*2806 1. Amounts paid by the petitioner in the year 1918 to creditors whose claims had been discharged by bankruptcy proceedings in 1911 held not deductible from income in the year 1918.
2. The respondent's disallowance of deductions for additional salaries and commissions paid by petitioner to its officers allowed in part and disallowed in part.
*673 This is a proceeding for the redetermination of a deficiency in income and profits taxes for the calendar year 1918 in the amount of $108,026.87.
The petitioner alleges that the determination of tax was based upon the following errors:
(a) In determining the taxpayer's net income for 1918 the amount of $200,000 has been erroneously added to taxable income for proportion of officers' compensation disallowed as deduction.
(b) In determining the taxpayer's net income for 1918 the amount of $42,818.94 has been erroneously added to taxable income as representing so-called advertising expense disallowed.
(c) In determining the rate of excess and war-profits tax for 1918 a percentage amounting to*2807 58.73 per cent has erroneously been considered as representing the average rate of excess and war-profits tax paid by other representative concerns.
A motion to confine the hearing to the trial of issues defined in subparagraphs (a) and (b) of Rule 62 was granted.
FINDINGS OF FACT.
The petitioner was, during the year 1918, a corporation engaged in the manufacture of brushes of various kinds at Kingston, N.Y.
In 1911 petitioner filed a petition in bankruptcy. A settlement was thereafter effected with its creditors on the basis of 25 per cent of the amount of each of their claims. The amount unpaid was $42,818.94. There was a prospect that the business of the petitioner for 1918 would amount to $2,000,000 or $3,000,000 and, petitioner having but a limited working capital, it was necessary to obtain credit and borrow money in large sums upon the right terms. As a means of establishing this credit the officers of the petitioner, in the early part of 1918, orally promised a number of petitioner's former creditors with whom petitioner had made settlements, that if the business *674 prospered the petitioner would pay back the remaining 75 per cent of claims of the various*2808 concerns. One of such concerns was the First National Bank of Kingston. The result was that the bank loaned petitioner $40,000.
In August, 1918, the directors of the petitioner passed a resolution with respect to the payment of these claims in connection with "a vigorous advertising campaign" to be inaugurated "with a view of establishing the future good will, good name, and credit standing of the company." The resolution directed that the payment of the claims of these old creditors be made as a first step in this campaign and directed that checks be mailed to these old creditors, accompanied by a letter to read as follows:
We take pleasure in enclosing our check for $ and trust this means our good name and credit may be restored with you to the highest standing.
In view of our many past pleasant relations it is our earnest desire to begin the new year on this basis.
Wishing you a happy and prosperous New Year,
Yours very truly,
Both during the year in question as well as during the period when the petitioner went into bankruptcy the books of the Herbert Brush Manufacturing Co. were on the accrual basis.
During the year 1918 petitioner borrowed between $400,000*2809 and $500,000. Accounts payable at times were over $200,000 or $300,000.
In the latter part of 1918 petitioner did pay the old creditors, whether or not petitioner was then doing business with them, as it was thought that a single nonpayment might lead to an injury to petitioner's credit.
The total amount repaid to creditors for the balance of their unpaid claims of 1911 was $42,818.94, of which $8,983.37 was paid to banks and $33,835.57 to miscellaneous creditors. The amount was charged to "advertising" and taken as a deduction by the petitioner on its return for the year 1918. The full amount of $42,818.94 was disallowed as a deduction by the respondent.
On December 23, 1917, petitioner entered into a contract with its president, John F. Herbert, Sr., whereby it agreed to pay him a commission of 10 per cent on all raw material purchase orders or purchase contracts placed by him on behalf of petitioner in the execution of civilian business. It was provided that the commission to be earned by John F. Herbert, Sr., should not exceed the sum of $50,000 during the years 1918, 1919, and 1920.
On December 23, 1917, petitioner entered into a contract with Joseph M. Herbert, *2810 its vice president, and Albert A. Herbert, its treasurer, whereby it agreed to pay them a commission of 10 per cent on all orders to be obtained by them of civilian business, and on *675 all orders of civilian business to be obtained by them from all foreign countries not at war with the United States. It was provided that the commissions to be paid under said contract should not exceed the sum of $100,000 during the years 1918, 1919, and 1920. Ten per cent was the average rate of commission paid to salesmen in this business.
