*1080 1. FRAUD PENALTIES - BURDEN OF PROOF. - In any proceeding involving the issue whether the petitioner has been guilty of fraud with intent to evade the tax, the burden of proof is placed upon the Commissioner by section 907(a) of the Revenue Act of 1924, as amended by section 601 of the Revenue Act of 1928, and must be sustained by a preponderance of the evidence, and this evidence must be clear and convincing. In these proceedings the Commissioner has not sustained the burden of proof and fraud penalties are denied.
2. DEDUCTIONS - SO-CALLED SALARIES AND BONUSES HELD NOT TO BE SUCH AND THEREFORE NOT DEDUCTIBLE. - In the taxable years certain payments were made to officers and employees of petitioners in a group known as Group I, in addition to their regular salaries which had been agreed upon and these so-called additional salaries and bonuses were immediately paid over to the president of the corporations as a part of a plan whereby the president was to accumulate a million dollars out of the profits of the businesses and then turn over the management to the members of said Group I and retire. Held, that such payments were in the nature of dividend distributions to the*1081 president of petitioners and were not allowable deductions to the corporations in determining their net income.
3. CONSOLIDATION OF ACCOUNTS. - Section 240(f) of the Revenue Act of 1926 permits consolidation of accounts only where the facts show that it is necessary to do so in order to make an accurate distribution or apportionment of gains, profits, income, deductions or capital between or among related trades or businesses owned or controlled directly or indirectly by the same interests. In these proceedings the facts show that the books of each corporation were separately kept and accurately reflected all items of income and deductions of each corporation. Under such circumstances respondent's action in making a partial consolidation of accounts and prorating certain expenses was error.
4. INCREASED DEFICIENCIES - SUFFICIENCY OF COMMISSIONER'S AFFIRMATIVE ALLEGATIONS. - Where the Commissioner's amended answer includes an appropriately framed prayer for an additional deficiency against one of petitioners, the prayer must have the support of specific claims in each case based on specific grounds. Cascade Milling & Elevator Co.,25 B.T.A. 946">25 B.T.A. 946, followed. *1082 Held, Commissioner's allegations of specific grounds are insufficient to support the claims made in his behalf as to one series of transactions and as to this claim for increased deficiency, he fails; held, further, that as to another series of transactions, the Commissioner's allegations of specific grounds are sufficient so far as pleadings go, but the evidence is not sufficient to sustain the burden of proof required under Rule 30 of the Board's rules of practice and the Commissioner's claim for an increased deficiency against one of the petitioners on these grounds is denied.
*667 In these proceedings, which have been consolidated, respondent has proposed the following deficiencies:
| Drawoh, | Sredies, Incorporated | Rehtam, Incorporated | ||||
| Incorporated | ||||||
| Year | Tax | Penalty | Tax | Penalty | Tax | Penalty |
| 1924 | $700.00 | $189.61 | ||||
| 1925 | 93.41 | 106.66 | ||||
| 1926 | $910.83 | $455.42 | 11,509.04 | $5,754.52 | 5,994.20 | $2,997.10 |
| 1927 | 1,756.12 | 878.06 | ||||
| Total | 910.83 | 455.42 | 14,058.57 | 6,632.58 | 6,290.47 | 2,997.10 |
*1083 The petitioners, whose corporate names are proper names spelled backwards, will sometimes hereafter be referred to as follows: Drawoh, Inc., will be referred to as Howard, Inc.; Sredies, Inc., as Seiders, Inc.; and Rehtam, Inc., as Mather & Co.
At the hearing the petitioners admitted the correctness of the respondent's determination for the years 1924 and 1925, and the respondent in his amended answer admitted that he erred in alleging that any part of the deficiency in Howard, Inc., was due to fraud with intent to evade the tax, and fraud penalty in that proceeding was abandoned. The remaining issues involved in these proceedings will be stated and discussed in the opinion.
FINDINGS OF FACT.
The three petitioners are Illinois corporations, with their principal offices and places of business in Chicago, Illinois. The first company to be organized was Mather & Co., and the organization of the two other petitioner corporations followed later. Some time prior to the year 1926 Seth Seiders purchased an interest in Mather & Co. and during the calendar years 1925 to 1927, inclusive, was the president and principal stockholder of the three corporations.
The businesses of*1084 the petitioner corporations were similar in nature but each catered to a somewhat different clientele. Each *668 corporation produced and sold a service designed to inculcate principles of successful work and to induce practical application of these principles. The media used were the printed word and pictures. Those who purchased, or subscribed to the service were entitled also to consult the petitioner corporations upon any specific problems arising in the field to which the service applied. The services were designed for use by industrial and commercial organizations.
Seiders, Inc., sold a service designed for department heads, consisting of a series of 78 weekly letters on the principles of supervision and good leadership and management. Mather & Co. had a service of illustrative posters which were to be displayed on the walls in various offices and departments. Howard, Inc., had a service of small posters which were placed upon the desks of salesmen and executives. These services were sold by salesmen on a commission basis. They were manufactured and designed in the offices of the three companies.
These services, as indicated by the sales of the companies, *1085 were popular. The gross sales, less return for services sold for the years 1926 and 1927, as shown by the consolidated profit and loss statement attached to the consolidated income tax returns, were as follows:
| Year | Seiders, Inc. | Mather & Co. | Howard, Inc. |
| 1926 | $686,824.13 | $714,895.87 | $275,586.22 |
| 1927 | 519,624.02 | 671,548.41 | 266,952.72 |
The cost of creation and manufacture of these services was nominal, as is shown by "cost of goods sold" for the same years, by the consolidated profit and loss statement, as follows:
| Year | Seiders, Inc. | Mather & Co. | Howard, Inc. |
| 1926 | $33,599.79 | $78,799.67 | $16,683.55 |
| 1927 | 26,497.58 | 91,406.07 | 13,551.42 |
In or about January 1926, Seth Seiders was the president of the three companies; W. W. Hurd was the secretary and treasurer; A. M. Schultz was general sales manager for the eastern sales district; C. H. Rosenfeld was sales manager for the western district; and O. G. Tague was in charge of the creative departments of the petitioner corporations. These corporations filed a timely consolidated income tax return for the calendar year 1926. This return showed a consolidated net income of*1086 $143,031.41. Schedules attached to the return showed that the income of $143,031.41 was made up of taxable *669 net income of $98,927.10 alleged to have been earned by Seiders, Inc., during 1926; taxable net income of $75,713.57 alleged to have been earned by Howard, Inc., during 1926; and a net loss of $31,609.26 alleged to have been suffered by Mather & Co. during 1926.
