*88 Decision will be entered under Rule 50.
Petitioner was engaged during the years at issue in the business of acquiring undeveloped real estate, arranging for the construction of improvements thereon, leasing the improvements thereon, and attending to the maintenance and repair of certain portions of its rental properties. Held, petitioner was not a "mere holding or investment company" for purposes of the accumulated earnings tax provisions; held, further, the compensation petitioner paid to its officer-shareholders was reasonable, and consequently, was fully deductible under the provisions of
*1567 The Commissioner determined deficiencies in and additions to the petitioner's Federal income tax in the following amounts for the following fiscal years:
| Addition to tax, | ||
| sec. 531, I.R.C. | ||
| FYE Mar. 31 -- | Deficiency | 1954 |
| 1963 | $ 2,912.06 | $ 7,064.26 |
| 1964 | 2,803.75 | 6,089.99 |
| 1965 | 832.35 | 5,472.30 |
As a result of concessions made by the parties with respect to certain items reflected in the statutory notice, the issues remaining for our decision are as follows:
(1) Whether the petitioner was a mere holding or investment company within the meaning of
*91 (2) Whether petitioner was availed of for the purpose of avoiding the income tax with respect to its shareholders by accumulating its earnings and profits rather than distributing same as a dividend.
(3) Whether the amounts petitioner paid its officers as salary for personal services were reasonable for purposes of the compensation deduction allowed under
FINDINGS OF FACT
Some of the facts have been stipulated by the parties. The stipulated facts and the exhibits attached thereto are incorporated herein by this reference. A summary of the pertinent facts appears below.
At the time of filing its petition herein, Dahlem Foundation, Inc. (hereinafter referred to as the petitioner), was a Kentucky corporation, which had its principal place of business in Louisville, Ky. The petitioner filed its Federal corporate income tax returns for its fiscal years ended March 31, 1963, March 31, 1964, and March 31, 1965, with the district director of internal revenue at Louisville, Ky.
In 1947 petitioner was organized as a for-profit stock corporation under the provisions of
Petitioner's business consists of locating and acquiring raw land suitable for a shopping-center site; arranging for the development *1568 and construction of a shopping center thereon; leasing the buildings located in the shopping center to various businesses; collecting the rents from such business tenants; and maintaining specified portions of the shopping-center grounds. During the years involved herein, the issued and outstanding stock of the petitioner was owned by the following persons in the following percentages:
| Stockholder | Class A stock | Class B stock | ||
| Joseph C. Dahlem | 4,200 | 92% | 13,308 | 67% |
| Bernard A. Dahlem | 350 | 8% | 6,384 | 32% |
| Sebastian V. Dahlem | 104 | 1% | ||
Throughout the years at issue, the membership of petitioner's board of directors was comprised of Joseph C. Dahlem, Bernard A. Dahlem, and Sebastian V. Dahlem. Petitioner's board of directors held at least 18 annual and special meetings during the period involved.
The only employees of the petitioner during*93 the years here in issue were Joseph C. Dahlem, president; Bernard A. Dahlem, vice president-secretary; Sebastian V. Dahlem, treasurer; and Mary D. Freville, assistant secretary. Sebastian V. Dahlem received no compensation for any services which he rendered, and the only services which he actually performed were those of fulfilling the statutory office of treasurer. The total compensation paid by the petitioner to its officer-employees during its fiscal years ended March 31, 1963, 1964, and 1965, was as follows:
| Mar. 31, 1963 | Mar. 31, 1964 | Mar. 31, 1965 | |
| Joseph C. Dahlem, president | $ 5,000 | $ 5,000 | $ 5,000 |
| Bernard A. Dahlem, vice | |||
| president-secretary | 3,000 | 3,000 | 3,000 |
| Mary D. Freville, assistant | |||
| secretary | 500 | 200 | 200 |
Upon motion duly made and seconded, petitioner's board of directors unanimously authorized payment of the foregoing officers' salaries during each of the years involved herein.
