Decision will be entered under Rule 50.
The stockholders of petitioner, which was engaged in the manufacture and sale of concentrates to bottlers for processing and sale of soft drinks to the public, in order to effectively overcome merchandising difficulties, provide better cooperation with the bottlers, create an increased demand by the public for the bottlers' products and thereby increase sales of petitioner's products, created a partnership which thereafter carried on the business for which it was organized under a contract with the petitioner. Their interests in the partnership were the same as their stock interests in petitioner. Separate books of account were kept and maintained by the two organizations which clearly reflected the income of each. Held, under the facts, the Commissioner erred in including the net profits of the partnership in petitioner's gross income under section 45, Internal Revenue Code.
*1216 By these consolidated proceedings petitioner challenges deficiencies in tax determined by the Commissioner for the calendar year 1940, Docket No. 1060, *174 and the nine-month period January through September 1941, Docket No. 2332. The tax deficiencies are as follows:
| 1940 | 1941 | |
| Income tax | $ 41,381.30 | $ 41,338.39 |
| Declared value excess profits tax | 4,065.70 | |
| Excess profits tax | 9,487.87 | 112,680.02 |
The sole issue is whether Commissioner erred in including in petitioner's income under section 45 of the Internal Revenue Code the amounts of $ 177,441.25 for the taxable year 1940 and $ 242,248.15 for the taxable period in 1941 which were reported as income of the Seminole Flavor Co., Ltd., a partnership.
FINDINGS OF FACT.
The petitioner is a Tennessee corporation, organized on March 8, 1928, under the corporate name of Seminole Fruit Flavor Co. On or about December 31, 1929, the latter company acquired the assets of the Good Grape Co. in exchange for 550 shares of its capital stock. The corporate name was changed to Seminole Flavor Co. by amendment of the charter on January 29, 1932. Petitioner's principal place of business is in Chattanooga, Tennessee. Its tax returns for the taxable periods herein were filed with the collector of internal revenue at Nashville, Tennessee. Since November 7, 1934, through the taxable years petitioner's 750 shares of stock *175 issued and outstanding have been held by the same stockholders without change. The term "petitioner," as hereinafter used, includes the Seminole Fruit Flavor Co.
During the taxable periods the petitioner manufactured a full line of flavors, sometimes referred to as a "concentrate," which it sold solely to bottlers engaged in the business of bottling soft drinks. The bottler diluted this concentrate with simple sirup, or sugar and water, aged the solution 24 to 72 hours, and then added carbonated water to make the bottled beverage distributed for consumption. Petitioner's concentrates were sold under the trade names of Double-Cola, Double-Orange, Double-Lemon, Double-Strawberry, Double-Peach, Double-Grape, Double-Root Beer, etc.
Petitioner's Double-Cola concentrate was introduced to the trade late in 1935 or early in 1936. In 1937 its sales of Double-Cola concentrate amounted to approximately 75 percent of its total sales, and during the taxable periods herein such sales amounted to more than 90 percent of the total sales. Double-Cola is manufactured from a *1217 secret formula consisting of approximately 16 different ingredients. The formula was perfected over a period of years by the *176 efforts of C. D. Little and J. S. Foster, president and treasurer, respectively, of the petitioner, and no other persons have knowledge of the component parts of the formula.
When the petitioner brought out its Double-Cola concentrate its Cola accounts were very limited. Its fruit flavors, and a Cola concentrate known as Jumbo-Cola, were handled principally by independent bottlers and company owned or controlled bottling plants. Petitioner's first efforts to distribute Double-Cola followed the usual procedure of employing traveling salesmen to sell its product to established bottlers. Petitioner also attempted to interest people who wanted to go into the bottling business in the use of Double-Cola. Wherever possible petitioner entered into an agreement with the bottler granting him an exclusive franchise for bottling Double-Cola in his territory. Under this type of franchise the bottler agreed to bottle the flavors manufactured by petitioners and no other flavors. Other bottlers executed nonexclusive franchise agreements which did not restrict their use of flavor concentrates to petitioner's products. Both types of franchise agreements provided for advertising, merchandising, and *177 supervising services by the petitioner with respect to and over the bottler's operations. Certain advertising matter was to be furnished the bottler free of cost, and the bottler agreed to put up and erect all advertising according to petitioner's instructions and to feature and advertise Double-Cola as his leading drink. Bottling and sanitary requirements were set up, petitioner's representatives could inspect the bottler's plant to ascertain whether the requirements were being met, and the bottler agreed to submit samples of the Double-Cola he was distributing for analysis by petitioner and obligated himself to keep and maintain the standards set by petitioner for its product.
The number of petitioner's Double-Cola accounts materially increased during the calendar years 1936, 1937, and 1938. Thereafter the number of Double-Cola accounts gradually declined through 1943, but petitioner's total sales increased each year from 1936 through the calendar year 1943. Petitioner's Double-Cola accounts were scattered over the United States and its facilities and organization were so inadequate that it was unable to give its bottlers the advertising, merchandising, and supervisory services *178 called for in their franchise agreements. During 1937, 1938, and 1939 petitioner received numerous complaints from its bottlers about the unsatisfactory services petitioner was rendering. Petitioner lost a large number of bottling accounts during these years, some of which were potentially very good accounts, because it did not assist the bottlers with satisfactory advertising and merchandising services. Among other things, the bottlers *1218 demanded newspaper, billboard, moving picture, and radio advertising and sampling campaigns, none of which was being furnished by petitioner.
In 1936 petitioner brought into its home office the manager of its bottling plant at La Grange, Georgia, James M. Geeslin, and placed him in charge of the distribution of its products. Geeslin had developed a profitable business for the petitioner at La Grange during a period of depression after taking over a company owned plant that appeared to be hopelessly insolvent. Prior thereto he had been a specialty man for the petitioner, interviewing bottlers and assisting them in advertising and merchandising their products.