These corporations also filed a timely consolidated income tax return for the calendar year 1927. This return showed a consolidated net loss of $64,658.09. The schedules attached to the return showed that the consolidated net loss of $64,658.09 was made up of net losses alleged to have been suffered by the three corporations during 1927 as follows:
| Seiders, Inc | $21,293.84 |
| Mather & Co | 37,097.10 |
| Howard, Inc | 6,267.15 |
| Total net loss | 64,658.09 |
Both of the above mentioned returns were subscribed and sworn to by Seth Seiders, as president, and W. W. Hurd, as treasurer. The corporations were held not to be affiliated by the respondent and the ruling was not contested by the petitioners and therefore the question of affiliation is not an issue in these proceedings.
The books of the*1087 corporations show that the following amounts were charged as salary and bonuses paid to Hurd, Cunningham, Rosenfeld, Tague and Schultz during the years 1925 to 1927, inclusive:
| Mather & Co. | ||||||
| 1925 | 1926 | 1927 | ||||
| Name | Salary | Bonus | Salary | Bonus | Salary | Bonus |
| W. W. | $6,500.00 | $1,328.50 | $13,125.00 | None. | None. | None. |
| Hurd | ||||||
| C. J. | 7,775.00 | 6,887.28 | 26,150.00 | $1,162.47 | $21,800.00 | $3,568.32 |
| Cunning- | ||||||
| ham | ||||||
| C. H. | 9,100.00 | 6,382.64 | 26,175.00 | 377.26 | 21,800.00 | 3,164.81 |
| Rosenfeld | ||||||
| A. M. | 8,950.00 | 7,092.50 | 22,570.00 | 2,176.32 | None. | None. |
| Schultz | ||||||
| O. G. | None. | 3,325.00 | None. | None. | None. | 800.00 |
| Tague | ||||||
| Total | 32,325.00 | 25,015.92 | 88,020.00 | 3,716.05 | 43,600.00 | 7,233.13 |
| Seiders, Inc. | ||||||
| W. W. | $5,225.00 | $2,828.50 | $13,125.00 | $14,000.00 | $21,800.00 | $4,195.12 |
| Hurd | ||||||
| C. J. | None. | 7,855.22 | None. | 14,433.33 | None. | 800.00 |
| Cunning- | ||||||
| ham | ||||||
| C. H. | None. | 7,960.80 | None. | 14,000.00 | None. | 800.00 |
| Rosenfeld | ||||||
| A. M. | 1,050.00 | 7,507.50 | None. | 12,334.00 | None. | None. |
| Schultz | ||||||
| O. G. | 6,800.00 | 3,175.00 | 26,150.00 | 11,617.27 | 21,800.00 | 3,950.00 |
| Tague | ||||||
| Total | 13,075.00 | 29,327.02 | 39,275.00 | 66,384.60 | 43,600.00 | 9,745.12 |
*1088 The books of Howard, Inc., do not show any amounts as salary and bonuses paid or credited to any of the above mentioned five individuals during the years 1925 to 1927, inclusive.
*670 The above mentioned amounts totaling $127,295 for salaries in 1926 and $87,200 for salaries in 1927, and totaling $70,100.65 for bonuses in 1926 and $16,978.25 for bonuses in 1927, were claimed as expense deductions in the consolidated income tax returns filed by the petitioner corporations for the calendar years 1926 and 1927. For the year 1926 respondent disallowed salary and bonus payments in the amount of $108,340 to the three corporations and for the year 1927 respondent disallowed salary and bonus payments to Seiders, Inc., in the amount of $36,889.01. Only Seiders, Inc., is before us for 1927. No deficiencies were determined against either Howard, Inc., or Mather & Co. for 1927. Of the so-called salaries received in 1927 from Seiders, Inc., Hurd and Tague turned over $210 a week in cash from January 1 to October 1, 1927, amounting to $4,800 each to Seth Seiders as a part of the pay-off under the "Big Plan." None of the parties receiving bonuses from Seiders, Inc., turned over to*1089 Seth Seiders any of the bonuses which they received in 1927. During 1927 Cunningham and Rosenfeld rbceived their salaries of $21,800 each from Mather & Co. and turned over $4,800 each to Seth Seiders as pay-off under the "Big Plan", but we are not concerned with that here because Mather & Co. is not before us for 1927.
Prior to the beginning of the year 1926 the five men above mentioned, subsequently members of Group I, to be hereinafter described, were paid salaries and bonuses which varied according to the individual.
The bonuses paid to Schultz, Rosenfeld and Cunningham in the year 1925 were based on a certain percentage of the sales of the petitioner corporations and a small bonus of this kind was paid to each of these men in the early part of 1926, which were past due payments based on the sales made in 1925.
The duties of the five individuals whose salaries and bonuses were partially disallowed during the taxable years in question were as follows:
Hurd was the financial man and treasurer for all three petitioner corporations. He had charge of the office employees, the shipping department, the bookkeeping department and of finances and collections. Hurd devoted long*1090 hours to the business.
Rosenfeld directed and supervised sales over the central western territory, both for Mather & Co. and Seiders, Inc. This territory extended from the Pacific coast as far east as Buffalo, New York. He had approximately one hundred men under his supervision and control of whom ten or eleven were supervisors. He devoted long hours to his work.
