1941 BTA LEXIS 1130">*1130 1. Payments made by petitioner to two of its officers for services rendered by them in supervising and directing the remodeling of certain of its buildings, and the construction of others, which services were equivalent to those of a general contractor and supervising architect, held, to be capital expenditures constituting a cost of construction and not deductible as reasonable compensation for services rendered in carrying on business.
2. Where petitioner on the cash basis was indebted to its tenant for advances made by the latter, and such tenant was indebted to petitioner in a lesser amount for rental, and petitioner had the authority to offset the rental due against its indebtedness, and it was understood that such offset would be made, it is held, that petitioner was thereupon in constructive receipt of the amount of the rentals due, although the offsetting entry was not made on its books before the close of that year.
3. On the record, it is held, that there was no negligence or intentional disregard of rules or regulations by petitioner in the filing of its returns, and the imposition of 5 percent negligence penalties is not warranted.
45 B.T.A. 333">*333 This proceeding is for the redetermination of deficiencies in income and excess profits taxes and for penalties thereon for the taxable years ended January 31, 1936, 1937, and 1938, as follows:
| Income tax | Exces profits tax | |||
| Year | Deficiency | 5% penalty | Deficiency | Penalty |
| 1936 | $1,350.94 | $67.55 | $474.78 | $23.74 |
| 1937 | 2,763.08 | 138.15 | 915.66 | 45.78 |
| 1938 | 3,652.94 | 182.65 | 257.91 | 12.90 |
| Total | 7,766.96 | 388.35 | 1,648.35 | 82.42 |
The issues are (1) whether or not salaries of petitioner's president and secretary-treasurer, in the amount disallowed by respondent, constituted "ordinary and necessary" expenses paid or incurred in carrying on the petitioner's business; (2) whether or not the petitioner was in constructive receipt of an unpaid portion of rent which was due it from its principal tenant; and (3) whether or not a 5 percent penalty should be imposed on petitioner on the ground of negligence or intentional disregard of rules and regulations. One other adjustment made by the respondent with respect to the profit realized on the1941 BTA LEXIS 1130">*1132 sale of a bond was assigned as error but apparently was abandoned by petitioner, since no evidence relative thereto was submitted.
45 B.T.A. 333">*334 FINDINGS OF FACT.
Petitioner is a corporation organized in 1908, with its principal place of business at Big Bend and Grant Roads, St. Louis County, Missouri. It filed its income tax returns for each of the years here in question with the collector of internal revenue for the first collection district at St. Louis, Missouri.
Prior to 1933, practically the entire activity of petitioner was the holding of title to certain improved real estate in St. Louis County occupied under lease by the Clenwood Sanatorium Co., hereinafter referred to as the sanatorium, and the collection of rentals from that tenant. In 1933, plans were made for the remodeling and enlarging of the facilities leased to the sanatorium. Following this, petitioner's activities, in addition to collection of rentals, was the construction of certain new buildings, the remodeling of some of the old buildings, and the improvement and landscaping of a considerable additional area of the surrounding grounds.
Prior to his death in 1932, Henry North had been president of1941 BTA LEXIS 1130">*1133 petitioner and also operated the sanatorium. After his death and during the taxable years here in question, petitioner's president was Anna M. Bennett and its secretary-treasurer was Bertha M. North. These individuals are, respectively, the widow and sister of Henry North. During this period, 279 of the 330 issued shares of stock of petitioner were owned by Anna M. Bennett and the others, with the exception of one share, were owned by or held in trust for Bertha M. North. All of the stock of the sanatorium was owned by these two individuals and the estate of Henry North.
Upon determining to remodel and expand the facilities of petitioner leased to the sanatorium, Mrs. Bennett and Mrs. North traveled through various states inspecting the facilities of different sanatoriums engaged in the same character of work as that carried on by petitioner's tenant, with a view to securing plans for the most modern and efficient type of facilities required. The program of construction was begun in July 1933. At that time it was difficult to borrow the necessary funds to finance the work. However, largely through the efforts of Mrs. Bennett, a loan of $20,000 was secured on a note signed1941 BTA LEXIS 1130">*1134 by petitioner and the sanatorium as comakers, secured by a $25,000 deed of trust on the property owned by petitioner and also by certain securities belonging to petitioner and the sanatorium. Mrs. Bennett personally advanced, from time to time, funds of her own for the building program. No interest was charged by her on these advances. At times during the period of construction the amount owing Mrs. Bennett by petitioner was between ten and fifteen thousand dollars.
Petitioner's program of construction and improvement was carried on throughout the taxable years in question. Two buildings known 45 B.T.A. 333">*335 as the North and South Buildings were modernized, a new barn was built, and a new building known as the Administration Building, representing 350,000 cubic feet of construction, was completed in 1935. Another new building of 210,000 cubic feet, known as the West Building, was begun in 1936 and completed in 1938. There was also constructed a modern occupational therapy building, two garages, two store buildings, and other improvements.
