*47 Decision will be entered for the respondent.
The Commissioner, in his determination of the deficiencies in these proceedings, allowed the wholly owned subsidiary of petitioner a deduction of $ 4,753 as ordinary and necessary business expenses representing the amount which the subsidiary paid to petitioner in reimbursement for the time which its officers and employees devoted to the subsidiary's business affairs. He disallowed as a deduction to the subsidiary one-third of the subsidiary's gross income from royalties paid over to the petitioner within the taxable year under contract entered into between petitioner and the subsidiary, and claimed by the subsidiary as an ordinary and necessary business expense. Held, the action of the Commissioner is sustained.
*1025 The proceeding in Docket No. 3505 involves the determination by the respondent of a deficiency of $ 2,712.68 in the consolidated excess profits tax of petitioner and its wholly owned subsidiary, Atlantic Monthly Press, Inc. (hereinafter sometimes called "Press"), for the fiscal year ended April 30, 1941. The proceeding in Docket No. 3506 involves the liability of petitioner, as transferee, for deficiencies in *1026 income and declared value excess profits taxes of Press for the fiscal years ended April 30, 1940 and 1941, as follows:
| Deficiency | Apr. 30, 1940 | Apr. 30, 1941 |
| Income tax | $ 22.34 | $ 8,309.04 |
| Declared value excess profits tax | 1,113.86 |
Petitioner concedes that it is liable as the transferee of property of Press for the payment of the income tax deficiency for the fiscal year ended April 30, 1940, and for the payment of any income and declared value excess profits taxes for the fiscal year ended April 30, 1941, plus interest on any such taxes as provided by law which may be due from Press as a result of our determination of the remaining issue, which is raised*49 in both proceedings by appropriate assignments of error. This issue is whether the respondent erred in refusing to allow Press a deduction as an ordinary and necessary expense the amount of $ 23,814.69 in computing the net income of Press for income and declared value excess profits tax purposes for the fiscal year ended April 30, 1941, and in computing the consolidated excess profits net income of petitioner and Press for the same fiscal year, which amount Press paid petitioner during the said fiscal year in accordance with a certain agreement entered into between petitioner and Press on February 3, 1941. The respondent also made other adjustments which are not contested. The deficiency of $ 22.34 for the fiscal year ending April 30, 1940, is conceded. The two proceedings were consolidated.
FINDINGS OF FACT.
Petitioner is a corporation and the Atlantic Monthly Press, Inc., was a corporation, each with its principal office in Boston, Massachusetts. The books of petitioner and of Press were kept on the accrual basis. Returns for the fiscal year ended April 30, 1941, were compiled on the accrual basis and filed with the collector for the district of Massachusetts. At all times*50 during the life of Press petitioner owned all of its capital stock. The assets of Press have been assigned to petitioner, and petitioner has assumed all the liabilities of Press, including that of all Federal taxes ultimately found to be due from Press.
Petitioner was incorporated in 1908 for the purpose of publishing the Atlantic Monthly Magazine (hereinafter sometimes referred to as the magazine). The magazine had been founded about 1857 by James Russell Lowell, and its early contributors included Ralph Waldo Emerson, Thomas Bailey Aldrich, William D. Howells, Henry James, Bret Harte, John Burroughs, John Fiske, and others. The magazine has a large domestic and foreign circulation, and for many years has *1027 enjoyed a reputation for high literary standards. As a result of this reputation, and because of established contacts with authors, large numbers of manuscripts were submitted to petitioner. Some of the manuscripts were not suitable for publication in the magazine but were suitable for publication in book form. Since petitioner did no book publishing, many of these manuscripts suitable for publication in book form were secured and published by other publishing houses*51 without payment to petitioner. In 1917 petitioner decided to form a publishing house for the purpose of handling the book output of authors contributing to the magazine. Press was incorporated to carry out that purpose.
From the time of its organization in 1917 until January 1925 Press conducted its own complete book-publishing business, making contracts with authors for the publication of their manuscripts, arranging for and financing the printing, advertising, selling, and distribution of its books.
