*2169 1. Where under contracts a corporation agrees to pay some of its employees a fixed annual salary plus a percentage of its profits for services rendered, it may not deduct from gross income each year, as additional compensation for services rendered, the amount of profits credited to the account of such employees in the absence of proof that the contingencies to which the credits are subject are not present.
2. Respondent's allowance of salary to petitioner's officers not disturbed, because of lack of evidence showing the amounts to be unreasonable.
*1206 This proceeding was instituted to redetermine the following deficiencies in income taxes:
| 1922 | $3,690.13 |
| 1923 | 1,514.86 |
| 1924 | 4,128.89 |
| 1925 | 3,757.82 |
The issues are whether certain sums credited to the accounts of the managers of petitioner's business are deductible as compensation for services rendered, and whether the salaries paid to two of petitioner's officers represent reasonable compensation for services rendered.
FINDINGS OF FACT.
The wholesale grocery business*2170 of the petitioner was started in 1884 by E. C. Field and W. H. Start, and was operated by them as partners until 1917, when it was incorporated under the laws of the State of New York. The business prospered and during the taxable years was the largest of its kind in the central part of New York. Since 1917 the petitioner's yearly sales have averaged about $1,750,000; its inventory and accounts receivable have averaged approximately $350,000 and $200,000, respectively, and it has had from 45 to 50 employees.
For some time prior to 1921, Field and Start, president and treasurer, respectively, of the petitioner since its incorporation, desired to be relieved of the details of the business. To accomplish that object, on January 1, 1921, they and the petitioner entered into a written agreement with F. O. Jones, A. C. Thomas, and C. H. Roberts, employees of petitioner, hereinafter to be referred to as the *1207 "managers," in which the managers agreed to devote all of their time towards the active management of the business and Field and Start agreed to relinquish in favor of the managers "the active charge and control of the corporation business, retaining, however, general*2171 supervision and direction of the affairs of the corporation." Field and Start agreed to leave in the business the capital represented by their respective stockholdings, and the managers agreed to contribute to the petitioner an undisclosed amount in excess of $16,000. Field and Start also agreed to give the managers the benefit of their experience and advice whenever sought but reserved to themselves the right to decide questions of policy and the amount of time they should devote to the affairs of petitioner.
The agreement provided for an annual salary of not to exceed $3,000 to each of the managers and a yearly payment of $11,323.52 each to Field and Start for "their investments, responsibilities assumed and services rendered and to be redndered by them," in connection with the petitioner's business. After the payment of these and other expenses of petitioner, and the setting up of a reserve for depreciation at the rate of $1,500 per year until the amount totaled $9,000, 80 per cent of any profits was to be credited to the joint profit accounts of the managers and thereafter held and used in accordance with the following provision of the agreement:
Of the remaining profits*2172 of the corporation, if any, eighty percent shall be credited upon the corporation's books to the joint profit account of parties of the third part, [managers] until such time as borrowed capital shall no longer be required for corporation business. At that time all future profits to the same amount shall be used for the purchase of shares of the capital stock of the corporation, at its book value as of January 1st, 1921, which stock parties of the second part, [Field and Start] hereby agree to sell at said price for cash to parties of the third part in such proportion as parties of the third part may mutually agree upon, among themselves, until a total of 49 percent of the capital stock is held by parties of the third part.
The remaining 20 per cent of petitioner's profits was to be distributed among the employees of petitioner.
The managers were to agree among themselves as to the amount of their contributions to petitioner and the ratios in which any net profits should be divided among them, with the provision, however, that the "total amount of the net profits so divided shall be charged against the joint profit account of the parties of the third part and not distributed*2173 until said joint account shall be used for the purchase of stock or otherwise distributed."
Clause eight of the agreement contained the following provisions:
This contract may be terminated in any of the following ways.
A. Parties of the third part may terminate this contract at the end of any fiscal year that they may so desire by giving sixty days' notice, in writing, to *1208 the parties of the first and second part of their election so to do, personally or by registered mail, on or before February first of any given year.