Cunningham supervised and directed the sales of both Seiders, Inc., and Mather & Co. in the eastern territory. His territory was *671 smaller in extent than that of Rosenfeld, though approximately equal in sales volume. He had eighty to ninety men under his direction, supervision and control, and had charge of all the sales for his territory.
Schultz was general sales manager for both Mather & Co. and Seiders, Inc. He was in direct charge of the sales over the entire country and was the direct supervisor of both Rosenfeld and Cunningham and devoted long hours to his duties.
Tague was head or director of editing and the art and creative departments. These departments created the business services and included writers and artists in their personnel. Tague edited their work, supervised the department*1091 rendering the consultation services, and approved the finished products.
"The Big Plan."
Some time during the latter part of the year 1925, Seth Seiders called Hurd, Schultz, Cunningham, Rosenfeld and Tague to a meeting held in his Sheridan Road home in Chicago. This meeting was held on a Sunday and lasted for a number of hours. Seiders called these men to the meeting for the purpose of announcing to them a plan which he had formed and which he later designated as the "Big Plan" or the "Turnover Plan." Under this plan Seiders proposed to divide his organization in the three companies into groups. The first group was to be known as Group I, and was to comprise the heads of the principal departments of the three corporations, which positions were occupied at that time by the men present at this meeting. The second group was to comprise lesser executives, and other groups were to be formed as the plan developed.
Seiders, at this meeting, informed the members of Group I that when he had accumulated a million dollar estate, which was to consist of cash and bonds to be taken out of the business, he would then turn the business over to the members of Group I. This group thereafter*1092 was to conduct and own the business until each of them had accumulated an estate of one million dollars and the business was then in turn to be passed on to Group II, and when that group had accumulated their assets of a million dollars each it was to be passed on to Group III.
Seiders at this meeting argued that it was to the best interest of each of those present in Group I to have Seiders accumulate his estate of a million dollars at the earliest possible date, so that the business might the earlier be turned over to them. He urged that the overhead expenses of the business be kept as low as possible so that the million dollar payment to him might be the earlier made. To this end he proposed that the members of this group should call a *672 meeting to determine a minimum amount of salary upon which they could live and maintain themselves with dignity and comfort, and that the salary so agreed upon would be all that members of Group I would retain for their services, and that any other payment, such as bonuses and dividends which they would receive, would be turned over to Seth Seiders to be applied by him to the pay-off under the so-called "Big Plan."
At this meeting*1093 Seiders spoke of his Federal income tax, saying that the Government had been exacting huge sums from him for income taxes, and that the amounts were more than he thought he ought to pay. Seiders said that the members of Group I would have to do something to help him get relief from these high income taxes. No agreement was reached at this meeting as to methods to be pursued by members of Group I toward helping Seiders to secure reductions in his income taxes.
The duty of drafting an outline of the so-called "Big Plan" was delegated to Tague, with the understanding that after the details were agreed upon it would be signed. The day after the meeting at Seiders' home, the members of Group I conferred for the purpose of fixing their salaries. Various amounts were suggested, but as it was understood that an amount in the neighborhood of $15,000 a year each would be satisfactory to Seiders, this amount was agreed upon. While this meeting was in session Schultz was delegated to notify Seiders. Seiders came into the meeting and asked whether they had agreed upon an amount. He was told that they had agreed upon an amount of $15,000 a year each. Seiders stated that this amount was*1094 satisfactory and he added that they would be given a check for $500 each week, of which amount they were to keep $290 each to apply on their $15,000 salary and the balance, $210 each, they were to return to him in cash, to apply as a part of the pay-off under the "Big Plan."
From the time of this meeting to fix salaries, beginning with the first week in January 1926, each of these five men in Group I received a cheek for $500 each week. Later a practice arose of returning these sums each month. Most of these payments were made in cash, although at times, for the sake of convenience, particularly in the case of Cunningham, sales manager for the eastern district, checks were made out to cash and handed over to Seiders. These monthly returns of salary amounted to $840 or $1,050 a month, according to the number of Saturdays in a month. This practice continued until September or October of 1927, at which time the salaries of Group I were reduced to $200 a week. It was about this time that the "Big Plan" was definitely discontinued, although no reason was given for its discontinuance. When one of the members of Group I *673 asked Seiders why the salaries had been reduced to*1095 $200 a week, he said: "These men are dead on their feet. I want to give them a jolt." A few weeks later the salaries were raised to $300 a week, but at this time no demand was made that any money be turned over to Seiders, to count as pay-off on the "Big Plan." They were permitted to keep the entire amount and from then on the "Big Plan" was abandoned. A holding company was formed after the taxable years here involved, whereunder Hurd and Rosenfeld, with others, purchased from Seiders all his interest in the three corporations.
During the course of the years 1926 and 1927, Seiders, either by himself or by Hurd, the secretary of the petitioner corporations, paid so-called bonuses to the members of Group I. At the time of the payment of these bonuses Seiders would go to the offices of the members of Group I and lay before them, face down upon their desks, checks which he would ask them to endorse. None of these members of Group I ever received or kept these particular moneys here in question, paid out as bonuses, and in no case did any of them suggest that they should keep them. In this manner checks for $5,000 each were endorsed by members of Group I on March 9, 1926, and checks*1096 for $6,000 each were endorsed in the same manner by all of these men on June 14, 1926. All of the above mentioned checks were turned over to Seiders and deposited to his personal bank account. The amounts of these checks, totaling $55,000, were charged on the books of Seiders, Inc., as bonuses, and were deducted as expenses in the consolidated income tax return filed by the petitioners for the calendar year 1926.
The so-called "Big Plan" under which the members of Group I thought they were operating was never reduced to writing for final signature. Several drafts of it were made, some by Tague and others by Seth Seiders' father, C. A. Seiders, an attorney of Toledo, Ohio. As these drafts were submitted, technical objections were raised by Seiders, so that no written plan was ever signed. These tentative drafts of the so-called "Big Plan" prepared by Tague and C. A. Seiders, but never signed by the parties, were introduced in evidence. They are quite lengthy and are incorporated herein by reference.
