*3983 1. Determination that salaries of $15,000, each, for the four active executive officers of the petitioner were reasonable.
2. Hatzel & Buehler and Russum & Co. held to have been affiliated corporations in 1919 and 1920.
3. Certain losses and bad debts held not deductible.
*993 The respondent has asserted deficiencies in income and profits tax for the years 1919 and 1920, in the respective amounts of $18,660.64 and $5,970.15. The issues are, (1) whether the Commissioner exceeded his authority in reopening the case; (2) reasonableness of salaries paid to executives; (3) whether petitioner and Russum & Co. were affiliated in the taxable years; and (4) whether certain losses and bad debts are deductible from the petitioner's gross income for the taxable years.
FINDINGS OF FACT.
Petitioner is a New York corporation, organized and incorporated in 1917, having its principal office in the city of New York during the years here involved. The capital stock of the company consisted of 500 shares, of which John C. Hatzel owned 254, Allen Coggeshall*3984 82, Harry J. Kurrus, 82, and Charles Metzger 82. It has at all times since its incorporation been engaged exclusively in the business of electrical engineering and contracting, which has included every phase of electrical construction and installation, such as electrical power plants, fire alarm systems, light, telephone and call bell systems, save, as appears in these findings when for about two years it assisted in organizing and conducting a corporation, the *994 principal business of which consisted in securing and executing building contracts with E. I. DuPont de Nemours Co. and allied interests.
The corporation is one of the largest four companies in similar business which during the times here involved operated in the eastern part of the United States. Its four organizers and stockholders, who were also its executive officers, with one exception, were electrical engineers of experience who for many years prior to the organization of petitioner had held important positions with other companies. Its president, John C. Hatzel, was a man sixty years of age who had entered the subfreshman school of the College of the City of New York in 1873. Afterwards, he spent a*3985 short time at Annapolis and at sea and in May, 1881, began work in the Edison laboratories and around the Edison electric works and was later sent around the country installing isolated electrical plants for the Edison Company. In 1884 he was sent to Baltimore as superintendent of construction covering the southern district from Baltimore to New Orleans. In 1888 he accepted a position with the Western Edison Co., which required his presence in Denver. This company was not financially successful. His salary there was $8,000 per year, only a part of which was paid. In 1889 he entered into a partnership with Joseph Buehler under the firm name of Hatzel & Buehler, which continued until 1911, when Buehler retired from business. The partners had drawn from the income only so much as to satisfy their actual needs and built up a capital of approximately $300,000. The average profits of the firm during the last ten years of this period were about $40,000 per year. Hatzel continued the business alone for about six years, but due to severe illness he was obliged to neglect it somewhat until 1917, when he regained his health and associated with himself Coggeshall, Kurrus, and Metzger and*3986 incorporated with them under the name of Hatzel & Buehler, Inc.
Coggeshall, vice president of the corporation in charge of engineering and construction, was thirty-seven years of age in 1919. He was graduated from Columbia University, New York City, in 1903, with the degree of electrical engineer. During his college course he did electrical work with the Western Electric Co. and the New York Edison Co. and some private work one summer. On graduating, he passed an examination and was appointed as subinspector in the equipment department of the Brooklyn Navy Yard. From there he went as assistant professor of electrical engineering to the Ohio State University, and after two and one-half years there, he went to the Plant Department of the New York City Telephone Co., Long Island division. Becoming ill, in 1909 he visited New Mexico and on his return took a position as estimator *995 and sales engineer with the L. K. Comstock Co., of New York, one of the largest electrical companies in the United States, at a salary of $65 per week. He remained there on a meager salary until 1917, when with two of his associates he joined in incorporating petitioner company.
Kurrus, *3987 secretary and sales manager, devoted his time to securing and managing the business of the company, taking charge of the men, running the jobs and seeing them through to completion. At the age of nineteen he had started in with the George A. Fuller Co. as office boy, typist, bookkeeper and estimator, taking care of their pay roll and time sheets. In 1904 the company gave up its mechanical department and discharged all of its one hundred or more employees in that department, except Kurrus, whose salary it doubled. Among those discharged was L. K. Comstock, who, having gone into business for himself, offered Kurrus the same salary he was then receiving, with the promise of an increase and an interest in the business, which offer the latter accepted. During the whole thirteen years he worked for this company he held the highest position in his branch of the service. As the company grew it took on more employees but they all worked under him. When he left the company in 1917, he was its sales engineer and it was doing a business of more than $1,000,000 per year. Dissatisfied with his position and also his compensation, which was at that time $5,420 per year, he resigned and assisted*3988 in the organization of the petitioner. During 1918 he devoted all of his time to the installation, etc., of electric work in the plants of the DuPont people at Wilmington, Del., sometimes remaining steadily in the building for from ten days to two weeks, working from ten to fifteen hours per day and going directly from his office to his bedroom, which was in the same building.
