*13 Decision will be entered for the respondent.
Where one of three partners sells his partnership interest to the other two partners, who thereby acquire all the partnership assets in equal proportion and the remaining partners then sell substantially all the partnership property to a corporation over 80 per cent of whose stock is owned in equal shares by the remaining partners, held, the income of the partnership during the base period years prior to the withdrawal of one partner can not be included in the base period income of the corporation for excess profits tax purposes. Regulations 112, section 35.740-4, approved.
*994 This case involves deficiencies in excess profits taxes for the calendar years 1942 and 1943 in the respective amounts of $ 22,611.38 and $ 92,623.04.
Two questions are presented:
1. Was petitioner an "acquiring corporation" and were the seven partnerships acquired by petitioner "component corporations" within the meaning of section 740 of the Internal Revenue Code so that petitioner may include the average base period net income of the partnerships in computing its excess profits credit under the average earning method for the years 1940 to 1943, inclusive?
2. If so, have the base period net incomes of the partnerships been properly adjusted to reflect reasonable deductions for salaries or compensation of the partners?
FINDINGS OF FACT.
Petitioner is a corporation, incorporated under the laws of Texas, with its principal office in Fort Worth, Texas. *15 Its books are kept and *995 its Federal income and excess profits tax returns are filed on an accrual basis, and on the basis of the calendar year. The returns involved herein were filed with the collector of internal revenue for the second district of Texas, at Dallas.
Petitioner was originally incorporated in or about the year 1919 as "Renfro Drug Store No. 5," with authorized and issued capital stock of $ 28,000. It has since engaged in the drug business at Fort Worth, Texas. In 1939, petitioner increased its authorized capital stock from $ 28,000 to $ 433,000 and, through the issuance of such increased capital stock, it acquired the assets and business of some twenty-one partnerships and two corporations, all of which were engaged in the drug business. Among these partnerships so acquired was one group referred to as the Horn group, which also were known as Stores Nos. 2, 8, and 16. There was another group designated the Wren group, being also designated as Stores Nos. 1, 9, 15, and 20.
The owners of the Horn group, on January 1, 1939, were Inez Renfro, having a three-eighths interest; her daughter, Inez Renfro Allen, having a three-eighths interest; and Joe L. Horn, *16 having a one-fourth interest. The partnership agreements in all of the Horn and Wren partnerships were oral.
In August 1939 Inez Renfro and Inez Allen agreed verbally to buy out the Horn interest, the purchase to be effective as of August 31, 1939, at the book value as it appeared on that day, to be arrived at by an agreed formula. This formula could not be put in operation until after the effective date, so that it was not until September 23, 1939, that the actual bill of sale was made, but it was effective as of the close of business August 31, 1939. Horn received a total cash consideration of $ 34,681.25 for his one-fourth interest and for some corporate stock and property of undetermined value included in the bill of sale.
On October 28, 1939, Inez Renfro and Inez Allen gave a bill of sale for the assets and business of the Horn partnership to petitioner. The bill of sale, however, was effective as of the beginning of business on October 1, 1939. The vendors received therefor 364 shares of the common capital stock of petitioner, to be issued and delivered one-half thereof to Inez Renfro and one-half to Inez Allen. The bill of sale to petitioner included all of the profits*17 and business of the Horn partnership stores, except accounts receivable from a wholesale purchasing house operated on a cooperative basis by all of the Renfro Drug Stores, in the amount of $ 60,689.81, together with liquor and wines of the total inventory value of $ 2,212.75 and permits for the sale thereof. These two items of accounts receivable and liquor and wine were retained by Inez Renfro and Inez Allen as their personal property.
At January 1, 1939, Inez Renfro, Inez Renfro Allen, and C. L. Wren were equal partners, each owning a one-third interest in the four separate *996 partnerships known as Renfro Drug Stores Nos. 1, 9, 15, and 20.
In October 1939 Inez Renfro and Inez Allen entered into a verbal agreement to purchase the interest of Wren in the partnerships with which he was connected. It was agreed that this sale should be effective as of December 31, 1939, and that Wren should receive the book value of his interest in the partnerships as of the close of business on that day, according to a formula agreed upon by the parties. To operate this formula time was necessary after the close of business on the effective date, so that a bill of sale was not actually delivered*18 by Wren to Inez Renfro and Inez Allen until February 3, 1940.