B. Parties of the first or second part may terminate this contract, at any time, at their option by giving sixty days' notice, in writing, personally or by registered mail to the parties of the third part of their election so to do.
In the event that this contract is terminated by either of the parties hereto, an inventory of the company and balance sheet shall be immediately prepared and if any shrinkage in the net worth of the corporation shall appear as compared with the net worth of the corporation on January 1st, 1921, said shrinkage shall be charged against the joint profit account, if any, of the parties of the third part.
If the*2174 joint profit account is insufficient to meet said shrinkage, resort shall be had to the individual credit accounts of parties of the third part and to the Reserve for Depreciation to make up any deficiency.
Party of the first part shall also be permitted to retain for fifteen months, to allow for any possible shrinkage in accounts receivable or otherwise not then forseen or allowed for, such further sums as parties of the third part may have to their credit, not however exceeding $15,000.00.
Any funds in excess of the above, standing to the credit of the parties of the third part, shall be returned to them upon termination of this contract and at the end of fifteen months an accounting shall be had of the $15,000.00 retained for further possible shrinkage and the same, less any sums deducted for actual shrinkage and depreciation, shall be returned to parties of the third part by party of the first part.
The agreement of January 1, 1921, remained in effect until superseded by a similar contract entered into by the same parties on January 1, 1924. Under the terms of the new contract Field and Start renewed their agreement to permit their investment in petitioner to remain in*2175 the business, and the managers agreed to contribute a total of $16,000 to petitioner, of which Jones was to contribute $6,000 and Roberts and Thomas $5,000 each. The contract increased the annual salaries of each of the managers to $3,600. The provision in the first contract for the payment of a specific sum each year to Field and Start was inserted in the new agreement without any change. The provision of the first contract relating to the crediting of 80 per cent of petitioner's profits to the joint account of the manager was revised to read as follows:
Of the remaining profits of the corporation, if any, Eighty Percent (80%) shall be used as a bonus to be distributed to the parties of the third part as follows: Six Sixteenths to Fred O. Jones, Five Sixteenths to Charles H. Roberts, Five Sixteenths to Adelbert C. Thomas and shall be credited upon the books of the corporation to be [the] individual bonus account of the parties of the third part until such time as borrowed capital shall no longer be required for corporation business. At that time all future bonuses to the same amount shall be used for the purchase of shares of the capital stock of the corporation, at its book*2176 value $323,529.23, which stock parties of the second part hereby agree to sell at said pro rata price for cash to parties of the third part in such proportion as parties of the third part may mutually agree upon, among themselves, until a total of 49 per cent of the capital stock is held by parties of the third part.
*1209 The provisions of the old contract relating to the termination thereof were altered in the new agreement to read as follows:
In the event that this contract is terminated by either of the parties hereto, an inventory of the company and balance sheet shall be immediately prepared and if any shrinkage in the net worth of the corporation shall appear as compared with the net worth of the corporation on January 1st, 1924, said shrinkage shall be charged against the bonus account of each of the parties of the third part in the same ratio as each has been credited with a bonus out of the eighty percent of the net profits.
* * *
Any one of the parties of the third part, with the consent of his two associates, may with-draw from this agreement upon the last day of any month by giving thirty days' notice in writing to the parties of the first and second part, *2177 and to his associates of the third part of his election so to do, personally or by registered mail, but not more than one of the parties of the third part may withdraw in any one fiscal year, without the written consent of parties of the second part.
In the event that one of the parties of the third part does so withdraw, his rights and interests herein shall be determined as from the last preceding inventory of party of the first part, plus any adjustment of drawing account for the current year.
If any shrinkage, in the net worth of the corporation, shall appear as compared with the net worth of the corporation on January 1st, 1924, said shrinkage shall be charged against the Bonus Account of the individual with-drawing and if said Bonus account is insufficient to meet said shrinkage, resort shall be had to his proportinate share of the Reserve for Depreciation and if that is insufficient then to his individual credit and investment accounts.
Party of the first part may retain for fifteen months after said withdrawal to allow for any possible shrinkage in accounts receivable or otherwise, not forseen or allowed, such further sum as said with-drawing party may have to his*2178 credit, not however exceeding $5,000.
