*13 Decision will be entered under Rule 50.
1. Where by reading together the simultaneously executed declaration of gift and articles of partnership it appears that the gift by petitioner to his wife of one-half his gambling machine business and of the property used therein was conditioned on the formation of a partnership for the continuation of such business and where it further appears that by the state law such a partnership could not be formed because of its illegal purpose, held, the gift failed at the outset because it was expressly or by implication made upon a condition or limited to a purpose which failed, and hence the entire net income of the business was that of petitioner.
2. A partnership void by state law because of illegality is not recognized for tax purposes any more than it is otherwise recognized by the courts except in those instances where there is no other feasible solution.
*407 These proceedings involve proposed deficiencies in income tax for the years 1938, 1939, 1940, and 1941 in the respective amounts*14 of $ 482.59, $ 25,751.73, $ 55,339.05, and $ 16,541.27. The principal issue is whether petitioner and his wife were members of a partnership engaged in the business of operating slot machines during the years 1939, 1940, and 1941. Other issues are: (1) Whether $ 500 paid in 1938 toward defraying *408 the cost of a banquet was deductible as an ordinary and necessary business expense; (2) whether a loan of $ 50 was deductible as a bad debt; and (3) whether the disallowance by respondent of a deduction for the salary of petitioner's wife of any amount in excess of $ 8,000 for 1940 and $ 2,666.67 for four months in 1941 was erroneous.
FINDINGS OF FACT.
The petitioner, a resident of Akron, Ohio, during the years 1938, 1939, 1940, and 1941 filed income tax returns for those years with the collector of internal revenue for the eighteenth Ohio collection district at Cleveland, Ohio. For some years prior to 1938 through a part of the year 1941 the petitioner operated slot machines in the clubs of the Fraternal Order of Eagles. These machines were gambling machines. When the player inserted a coin and pulled a lever, dials would spin and a number of coins would be ejected from the*15 machine if the right combination was hit. The slot machines were operated by the petitioner under the following agreement dated November 1933, which was amended from time to time:
AGREEMENT.
This agreement entered into by and between The Ohio Organization Department of the Fraternal Order of Eagles (H. J. Berrodin of Akron, Ohio, Chairman, and M. L. Brown of Springfield, Ohio, Secretary) to be hereinafter known as Party of the First Part, and E. C. Ellery of Akron, Ohio, to be hereinafter known as Party of the Second Part.
Witnesseth: That Party of the Second Part is now in the mechanical equipment business, having in his possession and is the owner of numerous mechanical devices that he is now furnishing to various Clubs operated by the Fraternal Order of Eagles in the State of Ohio, and that upon demand of Party of The First Part, Party of the Second Part shall furnish as many mechanical devices as Party of the First Part shall deem necessary.
In consideration of one-dollar, receipt of which is hereby acknowledged and other monetary consideration, Party of the Second Part agrees to place mechanical devices in various Clubs operated by the Fraternal Order of Eagles in the State *16 of Ohio upon the direction of Party of the First Part. It being agreed that the proceeds from these mechanical devices in operation in various Clubs operated by the Fraternal Order of Eagles in the State of Ohio were operated by the Party of the Second Part has now or will hereafter cause the said mechanical devices to be displayed. [Sic.] Party of the First Part shall receive five percent of the gross income from all mechanical devices; Party of the Second Part shall receive twenty percent of all the funds from the mechanical devices, and the management of each club shall receive seventy-five percent of all the funds from the mechanical devices.
Party of the Second Part further agrees to furnish without cost to Party of the First Part all mechanical devices necessary to carry out the purpose of this agreement, and to visit and collect funds from the mechanical device at least once per week without charge to Party of the First Part. And that upon each collection, there shall be furnished to Party of the First Part a statement signed by at least the Custodian, one Trustee, and the Party of the Second Part, or *409 his representative; or two Trustees, Party of the Second *17 Part, or his representative, and that a copy of said statement shall be given to the management of the Club.
In addition to furnishing the mechanical devices to the Clubs as above mentioned, Party of the Second Part shall furnish a steel cabinet or container upon request of the Trustees of any Club as directed by the Party of the First Part.
Party of the Second Part further agrees to keep all mechanical devices in first-class condition as directed by the Party of the First Part, and to change equipment upon the direction of the Party of the First Part without cost to the Party of the First Part.
Party of the Second Part further agrees to stand all losses and replace the same, and to pay all of the costs that may result from any suits, fines or other penalties that may involve Party of the First Part in this contract.