On February 19, 1925, a contract to which both petitioner and Press were parties was entered into with Little, Brown & Co., a book-publishing concern. This contract effected the transfer to Little, Brown & Co. of all books theretofore published and still owned by Press, together with the plates, cuts, dies, and the like of all such books and also the exclusive right to use the name "The Atlantic Monthly Press" in connection with the publication of books and the colophon. Under this contract petitioner agreed to use its best efforts to bring to the attention of Little, Brown & Co. all material suitable for publication in book form which might come to its attention through the publication*52 of material in the magazine or otherwise, before offering the same for publication to any other publisher. Press agreed to edit the manuscripts of new books, to answer proofreaders' queries with respect thereto, to recommend suitable formats, bindings and jackets, and to advertise such publications in the magazine. All other expenses of manufacturing, advertising, and marketing were assumed by Little, Brown & Co. The latter agreed to pay royalties to Press based on the retail sale prices of all books published by it as Atlantic Monthly Press publications. After entering into this contract Press discontinued all of its operations except the securing of authors and putting their manuscripts in proper shape for publication in book form. This contract covered a period of ten years from its date. The period was thereafter extended between Press and Little, Brown & Co. from time to time, and, with modifications not here material, the contract between Press and Little, Brown & Co. remained in force throughout the taxable year in question. During the negotiations between Press and Little, Brown & Co. in August 1939 looking toward the extension of the original contract, officials of*53 Little, Brown & Co. insisted that in any new contract it should be provided that if the magazine were sold *1028 or absorbed by another party, Little, Brown & Co. would have the right, if it chose, to terminate the contract.
During the taxable year in question the sole activity of Press was the securing of manuscripts from authors and the preparation of these manuscripts for submission to Little, Brown & Co. for publication, and its sole source of income was royalties from Little, Brown & Co. under the contract as extended.
Press attempted at various times to secure new authors and manuscripts through the activities of its own editorial staff, but the results from such efforts were meager. It consistently secured its most profitable book manuscripts from its close connection with petitioner. The magazine served as a testing ground for authors and, when one was found whose material was suitable for publication in book form, Press, by virtue of its connection with petitioner, was able to secure such manuscripts without the expense it would otherwise have had to incur for separate editors and unsuccessful publishing projects.
The magazine had contacts with many well known authors*54 and also specialized in the publication of manuscripts by hitherto unpublished authors. The editor of the magazine made a practice of writing to every contributor to the magazine who showed any potentiality of becoming a successful book author. When such an author achieved the ability to work on the longer book lengths, he was turned over to Press. None of the employees of Press did any of the editing on book manuscripts which had been written by authors who had contributed to the magazine. This editing or creative revision was done solely by the editors of the magazine. "Creative revision" is a type of editing which is entirely distinct from what is known as "copy editing," and it includes making suggestions for major alterations to the author, working them out in detail with the author, and other services of that kind.
On February 3, 1941, petitioner and Press entered into a contract which, except for the formal provisions and signatures thereto, is as follows:
Whereas the editorial and publishing staff of The Atlantic have devoted in the past and are continuing to devote a large amount of time and attention to the development of The Press, for which services The Press has *55 not adequately compensated The Atlantic, and without the services of The Atlantic in finding new manuscripts the continued successful operation of The Press would be very difficult, if not impossible; and
Whereas the publication of The Atlantic Monthly by The Atlantic is of the greatest value to The Press directly and indirectly in the operation of The Press; and
Whereas for some time there has been under consideration by the Directors of both companies arrangements for a fair compensation to The Atlantic for services directly or indirectly to The Press,
Now, Therefore, the parties hereto agree that The Press shall pay to The Atlantic for the fiscal year ending April 30, 1941, for services rendered and to *1029 be rendered during such year, an amount equal to one-third (1/3) of the gross receipts from royalties of The Press during such fiscal year, a first payment on account of $ 15,000. to be made on or before March 21, 1941, and the balance on or before April 30, 1941. Such payments shall be in addition to the reimbursement of The Atlantic for direct expenses by The Atlantic for The Press.