After working with company owned or controlled bottling plants and with plants owned by *179 individual bottlers, Geeslin became convinced that company owned plants were far superior. He found that many of the independent bottlers did not know how to do business, did not have the proper facilities for doing business, and needed supervision. A few months after he took charge of petitioner's distribution Geeslin discussed with Little the necessity of a medium through which the petitioner could exercise more control over, and could work closer with, the independent bottlers for the purpose of expanding their sales and distribution. Subsequent events further convinced Geeslin of the merits of his idea and he continued to urge upon the officers and the directors the necessity and desirability of setting up some form of organization which would improve petitioner's advertising and merchandising services and at the same time would work more closely with the bottlers. Two of petitioner's directors opposed the idea; two were interested but not entirely convinced. Early in 1937 Geeslin obtained permission from Little to move his office, and the offices of about five other employees, from the manufacturing building to the Hamilton National Bank Building. Lack of space at the factory, *180 the availability of space at the bank building, better accommodations, and a nicer atmosphere in which to meet representatives of the bottlers, prompted this move. Geeslin was in complete charge of the office and the salesmen.
At the annual meeting of petitioner's stockholders on April 29, 1938, their concern over the company's situation is recorded in the following minutes:
* * * *
The President submitted a statement of the operation of the company during 1937, and also a comparative statement of the operation of the company during the first three months of 1938 as compared with the first three months of 1937.
* * * *
The question of whether or not the company would surrender its charter and reincorporate, or would create or take over another company and use one as a manufacturing company and the other as a sales company was discussed at length, and the directors were authorized to make investigation as to what would be the most feasible plan, if there should be any change at all.
*1219 Many other things with reference to the operation of the business were discussed at length.
* * * *
There was extensive discussion as to whether or not the company should adopt a six ounce or seven ounce bottle *181 to be used along with the twelve ounce bottle, but no definite action was taken on this.
* * * *
During 1938 and 1939 petitioner's officers and directors continued to discuss whether petitioner should change its method of sales promotion and distribution and the merits of the various plans suggested. They recognized that petitioner had more bottling plants to service than its facilities or organization could handle and that complaints of the bottlers about inadequate service were merited. Petitioner had been paying a nationally known advertising firm a monthly retainer of $ 500 for its services and, in addition, paid the cost of making up any art work, employing the artist, and other costs that entered into its advertising material, plus its own costs in connection with its advertising program. In or about July 1938 petitioner was advised by the advertising agency that it was unprofitable to continue the account. In response thereto and in an effort to improve the advertising services rendered to its bottlers, petitioner dispensed with the services of the agency and employed its own advertising expert, L. B. Krick, who had had years of experience in advertising and merchandising *182 bottled beverages. Despite changes thereafter made in its advertising services and additions to its personnel, petitioner's relations with its bottlers continued to be unsatisfactory.
By the latter part of 1938 or early in 1939 petitioner had lost approximately 50 percent of its bottling accounts, principally because petitioner did not assist the bottlers sufficiently in merchandising and advertising the product. Little, who had been in the bottled beverage business since 1914, realized that unless something was done to correct existing conditions petitioner might be forced out of business. He had seen his own bottling plants, the bottling plants of others, and the manufacturers that supplied the bottlers forced out of business because of the manufacturers' failure or inability to remedy conditions similar to those confronting the petitioner. Little realized that more drastic changes in the services rendered to bottlers were necessary, as the bottlers were even then discussing among themselves the organization of an association for advertising and merchandising their products.
On or before August 5, 1939, Little and the other stockholders and directors decided that a partnership *183 would afford the most feasible and flexible arrangement for promoting the sale and distribution of petitioner's products. Accordingly, petitioner's five stockholders executed a partnership agreement on August 5, 1939, for the purpose of forming a limited partnership under the Uniform Partnership Act of *1220 Tennessee. The general partners were C. D. Little and J. S. Foster; the limited partners were Mae S. Little, wife of C. D. Little, F. L. Underwood, and J. Lon Foust. The partnership was to continue for five years unless sooner terminated by agreement, or by the death, retirement, or insanity of one of the general partners. The general and limited partners paid $ 10,000 cash into the partnership and acquired thereby interests in the partnership. The interests of the several partners, as reflected by the amendment to the partnership agreement of August 15, 1939, were almost identical with their stock interests in petitioner, as shown by the following table:
| Stock interest | |||
| Partnership | |||
| interest | |||
| Shares | Percent | ||
| Percent | |||
| C. D. Little | 43.2 | 324 | 43.2 |
| Mae S. Little | 42.4 | 318 | 42.4 |
| J. S. Foster | 9.34 | 70 | 9.33 |
| F. L. Underwood | 4.8 | 36 | 4.8 |
| J. L. Foust | 0.26 | 2 | 0.27 |
| Total | 100.00 | 750 | 100.00 |
The name adopted by the partnership *184 was Seminole Flavor Co., Ltd., and the purpose for which the partnership was created was stated by the agreement to be as follows:
2. The business of the partnership shall be commercial, and shall consist of services to be rendered in connection with the promotion, advertisement, sale and distribution of the products and merchandise of Seminole Flavor Company of Chattanooga, Tennessee, used for bottling soft drinks.
Management of the partnership's affairs was vested in the general partners, who were entitled to be paid a salary for their services in addition to their share of the profits. The managing partners were empowered to employ suitable persons to assist in the performance and discharge of the duties of the partnership and to carry on the business for which it was formed.
Under date of August 14, 1939, the partnership submitted a written proposal to petitioner to take over the sales, advertising, and distributing end of its business, purchase the furniture and fixtures used by petitioner in connection therewith, and render specified services in promoting the sale and distribution of petitioner's products, paying all costs and expenses incurred, in consideration of a commission *185 measured by gross sales less prepaid freight.
On August 15, 1939, petitioner's directors, Little, Foster, Geeslin, Underwood and Foust, met and considered the above proposal. The minutes of this meeting recite that the directors unanimously approved *1221 the partnership's proposal, provided that an agreement should be entered into specifically fixing the compensation to be paid the partnership for services rendered, and directed its officers to prepare a contract to carry out the proposal and submit the contract to them for consideration before it was executed. The minutes also recite that, after a short adjournment for the officers to consider the form of the contract, the meeting was reconvened, the contract was submitted for the consideration of the directors, and, after full discussion thereof, the proper officers of the petitioner were authorized to execute the agreement and to sell and transfer to the partnership the office equipment and furniture used in the sales, distribution, and advertisement department for the price of $ 3,530.22.
