*2236 1. The petitioner is entitled to have its profits tax computed under the provisions of section 328 of the Revenue Act of 1918 for the period January 1 to May 31, 1919.
2. The petitioner is entitled to deduct accrued salesmen's commissions for the period january 1 to May 31, 1919, in the computation of its net income.
*1186 This proceeding is for the redetermination of a deficiency in income and profits taxes for the five-month period ended May 31, 1919, amounting to $36,617.18.
The petitioner alleges and contends that the respondent erred:
(1) In his failure to compute its profits tax under the provisions of section 328 of the Revenue Act of 1918, and
(2) In failing to allow as a deduction from income the amount of $5,886.26 representing commissions earned by salesmen in excess of *1187 their regular drawing allowance which were accruable but were not deducted in its return.
FINDINGS OF FACT.
The petitioner is a corporation organized and incorporated under the laws of the State of Georgia in 1900, and was engaged in the manufacture*2237 and sale of mattresses, spring beds, cots, and pillows, until it was acquired by the Simmons Co. in May, 1919, as hereinafter related.
At the invitation of the aforesaid Simmons Co., negotiations were first begun late in the fall of 1918 toward the acquisition of the petitioner's business by that company. It was not, however, until late in January or early in February of 1919, after the principal stockholders of the petitioner, J. H. Hirsch and H. M. Spitz, had discussed the matter that the petitioner communicated to that company that acquisition could be accomplished upon proper terms. The transaction was finally consummated by written agreement in May, 1919, effective as of January 1, 1919, and the petitioner's business was acquired through the surrender of its stock to the Simmons Co. for $1,400 a share, and the petitioner ceased to operate as Hirsch & Spitz Manufacturing Co. on June 1, 1919. It was understood and agreed that the Simmons Co. should take over the entire business, including the profits for the first five months, and pay the taxes thereon, excluding, however, certain Government bonds.
The capital stock of the petitioner was recorded on the books of account*2238 in the names of the following on January 1, 1919, and May 31, 1919:
| Shares | |
| Charles Franklin | 20 |
| Leo Weiss | 20 |
| J. H. Hirsch | 50 |
| H. M. Spitz | 120 |
| J. D. Spitz | 20 |
| Ralph Herzog | 10 |
| H. L. Campbell | 10 |
J. D. Spitz, who was a brother of H. M. Spitz, and Leo Weiss were traveling salesmen, and Charles Franklin was a salesman and office man. Herzog was also a salesman and H. L. Campbell was superintendent.
All of the foregoing employees, with the exception of Weiss and Campbell, started with the petitioner at its inception, all earning low salaries. They were told that if the company succeeded they would be compensated in some manner. After some years Hirsch and Spitz allotted certain of their shares to the employees, for which they paid nothing, with the understanding that the company would hold the stock until the earnings had paid therefor, when it would be delivered *1188 to the employees, which, in fact, was done after a time. Hirsch finally relinquished 100 shares of his holdings between the employees, Even Weiss and Campbell, who came to the petitioner afterwards, shared in this arrangement and the stock was sold to them under the same agreement. *2239 This was all done in recognition of, and to compensate those men for, their services, which had been performed at less than the true value thereof.
Prior to the sale to the Simmons Co. in 1919 the petitioner's products were sold under the following trade brands, developed and owned by the petitioner:
| Trade brands on mattresses: | Trade brands on springs: |
| Luxyoury. | Crimp Link. |
| Keystone. | Web Lock. |
| Cloverleaf. | Gold Medal. |
| Manhattan. | De Luxe. |
| White Knight. | Le Grande. |
| Hirsch and Spitz Special. | |
| Deer Point. |
The foregoing trade names were developed over the nineteen years of the petitioner's business and were well recognized in Georgia, Florida, North and South Carolina, and a small portion of Tennessee, Virginia, and Mississippi where it did business. They were advertised and illustrated in catalogues, newspapers, and upon bill boards. Most of its business was confined to Georgia and North and South Carolina.
After acquisition by the Simmons Co. it continued to use the trade names as they had formerly been used until the name of Simmons became familiar to the trade. All of said trade names were finally abandoned except Luxyoury, Cloverleaf, and Manhattan, *2240 which were continued in use under the firm name of Simmons Co.
The Simmons Co. employed from 130 to 140 salesmen during the period January 1 to May 31, 1919, covering every part of the United States. During that period those salesmen sold mattresses manufactured by the petitioner in addition to the line of merchandise manufactured and sold by their own company. None of the sales expenses incurred by the Simmons Co. in the sale of the petitioner's mattresses was allocated or charged to the petitioner.
