*245 Decision will be entered under Rule 50.
1. Engineering and designing expenses in the amount of $ 82,702.47 held deductible. Sec. 23 (a)(1), I. R. C. 1939.
2. Petitioner had only a skeleton staff. Many valuable services were performed on its behalf over a period of nearly 3 years by R-E Corporation which owned 50 per cent of petitioner's stock. At about the time that R-E Corporation acquired the remaining 50 per cent of petitioner's stock it billed petitioner for such services in the amount of $ 114,655.16. Held, the amount was reasonable, and petitioner, being on the accrual basis, may deduct it during the taxable period when the bill was rendered.
3. Petitioner had an agreement with S Company whereby the latter was to distribute petitioner's products. Pursuant to that agreement petitioner set aside in a separate fund (consisting in part of separate bank accounts and in part merely of book entries) 10 per cent of its net sales for advertising and 6 per cent of its net sales for demonstration expenses. S Company was authorized to draw upon that fund for such purposes. Held, the unexpended portions of the fund (where it was not shown that S Company had created*246 any obligations against petitioner for advertising and demonstration expenses beyond the amounts actually paid out) are not deductible by petitioner.
*922 The respondent determined the following deficiencies in income tax:
| Taxable period | Deficiency |
| Year ended Dec. 31, 1946 | $ 30,579.85 |
| Jan. 1 to Sept. 30, 1947 1 | 49,187.56 |
The principal issues are:
1. Are engineering and designing expenses incurred*247 by the petitioner in the 1947 taxable period in the amount of $ 82,702.47 deductible as business expenses under section 23 (a)(1) of the Internal Revenue Code of 1939?
2. Are certain administrative fees accrued in the 1947 taxable period in the amount of $ 114,655.16 for services rendered to or on behalf of petitioner deductible as business expenses under section 23(a)(1)?
3. Are amounts which were placed in a separate fund for advertising and demonstration purposes during the year 1946 and the 1947 taxable period, respectively, deductible as business expenses under section 23(a)(1)?
FINDINGS OF FACT.
The parties have stipulated various facts which are incorporated herein by reference.
Petitioner was organized as a Delaware corporation on October 26, 1944. Its principal office was in New York. It kept its books and filed its returns on a calendar year and accrual basis of accounting. On October 1, 1947, as a result of a change in ownership of some of its stock, it became a member of an affiliated group of corporations filing a consolidated return on a calendar year basis. Its returns for 1946 and the period January 1 to September 30, 1947, were filed with the then collector of*248 internal revenue for the third district of New York.
Prior to October 1, 1947, the outstanding stock of petitioner was owned as follows: *923
| Class A | Class B | |
| shares | shares | |
| Reeves-Ely Laboratories, Inc | 250 | |
| Fred R. Sanford | 125 | |
| D. E. Sanford | 125 |
Reeves-Ely Laboratories, Inc. (hereinafter referred to as Reeves-Ely), was essentially a holding company, providing management, engineering, and scientific services for its subsidiaries. It had about 300 employees, some of whom were engineers or scientists. Its principal offices were in New York.
Fred R. Sanford and D. E. Sanford were brothers, living in California. They controlled D. E. Sanford Company, a partnership engaged in marketing electrical appliances.
On or about October 1, 1947, Reeves-Ely purchased the foregoing stock in petitioner owned by the two Sanfords, as hereinafter more fully set forth.
Petitioner had been formed to take over and exploit an exclusive license under certain patents, giving it the right to make, use, and vend certain electric appliances, notably, a domestic mixing device known as a "Blendor," and a steam iron known as "Aluron."
From the time of its formation through 1947 petitioner*249 had only a skeleton administrative staff with no facilities for manufacturing, warehousing, or selling. Its general plan was to have its products manufactured and distributed for it by others. During the first year of its life petitioner's operations were limited to planning and preparatory activity.