It is further agreed that employees of Party of the Second Part shall be subject to the approval of the Party of the First Part.
This agreement entered into this day of November, 1933, by Party of the First Part (Ohio Organization Department, F. O. E.)
H. J. Berrodin, Chairman.
M. L. Brown, Secretary.
Party of the Second Part
E. C. ElleryWitnessed
*18 On June 14, 1939, following his plea of guilty, petitioner commenced serving a six-month sentence for income tax fraud in connection with his tax liability for the year 1935. Knowing that he would have to be away, he had decided to make his wife, Bernice, his business partner. It was felt there would be less likelihood of insubordination of employees, a danger in this sort of a business, if Mrs. Ellery were known to be a partner. Also, she could deal with outsiders with more freedom if she were a partner rather than merely a manager, in that no one would contradict her right to conduct the business. On June 10 petitioner executed a document entitled "Declaration of Gift," which reads as follows:
I, Emmett C. Ellery, Akron, Ohio, the undersigned, d. b. a. "Ohio Organization Department Fraternal Order of Eagles," do hereby give, transfer and deliver as of the close of business Saturday, June 10, 1939, an undivided one-half interest in all property and business, including good-will belonging to me and used by me in the operation of said business to my beloved wife, Bernice Ellery.
In Witness Whereof I have hereunto set my hand at Akron, Ohio, this 10th day of June, 1939.
Signed*19 and delivered in the presence of:
[Signed]
Frederick C. Witwer [Signed] Emmett C. Ellery
E. B. Graham
At the same time he and his wife executed a document headed "Articles of Partnership." This instrument recited that the declaration of gift *410 was executed and delivered on June 10, 1939, to be effective at the close of business that day. It provided that the parties agreed that the purpose and business of the partnership was the operation of slot machines in the club rooms of the Fraternal Order of Eagles and that each partner would devote his entire time to the business. Each partner was given the power to make contracts and discharge employees. Mrs. Ellery was given a salary of $ 125 a week and petitioner was given $ 300 a week, except that, when either party was away from the business for any reason other than sickness or a reasonable vacation, that partner's salary would cease. During such absence of petitioner Mrs. Ellery was to receive $ 250 a week and during such absence of Mrs. Ellery petitioner was to receive $ 400 a week. All profits and losses were to be shared equally. The agreement was to be binding until the death of one of the partners or marital difference*20 between them. In the event of death of either, each partner was given the right of survivorship to the other's interest. In the event of marital difference, Mrs. Ellery was required to sell her entire interest in the partnership to petitioner at a price to be agreed upon by them at that time. If they could not agree they were to submit the matter of the price and terms to three arbitrators, one chosen by each party and the third by the two so chosen. Decision of the arbitrators was to be final and conclusive upon each party.
The gift of an undivided one-half interest in petitioner's business to his wife was made solely for the purpose of enabling them to form a partnership.
A gift tax return was filed. A new name, "E. C. Ellery and Company," was chosen under which to operate. The employees, the bank, and the suppliers were told of the partnership. The profits were divided equally at designated intervals and kept in separate accounts. Each drew checks. New Federal excise tax and social security reports were filed and the Ohio Unemployment Compensation Commission was notified of the change.
Mrs. Ellery invested no money or other property in the slot machine business. She had*21 begun to work for petitioner in May 1935 as a bookkeeper at $ 35 a week. They were married in March 1936. In 1937 her salary was increased to $ 100 a week and at the end of 1938 she received a bonus of $ 2,000. From January 1 until June 10, 1939, her salary was $ 125 per week.
When petitioner went to prison, Mrs. Ellery took charge of the business in so far as relations with the employees was concerned. She purchased equipment, handled the correspondence, rented a larger room for the repair shop, made the decisions on complaints, and did such hiring and firing of the help as was necessary. She also performed the function of rearranging the field agents' routes so as to carry out petitioner's policy of keeping their commissions approximately *411 equal. At that time there were 12 field men or agents whose job it was to collect the money from the machines and keep them in repair. They worked on a commission basis and extracted their own salaries from the receipts they had collected. Each agent had a designated territory of club rooms to handle. Harold R. Horn, who had worked for Ellery since 1934 originally as one of these agents, became supervisor of agents in 1937. *22 His duties as such consisted in contacting the men, teaching new men the repair business, and watching the honesty of the men. Mrs. Ellery consulted Horn on all matters of policy.
