July 17, 1955, at an annual rental of $ 4,050. Included in the premises described in this instrument was Lot 4, which had been acquired by the partnership in September 1955. The other instrument purported to lease the plant itself to Manufacturing for a like 5-year term, at a total rental of $ 487,000 for the 5 years.
An instrument entitled "Truck Lease Service *150 Agreement" was also prepared at an undisclosed time and backdated to July 20, 1955. This instrument was a purported lease from Transportation to Sausage of certain motor vehicles, as described in schedule A to be attached thereto, upon the terms and conditions in schedule A. No schedule A was attached to the instrument.
A checking account for Transportation was opened on November 29, 1955. No checking accounts were opened for any of the other Made Rite corporations during 1955.
All employees of the business were paid throughout 1955 by checks drawn on the partnership payroll checking account at the Anglo California National Bank, except for two mechanics, who, beginning December 2, 1955, were paid by checks drawn on the Transportation checking account. The partnership payroll account had been maintained since 1943, and all partnership employees had been paid from that account. All sales and meat-processing employees continued to be paid by checks drawn on the partnership payroll checking account throughout the taxable years. Beginning November 11, 1955, checks drawn to pay meat-processing employees bore a different series of *769 numbers from those drawn to pay sales employees, but *151 both series were drawn on the partnership payroll account. Both series bore the name "Made Rite Sausage Company" until February 8, 1957, when checks drawn on the account to pay meat-processing employees bore the name of Manufacturing.
During the fourth quarter of 1955, Dillier, Johnson, Halter, Kaelin, and Curnow each received total payments of $ 6,850 (consisting of 14 weekly payments of $ 400 each and an additional payment of $ 1,250 on November 11, 1955), less payroll taxes withheld. All of these payments were made by checks drawn on the partnership payroll checking account, with the exception of Dillier's checks commencing December 5, 1955, which were drawn on the Transportation account. On their individual income tax returns for the year 1955, each of the five partners reported the $ 6,850 so received as salary from Made Rite Sausage Co.
An employer's quarterly Federal tax return, Form 941, was timely filed by the partnership for the fourth quarter of 1955. Dillier, Johnson, Kaelin, Curnow, and Halter were listed as employees and the $ 6,850 received by each during the quarter was shown on the return. All employees of the business were listed on the return, and no return was *152 filed in the name of any of the Made Rite corporations for that quarter.
California unemployment insurance returns were filed by the partnership for both the third and fourth quarters of 1955. No such return was filed by any of the Made Rite corporations for either of those quarters.
At various times during the second half of 1955, five trucks were purchased from a GMC truck distributor and subsequently registered to the partnership, the last one being purchased on December 19, 1955.
Customers of the business were not advised of any change in the business form, and no formal notification of a change in form was made to suppliers. All of the various suppliers with whom the business dealt continued to address their invoices throughout 1955 to "Made Rite Sausage Company" or, in a few instances, merely to "Made Rite," with only one exception. The exception was the invoice of a Sacramento company supplying a quantity of imprinted check blanks, which was addressed to Manufacturing, the company for which the checks had been ordered. All of the invoices received during 1955, including the one for the check blanks, were paid by checks drawn on the partnership checking accounts.
Throughout 1955 *153 and for an undisclosed period of time thereafter the only stationery used in the business bore the name Made Rite Sausage Co.
A Federal partnership income return, prepared on an accrual method of accounting, was filed for the partnership for the period *770 from January 1, 1955, through July 16, 1955, showing gross sales of $ 3,716,119.06, ordinary income of $ 360,751.10, and net long-term capital gain of $ 200.
On the income tax returns filed by the Made Rite corporations for the period from July 18, 1955, 4 through December 31, 1955, net income was reported as follows:
| Sausage | $ 12,740.72 |
| Manufacturing | 112,101.02 |
| Investment | 21,744.44 |
| Transportation | 30,974.40 |
| Total | 177,560.58 |
California corporation franchise tax returns for 1955 *154 were timely filed on behalf of the four Made Rite corporations and the taxes due thereon were timely paid.
On January 6, 1956, the partnership general checking account at the Anglo California National Bank was converted into a corporate account for Sausage. On the same date, checking accounts for Investment and Manufacturing, respectively, were opened at the same bank.
In February 1956, title to 30 motor vehicles was transferred from the partnership to Transportation. Included among the vehicles transferred were five executive automobiles, one each for Dillier, Curnow, Halter, Johnson, and Kaelin.
An insurance policy written on the partnership vehicles, which expired on January 20, 1956, was renewed by another policy in the partnership name issued March 14, 1956, but effective January 20, 1956. 5
In February 1956, checks in the amount of $ 2,200 each were issued from the Manufacturing bank account to Dillier, Johnson, Curnow, Halter, and Kaelin, respectively. The check register entries *155 labeled the amounts so paid as dividends. At the time of these payments no stock had yet been issued by Manufacturing or any of the other Made Rite corporations.
Applications to the California commissioner of corporations for permits to issue stock and notes were filed by the Made Rite corporations on the following dates:
| Sausage | February 24, 1956 |
| Investment | March 7, 1956 |
| Manufacturing | March 7, 1956 |
| Transportation | March 16, 1956 |
*771 To each of the four applications was attached a number of exhibits, including the following:
Exhibit D: A copy of a document entitled "Minutes of First Meeting of Board of Directors of [the respective corporation]," dated August 1, 1955.
Exhibit F: A copy of an "Offer to Transfer Assets" by the partnership to the respective corporation.
Exhibit G: A copy of a proposed "Stock Purchase Agreement" concerning the stock of the corporation.
The minutes of the purported directors' meetings of the four corporations were prepared in the attorney's office early in 1956. It was stated in each of the four sets of minutes that the meeting reported therein took place on August 1, 1955, at 11 a.m. Each set of minutes contained reference to various actions relating to the organization *156 of the particular corporation purportedly taken by its board of directors, including: adoption of corporate bylaws; election of officers; acceptance of the partnership "offer to transfer assets"; authorization to apply for a permit to issue stock and notes; authorization to issue the stock and notes upon receipt of the permit; approval of the "stock purchase agreement"; authorization to amortize organization expenses; and authorization to open a corporate bank account. The officers named in the minutes were as follows:
| Sausage | Manufacturing | Transportation | Investment | |
| President | Curnow | Halter | Kaelin | Johnson. |
| Vice president | Halter | Kaelin | Curnow | Halter. |
| Secretary | Johnson | Johnson | Johnson | Kaelin. |
| Treasurer | Kaelin | Curnow | Halter | Curnow. |
Although it was recited in the minutes of all four corporations that resolutions had been adopted concerning the amortization of the organization expenses, the decision to amortize such expenses was not in fact made until an undisclosed time subsequent to August 1, 1955. Thereafter, the resolutions dealing with amortization contained in the minutes were prepared in the attorney's office. It was also stated in the minutes that the directors had approved the stock purchase agreements *157 at the meetings, but the agreements purportedly approved were not in fact prepared in a form satisfactory to Dillier, Curnow, Halter, Johnson, and Kaelin, who were the directors of each corporation, until sometime in 1956.