Metzger, petitioner's treasurer, had charge of all receipts and disbursements and bookkeeping and was familiar with all financial matters connected with the business. He also came from the Comstock Company, where he had been actively engaged as an officer and director for ten years, and assisted in the organization of the petitioner. Like the other three stockholders and officers, he was familiar with all of the business of the company, but unlike those three, he was not an electrical engineer. Each of the four had the same salary as the others.
When these four men incorporated Hatzel & Buehler, they agreed that until they had placed their business on a solid foundation and accumulated sufficient capital to run it without being inconvenienced from lack of funds, they would only draw just enough from*3989 the company's treasury for necessary living expenses, and they adhered to this agreement. In February, 1919, they increased their respective *996 salaries to $10,000 per year and on December 15 of that year the board of directors adopted the following resolution:
Resolved, that each of the officers of the company receive as additional compensation for his services during the year 1919, the sum of $5,000 to be credited to his account at once, to be paid by the treasurer upon request of such officer.
Like salaries were voted for the year 1920. The compensation so voted was paid and credit therefor claimed in petitioner's tax returns for the respective years. Respondent disallowed the claim as to $5,000 for each of the four - a total of $20,000 for each of the two years. From this disallowance the petitioner has appealed. For the same year J. Livingston & Co. paid all its officers salaries of $15,000 each, which was much lower than they had been before, owing to losses sustained, etc. The Lord Electric Co. paid its president $24,000 and each of its other three executive officers $18,000. The presidents of both of these companies deposed that they considered $15,000*3990 salaries too low for the services rendered. The president of J. Livingston & Co. received a salary of $35,000 for the year 1926.
During the years 1917 to 1920 petitioner was continuously employed under contract with the E. I. DuPont de Nemours Power people in the installation of electric work in their buildings at wilmington, Del. F. W. Russum was department superintendent of construction for the DuPont Company at Wilmington. Harry J. Kurrus, secretary of Hatzel & Buehler, was in charge of sales and installation for the DuPont Company and became quite well acquainted with Russum. Early in 1919 reports became current that the DuPont people had purchased an interest in the General Motors Co. and were going to enlarge their plants throughout the country and spend millions in building construction. Kurrus conceived the idea that his company should join with Russum in the organization of a construction company, Russum to use his influence with the DuPont people in securing construction contracts from them. It was thought that this would have the way for petitioner to secure was thought that this would pave the way for petitioner to secure his scheme to his fellow officers and they*3991 approved. The matter was then taken up with Russum, with the result that an agreement was reached to form a company under the name of F. W. Russum & Co., Building Constructors and General Contractors. The agreement is as follows:
MEMORANDUM OF AGREEMENT made this 29th day of March, 1919, between HATZEL & BUEHLER, INC., a corporation of the State of New York, party of the first part, and
F. W. RUSSUM, of Wilmington, Delaware, party of the second part,
*997 WITNESSETH:
WHEREAS: The party of the second part desires to organize a general contracting corporation, for which purpose working capital is needed, and
WHEREAS: The party of the first part is prepared to furnish such capital and financial backing as is hereinafter referred to,
NOW, THEREFORE, in consideration of the mutual promises hereinafter set forth, it is agreed as follows:
FIRST: That the party of the first part will cause to be formed, at its own expense, to be later reimbursed from funds of the new company, a general contracting corporation to be known as "F. W. RUSSUM COMPANY", the principal purpose in organizing which will be to secure and execute building contracts for E. I. du Pont de Nemours & *3992 Company and allied interests, but shall not be limited to such work.
SECOND: The capital stock of such company shall be One Hundred and fifty thousand ($150,000.) dollars par value. Said stock shall be divided into Fifty thousand ($50,000.) dollars preferred, and One hundred thousand ($100,000.) dollars common stock. The preferred stock shall be entitled to a cumulative six per cent. dividend and shall be preferred over the common stock both with respect to dividends and assets on dissolution, but shall have no voting power. Twenty-five thousand ($25,000.) dollars of said preferred stock shall be subscribed for by the party of the first part and paid for in cash upon the commencement of business. If during the first two years of the operation of the company additional capital shall be needed, the party of the first part shall purchase additional preferred stock not to exceed Twenty-five thousand ($25,000.) dollars in par value.