Any funds in excess of the above shall be turned over to the withdrawing party, within thirty days after he has duly withdrawn and at the end of fifteen months after making due and proper allowance for any further depreciation and shrinkage, if any, said five thousand dollars retained or such portion thereof as may be due shall likewise to turned over to him.
The business of petitioner was operated under the contract of January 1, 1924, until December 31, 1925.
From 1922 to 1925, inclusive, the following amounts, representing 80 per cent of petitioner's profits for those years, were credited to the accounts of the managers:
| 1922 | 1 $8,389.33 |
| 1923 | 23,332.92 |
| 1924 | 17,474.98 |
| 1925 | 20,213.01 |
The profits earned in 1922 and 1923 were entered in an account designated "Undivided Profits," and the profits made in 1924 and 1925 were credited to the individual bonus accounts of the managers. *1210 The remaining profits made by petitioner during the taxable years were paid to its employees, in accordance with the terms of the contracts.
The managers*2179 devoted all of their time to the affairs of petitioner. Jones managed the business under the supervision of Field and Start; Thomas spent two days each week traveling and the remainder of his time in the office, and Roberts devoted four days each week traveling and the remainder in the office in the capacity of an assistant sales manager.
Field spent an average of one hour per day at the office attending to corporate affairs. His activities consisted of advising Jones on purchases; conferring with customers regarding complaints, accounts receivable and other corporate business affairs, and executing contracts as president. He also spent many evenings with Jones discussing the business of petitioner.
Start spent from 3 to 5 hours every day at petitioner's office looking after financial matters of the corporation, signing contracts, and supervising the activities of the office in general.
The amounts specified in the contracts to be paid to Field and Start each year, were paid.
The amount of profits placed to the credit of Jones for the years 1922 and 1923 was included in his return for 1923 as income for that year.
Thomas withdrew as one of the managers on December 31, 1925. *2180 Such sums as had been credited to his account, representing his share of petitioner's profits, were paid to him in cash.
During the taxable years, petitioner kept its books and reported its income on the accrual basis. In its returns for the years 1922 and 1923 the petitioner did not claim any part of the sums credited to the accounts of the managers as a deduction from gross income. The profits credited to the account for the years 1924 and 1925 were deducted from gross income as compensation for services rendered, and disallowed by the Commissioner on the ground that the amounts were not fixed liabilities of the petitioner and subject to the demands of the managers. Of the total of $22,647.04 claimed each taxable year as a deduction for salaries paid to Field and Start, the Commissioner allowed an annual salary of $5,000 to each officer, and disallowed the remainder.
OPINION.
ARUNDELL: The petitioner is claiming the right to deduct from gross income each taxable year as compensation for services rendered, the amount of profits credited on its books in favor of its managers, on the ground that upon determining the profits at the end of each *1211 year, the amounts*2181 payable to its managers under the contracts of employment became fixed liabilities of the corporation for the current year.
Since the petitioner kept its books and filed its returns for the taxable years on the accrual basis, to be entitled to the claimed deductions it must show that the liabilities were incurred in the respective years. . The liability to pay must be fixed and definite and not subject to indeterminable future events. ; affd., ; certiorari denied Oct. 21, 1929; and , affd., .
In each of the contracts of employment, Jones, Roberts, and Thomas, as compensation for their services in actively managing the petitioner's business, were to receive a stipulated annual salary, plus 80 per cent of the profits, computed as provided for in the agreements, such profits to be credited to the accounts of the managers until such time as the petitioner no longer required borrowed capital to operate its business. When the financial condition of the petitioner became*2182 such that it did not have to use borrowed money to conduct its affairs, future profits in an amount equal to the credits already made to the account of the managers were to be used for the purchase of petitioner's stock owned by Field and Start. The first agreement specifically provided that the profits credited to the account were not to be distributed by the managers until used for the purchase of petitioner's stock from Field and Start, "or otherwise distributed." This provision of the agreement was not inserted in the contract entered into on January 1, 1924.