The four "Offers to Transfer Assets" were undated. Each was a form by which the five partners purported to offer to transfer, as of June 30, 1955, a certain portion of the partnership assets to one of the corporations, and the corporation purported to accept such offer. The consideration was to be the assumption by the corporation of certain partnership liabilities and the issuance of stock and notes to the partners. *772 The obligation to issue the stock and notes was made "subject to [the corporation] obtaining an appropriate permit from the Commissioner of Corporations of the State of California."
The "Stock Purchase Agreements" concerning each of the four Made Rite corporations were identical in form, with the exception of the reference to the names of the corporations. In each agreement it was provided that a stockholder, before disposing of any of his stock in the corporation during his lifetime, was required to offer to sell it first to the corporation and then *158 to the remaining stockholders. These restrictions were not applicable to sales or gifts of the stock to children of the stockholders, but such sales or gifts could be effected only if the stockholder sold or gave to such children an equal percentage of his stock in all four Made Rite corporations. It was further provided that the stock could be bequeathed by will only to certain family members of the stockholder or could be placed in inter vivos or testamentary trusts for the benefit of the family members. Otherwise, upon the death of a stockholder, the corporation had the right to purchase the stock owned by the decedent, and the remaining stockholders were required to purchase, pro rata among themselves, any of such stock not purchased by the corporation. The purchase price of stock purchased by the corporation or the stockholders pursuant to the agreement was to be determined according to a formula based upon book value of the stock and the net income of the corporation for the 5 previous years.
In each stock purchase agreement it was provided as follows:
The original stockholders hereby specifically cancel, terminate and put to an end that certain agreement, dated the 26th day *159 of February, 1949, by and between Joseph Dillier, Thores G. Johnson, Clarence W. Curnow, Frank Halter and Fred Kaelin entitled "Articles of Copartnership of Made Rite Sausage Co.," * * *
It was further provided in each stock-purchase agreement that the agreement was "mutual with and reciprocally dependent upon corresponding agreements executed this date between [the five stockholders and each of the other three Made Rite corporations] and that an election, an offer to sell, or any notice given in pursuance of those agreements shall also be considered and construed as exercising the same act under this agreement."
The California commissioner of corporations, by permits issued on the following dates, authorized issuance by the Made Rite corporations of $ 100 par value stock and notes as follows:
| Date of | Shares of | Notes | |
| Corporation | permit | common stock | authorized |
| authorized | |||
| Sausage | Mar. 15, 1956 | 200 | $ 30,000 |
| Investment | Apr. 12, 1956 | 1,250 | 275,000 |
| Manufacturing | Apr. 12, 1956 | 1,100 | 300,000 |
| Transportation | Apr. 12, 1956 | 200 | 40,000 |
*773 On April 16, 1956, Dillier, Johnson, Curnow, Halter, and Kaelin were issued the stock and notes of the four corporations, in the full amount authorized by the commissioner. The stock of *160 each corporation was issued to the five stockholders in equal amounts, as were the notes of each corporation. On the same date, the stock-purchase agreements were executed by the five stockholders and the four Made Rite corporations.
Employer's quarterly Federal tax returns, Form 941, were filed by the four Made Rite corporations for the first quarter of 1956. California unemployment insurance returns were also filed by the four corporations for that quarter.
On April 20, 1956, two insurance policies previously held in the name of the partnership were endorsed to show one or more of the Made Rite corporations as the insured.
By a deed executed May 2, 1956, and recorded May 8, 1956, Investment acquired from an unrelated person another parcel of property, known as lot 6, in the block in Sacramento in which the main plant was located.
By a deed executed on July 2, 1956, and recorded on August 7, 1956, title to the plant and surrounding real property was transferred by the partnership to Investment. On August 14, 1956, a first deed of trust on this property and the recently acquired lot 6 was recorded. This deed of trust secured the promissory notes of Investment to the five stockholders *161 totaling $ 275,000.
By a deed executed on July 2, 1956, and recorded on August 15, 1956, a warehouse and adjoining realty located at Chico, Calif., was transferred by the partnership to Sausage.
In August 1956, the insurance agency handling the insurance on the vehicles used in the business was notified that the vehicles had been transferred by the partnership to Transportation. An endorsement to the policy was made, effective August 20, 1956, substituting Transportation as the insured.
During 1956 certain suppliers of goods or services to the business, who billed on a regular monthly basis, continued to send their invoices to "Made Rite Sausage Company" until the following dates:
| Name of supplier | Goods or services | Dates billed to Made | Thereafter |
| supplied | Rite Sausage Co. | billed to | |
| Acme Steel | |||
| Products | Binding tape | Until Feb. 16, 1956 | Manufacturing |
| Dobeckmun Co | Not disclosed | Until Mar. 18, 1956 | Not disclosed |
| Cryroac | Artificial casings | Until May 22, 1956 | Manufacturing |
| Blake, Moffitt | |||
| & Towne | Paper products | Until May 31, 1956 | Not disclosed |
| Union Oil Co | Not disclosed | Until Sept. 28, 1956 | Transportation |
| Rouse Brothers | do | Through Oct. 1956 | Do. |
| Consolidated | |||
| Terminals | do | Until Nov. 3, 1956 | Manufacturing |
| Crystal Creamery | do | Until Dec. 1956 | Do. |
| Colyer Motors | Automotive parts | Throughout 1956 | Not disclosed |
| Chanslor and Lyon | do | Throughout 1956 | Do. |
| Pacific Gas and | |||
| Electric Co | Gas | Through Apr. 30, 1956 | Do. |
| Sacramento Municipal | |||
| Utility District | Electricity | Until Dec. 31, 1956 | Manufacturing |
*162 *774 The business conducted by the four Made Rite corporations in 1956 and thereafter was the same business as that previously conducted by the partnership. The same division of duties among the five former partners prevailed as under the partnership. The meat products manufactured or processed by Manufacturing were sold only through Sausage, and all receipts therefrom were deposited in the Sausage bank accounts. In addition, Sausage distributed small amounts of certain products, such as cheese, purchased by the business from others, as the partnership had done previously. The gross sales of Sausage, as shown on its returns for the years 1956 through 1959, were as follows:
| Year | Gross sales |
| 1956 | $ 6,586,462.06 |
| 1957 | 7,369,466.31 |
| 1958 | 8,284,965.42 |
| 1959 | 7,693,123.90 |
No inventory was recorded on the books of Sausage. The entire inventory of the business was recorded on the books of Manufacturing, and the dollar amounts of "sales" from Manufacturing to Sausage were determined by calculations made after Sausage had sold the products to customers. These calculations were alternately made by one of two methods. One method was to take the amounts by weight of the various types of products sold by Sausage *163 and apply thereto certain prices per pound or ton for each type. The other method was to apply percentage figures to the dollar amounts of the gross sales of Sausage.
All of the amounts reported as rental income on the returns filed by Investment represented intercompany payments from Sausage, Manufacturing, and Transportation, except for small amounts derived from rental to unrelated parties of a parking lot and a few residential units.
All of the amounts reported as rental income on the returns filed by Transportation represented intercompany payments from Sausage, including payments for the five executive automobiles. No rental payments to Transportation for use of the executive automobiles were made by or accrued on the books of Manufacturing or Investment. No vehicles owned by Transportation were rented to outsiders.
