*62 Decision will be entered under Rule 50.
1. Allocation of income between husband and wife determined, where both contributed capital and the husband contributed services to a business enterprise.
2. Held, imposition of negligence penalty not justified.
*944 The respondent determined deficiencies of $ 260.48 and $ 8,429.22 in the petitioner's income tax for the calendar years 1940 and 1941, respectively. He also*63 asserted negligence penalties of $ 13.02 and $ 421.46 against the petitioner for the same respective years. The petitioner has appealed from the respondent's determination of deficiency relating to the year 1941 only.
The major issue is whether, beginning October 10, 1941, the business conducted under the name of "Canfield Motor Sales" was a partnership composed of the petitioner and his wife, Elsie Canfield, and hence the income therefrom was taxable to the individual partners, or was taxable wholly to the petitioner. A partnership was allegedly established on October 10, 1941.
The petitioner also challenges the propriety of the negligence penalties.
FINDINGS OF FACT.
Certain facts were stipulated or admitted in the pleadings. In so far as they are pertinent to the issue, they are as follows:
The petitioner is an individual whose office and place of business is in Detroit, Michigan. He filed his income tax return for the year 1941 with the collector of internal revenue at Detroit, Michigan. He kept his books on a cash receipts and disbursements basis.
In September 1936 the petitioner established an automobile agency dealing in Packard cars, operating such business as an individual*64 proprietorship under the assumed name of Canfield Motor Sales. The capital with which the business was established by the petitioner was in the amount of $ 5,898.20. The source of the funds contributed by him in cash as the initial capital was as follows:
| Proceeds of adjusted service certificate issued to the petitioner as a member | |
| of the Army during World War I and cashed in 1936 | $ 1,577.00 |
| Amount of joint savings account of the petitioner and his wife, | |
| Elsie Canfield | 2,421.20 |
| Advance to the petitioner from his wife, Elsie Canfield | 1,900.00 |
*945 The amount of $ 1,900 had been borrowed by Elsie Canfield from her mother, Albertine Zemke, for the purpose of advancing it to the petitioner to invest in his business. Upon obtaining the loan, Elsie Canfield executed a promissory note, payable to her mother and bearing interest at the rate of 5 per cent per annum, payable annually. Interest on the note, as it accrued, was paid by the petitioner to his wife and by her in turn to Albertine Zemke until the death of Albertine Zemke.
Albertine Zemke died in January 1938, leaving a will bequeathing her estate in equal shares to her daughters, Elsie Canfield and Frieda*65 Bohne. The estate was settled by agreement and was divided equally between the two heirs in February 1938. Elsie Canfield received as her distributive share the sum of $ 3,632.99 in cash, plus certain securities, the amount and value of which are not relevant to this proceeding. Thereafter, on February 26, 1938, she advanced to the petitioner the sum of $ 3,000 in cash.
On May 31, 1938, the automobile agency known as Canfield Motor Sales ceased operations. On June 1, 1938, the petitioner acquired, by purchase from Robert E. Needham, a 50 per cent interest in the assets and business of an individual proprietorship theretofore carried on under the name and style of Needham Motor Sales. Between June 1 and November 17, 1938, the business continued to be operated as a copartnership under the name and style of Needham Motor Sales.
On November 18, 1938, for a cash consideration of $ 2,500, the petitioner acquired from Robert E. Needham the remaining 50 per cent interest in Needham Motor Sales, thereby becoming the sole owner of the business. The source of the cash consideration of $ 2,500 paid to Robert E. Needham by the petitioner was the advance of $ 3,000 to the petitioner by his*66 wife, Elsie Canfield, in February 1938.
From November 18, 1938, to and including October 9, 1941, the business theretofore conducted under the name of Needham Motor Sales was carried on by the petitioner as an individual proprietorship under the assumed name of Canfield Motor Sales.
The advance of $ 3,000 made to the petitioner by his wife in February 1938 was never evidenced by a promissory note. Neither the advance of $ 1,900 made to the petitioner in September 1936 nor that of $ 3,000 made to him in February 1938 was ever recorded on the books of Canfield Motor Sales as a liability of that business. Neither the petitioner nor his wife maintained individual books of account.