Some time after the first meeting in Seiders' home, the problem of the individual tax returns of each of the members of Group I arose. Complaints were made to Seiders that he*1097 had apparently overlooked the matter of their individual tax returns. They were credited with having received money which they did not keep and they were unwilling to pay a tax on these extra amounts, especially in view of the failure of the "Big Plan" to be better authenticated and the failure of the members of Group I to have more tangible evidence of its *674 avails to them. Seiders advised that this situation would be taken care of, and payments were made quarterly by Seiders, Inc., and Mather & Co. in 1927 to each of the members of Group I, equaling the difference which they would have to pay in taxes on income which they kept and the amounts credited to them as part of the "Big Plan" which they did not receive. Hurd assisted the other members of Group I in the preparation of their income tax returns and paid over to them either in cash or by check the difference in the computed amount of tax. These payments were made to some of the men after they had left the employ of the petitioner companies, and the amounts paid were charged on the books of the paying companies as bonuses.
Canadian Companies.
In 1927 three Canadian companies, with names similar to those*1098 of the domestic petitioner corporations, were organized. In the sale and distribution of the stock in the Canadian companies, petitioners Seiders, Inc., and Mather & Co. gave to each member of Group I a check for $2,000, except Schultz, who had been discharged in 1926, and Tague, who received a check for $1,850, and requested that they give Seth Seiders in return their personal check for $250. In this transaction approximately $750 of the $2,000 paid to members in Group I was to apply upon quarterly payments of their income tax and the balance of $1,250 which they returned to Seiders was to apply upon the purchase of stock in these Canadian companies. The members of Group II also participated in this transaction. They paid more money and got less stock.
The following amounts were charged on the books of the petitioner Seiders, Inc., for 1927 as bonuses and claimed in the 1927 consolidated income tax returns as expense deductions.
| O. G. Tague | $1,850 |
| W. W. Hurd | 2,000 |
| C. Goodstein | 4,800 |
| L. R. Fox | 4,800 |
| P. W. Medley | $4,800 |
| R. E. Baker | 4,800 |
| Total | 23,050 |
The number of shares of stock issued by each of the Canadian companies totaled 7,000, and of*1099 this number 2,995 were issued to Seiders, president and main stockholder of each corporation issuing the bonus, for which Seiders did not pay anything, and 600 were issued to Seiders' wife, for which she paid nothing. Hurd, Tague, Rosenfeld and Cunningham received 500 shares each. No dividends were paid by the petitioner companies in 1927. The respondent's deficiency notices made it clear that the only amounts which he disallowed therein were those of salaries and bonus payments to employees which were upon receipt thereof turned over to Seth *675 Seiders. These amounts have already been stated in our findings of fact. Respondent's amended answer, however, alleges that he should have disallowed the foregoing amounts paid on account of the Canadian companies and that the deficiency should be increased accordingly.
Respondent's affirmative allegations on this point are in part as follows: "The foregoing amounts designated as bonuses were paid to said individuals in addition to their regular authorized salaries and were paid under the guise of bonuses, but were not in fact bonuses due them but were paid to said individuals with the direct understanding and agreement that*1100 said amounts should be used for the purpose of financing certain corporations in the Dominion of Canada * * *, with the exception of $2,000 retained by O. G. Tague, C. H. Rosenfeld, C. J. Cunningham and W. W. Hurd in the sums of $500 each, etc."
Insurance Agreements.
On May 18, 1926, after the first bonuses had been paid to them, and while they were turning over to Seiders $210 a week, the five individuals composing Group I entered into an agreement which began as follows:
AGREEMENT.
A. M. Schultz, W. W. Hurd, C. J. Cunningham, C. H. Rosenfeld, Otto G. Tague, being parties to a certain agreement entered into by and between themselves and Seth Seiders, of Chicago, Illinois, as of December 1, 1925, said agreement being for the purpose of carrying out the perpetuation and control of certain businesses owned and controlled by Seth Seiders under what he has designated as his Automatic Estate Building Plan * * *.
The agreement provided that in the event one or more of the parties thereto should die or become incapacitated prior to the time "on which Seth Seiders shall have accumulated the net estate of one million dollars" the estate of each of the parties so deceased or*1101 incapacitated should receive $100,000 as provided therein.
On November 18, 1926, after the payment of the bonuses, and while the members of Group I were still paying the $210 a week to Seiders, except Schultz, who had been dismissed from the organization and was no longer a member of Group I, the remaining four members of Group I entered into an agreement, the introduction of which is as follows:
AGREEMENT.
W. W. Hurd, C. J. Cunningham, C. H. Rosenfeld and Otto G. Tague, being parties to a certain agreement entered into by and between themselves and Seth Seiders of Chicago, Illinois, as of December 1, 1925, said agreement being *676 for the purpose of carrying out the perpetuation and control of certain business owned and controlled by Seth Seiders under what he had designated as his Automatic Estate Building Plan * * *.
This agreement made a provision for insurance similar to that made by the agreement of May 18, 1926, and by its terms superseded and nullified the prior agreement, to which Schultz had been a party.
Adjustment Agreements upon which Commissioner Made Partial Consolidation of Accounts.
During the course of the investigation of the cases of*1102 the petitioners by an internal revenue agent, three documents were given to him by an accountant representing the petitioner corporations. These documents applied respectively to each of the petitioners and were all signed by W. W. Hurd, as secretary and treasurer of each company, and they each bore the appropriate corporate seal of the company. These documents are in words and figures exactly the same, except as to signatures and seals and except as to the second paragraph, which contains the name of the corporation to which the particular adjustment relates. The body of the document in the case of Mather & Co. reads as follows:
The statements attached hereto indicate the amounts paid by Mather and Company, and Seth Seiders, Incorporated, to sundry employees and rent for the years 1926 and 1927, and postage for 1926, and the adjustment of such salaries, rent, and postage to show the correct amount chargeable to each of the three companies, Mather and Company, Seth Seiders, Incorporated, and C. J. Howard, Incorporated.