All four corporations used as their office the former office of the partnership at 3353 Second Avenue, Sacramento. The records for the four corporations were all kept at that office and generally by the same employees. The signs on the main plant were limited to "Camellia Brand" and "Made Rite Sausage." The only listing for the business in the telephone directories *164 was made in the name of Sausage.
*775 At least three labor unions had represented various employees of the partnership: The Teamsters Union, representing the driver-salesmen; the Butchers Union, representing certain meat-processing employees; and the Packers Union, representing other meat-processing employees. Beginning at undisclosed times after formation of the Made Rite corporations, labor contracts with the Teamsters Union were signed by Sausage, and those with the Butchers Union were signed by Manufacturing. The employees of the partnership belonging to the Packers Union became employees of Manufacturing, but neither the Packers Union nor the association which had bargained with that union on behalf of the partnership were ever advised of the change of the employer.
In 1957, Manufacturing applied to Crocker-Anglo National Bank for a line of credit in the amount of $ 200,000. As conditions to the granting of such line of credit, the bank required that Sausage, Investment, and Transportation guarantee repayment of the funds advanced to Manufacturing thereunder and that the notes payable by the four Made Rite corporations to the five stockholders be subordinated to the obligations to *165 the bank. On March 17, 1957, the boards of directors of Sausage, Investment, and Transportation authorized such guarantees. The stockholders also agreed to subordinate their notes, and the line of credit was granted by the bank. In 1958, Manufacturing sought to increase its line of credit with the bank to $ 300,000. Guarantees of the increased amount were authorized by the respective boards of directors on July 3, 1958, and subsequently made by the corporations.
By a deed executed on November 9, 1959, and recorded on November 12, 1959, Investment acquired from an unrelated corporation a building and underlying land located on 23d Street in Sacramento. The building was used by Manufacturing to house certain meat-processing operations.
California corporate franchise tax returns for the years 1956 through 1959 were timely filed on behalf of each of the four Made Rite corporations and the taxes due thereon were timely paid.
During the years 1956 through 1959, Dillier, Kaelin, Curnow, Johnson, and Halter were paid compensation by the four Made Rite corporations as follows: *776
| Sausage | Manufacturing | Transportation | Investment | Total | ||
| 1956 | ||||||
| Dillier | $ 2,000 | $ 23,800 | $ 25,800 | |||
| Kaelin | $ 25,800 | 25,800 | ||||
| Curnow | 25,800 | 25,800 | ||||
| Johnson | $ 25,800 | 25,800 | ||||
| Halter | 25,800 | 25,800 | ||||
| Totals | 27,800 | 51,600 | 23,800 | 25,800 | 129,000 | |
| 1957 | ||||||
| Dillier | 6,800 | 6,800 | 6,400 | 4,800 | 24,800 | |
| Kaelin | 24,800 | 24,800 | ||||
| Curnow | 24,800 | 24,800 | ||||
| Johnson | 9,520 | 11,520 | 1,760 | 1,760 | 24,560 | |
| Halter | 24,800 | 24,800 | ||||
| Totals | 41,120 | 67,920 | 8,160 | 6,560 | 123,760 | |
| 1958 | ||||||
| Dillier | 9,240 | 18,720 | 400 | 28,360 | ||
| Kaelin | 7,160 | 21,200 | 28,360 | |||
| Curnow | 28,360 | 28,360 | ||||
| Johnson | 13,560 | 15,120 | 160 | 28,840 | ||
| Halter | 3,000 | 25,360 | 28,360 | |||
| Totals | 61,320 | 80,400 | 560 | 142,280 | ||
| 1959 | ||||||
| Dillier | 6,240 | 18,720 | 24,960 | |||
| Kaelin | 4,160 | 30,300 | 34,460 | |||
| Curnow | 29,960 | 4,750 | 34,710 | |||
| Johnson | 10,400 | 24,310 | 34,710 | |||
| Halter | 34,960 | 34,960 | ||||
| Totals | 50,760 | 113,040 | 163,800 |
*166 The amounts so paid were claimed as deductions on the returns filed by the respective corporations.
Dividends were paid by the Made Rite corporations during the taxable years as follows:
| Sausage | Manufacturing | Transportation | Investment | |
| 1955 | ||||
| 1956 | 1 $ 11,000 | |||
| 1957 | $ 37,500 | |||
| 1958 | 25,000 | |||
| 1959 | 57,078 |
The net income (or loss) of the Made Rite corporations for the years 1956 through 1959, as shown on the returns filed for those years, was as follows:
| 1956 | 1957 | 1958 | 1959 | |
| Sausage | $ 100,401.42 | $ 57,609.51 | $ 37,922.00 | $ 73,162.91 |
| Manufacturing | 39,661.29 | (57,757.27) | 17,842.62 | 160,419.10 |
| Investment | 18,288.87 | 55,020.57 | 54,255.37 | 31,149.49 |
| Transportation | 30,133.25 | 33,695.23 | 41,531.81 | 57,513.89 |
| Totals | 188,484.83 | 88,568.04 | 151,551.80 | 322,245.39 |
*777 The respondent in his determinations of deficiencies determined that the gross income and deductions reported by the four Made Rite corporations for 1955 actually belonged to and were reportable by the partnership. The 1955 income of each of the partners was increased to give effect to his distributive share of the additional ordinary net income and long-term capital gain of the partnership, *167 as computed by the respondent.
The respondent denied surtax exemptions to the four Made Rite corporations for all of the taxable years on the ground that the corporations were created, availed of, and operated in order to avoid Federal income taxes by securing the benefit of the surtax exemption which they would not otherwise enjoy.
On its 1956 and 1957 income tax returns, Investment claimed deductions of $ 34,009.80 and $ 6,560, respectively, representing compensation paid as follows:
| 1956 | 1957 | |
| Thores Johnson | $ 25,800.00 | $ 1,760.00 |
| Joseph Dillier | 4,800.00 | |
| Geneva Hayhurst | 5,238.00 | |
| Chester Brewster | 2,916.80 | |
| M. Schoenbacker | 55.00 | |
| Totals | 34,009.80 | 6,560.00 |
Johnson devoted some time during 1956 to the affairs of a corporation named Zephyr Heights Subdivision, Inc., at Lake Tahoe, for which he received a salary of $ 4,800.
In September 1956, Johnson had one or more telephone conversations with a real estate brokerage firm in Los Angeles, Calif., and received a letter from that firm naming a prospective purchaser of the Made Rite plant, but no sale was made to the person named. Prior to or on January 29, 1957, Johnson met with one or more representatives of a company named Arden Milk Co. A letter dated January *168 29, 1957, written by a representative of Arden, stated that:
Arden is interested in working out a merager [sic] with the Maid-Rite Co. and are ready to do so as soon as we get the papers outlining the best exchange of Arden's stock for that of Maid-Rite plus the leaseback idea, talked about in your meeting.
No transaction was consummated with Arden Milk Co.