By letter of August 5, 1945, to D. E. Sanford Company, petitioner engaged the services of D. E. Sanford Company to distribute its products. The letter read as follows:
In accordance with our discussion regarding the utilization of Sanford services in the sales of Waring products, the Waring Products Corporation hereby appoints your company to represent it in the sale of the aforementioned appliances. The formula for such services as presented by Mr. Fred Sanford is acceptable to us.
It is agreed that the D. E. Sanford Company will be paid a commission of ten percent on the net billings to the distributor. These commissions are payable on the fifteenth of the month for the shipments of the preceding month.
The D. E. Sanford Company will carry on a demonstration program to promote the sale of the Waring products and will receive six percent of the net billings to distributors to cover*250 costs of such demonstration program. This sum is payable on the same due date that commissions are to be paid.
A sum equal to ten per cent of the net billings to distributors is to be reserved for advertising. If Sanford takes on the responsibility for the administration of this fund such monies will be paid at the same time as are commissions and demonstration funds. Should the Waring Corporation elect to handle its own advertising it would follow that disbursements would be made to advertisers by the Waring Corporation itself.
This arrangement should continue in effect for a period of ten years from this date.
*924 The letter was regarded by the parties as constituting an agreement, which, on May 22, 1947, was assigned by D. E. Sanford Company to D. E. Sanford Company, Inc., a corporation apparently controlled by the Sanford brothers.
Petitioner encountered difficulty in obtaining manufacturing services. It attempted to place contracts for the manufacture of the Blendor and Aluron with Air-Way Electrical Appliance Corporation (hereinafter referred to as Air-Way) at Toledo, Ohio. Air-Way had previously manufactured Blendors for the Waring Corporation from which petitioner*251 had obtained its license. Air-Way refused to accept an order from petitioner because of petitioner's unsatisfactory credit standing due to its limited capital and lack of financial operating experience. Accordingly, Reeves-Ely undertook to deal with Air-Way directly, pledging its own credit on behalf of petitioner. Contractual arrangements for the manufacture of 100,000 Blendors and 100,000 Alurons were formalized in an exchange of letters between Reeves-Ely and Air-Way, dated October 18 and 27, 1945. It was provided that the finished products would be packaged by Air-Way and shipped to customers directly from the Air-Way factory. Air-Way's charges were to be actual shop cost plus 10 per cent. Tools to be used in the production of the Aluron were to be paid for by petitioner. Target production figures were 3,000 Blendors per week at the earliest possible date and 2,000 Alurons per week with an eventual rate of 3,000 per week.
The contract between Air-Way and Reeves-Ely with respect to the manufacture of the Blendor was carried out. Between October 1945 and early 1947 Air-Way had manufactured and delivered 100,000 Blendors. Reeves-Ely had actively serviced the contract and*252 participated in major decisions as to quantity and quality of items because of the special knowledge which its personnel had with respect to the appliance field. The Blendors were finally priced at between $ 10 and $ 11 per unit, and Reeves-Ely accordingly incurred potential obligations with respect to the Blendor in excess of $ 1,000,000.
At first, Air-Way sent the invoices for the Blendors directly to Reeves-Ely which paid them and then obtained reimbursement from petitioner. Later, by agreement with Air-Way, the invoices were sent to petitioner, which made payment directly to Air-Way. However, the latter arrangement did not relieve Reeves-Ely of its obligation under the basic contract in the event that petitioner had failed to pay the invoices. Since petitioners had no warehouses, deliveries of Blendors were made by Air-Way directly to distributors and jobbers against orders which had been taken on behalf of petitioner; no deliveries were made to Reeves-Ely.
Although Air-Way manufactured Blendors successfully, it ran into difficulties with the manufacture of the Alurons. That program was *925 almost completely unsuccessful; the iron was difficult to make, parts were hard*253 to get, materials were in short supply, and Air-Way had no testing facilities. Both Air-Way and Reeves-Ely did considerable engineering work in an attempt to perfect the iron for production. Reeves-Ely sent its own engineers, designers, and executives to Air-Way's plant. The problem was frequently discussed with officers of Air-Way by telephone and in person. Expediters from the Reeves-Ely staff were dispatched to help obtain steel for Air-Way and a company airplane was also placed at the disposal of Air-Way personnel in connection with the iron program. In short, Reeves-Ely did everything it could to make the production of Aluron a success.