On February 14, 1940, Inez Renfro and Inez Allen conveyed to petitioner solely in exchange for 574.33 shares of the common stock of petitioner corporation, to be issued one-half to Inez Renfro and one-half to Inez Allen, all of their interest in and to the business properties and the partnerships of the Wren stores. The bill of sale to petitioner from Inez Allen and Inez Renfro was effective as of the close of business December 31, 1939.
The $ 19,144.65 paid to Wren for his interest in the Wren partnerships was advanced by petitioner corporation on behalf of Inez Renfro and Inez Allen, but these advancements were subsequently repaid to petitioner and the actual cash outlay to Wren was borne by Inez Renfro and Inez Allen personally.
The base period net income of the seven stores included in the Horn and Wren groups was as follows:
| Store No. | 1936 | 1937 | 1938 | 1939 |
| 1 | $ 2,682.15 | $ 1,182.39 | ($ 1,080.89) | ($ 1,123.81) |
| 2 | 9,181.99 | 13,103.34 | 11,940.32 | 6,505.50 |
| 8 | 1,903.66 | 3,381.22 | 2,256.24 | 936.70 |
| 9 | 9,448.82 | 12,452.56 | 12,405.59 | 8,216.35 |
| 15 | 6,165.63 | 4,235.84 | 3,141.26 | 1,807.50 |
| 16 | 4,355.92 | 6,184.14 | 5,616.66 | 1,936.89 |
| 20 | 2,819.19 | 2,991.83 | 3,760.31 | 1,159.17 |
| Total | 36,557.36 | 43,531.32 | 38,039.49 | 19,438.30 |
*19 After the transfer to petitioner of the Horn stores and also of the Wren stores, Inez Renfro and Inez Allen owned in equal amounts more than 80 per cent of the authorized issued and outstanding capital stock of petitioner corporation. The cooperative purchasing organization of the Renfro stores paid Horn $ 300 a month from the beginning of the base period to August 1, 1936, and then $ 400 a month until September 1939. Wren was paid by the wholesale house $ 300 per month from August 1, 1936, through 1939. Both of these men divided their time between working at the wholesale house and in supervisory duties throughout the Renfro stores generally. The wholesale house, upon payment of the salaries to these men, charged 40 per cent *997 thereof pro rata among all of the Renfro stores in proportion to the amounts of goods purchased by each retail store from the cooperative organization. At the end of the accounting period the remaining 60 per cent of said salaries was accounted for to the retail stores when the income from the cooperative wholesale establishment was divided among the retail stores in proportion to their purchases.
Each retail store of the Horn and Wren groups employed*20 a manager and an assistant manager, each of whom was paid out of the partnership funds, but Inez Renfro and Inez Allen rendered no services for the partnership and received no compensation. The only compensation which Horn and Wren received from the stores in which they had a partnership interest were the pro rata contributions of said stores to the general salary of Horn and Wren, as employees of the cooperative wholesale house.
Partnership returns on Form 1065 were filed for Stores Nos. 2, 8, and 16 for the month of September 1939, listing Inez Renfro and Inez Renfro Allen as partners. Each of these returns stated that a return was filed by the partnership for the preceding year, and the returns for Stores Nos. 8 and 16 stated that the date of organization of these partnerships was 1919 and 1929, respectively. Do date of organization was given in the return for Store No. 2.
OPINION.
Petitioner contends that it is entitled to include the base period net income of the Wren and Horn partnerships in computing its excess profits credit under the average earning method for the years 1940 to 1943, inclusive, as provided in sections 740 and 742 of the Internal Revenue Code. The pertinent*21 provisions of these sections (and of section 112 (b) (5), referred to therein) are set forth in the margin. 1
*22 *998 The Commissioner contends that the partnerships whose property was acquired by petitioner were the partnerships consisting only of Inez Renfro and Inez Allen, and that the two sets of partnerships in which Horn and Wren, respectively, were partners, are not under the statute "component corporations" of petitioner. The Commissioner argues therefore that the income of the Horn and Wren partnerships during the base period years can not be included in the computation of petitioner's base period income for excess profits tax purposes.
The Commissioner relies upon a regulation which he prescribed under authority granted in section 742 (g) of the code, which regulation was published in Regulations 112, section 35.740-4, and reads as follows: "A partnership (or a business owned by a sole proprietor) cannot be an acquiring corporation."
Petitioner relies on Ransohoffs Inc., 9 T. C. 376, to support its contention that it is entitled to the business experience of its component partnerships during the base period years, even though a member of those partnerships withdrew therefrom before the partnerships' assets were acquired by petitioner corporation.