Geneva Hayhurst had been employed by the partnership in 1941 as a bookkeeper. She had taken a bookkeeping course in high school and had worked as a bookkeeper for another sausage company prior to being employed by the partnership. During 1956 she was the office manager for the four corporations, but received compensation only from Investment. Her duties included supervision of the office services for all four corporations and keeping the books for Sausage and *778 Manufacturing. The bulk of her work was concerned with the business of Sausage, with only a small portion of her time being devoted to the affairs of Investment. The books of Investment and Transportation were kept by another bookkeeper in the office. Investment paid no other office salaries during the years 1956 through 1959, nor did it claim a deduction for any office expenses *169 on its returns for those years. During 1957, 1958, and 1959, Geneva Hayhurst received no compensation from Investment. 6
Chester Brewster had been the night watchman for the partnership and continued to perform the same function after the four corporations took over the business. His duties were to guard the main-plant building, title to which was transferred to Investment during 1956, as well as the property belonging to the other Made Rite corporations located on the plant premises, including trucks, title to which was in Transportation, and machinery and inventory, which were listed as belonging to Manufacturing. Schoenbacker acted as night watchman for one week during 1956 while Brewster was on vacation. The amounts paid by Investment during 1956 to Brewster and Schoenbacker were the only amounts paid by any of the Made Rite corporations for the services of night watchmen during that year. During 1957, 1958, and 1959, the night watchmen employed in the Made Rite business received their entire compensation from Manufacturing.
The respondent in his determination of deficiency *170 disallowed as unreasonable $ 32,009.80 of the total $ 34,009.80 claimed as a deduction by Investment for salaries in 1956 and $ 4,300 of the $ 6,560 claimed in 1957.
The respondent also determined that out of the $ 23,800 and $ 6,400 paid by Transportation to Dillier in 1956 and 1957, respectively, $ 500 in each of those years was a reasonable annual allowance for services rendered.
By a deed executed on May 4, 1961, and recorded on June 1, 1961, Investment acquired from an unrelated person another parcel of real property in the block in which the main plant was located.
In 1962, Transportation sold its fleet of trucks to two truck rental companies and leased the trucks back from those companies. At the time of the trial, Transportation was being liquidated.
The business activities of the partnership were not taken over by the four Made Rite corporations during 1955. The business continued to be operated by and for the benefit of the partnership throughout that year.
The principal purpose for the organization of the four Made Rite corporations, rather than a single corporation, and the acquisition by the partners of all of the stock of those corporations was to avoid *779 Federal income tax *171 by securing the benefit of three additional surtax exemptions, which would not otherwise have been available.
Reasonable compensation for services rendered to Investment by its officers and employees during 1956 was as follows: Thores Johnson, $ 1,760; Geneva Hayhurst, $ 500; Chester Brewster, $ 1,200; M. Schoenbacker, $ 25. Reasonable compensation for services rendered to Investment by its officers and employees during 1957 was as follows: Thores Johnson, $ 1,760; Joseph Dillier, $ 500.
Reasonable compensation for services rendered to Transportation by Dillier during the years 1956 and 1957 did not exceed $ 500 for each of those years.
OPINION
The first issue presented is whether the income of the Made Rite business for the period from July 18, 1955, through December 31, 1955, is taxable to the four Made Rite corporations, as the petitioners allege, or to the five partners, as the respondent contends. The respondent has conceded that the income earned during 1956 and succeeding years is taxable to the corporations.
The four Made Rite corporations came into existence when the respective articles of incorporation were filed with the secretary of state of California on July 29, 1955. Cal. Corp. Code, sec. 308. *172 Therefore, our determination of this issue depends upon the time at which the business activities conducted by the partnership were taken over by the corporations. Skarda v. Commissioner, 250 F. 2d 429; Central Auto Market, 7 B.T.A. 973">7 B.T.A. 973; Niles Fire Brick Co., 6 B.T.A. 8">6 B.T.A. 8.
The petitioners contend that the transfer of the business to the corporations took place on July 17, 1955, and in any event no later than August 1, 1955. It is the contention of the respondent that such transfer did not occur prior to 1956.
The facts show that no stock was issued by any of the corporations during 1955. Under California law, a permit from the California commissioner of corporations was a prerequisite to the issuance of stock by a corporation, Cal. Corp. Code, secs. 25500, 26100, but no application was made on behalf of any of the Made Rite corporations for such a permit during 1955.
At no time during 1955 was the partnership dissolved. The business was managed and operated by the partners after the filing of the articles of incorporation in the same manner as before. The bank accounts were maintained in the partnership name. No bank accounts were opened for any of the corporations during 1955, with *173 the exception of a checking account for Transportation, which was opened on November 29, and was used, during the final month of 1955, to pay salaries to two mechanics and to Dillier. All other employees were paid throughout 1955 from the partnership account.
*780 Customers of the business were not advised of any change in the business form, and no formal notification was made to suppliers. Nor can we conclude that the suppliers became aware informally of any change during 1955. When Johnson, the only one of the five partner-stockholders testifying, was queried on this point, he replied merely:
I know that when people would call whom we were dealing with we would assure them that the same people were responsible so that they would continue to supply us with meat, but some of them were aware that there were other corporations. There was information available * * * in the Credit Managers Association files in Sacramento; they had a change in the listing to show the four corporations, and there was a notice in the papers that we had incorporated.
No further evidence was introduced concerning the credit information or the newspaper notice, and the record does not shown that these events occurred *174 during 1955.
On the other hand, the facts show that all of the various suppliers with whom the business dealt continued to address their invoices throughout 1955 to "Made Rite Sausage Company" or, in a few instances, merely to "Made Rite," with only one exception. The exception was an invoice for a quantity of imprinted check blanks, which was addressed to Manufacturing, the company for which the checks had been ordered. "Made Rite Sausage Company" was the name of one of the corporations, as well as the partnership, but the identity of names does not explain the continued billing in that name, since the corporation bearing that name purportedly made the bulk of its purchases from Manufacturing. Until various times in 1956 suppliers of many types of goods purportedly purchased by the other Made Rite corporations addressed their invoices to "Made Rite Sausage Company." Payment on all of the invoices received during 1955, including the one for the check blanks, was made from the partnership checking accounts.
The practice of the five partners of withdrawing $ 250 per week from the partnership general checking account continued unchanged during the third quarter of 1955. During the fourth *175 quarter, payroll taxes were withheld from the increased weekly amounts they received, but the payments continued to be made from the partnership checking accounts, with the exception, as noted, of the payments to Dillier during December 1955.
The compensation paid to all employees throughout 1955 and to the five partners during the fourth quarter was reported on employer's quarterly Federal tax returns filed by the partnership. No such returns were filed by any of the Made Rite corporations during 1955. No State unemployment insurance returns were filed by any of the corporations during 1955, but such returns were filed by the partnership for both the third and fourth quarters of 1955.
*781 Other business transactions in which the partnership participated during 1955 are shown by the evidence. Real estate was purchased by the partnership in September 1955. An application for an average rate for fire insurance on partnership property was submitted in October 1955, and an insurance policy was subsequently issued to the partnership as a result of the application. At various times during the second half of 1955, trucks were purchased and registered to the partnership. Throughout 1955 the *176 only stationery used in the business bore the name Made Rite Sausage Co. The corporations appear from the record to have been mere corporate shells throughout 1955. Not until 1956 were any important steps taken to transfer operation of the business to them. During 1956 bank accounts were opened for Sausage, Manufacturing, and Investment; application was made for permits to issue stock and notes; the stock and notes were issued; the partnership agreement was terminated; title to the partnership motor vehicles and real estate was transferred to the corporations; suppliers were advised of the change in business form; the corporations began filing employer's quarterly Federal tax returns; and partnership insurance policies were endorsed to the corporations.
