*291 Decision will be entered under Rule 50.
The stockholders of the petitioner, a corporation engaged in the manufacture and sale of liquid meters, organized a partnership to take over a portion of the petitioner's business. It rented floor space and machinery to the partnership at a fair rental value and sold its output to the partnership at market prices. The petitioner and the partnership operated as entirely separate economic units and did not commingle their funds or accounts or shift income or deductions between themselves. Held, that the respondent erred in refusing to recognize the partnership for tax purposes and in holding the petitioner taxable on the income of the partnership either under section 22(a) or under section 45.
*84 The respondent has determined deficiencies against the petitioner as follows:
| Declared | |||
| Income tax | value excess | Excess profits | |
| profits tax | tax | ||
| Year ended 3-31-43 | $ 5,443.99 | $ 3,742.22 | $ 35,134.47 |
| Year ended 3-31-44 | 14,430.07 |
The sole issue is whether the respondent erred in including in petitioner's gross income the earnings of a partnership which the petitioner's stockholders organized to take over a portion of petitioner's manufacturing business.
FINDINGS OF FACT.
The petitioner is a corporation, organized in 1894. Its principal place of business is located at Buffalo, New York. Its returns for the taxable years ended March 31, 1943 and 1944, were filed with the collector of internal revenue for the twenty-eighth district of New York.
The petitioner was engaged for many years in the manufacture and sale of various types of meters used in measuring water, oil, and*293 other liquids. The business was founded by two brothers, George B. Bassett and Edward M. Bassett, in 1892 and was operated as a partnership until its incorporation in 1894. The stockholders were the founders named above and their brother-in-law, Charles M. Harrington. The petitioner's capital stock at all times has been owned by members of the Bassett family. In 1942 it was owned by Charles K. and Robert S. Bassett, sons of George B. Bassett. Robert S. Bassett succeeded his father as president of the petitioner in 1945.
Prior to 1942 the petitioner did all of the work required in the manufacture and sale of its meters. It operated a foundry in which castings were made from brass ingots and a machine shop in which the finishing and assembling was done. This was all located in a 4-story, concrete and brick building which the petitioner owned, located at 2917 Main Street, Buffalo, New York. The foundry occupied a space about 80 by 120 feet on the east end of the fourth floor. The rest of the building was used for machine work, assembling, shipping, storage, and other purposes essential to the business.
In its various operations the petitioner had the use of certain patents which*294 were owned by members of the Bassett family. Some of these patents had been obtained in earlier years and had expired by 1942.
For some time prior to 1942 Robert and Charles Bassett had had under consideration a plan to separate the manufacturing business from the foundry and transfer it to a family-owned partnership to which their sons might be admitted upon graduation from college. Each of them had a son in college in 1942. On several occasions after *85 our entry in World War II representatives of the United States Government had visited petitioner's plant and suggested that its manufacturing facilities might be required for the manufacture of fuses or other war materials. Petitioner's officers thought that in this eventuality it would be advantageous to have the manufacturing business separate from the foundry business. Accordingly, they decided in the latter part of 1942 to carry out the organization of the partnership. On November 24, 1942, Charles and Robert Bassett executed a partnership agreement to engage as equal partners in "manufacturing, mercantile and financial enterprises, as may be hereafter adopted by the parties hereto" under the name of "Buffalo Meter*295 Company." This agreement contained the usual provisions relative to the rights and interests of the partners and conferred upon them broad powers for conducting the business. Each of the partners made a capital contribution to the partnership of $ 5,000 at that time.
A lease agreement was entered into on November 27, 1942, by the petitioner, party of the first part, and Robert and Charles Bassett, as partners in Buffalo Meter Co., parties of the second part, the material provisions of which were as follows:
Witnesseth, That the said party of the first part hath agreed to let, and hereby doth let, and the said parties of the second part have agreed to take, and hereby do take, those certain premises having a floor area of approximately 54,400 square feet manufacturing space comprising the lower three stories and the western section of the fourth story of the four story and basement building situated at #2917 Main Street, Buffalo, N. Y., for the term of twenty (20) years to commence on the 1st day of January 1943 and to end on the 1st day of January 1963, at eight o'clock in the forenoon. It is understood and agreed that this lease can be terminated by either party by 30 days written*296 notice.
Also that the said party of the first part hath agreed to rent, and hereby doth rent, and the said parties of the second part have agreed to hire, and hereby do hire, the machinery and equipment located now on said premises, for the term of twenty (20) years to commence on the 1st day of January 1943 and to end on the 1st day of January 1963, at eight o'clock in the forenoon. It is understood and agreed that this lease can be terminated by either party by thirty days written notice, to be served personally.