The income of the business of Canfield Motor Sales for the calendar year 1941, as shown in the respondent's deficiency notice in the amount of $ 31,192.60, is overstated by the amount of $ 1,625.17.
During the year 1941 Canfield Motor Sales had on its books an account captioned "Reserves," and in such account there was recorded the receipt during 1941 of rebates from the finance company in the *946 amount of $ 3,623.24. The correct amount of such rebates received by Canfield Motor Sales during the year*67 1941 is $ 3,827.17, representing an omission in that account of rebates of $ 203.93.
The record discloses the following additional facts:
At the time the petitioner's wife made advances of $ 1,900 and $ 3,000 to the petitioner in September 1936 and February 1938, respectively, they agreed that such advances constituted loans to him and he continued to recognize his obligation to repay her these sums until October 10, 1941. When the petitioner bought the remaining one-half interest in the Needham Motor Sales business on November 18, 1938, his wife stated that she desired to have a one-half interest in the petitioner's business, thereafter conducted as Canfield Motor Sales. She stated that she wanted to be protected in the amount of her loan to him.
The petitioner thereupon, being aware that she might jeopardize her separate estate by establishing such a partnership, warned his wife of the dangers involved if the business were not successful. He then opened a bank account in the name of Canfield Motor Sales with both the petitioner and his wife having the authority to draw on it. The establishment of the joint account was for the purpose of protecting the petitioner's wife in the*68 event of his death. The formation of a partnership continued to be discussed frequently by them. Early in 1940 the petitioner consulted an attorney, Albert M. Stern, who explained the danger of Mrs. Canfield's losing her other assets if the business failed.
The petitioner related to his wife the substance of his conversation with Stern. The discussions relating to the formation of a partnership continued until the summer of 1941, when Mrs. Canfield consulted Stern, who repeated the warning which he had given to her husband. At the time she explained fully the source of the loans which she had made to the petitioner and the fact that she also possessed a separate estate. After further discussion the petitioner and his wife asked Stern to prepare a partnership agreement. Stern stated to Mrs. Canfield that she might have security for her investment in the form of a mortgage, but she insisted that she wanted to become a partner in the business of Canfield Motor Sales. Stern recommended that an accountant be employed to supervise the books of the business.
At first Mrs. Canfield insisted that in the agreement restrictions be placed on her husband's authority and on the extent of*69 possible business expansion, but, at their attorney's suggestion, all such provisions were eliminated from the formal agreement.
The partnership agreement was executed by the petitioner and his wife on October 10, 1941. The firm name was Canfield Motor Sales, which was to carry on the business of selling and distributing automobiles, *947 selling accessories, and repairing automotive vehicles. It was to continue for 10 years. The agreement contained the following pertinent paragraphs:
5. The capital of said partnership shall consist of the assets of Canfield Motor Sales heretofore exclusively owned by Claire L. Canfield, and by this agreement second party is granted a one-half interest therein, and said interest, together with all the income and profits arising from the employment thereof, to become and constitute partnership funds.
6. Claire L. Canfield shall be entitled to draw from the proceeds of the said business, for his own separate account, One Hundred ($ 100.00) Dollars per week, while the partnership continues, but with the condition that all such sums drawn by him for the term shall not exceed his share of the profits of said partnership, and if they do, he shall*70 repay the same at the close of the term, the agreement being that each partner shall share equally in all profits and losses that may arise out of or occur in the prosecution of the said partnership operation.
Immediately after the partnership agreement was signed the petitioner gave notice thereof to all the finance companies, banks, and insurance companies with which he did business. He also gave similar notices to the Sales Tax Department of the State of Michigan, the Unemployment Commission, and the Secretary of State. Pursuant to such notice to the Sales Tax Department, he received a license naming him and his wife as copartners. The license has been posted on the door of the plant continuously.