The building in which the petitioner conducted its business, a two-story and basement of mill construction, on a lot 100 by 200 feet, facing three streets, with adjacent railroad frontage and containing 49,000 to 52,000 square feet of available floor space, was owned by Hirsch and Spitz personally. Before acquiring the property Hirsch negotiated a contract with the Southern Railroad to tunnel under the street in order to effect an entrance from the property of the petitioner to that of the railroad. A tunnel was constructed, at an *1189 initial cost of $1,200, which after two years caved in and was rebuilt with concrete at a cost of $2,800, the expense of which was borne*2241 by said Hirsch and Spitz. It was the understanding and agreement at that time that should this piece of property be closed the tunnel too would be closed. The railroad agreed to extend a receiving platform 20 feet and to give to the petitioner the exclusive right and use thereof as long as it continued in business; also the right to three car lengths of side track against said platform, which made possible the switching of all carload freight to the platform, where it was unloaded into the basement. This arrangement gave the petitioner the advantage of shipping over 90 per cent of its products over the Southern Railroad, and obviated the necessity for having to move its freight by horse and wagon. The property was so situated that the farthest retail store in Atlanta, by truck, was not more than 15 minutes distance. It was 12 minutes walking distance from the post office located in the center of the city. When the property was originally acquired that section of the city consisted mostly of shanties, but has since been built up and there are not located in the immediate vicinity such plants as the Western Electric & Manufacturing Co., American Can Co., and National Paper Co.*2242 Those three plants, with exception of the Western Electric & Manufacturing Co., were located there in 1919.
It was estimated by the petitioner that the location of its plant and the tunnel arrangement which it had with the Southern Railroad effected a saving to it of from $5,000 to $7,500 a year in drayage and expenses incident thereto.
Hirsch and Spitz rented the building to the petitioner at $259 a month for the five-month period under consideration, the highest rental ever charged. The peak rental for that period is accounted for by the fact that an addition, costing $3,500, was made to the building during the war. The owners computed the rent charge upon the basis of what they considered they should get as interest upon their investment.
Hirsch and Spitz received an offer of $10,000 for a release before the petitioner moved into the building. At or about this time investigation disclosed that 30 cents per square foot was the normal charge for ordinary floor space, but the charge for a manufacturing building would have been higher.
Hirsch and Spitz individually sold that land and building to the Simmons Co. for $75,000. The respondent determined the March 1, 1913, value*2243 of the land and building to be $20,000 and $51,732.15, respectively.
The monthly drawings of Hirsch and Spitz were $150 and $125, respectively, in 1901, and $100 and $175 in 1904. In 1908 the drawings were $400 each, and they remained the same in 1916. In 1917 *1190 when the employees were given stock they increased their salaries or drawings to $525 and $700, respectively, at which amounts they remained until the end.
Hirsch and Spitz were highly regarded by the Simmons Co. In fact that company had endeavored to interest both of them in a position in New York in August or September, 1918, and a salary of $50,000 for Spitz, as general sales manager was suggested, if he would leave Atlanta, but they did not accept, preferring to remain where they were.
After the Simmons Co. took over the business Hirsch and Spitz received salaries of $10,000, and bonuses of $5,000 each, which sums were increased to $15,000 salaries, and $5,000 bonuses.
The petitioner had no Government contracts during the period in question.
The earnings and expenses of the petitioner from 1901 to May 31, 1919, were as follows:
| Year | Earnings | Expenses |
| 1901 | $3,894.78 | $16,119.02 |
| 1902 | 12,575.70 | 20,272.38 |
| 1903 | 23,570.01 | 23,320.94 |
| 1904 | 30,831.12 | 28,121.20 |
| 1905 | 29,351.93 | 32,025.03 |
| 1906 | 40,122.28 | 40,148.96 |
| 1907 | 38,030.07 | 44,705.72 |
| 1908 | 13,895.94 | 42,505.84 |
| 1909 | 32,719.79 | 42,871.54 |
| 1910 | 31,041.14 | 47,265.86 |
| 1911 | $34,964.54 | $47,304.58 |
| 1912 | 38,965.07 | 49,727.19 |
| 1913 | 29,259.27 | 53,503.82 |
| 1914 | 17,224.31 | 47,712.41 |
| 1915 | 37,113.02 | 43,219.88 |
| 1916 | 50,950.51 | 51,037.14 |
| 1917 | 57,087.33 | 62,069.17 |
| 1918 | 60,585.45 | 82,413.04 |
| 5 months, 1919 | 90,222.74 | 24,772.41 |
*2244 The marked disparity in the ratio of expenses to earnings during the five months in 1919, as compared with the preceding years, is accounted for by the fact that the petitioner enjoyed the use of the Simmons Co. organization, particularly its 130 to 140 traveling salesmen, without any additional cost to it, as hereinbefore stated.