The petitioners attempt to justify the delay in transferring the business to the corporations as being common under California incorporation procedure. While a permit from the California commissioner of corporations was a prerequisite to the issuance of stock, the facts show that such permits were granted by the commissioner to the Made Rite corporations within 5 weeks after the respective applications had been made therefor. Had *177 the applications been timely filed, there appears to be no reason why the stock could not have been issued within a short time after the filing of the articles of incorporation. It may be true, as the petitioners contend, that one of the reasons for the failure to file the applications earlier was the inability of the partners to agree upon the terms of the stock purchase agreements. Any such agreement, we note, was apparently required to be filed with the applications. 7 This excuse, while it may partially explain the delay, does not, however, justify the taxation to the corporations of the income earned by the partnership.
In contending that the income for the period in question should be taxed to the corporations, the petitioners emphasize the execution by the partners and the corporations of the "offers to transfer assets," *178 the closing of the partnership books and the opening of the corporation books, and the filing of 1955 income tax returns on behalf of the corporations.
*782 The "offers to transfer assets," which purport to transfer the partnership assets to the respective corporations as of June 30, 1955, are undated but the petitioners claim that the offers were executed on August 1, 1955, at the directors' meetings purportedly held on that date. The evidence shows that the minutes of the purported meetings were not prepared until early in 1956, when they were written up in the attorney's office, and that certain of the actions recited in the minutes as having been taken at the meetings were not in fact taken on the date claimed. In view of this evidence, we think that doubt must be cast upon the testimony of the petitioners' witnesses that the offers to transfer assets were executed on August 1, 1955. Regardless of the date of their execution, however, the instruments appear to be merely in the nature of stock subscriptions, with the consideration for the issuance of the stock being the transfer of certain partnership assets. In our opinion, these instruments, whenever they were executed and however *179 binding they may have been upon the parties, did not operate to shift the incidence of taxation to the corporations, prior to the actual taking over of the business operations by them.
Accounting ledgers for the four Made Rite corporations were opened by the accountant in October or November 1955, but it appears from the record that any figures which might have been entered in those ledgers lacked substance. With the exception of a bank account for Transportation existing during the final month of 1955, it has not been shown that any of the corporations had any assets during that year. Any purchases recorded on the corporate books were paper allocations of purchases for which payment was made out of the partnership bank account. All corporate salaries recorded, with the exception of the Transportation payroll for December, were allocations of amounts paid from the partnership payroll account. Figures for sales of meat products from Manufacturing to Sausage were the result of journal entries, with no money passing between the corporations. Rents from Manufacturing to Investment were merely the accountant's accruals based upon oral advice from Johnson, and none of the amounts so *180 accrued were actually paid during 1955. The amount used as the closing inventory of the partnership and the opening inventory of Manufacturing was merely the figure obtained from the regular taking of inventory at the end of a 4-week period, which practice had been followed since at least as early as 1949. Nor do we think that the fact that income tax returns were filed on behalf of the four corporations for 1955 gives any substance to the transactions reported therein when the facts show that the business was still being conducted by the partnership. We note in passing that in the returns filed by the partnership and the corporations June 30, 1955, was stated as the closing date for the partnership business and July 1 as the commencement *783 date of the corporation businesses, even though the inventory used was taken on July 15, 16, and 17 and the articles of incorporation were not filed until July 29. In view of the considerable evidence that the corporations did not take over the operation of the business until 1956, the opening of the corporate books during 1955 and the filing of corporate returns for that year do not, in our opinion, require us to hold that any part of the income *181 earned during 1955 is taxable to the corporations.
Upon consideration of all the evidence, we have concluded and found as a fact that the business activities of the partnership were not taken over by the four Made Rite corporations during 1955, and that the business continued to be operated by and for the benefit of the partnership throughout that year.
The cases relied on by the petitioners are distinguishable from this case. In R. L. Brown Coal & Coke Co., 14 B.T.A. 609">14 B.T.A. 609, it was found as a fact that, after the filing of articles of incorporation, the new corporation carried on a coal-mining business formerly conducted as an individual proprietorship. In the instant case the facts show the contrary.
In Vaughn Lumber Co. v. United States, 103 F. 2d 885, a partnership composed of individuals named Vaughan and Dascomb was dissolved and its business was subsequently taken over by a new association consisting of Dascomb and others. The association was held taxable on all the income of the business commencing with the date of dissolution of the original partnership. Dascomb and one of his associates, who had operated the business for a short period as an interim partnership while the details *182 of organizing the association were being completed, were held to be "operating as trustees for the benefit of the association." In the instant case the partnership was not dissolved during 1955, nor did any new entity take over operation of the business during that year. The five partners continued to operate the business throughout the year.
We hold that the ordinary income and long-term capital gains of the business for 1955 were properly taxable to the partners, and the determinations of the respondent to that effect are sustained. See Central Auto Market, supra;Niles Fire Brick Co., supra.
In view of our holding that the income of the business for 1955 was taxable to the partners, it follows that no income tax was payable by the Made Rite corporations for that year. We, therefore, hold that the deficiencies in income tax against the corporations for 1955 arising from the denial of surtax exemptions were erroneously determined. The surtax exemptions for the years 1956 and 1959 remain in issue, however, and we now turn to a consideration of that issue.
By amendments to his answers filed herein, the respondent stated that his determinations were made in accordance with sections 269*183 and *784 482 of the 1954 Code. On brief, however, he has set forth no argument with respect to section 482, and is therefore deemed to have abandoned his contention that said section is applicable.
In imposing the surtax on the taxable income of a corporation, section 11(c) of the Code provides an exemption of $ 25,000. In section 269(a), it is provided that if a person or persons acquire control of a corporation and the principal purpose of such acquisition 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 the deduction, credit, or allowance shall not be allowed. For the purposes of section 269(a)(1), control is defined as the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote.
Acquisition of control, as used in section 269, includes the formation of new corporations. James Realty Co. v. United States, 280 F. 2d 394; Kessmar Construction Co., 39 T.C. 778">39 T.C. 778.
Although in his determinations the respondent disallowed the surtax exemptions of all four of the Made Rite corporations, counsel for *184 the respondent in his opening statement conceded that one surtax exemption should be allowed, either to one of the corporations or apportioned among the four corporations.
It is clear that Dillier, Kaelin, Johnson, Halter, and Curnow organized and by their stockholdings acquired control of the petitioner corporations, and that by forming four corporations, rather than one, three additional surtax exemptions were made available. The respondent has determined that the principal purpose for this arrangement was the avoidance of Federal income tax by securing the benefit of the additional surtax exemptions. The burden of showing facts which will justify a conclusion to the contrary is on the petitioners.
It is the contention of the petitioners that each of the four Made Rite corporations was a viable business entity and actually engaged in a substantive business activity: That Sausage sold meat products; that Manufacturing processed or manufactured meat products; that Investment owned and leased real estate; and that Transportation owned and leased trucks.