In the business of operating the slot machines in its club rooms, the Fraternal Order of Eagles was represented by Matthew L. Brown, the executive secretary of the order. Prior to the time when petitioner went to jail, all Brown's contacts in connection with the operation of the slot machines were with petitioner. Petitioner told Brown that during his absence Horn would be in full charge of his interest in the machines. Several organization meetings of the Eagles were held during petitioner's period of confinement, at which Horn's attendance was required for the discussion of the business. The question of a change in the division of the proceeds of the slot machines was taken up by Brown with Horn during this period. Prior to that such changes were made pursuant to conferences with petitioner.
The agents were required to be members of the Eagles. As a woman, Mrs. Ellery could not have attended the meetings or gone to clubrooms as Horn did.
Shortly after his discharge from prison on November 11, 1939, *23 petitioner returned and managed the business until December 23, 1939, when he suffered a stroke which incapacitated him. On April 6, 1940, Mrs. Ellery took petitioner to Florida. On their physician's advice they remained there over a year. Mrs. Ellery kept the records and tried to conduct the business from Florida. In the spring of 1941 the business was terminated and the money received from the sale of the equipment was divided equally between petitioner and Mrs. Ellery.
The operation or exhibition of these gambling machines was illegal in Ohio.
Salaries paid to Mrs. Ellery for 1940 and 1941, respectively, and for which deductions were taken, were $ 13,000 and $ 10,000. Respondent disallowed $ 5,000 and $ 7,333.33, respectively of such deductions on the ground that such disallowances represented amounts in excess of reasonable compensation. Reasonable compensation to her for 1940 and 1941, respectively, was $ 8,000 and $ 2,666.67, and salary paid to her for such years beyond such amounts exceeded reasonable compensation.
On March 5, 1938, petitioner loaned $ 50 to W. I. Thomas, salesman of an equipment concern with which petitioner did business. The *412 loan was to be*24 repaid on Thomas' next pay day. In August of 1938 Thomas was killed in an accident, leaving no estate and the debt unpaid. The debt became worthless in 1938.
OPINION.
The first issue is whether the entire income of the slot machine business is taxable to petitioner or whether there was a partnership between him and his wife which must be recognized for tax purposes. The gift of an undivided one-half interest in petitioner's business to his wife was made solely for the purpose of enabling them to form a partnership. The testimony for petitioner indicated that the reason a partnership was deemed desirable was (1) that there would be less likelihood of insubordination of employees if they knew Mrs. Ellery to be a partner and (2) she could deal with outsiders with more freedom if she were a partner rather than merely a manager, in that no one would contradict her right to conduct the business. The declaration of gift and articles of partnership were executed simultaneously. The declaration of gift, executed on June 10, 1939, recites the conveyance of the interest in the business to be effective as of the close of business, Saturday, June 10, 1939. The articles of partnership made*25 and concluded June 10, 1939, state that the declaration of gift was made June 10, 1939, to be effective as at the close of business that day. Reading the two documents together, it appears that the gift was made on the condition or limited to the purpose of forming a partnership. "A donor may limit a gift to a particular purpose, and render it so conditioned and dependent upon an expected state of facts that, failing that state of facts, the gift should fail with it. * * * Whether in a given instance his gift is of one kind or the other, conditional and dependent or absolute, is an ordinary question of intention, to be determined by any express declaration in the making of the gift, or from the circumstances." Grossman v. Greenstein, 161 Md. 71">161 Md. 71; 155 Atl. 190.
The articles of partnership were executed in Ohio, which was also the domicile of petitioner and Mrs. Ellery and the situs of the business. In Ohio a partnership can not be formed for an illegal purpose. "A partnership is an association, with certain incidents recognized by law, for the convenient transaction of legitimate trade and business. It cannot therefore*26 be formed for an illegal purpose or one contrary to public policy." Jackson v. Akron Brick Association, 530 Ohio St. 303">530 Ohio St. 303; 41 N. E. 257; Farless v. Morehead, 201 Fed. 310. Petitioner's slot machine gambling business was illegal in Ohio. State v. City of Youngstown, 680 Ohio App. 254">680 Ohio App. 254; 40 N. E. (2d) 477.
*413 Section 13066 of the Ohio Code provides:
Exhibiting gambling device for gain. -- Whoever keeps or exhibits for gain or to win or gain money or other property, a gambling table, or faro or keno bank, or a gambling device or machine, or keeps or exhibits a billiard table for the purpose of gambling or allows it to be so used, shall be fined not less than fifty dollars nor more than five hundred dollars and imprisoned not less than ten days nor more than ninety days, and shall give security in the sum of five hundred dollars for his good behavior for one year.