Joseph C. Dahlem (hereinafter sometimes referred to as Joseph) is a licensed professional engineer and has been engaged in the construction business since 1919. He is a charter member of the International Council of Shopping Centers and has built more shopping centers*94 in the State of Kentucky than any other individual. He is a well-known businessman in the Louisville community, whose knowledge of the construction industry and business in general is widely known and respected.
In connection with the development by the petitioner of the Cliffboro Shopping Center during the years at issue, Joseph performed the following tasks: (1) Examined the prospective situs and determined the existence of any zoning restrictions, the availability of utilities, the amount of square footage available for use, the prospective *1569 construction cost of the center, and the estimated rental income to be derived therefrom; (2) negotiated the purchase price of the raw land; (3) personally contacted the appropriate officers of the Kroger Co. (hereinafter referred to as Kroger), Superex Drugs of Kentucky, Inc. (hereinafter referred to as Superex Drugs), Liberty National Bank & Trust Co. of Louisville (hereinafter referred to as Liberty National Bank), and One Hour Martinizing Dry Cleaning (hereinafter referred to as One Hour Martinizing) and negotiated leases with such businesses for the buildings to be situated in the center; and (4) arranged a $ 370,000 loan from*95 Franklin Pioneer Corp. to finance the construction of the improvements upon the Cliffboro Shopping Center site. Joseph also handled various other matters in his capacity as president of petitioner during the fiscal years at issue, including the following: (1) Negotiated leases with various business tenants occupying buildings and land owned by petitioner at locations other than the Cliffboro Shopping Center; (2) supervised the repair and maintenance of the parking lots and exterior walls and roofs of the buildings located in the shopping centers owned by petitioner; (3) received and wrote correspondence on behalf of the petitioner; and (4) reviewed petitioner's financial statements.
Bernard A. Dahlem (hereinafter sometimes referred to as Bernard) earned a bachelors degree in civil engineering from the University of Louisville. He is a registered engineer in the States of Kentucky, Indiana, and Tennessee, and is a member of two professional engineering societies as well as the International Council of Shopping Centers. Bernard has been designated as a Certified Shopping Center Manager (CSM) which signifies that, in the judgment of the International Council of Shopping Centers, he*96 is qualified to manage all aspects of a shopping center. In his capacity as vice president and secretary of the petitioner, Bernard performed the following services on behalf of petitioner during the years at issue: (1) Periodically inspected the physical condition of the grounds, parking lots, building roofs, and building exteriors of the various properties owned by petitioner and arranged for the repair and maintenance thereof; (2) reviewed gross sales of all tenants to make certain petitioner was receiving the appropriate amount of rental income from each tenant; (3) made suggestions to petitioner's tenants regarding maintenance of the leased property, display of merchandise, and other suggestions designed to increase the tenant's gross sales; (3) reviewed tenant's insurance policies to be certain that all tenants were maintaining the required insurance coverage; (4) handled tenant's phone calls and complaints; and (5) received and wrote letters pertaining to the petitioner's business.
*1570 In her capacity as assistant secretary of the petitioner, Mary D. Freville (hereinafter sometimes referred to as Mary) picked up and distributed petitioner's mail, attended and transcribed*97 the minutes at the meetings of petitioner's stockholders and board of directors, and typed petitioner's letters from dictation given by Joseph and Bernard.
