*3920 Additional compensation paid to employees of Crocker Lake Logging Co. for services actually rendered prior to the close of December 31, 1919, are deductible expenses incurred within that year.
*1221 This is a proceeding for the redetermination of deficiencies in income and profits taxes for the calendar years 1919 to 1923, inclusive, asserted by the respondent as follows:
| Year | Maryott & Spencer Logging Co. | Elliott Bay Mill Co. | Crocker Lake Logging Co. |
| 1919 | $6,838.80 | $23,352.78 | |
| 1920 | 1,809.28 | ||
| 1921 | |||
| 1922 | $2,850.92 | 709.29 | |
| 1923 | 281.12 | ||
| Total | 2,850.92 | 9,638.49 | 23,352.78 |
The issues raised by the pleadings are:
(1) Whether the respondent correctly ruled that the three corporations herein were not affiliated within the meaning of the Act, and, therefore, not entitled to file consolidated returns for the years 1919 to 1923, inclusive; and
(2) Failure of the respondent to allow as a deduction in the computation of net income certain additional compensation*3921 paid to employees by the Crocker Lake Logging Co.
FINDINGS OF FACT.
The petitioners are corporations, organized and incorporated under the laws of the State of Washington, with their principal offices in Seattle.
At the hearing of this proceeding it was stipulated and agreed by both parties that the Crocker Lake Logging Co., Elliott Bay Mill Co. and Maryott & Spencer Logging Co. were affiliated within the meaning of the Act for the years 1919 and 1920, and that the latter two were so affiliated for the years 1921, 1922 and 1923, the former having discontinued business prior to those years.
*1222 Maryott & Spencer Logging Co. and Elliott Bay Mill Co. were incorporated on January 8, 1918, with capital stock of $150,000 and $100,000, respectively. The stock of those companies was owned by the following stockholders:
| Maryott & Spencer Logging Co. | Elliott Bay Mill Co. | |
| Per cent | Per cent | |
| C. C. Maryott | 40 | 40 |
| Craig L. Spencer | 40 | 40 |
| John Forrest | 10 | 10 |
| N. I. Peterson | 10 | 10 |
On March 25, 1918, C. C. Maryott and Craig L. Spencer organized the Crocker Lake Logging Co. with capital stock of $100,000, 499 1/2 shares of which stock*3922 were originally subscribed for by the said Maryott and Spencer. During the years 1919 and 1920, John Forrest owned 6 1/2 per cent, and N. I. Peterson 6 1/2 per cent of the capital stock of that company, Maryott and Spencer owning the remaining shares.
The officers and board of directors of the Crocker Lake Logging Co. were Maryott, Spencer and Forrest. Maryott devoted most of his time to the business of these companies in the office of the Elliott Bay Mill Co., while Spencer devoted considerable of his time at the logging camp which was between sixty and eighty miles from Seattle. Forrest was secretary of the company in charge of the office and the books of account. Peterson was a logging superintendent and had been engaged in that capacity for a great many years prior to the years here under consideration.
Three of Peterson's sons, together with two other men, were employed by the Crocker Lake Logging Co., at or about the time of its organization in 1918, to carry on the logging operations for which that company had been organized. The salaries of those five men were considerably less than the prevailing wage scale during the years 1918 and 1919. It having been understood*3923 between the officers of that company and those men that whenever a new camp should be opened they would receive, in accordance with their wishes, something besides their salaries, it was orally agreed early in 1918 that that company would pay to the three sons of Peterson, 25 per cent of the profits of the company, to be divided equally between them, and 5 per cent to each of the other two employees, making a total of 35 per cent to be paid those five men. Arrangements for the payment of these additional amounts were made by Spencer, and while no formal action was ever taken by the board of directors as a body, both Maryott and Forrest, the other two directors, were thoroughly conversant with the agreement entered into and they agreed to and ratified it.
*1223 For the purpose of evidencing the aforesaid agreement with the employees of the Crocker Lake Logging Co., 35 per cent of the outstanding capital stock of that company was, on May 1, 1918, transferred in the records of the company from the name of Maryott to those of the five individual employees. Nothing, however, was ever paid by those employees for said stock, nor were the certificates ever delivered to them. The*3924 only reason why the stock was transferred to their names was because Spencer, contrary to the wishes of Forrest, was anxious to evidence the agreement of the company in that manner.