In spite of all efforts Air-Way never did successfully manufacture the Alurons in quantity. Many months passed after the date when the first deliveries should have been made on the irons before any were delivered. The first deliveries were shipped directly to distributors who sold them to customers. None of these irons was satisfactory. So much trouble developed that petitioner called them all back to avoid harming the market.
At this point a dispute arose as to whether Air-Way should receive compensation with respect to the defective*254 irons. Officers and members of the staff of Reeves-Ely entered into negotiations with Air-Way to settle the dispute. Settlement was achieved under the terms of a "Sub-license Agreement" entered into by petitioner and Air-Way on September 30, 1947; and performance by petitioner was guaranteed by Reeves-Ely. Pursuant to that agreement, petitioner gave Air-Way a nonexclusive and nonassignable license to manufacture and sell the irons in question and also transferred to Air-Way its title to all of the tools and dies owned by it which were used in the manufacture of the irons. In consideration of the transfer of the tools and dies Air-Way waived all claims which it had against petitioner with respect to the extraordinary expenses arising out of the manufacture of the irons. These tools and dies were located in Air-Way's plant and had been purchased by petitioner for $ 37,907.23. At the same time Air-Way executed a release from claims with respect to the irons manufactured by it under the prior contract.
Petitioner had employed a number of engineering specialists in an attempt to eliminate the "bugs" which had developed in connection with the manufacture of the irons by Air-Way. *255 During the period January 1 to September 30, 1947, petitioner incurred certain engineering and other designing costs in connection with the manufacture of the Blendors and Alurons as shown below:
| Blendor | $ 4,424.87 |
| Aluron | 40,371.37 |
| Total | $ 44,796.24 |
*926 On its return for the period January 1 to September 30, 1947, petitioner included as part of "cost of goods sold" an item of $ 82,702.47 designated as "engineering and designing." That item represents the aggregate of the amounts set forth in the two preceding paragraphs, and appeared as an accrued expense in petitioner's books for this period.
After the settlement with Air-Way, Reeves-Ely discontinued the Aluron program with Air-Way and found another manufacturer for the iron on behalf of petitioner.
The agreement between the petitioner and the D. E. Sanford Company (hereinafter sometimes referred to as Sanford Company) reflected in the letter of August 5, 1945, had worked satisfactorily at the outset. In the late spring of 1947, a dispute arose between officers of petitioner (who were also officers of Reeves-Ely) and the Sanford Company. The dispute involved the question of the proper administration of the*256 advertising and demonstration allowances provided by the agreement with the Sanford Company. The officers felt that the Sanford Company, as a national sales agency, was not giving petitioner proper coverage through the entire country. In addition, Sanford Company was billing petitioner on gross sales and not taking into account allowances on return sales. They also felt that demonstration funds were not being placed to the most advantageous use and were being improperly utilized. The complaint was not so much against the Sanford Company or the Sanford brothers individually as it was against the managers employed by the Sanfords in various areas.
For these reasons, relations between petitioner and the Sanford Company (as well as the successor corporation which will hereinafter also be referred to as the Sanford Company) became progressively worse during May, June, and July 1947. Petitioner regarded the Sanford Company as having breached the agreement of August 5, 1945, and therefore it ceased making payments of sales commissions under that agreement. Other steps were taken during that period to curtail the activities of the Sanford Company under the August 5, 1945, agreement. *257 Petitioner's officers refused to forward any more advertising moneys to the Sanford Company. The Sanford Company had been charging petitioner 3 per cent of net sales for handling petitioner's billings. Reeves-Ely rented office space for petitioner so that petitioner could handle its own billings at a cost less than that which had been paid to the Sanford Company.