At a meeting of the board of directors of the Herbert Brush Manufacturing Co. on January 16, 1918, officers of the corporation were elected and compensation voted them for the year 1918 as follows:
| Name | Office | Compensation |
| John F. Herbert, sr | President | $75,000 |
| Joseph M. Herbert | Vice president | 50,000 |
| John F. Herbert, jr | Secretary | 35,000 |
| Albert A. Herbert | Treasurer | 45,000 |
| Leo F. Herbert | Assistant secretary and assistant treasurer. | 35,000 |
| Total | 240,000 |
On September 28, 1918, the board of directors voted John F. Herbert, Jr., and Leo F. Herbert $25,000 additional compensation for the year 1918.
Under their agreement*2811 of December 23, 1917, Joseph M. Herbert and Albert A. Herbert, prior to the close of the year 1918, had secured civilian orders from the Belknap Hardware Manufacturing Co. of Louisville, Ky., amounting to $931,749.18, and in addition various other orders amounting to about $100,000. Aside from the orders covered by the contract referred to, Albert A. Herbert and Joseph M. Herbert secured about $3,000,000 of orders from the Government. The corporation shipped about $2,000,000 worth of goods during the year and had, at the end of the year, about $2,000,000 in unfilled contracts on the books.
John F. Herbert, Sr., had, prior to the close of 1918, performed all acts on his part required to be done under the agreement of December 23, 1917.
The total amounts paid petitioner's officers during the year 1918 were as follows:
| Name | Office | Compensation |
| John F. Herbert, sr | President | $125,000 |
| Joseph M. Herbert | Vice president | 100,000 |
| Albert A. Herbert | Treasurer | 95,000 |
| John F. Herbert, jr | Secretary | 60,000 |
| Leo F. Herbert | Assistant secretary and assistant treasurer. | 60,000 |
| Total | 440,000 |
*676 Such amounts were actually paid to each of the officers*2812 during the year 1918 and were charged off the books of the corporation during that year. Respondent allowed compensation to officers in the amount of $240,000 and disallowed $200,000.
Gross sales, less returns and allowances, for the year 1918 amounted to $2,022,525.50 and gross income amounted to $1,045,409.01. The statutory invested capital for the year was not excess of $339,146.88.
The stockholdings in the petitioner as of January 16, 1918, were as follows:
| Stockholder | Preferred stock | Common stock |
| John F. Herbert, sr | 30 | 97 |
| Joseph M. Herbert | 3 | 40 |
| Luella Herbert | 2 | |
| Albert A. Herbert | 10 | 30 |
| Amos Van Etten | 8 | |
| John F. Herbert, jr | 1 | |
| 46 | 175 |
There were 29 additional shares of preferred stock owned by citizens of Kingston. The original capitalization was $17,500 common stock and $7,500 preferred stock. In July, 1918, the common stock and the preferred stock were each increased to $150,000. A large part of the new stock was issued for property.
The stockholdings in the petitioner as of September 26, 1918, were as follows:
| Stockholder | Preferred | Common |
| John F. Herbert, sr | 400 | 520 |
| Joseph M. Herbert | 398 | 140 |
| Luella Herbert | 2 | |
| Albert A. Herbert | 300 | 130 |
| John F. Herbert, jr | 200 | |
| Leo F. Herbert | 200 | |
| Amos Van Etten | 8 | |
| 1,500 | 798 |
*2813 Preferred stock did not have the power to vote.
John F. Herbert, Sr., died May 5, 1923. He had been president of Herbert Brush Manufacturing Co. since the time of its incorporation in 1896, until its dissolution June 19, 1920. As president of the corporation he had the responsibility of the general administration of the business. He had been in the brush business about 50 years. He directed the business and his judgment was followed in all important transactions. By reason of his long experience in the brush business, particularly in the purchasing of supplies such as bristles and leather, which required expert knowledge, he was one of the leading judges of these materials in the brush business. He *677 purchased all the supplies and he was in constant consultation with his sons as to the policy of the sales and the policy of production, the methods of conducting the business and the financing of the corporation's affairs. No important step in the business was taken without his first being consulted. He devoted about 12 or 14 hours a day, including Sundays and holidays, to the business. He was better qualified to purchase supplies than any of the other officers.