The adjustment as shown on these statements will be entered upon the books of Mather and Company, so as to reflect the correct expense of the company for the*1103 years 1926 and 1927.
These inequalities in salary payment and rent were made through the assumption by the Officers of the Company that they were more or less consolidated and that there was little difference to either the United States Government or the Stockholders of the sundry companies in charging any particular Company or dividing the charges to the three Companies at the time of payment.
The statements referred to in the above quoted documents contain detailed figures showing the amounts paid out in bonuses and salaries, rent and postage by Mather & Co. and by Seiders, Inc., for the years 1926 and 1927, and how these amounts should be allocated on the books by the three corporations, Mather & Co., Seiders, Inc., and Howard, Inc., so as to bring about a proper adjustment of the expenses of each corporation in proportion to the amount of business transacted by each. The figures are contained in the respective documents which are in evidence and are incorporated herein by reference, and need not be given in detail here.
*677 Determinations Made by Commissioner in Deficiency Notices.
The $210 so-called salary payments which were made to Schultz, Tague, Cunningham, *1104 Rosenfeld and Hurd during the year 1926 and by them turned over to Seiders, which payments totaled $53,340, and the $5,000 and $6,000 bonuses made to each of these men and by them turned over to Seiders, which payments totaled $55,000, were disallowed by the respondent as expense deductions. All of the bonus payments were made by Seiders, Inc., $16,380 of the so-called salary payments were made by Seiders, Inc., and the remainder or $36,960 were made by Mather & Co.
The $290 a week paid to each member of Group I as regular salaries and retained by them, respondent has allowed as deductions in determining the net income of the respective corporations, and as to these payments there is no issue.
Although of the total disallowed, namely, $108,340, Seiders, Inc., made payments totaling $71,380 and Mather & Co. made payments of the remainder of $36,960, on account of the documents submitted to the revenue agent asking that adjustments be made with reference to salaries, bonuses, rents and postage, the net income ($98,927.10) of Seiders, Inc., as shown by the schedules attached to the consolidated return for 1926, was increased on account of the above mentioned disallowance by the*1105 sum of only $43,185, instead of $71,380 and the net loss ($31,609.26) of Mather & Co., as shown by the schedule attached to the consolidated return for 1926, was decreased on account of the above mentioned disallowances by the sum of $41,515.73 instead of $36.960. The difference between the total amount disallowed, namely, $108,340 ($55,000 plus $53,340), and the total amounts used in the cases of Seiders, Inc., and Mather & Co., namely, $84,700.79 ($43,185.06 plus $41,515.73), or $23,639.21, was used to increase the net income of Howard, Inc., by prorating that much of the disallowance to it.
The net income of Howard, Inc., was decreased by the respondent in the amount of $30,524.03 in accordance with the aforementioned request for adjustment of accounts. In making this adjustment for the yhar 1926, the Commissioner stated in his deficiency notice as follows: "Inasmuch as the Bureau has disallowed your contention relative to a consolidation, it was necessary to adjust your accounts, so that each corporation clearly reflected its proper deductions. This adjustment has been made to reach that object." Similar statements were made in the deficiency notices to Mather & Co. and Seiders, *1106 Inc., as to the adjustments made in their expense deductions. The net loss of Mather & Co. was decreased in the amount of $19,754.99 and the net income of Seiders, Inc., was increased in the amount of *678 $10,769.04 for the year 1920, in accordance with the instructions contained in the above mentioned documents, and the income of Seiders, Inc., for 1927 was thereby increased $12,890.66.
OPINION.
BLACK: The issues raised by the pleadings may be summarized as follows:
(1) The Commissioner erred in imposing the fraud penalties.
(2) The Commissioner erred in disallowing certain deductions taken by petitioners in 1926 and 1927, representing amounts which petitioners had paid certain of their officers and employees as alleged salaries and bonuses, said payments being alleged as reasonable compensation for services actually rendered.
(3) The Commissioner erred in adjusting and prorating certain expenses among the several petitioners in accordance with alleged agreements filed with the Commissioner by petitioners.
(4) To the above issues may be added the issue raised by the Commissioner in the affirmative allegations of his amended answer, wherein he asks that the*1107 deficiencies in the case of Seiders, Inc., Docket No. 45015, be increased because of certain allegations made in detail in said amended answer.
We will take up these issues separately and discuss them in their order.
(1) Fraud. - At the hearing the Commissioner conceded that the imposition of fraud penalties against Howard, Inc., was error. Effect to this admission will be given in a recomputation under Rule 50. The answer to the question whether fraud penalties should be imposed against Seiders, Inc., and Mather & Co., it seems to us depends upon whether the so-called "Big Plan" or "Turnover Plan" detailed in our findings of fact was entered into in good faith by the parties, or whether the whole thing was a mere scheme and a sham to evade income taxes. While it is of course lawful for taxpayers to use means and methods which are legal and not tainted with fraud to avoid taxes, ; , it is never lawful for taxpayers to use methods of concealment and deception to evade taxes. It is in the use of the latter methods that taxpayers run afoul of the fraud*1108 penalties. In asserting fraud penalties the burden of proof to show fraud is placed upon the Commissioner by section 907(a), Revenue Act of 1924, as amended by section 601, Revenue Act of 1928. This burden of proof must be sustained by a preponderance of the evidence and by evidence which is clear and convincing. . In discussing the rule applicable to fraud cases, the court there said:
*679 The general rule is that fraud must be made out by a preponderance of evidence, which should be so clear and strong as to preponderate over the general and reasonable presumption that men are honest and do not ordinarily commit fraud or act in bad faith. 27 C.J. 62. And in Wigmore on Evidence, vol. 4, § 2498, alluding to the rule that in civil cases a preponderance of evidence is sufficient, he states that a stricter standard is applied in cases of fraud. He says:
"But a stricter standard, in some such phrase as 'clear and convincing proof,' is commonly applied to measure the necessary persuasion for a charge of fraud and in a few related classes of cases."
