*250 Decision will be entered under Rule 50.
Petitioner, on an accrual basis, while under contract, as to borrowing funds with the Reconstruction Finance Corporation, to limit compensation to each of two officers to $ 4,000 per year, by resolution set compensation at $ 6,000 to each, but payment was in large part made after the taxable years, and after the loan to the Reconstruction Finance Corporation was paid. Held, that the liability for compensation above $ 4,000 per year for each officer was contingent and no accruable liability, and that denial of deduction of the amount unpaid in the taxable years was not error. Deduction approved as to amount of compensation actually paid during taxable years.
*503 This proceeding involves deficiencies determined by the Commissioner as follows:
| 1938 | 1939 | |
| Income tax | $ 458.74 | $ 445.80 |
| Excess profits tax | 330.08 | |
| Declared value excess profits tax | 360.77 |
The sole question at issue is whether the respondent erred in disallowing $ 4,000 of the amount of the deduction claimed by petitioner*251 for compensation of officers in each of the taxable years.
FINDINGS OF FACT.
The petitioner is a corporation having its principal office in the city of Cleveland, Ohio. It kept its books on an accrual basis of accounting and filed its income and excess profits tax returns for the taxable years with the collector of internal revenue at Cleveland.
During 1938 and 1939 petitioner's president was S. A. Smith and its vice president and treasurer was M. J. Lustig. Through the early part of 1938 up to about July each was paid a salary of $ 100 per week. In that year petitioner applied to the Reconstruction Finance Corporation for a loan of $ 10,000. In about July 1938, while negotiations for the loan were pending, a representative of the Reconstruction Finance Corporation advised petitioner that it would be required from that time on to limit salary payments to Smith and Lustig to $ 4,000 per annum each, and to pay $ 75 per week, as a condition for granting the loan. On August 12, 1938, the executive *504 committee of the Reconstruction Finance Corporation resolved that the loan of $ 10,000 be made upon the condition, among others, that:
3. Compensation to S. A. Smith and M. J. *252 Lustig to be limited to $ 4,000 each annually.
* * * *
5. Guaranty of S. A. Smith and M. J. Lustig.
Under date of October 20, 1938, petitioner executed a "Borrower's Closing Agreement" and Lustig signed a "Borrower's Closing Certificate" in connection with the loan. The former recited that petitioner executed it "In consideration of the making of a loan by Reconstruction Finance Corporation (hereinafter called 'RFC') * * * upon the terms and conditions of the Resolution and Closing Schedule adopted by the Executive Committee of RFC August 12, 1938, as amended, * * *," and the latter that Lustig signed it "for the purpose of complying with the resolution and Closing Schedule adopted by RFC August 12, 1938, as amended, * * *." Neither document made mention of salary payments permitted to be made by petitioner to its officers, other than by way of the above quoted references to the resolution of August 12, 1938, as amended. No amendment of that resolution appears in evidence.
The minutes of a special meeting of petitioner's board of directors held October 15, 1938, are as follows:
Meeting called to order by M. J. Lustig at 4:00 P. M.
Motion made by M. J. Lustig that the amount drawn*253 by M. J. Lustig and S. A. Smith shall not exceed $ 4,000.00 for the year of 1938 and that a salary not to exceed $ 6,000.00 be allowed each for their services rendered to the corporation, the difference of $ 2,000.00 shall be credited to the un-earned surplus, as an additional investment of each.
There being no further business, meeting was adjourned at 4:30 P. M.
The minutes of the annual meeting of the directors held January 6, 1939, are as follows:
Meeting was called to order by President S. A. Smith at 3:30 P. M.
Motion made by M. J. Lustig that the salaries for the ensuing year be set at $ 6,000 for M. J. Lustig to act as Sales Manager, and $ 6,000 for S. A. Smith to act as Superintendent.
Motion made that if the year 1939 prove to be profitable the Superintendent and Sales Manager are to receive a bonus of not more than $ 2,000 each.
There being no further business the meeting was adjourned.