The facts show that the stock of each of the four Made Rite corporations was held in equal amounts by each of the five stockholders, *185 and that when the corporations began to transact business, they operated a single, integrated business enterprise. Meat supplies were purchased and processed into sausage products, ham, and bacon, and the finished products were sold to retail outlets by driver-salesmen working in assigned territories. This was the same business that had theretofore been operated by a single entity, the partnership. The same division of duties among the five former partners prevailed as under the partnership.
*785 The meat products manufactured or processed by Manufacturing were sold only through Sausage, and all receipts therefrom were deposited in the Sausage bank accounts. Although Sausage was purportedly an independent company selling meat products, it sold only the products of Manufacturing, with minor exceptions, and carried no inventory on its books. The entire inventory of the business was recorded on the books of Manufacturing, and "sales" from Manufacturing to Sausage were determined by calculations made after Sausage had sold the products to customers. All of the rental income of Investment represented intercompany payments from Manufacturing and Transportation, except for small amounts *186 received from rental to unrelated parties of a parking lot and a few residential units. All of the rental income of Transportation represented intercompany payments from Sausage. No vehicles owned by Transportation were rented to outsiders.
The four corporations used a single office, at which the records for all four were kept. The signs upon the main plant and office building were limited to "Camellia Brand" and "Made Rite Sausage." The only listing for the business in the telephone directory was made in the name of Sausage.
It was the testimony of Johnson, who was the petitioners' principal witness, that at the time of incorporating the four Made Rite corporations it was his understanding that the business would get additional surtax exemptions if four corporations were formed rather than one, although it was his further testimony that this was not a decisive factor in making the decision. Johnson recited a number of alleged business purposes which he claimed motivated the organization of multiple corporations. Although some of the reasons advanced were unclear, the principal ones appear to be as follows: (1) That problems potentially arising from the death of a stockholder would *187 be reduced; (2) that labor problems would be minimized; (3) that more accurate accounting figures for each function of the business would be obtained; (4) that limited liability would be obtained for each corporation; (5) that the adoption of profit-sharing or incentive plans would be facilitated; (6) that unequal cash withdrawals by the partners would be eliminated; and (7) that the discounting of secured notes issued to the stockholders could provide funds to pay off certain personal obligations of the stockholders.
An examination of the alleged business purposes reveals their lack of substance. According to Johnson, it had been felt that, in the event of the death of a stockholder, his heirs might be persuaded to retain the stock of the corporations holding the real estate and trucks. The benefit of this arrangement to the business would apparently be that if the heirs so decided, it would be necessary to raise cash only to acquire the decedent's stock in the sales and manufacturing companies. *786 The purported intention to hold the real estate and trucks for this purpose is not supported by the facts, however, which show that the trucks were sold and leased back and that efforts *188 were made by the petitioners to do the same with the real estate. No reason was given as to why the stock of separate corporations holding the real estate and trucks would be more attractive to the heirs than the stock of a single corporation conducting the entire business, except to say that the two corporations would have "fixed income." However, the record shows that no dividends were paid by either Investment or Transportation during the taxable years. The record further shows that the trucks provided no income except through their use in the meatpacking business, which the petitioners maintain was speculative, and that the real estate did not provide a significant amount of outside income. If the heirs did not wish to retain their stock in these two corporations, Johnson testified, the real estate or trucks could be sold to raise cash to pay the heirs. No explanation is given as to why the real estate or trucks, if held in a single corporation, could not as readily have been sold to raise the needed cash.
With respect to labor problems, the contention appears to be that if the employees of either the manufacturing corporation or the sales corporation went on strike, the other *189 corporation could continue to operate, since its employees would be members of different unions. Johnson testified, however, that the Made Rite business had "never had a strike of any consequence," and that "in the last thirty years we have had only a couple of days lost because of strikes." It was his further testimony that when there had been a strike by the members of the Teamsters Union, who worked for Sausage, their picket line had been honored by the members of the Butchers Union, who worked for Manufacturing. The facts also show that the employees of the partnership belonging to the Packers Union became employees of Manufacturing, but that neither the Packers Union nor the association which had bargained with that union on behalf of the partnership were ever advised of the change of employer.
We see little merit in the contention that the use of multiple corporations was necessary to provide accurate accounting figures for each department. Proper allocation of income and expenses could have been attained by a divisional accounting system, and it does not appear that the allocation between the corporations was made with precision. For example, rental payments for the five *190 executive automobiles were all accrued against Sausage, even though some of the five stockholders were purportedly rendering services primarily to other corporations. As a further example, no office expenses were charged to Investment.
Johnson testified that at the time the corporations were organized the Made Rite business faced increasing competition from national *787 meatpacking firms. He stated that in the event the manufacturing operations became unprofitable, those operations could be discontinued and the sales company could continue to operate, selling products to be manufactured by others under the Made Rite label. By reason of the multiple corporations, the liability of the manufacturing corporation would be limited to the extent of its own assets. Yet the facts show that when Manufacturing sought sizable lines of credit from a bank in 1957 and 1958 the other three Made Rite corporations guaranteed repayment of the funds to be advanced by the bank and the five stockholders subordinated the notes they personally held against the corporations to the obligations to the bank.
The argument concerning the adoption of incentive or profit-sharing plans is also without foundation in *191 the record. According to Johnson's testimony, the partners anticipated "that with the sales and manufacturing as separate organizations we could set up profit sharing incentive plans so that junior executives, which we would develop, would be in a position to share in the results of their efforts." There is no evidence, however, that the corporations ever adopted any such plan or seriously considered doing so. Nor is there evidence as to the identity of the "junior executives" for whose benefit the plans were to be instituted. The only executives appear to have been the five stockholders, who received approximately equal total compensation from the various Made Rite corporations, regardless of the profits or losses of the particular corporation or corporations purportedly employing them.
Neither of the final two alleged business purposes for the multiple corporations demonstrates any reason why a single corporation would not have been sufficient. Johnson testified that it had been a practice of the partners to make withdrawals of cash from the partnership to pay their individual taxes, and that the unequal withdrawals which resulted had caused friction among the partners. With the *192 corporate setup, he said, "any dividend or any money coming out of the corporations would be in proportion to the shareholder's interest and not in proportion to his tax burden as an individual." The facts show that the stock of each of the four corporations was issued to the five stockholders in equal amounts. Therefore, the five would receive equal dividends in the same manner as though they had owned equal shares in a single corporation. Johnson also testified that the stockholders learned that a bank would discount corporate notes held by them and secured by real estate, and they could use the funds so received to pay off certain outstanding personal obligations. While it has been shown that the notes issued by Investment to the stockholders were secured by a first deed of trust on the plant and surrounding real property, no reason is advanced why it was necessary to place the real estate in a separate corporation in order to use it as security for the notes.
*788 We are convinced, from our study of the record, that the alleged business objectives did not in fact motivate the organization of the multiple corporations. The one purpose of apparent substance was the obtaining of the *193 additional surtax exemptions of which Johnson had cognizance.
