*3680 Under the terms of a five-year contract of employment expiring January 31, 1923, providing for the payment of a certain bonus based upon final net profits of the entire contract period in excess of a certain amount, which final net profits could not be accurately computed, and where the bonus was not paid before the termination of the contract, the Commissioner's disallowance of a claimed deduction of a certain part of the 2 per cent bonus as an ordinary and necessary expense for 1920 and 1921 is approved.
*949 This is a proceeding for the redetermination of deficiencies in income and profits taxes for the calendar years 1920 and 1921 in the respective amounts of $44,876.90 and $6,448.63. The petition and the amendment thereto contained six allegations of error, four of which were abandoned at the trial. In the remaining two the petitioner alleged that the Commissioner erred in refusing to allow as a deduction for expense as part of a manager's compensation the amounts of $30,194.50 in 1920, and $19,652.00*3681 in 1921.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the State of New York, with its principal place of business at Pittsburgh, Pa., where at the time of the hearing and during the years 1920 and 1921, it was engaged in the department store business. On August 6, 1918, the petitioner entered into a written employment agreement with Samuel Mundheim, which was as follows:
Made this 6th day of August, 1918, between KAUFMANN DEPARTMENT STORES, INC., a corporation organized under the laws of the State of New York, party *950 of the first part, hereafter called the "corporation," and SAMUEL MUNDHEIM, of the City of Pittsburgh, State of Pennsylvania, party of the second part, hereinafter called "Mundheim."
In consideration of the mutual covenants hereinafter contained, and of the sum of One Dollar by each of the parties hereto to the other in hand paid, the receipt whereof is hereby acknowledged, IT IS MUTUALLY AGREED BY AND BETWEEN THE PARTIES as follows:
1. The corporation hereby engages the services of Mundheim for a period beginning on the 1st day of February, 1918, and ending on the 31st day of January, 1923. The services to be*3682 rendered by said Munheim are to be such as the corporation through its Board of Directors may from time to time direct.
2. The said Mundheim hereby accepts said employment and agrees to render services to the best of his ability, and agrees during said term to devote his entire time and attention to the business of said corporation. It is expressly agreed that such reasonable time as may be required to attend directors' meetings of companies where said Mundheim is now director will not be considered a violation of the contract.
3. The corporation agrees to pay Mundheim for said services, and Mundheim agrees to accept in full payment, the sum of Fifty thousand dollars ($50,000) per annum, payable in equal monthly instalments of Forty-one hundred and sixty-six and 67/100 dollars ($4166.67) on the last day of each month during the said term.
The said Mundheim, however, shall be entitled to increases of salary in the nature of bonus in addition to the said sum of Fifty thousand dollars ($50,000) per annum, as follows:
If the net profits for the year 1918 are not less than nine hundred thousand dollars ($900,000), said Mundheim shall receive a bonus of twenty-five thousand*3683 dollars ($25,000).
If the net profits for the year 1919 are not less than nine hundred thousand dollars ($900,000), said Mundheim shall receive a bonus of thirty thousand dollars ($30,000).
If the net profits for the year 1920 are not less than nine hundred thousand dollars ($900,000), said Mundheim shall receive a bonus of forty thousand dollars ($40,000).
If the net profits for the year 1921 are not less than nine hundred thousand dollars ($900,000), said Mundheim shall receive a bonus of forty-five thousand dollars ($45,000).
If the net profits for the year 1922 are not less than nine hundred thousand dollars ($900,000), said Mundheim shall receive a bonus of fifty thousand dollars ($50,000).
It is understood, however, that if the net profits do not amount to nine hundred thousand dollars ($900,000) in any one year, profits in excess of nine hundred thousand dollars ($900,000) earned in other years during the term of the contract of service shall be treated as if earned in such years in numerical order as the net profits shall be found to be under nine hundred thousand dollars ($900,000); but the total net profits for the five years of the contract of service shall*3684 be not less than four million five hundred thousand dollars ($4,500,000) in order to secure to the said Mundheim all bonuses above specified.