The only compensation that Joseph, Bernard, and Mary received for the services they rendered on behalf of the petitioner was the above-mentioned salaries. During the years at issue, Joseph, Bernard, and Mary were also employed by other corporations and were paid the following amounts for services rendered thereto:
| Joseph C. Dahlem | |||
| 1963 | 1964 | 1965 | |
| Dahlem Construction Co | $ 33,021.58 | $ 47,181.72 | $ 81,811 |
| Indian Trail Trading Post | 4,875.00 | 10,666.67 | 10,000 |
| Dahlem Center, Inc | 2,600.00 | 2,600 | |
| Modern Concrete Products Co | 3,000.00 | 3,500.00 | |
| Modern Concrete Supply Co | 1,500.00 | ||
| Dahlem Stores, Inc | 2,732.00 | 2,732 | |
| Bernard A. Dahlem | |||
| 1963 | 1964 | 1965 | |
| Dahlem Construction Co | $ 9,605.94 | $ 16,985.64 | $ 19,741 |
| Indian Trail Trading Post | 5,541.66 | 10,000.00 | 10,000 |
| Dahlem Center, Inc | 400.00 | 2,850.00 | 2,600 |
| Dahlem Stores, Inc | 400.00 | 2,850.00 | 2,600 |
| Mary D. Freville | |||
| 1963 | 1964 | 1965 | |
| Dahlem Construction Co | $ 6,069.00 | $ 6,069.00 | $ 6,522 |
The Dahlem Construction Co. is the largest construction *98 company in Kentucky and is among the 400 largest contractors in the country. It was founded by Joseph in 1930 and he continues to own a majority of its stock. During the period involved herein, it employed 300 to 400 construction workers, three bookkeepers, three stenographers, a superintendent, two engineers, two estimators with two assistants each, a receptionist, a comptroller with three additional bookkeepers, two vice presidents, one president, Bernard as vice chairman of the board, and Joseph as board chairman. Joseph performed the following services for Dahlem Construction Co. during the years at issue: (1) Supplied the capital for the business operations; (2) checked to see that bills were mailed and invoices paid; (3) approved credit of customers and subcontractors; (4) visited the jobsites to see that the work was being carried on properly; (5) reviewed the large purchases of equipment; and (6) solicited new contracts.
Joseph and Bernard were also salaried executives of several other smaller corporations. Included among such corporations was Indian *1571 Trail Trading Post, Inc. (hereinafter sometimes referred to as Indian Trail), which owned and managed a 30-acre*99 regional shopping center having approximately 30 tenants. The services performed by Joseph and Bernard for Indian Trail were similar to those they performed for petitioner. Joseph helped organize and owns a 20-percent interest in Modern Concrete Block Co. and Modern Concrete Supply Co. In his position as chairman of finance of Modern Concrete Supply Co., Joseph reviewed the financial statements and reports from the president from a financial and investment standpoint, examined the accounts receivable for credit extension purposes, and examined the company's equipment to determine whether new equipment should be purchased. Joseph and Bernard were also responsible for the business operations of Dahlem Enterprises, Inc., Dahlem Center, Inc., and Dahlem Stores, Inc. These companies were in the business of leasing and managing commercial properties, which included two shopping centers and a Howard Johnson's.
During the period involved herein, Joseph owned a majority of the stock of petitioner, Dahlem Construction Co., Dahlem Enterprises, Inc., and Dahlem Center, Inc. Bernard owned all of the common stock of Dahlem Stores, Inc., and a majority of the stock of Indian Trail. Joseph *100 had ultimate responsibility for the business matters of all the above-mentioned corporations, except for Dahlem Stores, Inc., and Indian Trail, which were controlled by Bernard. With respect to Dahlem Construction Co., Joseph delegated much of his authority to its president, vice president, and other executive officers.
Petitioner owned and managed the following properties during the years at issue:
1. 2310 South Preston Street, containing a four-plex apartment house and stores leased to: a. Kroger, b. F. W. Woolworth Co.
2. Cliffboro Shopping Center containing stores leased to: a. Kroger, b. Superex Drugs, c. Liberty National Bank, d. One Hour Martinizing.
3. Property at the apex of Preston and Indian Trail in front of Indian Trail Trading Post, Inc., including -- a. Store leased to Frisch's Big Boy Restaurant, b. Land on ground lease to Phillips Petroleum Co.
The property at 2310 South Preston Street was acquired and improved by petitioner prior to the years involved herein. As of March 1, 1964, petitioner had invested $ 208,435 in the land and improvements at this location. The land upon which the Cliffboro Shopping Center is situated was purchased by petitioner on July*101 12, 1963, at a cost of $ 121,663. Petitioner borrowed the sum of $ 370,000 from Franklin Pioneer Corp. for the purpose of constructing the Cliffboro Shopping *1572 Center, and subsequently erected and leased the above-mentioned stores during the period at issue.