The agreement between the petitioner and the partnership was executed on the same day, Geeslin and Foust executing the instrument for petitioner, *186 as vice president and secretary, respectively, and Little and Foster, as general partners, executing the instrument for the partnership. Pertinent paragraphs from the agreement read as follows, the petitioner being referred to as the first party and the partnership as the second party:
Whereas from the time of the organization of the party of the first part, and up to the present time, it has endeavored to carry on the business of manufacturing "Double-Cola" concentrate and sundry flavors, and at the same time maintain a department for the advertisement and distribution of such products, and the sale of same to persons, firms and corporations engaged in the business of bottling soft drinks; and
Whereas, the party of the second part proposes to take over, manage and control the features of the business of the party of the first part that have to do with the advertisement, distribution, sale and consumption of the products of the party of the first part; and to increase the sale and consumption of such products in the use of bottling soft drinks.
Now, Therefore, it is agreed between the parties hereto as follows:
1. That the party of the first part will sell and transfer to the party of *187 the second part all of its office equipment and furniture located in its distribution office in the Main Street Branch of the Hamilton National Bank Building, in Chattanooga, Tennessee, situated at the corner of Main and Market Streets, Chattanooga, Tennessee, at the price of $ 3,530.22.
2. The party of the second part agrees to take over, manage, handle and control all of the business of the party of the first part that pertains to the advertisement, sale and distribution of its products, and in connection with the sale and distribution of such products, render to the party of the first part the following services, viz:
(a) To perform all work and services incident to maintaining and developing markets for the sale and distribution of the products of the party of the first part.
(b) Supervise and service all contracts and franchises with persons, firms or corporations for the purchase of the products of the party of the first part which are used in bottling soft drinks; and do all things that are necessary and expedient to increase the sale and consumption of the products of the party of the first part to persons, firms or corporations engaged in the business of bottling soft drinks.
*1222 *188 (c) Do all things necessary and expedient to enlarge and extend the territory and markets in which the products of the party of the first part are sold, or may hereafter be sold, by selecting new locations for bottling plants and entering into agreements with responsible persons, firms or corporations, to engage in the business of bottling soft drinks with the use of the products of the party of the first part; and to render to such distributors and bottlers such financial aid and assistance as may be necessary and expedient under circumstances where new bottling plants are to be established.
(d) Design, execute and manage all plans for the advertisement and sale and consumption of the products of the party of the first part in an efficient and artistic manner.
(e) To keep a careful watch over the credit rating and standing of persons, firms or corporations who purchase the products of the party of the first part, perform all services incident to sending out statements for merchandise shipped and sold from the manufacturing plant of the party of the first part, make all collections of accounts receivable for merchandise shipped and sold by and for the party of the first part.
3. In addition *189 to the foregoing services to be rendered by the party of the second part to the party of the first part, the party of the second part agrees to bear and pay all expenses and costs incident to and incurred in connection with rendering such services; keep an accurate record of all statements sent out for merchandise shipped by the party of the first part, also an accurate record of all collections made on account of such shipments, and make settlement therefor to the party of the first part.
4. It Is Agreed between the parties hereto that for the services to be rendered by the party of the second part to the party of the first part, that the party of the second part shall be paid a commission on the gross sales of all the products and merchandise shipped and sold by the party of the first part at the rate of 50% of the invoice price of such products and merchandise, less prepaid freight charges where freight is to be prepaid on shipment.
5. It is further agreed between the parties hereto that in connection with services to be rendered by the party of the second part in promoting, advertising, distribution and sale of the products of the party of the first part, the party of the second *190 part shall pay and bear all expenses incurred by it out of the commission to be paid it for such services as provided in paragraph 4 of this agreement. That inasmuch as the party of the second part is responsible to the party of the first part for the invoice price of all merchandise and products shipped and sold; and is to make collections for all such merchandise, the amount of the commission to be paid the party of the second part, as aforesaid, shall be retained by it in remitting to the party of the first part.
6. The party of the second part shall furnish to the party of the first part, on or before the 10th day of each calendar month, a statement of the invoice price of all merchandise and products of the party of the first part shipped and sold during the previous calendar month, and shall at intervals of quarterly periods of three calendar months each make full and complete remittance to the party of the first part of 50% of the invoice price of all merchandise and products of the party of the first part shipped and sold during such previous quarter of three calendar months.
The agreement was to run for five years, but petitioner expressly retained the right, power, and authority *191 to change the basis of compensation within the first 30 days of any calendar year by giving written notice of the change in the rate of commissions to be paid. Either *1223 party could terminate the agreement by giving written notice of 6 months.
On December 12, 1940, the parties to the above contract amended paragraph 4 of the agreement so that the rate of compensation, viz., 50 percent of the invoice price, was to be reduced by "manufacturing cost" and by "prepaid freight charges where freight is to be prepaid on shipments." (Emphasis supplied.) This amendment was made effective as of the date of the original agreement "so as to clarify the meaning of" paragraph 4. Proper adjustments were authorized to be made in the accounts of the respective parties giving due effect to such change. The adjustment made in accordance with this agreement reduced the partnership income for the period August 16 to December 31, 1939, inclusive, by $ 56,316.71 and increased the petitioner's 1939 profits by a like amount. This sum was ratified as a dividend to stockholders by petitioner's directors at a meeting on July 1, 1941, the stockholders having reported this amount in their 1939 income tax returns *192 as profits received from the partnership.
In May 1942 a further adjustment of $ 56,040.53 was made with respect to petitioner's 1939 profits and the partnership income was reduced in a like amount. As a result of these two adjustments the partnership books for the period August 16 to December 31, 1939, inclusive, showed a net profit of $ 11,148.88, of which approximately $ 500 represented compensation paid the partnership under the agreement of August 15, 1939, and the remainder represented profit realized from the sale of crowns. This adjustment was made soon after the tax liabilities of the petitioner for 1939 were adjusted with the Commissioner in Docket No. 108965, decision entered, April 4, 1942.