As supporting their contention that the obtaining of additional surtax exemptions was not the principal purpose of organizing the multiple corporations, the petitioners also point to the fact that one surtax exemption was voluntarily given up when Sausage elected to report its income for the years 1958 and 1959 as a small business corporation under subchapter S of chapter 1 (secs. 1371-1377) of the Code. Subchapter S, which had not been enacted at the time the corporations were organized, provides in general for taxing the income of an electing corporation directly to its stockholders. Since there is no tax to the corporation, there is correspondingly no surtax exemption. An examination of the facts shows that the net income of Sausage was $ 37,922 in 1958 and $ 73,162.91 in 1959, and that dividends in the amount of $ 25,000 in 1958 and $ 57,078 in 1959 were paid to the stockholders. No dividends were paid by any of the other Made Rite corporations during those years. By making the election, therefore, it was possible to make all dividend payments to the stockholders from Sausage and avoid corporate taxation on the amounts *194 so paid, retaining in the meantime the benefit of the surtax exemptions of the other corporations. Certainly this procedure did not make the three additional surtax exemptions less beneficial. The year 1958 was the first year for which such an election could have been made, as subchapter S became effective for the taxable years beginning after December 31, 1957.
The respondent in his determinations of deficiencies did not exercise the authority granted to him under section 269(b)8*196 to allow a surtax exemption to one of the corporations or to allocate a single exemption among the four corporations. Instead, he disallowed the exemptions of all four corporations. Counsel for the respondent has conceded, however, that one surtax exemption should be allowed, and we think *789 that the exemption should be allowed to Sausage. Sausage was the successor in name to the partnership. It did all of the selling and except for comparatively small amounts received as rent on a parking lot and a few residential units, the income of the entire operation was realized on the sales so made. All of the receipts from sales were deposited by Sausage in its bank account, and except for the aforesaid amounts *195 of rent the income of the other three corporations consisted entirely of book allocations and intercompany transfers made directly or indirectly from Sausage. In light of the record, we have concluded that Sausage is entitled to surtax exemptions for the years 1956 and 1957, and we so hold. No corporate tax was payable by Sausage for 1958 and 1959, by virtue of its election to report its income under subchapter S, and therefore no surtax exemptions were available to it for those years.
The determinations of the respondent denying surtax exemptions to Manufacturing, Investment, and Transportation for the years 1956 through 1959 are sustained. James Realty Co. v. United States, supra;Kessmar Construction Co., supra.
The remaining issues deal with the deduction of amounts paid as compensation to officers and employees by two of the Made Rite corporations. In section 162(a)(1) of the Code, it is provided that deductions are to be allowed for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including "a reasonable allowance for salaries or other compensation for personal services actually rendered."
Investment, on its returns for 1956 and 1957, claimed deductions of $ 34,009.80 and $ 6,560, respectively, being the full amounts paid *197 by it as compensation to officers and employees in the said years. The respondent in his determination of deficiencies allowed as deductions $ 2,000 of the amount claimed in 1956 and $ 2,260 of the amount claimed in 1957, and disallowed the balance of the amounts claimed. Since the respondent did not make any determinations with respect to the individual salaries paid, but merely determined that the total deductions claimed were unreasonable, we must examine the individual salaries comprising those deductions.
The claimed deductions by Investment included $ 25,800 paid to Johnson in 1956 and $ 1,760 paid to him in 1957. With respect to the services performed by Johnson, the facts show that he performed general managerial duties for the business conducted by the Made Rite corporations, and was in charge of office and clerical functions, credit and collections, advertising, bookkeeping, purchasing of packaging supplies, and labor relations. The facts do not show what portion of his working time was devoted to the affairs of Investment, and from the description of his duties and the activities of Investment we cannot conclude that any substantial amount of his *790 time was so spent. *198 The facts show that Johnson also devoted some time during 1956 to the affairs of a corporation named Zephyr Heights Subdivision, Inc., at Lake Tahoe, for which he received a salary of $ 4,800.
In attempting to justify the $ 25,800 paid to Johnson by Investment in 1956, the petitioners contend that such amount was set with a view toward "the time which he would have to devote in an endeavor to secure a sale and/or lease-back of the plant property." Although it was the testimony of Johnson that he attempted "many times" to sell the property, substantiating evidence was introduced with respect to only two efforts during the taxable years. The evidence shows that Johnson, in September 1956, had one or more telephone conversations with a real estate brokerage firm in Los Angeles, Calif., and received a letter from that firm naming a prospective purchaser of the Made Rite plant. A letter dated January 29, 1957, indicates that Johnson had met with representatives of Arden Milk Co., regarding a proposed exchange of stock with Arden. Although a leaseback is mentioned, the letter does not indicate what property was to be leased or to whom. No other evidence was introduced regarding Johnson's *199 purported endeavors to secure a sale and leaseback of the plant, and it is clear that Investment never actually entered into such a transaction.
On the other hand, the facts show that the compensation of $ 25,800 paid to Johnson by Investment during 1956 was equal to the compensation paid during that year to each of the other four stockholders by one or more of the other Made Rite corporations. Nothing in the record indicates to us that such allocation of identical salaries was made other than arbitrarily, or that in setting the amount of compensation any consideration was given to the value of the services which Johnson was actually expected to render to Investment. As stated, the compensation paid Johnson by Investment was reduced to $ 1,760 for 1957. During 1958 and 1959 he received no compensation from that corporation. The respondent has conceded that the $ 1,760 paid to Johnson in 1957 was reasonable compensation for his services to Investment in that year. Considering the evidence and taking into account the activities of Johnson, which, so far as the record shows, were the same in 1956 as in 1957, we have found that a like amount of $ 1,760 represents reasonable compensation *200 for his services to Investment during 1956.
Of the amount claimed as a deduction for 1956 by Investment, $ 5,238 represents compensation paid to Geneva Hayhurst. During 1956, she was the office manager for the business conducted by the four corporations but received compensation entirely from Investment. Her duties included supervision of the office services for all four corporations *791 and keeping the books for Sausage and Manufacturing. The bulk of her work was concerned with the business of Sausage, with only a small portion of her time being devoted to the affairs of Investment. It was the testimony of Geneva Hayhurst that she had threatened to quit her position in 1955 because her workload had become greater than she could handle, and that as a result of her threat the job of bookkeeping for Transportation and Investment had been assigned to another employee in the office. During 1957, 1958, and 1959 she received no compensation from Investment. The petitioners do not contend that the amount paid to Geneva Hayhurst by Investment during 1956 represented reasonable compensation for her services to that corporation. It appears to be their contention, instead, that her entire salary *201 was paid by Investment in order to offset the fact that Investment was not being charged by the other corporations for any office expenses, such as salaries of other personnel, stationery, and use of office equipment. The fact that the petitioners may have failed to allocate such expenses to Investment does not provide grounds for the deduction by Investment of the entire $ 5,238 paid to Geneva Hayhurst as "compensation for personal services actually rendered," under section 162(a)(1). No attempt was made to show what portion of the amount paid to her in fact represented reasonable compensation for services rendered to Investment. Using our best judgment based upon the evidence presented, we have found that $ 500 represented reasonable compensation for such services during 1956.