All of the tenants occupying petitioner's properties were of high calibre and many had a triple-A credit rating. Under the terms of the leases that petitioner entered into with Kroger, F. W. Woolworth Co., Superex Drugs, One Hour Martinizing, and Frisch's Big Boy Restaurant, petitioner was entitled to rental payments based upon gross sales in addition to a fixed rental. With the exception of the ground lease to Phillips Petroleum Co., petitioner's leases with its tenants were "gross leases" wherein petitioner was obligated to pay taxes, insurance, and other expenses. Generally, petitioner was responsible for exterior repair and maintenance (i.e., building roofs and exteriors, sidewalks, parking lots, etc.) of its properties; whereas, the tenants were obligated to repair and maintain the building interiors.
During the years in issue all of the Dahlem companies operated out of the offices at 984 Baxter Avenue, Louisville, *102 Ky. The building was owned by Dahlem Realty Co. and contained a reception area, a bookkeeping room, secretary's office, a drafting room, and three executive offices. The petitioner had no specific room, desk, or area at 984 Baxter Avenue which was designated as the place to conduct its business. Petitioner had no telephone listing and engaged in no advertising or promotional activities.
Petitioner's net income (prior to respondent's adjustments) for the fiscal years ended March 31, 1963, March 31, 1964, and March 31, 1965, was $ 20,123.76, $ 16,667.62, and $ 17,883, respectively. Petitioner's balance sheet during the fiscal years involved herein reflected the following:
| Mar. 31, 1963 | Mar. 31, 1964 | Mar. 31, 1965 | |
| Total assets | $ 375,536 | $ 702,057 | $ 792,015 |
| Total liabilities | 21,071 | 330,926 | 417,172 |
| Stockholders equity: | |||
| Capital stock outstanding: | |||
| Original issue | 47,000 | 47,000 | 47,000 |
| Stock dividends | 196,460 | 196,460 | 196,460 |
| Retained earnings | |||
| (less stock dividends) | 111,005 | 127,672 | 131,383 |
| Total stockholders equity | 354,465 | 371,132 | 374,843 |
| Total liabilities and | |||
| stockholders equity | 375,536 | 702,058 | 792,015 |
Petitioner did*103 not pay any dividends during any of the fiscal years ended March 31, 1963, March 31, 1964, and March 31, 1965. Since financial institutions require an equity investment by the developer before *1573 they will finance the construction of a shopping center, petitioner customarily paid cash for the undeveloped land and then financed the cost of the improvements thereto. In order that petitioner would be in a financial position to purchase the undeveloped land for a shopping center when an attractive opportunity presented itself, Joseph and Bernard deemed it necessary to petitioner's continued expansion that it accumulate its earnings in lieu of making dividend distributions.
On its Federal corporation income tax returns for the fiscal years ended March 31, 1963, March 31, 1964, and March 31, 1965, petitioner claimed a business expense deduction for the officers' salaries that it paid to Joseph, Bernard, and Mary during each of the 3 years at issue. The Commissioner disallowed a portion of such deduction for each of the years involved on the grounds that the claimed amounts exceeded a reasonable allowance for the compensation of petitioner's officers for their personal services. *104 The amounts claimed, allowed, and disallowed as officers' compensation are set forth below:
| Mar. 31, 1963 | Mar. 31, 1964 | Mar. 31, 1965 | |
| Claimed | $ 8,500.00 | $ 8,200.00 | $ 8,200.00 |
| Allowed | 3,316.14 | 3,802.80 | 6,525.82 |
| Amount disallowed | 5,183.86 | 4,397.20 | 1,674.18 |
Furthermore, the Commissioner asserted an accumulated earnings tax under
OPINION
Issue 1. Accumulated Earnings TaxThis case presents for our determination inter alia the narrow issue of whether during the period involved herein petitioner was a "mere holding or investment company" for purposes of the accumulated earnings tax provisions, which are embodied in
To facilitate the making of the determination of whether this proscribed purpose is present in a given factual pattern,
Respondent urges that we respond affirmatively to the query concerning whether petitioner was a "mere holding or investment company" during the period relevant hereto. The practical significance of such a holding would be two-fold: (1) The previously mentioned presumption that petitioner was formed or availed of for the purpose of avoiding income tax with respect to its shareholders would be raised in accordance with the provisions of
Petitioner contends that it is beyond the pale of the definition of a "mere holding or investment company" due to its engagement in a considerable amount of substantial business activity throughout the period relevant hereto. The question whether a corporation comes within the definition of a "mere holding or investment company" is one of a factual nature, the determination of which turns upon the facts and circumstances of each individual case.