The said parties of the second part agree to pay to the said party of the first part a monthly rent of One Thousand Two Hundred and Fifty Dollars ($ 1,250.00) for said manufacturing space which is at the rate of approximately 27.5 cents per square foot per year, and a monthly rent of Seven Hundred and Fifty Dollars ($ 750.00) for the use and hire of said machinery and equipment, payable the fifteenth day of each month. This lease does not include the foundry department now and hereafter operated by the party of the first part. If additional machinery and equipment is furnished after the beginning of the lease by the party of the first part at the request of the parties*297 of the second part, an added monthly rent of Ten Dollars ($ 10.00) shall be paid for the use and hire of each full additional One Thousand Dollars ($ 1,000.00) cost of such added items.
It is understood and agreed that the parties of the second part will make all necessary and required alterations and repairs at their expense, except major repairs to the elevators, plumbing, heating and roof, and that the party of the first part will pay all city, county and sewer taxes.
*86 This agreement was signed by George B. Bassett, president, and Charles K. Bassett, vice president, on behalf of the petitioner.
A further agreement was entered into by the same parties on December 31, 1942, reading in material part as follows:
Witnesseth, That the said party of the first part hath agreed to assign, and hereby doth assign, and the said parties of the second part have agreed to assume, and hereby do assume, the accounts receivable of Buffalo Meter Company and the inventory of materials and supplies of all types of the Buffalo Meter Company at their book value other than foundry supplies and materials, as valued by Buffalo Meter Company in their inventory made at the end of the calendar year*298 1942.
Also that in consideration of the leasing of the building, land, machinery, equipment, and other manufacturing facilities by the said parties of the second part, the party of the first part hath agreed to assign and hereby doth assign, and the parties of the second part have agreed to assume, and hereby do assume, the royalty agreements, designs, copyrights, trade marks, sales agency agreements, sales contracts, agreements for purchase of labor and material, and unfilled orders now in force and on the books of the party of the first part at the close of business on the 31st day of December 1942.
Upon the termination of said lease of said building, the parties of the second part agree to assign and the party of the first part agrees to assume any such agreements, contracts, designs, copyrights and trade marks in force at the time of the termination of said lease, without payment by the party of the first part to the parties of the second part.
It is understood and agreed that at the option of the parties of the second part, part or all of the payments due for the accounts receivable and inventory assumed may be made with demand notes bearing 2% annual interest.
The party of the*299 first part hereby agrees to act without compensation as intermediary agent for the parties of the second part in such cases, including those involving sales and purchases, in which the use of the corporate form is desired in contracts by outside parties. In case of any such contracts, the parties of the second part do hereby covenant and agree with the party of the first part to indemnify and save said first party harmless from any and all liability whatsoever, arising to any third party by reason of any such contract.
It is understood and agreed that the parties of the second part are in no way obligated as to the royalty payments still to be made by the party of the first part prior to March 31, 1943 under existing contracts, or for any accounts payable of the party of the first part incurred prior to the 31st day of December 1942.
Both of the above agreements were fully performed in accordance with their provisions. The stipulated rentals of $ 1,250 a month for the floor space and $ 750 a month for the equipment leased to the partnership by the petitioner under the agreement of November 27, 1942, represented the fair rental values of such properties.
The partnership took over*300 the meter-manufacturing business, together with the assets and equipment described in the above agreements, on January 1, 1943, and continued to operate it as a separate business throughout the taxable year 1944. The inventory values of *87 the items referred to in the agreement of December 31, 1942, as of that date, were determined to be as follows:
| Office supplies, catalogues, and stationery | $ 3,763.98 |
| General and miscellaneous supplies | 4,370.67 |
| Material (other than raw material for foundry) | 184,695.49 |
| Accounts receivable (without reserve for bad debts) | 60,608.50 |
| Total | 253,438.64 |
The partnership gave the petitioner corporation its promissory notes for the stated amount of $ 253,438.64, dated January 1, 1943, bearing interest of 2 per cent. These notes were subsequently paid in full.
The petitioner continued to operate the foundry throughout the taxable years involved. There was no substantial change, after formation of the partnership, in the methods of operation of either division of the business. About forty of the employees went with the partnership and about ten, including officers, remained with the petitioner. The employees of each were carried*301 on separate pay rolls and none of the employees of either company performed any services for the other.
At all times after the partnership commenced operations its books and accounts and those of the petitioner were kept separately and there was never any commingling of their separate funds or shifting of expenses or income from one to the other. The partnership conducted all of its business transactions in its own name. It purchased the castings which the petitioner produced in its foundry at market prices. It also sold back to the petitioner, at market, the brass scraps from the machine work which it did on the castings. These were the only operational transactions between the petitioner and the partnership during the taxable years involved.
For the three-month period ended March 31, 1943, the gross receipts of the partnership from the sale of meters were $ 137,777.05 and its net profit, after the deduction of cost of goods sold, labor, rent, etc., was $ 41,226.50. For the fiscal year ended March 31, 1944, the gross sales of the partnership were $ 545,142.77 and the net profit was $ 36,060.59.