In several cases the Board has applied and followed substantially*1109 the same rule as laid down by the court in the above quotation. Cf. ; ; .
In the instant case there appears to be no doubt that the members of Group I, officers and employees of petitioners, in good faith entered into a plan with Seth Seiders, acting for himself, and the three petitioner corporations, by which Seiders was to receive a million dollars from the businesses and then retire and turn the corporations over to the management of Group I. The object of this plan, as contended by petitioners, was to inspire all employees to render to the three corporations the most efficient services of which they were capable and to establish a definite means whereby the employees would be rewarded, within the bounds defined, in proportion to their loyalty and contributions to the success of the businesses - a definite system under which employees would progress through the organizations from the status of employees to that of owners, and thence to financial independence and retirement from active business. Whether Seth Seiders entered into this arrangement*1110 with the same good faith as these members of Group I is not so clear. He did not testify at the proceedings and his version of the arrangement is not before us.
Respondent's contention that the "Big Plan", or the "Turnover Plan", as it was sometimes referred to in the testimony, or the "Automatic Estate Building Plan", as it was referred to in the written drafts of the plan which were drawn up by Tague and Seth Seiders' father, but never signed by the parties, was a mere sham to help Seth Seiders evade his income taxes, was not borne out by the testimony. The evidence seems to establish with at least a fair degree of certainty that the members of Group I entered into this "Big Plan" in good faith. They evidenced this good faith by having elaborate details of the plan reduced to writing in two tentative drafts, both of which are in evidence in this proceeding, although neither was ever finally agreed upon and signed by the parties.
*680 Also, the good faith of members of Group I is evidenced by their entering into insurance agreements with each other by which it was agreed that if any member of Group I should die or become incapacitated prior to the time that Seth Seiders*1111 had accumulated his million dollar estate out of the business, the estate of each of the parties so deceased or incapacitated should receive $100,000 as provided therein. These insurance agreements are referred to in our findings of fact. Other evidence of the good faith of members of Group I could be cited from the testimony.
Upon this issue of fraud, we must reach our conclusion not on isolated bits of testimony, but upon the whole record. As we said in :
* * * The question is whether upon the entire record properly before the Board the conclusion is fairly to be drawn that fraud was committed. Doubts and omissions are to be held against respondent. His is the risk of failure - not of failure to bring forward enough witnesses or enough testimony through his own witnesses, but of failure to submit a record of persuasive evidence of fraud. His risk is only that the truth may be contrary to his determination, not that he or his organization may not have been aware of it. If the weight of all the valid evidence properly in the case is such as to establish fraud, his burden is discharged; and it matters not by which of the opposing parties*1112 the evidence was introduced or in what order it was received. Adjective considerations of convenience as to the order of proof may arise at the trial, but they do not affect the ultimate question whether the evidence adequately supports the respondent's determination.
We think that, taking into consideration all the evidence, both that introduced by respondent and that introduced by petitioner, we must hold that respondent has failed to establish fraud by a preponderance of the evidence. Of course it may well be conceded that, looking back from a distance of seven or eight years, as we can now do, and after the castles in the air builded by Seth Seiders and his associates have collapsed, the so-called "Big Plan" appears more or less grotesque. No doubt the frauits of the "Big Plan" appeared in reasonable prospect at the time the parties designed it. Our task is to place ourselves where they then stood - to sit where they sat and not to judge by what has transpired after a lapse of seven or eight years. When we consider that the gross sales of these three petitioner corporations in 1926, the year when the so-called "Big Plan" was adopted, were $1,677,306.22, and large profits*1113 were being made, the "Big Plan" does not appear so ridiculous after all. On the issue of fraud penalties, we hold for petitioners.
(2) Disallowance as deductions of so-called salaries and bonuses. - As has been pointed out in our findings of fact, the petitioners, Seiders, Inc., and Mather & Co., paid certain sums of money to members of Group I which the members of that group did not *681 retain but turned over to Seth Seiders, president of all three corporations, as fast as received, as payments under the so-called "Big Plan." These sums the respective corporations paying them claimed as deductions for business expenses. As to these payments petitioners contend that they represented reasonable compensation for services performed by the five individuals to whom they were paid and should be allowed as deductions. Respondent in his determination of the deficiencies prorated these so-called salaries and bonuses to the three corporations in proportion to the amount of annual business transacted by each and then disallowed such payments as deductions. We approve respondent's action in disallowing these deductions. The validity of respondent's action in prorating a certain*1114 part of these so-called salaries and bonuses to Howard, Inc., although Howard, Inc., had paid none of them and had claimed none of them as deductions, will be discussed under issue (3).
Petitioners argue that these salary and bonus payments in question should be treated in the same way and allowed as deductions as were the $15,000 ( $290 per week) payments which were paid to each of the members of Group I as salaries and retained by them. One of the principal arguments used by petitioners as to why this should be so, is that in 1925, the year prior to the putting into effect of the "Big Plan", large bonuses were paid to members of Group I by rhe corporations in addition to their regular salaries. But again we say we must take facts as we find them and not as someone may suppose them to be, and the facts as we find them show that, when the so-called "Big Plan" was put into effect, it was agreed that overhead expenses would be kept as low as possible, so that Seiders could receive his pay-off under the "Big Plan." That members of Group I were resolved to hold down expenses so Seiders could be paid off as soon as possible is shown by section 2 of the tentative "Big Plan" or "Turnover*1115 Plan" drawn up by Tague. Section 2 of that tentative plan reads:
In order that the purpose of this plan may most quickly be realized, it shall be the policy of the members of the organization to do everything in their power to reduce and hold down to the minimum overhead and operating expense of the business so that net profits out of which all cash rewards must be paid, may be accumulated as rapidly as possible, consistent with good business practice.
To that end members of Group I held a meeting early in 1926 and agreed with themselves and with Seth Seiders, president of all three corporations, that they would accept $15,000 each as salaries for 1926. This arrangement also continued into 1927. The $15,000 salary due to each was paid during most of the time by the $290 a week which they received in cash and retained. The $210 a week which *682 they received and immediately turned over to Seth Seiders and the bonus checks which were made out to them and immediately endorsed by them over to Seth Seiders, were in fact distributions by the respective corporations to Seth Seiders. Members of Group I were merely conduits through which these distributions were made to Seiders.