Subsequent to the acquisition by the Simmons Co. the Hirsch and Spitz division of the business earned the following profits:
| June 1 to December 31, 1919 | |
| (approx.) | $83,000.00 |
| 1920 | 124,948.22 |
| 1921 (loss) | 26,107.02 |
| 1922 | 68,193.52 |
| 1923 | 203,795.00 |
| 1924 | $257,168.00 |
| 1925 | 511,744.00 |
| 1926 | 438,786.00 |
| 1927 | 370,891.00 |
| 1928 | 186,883.00 |
The aggregate amount of the petitioner's capital, surplus and undivided profits for each of the years 1905 to 1918 is as follows:
| 1905 | $86,204.51 |
| 1906 | 113,826.79 |
| 1907 | 149,356.86 |
| 1908 | 163,252.80 |
| 1909 | 165,972.59 |
| 1910 | 179,913.73 |
| 1911 | 159,253.27 |
| 1912 | $165,718.34 |
| 1913 | 174,412.61 |
| 1914 | 156,656.92 |
| 1915 | 171,249.94 |
| 1916 | 187,200.45 |
| 1917 | 201,787.78 |
| 1918 | 234,373.23 |
*1191 The petitioner's oral agreement with its salesmen provided por a specified drawing account*2245 plus an amount equal to an average of 5 per cent of gross sales in excess of said drawings. The drawings were credited upon the books of account monthly and the commissions were credited or paid annually on December 31.
Salesmen's commissions earned in addition to drawing accounts for the period January 1 to May 31, 1919, amounted to $5,886.26. When the Simmons Co. took over the business of the petitioner it assumed the payment of that amount. No deduction was claimed therefor by the petitioner in the computation of its net taxable income.
The petitioner's books were kept and its return filed upon the accrual method of accounting.
The Simmons Co. reported the profits earned by the petitioner for the period January 1 to May 31, 1919, which, the respondent informed it, were incorrect. The petitioner thereupon filed a separate return, in which it showed:
| Gross income | $124,033.56 |
| Deductions | 28,878.95 |
| Net income | 95,154.61 |
| Invested capital | 221,164.94 |
The respondent's letter to the petitioner dated March 12, 1923, upon which the final deficiency notice was based, informed the petitioner that since no return had been filed for the period January 1 to May 31, 1919, the*2246 data for assessment had been taken from the revenue agent's report on the Simmons Co., and he found invested capital of $217,949.98, and net income of $90,222.74. The respondent's deficiency notice of December 18, 1926, out of which this action arose, informed the petitioner of the denial of its application for assessment of its profits tax under the provisions of section 328 of the Revenue Act of 1918, and it set forth a deficiency of $36,617.18, which is the amount in dispute.
OPINION.
MORRIS: The petitioner alleges and contends, and requests the Board to determine, that abnormalities, respecting both income and capital, exist within the meaning of subdivision (d) of section 327 of the Revenue Act of 1918, and that it is entitled to compute its profits tax under the provisions of section 328 of said act. That portion of section 327 urged for consideration reads:
SEC. 327. That in the following cases the tax shall be determined as provided in section 328:
* * *
(d) Where upon application by the corporation the Commissioner finds and so declares of record that the tax if determined without benefit of this section *1192 would, owing to abnormal conditions affecting*2247 the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross disproportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328. * * *
In support of its allegation that abnormal conditions are present in its capital and income the petitioner complains of the respondent's action in holding that it and the said Simmons Co. were not affiliated, for tax purposes, during the period January 1 to May 31, 1919, resulting in the exclusion of its taxable income from a consolidated return filed for said period, notwithstanding during such period it had the use and benefit of the large sales organization of the said Simmons Co. It is further contended by the petitioner that it had the use of its manufacturing building, which belonged to its principal stockholders, at a rate considerably below a fair and reasonable rental, and finally that during the period under consideration it had the use of its officers' services for less compensation than they were normally worth and entitled to.
