*549 1. Amounts paid by a corporation to two of its officers for architectural and other services relating to the construction of a building may be included in the cost of the building to determine gain or loss from sale.
2. The amount paid in 1932 in settlement of a claim of an employee, growing out of an alleged promise in 1928 to pay the claimant a bonus when a building was sold, held, upon the evidence, to be no part of the cost of the building sold in 1930.
3. Property placed in escrow as part of the entire price of a building sold on the installment basis, held no part of the initial payment but properly included in the entire contract price at its fair market value on the date when the sale is in all substantial respects complete.
*205 The Commissioner determined a deficiency of $19,571.52 and a penalty of $978.58 in petitioner's income tax for 1930. Petitioner assails (1) the computation of gain from the sale of a building, (2) the disallowance, as a deduction, of a part of the salaries paid to its officers, (3) the inclusion in*550 income of interest accrued on a note, (4) the disallowance, as a deduction, of attorney fees, and (5) the imposition of a negligence penalty.
FINDINGS OF FACT.
Petitioner, a corporation with principal office at Seattle, Washington, was organized in January 1928, to engage in the construction and sale of buildings. Its 1,000 common shares of no par value were issued in equal parts to its president, James A. Gibbs, and to its secretary, Harry E. Hudson, in exchange for a tract of land in Seattle, which was improved by an apartment house completed in 1928 and known as The Emerson.
1. A second and larger apartment house, known as The Lowell, was begun in June and completed in December 1928, on land which petitioner deeded to Gibbs and Hudson to enable them to procure bank loans for its financing. After signing a mortgage note for $390,000, they deeded the property back to petitioner. Gibbs advanced $25,000 and deposited collateral of a value of about $60,000 to procure an additional bank loan of $30,000 for construction purposes. Both endorsed other notes. Hudson prepared the architectural plans and specifications and actively superintended the work *206 of construction. *551 Gibbs acted as general contractor, took charge of the pay rolls, general office work, and supplemental drafting of plans for wiring, plumbing, heating and plastering, which were installed under contracts approved by him and Hudson.
(a) On June 15, 1928, the corporation resolved that Hudson and Gibbs each receive 5 percent of the total cost of construction of The Lowell as remuneration for services in connection with construction, said remuneration to be taken out of the first net earnings of the building from rents or sale proceeds after all other contracts, bills and salaries had been paid. These percentage fees amounted to $41,593, and were reasonable compensation for the services performed. They were paid in equal installments of 50 percent to Gibbs and Hudson, respectively, in 1930 and 1931. Gibbs and Hudson received no other compensation for services rendered to petitioner in 1928.
(b) In 1928 Gibbs promised Logan, a clerk employed by petitioner, that a "bonus" would be given him when The Lowell was sold. After the sale in 1930, Logan pressed a claim and instituted suit in 1931. In January 1932 petitioner settled the claim by a payment of $2,250, which was less than*552 the claim.
(c) After completion, petitioner rented all the apartments in The Lowell through the efforts of Gibbs and Hudson, and also offered it for sale through several local real estate brokers. The brokers were advised that a cash price of $550,000 would be acceptable, or that property might be received in trade but at a higher selling price. The listed prices ranged from $650,000 to $850,000.
On April 4, 1930, Fred G. Gunther, a real estate broker, acting as petitioner's agent, made a contract with George Youell, a financially responsible person. Thereby Youell agreed to purchase and petitioner agreed to sell The Lowell for a recited consideration of $632,500. This figure was made up of $10,000, immediately paid in cash; $15,000, payable upon petitioner's delivery of a deed and bill of sale to the Dexter Horton National Bank; $25,000, payable by the purchaser's note due on or before July 5, 1930; $50,000, payable by the purchaser's note due on or before October 5, 1930; $18,990, payable by the purchaser's assumption of taxes and furniture bills due on the property; $93,789.94, payable by assignment to petitioner, with collateral but without recourse to the assignor, of*553 two installments due October 1, 1937, and April 1, 1938, respectively, on a note of the General Fruit Corporation; $390,000, a first mortgage bond issue which was not assumed by the purchaser; and $30,000, payable by assignment to petitioer, with collateral but without recourse, of an installment of the General Fruit Corporation's note due October 31, 1931. Minor adjustments for interest, insurance, etc., were to be *207 made. Petitioner bound itself to deliver to the purchaser within 10 days title insurance in the amount of $550,000, and, in case sound title could not be delivered, to refund the earnest money and treat the contract as void. After title had been made good, however, it was to deliver its warranty deed, assignment of tenants' leases, and bill of sale in escrow to the Dexter Horton National Bank, and the purchaser was to give petitioner the $15,000 in cash and his two notes for $25,000 and $50,000, due July 5 and October 5, 1930, respectively. Upon payment of the notes when due, the escrow agent was to deliver the deed, lease assignments and bill of sale to the purchaser; upon failure of payment, however, it was to return them to petitioner. In such event*554 the purchaser would lose all rights under the contract, and petitioner would be entitled to retain, as liquidated damages, all amounts paid. Until default should occur, the purchaser was entitled to possession and profits of "the property hereby sold."