In calculating net profits under the terms of this contract no Federal taxes shall be charged against profits except Income Tax at two per cent. (2%) of net profit and Capital Stock Tax at one-twentieth of one per cent. (1/20th of *951 1%) of capital stock valuation, and inventories, depreciation and all additions to fixtures and equipment in each year are to be figured on the same basis as for year ending December 31, 1916.
The bonuses to be paid shall be payable within ninety (90) days after each annual inventory taken by the corporation has been made.
It is understood and agreed that notwithstanding the three clauses above, the annual bonus specified in this contract will not be paid in any or all of the years of said contract unless the final net profit after charging for all Taxes of every description incurred during life of this contract, whether paid or unpaid, all Depreciation and other reasonable adjustments incurred during life of this contract, shall exceed the sum of Six hundred fifty thousand dollars ($650,000). It*3685 is understood, however, that if the net profits do not amount to Six hundred fifty thousand dollars ($650,000) in any year, profits in excess of Six hundred fifty thousand dollars ($650,000), after deducting all taxes aforesaid, in other years during the term of the contract of service, shall be treated as if earned in such years, in numerical order as the net profits shall be found to be under Six hundred fifty thousand dollars ($650,000); but the total final net profits for the five years of the contract of service shall be not less than three million two hundred fifty thousand dollars ($3,250,000) in order to secure to the said Mundheim all bonuses above specified. In calculating final net profit as above, inventories, depreciation and addition to fixtures and equipment in each year shall be figured on the same basis as that used in the year ending December 31, 1917.
4. It is further understood and agreed that if the net profits for the five years covered by this contract, as figured on the same basis as that for the year ending December 31, 1916, exceed the sum of Five million dollars ($5,000,000), said Mundheim shall be entitled to two per cent. (2%) of all said net profits*3686 earned in excess of four million five hundred thousand dollars ($4,500,000) as additional and extra bonus; subject, however, to the provision that this bonus will not be paid unless the final net profit, after deducting all taxes of every description incurred during life of this contract, whether paid or unpaid, depreciation, etc., exceeds the sum of Three million seven hundred fifty thousand dollars ($3,750,000) for the said term of five years. In calculating final net profit as above, inventories, depreciation and addition to fixtures and equipment in each year shall be figured on the same basis as that used in the year ending December 31, 1917.
5. It is further understood and agreed that the death of the said Mundheim, if occurring prior to the expiration of this contract, or the failure or inability of the said Mundheim to perform his duties for a consecutive period longer than thirteen (13) weeks shall terminate this contract at the option of the said corporation as expressed by its Board of Directors, and in this event the monthly salary that may have been received by the said Mundheim from time to time shall be considered full consideration, compensation and satisfaction*3687 of all claims of the said Mundheim under this agreement.
The parties hereto expressly agree that the service covered by this contract is strictly personal, and that the contract has been entered into because of the special and peculiar fitness and exceptional experience of the said Mundheim in the particular line of employment which he is engaged to render, and that by reason of these facts, a breach of the contract on the part of the said Mundheim will incur financial loss which cannot be adequately measured by the rules of law, and therefore the parties now covenant and agree with each other as follows:
The said Mundheim agrees that he will not within the term of this contract accept employment in any other department store in the City of Pittsburgh *952 or the City of Philadelphia in the State of Pennsylvania, or the City of Chicago, in the State of Illinois, the City of Baltimore in the State of Maryland, or the City of Cleveland or the City of Cincinnati in the State of Ohio, or the City of New York, in the State of New York, or the City of Boston in the State of Massachusetts, or the City of St. Louis in the State of Missouri; and that in case he shall without just*3688 cause leave the service of the corporation in violation of this contract, he will pay to it as liquidated damages for the breach of this contract a sum which shall be equal in amount with the amount of salary, together with the full amount of bonuses, which the said Mundheim might have received from the said corporation, under his contract, from the time of such breach to the time fixed for the termination of the contract of service. And in consideration of the covenants of the said Mundheim in this respect, the said corporation covenants and agrees to pay to the said Mundheim, in case it shall violate this contract of service by dismissing the said Mundheim without just cause before the termination of the contract of service, as liquidated damages for such breach, a sum of money equal to the amount of salary, together with the full amount of bonuses, which the said Mundheim might have earned from the date of such breach to the termination of the contract of service, in case he had been permitted fully to perform the terms of his engagement; and as a further remedy granted to the said corporation under the breach of this contract by the said Mundheim, it is expressly agreed that the*3689 said corporation may proceed against the said Mundheim by writ of injunction to prevent the said Mundheim from engaging in the service of any other department store contract to the terms of this contract in case of its violation by the said Mundheim.