This program of construction and improvement was managed and directed by Mrs. Bennett and Mrs. North. In her planning and supervision of1941 BTA LEXIS 1130">*1135 construction Mrs. Bennett was assisted and advised by her husband, who had considerable experience in such matters and was himself engaged in the construction business. The work was done through the purchase of materials and the hiring of labor and the letting of subcontracts for different parts of the construction. In this way the expense of a general contractor and a supervising architect was eliminated, resulting in a considerable saving to petitioner. Bids had been asked on the Administration Building without garage and a completed third floor and the lowest received was $106,000, whereas this building with garage and third floor was erected under the supervisions of petitioner's president and secretary-treasurer for less than $70,000. The construction of the other buildings and facilities was effected with a very considerable saving by reason of the method used by petitioner and through the supervision of the work by its president and secretary-treasurer.
Petitioner's president and secretary-treasurer drew no salaries until June 1, 1934, on which date the president was voted a salary of $325 per month and the secretary-treasurer $50 per month. These salaries continued1941 BTA LEXIS 1130">*1136 until February 1, 1935, when they were increased to $650 and $100 per month, respectively. On August 1, 1935, the president's salary was again increased, to $975 per month, and the secretary-treasurer's salary was increased to $150 per month. These salaries remained at these amounts until February 1, 1938, at which time the expansion program was completed.
The amounts of the salaries claimed by petitioner or its returns for the years in question as ordinary and necessary expenses in carrying on its business and the amounts thereof allowed by respondent are as follows:
| Salary of president | Salary of secretary-treasurer | |||
| Claimed on return | Allowed | Claimed on return | Allowed | |
| 1936 | $10,075 | $1,200 | $1,550 | $600 |
| 1937 | 9,750 | 1,200 | 1,650 | 600 |
| 1938 | 11,700 | 1,200 | 1,800 | 600 |
45 B.T.A. 333">*336 Petitioner's president, Anna M. Bennett, performed all the services necessary to the management of the construction of the buildings, the landscaping, the location of the buildings, and building water lines. Bertha M. North, petitioner's secretary-treasurer, did not have the business ability of the president, but she helped in the management of petitioner's1941 BTA LEXIS 1130">*1137 expansion program. She attended business and directors' meetings and passed on construction bids and obtained and furnished lien waivers.
Petitioner maintains its books of account and makes its returns upon the cash basis.
During or prior to the fiscal year ending January 31, 1938, the sanatorium made advances to petitioner totaling $10,500. The rental for which it was obligated to petitioner for that year was $18,000. After making payments during that year to petitioner in the sum of $9,300 for rent, the sanatorium ceased making further payments, it being contemplated that the additional rental due would be offset against petitioner's obligation to its tenant for advances made. Although petitioner had the right to do so, this offset was not entered upon the books of the petitioner during that fiscal year, for the reason that the completion of the construction work was anticipated within that year, which would result in an increase of the rental from the sanatorium. The construction work was not completed until some months after the fiscal year and the fact that there would be no increase in the rental due from the sanatorium was determinable prior to the close of that year.
1941 BTA LEXIS 1130">*1138 There was no negligence or intentional disregard of rules and regulations on the part of petitioner in making its return and reporting income in any of the years here involved.
OPINION.
LEECH: The first issue presents only the question of the propriety of respondent's disallowance of the deduction of a portion of the salaries paid by petitioner to its president and secretary-treasurer, respectively, during the tax years, as ordinary and necessary expenses.
Under section 23(a) of the Revenue Act of 1936, there are allowed as deductions "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 * * *."
Petitioner has the burden of showing that the salaries of its officers were "ordinary and necessary" expenses in carrying on its business. ; and in determining this a strict application of the statute is required. See 1941 BTA LEXIS 1130">*1139 .
45 B.T.A. 333">*337 Petitioner does not contend that prior to the start of its building program its activities were such as to justify the payments made by it to its two officers as salaries in the three taxable years here in question. In fact, the evidence presented by it is directed to establishing the fact that the services rendered by these two in supervising and directing the building were equivalent to and in the nature of the services which would have been rendered by a general contractor and supervising architect and that by the employment of these two individuals that cost, which would have exceeded the salaries paid, was saved. Petitioner seeks to justify the amount paid as salary to each, wholly on the ground of the value of these particular services in the building program. That the payments were made for these services is further shown by the fact that they were discontinued as soon as the building program was finished. Moreover, the payments to these two officers were substantially proportionate to their respective stock ownership in petitioner. Each time such salaries were increased this proportion was maintained and, 1941 BTA LEXIS 1130">*1140 although we are not advised as to the income of the corporation for the first two of the three years here in question, it is established that for the fiscal year 1938 these salaries were largely in excess of the gross income reported by petitioner for that year.
