*3039 1. Reasonableness of salaries determined.
2. Bonus paid by petitioner to its stockholders held to constitute a distribution of profits.
*4 This proceeding is for the redetermination of deficiencies in income and excess-profits taxes asserted by the respondent for the fiscal years ending March 31, 1921, and March 31, 1922. The deficiencies arise from the disallowance of bonuses paid to the stockholders during the taxable years and from the disallowance of an alleged loss with respect to certain patents. The amounts of the deficiencies are $3,817.39 and $3,354.21 for the taxable years, respectively.
FINDINGS OF FACT.
In 1919 there was formed in Los Angeles, Calif., a corporation known as the Bastian Combination Water Heater Co., for the purpose of manufacturing and selling water heaters. Preferred stock of the company was issued as follows:
| Shares | |
| W. B. Bastian, For patents and patent applications | 90 |
| R. L. Hinckley, For cash | 90 |
| G. B. Hinckley, For cash | 90 |
| D. H. Smith, For cash | 90 |
| C. A. W. Beach, For cash | 90 |
*3040 *5 With each share of preferred there was also issued, as a bonus, four shares of common stock, of a par value of $100 per share.
At the time of organization, W. B. Bastian entered into an agreement with the other four stock subscribers. The parts of this agreement which are pertinent to the question involved in this proceeding, are as follows:
WHEREAS, the Manager, (W. B. Bastian) has had many years experience in the manufacture and sale of water heaters and other devices,
* * *
In consideration of one dollar ($1.00) to him in hand paid the Manager agrees to transfer to said company when formed all patents now applied for, owned or controlled by hin and all patents relating to future improvements in such devices made by said Manager during his connection with said company, the Company agreeing as a further consideration for the transfer of said patents to issue to said manager immediately upon the formation of said Company preferred stock having a par value of nine thousand ($9,000.00) and common stock having a par value of thirty-six thousand ($36,000.00) dollars.
III.As a further consideration for the transfer of said patents and for the services of said*3041 manager, the Company shall agree to pay said Manager two per cent. (2%) of the net selling price received by said Company on any and all devices made and sold by said Company. Settlement of Commissions to be made quarterly on the 10th day of January, April, July and October. It is understood that the Manager shall receive for his services as General Manager of the Company, such salaries and expenses as may be later agreed upon by the Board of Directors.
Early in January, 1921, Bastian sold his stock to the other four stock subscribers and retired from the company. At about the same time the two Hinckleys bought from Beach his stock. The 2 per cent commission payable to Bastian by the contract with him was, after his retirement, paid to the two Hinckleys and to Smith in equal proportions.
Bastian had been general manager of the company, R. L. Hinckley was president, Smith was vice president, and G. B. Hinckley was secretary-treasurer. On January 3, 1921, after Bastian retired, the two Hinckleys and Smith, being the owners of all the outstanding stock, met as directors and by resolution fixed their compensation for the fiscal year ending March 31, 1921; on January 4, 1922, they*3042 had a similar meeting to fix compensation for the fiscal year then *6 drawing to a close. Smith owned 25 per cent of the stock and each of the Hinckleys owned 37 1/2 per cent. The compensation granted and common stock held by each, are shown in the following tables:
| Table of stockholding and compensation claimed fiscal year ended March 31, 1921 | ||||
| Compensation claimed | ||||
| Stockholders | Shares of common stock held | Salary | Bonus | Total |
| R. L. Hinckley | 540 | $5,000.00 | $2,787.40 | $7,787.40 |
| G. B. Hinckley | 540 | 5,000.00 | 2,787.40 | 7,787.40 |
| D. H. Smith | 360 | 3,333.33 | 1,858.26 | 5,191.59 |
| 13,333.33 | 7,433.06 | 20,766.39 | ||
| Fiscal year ended March 31, 1922 | ||||
| Compensation claimed | ||||
| Stockholders | Shares of common stock held | Salary | Bonus | Total |
| R. L. Hinckley, vice president | 641 | $5,000 | $3,983.33 | $8,983.33 |
| G. B. Hinckley, treasurer | 641 | 5,000 | 3,983.33 | 8,983.33 |
| D. H. Smith, president | 457 | 3,750 | 2,643.33 | 6,393.33 |
| 13,750 | 10,609.99 | 24,359.99 | ||
In July, 1921, a new corporation, the petitioner herein, was formed to take over the Bastian Company.