Smith and Lustig each actually drew $ 4,569.84 in salary during 1938. On December 31, 1938, $ 6,000 was credited on petitioner's journal to the drawing account of each officer, and $ 1,430.16, the undrawn portion of $ 6,000, was debited to the drawing account of each and credited to accounts*254 entitled "M. J. Lustig Special Account" and "S. A. Smith Special Account." During 1939 Smith and Lustig each actually drew between $ 3,900 and $ 4,000 in salary. Book entries corresponding to *505 those of the prior year were made transferring the undrawn portions of $ 6,000 to the special account of each officer. At some time subsequent to their entry in the special accounts, these amounts were in part transferred to petitioner's unearned surplus account.
Smith and Lustig each reported receipt of annual salary of $ 6,000 from petitioner on his individual income tax returns for 1938 and 1939. Petitioner did not seek permission of the Reconstruction Finance Corporation for payment of the additional amounts of salary. Its cash on hand was insufficient for their actual payment in 1938 and 1939, and it made no attempt to borrow money for that purpose. No note or other evidence of indebtedness on account of unpaid salary was given to either officer. The loan was repaid to the Reconstruction Finance Corporation in December 1940, and shortly thereafter each officer was paid the difference between the $ 6,000 credited to him in both of the taxable years and the amount he had actually*255 drawn.
Annual salaries of $ 6,000 each for Smith and Lustig did not constitute excessive or unreasonable compensation for the services performed by those officers in the taxable years.
Petitioner claimed a deduction of $ 12,000 on its 1938 income and excess profits tax return and a deduction in the same amount on its 1939 return, for compensation of officers. Respondent disallowed $ 4,000 of the amounts claimed with respect to each year and determined the deficiencies involved in this proceeding.
OPINION.
In 1938 the Reconstruction Finance Corporation, in making a loan to the petitioner, by contract limited the petitioner's right to pay compensation to its president, S. A. Smith, and vice president, M. J. Lustig, to $ 4,000 for each; for a closing agreement was subject to the terms of a resolution passed by the Reconstruction Finance Corporation, so limiting compensation to be paid. Another term of the resolution entering into the contract was a guaranty by Smith and Lustig. The Commissioner determined the deficiency by allowing in each of the taxable years deduction for $ 4,000 compensation to each of such officers, but denied a claim of deduction of $ 6,000 for each, made because*256 that amount was set as compensation by corporate resolution, though not paid in full until after the taxable years. Each officer actually was paid $ 4,569.84 compensation in 1938 and $ 3,900-$ 4,000 in 1939. The burden is upon the petitioner to show error. The contract with the Reconstruction Finance Corporation was executed by Lustig for the corporation, and it is not shown that Smith had no knowledge of its terms. The contrary appears, since he was not only president of the corporation, but guarantor on the contract. It is clear, therefore, that, regardless of the form of the *506 resolution of the petitioner's directors, relied upon by the petitioner (which was on the accrual basis) as a contract rendering accruable $ 6,000 compensation to each officer, such resolution is subject to the agreement with the Reconstruction Finance Corporation. In Cotton States Fertilizer Co., 47 B. T. A. 748, we considered a situation parallel to that here involved, and held that the right to accrue compensation was not accruable because contingent upon payment of a loan from the Reconstruction Finance Corporation, or its consent. Though the provisions setting*257 forth the contingency there were more specific than we here find, nevertheless it is plain that breach of contract with the Reconstruction Finance Corporation was involved in this matter in the incurring by the petitioner of liability to Smith and Lustig for more than $ 4,000 compensation each per year.
Section 576 of the Restatement of Contracts provides: "A bargain, the making or performance of which involves breach of a contract with a third person, is illegal." The first sentence of the comment immediately following the statement of the above rule is as follows: "a. Since breach of contract is a legal wrong, a bargain that requires for its performance breach of a contract with another, is opposed to public policy."