A further consideration of the above contract was contained in a letter of the same date from Mundheim to the corporation which read as follows:
DEAR SIRS: In consideration of the contract entered into to-day between myself and the corporation, I hereby agree that in the event of my earning the 2% bonus provided in paragraph four of said contract on all profits over $4,500,000 earned during the term of the contract, I consent to the corporation deducting from said bonus 2% of such a sum as may be equal to an additional depreciation of 5% on Fixtures and 2 1/2% on Automobiles in each year.
Very truly yours,
(Signed) SAMUEL MUNDHEIM.
Witness:
(Signed) H. WEILAND.
Mundheim thereafter served the full period of five years as general manager of the petitioner and also held the office of vice president until 1922, when he became president. During the five-year period he was directly in charge of the business and had full responsibility*3690 for every branch thereof. The petitioner's gross sales for this period were approximately twice as large as those for the five years preceding the execution of the contract.
The net profits at the end of the year 1920, figured on the same basis as that used in the year 1916, but embracing only those items determinable and known at the end of 1920, first exceeded $5,000,000. They amounted to $6,009,724.91 or an excess of $1,509,724.91 over *953 $4,500,000. The net profits at the end of 1920, figured on the same basis as that used in the year 1917, but embracing only those items determinable and known at the end of 1920, for the first time exceeded $3,750,000. For the year ending December 31, 1921, the net profits figured on the 1916 basis embracing only those items determinable and known at the end of 1921, were $982,599.76.
In the petitioner's private ledger there was set up as of December 31, 1920, under "Manager's Bonus Unpaid" account, an account payable of $318,010.28, and as of December 31, 1921, under the same heading, an account payable of $259,284.35. These amounts included any bonuses which the petitioner set up during those years as payable to the managers*3691 of its different departments, including any bonuses which it set up as payable to Mundheim. The amount of Mundheim's 2 per cent bonus was not computed accurately or paid until after the expiration of the contract period. The Commissioner allowed the petitioner deductions of $90,000 for 1920, and $95,000 for 1921, representing for each of these years the amounts of Mundheim's salary and his bonuses provided for under paragraph 2 of the contract and disallowed any amounts as deductions for accruals of the 2 per cent bonus for each of those years. The petitioner's books of account were kept and its income-tax returns were filed on the accrual basis.
OPINION.
MURDOCK: The petitioner claims the right to deduct as ordinary and necessary expenses the amounts of $30,194.50 and $19,652.00 for 1920 and 1921, respectively, representing 2 per cent of the amount by which its total net income of the period beginning with the date of the contract and ending December 31, 1920, calculated on the December 31, 1916, basis, exceeded $4,500,000 and 2 per cent of the amount of its net income for 1921, figured on the same basis. It contends that these amounts were incurred expenses and proper deductions*3692 for the respective years since it kept its books and made its returns on the accrual basis.
One of the early cases decided by this Board, and frequently cited, is that of , in which a lessee claimed the right to deduct from yearly income the liability, which would arise upon the termination of its lease, to restore the leased property to the lessor in as good condition as when received. In denying such deductions we stated, in part, as follows:
* * * Since the taxpayer kept his books on the accrual basis, all deductions allowable in determining his net income should be on that basis, including his contractual obligation under the terms of the lease. In order that an item may be accrued, however, a liability must actually be incurred in the taxable year. . The statute recognized *954 the accrual basis of making returns by providing for the deduction of expenses incurred but not paid. It is apparent that no liability in praesenti was incurred under the terms of the lease in question in the years 1918 and 1919 however well known it might have been that a liability*3693 in some amount would be incurred at some time in the future. * * *
While it might have been sound business practice on the part of the taxpayer to set up a reserve out of his income to meet a future liability, such a reserve is not deductible in determining net income.