The Internal Revenue Code nowhere defines "a mere holding or investment company" as that term is used in the accumulated earnings tax provisions of the statute. The "mere holding company" language has appeared in the predecessor provisions of
The words "investment company" were added to a predecessor of
In ferreting out the true meaning of the term "mere holding or investment company," the courts have laid great stress on the word "mere." For instance, in the case of
There is much evidence in the record bearing upon petitioner's business activities, both during the taxable years and prior years. We think that this evidence shows that petitioner was primarily a holding and investment company. * * * But while we think that the facts show that petitioner*110 was primarily a holding and investment company, we would be unwilling to say that it was a mere holding or investment company, within the meaning of the applicable statute. [Citations omitted.]
*1576 Similarly, in the recent opinion of
The adjective "mere" which is used in
Generally speaking, the foregoing cases and the authorities*111 relied upon therein seem to stand for the proposition that the presence of the word "mere" in the statutory language at issue manifests an intention to draw a distinction between holding or investment corporations which are strictly passive in nature and those which engage in some measure of business activity. Perhaps the most graphic illustration of the degree of business activity sufficient to extricate a corporate taxpayer from the "mere holding or investment company" classification is found in our opinion in
In that case, the petitioner had been a personal holding company throughout the 22-year period immediately preceding the taxable year involved therein. During such year, the petitioner purchased a working interest in 18 gas condensate wells. Petitioner's working interest in such wells was managed and operated during the year at issue by an agent, but it was contemplated that the petitioner would eventually gradually assume these responsibilities. Based upon these facts, we held that the scope of this business activity was *112 of sufficient magnitude to disqualify petitioner from being a "mere holding or investment company."
In our view, the opinion in
Furthermore, the facts herein show that petitioner owned and actively managed properties at *113 two other locations, including another shopping center, an apartment house, a restaurant, and a ground lease to a service station. Under the provisions of a majority of the leases which petitioner entered into with its tenants, petitioner was entitled to rental payments based upon gross sales in addition to the customary fixed rental amount. This prompted petitioner's officers (particularly Bernard) to review carefully the tenants' reports of gross sales and then to conceive of and suggest to the tenants various means by which they might increase their sales volume. Additionally, petitioner was generally responsible for exterior repair and maintenance (i.e., building roofs and exteriors, sidewalks, parking lots, etc.) of its leased properties, and petitioner's officers periodically inspected such properties and arranged for the necessary repair thereof. Finally, each of petitioner's principal officers received and answered correspondence and telephone calls concerning petitioner's business affairs.
Of course, we are not unmindful of the fact that Joseph and Bernard in their testimony before us were not prone to underestimate either the amount of activity engaged in by the petitioner*114 or the degree of effort each personally expended on its behalf. Moreover, the record shows that Joseph and Bernard were officer-shareholders in and devoted their time and efforts to various other corporations, including the largest construction company in the State of Kentucky (Dahlem Construction Co.). Furthermore, all of the Dahlem companies operated from the same office building, and petitioner did not have a separate telephone listing or any specific area designated as the place to conduct its business. Nevertheless, we are unaware of any legal requirement that petitioner must conduct a large-scale day-to-day operation in order to fall without the "mere holding or investment company" category. Certainly, the degree of business activity which the evidence of record establishes petitioner to have engaged in during the period at issue will suffice to effect this result.