A period of negotiations then commenced between petitioner and the Sanford Company. These negotiations proved fruitless since a deadlock developed in the petitioner's board of directors. Thereupon, Reeves-Ely conducted the negotiations with the Sanford Company on behalf of petitioner.
*927 During these negotiations the Sanford Company had employed two law firms and Reeves-Ely was represented by two of its officers as well as other staff members, a law firm, and its own house counsel. Petitioner was also represented by counsel. Sanford Company instituted lawsuits against both the petitioner and Reeves-Ely.
Finally, as a result of negotiations, settlement was arrived at and the dispute was terminated. The agreement which terminated the dispute was entered into as of October 1, 1947. The petitioner, Reeves-Ely, *258 the Sanford brothers, and the Sanford Company were parties to the agreement. It provided, among other things, that Reeves-Ely would buy and the Sanfords would sell the 250 shares of stock of petitioner owned by them for $ 250,000; and that petitioner would pay certain amounts in satisfaction of claims for commissions, advertising expense, and demonstrators' fees. The agreement of October 1, 1947, contained a number of other provisions; it is incorporated herein by reference.
After October 1, 1947, petitioner employed its own sales manager and demonstrators, and handled its own advertising.
From the time of petitioner's formation in October 1944 through September 30, 1947, Reeves-Ely furnished staff and management to or for the benefit of petitioner. Petitioner was constantly calling upon employees of Reeves-Ely on a daily basis for advice and service. Among the services obtained from Reeves-Ely were those of engineers, attorneys, financial experts, accountants, bookkeepers, secretaries, and the use of office space and equipment.
Reeves-Ely rendered an invoice in the amount of $ 114,655.16 to petitioner dated September 30, 1947, that was intended to cover administrative services*259 furnished by Reeves-Ely from the time of petitioner's formation in 1944 to September 30, 1947. The amount was arbitrarily computed at 10 per cent of petitioner's sales during the period January 1 to September 30, 1947. Among the services intended to be covered by the invoice were the services in obtaining the Air-Way contract, the assistance in settling the dispute with the Sanford Company, and the various miscellaneous general services required in the day-to-day conduct of petitioner's business. Other than in a few instances pertaining to specific items (involving payments aggregating "several thousand dollars"), Reeves-Ely did not bill petitioner for so-called administrative charges in 1945, 1946, or at any time in 1947 prior to the invoice of September 30, 1947. The amount of $ 114,655.16 was reflected as an accrued expense in petitioner's books for the period ending September 30, 1947.
On petitioner's return for the period January 1 to September 30, 1947, a deduction for administrative fees was taken in the amount of $ 124,655.16; it now concedes that this amount was overstated by $ 10,000. The Commissioner disallowed the deduction in its entirety.
*928 Reeves-Ely was*260 actually paid the sum of $ 114,655.16 by petitioner between October 31, 1947, and March 3, 1949, as shown below:
| Date | Amount |
| Oct. 31, 1947 | $ 11,462.14 |
| Nov. 13, 1947 | 12,783.41 |
| June 23, 1948 | 15,629.13 |
| July 19, 1948 | 12,907.87 |
| Dec. 28, 1948 | 30,000.00 |
| Mar. 3, 1949 | 31,872.61 |
| Total | $ 114,655.16 |
Reeves-Ely treated the amount of $ 114,655.16, invoiced on September 30, 1947, as income both on its books and on its tax return filed for the year 1947.
There always was an understanding on the part of the officers of both Reeves-Ely and the petitioner that the petitioner would pay for the services furnished by Reeves-Ely. This understanding had never been incorporated in a formal written document but was on the basis of an oral agreement. The foundation for this agreement was that the reimbursement would be equal to the reasonable value of the services rendered in the considered opinion of the officers of both companies.
Reeves-Ely has continued to charge the petitioner for administrative services rendered since the initial charge on September 30, 1947.
The amount of the bill rendered by Reeves-Ely on September 30, 1947, was reasonable.