In the above case it was certain that the lessee would at some later period be compelled to pay out something as a result of its lease, while in the present case, as will be later demonstrated, it was not certain that the petitioner would ever be called upon to pay the amount claimed as a deduction, or any part thereof.
The petitioner contends that the decisions of the Supreme Court of the United States in , and , are authority for the accrual of the amounts in question in this case. In the Anderson case the court said that the purpose of sections 12(a) and 13(d) of the Revenue Act of 1916 was
* * * to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, *3694 the expenses incurred in and properly attributable to the process of earning income during that period; * * *
It further stated that:
In a technical legal sense it may be argued that a tax does not accrue until it has been assessed and becomes due; but it is also true that in advance of the assessment of a tax, all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it.
It then held that events had occurred before the tax in that case became due which fixed the amount of it. The present case is affected only by the broad principles laid down in the Anderson case, since the facts in the two cases have almost mothing in common.
In the American National Co. case the Supreme Court quoted a considerable portion of the Anderson opinion, and held that the American National Co. was entitled to accrue in each year the total amount of certain bonuses to be paid later in connection with notes which it sold during the year. These bonuses were annual payments during each of five years of 1 per cent of the balance of each note remaining unpaid during each year. Although the notes might be reduced or paid off during the*3695 five-year period, nevertheless the company accrued the full amount which it might ultimately be required to pay. The company sold notes due in five years, and at the time the borrower executed the note he also gave the company another note due in two years, without interest, for 10 per cent of the loan as the company's commission or compensation for making and negotiating *955 the loan. From these commission notes the company derived its income and it reported as income during each year the total amount of the notes which it received during that year, and if later it did not have to pay all of the bonus which it had accrued it reported the unpaid portion as income. The court held that the method adopted by the company clearly reflected its income and allowed the accrual.
In the present case, at the ends of the two years in question, all of the events had not occurred which fixed the amount of the bonus and determined the liability of the petitioner to pay it. The method adopted by the petitioner does not clearly reflect its income and does not charge against income earned during the taxable periods the expenses incurred in and properly attributable to the process of earning*3696 income during those periods.
The bonus involved in this case was a percentage of all net profits for a five-year period over and above certain minimum amounts. The net profits of the first two years did not exceed the minimum amounts yet they formed a part of the final net profits and in this way affected the amount of the bonus. It would have been impossible for the petitioner to have determined the amount of the bonus before the end of the five-year period and it did not make any estimate in regard to the amount until the end of the third year. The total amounts which it attempted to accrue as expenses of earning income in the third and fourth year of the contract were no more properly attributable to the process of earning income during those periods than a portion thereof was attributable to the process of earning income during the preceding years. The petitioner does not contend that the bonus should be spread over the five-year period and has not made allegations to support such a method. Even if we knew sufficient facts regarding the income of these years and the total final net profits to enable us to spread the bonus over the five-year period, still we are not convinced*3697 that such a method could be adopted as one clearly reflecting income.
Also we think that the deductions claimed by the petitioner are not such as are authorized by the taxing statute. A consideration of all the provisions of the contract, the subject matter and the objects to be accomplished is necessary in order to find the true intent of the parties in regard to the considerations which Mundheim was to receive. ; . This is a five-year employment contract, the compensation of the employee being derived from three sources; first, an annual salary payable monthly; second, an annual amount in the nature of a bonus increasing each year and payable within 90 days after each annual inventory, in case the profits of the year exceeded a certain sum; and, third, with which source alone we are concerned in this proceeding, a certain percentage of *956 the amount by which the net profits for the entire term of the contract calculated on a certain basis, exceeded $4,500,000, not payable to Mundheim unless such final net profits calculated upon another basis exceeded $3,750,000, *3698 neither of which calculations could be made until the expiration of the contract period. The amount of the 2 per cent bonus was not calculated or paid until the expiration of the contract. If at any time before the expiration the net profits figured upon the 1916 basis, exceeded $5,000,000, and figured upon the 1917 basis, exceeded $3,750,000, nevertheless such excess might be wiped out later by losses, taxes, depreciation, or other reasonable adjustments incurred or made after such time and before the expiration of the contract. If the employee died or was unable to perform services for thirteen consecutive weeks during the existence of the contract it could be terminated at the option of the employer, and, in such event, the monthly salary received by the employee was to be considered "full consideration, compensation and satisfaction of all claims of the said Mundheim under this agreement." It also appears from the contract that Mundheim was employed by the petitioner because of his exceptional experience in the particular line of employment and his peculiar fitness for the position, and that a breach of the contract by Mundheim would entail upon the petitioner a financial loss*3699 which could not be adequately measured by the rules of law.