Respondent strains mightily to fit the instant case within the holding company definition supplied by
A corporation having practically no activities except holding property and collecting the income therefrom or investing*115 therein shall be considered a holding company within the meaning of
Manifestly, petitioner did considerably more than merely hold rental property and collect the rents therefrom, i.e., it actively developed, *1578 managed, and maintained its properties. Hence, even under respondent's own regulations petitioner would not qualify as a holding company for
Based on the foregoing, we hold that petitioner was not a "mere holding or investment company" as that term is used in
| Mar. 31, 1963 | Mar. 31, 1964 | Mar. 31, 1965 | |
| Joseph C. Dahlem, president | $ 5,000 | $ 5,000 | $ 5,000 |
| Bernard A. Dahlem, vice | |||
| president-secretary | 3,000 | 3,000 | 3,000 |
| Mary D. Freville, assistant | |||
| secretary | 500 | 200 | 200 |
| Total compensation | 8,500 | 8,200 | 8,200 |
In accordance with the above-quoted Code provision, petitioner claimed a business expense deduction for officers' compensation in the amounts set forth above on its Federal corporation income*117 tax returns filed for its fiscal years 1963, 1964, and 1965. Respondent disallowed a portion of such deduction for each of the years involved on the grounds that the claimed amounts were in excess of a reasonable allowance for the compensation of petitioner's officers. The total amounts claimed, allowed, and disallowed as officers' compensation are set forth in the chart below: *1579
| Mar. 31, 1963 | Mar. 31, 1964 | Mar. 31, 1965 | |
| Claimed | $ 8,500.00 | $ 8,200.00 | $ 8,200.00 |
| Allowed | 3,316.14 | 3,802.80 | 6,525.82 |
| Amount disallowed | 5,183.86 | 4,397.20 | 1,674.18 |
The burden of proving reasonableness is upon petitioner, and the question is one of fact to be determined from all the facts and circumstances of each individual case.
The position advanced by the respondent, to the effect that the compensation paid Joseph, Bernard, and Mary was excessive and unreasonable in relation*118 to the services they performed in their respective capacities as officer-employees of petitioner, is deserving of only short shrift. We are confident that respondent compensates his own employees on a more generous basis than he is apparently willing to permit petitioner to compensate its officers. We do not feel it necessary to reiterate here the extensive services Joseph and Bernard performed on behalf of the petitioner. These services are outlined in detail in our Findings of Fact and partially repeated in our discussion of the first issue. We shall therefore merely highlight a few of the considerations that have led to our strong convictions regarding this issue.
Joseph is a recognized pioneer in the State of Kentucky in the field of planning, constructing, and managing shopping centers. A reasonable consultant's fee for the knowledge and expertise he brought to the handling of petitioner's business affairs would exceed the meager salary he received from petitioner. Moreover, it is clear from the record that Joseph's personal contacts with influential businessmen in the Louisville community were instrumental in securing triple-A tenants for petitioner's properties. The *119 standard brokerage fee of 4 percent to 6 percent of the gross rentals that petitioner derived from the leases that Joseph secured would also aggregate a substantial amount.
Bernard is a registered engineer in three States and has been designated as a Certified Shopping Center Manager by the International Council of Shopping Centers. Certainly, the efforts he directed toward the review of the gross sales of petitioner's tenants, the maintenance of its properties, and the handling of its correspondence should easily command the $ 3,000 annual salary he was paid. Likewise, the abundance of correspondence and corporate minutes which were typed by Mary and which were introduced into evidence herein *1580 attest to the fact that the secretarial services she rendered for petitioner were more than ample to justify the $ 500 salary she received during the fiscal year ended March 31, 1963, and the $ 200 salary she received in each of the two subsequent fiscal years.
The parties devote much discussion on brief to the traditional factors employed by the courts in determining the reasonableness of compensation. These factors are well summarized in the case of
We therefore hold that petitioner is entitled to the full amount of the ordinary and necessary business expense deduction that it claimed on its returns for the compensation it paid to its officer-employees during each of the 3 fiscal years at issue. Due to concessions by the parties with respect to other items reflected in the statutory notice,
Decision will be entered under Rule 50.
Footnotes
1. Unless designated otherwise, all future statutory references are to the Internal Revenue Code of 1954.↩