During the fiscal year ended April 30, 1941, Press received royalties from Little, Brown*56 & Co. of $ 71,444.07. It paid one-third of these royalties in the amount of $ 23,814.69 over to petitioner in accordance with the agreement of February 3, 1941. Press deducted this amount on its returns as an ordinary and necessary business expense. The respondent disallowed the deduction and in the statement attached to the deficiency notice in Docket No. 3505 said:
Royalties received by The Atlantic Press, Inc., and credited to the account of The Atlantic Monthly Company in 1941 in the aggregate amount of $ 23,814.69 do not constitute ordinary and necessary business expenses. Therefore, the deduction claimed for this item has been disallowed.
A similar explanation was made in the statement attached to the deficiency notice in Docket No. 3506.
The following statement introduced in evidence by petitioner shows the income and disbursements by Press for the fiscal year ended April 30, 1941:
| Income from Little, Brown & Company | $ 71,444.07 | ||
| Operating Expenses | |||
| Salaries and Wages | $ 16,382.01 | ||
| Prize Contests | 215.12 | ||
| Advertising | 3,089.34 | ||
| Editorial Expense | 3,500.62 | ||
| General Expense | 2,987.36 | ||
| Taxes -- Social Security | 580.24 | ||
| Mass. Excise | 750.00 | ||
| Capital Stock | 275.00 | ||
| Additional Charges by The Atlantic Monthly | |||
| Company for services and expenses for the year | 4,753.00 | 32,532.69 | |
| Operating Profit | $ 38,911.38 | ||
| Other Income | |||
| Discount Earned | 2.73 | ||
| Sales of Consigned Books | 76.49 | ||
| Bad Debts Recovered | 87.18 | ||
| Advances Charged Off | (50.00) | 116.40 | |
| $ 39,027.78 | |||
| Other Charges | |||
| Interest Paid | 1.73 | ||
| $ 39,026.05 | |||
| Loss 1/3 of Little, Brown & Co. Income | |||
| (1/3 of $ 71,444.07) | 23,814.69 | ||
| Net Income for Year (Before Federal Taxes) | $ 15,211.36 |
*57 *1030 Petitioner reported a net loss of $ 64,396.51 in its Federal income tax return which it filed for the fiscal year ended April 30, 1941.
Press had total receipts from Little, Brown & Co. of $ 185,877.37 during the three calendar years 1939, 1940, and 1941. Of this amount $ 108,506.74 was attributable to sales of books by authors originally secured by petitioner.
A charge was made against Press by petitioner to reimburse petitioner for certain direct out-of-pocket expenses which it had incurred on behalf of Press. During the fiscal year ended April 30, 1941, this amounted to $ 4,753. For the time of the editors of petitioner which was spent on activities of Press, this reimbursement was on a strictly time basis. This charge did not purport to reflect the value of the services of any of petitioner's officers other than on a time basis. It did not include the value of the contacts which the magazine had with authors.
Any part of the stipulation of facts not specifically set forth herein is incorporated herein by reference and made a part of these findings of fact.
OPINION.
The question remaining for our disposition is whether the amount of $ 23,814.69 paid by Press to *58 petitioner under the contract and attendant circumstances set out in our findings of fact is deductible by Press as an ordinary and necessary business expense. The applicable statute is section 23 (a) (1) (A) of the Internal Revenue Code, which is set forth in the margin. 1 Petitioner contends that the amount is so deductible, whereas the respondent contends (a) that under the facts of this case it was neither ordinary nor necessary for Press to have entered into the February 3, 1941, contract with petitioner; (b) that the payment of the claimed expense constituted a voluntary payment which Press was under no legal obligation to make; and (c) that in any event the payment was excessive and unreasonable in amount.