On December 15, 1942, the parties to the contract of August 15, 1939, mutually agreed to the termination thereof as of January 1, 1943, and that thereafter the relations between them, if any, should be that of seller and buyer of petitioner's products at prices to be agreed upon. On January 1, 1943, the parties entered into an agreement providing for the purchase and sale of minimum and maximum gallonage, per annum, of Double-Cola concentrate, at an agreed price, subject to change in *193 proportion to any increase in the cost of production. The agreement continued in effect for one year and after such year from year to year in the absence of written notice of intention to terminate.
After August 15, 1939, petitioner's business activities were devoted entirely to manufacturing. Its accounts receivable, sales and advertising accounts and records, and the employees who kept these records were transferred to the partnership, which thereafter maintained a separate and distinct system of accounting from that maintained by petitioner. Geeslin became the manager of the partnership and Krick was placed in charge of advertising, although final authority in all *1224 partnership matters was vested in Little and Foster. Little devoted between 80 and 90 percent of his time to supervising the partnership. Foster was production manager and treasurer of the petitioner in full charge of all the help, the factory, and the manufacture of all flavors; his services to the partnership were mostly advisory. Claude A. Findley, who served as comptroller for the petitioner and the partnership, received his salary from the petitioner. J. L. Foust, judge of the Chancery Court, and F. L. Underwood, *194 vice president and trust officer of the Hamilton National Bank in Chattanooga, served as directors, but otherwise took no active part in petitioner's business.
The partnership changed the entire set-up with reference to sales promotions, advertising, and merchandising services previously rendered bottlers. Instead of having a selling organization with high pressure salesmen operating in large territories, it employed men experienced in the bottling industry who were capable of making decisions and advising bottlers. These men visited each bottler in their district five or six times a year, worked with the bottler at his plant, analyzed the problems confronting each bottler, and helped in the solution thereof. Bottlers who were losing money were placed on a profitable basis. A system of cost accounting was approved for the use of the bottlers. An operations chart or yardstick was furnished the bottler against which he could check the results of his own operations. An advertising catalog was furnished the bottler which displayed in detail the various pieces of advertising adopted by the partnership, most of which was furnished the bottler without cost. Some of the advertising listed *195 was not furnished, but could be procured for the bottler by the partnership at cost. The partnership, in conjunction with its bottlers, instituted motion picture, radio, billboard, newspaper and other advertising campaigns to promote the sale of its Double-Cola and other flavors. A bulletin service was maintained by the partnership by means of which new ideas, changes in the industry, or any information of value was circularized to and for the use of its bottlers. The partnership also provided technical and laboratory services for controlling the bottling operations. It acted as purchasing agent for machinery and supplies for the bottlers, generally without profit to itself. Bottlers at one time or another sought and received the advice and services of the partnership on all phases of the operation of a bottling plant.
The services rendered by the partnership to all bottlers alike would have been too expensive for any individual bottler to have maintained. The continued increase in sales volume during and after the taxable periods was due in part to the adequacy and sufficiency of the services rendered to the bottlers, some of whom testified that without such services they would *196 have to close their plants.
Petitioner's growth is reflected in the following comparative statement *1225 of its total net profits, dividends paid, and surplus for the years and period listed, taken from petitioner's books:
| Total net | Dividends | ||
| Year | profits | paid | Surplus |
| 1931 | $ 2,773.89 | $ 7,500.00 | $ 18,193.36 |
| 1932 | 11,186.60 | 4,500.00 | 2,506.76 |
| 1933 | 2,003.42 | none | 4,701.40 |
| 1934 | 4,498.30 | 7,500.00 | 1,410.10 |
| 1935 | 10,295.03 | 11,250.00 | 64.21 |
| 1936 | 92,646.68 | 90,000.00 | 1 (11,462.67) |
| 1937 | 186,524.58 | 86,250.00 | 47,323.96 |
| 1938 | 217,432.37 | 108,750.00 | 115,753.73 |
| 1939 | 241,889.16 | 2 172,355.24 | 253,497.65 |
| 1940 | 303,583.32 | 60,000.00 | 411,384.35 |
| 3 1941 | 296,194.08 | 105,000.00 | 538,194.05 |
Included in petitioner's annual net profits shown by the above table is the profit it realized from the sale of crowns for each of the years 1934 to 1939, inclusive, as follows:
| 1934 | $ 16.38 |
| 1935 | 115.85 |
| 1936 | 11,173.00 |
| 1937 | $ 15,503.76 |
| 1938 | 16,457.49 |
| 1939 | 17,949.69 |
Petitioner's plant cost of sales, its total selling expenses, including net advertising expenses and salesmen's salaries and traveling expenses, from 1931 to September 30, 1941, inclusive, are shown by its books to be as follows:
| Selling expenses | ||||
| Year | Plant cost | |||
| Advertising | Salesmen | Total | ||
| 1931 | $ 23,047.36 | $ 13,586.42 | $ 11,772.31 | $ 29,551.31 |
| 1932 | 23,555.41 | 7,408.35 | 10,016.04 | 20,291.48 |
| 1933 | 22,064.65 | 6,317.04 | 5,754.56 | 14,319.92 |
| 1934 | 44,425.30 | 30,539.68 | 12,673.80 | 47,378.60 |
| 1935 | 54,950.42 | 29,884.93 | 19,966.81 | 53,006.47 |
| 1936 | 112,707.09 | 40,170.91 | 26,021.82 | 74,391.95 |
| 1937 | 186,589.07 | 90,423.69 | 37,789.09 | 136,163.69 |
| 1938 | 222,451.05 | 146,258.07 | 55,645.20 | 212,880.72 |
| 1939 | 274,290.13 | 85,448.74 | 31,838.49 | 291,750.00 |
| 1940 | 322,747.12 | 35.72 | 160.02 | 346,129.63 |
| 1 1941 | 356,073.04 | 353,411.23 |
Petitioner's total selling expenses for 1939, 1940, and 1941, set forth in the foregoing table, included "Compensation Paid to Seminole Flavor Co., Ltd." in the respective amounts of $ 170,622.64, $ 342,468.24, and $ 352,919.18. These amounts were reflected upon the books of the partnership as "Income per Agreement" for the period August 16 to December 31, 1939, the calendar year 1940, and the fiscal year ended September 30, 1941, respectively.