Had petitioner employed a general contractor and supervising architect in its construction, there is no question but that expense would have constituted a building cost, not deductible in computing taxable income. If, instead of this, it employs and pays its two officers to perform that service, is such payment to be considered different in character? We think not. In , we held as capital expenditures amounts paid by the taxpayer to its general manager and plant superintendent for services over and beyond their usual and customary duties and analogous to services of designing and supervising engineers in the completion of its plant.
We see no reason here to question the amounts paid in each year as reasonable compensation for the services rendered. However, it is clear that these payments were not made as compensation of these two officers, as such. They were1941 BTA LEXIS 1130">*1141 made for unusual, nonrecurrent services, the cost of which is represented now in the value of the capital assets thus acquired and now owned by petitioner. Compensation paid individuals for services incidental to the construction or improvement of buildings, or in connection with the acquisition of capital assets, is a capital expenditure and not an ordinary and necessary expense of carrying on business. ; W. P. Brown & sons ; ; ; 45 B.T.A. 333">*338 affd., ; certiorari denied, . Respondent is affirmed on this issue.
Petitioner contends that the respondent, in arguing for the first time on brief that the proof indicated the expenditures in controversy to be capital, has injected a new issue in the case. This position has no merit. The issue here is whether these payments, in fact, represented reasonable allowances for services performed in carrying on business, and the burden of establishing that fact rests upon petitioner. Respondent1941 BTA LEXIS 1130">*1142 contends merely that petitioner's proof not only fails to establish the fact necessary to sustain his deduction, but, on the other hand, shows affirmatively that the expenditures, even if ordinary and necessary, are nondeductible in character. That deductibility has always been the issue.
The second issue is whether or not petitioner was in constructive receipt of rent due it from its principal tenant, the sanatorium. Petitioner maintains its accounts upon a cash basis and in the fiscal year 1938 owed the sanatorium $10,500 for advances made it by the latter. In that year the sanatorium was obligated to petitioner for a rental of $18,000, but after paying $9,300 of this amount it ceased to make further payments, leaving a balance of rent due in the amount of $8,700. It is respondent's position that petitioner was in constructive receipt of this latter amount since it had the right to offset it on its books against the amount it owed the sanatorium, although no such book entry was actually made during that year.
The doctrine of constructive receipt is an "artificial concept which must be sparingly applied", 1941 BTA LEXIS 1130">*1143 ; and then only under "unique circumstances", . Its "primary function is to bring about a fair and reasonable application of the income tax" and "its application may vary with varying circumstances", ; and the test as to its applicability is "whether the debtor has funds standing to the credit of the taxpayer which the debtor is able to pay and which are available and unqualifiedly subject to the taxpayer's demand", .
Does this case come within the principles applicable to constructive receipt? In our opinion it does. It is true that the debts of the sanatorium and petitioner to each other were carried as separate obligations on their respective books. Although there is no evidence that an offset was not entered on its books by the sanatorium in the tax year, petitioner made no offsetting entry.
The evidence here in connection with this mutual indebtedness is contained in the testimony of the present president of petitioner, who is the husband of Anna M. Bennett, and one Rothweiler, 1941 BTA LEXIS 1130">*1144 who was at all times here involved a director of petitioner and auditor for both petitioner and the sanatorium. Both of these witnesses were familiar 45 B.T.A. 333">*339 with all the conditions surrounding the transactions between petitioner and the sanatorium. Bennett in his testimony admits that petitioner had the right to make the offset but contends that it was not required to do so but could, if it desired, postpone the credit to a future period. Rothweiler testifies that it was intended that the balance due petitioner from the sanatorium was to be offset against petitioner's indebtedness to the latter and that the offsetting entry was not immediately made because of the fact that it was anticipated that certain of the new buildings would be ready for occupancy before the close of the year, requiring an increase in the rent due for that year from the sanatorium. His testimony is that petitioner delayed making the offsetting entry until the determination of the exact amount which would be due. But the buildings in question were not completed for occupancy until some months after the tax year.
It is true that, at least under some circumstances, "mutual debts do not per se extinguish1941 BTA LEXIS 1130">*1145 each other." But here, we think, the intention of the parties was that these mutual debts were to be treated as parts of one transaction. The offset of one debt against the other was intended and petitioner had an absolute right to make it during the tax year. Cf. . We think that the requirements of constructive receipt are satisfied and that petitioner could not, by merely delaying the making of a book entry, postpone this rent receipt to a future period. Respondent is affirmed.
The remaining issue upon the imposition of a 5 percent negligence penalty under section 293 of the Revenue Act of 1936 we have disposed of by finding that there was no negligence or intentional disregard of rules and regulations. Respondent is reversed on this issue.
Decision will be entered under Rule 50.