When the operations of the Crocker Lake Logging Co. were completed in 1919, all of the equipment was sold and the capital of $100,000, originally invested in the company, was returned to the investors therein before any division of profits was made. No portion of the capital, represented by the 35 per cent of the stock in the names of the five employees, was distributed to them. The capital having been set aside or distributed to the original investors, the profits from operations were divided, 65 per cent to the original stockholders and 35 per cent to the five employees.
While the operations of the Crocker Lake Logging Co. had been completed in 1919, a number of accounts remained uncollected at December 31, 1919, and there were certain expenses, such as taxes, etc., that had not been anticipated, which caused some delay in rendering a final statement of affairs, but the profits from operations could have been determined at the end of 1919.
In 1919 the Crocker Lake Logging Co. paid those employees*3925 $14,882.50 on account of their additional compensation. Not having sufficient cash with which to pay the balance in that year, due to the fact that a number of accounts were still uncollected, it paid the further sum of $21,600 in 1920. The amounts paid were not charged to expense accounts as they were paid, but were treated as advances, or as partial payments, as the payments were made, and charged to their individual accounts.
The net income as disclosed by the revenue agent's report was $51,497.75, which the respondent in his deficiency notice has increased to $66,380.25, or an addition of $14,882.50, which is the exact sum of the payments actually made by the company to its employees in 1919. The respondent states as his reason for increasing the income as found by the revenue agent, "This additional compensation of $14,882.50 has been disallowed due to the fact that accounts receivable of the Crocker Lake Logging Co. show this amount due from officers. Also the liability for these amounts is based on oral agreements such agreement never having legally been authorized by the corporation."
The books of the company were kept on the accrual basis.
*1224 OPINION.
*3926 MORRIS: The petitioner's right to file a consolidated return has been conceded by the respondent and has been agreed to by stipulation of the parties; therefore, we are concerned solely with the question of whether the respondent erred in disallowing as a deduction, in the computation of net income for 1919, certain additional compensation paid to employees of the Crocker Lake Logging Co.
The petitioner contends that the Crocker Lake Logging Co., through its officers, contracted to pay its employees 35 per cent of its net profits and that, therefore, in view of the fact that the books of the company are kept on the accrual basis, it is entitled to deduct the entire 35 per cent in the computation of net income for 1919, notwithstanding a portion of that sum was not paid to said employees until 1920. The respondent, on the other hand, contends that any agreement entered into with these employees was in effect an agreement by the two main stockholders that the employees receive, in their stead, the profits to which they were rightfully entitled on their stock, to the extent of 35 per cent, and he cites in support of his proposition the fact that stock of the corporation was transferred*3927 to the names of the employees. All presumptions that may have arisen by reason of the transfer of the corporate stock to the employees have, in our opinion, been overcome by evidence as to the true nature of the transaction.
Section 234(a)(1) of the Revenue Act of 1918 provides in part as follows:
That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
(1) All the 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 * * *.
The reasonableness of the amounts claimed as deductions by the petitioner is undisputed.
Respondent's counsel complains that there was no formal corporate action and he in effect says there was no informal corporate action. This argument is wholly unsupported by the record. While strict formalities were dispensed with and while the payments in 1919 and 1920 were improperly recorded in the books of account, the testimony is clear that the Crocker Lake Logging Co. agreed, through its officers. to pay these five employees*3928 certain specified percentages of its net income in addition to their regular salaries; that the agreement was ratified and agreed to by all of the officers and directors of the company, and that the services were actually rendered prior to the close of December 31, 1919, and the sums agreed to be paid were in fact *1225 paid in 1919 and 1920. Therefore, since the respondent's counsel expressly admits that the reasonableness of the sum claimed as a deduction is not in dispute, we are of the opinion that section 234(a)(1), supra, has been complied with.
Since the petitioner's books are kept on the accrual basis, the total amounts of $14,882.50 and $21,600, paid in 1919 and 1920, respectively, are deductible in 1919 in the computation of net income for that year.
Judgment will be entered on 15 days' notice, under Rule 50.