A condensed comparative statement of the partnership's operations, *1226 as shown by its books, reflects the following items of income and expenses for the period August 16 to December 31, 1939, the calendar year 1940, and the fiscal year ended September 30, 1941:
| Receipts | 1939 | 1940 | 1941 |
| Income per agreement of 8/15/39 | $ 170,622.64 | $ 342,468.24 | $ 352,919.18 |
| Profit from sale of crowns | 10,615.02 | 27,765.10 | 40,926.45 |
| Advertising paid by bottler | 11,950.46 | 73,899.93 | 42,788.93 |
| Total gross income | 193,188.12 | 444,133.27 | 436,634.56 |
| Disbursements | |||
| Advertising | 36,861.35 | 133,146.26 | 121,161.65 |
| Salesmen's salaries, commissions and | |||
| traveling expenses | 18,759.20 | 56,043.35 | 39,058.63 |
| Other selling expenses | 3,141.56 | 46,557.74 | 7,977.14 |
| Total selling expenses | 58,762.11 | 235,747.35 | 168,197.42 |
| Selling profit | 134,426.01 | 208,385.92 | 265,437.14 |
| Total administrative expenses | 10,919.89 | 30,944.67 | 26,188.99 |
| Net profit | 123,506.12 | 177,441.25 | 242,248.15 |
*198 The partnership's returns of income on Form 1065 reported ordinary income for the period in 1939, the calendar year 1940, and the period January 1 to September 30, 1941, in the amounts hereinabove shown as net profits for 1939, 1940, and 1941, and showed the distributive share of each partner therein.
The following comparative statement shows the salaries paid the principal officers of the petitioner and the partnership for the calendar years 1939, 1940, and 1941:
| 1939 | ||||
| Petitioner | Partnership | |||
| Title | Salary | Title | Salary | |
| C. D. Little | President | $ 40,000 | General partner | |
| J. M. Geeslin | Vice president | 4,300 | Manager | $ 2,500 |
| L. B. Krick | Vice president | 8,600 | Advertising | 5,000 |
| J. S. Foster | Treasurer | 10,880 | General partner | |
| Total | 64,580 | 7,500 | ||
| 1940 | ||||
| C. D. Little | President | 40,000 | General partner | |
| J. M. Geeslin | Manager | 6,800 | ||
| L. B. Krick | Advertising | 16,750 | ||
| J. S. Foster | Treasurer | 10,800 | General partner | |
| Total | 51,600 | 23,550 | ||
| 1941 | ||||
| C. D. Little | President | 40,800 | General partner | |
| J. M. Geeslin | Vice president | 3,000 | Manager | 6,800 |
| L. B. Krick | Advertising | 15,850 | ||
| J. S. Foster | Treasurer | 15,380 | General partner | |
| Total | 59,180 | 22,650 |
*1227 Little and Foster, as general partners, fixed the amounts of net profits that should be added to the partners' capital accounts and the *199 amounts that should be distributed. Such additions and distributions were always pro rata. Withdrawals authorized by the general partners prior to and during the taxable periods were: $ 90,000 for the period August 16 to December 31, 1939; $ 168,750 for the calendar year 1940; and $ 37,500 for the fiscal period ended September 30, 1941, or a total for the 25 1/2 months of $ 296,250. During this same period additions to the capital accounts of the partners increased their capital investment from the original $ 10,000 to $ 256,945.52 on September 30, 1941. The distributive share of partnership net profits was reported on the individual income tax returns of each partner, whether distributed or not, and the tax due thereon was paid.
Federal taxes paid by the petitioner in 1935 in the amount of $ 1,708.58 were the largest in its history. Federal taxes paid thereafter, and prior to the formation of the partnership, were: $ 12,913.04 in 1936; $ 41,669.56 in 1937; and $ 38,594.18 in 1938. Petitioner's income tax returns for the taxable periods herein reported tax liabilities of $ 63,944.97 for 1940 and $ 105,771.45 for the fiscal period January 1 to September 30, 1941. Respondent determined *200 petitioner's Federal tax liability for 1940 and the fiscal period 1941 to be $ 118,879.94 and $ 259,789.66, respectively. His principal adjustment for each taxable period carries the same explanation, which, except for a difference in amount, is as follows:
Under the authority of Section 45 of the Internal Revenue Code $ 177,441.25 [or $ 242,248.15] of the gross income of Seminole Flavor Co., Ltd., a partnership which is owned or controlled by your officers and stockholders, has been allocated to you and the income reported on your return is increased accordingly. It has been determined that this allocation is necessary in order that your income and the income of Seminole Flavor Co., Ltd. may be clearly reflected.
For the calendar years 1940 and 1941 the aggregate tax liability reported and paid by the individual partners and stockholders (Little, Mrs. Little, Foster, Underwood and Foust) was $ 142,850.97 and $ 272,113.62, respectively. The aggregate tax liability of the same individuals for the same periods computed after deducting all partnership income from their respective returns would be $ 42,130.47 and $ 110,370.52, respectively. The aggregate tax liability of the same individuals *201 for the same periods computed by including in income only that portion of partnership profits actually distributed to them would be $ 137,275.51 and $ 134,275.20, respectively. It is stipulated that the above stated tax liabilities ignore any adjustments that the Commissioner has made in auditing the several returns.
Petitioner's books of account clearly reflect its income. The partnership's income is clearly reflected by its separate books of account and no part thereof constituted income of the petitioner. The partnership, *1228 organized and operated by petitioner's stockholders, was a business enterprise separate and distinct from the manufacturing business conducted by the petitioner. The predominant purpose of petitioner's stockholders in creating and operating the partnership was to solve the merchandising difficulties confronting the petitioner.
OPINION.