*1116 Whether we regard these distributions as ordinary dividends by the corporations to Seiders or as part of the pay-off to Seiders under the "Big Plan", the effect is the same. For the purposes of taxation, they must be treated as dividend payments made by the corporations, and not as business expenses for which deductions may be taken. Cf. ; approved by the Court of ; ; ; certiorari denied, . We hold that as to these particular items of claimed deductions, petitioners have not sustained their burden of proof for proving that the so-called salaries and bonuses were paid as reasonable compensation for services rendered, and not as mere gratuities or payments in the nature of dividends. Cf. .
(3) Proration to Howard Inc., by consolidation of accounts in part. - As pointed out in our findings of fact, respondent made certain prorations of amounts paid during*1117 the taxable years as rent, postage, and so-called salaries and bonuses by Seiders, Inc., and Mather & Co. to Howard, Inc. He disallowed these items to Seiders, Inc., and to Mather & Co. and allowed them as deductions in part to Howard, Inc., and disallowed them in part. These prorations were made in accordance with certain agreements signed by the respective corporations and filed with respondent by duly authorized representatives of petitioners. The action of respondent as to these items is assigned by the petitioners, Seiders, Inc., and Mather & Co. as error. Respondent in his brief says: "It is conceded that the respondent erred in increasing the net income of Howard, Inc., as shown by the schedules attached to the consolidated return for 1926, by the sum of $26,639.20, representing a portion of the so-called salary and bonus payments which were made by Seiders, Inc. and Mather and Company during 1926."
But respondent says he "did not err in holding that a portion of the bona fide payments for salaries, rents and postage made by Mather and Company and Seiders, Inc., which said payments were claimed as expense deductions in the consolidated income tax return filed for 1926*1118 and 1927 should be allowed to Howard, Inc. and disallowed to Seiders, Inc. and Mather and Company." These latter *683 account adjustments, as to which respondent is affirming his correctness in making, amount to a deduction of $30,524.03 allowed to Howard, Inc., for 1926 which it did not take on its books or in the consolidated income tax return. At the same time these adjustments amount to a disallowance to Seiders, Inc., for 1926 of $10,769.04 and to Mather & Co. for 1926 of $19,754.99, both of which claim they are entitled to the deductions which respondent has disallowed to them and has allowed to Howard, Inc. Respondent made a similar adjustment in the return of income of Seiders, Inc., for 1927 amounting to $12,890.66. This adjustment Seiders, Inc., contests on the same grounds as above stated. Seiders, Inc., is the only one of petitioners which is before us for the year 1927.
Respondent, in justification of these adjustments, says that what he did was in effect a consolidation of the salary, rent, and postage accounts of petitioners, by allowing to Howard, Inc., as deductions, certain of the amounts expended for salaries, postage, and rent by Seiders, Inc., and*1119 Mather & Co. during 1926 and certain of the amounts expended for salaries and rents by Seiders, Inc., and Mather & Co. during 1927, and disallowing these amounts as deductions in the cases of Mather & Co. and Seiders, Inc. What appears to have been attempted by respondent was to consolidate accounts only in part, after having denied affiliation to the three corporations. Petitioners contend that this the respondent had no right to do and that if these petitioners were asking the Board to consolidate their accounts only in part, giving as a reason the fact that rent and postage were not charged on their books in proportion to their sales, the Board would rightly deny the request. They cite . In that case, in denying petitioner's request for a consolidation of accounts, we said: "Separate books of accounts were maintained in which were recorded the usual revenues and expenses. The mere fact that lump purchases may have been made for both businesses, especially when, as here, the purchases were allocated to each business, or the fact of an occasional exchange of an employee, without more, does not prove that this section*1120 should be invoked." In , we held that under section 240(f) of the Revenue Act of 1926 a taxpayer invoking the provisions of the section must show the necessity for the consolidation of accounts and a method of "accurate distribution or apportionment" of the income and expenses of the two companies engaged in related trades or businesses and owned or controlled by the same interests. Cf. also ; ; .
*684 In all of these cases we denied consolidation of accounts. In the instant case the books of account of each petitioner are in evidence and show a complete separation of accounts in which the income and the deductions of each petitioner can be clearly and accurately determined. There is no confusion as to the income of the respective corporations. Under such circumstances there is no necessity for a consolidation of accounts and we think that none is permissible under the statute, even if it be conceded that petitioners did request it. Petitioners are well within their*1121 rights in resisting respondent's action in making a partial consolidation of their accounts. Respondent has denied the entire consolidation of accounts which would result from affiliation, and, having denied the right to file consolidated returns as affiliated corporations, he cannot consolidate accounts piecemeal under the conditions proved in these proceedings. Respondent has conceded error as to part of his action in consolidating accounts and we hold that the balance of his action in that respect was error. The deficiencies of all three petitioners should be recomputed accordingly.
(4) Commissioner's affirmative allegations asking increased deficiencies. - Respondent in his amended answer asks for increases in the deficiencies in the case of Seiders, Inc. As reasons for such increases, respondent alleges in detail in his brief, but not in his amended answer, that $71,380 of the alleged salaries and bonuses paid to Group I in 1926, and by them immediately turned over to Seth Seiders, was paid by Seiders, Inc., and deducted as business expenses, whereas respondent increased the net income of Seiders, Inc., on account thereof in his deficiency notice by the sum of only*1122 $43,185.06. Respondent alleges that therefore, inasmuch as the payments in question were not allowable deductions, the Board should allow an increase in the deficiency in the case of Seiders, Inc., for 1926, which increase should be based on the further disallowance of the amount of $28,194.94 ($71,380-$43,185.06). Respondent also concedes in this same connection in his brief, but not in his amended answer, that inasmuch as Mather & Co. made payments with reference to the so-called salaries and bonuses of only $36,960 during 1926, respondent should have disallowed this amount as a deduction to Mather & Co. instead of $41,515.73, which he did disallow. This concession by respondent will have the effect of reducing the income of Mather & Co. for 1926, as determined by respondent in the deficiency notice, by $4,555.73. Respondent alleges in his brief, but not in his amended answer, with reference to 1927 in the case of Seiders, Inc., that respondent has shown that so-called bonuses and salaries totaling $39,010 were paid by Seiders, Inc., and deducted by it in determining consolidated net income for 1926, and that respondent *685 in his deficiency notice disallowed to Seiders, *1123 Inc., only $36,889.01 on account of these items and that the deficiency in the case of Seiders, Inc., for 1927 should be increased to the extent that will be represented by adding $2,120.99 ($39,010-$36,889.01) to income for 1927.