He sent the same notice to the Dodge factory, but his franchise with the Dodge Co. was not amended. He likewise notified the partnership's landlord, who told him to leave the lease as it was. He further sent to the county clerk a notice of discontinuance of the individual proprietorship under an assumed name, and a certificate of copartnership, naming him and his wife as partners conducting the business under the assumed name of Canfield Motor Sales. The notice of continuance was*71 filed by the clerk, but the certificate of copartnership was returned, in view of the Michigan law then relating to the separate estate of a married woman.
On October 10, 1941, the net worth of the assets of Canfield Motor Sales was $ 17,443.49. The petitioner employed an accountant to set up capital accounts, to audit the books of the partnership, and to prepare its income tax return. In March 1942 the petitioner filed an individual gift tax return because one-half of the value of the business exceeded the amount of his indebtedness to his wife. The petitioner told the president of his bank that the loans of Mrs. Canfield to the petitioner were never entered on the petitioner's books prior to the formation of the partnership.
On October 10, 1941, capital accounts reflecting the capital interests of the petitioner and his wife were set up by a certified public accountant upon the books of the partnership. Personal accounts, *948 recording the withdrawals of the petitioner and his wife, were also established. Each partner has withdrawn amounts at irregular intervals since October 10, 1941. The withdrawals were equalized on February 28, 1945. The total amounts withdrawn *72 up to August 31, 1945, were $ 46,478.02 by the petitioner and $ 41,198 by Mrs. Canfield.
The petitioner paid the household and living expenses of his family from his monthly withdrawals. His wife paid none of them. The title to their home was taken jointly by the petitioner and his wife. From their withdrawals, the petitioner and his wife have paid their respective income taxes and each has paid $ 4,166.47 on the mortgage on their home, $ 1,000 for furnishings therefor, and $ 1,125 to purchase war bonds. Mrs. Canfield purchased a fur coat for her daughter at a cost of $ 350.
The surplus withdrawals of both the petitioner and his wife were kept in liquid form and deposited in a joint safe deposit box.
At the time the partnership was formed it was understood that Mrs. Canfield would not perform daily services. She examines the monthly financial statements of the firm and discusses with the petitioner the events of the past month.
After the war started, at the insistence of Mrs. Canfield, the partnership engaged in the machining business, producing small parts for use in the war effort. The petitioner had had no experience in that activity and the venture was unsuccessful. A problem*73 arose in 1942 when, on January 1 of that year, the Government froze the sale of new automobiles. The partnership had approximately 100 new cars in stock at that time. The petitioner became somewhat panic-stricken and wanted to sell the cars back to the Chrysler Corporation, or to other dealers who would be willing to gamble on them. Mrs. Canfield would not agree to the sale. The firm eventually sold the cars at a profit.
In his income tax return for the year 1941 the petitioner reported a net income of $ 13,249.38, including $ 12,267.55 profits earned by him in Canfield Motor Sales for the period from January 1 to October 10, 1941. No partnership income was reported in the year 1941. In his notice of deficiency the respondent stated: "It is held that all the income from the business carried on in the name of Canfield Motor Sales [for the entire year 1941], in the amount of $ 33,192.60, is taxable to you."
The Commissioner asserted a 5 per cent penalty "under the provisions of section 293 (a) of the Internal Revenue Code." The petitioner was not negligent in reporting his income for the taxable years, nor did he intentionally disregard the Commissioner's rules and regulations.
*74 *949 OPINION.
The case before us presents the question whether the income from an alleged partnership between husband and wife is properly taxable to the husband or may be divided between them.
In Commissioner v. Tower, 327 U.S. 280">327 U.S. 280, the Supreme Court stated:
* * * A partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses. When the existence of an alleged partnership arrangement is challenged by outsiders, the question arises whether the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both. And their intention in this respect is a question of fact, to be determined from testimony disclosed by their "agreement, considered as a whole, and by their conduct in execution of its provisions." ( Drennen v. London Assurance Co., 113 U.S. 51">113 U.S. 51, 56; Cox v. Hickman, 8 H. L. Cas., 268.) We see no reason why this general rule should*75 not apply in tax cases where the Government challenges the existence of a partnership for tax purposes. * * *
In the instant case it will not be gainsaid that Mrs. Canfield contributed $ 4,900 out of $ 17,443.49 stated to be the net worth of the company as of October 10, 1941, when they purportedly formed a partnership. It is likewise clear that she did not contribute substantially to the control and management of the business nor otherwise perform vital additional services. Commissioner v. Tower, supra.Though capital was an essential factor, the income earned by the business was undoubtedly principally due to personal services. The contract of partnership made no mention of capital contributions or to services to be rendered by the parties. The execution of the agreement made no change in the management or operation of the business. The parties knew that the contract of partnership was ineffective under the law of Michigan.