The issue herein involves an interpretation, construction, and application of section 45 of the Internal Revenue Code, set forth in the margin. 1*204 Section 19.45-1 of Regulations 103 defines the terms used in section 45, its scope and purpose, and the application thereof. Section 45 is not a new provision in the code. Much of *202 the language found therein can be traced back through prior acts to section 240 (d) of the Revenue Act of 1921. It first appeared in its present form as section 45 in the Revenue Act of 1928. Despite its long history as an integral part of the revenue statutes, the section has been sparingly applied. However, where section 45 has been at issue, it has been held that it confers broad discretionary power upon the Commissioner to allocate income or deductions "if he determines" that such allocation "is necessary in order to prevent evasion of taxes or clearly to reflect the income * * *." Briggs-Killian Co., 40 B. T. A. 895; Asiatic Petroleum Co. ( Delaware), Ltd., 31 B. T. A. 1152; affd. (C. C. A., 2d Cir.), 79 Fed. (2d) 234; certiorari denied, 296 U.S. 645">296 U.S. 645; National Securities Corporation v. Commissioner (C. C. A., 3d Cir.), 137 Fed. (2d) 600, affirming 46 B. T. A. 562. The congressional committee reports show that Congress in enacting this section had particularly in mind the evasion of taxes by the shifting of profits, the making of fictitious sales, and other methods frequently adopted for the purpose of "milking." See Asiatic Petroleum, supra, 31 B. T. A., at pp. 1155-56. If *203 the Commissioner determines that an allocation is necessary, the taxpayer has the burden of proving that the Commissioner's determination was arbitrary and that its situation is not one to which the statute applies. Essex Broadcasters, Inc., 2 T.C. 523">2 T. C. 523, 529; Glenmore Distilleries Co., 47 B. T. A. 213, 224; G. U. R. Co. v. Commissioner (C. C. A., 7th Cir.), 117 Fed. (2d) 187, affirming 41 B. T. A. 223; Welworth Realty Co., 40 B. T. A. 97, 100. Application of section 45 has been denied where the Commissioner attempted to set up income where none existed, Tennessee- Arkansas Gravel Co. v.*1229 (C. C. A., 6th Cir.), 112 Fed. (2d) 508, reversing Board of Tax Appeals memorandum opinion; E. C. Laster, 43 B. T. A. 159, 176; affirmed on another point, 128 Fed. (2d) 4, or to use the section for the disallowance of a deduction. General Industries Corporation, 35 B. T. A. 615.
The basic facts here are that prior to August 16, 1939, petitioner manufactured, advertised, sold, and supervised the bottling of its flavor extracts; thereafter it only manufactured the flavor extracts. After August 15, 1939, advertising, merchandising, and supervisory services were handled under contract by a partnership composed of petitioner's stockholders, whose interests in the partnership were identical with their stock interests in the petitioner. In view of these facts respondent has determined under section 45 that it is necessary to allocate to petitioner for each taxable year a stated portion of the gross income of the partnership "in order that your income and the income of Seminole Flavor Co., Ltd., may be clearly reflected," and he contends that the existence of the partnership should be ignored for tax purposes. Under the statute and the *205 decided cases petitioner must prove Commissioner's determination was arbitrary in order to prevail.
Petitioner's proof can be summarized under three main contentions. In the first place it is contended that the books and records of the petitioner and the partnership, separately kept and maintained, clearly reflect the income of each. Secondly, it is contended, at least in effect, that petitioner and the partnership were separate and distinct business enterprises, each organized and operated for a definite business purpose and each actively engaged during the taxable years in carrying on a trade or business, so that there was no compelling reason to ignore the existence of the partnership. Thirdly, it is contended that section 45 seeks only to adjust and correct improper bookkeeping entries between separate businesses, that application of the section should be strictly confined to this purpose, and that the Commissioner should not be permitted to use the section to justify his arbitrary consolidation of the net incomes of two separate businesses.
After carefully weighing and scrutinizing the entire record herein, and limiting our conclusion solely to the particular facts and circumstances *206 before us, it is our opinion that petitioner has sustained its burden of proof. Our findings show that petitioner and the partnership kept and maintained separate books of account. The accuracy of the books of account and record is emphasized by the Commissioner's use of the partnership net profits, per its books, as the exact amount of gross income to be allocated for each taxable year to the petitioner. The Commissioner directs our attention to no single entry or account which he contends is improper or inaccurate or which he *1230 now seeks to correct. His contention is that the entire arrangement was devised so that all of the partnership profits would be liverted from the petitioner for the purpose of reducing and evading its income tax liabilities.
The Commissioner supports his determination by pointing out that it was immaterial to Geeslin what form of organization was adopted, so long as he had control of it, and that Little and the other directors only became interested in Geeslin's plan in April 1938, after they realized that 1937 taxes amounted to $ 41,487.95 2 and first quarter earnings indicated that 1938 would be a higher tax year than 1937. Furthermore he points out that *207 in August 1939, when the directors decided to adopt Geeslin's plan, they knew 1938 taxes amounted to $ 38,374.66 2 and that they rejected a subsidiary corporation and organized a limited partnership, with no reasons assigned therefor. The Commissioner also points out that his exhibits R, S, and T, which set forth the tax computations mentioned in our findings, show the tax savings which resulted from the creation of the partnership and channeling of income to it which otherwise would have been taxable to the petitioner. And, finally, the Commissioner supports his determination by charging that the contract fixing the commissions between the petitioner and the partnership was not an arm's length transaction such as petitioner would have entered into with strangers, but was subject to and was changed at will by the parties.
The difficulty we have with the first points made by the Commissioner is that the facts preponderate against his contentions. Geeslin did testify that the type of organization adopted to carry out his plan *208 of operation was immaterial to him, but we don't see how this testimony helps the Commissioner. Geeslin also testified that a string of company owned bottling plants was considered and rejected. Why a subsidiary corporation or a string of company owned bottling plants should be rejected in favor of a limited partnership is beside the point. We must look to the things that were done and not to what might have been done; and it is here established that a limited partnership was decided upon, was organized, and was thereafter operated. Whether the stockholders were principally influenced in what they did by a consideration of future tax liabilities would seem to depend in a large measure upon their ability to foresee continually increasing earnings.