Pursuant to the agreement of August*261 5, 1945, with the Sanford Company it was agreed that petitioner would pay 6 per cent of net billings for demonstration costs and that a sum equal to 10 per cent of net billings would be reserved for advertising. The parties have stipulated that on its returns petitioner accrued the following amounts for advertising and demonstration expenses and actually expended the amounts indicated as shown below: 2
| Taxable year ended | Accrued | Expended | Balance |
| Dec. 31, 1945 | $ 3,460.85 | $ 7,055.71 | ($ 3,586.86) |
| Dec. 31, 1946 | 108,742.56 | 17,796.80 | 87,170.90 |
| Sept. 30, 1947 | 182,501.97 | 47,596.43 | 222,076.44 |
| Dec. 31, 1947 | 21,384.45 | 200,691.99 | |
| Dec. 31, 1948 | 200,691.99 | ||
| Totals | 294,705.38 | 294,705.38 |
Petitioner segregated and placed "in a separate fund" the moneys for advertising and demonstration expenses. The "separate fund" consisted *929 in part of separate bank accounts and in part simply of book entries. The fund was in possession of petitioner in New York City, and it was the practice in the early days under the agreement of August 5, 1945, to have petitioner pay out of the fund all bills incurred by the Sanford Company for advertising and demonstration. *262 Petitioner paid either the Sanford Company directly or the persons with whom the Sanford Company had incurred debts in this respect. Occasionally, petitioner itself would incur and pay for advertising out of the fund. After the dispute with Sanford Company arose in May 1947 petitioner refused to make payments to the Sanford Company for such expenses but it did make payment to others with respect to such items in order to maintain its credit standing. The control and administration of the fund were at all times in the hands of the petitioner.
The Commissioner disallowed deductions to the extent of $ 87,170.90 and $ 134,904.74 for advertising and demonstration expenses for 1946 and the period January 1 to September 30, 1947, respectively, on the ground that "such amounts did not accrue" during those periods.
OPINION.
*263 1. The Commissioner disallowed a deduction in the amount of $ 82,702.47, which petitioner claims to be allowable as engineering and designing expenses. A small part of these expenses pertained to the manufacture of the Blendor; the great bulk of the item represents costs incurred in connection with the unsuccessful effort to manufacture the iron. The Commissioner has conceded that these costs are not to be capitalized, nor does he contest the amount. His sole argument is that the deduction is not available because petitioner "was not legally obligated" to turn over to Air-Way $ 37,907.23 worth of steam iron tools or to pay $ 44,796.24 for engineering and designing costs, the two components of the amount in dispute.
We think that there is no merit to respondent's position. We know of no requirement that there must be an underlying legal obligation to make an expenditure before it can qualify as an "ordinary and necessary" business expense under section 23 (a) (1), Internal Revenue Code of 1939. The basic question is whether, in all the circumstances, the expenditure is ordinary and appropriate to the conduct of the taxpayer's business. Unlike the situation in Welch v. Helvering, 290 U.S. 111">290 U.S. 111,*264 relied upon by respondent, no part of the amount involved represents a gratuitous payment. Certainly, as to the $ 44,796.24 item, the payment was for engineering services rendered to petitioner; and, as to the $ 37,907.23 item, the transfer of tools in that amount was, in part at least, in satisfaction of Air-Way's contested *930 claim for reimbursement for costs incurred in connection with the production of the irons. We hold for petitioner on this issue.
2. Petitioner seeks to justify a deduction of $ 114,655.16, as an ordinary and necessary business expense, representing the amount of the bill rendered to it on September 30, 1947, by Reeves-Ely for administrative services.