The Supreme Court has held that the gift of a partnership interest by a husband is not effective, tax-wise, to create in the wife an interest in the partnership. Commissioner v. Tower, supra.*76 Therefore, although the agreement provided for equal division of the profits and petitioner made a purported gift to his wife of a 50 per cent interest, the capital interest of petitioner's wife was limited to her original cash contribution.
Section 3797, Internal Revenue Code, states that "The term 'partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation." The *950 arrangement between petitioner and his wife seems to fall within the broad scope of this definition, although it was not recognized by the law of Michigan and albeit in this case the agreement between the parties can not be held to fix the incidence of taxation. Although the statute defines joint ventures as partnerships, that classification does not carry with it all the common law incidents of partnership. In this, as in many instances, the tax law supplies its own criteria by which to gauge the rights and duties of taxpayers.
Certain basic concepts are to be borne in mind. These are: That taxation*77 is an eminently practical matter; that income is normally taxable to him who earns it; and that agreements between members of an intimate family group are to be closely scrutinized and tested in the light of reality to the end that realism and not mere form shall fix tax consequences. Thus, in the present case, though the agreement of the parties may come within the scope of the statutory definition of partnerships, we find that it lacks the necessary reality to determine by its terms the taxability of income earned.
It is our opinion that the agreement resulted in a business arrangement in which the parties should be taxed in proportion to their respective contributions to capital and services. Since exact measurement of the amount of income attributable to either capital or services is impossible, a practical approach to the problem is required. Certain facts are to be noted: The income was principally due to the services of the husband; the wife contributed no substantial services; the wife contributed $ 4,900 in cash to the enterprise; the petitioner's contribution to capital as of the basic date was $ 12,543.49.
We accordingly hold that a reasonable allocation of income should*78 be made and that 75 per cent of the earnings of the business, beginning October 10, 1941, was attributable to petitioner's services and 25 per cent to the employment of capital. Petitioner is solely taxable on all income attributable to services. Of the remaining 25 per cent of the earnings, attributable to capital, petitioner and his wife are respectively taxable in proportion to their respective contributions to capital, as set out above. (See sec. 182, I. R. C.).
A minor issue is the propriety of imposing a negligence penalty. In his notice of deficiency the respondent did not specify the ground on which he imposed the penalty, but in his opening statement his counsel explained that the respondent's action was based on "an omission to record on the books certain items of finance company rebate which, * * * when finally reported, did not correspond to the correct amounts." However, it was stipulated that such an account appeared on the books of Canfield Motor Sales, captioned "Reserves," in which rebates of $ 3,623.24 from the finance company were recorded. The correct amount of such rebates was $ 3,827.17, or $ 203.93 more than the recorded amount.
*951 It is obvious *79 that this minor discrepancy resulted from a clerical error. There is no evidence or indication of intentional disregard of rules and regulations, or of negligence. The rebates themselves, which apparently the Commissioner determined were unrecorded, were found in the "Reserve" account and, with the exception of $ 203.93, were included in the partnership's return of income. We see nothing in the record to warrant the imposition of the negligence penalty for either taxable year.
This report supersedes a report promulgated June 13, 1946 (7 T. C. 135).
Decision will be entered under Rule 50.
Black, J., dissenting: I find myself in disagreement with the majority opinion because I think the reasoning used therein is inadequate to support the conclusion reached.