In carrying out the terms of this contract, petitioner delivered the deed, assignment of leases, and bill of sale, all dated April 15, 1930, to the escrow agent, instructing it to deliver them to Youell upon his payment of the two notes when due, or upon his failure to pay, to return them to petitioner. Youell's notes and assignments of the installments of the General Fruit Corporation's note, all bearing date of April 15, 1930, were also placed in the hands of the escrow agent. In July 1930 Youell advised Gibbs that he would be in Europe when the $50,000 note fell due on October 5, and requested that time of payment be postponed until January 5, 1931. Petitioner replied by letter that this was satisfactory. The note was paid in January 1931.
The items of $93,789.94 and $30,000 of the recited purchase price were respectively the result of a computation by Gibbs and Gunther, designed to reflect a reduction in face value by the*555 total of unaccrued interest, compounded semiannually, of two installments of $79,000 each, due on October 1, 1937, and April 1, 1938, and one installment of $33,129.87, due in 1931, on the note of the General Fruit Corporation. The note, which was for a total of $1,121,050, bore 7 percent annual interest, which was included in its face amount and payable as a part of the installments. Payment of the installment of 1931 was secured by 324 shares of common and 366 shares of preferred stock of Pacific Fruit & Produce Co., and 230 shares of Ryan Fruit Co.; the installments of 1937 and 1938, by 493 and 507 common shares of Pacific Fruit & Produce Co., respectively. These shares were held by the Dexter Horton National Bank as trustee under a trust agreement providing for their application to payment of the note in case of a default by the maker.
*208 In 1931 petitioner received $77,895.99 in satisfaction of the installments, representing settlement on a basis of 75 percent of the principal and interest accrued as of that time. On April 15, 1930, the fair market value of the two installments of 1937 and 1938 was $11,883.39 and $9,195.74, respectively, and of the installment*556 of 1931, $27,000.
2. In 1930 Gibbs and Hudson were engaged in the operation and management of The Lowell until its sale. Thereafter they performed substantial service for the petitioner during the entire year. As compensation for services, petitioner paid Gibbs and Hudson salaries of $15,000 each, which were authorized in 1930. The amount of these salaries was reasonable for the services performed. Petitioner keeps its books and files its income tax returns on an accrual basis.
3. Youell's note for $50,000, due October 5, 1930, and deposited with the escrow agent pursuant to the contract of sale of The Lowell, bore: "* * * interest at the rate of 7% per annum from date of consummation of this sale until maturity * * *." It was paid in January 1931, after an extension of the time of maturity to January 5, 1931, had been granted on Youell's request. Petitioner accrued no interest from it on its books. The interest accrued from April 15 to December 31, 1930, was $2,429.17.
4. In 1930 petitioner paid $900 in legal fees to R. W. Hunton, who had been in charge of its legal work and had received an annual retainer of $300.
5. In its income tax return for 1930 petitioner*557 described its disposition of The Lowell as an installment sale and reported a profit of $13,607.76 therefrom. It omitted from the total selling price any amount representing the value of the assigned three installments on the General Fruit Corporation's notes and Youell's note for $50,000, which was paid in January 1931. The return for 1930 was prepared on March 10, and filed on March 11, 1931. Petitioner's failure to report the value of the notes received for The Lowell was due to an intentional disregard of rules and regulations but without intent to defraud, or was due to negligence.
OPINION.
STERNHAGEN: 1. The Commissioner, in the notice of deficiency, said, as to 1930:
| 1. Gain from sale of apartment understated | $142,031.55 |
and explained this item thus:
Profit realized in 1930 is $155,639.21, whereas the profit reported on the 1930 return was $13,607.76; the difference, or $142,031.55, is included in the adjusted income. *209 This adjustment by the Commissioner is not broken down in the deficiency notice, but it seems to embrace several adjustments which must be separately considered.
(a) In computing the gain from the sale of the Lowell*558 apartment building, the petitioner includes, and the Commissioner refuses to include, in cost the $41,593 paid to Gibbs and Hudson, pursuant to the corporate resolution of June 15, 1928, for services performed. The services were entirely related to the construction of the building, being the architectural plans and specifications, the engineering and supervision of construction, the purchasing of materials, and the securing of loans and signing of the mortgage. The general duties of Gibbs and Hudson as officers of the corporation were not covered by this payment or the resolution authorizing it. The fact that these individuals were officers and equal shareholders, and their compensation for architectural and construction services were also equal, is a circumstance to be considered but not sufficient to establish the character of the payment of $41,593 as other than part of the cost of the building. The Commissioner's exclusion of this amount from cost was error, ; ; cf. *559 ; .