The total issue, to wit, one hundred thousand ($100,000.) dollars, of the common stock, full paid and non-assessible, shall be issued to the party of the second part for a consideration acceptable to the directors of the corporation. In consideration*3993 of the furnishing of the capital herein provided for, the party of the second part shall transfer to the party of the first part seventy-five thousand ($75,000.) dollars of the common stock so issued to him.
THIRD: The party of the second part shall be the president of the company, which office shall carry with it the general directional powers that usually go with that office in general contracting corporations. The party of the first part shall select the treasurer of the company. The Board of Directors shall consist of the party of the second part, one of the officers or directors of the party of the first part, the individual nominated by the party of the first part to hold the office of treasurer, and a fourth person to be agreed upon by the parties to this contract.
FOURTH: The party of the second part shall have the privilege at any time during which he is actively connected with the company, of purchasing from the party of the first part common stock held by it at the book value thereof up to but not exceeding twenty-four per cent. to be retained by him as above provided for, making in all a maximum of forty-nine per cent. to be held by him.
The acquisition of any*3994 further stock by the party of the second part shall be left to future agreement, but in the event that either of the parties to this contract desires to dispose of the whole or any part of its or his stock holdings, it or he shall offer such stock to the other party to this contract at the book value thereof and afford it or him a reasonable opportunity to purchase same before disposing of said stock elsewhere.
FIFTH: The salary of the party of the second part for the first year shall be ten thousand ($10,000) dollars, it being understood, however, that he will actually draw as much less than this amount as conditions from time to time warrant.
*998 SIXTH: The party of the second part shall devote his entire time to the interests of the F. W. Russum Company and shall not do any acts or form any other connections which shall be derogatory to the interests of the party of the first part or the corporation to be formed under the terms of this agreement, while he is connected with said company.
SEVENTH: The party of the first part shall pay to the party of the second part ten per cent, of the net profits realized on electrical contracts secured by it after the formation*3995 and incorporation of said company, and while the party of the second part is actively connected therewith, from any of the du Pont interests and on all other electrical contracts secured through the influence and efforts of the party of the second part, except work done for the F. W. Russum Company or the owner on a cost plus percentage basis. This percentage shall be paid so long as the parties hereto are interested in the stock of the F. W. Russum Company, in the proportion above agreed upon. In the event that the party of the second part acquires a greater stock interest in said F. W. Russum Company, the percentage to be paid under this clause of the contract shall be proportionately decreased.
IN WITNESS WHEREOF the parties above named have hereunto set their hands and seals the year and day first above written.
HATZEL AND BUEHLER, INC.,
By JOHN C. HATZEL,
President.
F. W. RUSSUM.The company organized in accordance with the agreement and was promptly incorporated. Petitioner purchased all the preferred stock, paying therefor $30,000 in cash. The common stock was issued and divided between the two parties to the organization, petitioner receiving $75,000*3996 and Russum $25,000 thereof. No payment therefor except good will, was made or promised.
Soon after the organization of this company, Russum's health failed to such a degree that he was unable to give any attention to the business and it was a failure almost from the beginning. Toward the close of 1919 a firm of certified public accountants employed by the petitioner, having made an audit of the books of account of Russum & Co., furnished petitioner with a statement of their audit showing a loss by the company of $11,523.33. Petitioner charged the amount off on its own books and in making up its tax return for that year deducted it from its income as an ascertained and charged off loss. Respondent disallowed the deduction.
December 31, 1920, the $30,000 paid into Russum & Co. by petitioner for its preferred stock and $8,500 which it had loaned the company and held its promissory note therefor, were gone and the company had neither cash nor credit. Russum was sick and could not give the business any attention. Petitioner received statements either monthly or quarterly from the accounting firm, showing the financial condition of the company and had its own bookkeeper cover*3997 the company's books. Petitioner's treasurer visited the company's office quite often and kept in constant touch with its financial *999 condition. It had placed another man at the head of the company in order, if possible, to save something from the wreck, but at the end of the year, having ascertained beyond peradventure that the company had no property whatever save some $360 worth of furniture and absolutely no funds in its treasury, on December 31, 1920, it charged off the remainder of the $30,000 it had paid for the preferred stock and also the face value of the promissory note above referred to, and deducted this from its income reported in its tax return for the year 1920. Respondent disallowed both of these deductions.
Petitioner admits that the deduction of the $11,523.33 was erroneous for 1919, but now claims a deduction for 1920 of the whole amount of $30,000 invested by it in the preferred stock of Russum & Co. This stock was worthless at the close of 1920.
The $8,500 promissory note charged off bears date March 22, 1920, and was made in favor of petitioner by Russum & Co. for money totaling that amount advanced the latter company by petitioner on January*3998 20, February 17, and February 26, 1920. Petitioner appeals from the disallowance of the deduction of this amount.