The petitioner's business was organized in the year 1900 and*2248 it engaged successfully in the manufacture of mattresses, beds, cots, and pillows until it was acquired in 1919 by the Simmons Co., a manufacturer of mattresses. All of its capital stock was owned by its founders, Hirsch and Spitz, and certain of its principal employees, who because of their loyal services and in accordance with a promise that they would at some time be compensated for having served the company at low salaries during the earlier years of its existence, had been allotted a small number of shares by the founders of the business.
The Simmons Co., anxious to acquire the business of the petitioner, especially the services of its founders, began negotiations in the fall of 1918 which culminated in a written agreement being entered into in May, 1919, whereby the business of the petitioner was acquired by that company through the surrender of its capital stock for $1,400 a share, the purchase, according to said agreement, to take effect as of January 1, 1919, it being understood and agreed that the Simmons Co. should take over the business in its entirety, except certain Government bonds, including the profits for the first five months of 1919 upon which it should pay*2249 the taxes.
The Simmons Co., a nationally known enterprise, employed from 130 to 140 salesmen, dispersed throughout the United States, during the period January 1 to May 31, 1919, all of whom sold the petitioner's merchandise in addition to the merchandise sold by their own company. None of the sales expenses, however, incurred by the Simmons Co. in the sale of the petitioner's merchandise were allocated or charged to the petitioner. The petitioner's earnings for the *1193 entire year 1918 were $60,585.45, whereas for the first five months of 1919 they were $90,222.74, and its expenses for the entire year 1918 were $82,413.04, whereas for the first five months of 1919 they were $24,772.41. This marked disparity in the ratio of expenses to earnings during the five months in 1919 as compared with the preceding year or years, as we have already said in our findings of fact, "is accounted for by the fact that the petitioner enjoyed the use of the Simmons Co. organization, particularly its 130 to 140 traveling salesmen, without any additional cost to it, as hereinbefore stated."
It has been shown that the petitioner enjoyed the use of its manufacturing building, individually*2250 owned by Hirsch and Spitz, at a rent charge which was computed upon the basis of what they, as owners, should be entitled to as interest upon their investment, which, as a proven fact, was somewhat less than a fair and reasonable rental.
Hirsch and Spitz were men of proven and outstanding abilities in the business in which they were engaged, and particularly were they highly regarded by the Simmons Co. That company, as we have found, had endeavored to interest both of these men in positions in 1918, Spitz to receive a salary of $50,000 a year as general sales manager in New York. During the period here involved the salaries or drawings of Hirsch and Spitz were at the rate of $6,300 and $8,400 per annum, respectively. Upon the acquisition of the petitioner's business by the Simmons Co. they continued as employees and received salaries in the beginning of $10,000 and bonuses of $5,000 each, later increased to $15,000 and $5,000 each, respectively.
Therefore, the fact that there was a very close relationship between the petitioner and the Simmons Co. during the five-month period under consideration, its business having, as a matter of fact, been taken over as of January 1, 1919, enabling*2251 it to enjoy the full use and benefit of that company's organization and its large sales force, without any cost to it whatsoever, resulting in the disparity in income of which we have spoken hereinbefore; that the petitioner enjoyed the use and benefits of its manufacturing building at a considerably reduced rental; and the further fact that its officers and employees, who were responsible for its success, served the petitioner for salaries far below what they were normally entitled to and could have claimed, we believe, entitle it to the relief which it seeks and we hold, therefore, that its profits tax should be computed under the provisions of section 328 of the Revenue Act of 1918 for the period in question.
The issue numbered two herein is with respect to the failure of the respondent to allow a deduction of commissions earned by its salesmen in excess of their regular drawing accounts. The record *1194 shows that the petitioner was obligated to pay its salesmen a commission of 5 per cent of its gross sales in excess of certain specified drawings, and that they earned in addition to said drawings $5,866.26 for the period in question. *2252 Its accounting practice was to credit the amounts of drawings upon its books monthly and the commissions were credited or paid annually upon December 31. Since the petitioner was legally obligated to pay these commissions and since it appears that they were in fact earned, although paid by the Simmons Co., which assumed the petitioner's liabilities, and not by the petitioner, we are of the opinion that the respondent erred in disallowing the deduction. .
Reviewed by the Board.
Further proceedings will be had under Rule 62(c).
STERNHAGEN, SMITH, and MURDOCK dissent on the second point.