*2814 Joseph M. Herbert, vice president of the company, has been in the brush business about 34 years. He was a salesman and assisted his father in the general administration of the business. Aside from orders covered by the commission contract he and his brother, Albert A. Herbert, were responsible for securing orders for $3,000,000 in Government contracts.
Due to the increase of business in 1918 it was necessary to secure new plants and Joseph M. Herbert and his brother, Albert A. Herbert, decided upon the selection and desirability of the sites and buildings. Their recommendations were submitted to their father and brothers. Joseph M. Herbert frequently traveled both day and night in the course of his duties. He devoted an average of about 14 hours a day, including Sundays and holidays, to the business.
Another duty which fell to Joseph M. Herbert was the attention to financial details. He arranged with the banks for borrowing money and with individuals for the necessary credit.
Albert A. Herbert was the treasurer of the company in 1918. He had been in the brush-manufacturing business 34 years. He was associated with his brother in the contract of December 23, 1917, and*2815 received the commissions earned by him under that contract.
In addition to his office of treasurer and his position as salesman, Albert A. Herbert had charge of the cost department. He was responsible for securing the first contract from the Rock Island Arsenal, and in order to get the best results he went to Rock Island and lived there so as to learn the type of brush required. The machinery owned by the Herbert Brush Manufacturing Co. was not adaptable to manufacturing this type of brush. This necessitated tearing down the plant and practically making it all over again. Albert A. Herbert had charge of this work and was assisted by his brother, Joseph M. Herbert. He also made designs or patterns for the new type of brush, installed new machinery, and secured new dies and cutting-out machinery. He devoted about 14 or 15 hours a day to his duties on an average.
John F. Herbert, Jr., secretary of the corporation, has had about 20 years experience in the brush-manufacturing business. He, together with his brother Leo, had full charge of the six plants, which they operated after they had been first put in operation by Joseph M. and Albert A. Herbert. He had direct charge*2816 of five of the *678 plants. His work called for attention in the matter of repairing and keeping up machinery at the various plants; seeing that bits and needles were kept sharp so as to prevent defective work and to keep the men from being idle. Some of the plants ran at night and sometimes they would run double shifts in the daytime. Sometimes they would run until 9 o'clock in the night. During the early part of the war they would sometimes work all night, as they did not have many machines at that time. John F. Herbert, Jr., worked on Sundays and holidays.
Leo F. Herbert was assistant secretary and assistant treasurer. He was plant superintendent of the "horse brush" factory. His duties were that of general supervisor of all work at that plant. He hired and discharged employees and had direct charge of installation of new machinery. At the beginning of the year the company had about 70 or 80 drilling machines and the men were working two shifts. A good average operator turned out about 15 brushes a day. About two and a half dozen to three dozen from each machine each day were turned out and towards the end of the war the plant produced about 600 dozen brushes*2817 a day. On one exceptional day there were 8,500 brushes delivered. This plant sometimes operated two shifts and sometimes three shifts. One time during a busy period this plant operated 20 1/2 hours out of 24 hours per day. Leo F. Herbert devoted about 14 or 15 hours a day to the business. He spent all of one week in the plant from Monday morning to the following Sunday. He would spend part of each shift at the plant and he also worked on Sundays and on holidays. On Sundays he laid out his schedules, watched for weak spots, determined how he could catch up in a department lagging behind, and checked up generally on the condition of the plant. He also effected an economy in the saving of bristles which theretofore had been lost. He had to watch for supplies that were due to arrive and on occasions had to trace shipments that had become lost and arrange for their delivery. At the beginning of 1918 each of the 419 holes in the back of a brush were drilled separately, but during the year three machines were installed which would bore the 419 holes in one operation.