During the year 1920 petitioner bought for F. W. Russum a washing machine and two vacuum cleaners for the total price of $432.72, paid the bill and took his promissory note for the amount. At the close of the year Russum had failed to meet the obligation and was insolvent and unable to pay any part of it. Petitioner charged the amount off December 31, 1920, as a bad debt and deducted it from its income for that year, and respondent disallowed the deduction. From this disallowance petitioner appeals.
In January, 1921, petitioner did some "extra work like putting up partitions and fittings and decorating" in connection with one of the Russum & Co. contracts, for which it received compensation. The building itself had been completed before this time and the Mowry Restaurant with which the contract was made was "on its last legs." In 1922 petitioner received $359.08 as the result of the sale of some furniture belonging to Russum & Co. Other than these two amounts, it has received nothing from or on account of Russum & Co. since December 31, 1920. The petitioner*3999 still has the stock of Russum & Co., but it is worthless.
Under date of June 28, 1924, respondent mailed to petitioner a 60-day letter informing it that an examination of its income and profits-tax returns and of its books of account and records had disclosed that the two companies were affiliated within the purview of the Revenue Act of 1918 during the years 1919 and 1920 and asserted against it an additional tax of $2,186.02 for the year 1920 resulting *1000 in a net additional tax of $1,890.12. Petitioner did not appeal from the deficiency stated, and no further correspondence was had with regard to it until October 3, 1925, when the respondent mailed petitioner another 60-day letter holding that the two companies were not affiliated during the year 1919 and asserting a deficiency in tax amounting to $18,660.64. On December 14, 1925, respondent mailed petitioner another 60-day letter holding that the two companies were not affiliated during the year 1920 and asserting a deficiency of $5,970.15 in taxes for that year. The petitioner has appealed for both these years from the action of the respondent in reconsidering the question of affiliation.
OPINION.
LANSDON: *4000 The issues of this proceeding will be determined in the order in which they are stated above.
Since we hereafter hold that the petitioner and Russum & Co. were affiliated during the years 1919 and 1920, we make no decision on the first point.
For the second our determination is in favor of the petitioner. The salaries of $15,000 per year were not at that time in excess of reasonable compensation for services performed by competent and experienced officials devoting their whole time to the business of a great corporation. The officers receiving these salaries were especially qualified by natural ability and experience for the services devolved upon each. These men had spent from fifteen to twenty-five years in preparation for the work in which they were engaged and for the year 1919 for the first time received salaries commensurate with the services rendered. The salaries paid in each of the taxable years were no more than reasonable compensation for the services rendered.
The petitioner and Russum & Co. filed separate returns for each of the years 1919 and 1920. The respondent examined these returns, considering in connection with his examination a report of one of the*4001 agents made February 19, 1922. After 44 days spent in examining petitioner's books, etc., on June 28, 1924, respondent sent petitioner a 60-day letter stating that he had decided that the two companies were affiliated during both years. In October, 1925, without further evidence, he sent petitioner another 60-day letter stating that the companies were not affiliated during 1919 within the intent of the law, and, in December, 1925, another 60-day letter stating that they were not so affiliated during 1920. From these 1925 letters, petitioner appeals, contending that they were affiliated during both years.
*1001 The stock ownership in the two companies was distributed as follows:
| Russum & Co. | |||
| Owner | Hatzel & Buehler (Inc.) | Common | Preferred |
| Shares | Per cent | Per cent | |
| John C. Hatzel | 254 | ||
| Allan Coggeshall | 82 | ||
| Harry J. Kurrus | 82 | ||
| Chas. Metzger | 82 | ||
| Hatzel & Buehler (Inc.) | 75 | 100 | |
| F. W. Russum | 25 |
This without more would not justify the conclusion that the two companies were affiliated within the requirements of section 240(b) of the Revenue Act of 1918, especially in view of the fact that the preferred stock was without*4002 voting privilege. But the "Third," "Fourth" and "Seventh" sections of the "Memorandum of Agreement," we think, justify a decision that substantially all the stock of the two corporations was owned or controlled by the same interests in the taxable years.
Except the personal debt of $432.72 due to petitioner, the questions raised on the fourth point are settled by our decision that the petitioner and Russum & Co. were affiliated in each of the taxable years. The losses and bad debts claimed, except as noted, all resulted from intercompany transactions which must of necessity be reflected in the consolidated returns which the affiliated companies are entitled to file for each year in question here. The debt of $432.72 was ascertained to be worthless and charged off in 1920 and is a proper deduction from gross income for that year.
Reviewed by the Board.
Judgment will be entered on 20 days' notice, under Rule 50.