Professor Williston in his treatise on contracts, revised edition, at section 1738, says:
The Restatement of Contracts and recent decisions declare illegal a bargain necessarily involving a breach of a previous contract with another party or tending to induce such wrongful non-performance. The law on this subject is in the process of development. But there is authority that a bargain to buy goods which to the buyer's knowledge the seller was under contract to sell*258 to another is illegal and unenforceable. A few courts have upheld the second contract where the purchaser had not induced it, but this distinction seems ill-founded since bad faith exists from entering into the second contract with knowledge of the first and the wrongdoer would hardly need more encouragement than the knowledge of the availability of a ready market despite his breach. Collusion under these circumstances would certainly be promoted. * * *
The rule as laid down in the Restatement of Contracts is apparently broad enough in its terms to cover situations where the party entering into the second contract involving the breach of another contract is ignorant of that circumstance. Professor Williston's Discussion, however, seems to be limited to cases where knowledge of the former contract exists. Knowledge in Lustig is shown by the record, and lack of it as to Smith is not shown.
In Roberts v. Criss, 266 Fed. 296 (C. C. A. 2d Cir.), plaintiffs had entered into a contract with defendant's testator by which the latter obligated himself to secure to the plaintiffs the benefits to be derived from his seat on the New York Stock Exchange. *259 The agreement was in violation of the Exchange rules, by which the decedent had agreed *507 to be bound when he was admitted to membership. The court denied recovery to plaintiffs in their action for breach of their contract by the decedent. The court in part said:
The courts do not aid the parties to illegal agreements. If any principle of law is settled it is that a party to an illegal undertaking cannot come into a court either of law or equity and ask to have his illegal contract carried out * * * It makes no difference whether the contract has been executed, or remains still executory. The defense of illegality may be set up, not as a protection to defendant, but as a disability in the plaintiff. * * *
To the same general effect is Reiner v. North American Newspaper Alliance, 250">259 N. Y. 250; 181 N.E. 561">181 N. E. 561.
Any action brought by Smith or Lustig for recovery of salary in excess of $ 4,000 would seem to fall squarely within the doctrine of the foregoing cases and authorities. Petitioner's agreement to incur liability for salaries exceeding $ 4,000, then, is illegal and unenforceable. There is, therefore, no*260 properly accruable liability for the salaries in question in excess of that amount, for the liability is contingent upon exercise of the enforceable rights of the Reconstruction Finance Corporation until the discharge of the prior contract with it, and contingent upon any defense of unenforceability, by either party to the contract. Accrual above $ 4,000 was therefore not permissible. In the light of this conclusion, we find it unnecessary to decide whether the resolution to credit the salary allowed for 1938 above $ 4,000 to each officer, to unearned surplus, prevents accrual under Stern-Slegman-Prins Co. v. Commissioner, 79 Fed. (2d) 289.
The petitioner argues, however, that the contract was not made until October 20, 1938, and that it was not retroactive, therefore not effective upon the entire taxable year. We think the argument does not help the petitioner. Even on that theory petitioner must show that the amount sought as deduction by way of accrual was accrued prior to October 20, 1938, the date of the contract. That showing has not been made. Not only does the record indicate that the resolution depended on for accrual antedated*261 the contract by only five days, but it also indicates that up to that time salaries were being paid, to an extent not known. Therefore it is not shown that any of the $ 2,000 was accrued, instead of paid, prior to the contract. Since each officer, sometime during the year, was paid $ 4,569.84, since the salary of each up to "around July" was $ 100 per week, and the Reconstruction Finance Corporation suggested a limitation to $ 75 a week thereafter, it is clear that no proof is made that the accrual was prior to the contract, but that on the contrary it appears, at least largely, to have followed.
Contrary to the arrangement with the Reconstruction Finance Corporation, the petitioner did, as above appears, actually pay $ 4,569.84 in 1938 as salary to each of the two officers. No suggestion is made *508 that the Reconstruction Finance Corporation objected. We conclude and hold that the petitioner is entitled to deduction, for 1938, of $ 4,569.84 for each of the two officers. There was neither payment nor permissible accrual above $ 4,000 to each officer in 1939, therefore no deduction above that amount is approved for that year.
Decision will be entered under Rule 50*262 .