Unless the partnership was more successful in eliminating the complaints of bottlers than the petitioner had been, the tax benefits, if any, were purely speculative. Petitioner was operating in a highly competitive industry. Its earnings record was not impressive prior *1231 to 1936. Earnings for 1937 and 1938 were very satisfactory, but increasing merchandizing difficulties warned of disaster ahead unless an early solution was found. We *209 are convinced that prior efforts and endeavors had failed to remedy petitioner's problems, and Geeslin's plan was adopted as holding out a reasonable chance of success where other plans had failed. The record shows that a partnership was adopted as the vehicle to carry out the plan because it afforded the most feasible and flexible arrangement for promoting the sale and distribution of petitioner's products. The new plan provided for a new approach to petitioner's merchandizing problems and for services not previously rendered by petitioner. We do not mean to say that taxes were not considered in the new set-up. Undoubtedly they were, for taxes occupy a prominent place in the operation of any business. But recognition of this inevitable fact is not the equivalent of saying, or holding, that this partnership was primarily and predominantly a scheme or device for evading or avoiding income taxes.
Exhibits R, S, and T were compiled by respondent from figures in the record and are relied upon by him to show his determination was necessary in order to prevent the evasion of taxes. As to partnership earnings, these exhibits shows individual tax liability for 1940 and 1941 (a) if all *210 partnership net profits were taxed to the partners; (b) if only that portion of partnership net profits actually distributed were taxed to the partners; and (c) if none of the partnership net profits were taxed to the partners. An analysis of these exhibits in connection with the returns shows that the Government would receive additional revenue only if the corporation distributed such profits to the stockholders. When the Commissioner stripped the partnership of its net earnings by allocating such earnings to petitioner, no partnership income was left to be taxed to the partners. Eliminating the partnership earnings from the individual returns, as in (c), the aggregate tax of the individuals from all sources would be $ 100,000 less in 1940 and $ 161,000 less in 1941 than under (a). Including the partnership earnings in petitioner's income, its taxes for both years fell short of making good this loss of revenue by over $ 53,000. Certainly, this is not tax evasion. The Commissioner, however, argues that not only must the income of the two trades or businesses be consolidated, but the partnership profits he included in petitioner's income must also be considered as corporate distributions *211 to the stockholders, and taxed to them, notwithstanding no corporate action has been taken with reference thereto. Thus it is plain that it is only when allocation of the partnership profits to petitioner is followed by distribution and taxation of the partnership profits to the stockholders that it can be said that there is an understatement of taxes.
But we are by no means convinced that section 45 goes so far. The *1232 statute authorizes the Commissioner "to distribute, apportion, or allocate * * * between or among such organizations, trades or businesses," but it does not specifically authorize him "to combine." Certainly, the Commissioner's own regulations, section 19.45-1, Regulations 103, negative the use of section 45 for the purpose of combining or consolidating the separate net income of two or more organizations, trades, or businesses, as it states:
* * * It [sec. 45] is not intended (except in the case of computation of consolidated net income under a consolidated return) to effect in any case such a distribution, apportionment, or allocation of gross income, deductions, or any item of either, as would produce a result equivalent to a computation of consolidated net income *212 under section 141.
It is apparent that the Commissioner's action here has produced "a result equivalent to a computation of consolidated income." And even assuming that the statute does authorize the Commissioner to combine income under his power to distribute, apportion or allocate, it does not follow that section 45 also authorizes him to distribute as dividends to stockholders, who are separate and distinct entities from the corporation, the amount so allocated. 3*213 Nor does combining the income of the two businesses in petitioner, with its resulting increase in accumulating surplus without distribution thereof by dividends, necessarily bring section 102 into play. The evidence in this record indicates that petitioner may have a good defense against the application of that section, but, since section 102 is not before us, it is unnecessary to discuss this possibility.
Commissioner's final point is that the contract between petitioner and the partnership was not an arm's length transaction, but was a means or method of shifting profits for the purpose of evading tax. This contention, in our opinion, goes to the heart of the present controversy. There can be no doubt that the books and records herein clearly reflect the income of petitioner and the partnership. Nor can there be doubt as to the organization and existence of the partnership as a going concern. This brings us to the question of whether the contract between the partners was fair and reasonable. The heart of the contract is the compensation provision, and if the compensation agreed upon by the parties was fair and was fairly arrived at, it should be recognized and upheld for tax purposes. The compensation fixed by the contract was 50 percent of the invoice price, less prepaid freight charges. The Commissioner says that the testimony fails to disclose the exact factors which enabled the parties to agree on 50 percent instead of some other percentage, and he complains of the absence of evidence showing a value for the Double-Cola formula, the *1233 value of buildings, *214 or the return on invested capital, all of which, he says, are essential elements to be considered in arriving at a fair profit for the petitioner.
We doubt the need for such evidence even if it were available, and much of it would be unavailable. In our opinion the commission fixed in the contract should be examined and judged as to fairness by the services, duties and obligations imposed thereby on the partnership. Contrary to the Commissioner's argument, the consideration was not limited to the payment of $ 3,530.22 for office equipment and furniture. The partnership obligated itself to take over, manage, handle, and control all of petitioner's business pertaining to the advertisement, sale, and distribution of its products and in connection therewith to bear and pay all expenses and costs incident to rendering the following services: (1) Maintain and develop markets for the sale and distribution of petitioner's products; (2) supervise and service all bottling accounts, and do all things necessary to increase the sale and consumption of petitioner's products by the bottlers; (3) enlarge and extend the territory and market of bottlers, secure new bottling accounts, and render financial *215 aid and assistance where new bottling plants were established; (4) design, execute, and manage advertising campaigns for the sale and consumption of petitioner's products; (5) watch the credit rating and standing of bottlers, bill and collect from them for merchandise sold, keep an accurate record of statements mailed and collections made, and make settlements periodically with the petitioner. That the assumption of these obligations by the partnership was as much a part of the consideration as the cash payment for the office furniture and equipment would seem so obvious that no citation of authority is necessary.