Since the gift was conditioned on the formation of the partnership and the partnership could not be formed in Ohio because of its illegal purpose, the gift failed*27 at the outset. The gift failed "because it (was) expressly or by implication * * * made upon a condition or limited to a purpose, which has failed." Grossman v. Greenstein, supra.
We have not found it necessary to place this decision squarely on the ground urged by respondent that a partnership void by state law because of illegality should not be recognized for tax purposes any more than it is otherwise recognized by the courts. But in Commissioner v. Tenney, 120 Fed. (2d) 421, the First Circuit Court of Appeals held that where an agreement for a partnership between husband and wife providing for the sharing of profits from stock market operations carried on with wife's capital and husband's advice was unenforceable under Massachusetts law, the entire capital gain realized from the stock market operations was taxable to the wife, even though she had paid her husband his share of profits. Speaking for a unanimous court, Magruder, C. J., said, "But assuming in the taxpayer's favor that she and her husband intended to form a partnership, the insurmountable difficulty remains that in Massachusetts a married *28 woman is incapable of making a contract with her husband, and this includes a contract of partnership. * * * Legally, the whole gain accrued to the taxpayer, and any claim which Mr. Tenney might have to share in the profits necessarily rests upon the unenforceable agreement between himself and his wife. The whole of the gain is taxable to Mrs. Tenney." This is not to deny that there are instances where there is no other feasible solution than to recognize as a partnership for tax purposes that which would otherwise not be so recognized, whether it be because of illegality of the business or incompetence of a party. Thus where a man and woman each contribute capital and form a valid partnership and thereafter the man and woman marry, the fact that a husband and wife may not be partners by the applicable state law can not be conclusive for tax purposes. L. F. Sunlin, 6 B. T. A. 1232. Again if X and Y contribute equal amounts of capital and purport to form a partnership to run an illegal business, there is no reasonable solution but to recognize the partnership for tax purposes, even though such a partnership would not be recognized for other purposes.
*29 *414 In Christian H. Droge, 35 B. T. A. 829, relied on by petitioner, a husband and wife who had been bona fide partners in their hardware business each purchased two tickets in the Irish Hospitals' Sweepstakes, with the understanding that the winnings would be shared equally. The husband held the winning ticket. The Board held, as to the petitioner's first contention, that he and his wife were not joint owners of the winning ticket and its proceeds for the reason, among others, that the agreement to share was void by the law of their state, it being "fundamental that a partnership entered into for the purpose of engaging in gaming transactions or for the prosecution of an unlawful business is illegal." (P. 832.) The petitioner succeeded on his second ground, however, the Board relying on Mitchell M. Frey, Jr., et al., Executors, 1 B. T. A. 338. As this Court has explained: "In the Droge case the reasoning employed by the Board in permitting petitioner to deduct that portion of the winnings which he paid to his wife was that petitioner's arrangement with his wife was itself a gambling transaction. It was the*30 result of the pooling of their respective tickets. The Board held that petitioner was entitled to set off against his gambling gains the loss sustained in the gambling transaction with his wife." Harry J. Riebe, 41 B. T. A. 935, 938, 939. The case therefore is not applicable here.
Respondent has disallowed a deduction of $ 500 claimed by petitioner as an ordinary and necessary business expense which he paid to help defray the cost of a banquet held at a convention of Eagles. In Commissioner v. Heininger, 320 U.S. 467">320 U.S. 467, 474, the Supreme Court said: "The language of § 23 (a) contains no express reference to the lawful or unlawful character of the business expenses which are declared to be deductible. And the brief of the Government in the instant case expressly disclaims any contention that the purpose of tax laws is to penalize illegal business by taxing gross instead of net income." This case casts doubt on the validity of Israel Silberman, 44 B. T. A. 600, disallowing the deduction of expenses of an illegal business. But, we find no evidence in the record to indicate that $ 500 or *31 any other sum was so expended. Nor is there any showing how such expenditures, if made, would have increased the petitioner's business. Although there was evidence that increased membership, hence increased use of slot machines, would result from the convention, it was not shown that the presence of petitioner and his agents at the convention would increase that membership nor that the convention would not have been held without petitioner's contribution.
The $ 50 loan petitioner made to W. I. Thomas in 1938 should have been allowed as a worthless debt deduction in 1938 when Thomas died leaving no estate.
*415 There was no error in disallowing deductions for salary to Mrs. Ellery in excess of $ 8,000 for 1940, and $ 2,666.67 for 1941, since greater amounts would not have been reasonable.
Decision will be entered under Rule 50.