The amount claimed as a deduction by Investment in 1956 also includes $ 2,916.80 paid to Chester Brewster, the night watchman. His duties were to guard the main-plant building, title to which was transferred to Investment during 1956, as well as the property belonging to other Made Rite corporations located on the plant premises, including trucks, title to which was in Transportation, and machinery and *202 inventory, listed as belonging to Manufacturing. While Brewster was on vacation for one week in 1956, Investment paid to his replacement, M. Schoenbacker, the amount of $ 55, which was also included in the deduction claimed for that year. During 1957, 1958, and 1959, the night watchmen employed in the Made Rite business received their entire compensation from Manufacturing. Upon consideration of the evidence, we have concluded and found that $ 1,200 and $ 25 of the amounts paid to Brewster and Schoenbacker, respectively, during 1956 represent reasonable compensation for their services to Investment.
The $ 6,560 claimed by Investment as a deduction in 1957 represents, in addition to the $ 1,760 paid to Johnson, the amount of $ 4,800 paid to Dillier. Having conceded that the amount paid to Johnson represented reasonable compensation for his services, the respondent contends that the reasonable value of any services rendered to Investment *792 by Dillier did not exceed $ 500. The record is devoid of any evidence of services performed by Dillier for Investment during 1957, except to indicate that he acted in an advisory capacity for all four corporations. The burden rests upon the petitioners *203 to overcome the presumption of correctness which attaches to the respondent's determination, and the petitioners have failed to introduce evidence to do so. Accordingly, the determination of the respondent with respect to the compensation paid by Investment during 1957 is sustained.
Transportation, on its returns for 1956 and 1957, claimed deductions of $ 23,800 and $ 6,400, respectively, for compensation paid by it to Dillier. The respondent in his determination of deficiencies allowed as deductions $ 500 in each of the years and disallowed the balance. The facts show that the income of Transportation consisted entirely of intercompany allocations of rent from Sausage for vehicles used in the Made Rite business. The compensation of $ 23,800 paid to Dillier by Transportation during 1956, when added to the $ 2,000 paid to him by Sausage in that year, is equal to that paid during the year to each of the other four stockholders by one or more of the other Made Rite corporations. During 1957, Dillier's salary was allocated among all four of the Made Rite corporations, but the total compensation paid to him, $ 24,800, was equal to the compensation paid to Curnow, Halter, and Kaelin *204 and only slightly in excess of the $ 24,560 paid to Johnson. Dillier received only $ 400 from Transportation during 1958 and nothing in 1959. No evidence was introduced as to any services performed by Dillier for Transportation, and we have not been shown that the allocation of portions of Dillier's compensation to Transportation was done other than arbitrarily. In our opinion, the record supports the respondent's determination that a reasonable allowance for compensation to Dillier for services rendered to Transportation does not exceed $ 500 for each of the years 1956 and 1957, and we therefore sustain the respondent's determination.
Rule 50 computations will be necessary in several of the cases by reason of certain stipulations.
Decisions in docket Nos. 80949, 80954, 80955, 80957, 80958, 80959, 95427, 95428, 95429 and 95431 will be entered under Rule 50.
Decisions in docket Nos. 95425 and 95426 will be entered for the petitioners.
Decisions in docket Nos. 80950, 80951, 80952, 80953, 95430, 95432 and 95433 will be entered for the respondent.
Footnotes
1. The proceedings of the following petitioners are considered herewith: Fred Kaelin and Bertha Kaelin, docket No. 80950; Clarence W. Curnow and Inez Curnow, docket No. 80951; Thores Johnson and Dorothy Johnson, docket No. 80952; Frank Halter and Hedy Halter, docket No. 80953; Made Rite Manufacturing Co., docket No. 80954; Made Rite Investment Co., docket No. 80955; Made Rite Sausage Co., docket No. 80957; Made Rite Transportation Co., docket No. 80958; Made Rite Sales Co., docket No. 80959; Thores Johnson and Dorothy Johnson, docket No. 95425; Frank Halter and Hedy Halter, docket No. 95426; Joseph Dillier and Anna Dillier, docket No. 95427; Fred Kaelin and Bertha Kaelin, docket No. 95428; Made Rite Investment Co., docket No. 95429; Made Rite Sausage Co., docket No. 95430; Clarence W. Curnow and Martha Inez Curnow, docket No. 95431; Made Rite Transportation Co., docket No. 95432; and Made Rite Manufacturing Co., docket No. 95433.↩
1. The 1955 income tax return for Made Rite Sausage Co. was filed under the erroneous name "Made Rite Sales Co." Identical notices of deficiency were mailed both to Made Rite Sausage Co. and "Made Rite Sales Co." Petitions were filed in both names "for the sole purpose of establishing jurisdiction in this proceeding and to protect the petitioner."↩
2. This return was filed under the erroneous name "Made Rite Sales Co."↩
3. Cal. Corp. Code sec. 25500. Permit for sale of securities of company's own issue. No company shall sell any security of its own issue, except upon a sale for a delinquent assessment against the security made in accordance with the laws of this State, or offer for sale, negotiate for sale of, or take subscriptions for any such security, until it has first applied for and secured from the commissioner a permit authorizing it so to do.
* * * *
Sec. 26100. Void securities; issuance or sale without permit or in violation of permit↩. Every security of its own issue sold or issued by any company without a permit of the commissioner then in effect authorizing the issuance or sale of the security is void. Every security of its own issue sold or issued by a company with the authorization of the commissioner but which has been sold or issued in nonconformity with any provision in the permit authorizing the issuance or sale of the security is void.
4. In the returns as filed, June 30, 1955, was used as the closing date of the period covered by the partnership return and July 1, 1955, was used as the commencement date of the period covered by the corporate returns. The parties have stipulated, however, that the partnership return actually reports the income earned through July 16 and that the period covered by the corporate returns commenced July 18. July 17 was a Sunday and presumably no income was earned on that day.↩
5. Due to an error in the premium rate of this renewal policy, it was later canceled and replaced by another policy, also in the partnership name, issued May 25, 1956, but effective as of January 20, 1956.↩
1. This amount represents the payments made by Manufacturing in February 1956, prior to the issuance of the stock.↩
6. The record does not indicate which of the other Made Rite corporations paid her salary for those years.↩
7. See Cal. Corp. Code sec. 25502:
Contents of application. In such application the applicant shall set forth all of the following:
* * * *
(g) A copy of any contract it proposes to make concerning such security.↩
8. SEC. 269. ACQUISITIONS MADE TO EVADE OR AVOID INCOME TAX.
(b) Power of Secretary or His Delegate To Allow Deductions, Etc., in Part. -- In any case to which subsection (a) applies the Secretary or his delegate is authorized --
(1) to allow as a deduction, credit, or allowance any part of any amount disallowed by such subsection, if he determines that such allowance will not result in the evasion or avoidance of Federal income tax for which the acquisition was made: or
(2) to distribute, apportion, or allocate gross income, and distribute, apportion, or allocate the deductions, credits, or allowances the benefit of which was sought to be secured, between or among the corporations, or properties, or parts thereof, involved, and to allow such deductions, credits, or allowances so distributed, apportioned, or allocated, but to give effect to such allowance only to such extent as he determines will not result in the evasion or avoidance of Federal income tax for which the acquisition was made; or
(3) to exercise his powers in part under paragraph (1) and in part under paragraph (2).↩