*59 The term "ordinary and necessary expenses" was construed by the Supreme Court in Welch v. Helvering, 290 U.S. 111">290 U.S. 111, in which the Court said:
We may assume that the payments to creditors of the Welch Company were necessary for the development of the petitioner's business, at least in the sense that they were appropriate and helpful. McCulloch v. Maryland, 4 Wheat. 316">4 Wheat. 316, 4 L. Ed. 579">4 L. Ed. 579. He certainly thought they were, and we should be slow to override his judgment. * * * Now, what is ordinary, though there must always *1031 be a strain of constancy within it, is none the less a variable affected by time and place and circumstance. * * *
Later, in Deputy v. Dupont, 308 U.S. 488">308 U.S. 488, the Supreme Court said that "ordinary has the connotation of normal, usual, or customary."
In the light of these discussions by the Supreme Court, can it be said that the $ 23,814.66 representing payment of one-third of the royalties received by Press in the fiscal year 1941 from Little, Brown & Co. was an ordinary and necessary business expense of Press paid or incurred during the taxable*60 year in carrying on its trade or business? We do not think under all the facts and circumstances present in this case that it can be so held. An examination of the statement printed in our findings of fact showing the income and disbursements of Press for the fiscal year ended April 30, 1941, will disclose that Press received royalties from Little, Brown & Co. aggregating $ 71,444.07. Of this amount it paid out as operating expenses items listed which aggregate $ 32,532.69. All of these items of expense respondent has allowed in his determination of the deficiencies. Among these items is one denominated "Additional charges by the Atlantic Monthly Company for services and expenses for the year, $ 4,753.00." Petitioner is contending that Press is not only entitled to have allowed to it as an ordinary and necessary business expense the foregoing item of $ 4,753, but it should also have allowed to it as ordinary and necessary business expenses the $ 23,841.69 shown in the statement as paid to Atlantic under the contract of February 3, 1941.
We think this latter payment falls into the category of the sort of payments which were made in Maine Central Transportation Co., 42 B. T. A. 350,*61 and claimed as business expenses. In that case the taxpayer was a wholly owned subsidiary of the Maine Central Railroad Co. and in the taxable years which were before us paid over all its net earnings except $ 500 in each year to the railroad company under a contract which it had entered into with the parent corporation in 1933 and claimed the payments as deductions for ordinary and necessary business expenses. We disallowed the deduction because it was not shown to be an "ordinary and necessary business expense."
It is true that in the instant case Press did not pay over to Atlantic all of it earnings except $ 500 as was done in the Maine Central Transportation Co. case; nevertheless, it seems to us that the nature of the $ 23,814.66 payment must be considered in the same category. Atlantic had organized Press as its wholly owned subsidiary to do the book publishing end of its business. It might well have kept this part of the business as a separate department of its own business without the organization of a separate corporation, but it did not choose to do it that way. It elected to do its book publishing business through a wholly owned subsidiary, which was, of course, *62 its right and privilege. However, we do not think that Press, after deducting payments to *1032 Atlantic as reimbursement for time spent by the officers and employees of Atlantic in helping to carry on Press business, could still further pay over to Atlantic one-third of its total income received from Little, Brown & Co. and deduct this latter amount as "ordinary and necessary business expenses."
The two corporations as between themselves could of course contract that such payments should be made, but this fact does not make such payments deductible under section 23 (a) (1) (A), supra. As we said in Eskimo Pie Corporation, 4 T. C. 669, 677:
It is not questioned by respondent, and we do not question the fact, that petitioner became obligated to make these so-called royalty payments by reason of the contract of June 1, 1937. The mere fact that an expense was incurred under a contractual obligation, however, does not make it the equivalent of a rightful deduction under section 23 (a). Interstate Transit Lines v. Commissioner, 319 U.S. 590">319 U.S. 590. * * *
On this issue we think the Commissioner must be sustained.
*63 Decision will be entered for the respondent.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) Trade or business expenses. --
(A) In General. -- All the ordinary 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; * * *↩