Upon the termination of the agreements in the manner provided for therein, the managers were not to receive any distribution of profits unless the credits made in their favor for prior earnings, less losses sustained in the operation of the business, exceeded any reduction in the net assets of the petitioner from the date of the agreement under which the business was being operated at the time, to the date of termination, and then only to the extent of the excess credits. The amount of profit standing to the credit of the managers was, therefore, always subject to be reduced or wiped out entirely by future losses in the*2183 business. The loss sustained by the business during the year 1921 was deducted from the profit earned in 1922 before the excess was credited to the undivided profit account set up on the corporate books pursuant to the first agreement.
The agreement entered into January 1, 1921, was terminated at the close of the year 1923. The record does not disclose what kind of a settlement, if any, was made with the managers at that time. In his brief counsel for the petitioner admits that no part of its *1212 profits was paid to any of the managers during the taxable years, and the fact that petitioner did not deduct any of the credits made for 1922 and 1923 profits in its return for the latter year or the year 1924, would indicate, if any inference is to be drawn from the fact, that it did not regard itself as being obligated to the managers for any definite amount. A cash settlement was made with Thomas subsequent to his withdrawal as a manager on December 31, 1925, but we have not been informed as to the amount of the payment or the date it was paid.
We find nothing in the agreements or other evidence of record contrary to the conclusion reached by the respondent at the time*2184 of his determination of the deficiencies in controversy that no part of the profits of petitioner was to become payable to the managers prior to the time when "borrowed capital shall no longer be required for corporation business." The petitioner appears to have been of the same opinion during the life of the first agreement since no part of the profits earned in 1922 and 1923 was claimed as a deduction in income-tax returns for those years.
As we have pointed out, the payment of additional salary prior to the termination of the contracts of employment was conditioned upon the need for borrowed money in the business, and the liability of the petitioner on the withdrawal of any one or more of the managers depended upon whether or not there had been any reduction in the net assets of the corporation and whether accounts receivable decreased in value within the next fifteen months. No evidence was submitted in value within the next fifteen months. No evidence was submitted to prove that borrowed capital was not required in the business at all times during the taxable years. We are also without information as to the value of petitioner's net assets at the time the contracts were*2185 entered into and at the close of each year, and the amount retained by the petitioner at the close of the year 1925 as a protection against any shrinkage in the value of accounts receivable. Without these facts we can not say that the petitioner was at any time during the taxable years liable to its managers for the payment of any part of the amounts being claimed as deductions.
The petitioner has failed to overcome the presumption in favor of the respondent's determination. Accordingly, we must affirm his action.
In determining the deficiencies involved here, of the total of $22,647.04 paid each year to Field and Start, one-half to each, and claimed as salary deductions, the respondent allowed a yearly salary of $5,000 to each officer and disallowed the remainder. In his answer filed herein, the respondent claims error in allowing such salaries as deductions and alleges that no salary deductions should be allowed for these officers. At the hearing, the petitioner amended its petition *1213 by alleging error on the part of the respondent in not allowing the full amount paid.
The agreements under which the claimed deductions were paid provided for a payment each*2186 year to each officer of $11,323.52, which amount was not only to compensate them for services rendered to petitioner but included a return on their investments in the business, represented by their stock. We do not know the amount or value of their investments, or what the parties to the agreements regarded as a fair return on money Field and Start had invested in the business. The testimony of Jones, the only witness at the hearing, that the services of each officer were worth from $10,000 to $15,000 during each taxable year, is too indefinite to accept as the basis for an allowance, in view of the fact that some part of the amount paid each year was regarded as a return on the investment of each officer.
The officers did perform some service for petitioner during each of the taxable years before us, and the latter is entitled to deduct a reasonable amount of compensation paid to them for services rendered. The respondent has failed to show that the amounts allowed by him are unreasonable. Under these circumstances, we will not disturb the respondent's action in allowing a deduction of $5,000 as salary each taxable year for each officer.
A final order will be entered finding*2187 the deficiencies in the amounts determined by the respondent.
Footnotes
1. After taking into account a loss of $29,265.53 for 1921. ↩