In the first place I think it is important that we bear in mind the issue which has been raised by the pleadings. In his explanation of adjustments made in the income tax return of petitioner for the year 1941, the Commissioner stated in his deficiency notice as follows:
(a) You reported net income from business in the amount of $ 12,267.55, representing the income earned for the period*80 of operation January 1, 1941 to October 10, 1941. Thereafter you contend the business was operated as a partnership between yourself and wife Elsie H. Canfield. No partnership income was reported in the year 1941.
* * * *
It is held that all the income from the business carried on under the name of Canfield Motor Sales, in the amount of $ 33,192.60, is taxable to you.
To this determination of respondent, the petitioner assigned error as follows:
(a) Respondent has erroneously refused to recognize the existence of a partnership entered into between petitioner and his wife on October 10, 1941 for the carrying on of a business theretofore conducted by petitioner as an individual proprietorship under the name of Canfield Motor Sales.
Assignment of error (b) is merely an elaboration of assignment of error (a). Respondent's answer to petitioner's assignments of error consisted of a general denial. His answer did not contain a statement of any facts upon which he relied for defense or for affirmative relief.
Thus, it seems to me that the issue squarely raised by the pleadings is whether during the period October 10 to December 31, 1941, petitioner and his wife were partners in the business*81 of Canfield Motor Sales. If the issue is decided in petitioner's favor, I think it should be held that in the state of the pleadings the wife would be entitled *952 to at least that proportion of the profits which would be based on her capital contribution of $ 4,900 to the enterprise as compared with her husband's contribution of $ 12,543.49. The petitioner should, of course, be taxed on his share of the profits thus arrived at. The majority opinion holds, properly I think, that, because the wife contributed $ 4,900 out of her own capital to the business, she thereby became a partner in the business under the written partnership agreement, within the meaning of the Federal statute.
But the opinion goes on to say that before there is any division of the profits there must first be taken out of the earnings 75 per cent attributable to petitioner's services. I do not see where any such issue has been raised by the pleadings. It would, of course, have been within the rights of the partners to have had such arrangement in the partnership agreement, but they did not do so. It may well be that the Commissioner himself could properly raise such a question by a determination of*82 that kind in his deficiency notice or by affirmative allegations in his answer, but he has not done so. It does not appear to me why we should raise such an issue.
Corpus Juris, vol. 47, sec. 232, p. 790, says:
* * * It is entirely competent for partners to determine by agreement, as between themselves, the basis upon which profits shall be divided, even without regard to the amount of their respective contributions, and such an agreement should be given effect, in the absence of a change; * * *
The Supreme Court of the United States, in Paul v. Cullum, 132 U.S. 539">132 U.S. 539, held to the same effect as the above quotation from Corpus Juris. In that case, among other things, the Court said:
While, in the absence of written stipulations or other evidence showing a different intention, partners will be held to share equally both profits and losses, it is entirely competent for them to determine, as between themselves, the basis upon which profits shall be divided and losses borne, without regard to their respective contributions, whether of money, labor, or experience, to the common stock. Story on Partnership, §§ 23, 24. Such matters are entirely within*83 the discretion of parties about to assume the relation of partners.
In Merten's Law of Federal Income Taxation, vol. 6, sec. 35.18, dealing with the subject of "Computation of Distributive Shares of Partners," the author, among other things, says:
Each partner is thus required to report his "proportionate share of the partnership net income." The proportionate share is determined by the partnership agreement, which involves an interpretation of the agreement.
But we must consider, of course, in a case of this kind the recent decisions of the Supreme Court in Commissioner v. Tower and Lusthaus v. Commissioner.
I agree that under the rationale of the Tower and Lusthaus cases, the wife did not acquire any interest in the partnership by reason of any gift from her husband of part of his interest in the business. *953 The extent of the interest which she acquired in the partnership was represented by the independent capital of her own which she contributed. That was $ 4,900. It would seem that her share of the profits would be 4,900/17,443.49 of the whole in the absence of an agreement that the husband should first be paid for his services out of the earnings*84 or the raising of such an issue by the Commissioner by affirmative allegations.
For the reasons above stated, I respectfully dissent from the majority opinion.