The petitioner's idea in employing Mundheim was apparently to acquire the services of an experienced and capable manager for its business, one capable of building the business up to a greater state of efficiency and a greater volume of sales with increased profits for the petitioner. This work in a business the size of the petitioner's was not estimated to be the work of a month or a year, but a task which could only be accomplished over a longer period of time. Therefore, a five-year contract was made providing for certain monthly compensation with a further bonus in case the petitioner's business should make a certain profit each year, and still a further provision that a bonus would be paid to Mundheim if net profits for the five-year period were in excess of certain amounts, and it is only reasonable to suppose upon consideration of the whole contract and the three sources of compensation that the last consideration recited was for the purpose of procuring Mundheim's best service for the entire period of the contract. In other words, this contract as to the 2 per cent bonus feature was an entire one and a full performance*3700 of it by Mundheim was a condition precedent to his right to claim such a bonus. This construction is borne out by that part of the contract which provided that in the event of Mundheim's death during the contract period, or his inability to perform services for a *957 consecutive period of thirteen weeks, the petitioner might treat the contract as terminated and the salary already received as full consideration for the services performed up to that time. The 2 per cent bonus was not earned by Mundheim at any time before the expiration of the contract. It did not have to be set aside, withdrawn from use of paid until the five-year period was over. It was measured by "final net profit." Its amount could not be determined before the expiration of the contract and a liability for it under the contract did not accrue before that time.
The petitioner, however, also relies on the case of , which, it contends, presents a state of facts similar to those in the present case, and is authority for allowing the deductions which the petitioner*3701 now claims. On the facts in the Block & Kohner Mercantile Co. case we allowed the deduction as an incurred expense on the ground that the one-third share of the profits of the company was at the end of the year in question definitely committed to Weinbach, subject only to be defeated by a subsequent net loss over which the taxpayer had no control. If Weinbach died, or if the contract was terminated before the expiration of the three-year period, he or his estate shared in the profits to the date of termination, while in the case at bar, as has been pointed out, the death of Mundheim during the contract period or the termination of the contract for any reason except his discharge without cause, defeated his right to receive the bonus in question or any part thereof, and even in the event that he was dismissed without just cause, he received by a special provision of the contract a certain amount as liquidated damages. In the Block & Kohner case the net profits at the end of any year could be determined and, since Weinbach was to get one-third of these, his share could be determined. In the present case Mundheim's percentage only applied to net profits over and above certain*3702 minimum amounts so that his share could not be accurately determined or even approximated until the termination of the contract. The contract in the Block & Kohner case was not necessarily an entire one, while as pointed out above the contract which we have in question was an entire one and Mundheim had no right of action for any part of the 2 per cent bonus until he had served the prescribed term of five years.
The Block & Kohner and Anderson cases are, we think, ones in which the right to compensation has already accrued or a liability to pay has been incurred, and only the enjoyment of the compensation is postponed or the amount to be paid is subject to be cut down or possibly wiped out by later events, whereas in the present case, after a careful consideration of the contract itself, we are of the opinion that neither the right to receive the compensation nor the *958 liability for its payment came into existence until the termination of the contract, and that in order to claim any part of the 2 per cent bonus the employee must first show that he has served the full term of the contract. It therefore follows that the Commissioner correctly disallowed deduction*3703 of a part of the 2 per cent bonus as an ordinary and necessary expense for 1920 and 1921.
Judgment will be entered for the respondent.