Sometime in July, 1918, Leo F. Herbert and John F. Herbert demanded additional compensation. The corporation*2818 had increased its capital stock and they were not sharers in the company. In the absence of John F. Herbert, Sr., they had taken charge of affairs generally, developed machinery, and organized the working forces. They had cut down losses due to defective work. At the time they asked for the increase the corporation was shipping approximately $6,000 worth of goods a day, or about $150,000 a month.
*679 The facilities of the corporation at the beginning of the year would have permitted the production of about one-fourth or one-third of the volume of business it was producing at the end of the year. At the beginning of the year it had three plants and at the end of the year it had six.
The corporation employed from 400 to 500 men, only a few of them being highly paid. One received $8,500, another $4,000, and some received $3,000 per annum.
The corporation had large contracts for the sale of brushes to the United States Government, but despite the fluctuation the price per brush to the Government at the end of the year was but slightly higher than the price at the beginning of the year. This was due partly to the efficiency of the officers in the management of the*2819 business.
OPINION.
SIEFKIN: The petitioner in 1911 filed a petition in bankruptcy and effected a settlement with creditors on the basis of 25 per cent of the amount of each of their claims. In 1918 the petitioner paid the remaining 75 per cent of such claims, amounting to $42,818.94. The officers of petitioner, in the early part of 1918, made oral promises to pay some of these creditors in order to establish and maintain the petitioner's future good will and credit standing. The petitioner claimed the amount of $42,919.94 as a deduction in the year 1918. The respondent disallowed the whole amount as a deduction.
An examination of the authorities leads to some doubt as to whether a payment of the amount of a debt which has been discharged by bankruptcy proceedings is payment of the old obligation or is payment of a new obligation. However, in the instant proceeding, the point is not material. If the payment be considered payment of the old obligation it is not deductible, since petitioner was upon the accrual basis in both the years 1911 and 1918, and the payment in 1918 would be for obligations accrued in prior years.
If, on the other hand, it be considered not a*2820 payment of the old obligation, then at best it represents consideration for good will and credit expected to arise from the payment of the moral obligation. The benefit anticipated from such payment was an improved credit reputation or standing, i.e., an intangible asset with a probable life coextensive with the business. As such it does not represent a current transaction for income-tax purposes.
We approve the action of the respondent in disallowing as a deduction the amount of $42,818.94.
The remaining question is whether the respondent erred in disallowing an amount of $200,000, a part of the amount claimed by the petitioner as a deduction for officers' salaries.
*680 The board of directors of petitioner, on January 10, 1918, voted the following salaries:
| Name | Office | Compensation |
| John F. Herbert, Sr | President | $75,000 |
| Joseph M. Herbert | Vice president | 50,000 |
| John F. Herbert, jr | Secretary | 35,000 |
| Albert A. Herbert | Treasurer | 45,000 |
| Leo F. Herbert | Assistant secretary and assistant treasurer | 35,000 |
| Total | 240,000 |
The respondent has allowed the above amounts as deductions as being reasonable compensation of officers. The remaining*2821 $200,000 which was disallowed by respondent as a deduction was composed of commissions and additional salaries.
John F. Herbert, Sr., received an additional amount of $50,000 as commissions on purchases of materials. This commission was provided for in a contract between John F. Herbert, Sr., and the petitioner on December 23, 1917.
Joseph M. Herbert and Albert A. Herbert during 1918 received orders totaling about $1,031,749.18, upon which each received $50,000 commission. Their commission was provided for in a contract dated December 23, 1917. The evidence discloses that the rate of 10 per cent commission which Joseph M. Herbert and Albert A. Herbert received was the usual rate of commission received by salesmen in this business. We hold that the commissions received by John F. Herbert, Sr., Joseph M. Herbert, and Albert A. Herbert constituted reasonable additional compensation for services rendered.
However, the record does not show that the additional amounts of $25,000 each received by John F. Herbert, Jr., and Leo F. Herbert were reasonable. To this extent the presumption of the correctness of the respondent's determination has not been overcome. We hold that the*2822 amount of $390,000 is a reasonable deduction as compensation for petitioner's officers.
The cause will be restored to the calendar for further proceedings under Rule 62.