Furthermore, there is testimony and documentary evidence in the record to the effect that prior to entering into this contract petitioner was expending yearly an average of approximately 48 percent of its manufacturing profits for advertising, selling, and promoting services. Since the plan and contract contemplated the foregoing and other services to the bottlers, the commission fixed does not appear to be out of line with petitioner's own experience. On this basis the transaction would seem to be fair and entitled to classification as an arm's length transaction. Whether *216 any such business agreement would have been entered into by petitioner with total strangers is wholly problematical. Petitioner was not seeking new blood or new capital in its business. It was seeking a solution of its merchandizing difficulties. It is entirely consistent, therefore, that the stockholders of petitioner in creating a new business organization to solve these difficulties would place the control thereof in the people most familiar and intimate with the problem. To say that the predominant purpose of a business *1234 enterprise so conceived and created was tax evasion places an undue emphasis upon incidental results that is entirely foreign to the stated purpose of Congress in enacting section 45.
Although the Commissioner's determination and argument are bottomed upon the authority conferred upon him by section 45, he also contends that the existence of the partnership should be ignored. While this contention is not set up in the alternative, we deem the matter of sufficient moment to merit discussion. As hereinabove indicated, petitioner's stockholders created a partnership and its existence in fact can not be denied. The question is, should its existence be ignored *217 for tax purposes? The Commissioner's determination recognizes the existence of the partnership, its conduct of a business, and the receipt of income to the extent of its deductible expenses. But, when he comes to the question of taxing petitioner's profits, the Commissioner wants to ignore the partnership's existence. The authorities, we believe, do not support the Commissioner's position.
In Nichols & Co. v. Secretary of Agriculture (C. C. A., 1st Cir.), 131 Fed. (2d) 651, it was held that a partnership composed of members who were stockholders in a corporation of the same name and whose interests in the partnership were identical with their stock interest in the corporation could not be disregarded by the Secretary of Agriculture in administering the Commodity Exchange Act.
In Ross v. Commissioner (C. C. A., 5th Cir.), 129 Fed. (2d) 310, reversing 43 B. T. A. 1155, the Circuit Court pointed out that in tax matters it is only under exceptional circumstances that the separateness of a corporation from its stockholders can be disregarded. It was there held that where a corporation's business consisted of selling horses and mules at auction for a commission and the principal stockholder *218 and other corporate officers carried on a separate partnership business of buying horses and mules at auction, the aggregation of the two separate businesses for income tax purposes was not justified, notwithstanding the fact that the partners were working at the same time for the corporation and for themselves and as between themselves divided corporate and partnership earnings on a similar basis. The Commissioner made no determination in the Ross case that section 45 applied; he simply held the partnership income to be part of the corporate income. Upon remand to the Tax Court the Commissioner contended that section 45 applied, but this contention was rejected in a memorandum opinion rendered September 18, 1943.
The question which occurs more frequently is whether a corporate entity should be ignored for tax purposes. On principle the rule would seem to be the same, whether a partnership or a corporation is involved. Asiatic Petroleum Co. ( Delaware) Ltd., supra;National Securities Corporation, supra;G. U. R. Co., supra;Welworth Realty Co., supra;*1235 Pennsylvania Indemnity Co., 30 B. T. A. 413; affirmed per curiam, 77 Fed. (2d) 92, and Majestic Securities Corporation, 42 B. T. A. 698; *219 affd., 120 Fed. (2d) 12, are all cases in which the separate corporate entity was ignored for tax purposes. None of them is comparable to or controls the present situation. In our opinion we should recognize the separate existence of the partnership just as the separate existence of individual, partnership, estate, and corporate enterprises was recognized in Briggs-Killian Co., supra;Nichols & Co. v. Secretary of Agriculture, supra;Ross v. Commissioner, supra;Essex Broadcasters, Inc., supra;Robert Gage Coal Co., 2 T. C. 488; Koppers Co., 2 T. C. 152; Burnet v. Clark, 287 U.S. 410">287 U.S. 410; Burnet v. Commonwealth Improvement Co., 287 U.S 415; Interstate Transit Lines, 319 U.S. 590">319 U.S. 590; Moline Properties Inc., 319 U.S. 436">319 U.S. 436.
Actually, the principal force behind all of the Commissioner's argument is that the petitioner could as well have done all the things that the partnership did and reaped all of the earnings of the related enterprises. Since petitioner could have had the earnings, the Commissioner would make it so by exercising the authority conferred by section 45. The same type of argument was made in the Koppers case, supra, which rejected the argument in language equally apt to the present *220 contention, due allowance being made for factual differences, p. 158:
The answer, however, to this argument is that petitioner did not do this. It was free to and did use its funds for its own purposes. It was under no obligation to so arrange its affairs and those of its subsidiary as to result in a maximum tax burden. On the other hand it had a clear right by such a real transaction to reduce that burden. Helvering v. Gregory, 293 U.S. 465">293 U.S. 465; Chisholm v. Commissioner, 79 Fed. (2d) 14; Commissioner v. Gilmore Estate, 130 Fed. (2d) 791; Coca-Cola Co. v. United States, 47 Fed. Supp. 109; Commissioner v. Kolb, 100 Fed. (2d) 920.
Here the stockholders used their separate funds to organize a new business enterprise which entered into a contract with the corporation to perform certain services for a consideration that we consider fair in the light of the previous experience of the corporation. Since there was no obligation on the stockholders to arrange their own and the petitioner's affairs so as to result in a maximum tax burden, cf. Stanley D. Beard, 4 T. C. 756, we should give effect to the realities of the situation and recognize the existence of the partnership, and we so hold. *221 Cf. J. R. Wood & Sons, Inc. v. United States, 46 Fed. Supp. 877.
Since other adjustments were involved in determining the deficiencies,
Decision will be entered under Rule 50.
Footnotes
1. Loss.↩
2. After adjustments of tax liability for 1939.↩
3. Fiscal year ended Sept. 30, 1941.↩
1. Fiscal year ended Sept. 30, 1941.↩
1. SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income or deductions between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.
2. Federal taxes paid upon original return. Discrepancies between these amounts and the amounts shown in our findings represent additional Federal tax payments.↩
3. In discussing corporate distributions in Putnam Estate v. Commissioner, U.S. (Mar. 28, 1945), the Supreme Court pointed out that corporate earnings are not available to stockholders "before the corporation makes those profits available." Similarly here, the Commissioner cannot substitute his action for the requisite corporate action.