R. L. Hinckley was a wholesale and retail dealer*3043 in plumbing supplies. As a director and officer of the Heater Company he attended directors' meetings, visited the place of business once or twice a week, and pushed the sales of the heater among the plumbing trade. In making such sales, he made the usual dealer's profit; and the Heater Company paid one-half of his cost of advertising the heater. He also devised some improvements respecting the heater.
G. B. Hinckley had been an accountant. His services to the Heater Company at first consisted of looking after purchases, signing checks, and three or four times a week he visited the plant to overlook the business generally. He kept no regular business hours at the plant. He attended directors' meetings. After Bastian left, he gave his entire time to the Heater Company business.
Smith was manager of the Glendale Branch of the Los Angeles Trust & Savings Bank. He arranged with his bank for a line of credit for the Heater Company, attended its directors' meetings, and put it in touch with prospective customers.
The respondent disallowed the bonuses paid as above set forth, on the ground that the salaries paid were ample for the services rendered. After the evidence was*3044 in, and before the hearing was closed, *7 the respondent moved to amend his answer herein filed by inserting an allegation that the salaries paid to Smith and the two Hinckleys were not earned by any services performed; that any services performed were fully compensated by the 2 per cent commission on net sales. This motion was allowed.
The following table shows the net income of the Heater Company for the taxable years, the compensation claimed, and the income balance after paying such compensation:
| Fiscal year | Net income before deducting alleged compensation | Amounts claimed as compensation | Net income after deducting alleged compensation |
| Mar. 31, 1921 | $24,156.48 | $20,766.39 | $3,390.09 |
| Mar. 31, 1922 | 29,837.95 | 24,359.99 | 5,477.96 |
The petition also alleged error with respect to disallowance of a claimed loss on some of the Bastian patents, but his point was abandoned at the hearing.
OPINION.
MARQUETTE: Section 234(a) of the Revenue Act of 1921 reads in part as follows:
SEC. 234. (a) That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
(1) All the ordinary*3045 and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, * * *
The services rendered to the petitioner and to its predecessor by the two Hinckleys and by Smith were for the most part no more than would be rendered by anyone who was a large stockholder and a director in a business enterprise. That such services were beneficial to the petitioner is very likely. They doubtless contributed materially to the success of the enterprise. But they did not take up all the time and attention of these three men, nor interfere with their earning capacity in their regular vocations. R. L. Hinckley profited, as any other merchant would profit, by the sales of heaters which he accomplished; Smith brought business to his bank by giving the Heater Company its line of credit. Neither of these activities constituted, we think, any such "service actually rendered" as would warrant the payment to Smith of approximately $5,200 for the first year and approximately $6,400 for the second year; nor the payment to R. L. Hinckley of approximately $7,800*3046 and $9,000, respectively, for the years in question. The same is true *8 of G. B. Hinckley, at least up to January 3, 1921, when Bastian left the company and Hinckley took over the duties of general manager. For this work the directors voted a salary $300of per month; that amount was not unreasonably large.
The last table set out in the findings of fact, above, shows, in our opinion, a great disproportion between net income and compensation to these three men. See ; Universal Milking Machine Co., 4. B.T.A. 506. The bonus voted to themselves is apparently based upon their stockholdings, and has all the indications of being a dividend distribution thinly disguised. In , this same question was before the Board, and in construing section 234 of the 1921 Revenue Act, it was said:
* * * It is not the policy of the law to allow a corporate taxpayer to deduct amounts paid in the form of compensation when, in reality, such payments amount to a distribution of profits or are made in lieu of the payment of dividends. When, as in this case, profits are distributed*3047 to the owners of all of the stock in proportion to the number of shares held by each, and claimed as deductions in addition to the regular compensation fixed by the directors, the evidence offered that such payments were in fact reasonable compensation for personal services actually rendered must be convincing, especially where the sole stockholders constitute the board of directors.
This very accurately describes the situation in the present proceeding; and the respondent was right in disallowing the bonus for each of the taxable years as a deductible expense.
In our opinion, also, the salaries fixed by the directors for themselves as officers were inordinately large, when considered in relation to the very meager services performed and in relation to the net income of the company. Allthings considered, we think that deductions for salaries should be as follows:
| For year ending March 31, 1921: | |
| To R. L. Hinckley | $2,500 |
| G. B. Hinckley | 3,000 |
| D. H. Smith | 2,000 |
| For year ending March 31, 1922: | |
| To R. L. Hinckley | $2,500 |
| G. B. Hinckley | 3,600 |
| D. H. Smith | 2,000 |
See *3048 . The petitioner's income taxes for the years in question should be recomputed upon the basis indicated in this opinion.
Judgment will be entered under Rule 50.