In its return for the fiscal year ended March 31, 1943, the petitioner reported gross*302 sales (of castings to the partnership) of $ 448,207.95, gross profit from sales of $ 57,875.28, and net profit of $ 43,864.68, including $ 6,000 rent from the partnership for the three-month period of its existence. A deduction of $ 7,800 was claimed as compensation for officers, being $ 2,600 for each of its three officers, George B. Bassett, president, Charles K. Bassett, vice president and secretary, and Robert S. Bassett, vice president and treasurer. For the year ended *88 March 31, 1944, the petitioner reported the following items of income and deductions:
| Gross sales | $ 133,097.64 | |
| Less cost of goods sold | 118,300.43 | |
| Gross profit from sales | 14,797.21 | |
| Interest | $ 721.67 | |
| Rents | 24,240.00 | |
| Dividends | 450.00 | |
| 25,411.67 | ||
| 40,208.88 | ||
| Compensation of officers | 7,800.00 | |
| Interest | 4,733.64 | |
| Taxes (mostly local taxes) | 10,039.65 | |
| Depreciation | 4,131.21 | |
| 26,704.50 | ||
| Net income | 13,504.38 |
The respondent determined in his deficiency notice to the petitioner that the partnership was not recognizable for tax purposes and that the income realized by it was all taxable to the petitioner.
OPINION.
The respondent's principal argument on brief is in support *303 of his determination that the partnership of Buffalo Meter Co. should not be recognized for tax purposes and that the income attributed to the partnership should all be taxed to the petitioner under section 22 (a). He argues, however, that section 45, Internal Revenue Code may also be applicable in the circumstances, with the result that all of the partnership income should be allocated to the petitioner.
The cases which the respondent cities in support of his principal position, such as United States v. Phellis, 257 U.S. 156">257 U.S. 156; Lucas v. Earl, 281 U.S. 111">281 U.S. 111; Higgins v. Smith, 308 U.S. 473">308 U.S. 473; Harrison v. Schaffner, 312 U.S. 579">312 U.S. 579; Helvering v. Horst, 311 U.S. 112">311 U.S. 112; and Paul G. Greene, 7 T. C. 142, dealt for the most part with unrealities or shams or anticipatory assignments of income by means of which the taxpayers sought to evade or reduce taxes. The situation here does not seem to us appropriate for the application of the rule of any of those cases. The partnership here was in no sense*304 "unreal or a sham." Higgins v. Smith, supra.As to the assets which it acquired from the petitioner, there was a complete shift of economic interests from the corporation to the partners. It was none the less so because the partners were, and continued to be, corporate stockholders.
The petitioner's stockholders here were under no obligation to continue *89 the business, either the whole or any part of it, in corporate form. They might have dissolved the corporation entirely and transferred all of its functions to the partnership. As has been said repeatedly, the tax laws do not undertake to deny taxpayers the right of free choice in the selection of the form in which they carry on business. The petitioner's stockholders chose here to retain, in corporate form, one of the major functions of petitioner's business, the foundry, and to transfer to the partnership the manufacturing and selling division. This was in no sense an unnatural division. The foundry and manufacturing operations were not interdependent. Either might have existed independently of the other. It is agreed that the corporation sold its products to the partnership at *305 market prices and paid market prices for what it acquired from the partnership. In effect, all dealings between the petitioner and the partnership were at arm's length. In the beginning the petitioner rented floor space and machinery to the partnership at a fair rental value. Apparently the partnership got no more in the way of income benefits than it was entitled to as a return on its manufacturing operations. In these circumstances we see no reason for disregarding the partnership for tax purposes.
The partners had what in their opinion were sound business reasons for organizing the partnership. The important consideration is that the partnership was real for all purposes and that it has at all times functioned as an entirely separate economic entity.
The facts here are not distinguishable, in any material respect, from those in Seminole Flavor Co., 4 T. C. 1215. There, the stockholders of the corporate taxpayer operating a soft drink-bottling business organized a partnership, in which their interests were the same as in the corporation, to perform certain "advertising, merchandising, and supervisory" services under contract with the corporation. *306 We rejected the Commissioner's contention that the partnership income should be taxed to the corporation under section 45, Internal Revenue Code. That case has been followed in a number of memorandum opinions which the parties have discussed in their briefs. The respondent seeks to distinguish the instant case from those cases and other cases upon which the petitioner relies on the facts. The slight factual differences, we think, do not warrant the distinction.
Since there was no shifting of income or expenses between the petitioner corporation and the partnership or any other circumstances that would justify any "distribution, apportionment, or allocation" of gross income between the petitioner and the partnership, section 45 of the Internal Revenue Code has no applicability.
Decision will be entered under Rule 50