During most of the period from the time of its formation in 1944 until September 30, 1947, petitioner operated with a skeleton staff. Reeves-Ely owned 50 per cent of petitioner's stock and played a dominant role in the conduct of petitioner's business. It furnished a wide variety of services to petitioner. We do not find it necessary to recount the evidence in this regard; suffice it to say, we are satisfied that such services were on a day-to-day basis and were of a high order of importance to petitioner. *265 If the amount involved is reasonable, it is plainly deductible. Cf. Smith-Bridgman & Co., 16 T. C. 287. Taking into account the scope and character of the services herein over a period of nearly 3 years, we cannot conclude on this record that the charge was excessive, and we have made a finding that it was reasonable, notwithstanding that it was arrived at in negotiations that were not conducted at arm's length.
The fact that petitioner was on an accrual basis does not deprive it of the deduction for the period January 1 to September 30, 1947. Neither the amount nor the formula for determining the amount was agreed upon until near the end of this period. Accordingly, the full amount accrued at the end of the period when the bill was rendered. We hold that petitioner is entitled to deduct the amount of $ 114,655.16 here in controversy.
3. The third issue relates to the deductibility of advertising and demonstration expenses. In its return for 1946, the petitioner claimed as a deduction $ 49,946.45 for advertising expense and $ 53,903.43 for demonstration expense. In its return for the 1947 taxable period it claimed as deductions $ 114,626.01 for*266 advertising expense and $ 67,875.96 for demonstration expense. The respondent disallowed $ 87,170.90 of the amount deducted for advertising and demonstration expenses in the 1946 return, and $ 134,904.74 of the amount claimed for these expenses in the return for the 1947 taxable period.
The petitioner contends that it was obligated by its contract of August 5, 1945, with the Sanford Company to set aside amounts for advertising and demonstration from the date of that contract through September 30, 1947; that these amounts were set aside and segregated into a separate fund "administered" by the Sanford Company; and that they were properly accrued and constitute allowable business expense deductions for the respective taxable years.
The agreement of August 5, 1945, provided that a commission of 10 per cent on the net billings to the distributors be paid by petitioner *931 to the Sanford Company on the 15th of the month for the shipments of the preceding month. It also provided that the Sanford Company would receive 6 per cent of the net billings to distributors to cover costs of a demonstration program to promote the sale of Waring products, which amount was payable on the same*267 due date that the commissions were to be paid. It further provided as follows:
A sum equal to ten per cent of the net billings to distributors is to be reserved for advertising. If Sanford takes on the responsibility for the administration of this fund such monies will be paid at the same time as are commissions and demonstration funds. Should the Waring Corporation elect to handle its own advertising it would follow that disbursements would be made to advertisers by the Waring Corporation itself.
During the year 1946 and the 1947 taxable period petitioner segregated and placed in a separate "fund" amounts equivalent to 6 per cent of net billings for demonstration expenses and 10 per cent for advertising and kept them in its physical possession and control in New York City. Petitioner never paid such amounts to the Sanford Company at the time it paid the commissions, or at any other time, and there is no convincing evidence that that company ever demanded their payment or claimed that petitioner was obligated to pay any more than the costs actually incurred for demonstration and advertising.
To the extent that the Sanford Company in fact created obligations against petitioner*268 for advertising and demonstration, the amounts would be accruable as a deduction even though unpaid. But we have been furnished with no evidence of any such specific obligations, apart from the actual payments made by petitioner out of the fund. Accordingly, we must hold that the Commissioner correctly disallowed the deduction to the extent of the unexpended portion of the fund, for, to that extent, no fixed obligation had been created against petitioner or the fund and it was therefore not accruable. At most, the Sanford Company had authority to create such obligation, but until it did so accrual would not be proper.
Petitioner is, of course, entitled to deduct the amounts actually expended, $ 17,976.80 in 1946 and $ 47,596.43 in the 1947 taxable period, and if the Commissioner's determination had the effect of disallowing these amounts, an appropriate adjustment may be made under Rule 50.
4. A final question remaining is whether the petitioner is entitled to the benefit of a net operating loss deduction affecting either 1946 or the 1947 taxable period. There is no conflict between the parties on this question, and the answer depends solely upon certain stipulated facts and the*269 resolution of the three preceding issues. The matter will be disposed of under Rule 50.
Decision will be entered under Rule 50.