Petitioners point out in their brief that the respondent did not by his amended answer, nor did he at the trial of the case, ask that the amounts disallowed by him, as discussed in the aforesaid allegations from respondent's brief, be changed to conform to the proof. "Therefore" say petitioners, "the Board will be required to find that the amount disallowed to Mather & Co. was excessive to the extent of $4,555.73, because the amount disallowed was excessive to that extent; and that the amount disallowed to Seiders, Inc., should stand as made by the Commissioner in his deficiency notice at $43,185.06." If the allegations of respondent's amended answer had been as full as the allegations in the brief concerning the particular transactions we are now discussing, they would have been sufficient to meet the test required by the rules of the Board with reference to affirmative allegations necessary to serve as a basis for an increased deficiency, but they are*1124 not sufficiently specific on these matters. In , we held that the prayer of respondent's answer, claiming "the increased deficiency, if any" resulting from a redetermination, unsupported by particular averments upon which an increased deficiency could be based, was bad and should be stricken. Cf. . In , we said:
* * * While, as indicated by the Moise decision, it is necessary for the respondent's pleadings to include an appropriately framed prayer for relief if an additional deficiency is sought, it is our understanding of the intent of the revenue act that the prayer must have the support of specific claims in each case based on specific grounds.
The undoubted purpose of section 274(e) was to put the taxpayer on notice of any demand that the Commissioner proposed to make for an increase in the deficiency determined. The respondent's determination when it comes before us is presumptively correct. He can not consistently rely on that presumption and at the same time urge that the determination is wrong*1125 by asking for an increase. If the determination is wrong in any particular, the respondent should be required to allege particularly wherein it is in error and state the facts relied on, as required by our Rule 14. [Italics supplied.]
We do not regard the allegations in respondent's amended answer as sufficiently specific to justify the Board in finding an increased deficiency in Seiders, Inc., Docket 45015, by reason of respondent's making insufficient disallowances in 1926 and 1927 for so-called bonuses and salaries paid to employees of Seiders, Inc., and by them immediately turned over to Seth Seiders. Respondent's claim for increased deficiencies on these grounds is denied.
*686 Respondent requested that the deficiency determined against Seiders, Inc., for 1927 be increased by the disallowance of certain bonuses which Seiders, Inc., paid to members of Group I in that year, to enable them to pay their increased income taxes due to 1926 income, and also be further increased by certain bonuses paid to certain employees to enable them to take stock in three Canadian corporations which were formed in that year. We think the bonuses paid by Seiders, Inc., in 1927*1126 to members of Group I to reimburse them for the differences in their income taxes for 1926 income over what such taxes would have been if the so-called salaries and bonuses paid over to Seth Seiders had not been included, should not be allowed as deductions. They fall in the same category as the so-called salaries and bonuses disallowed as deductions for 1926. They are in the nature of dividends to reimburse members of Group I for income taxes on income which was really not theirs, but was promptly paid over to Seth Seiders as part of the pay-off under the "Big Plan." The disallowance by respondent of these tax bonuses to Seiders, Inc., for 1927 will not result in any increased deficiency for that year. The respondent, however, did not include such disallowances in his original deficiency notice and it was therefore necessary for respondent to make affirmative allegations with reference to these tax bonuses in his amended answer, and sustain the burden of proof as to them, both of which we hold he has done.
We think respondent has failed to meet the burden of proof required of him to sustain the additional disallowances which he claimed in his amended answer as to the bonuses*1127 paid in connection with the organization of the Canadian corporations. These disallowances were not made by respondent in the original deficiency notice to Seiders, Inc., but were set up by affirmative allegations in an amended answer filed in Docket No. 45015, part of which are quoted in our findings of fact. As to these affirmative allegations on which increased deficiencies are asked, the burden of proof is on respondent. Board's Rule 30. Cf. .
In connection with this issue, the facts show that the taxpayer corporation charged these bonuses to salary expense and took deductions therefor in determining its net income for 1927. The petitioner Seiders, Inc., makes the contention that all the individuals to whom these bonuses were paid were employees of the company; that they had rendered valuable services to the company; and that if the president and principal stockholder of petitioner decided that the services rendered by these employees merited the reward of permitting them to participate in the stock ownership of subsidiary corporations, that was a matter within his reasonable discretion*1128 and *687 there is no evidence to show that this discretion was abused; that the respondent offered no adequate evidence to show that these bonuses given to employees with which to purchase stock in the Canadian subsidiaries were not as reward for services actually rendered and were reasonable in amount for services performed. We think these contentions of petitioner must be sustained. The bonuses in question were comparatively small in amount and do not belong in the classification which we have already discussed, where the so-called salaries and bonuses were not retained by the recipients but were immediately turned over to Seth Seiders and used by him as a part of the pay-off under the "Big Plan." Of course these employees should have and, so far as we know, did include these Canadian corporation bonuses in their individual income tax returns for 1927. . As to respondent's motion for an increase in the deficiency of Seiders, Inc., on account of these particular bonus payments, we hold for petitioner.
This disposes of all the issues raised by the pleadings, so far as we have been able to ascertain them from the mass*1129 of pleadings.
Decision will be entered under Rule 50.