(b) The petitioner now claims that the cost of The Lowell should include the $2,250 paid to Logan in 1932 in settlement of his claim to a "bonus" or share of the profit. The contention is not supported by the evidence. Neither the evidence as to the alleged promise to Logan in 1928 nor that as to the settlement in 1932 is sufficient to establish a liability in 1930 or that the settlement made in 1932 was properly part of the cost of the building. And there is no more support for a deduction in 1930 as an accrued or sustained expense. The petitioner's contention is not sustained. Cf. ; ; ; ; .
(c) Both parties are now agreed that the sale of the Lowell building was properly treated by the Commissioner as an installment sale under*560 Revenue Act of 1928, section 44(b), since in no event were the initial payments more than 40 percent of the selling price, the amount of the mortgage ($390,000) being treated as part of the selling price but not included in the initial payments, . 1 The controversy turns upon the proper treatment of the assigned right to certain future installments of the *210 General Fruit Corporation's note, the petitioner insisting that they may not be regarded as part of the initial payment, first, because they were in escrow and contingent upon the payment by the purchaser of his $50,000 note, and, if not for that reason, then because they were wholly without fair market value.
It has been held that when an escrow stands in the way of receipt by a vendor of his sale price, he may not be taxed as if he received the price directly. (on review, C.C.A., 2d Cir.); *561 . The petitioner, therefore, did not receive the escrow in 1930, and it may not be treated as part of the initial payment in that year.
But, although the assigned installments of the Fruit Co.'s note are no part of the initial payment, they are properly part of the sale price, and serve to measure the total profit to be realized from the entire installment sale of the building and in turn the proportionate part of the initial payment which is to be taxed in 1930 as gain. It is necessary for this purpose to determine their fair market value on April 15, 1930. The sale was on that date in all substantial respects complete, even though the deed was not delivered to the purchaser in 1930, ; affd., . It can not be held, as petitioner urges, that Youell had only an option, or that petitioner's right to the assigned installments of the Fruit Co.'s note was so contingent as not to be a present part of the price.
The question is their value on April 15, 1930, when they became part of the total price. Upon this there is substantial evidence of various*562 qualities and weight. As shown in the findings, the installments were of a face value, when payable in the future, aggregating $191,129.87, and were, on April 15, 1930, of a fair market value of $48,079.13. This finding is the result of a full consideration of all the evidence, and is the amount which should be included as the part of the total sale price represented by the Fruit Co.'s note. The other factors of computation of the total sale price and initial payment are not in dispute. This sale price should be applied against a cost which includes the $41,593 paid to Gibbs and Hudson and excludes the $2,250 paid to Logan.
2. The Commissioner reduced the deduction for salaries of Gibbs and Hudson from $30,000, the amount actually authorized in 1930, to $12,000, the amount which the Commissioner regarded as the maximum reasonable allowance for the services performed. The evidence shows what the services were and a reasonable measure of their value. Considering all the evidence results in the finding that has been made that the salaries of $30,000 were authorized and accrued in 1930 and *211 were no more than a reasonable allowance for the services performed. The amount*563 is, therefore, properly a part of ordinary and necessary expenses and properly deductible. The respondent's determination as to this is reversed.
3. The petitioner included no interest on Youell's note for $50,000 in its gross income for 1930. The Commissioner computed the interest at 7 percent from April 15 to December 31, 1930, and added the amount, $2,429.17, to gross income in determining the deficiency. This was correct. The petitioner's tax was computed on the accrual basis and the interest had clearly accrued. There is no force in the possibility that Youell might in fact have defaulted or that the maturity of the note was postponed until 1931. In either event the interest was a contractual obligation which accrued in 1930. This item of the respondent's determination is sustained.
4. The Commissioner disallowed the deduction of $300 out of $900 legal fees paid in 1930, because he thought the amount was a retainer for 1931. The evidence shows that the Commissioner was mistaken and that the attorney's employment was discontinued in 1930. The character or amount of the payment is not otherwise questioned. The Commissioner's disallowance is reversed.
5. The*564 Commissioner imposed a penalty of 5 percent under the Revenue Act of 1928, section 293(a), and this is proper "if any part of the deficiency is due to negligence or intentional disregard of rules and regulations." Unlike a fraud penalty, the burden is upon the taxpayer to prove the 5 percent penalty to have been imposed in error. Regulations 74, article 353, clearly requires that the total selling price be used in the computation of the total profit and as a means of computing the amount of profit in the initial payment of the taxable year. There was no good reason for the petitioner to omit entirely the Fruit Co.'s notes or the Youell $50,000 note from the total selling price. Nothing in the evidence justifies the omission, and it was in plain disregard of the clear rule of the regulation. That it was intentional is inescapable. If, however, there were any doubt about the intent, it would still be necessary to attribute the omission to negligence. The penalty of 5 percent was properly applied, although of course the amount will be modified in accordance with the modified deficiency.
Judgment will be entered under Rule 50.
Footnotes
1. Paul and Mertens, Law of Federal Income Tax, § 12.17. ↩