*23 The essential facts in Ransohoffs Inc., supra, were quite similar to those at bar, except that in that case the partnership agreement specifically provided that the partnership (not the partnership business only) should continue after the death or withdrawal of a partner. In deciding that case this Court laid primary emphasis upon this agreement among the partners. We have no such agreement in the case at bar, and the reasoning in the Ransohoff case therefore does not apply to the case at bar.
*999 It is obvious that with the sale of the Horn and Wren interests to Inez Renfro and Inez Allen one of two events occurred. Either there was then created a new partnership of Renfro and Allen which acquired the assets of the two sets of old partnerships, or the assets of the old partnership were acquired by Inez Renfro and Inez Allen in joint proprietorship. In either event the property of the Horn and Wren groups of partnerships passed through the hands of a partnership or of individuals who could not, under the statute and regulations, transfer to the corporation the business experience of the Horn and Wren partnerships during the base period *24 because the intervening proprietors were not "acquiring corporations" as defined in the Internal Revenue Code.
The regulation of the Commissioner, supra, which we deem reasonable within the statutory authorization and which has been in existence since 1941, properly interdicts the inclusion of the business experience of the partnerships herein involved in the base period income of petitioner for the purpose of computing excess profits taxes.
There is an additional reason which prevents the Horn partnerships from being component corporations of petitioner. Section 740 (a) (1) (D) provides that the acquiring corporation must acquire substantially all of the properties of a partnership in an exchange to which section 112 (b) (5) is applicable. The evidence discloses that Inez Renfro and Inez Allen did not transfer all of the properties of the Horn group of partnerships to petitioner, and that the properties retained by them consisted of accounts receivable amounting to $ 60,689.21 and wines and liquors having a value of $ 2,212.75. The record is silent as to the actual value of all of the properties of this group of partnerships on the effective date of the transfer, August 31, *25 1939. We do know that Horn owned a one-fourth interest in these partnerships and that the amount he was to receive for that interest was to be based on book value on the effective date. For his one-fourth interest and some other property of undetermined value, he received $ 34,681.25, which would indicate that the book value of the properties of these partnerships was not in excess of $ 138,725. Inasmuch as the value of the assets retained by the Renfro-Allen interests amounted to approximately $ 63,000, petitioner has not sustained its burden of proving that it acquired "substantially all the properties" of the Horn group of partnerships.
It is not, therefore, entitled to use their base period experience in computing its excess profits credit for the taxable years.
Decision will be entered for the respondent.
Footnotes
1. SEC. 740. DEFINITIONS.
For the purposes of this Supplement --
(a) Acquiring Corporation. -- The term "acquiring corporation" means --
(1) A corporation which has acquired --
* * * *
(D) substantially all the properties of a partnership in an exchange to which section 112 (b) (5), or so much of section 112 (c) or (e) as refers to section 112 (b) (5), or to which a corresponding provision of a prior revenue law, is or was applicable.
* * * *
(b) Component Corporation. -- The term "component corporation" means --
* * * *
(5) In the case of a transaction specified in subsection (a) (1) (D), the partnership whose properties were acquired.
SEC. 742. SUPPLEMENT A AVERAGE BASE PERIOD NET INCOME.
In the case of a taxpayer which is an acquiring corporation, its average base period net income (for the purpose of the credit computed under section 713) shall be the amount computed under section 713 or the amount of its Supplement A average base period net income, whichever is the greater. The Supplement A average base period net income shall be the amount computed without regard to subsection (h) of this section or computed under subsection (h) of this section, whichever is the greater. The Supplement A average base period net income shall be computed as follows:
* * * *
(g) In the case of a partnership which is a component corporation by virtue of section 740 (b) (5), the computations required by this Supplement shall be made, under rules and regulations prescribed by the Commissioner with the approval of the Secretary, as if such partnership had been a corporation. * * *
SEC. 112. RECOGNITION OF GAIN OR LOSS.
(a) General Rule. -- Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section.
(b) Exchanges Solely in Kind. --
* * * *
(5) Transfer to corporation controlled by transferor. -- No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. * * *
* * * *
(h) Definition of Control. -- As used in this section the term "control" means the ownership of stock possessing at least 80 per centum of the total combined voting power of all classes of stock entitled to vote and at least 80 per centum of the total number of shares of all other classes of stock of the corporation.↩