*1530 1. Upon consideration of the services actually performed, the amount of $4,000 is determined to be a reasonable allowance for the salary of an officer and director of a corporation who, together with a relative, owned all the capital stock.
2. The deduction for salaries of corporate officers is limited to amounts which are reasonably commensurate with the personal services actually rendered, and, though the judgment of corporate directors is not to be disregarded, there is no rule that it is conclusive or that it comports with the statutory qualifications of the tax deduction.
3. The test of reasonableness of salaries of corporate officers is not to be applied to the single aggregate amount of all officers' salaries, but to the salary of each officer considered in the light of the individual service performed.
4. A corporation may not deduct, as a business expense, an amount allegedly paid or incurred for the use of an idea covering a method of selling its product, conceived and carried out by its principal shareholder, who had used the idea in the same business prior to incorporation, where the subject matter of the royalty was not susceptible of patent, copyright, or*1531 trademark, and the shareholder had no property right therein which would support a demand for a royalty, and his conduct in permitting the corporation to use it would estop him from demanding any royalty.
5. There being no obligation to pay royalty, neither a corporate resolution, applicable by its terms only to a year prior to the taxable year, nor credits made by it in prior years to a general royalty account in its ledger, can afford any ground for the deduction.
6. The entries made in the corporation's books in an attempt to reflect in obligation for such royalties to the shareholder, and a payment by check which was immediately endorsed and deposited to the corporation's account, both occurring after the taxable year, were fictitious accounting and a simulated payment; and the projection of the fiction into the shareholder's personal tax return, made on the cash basis, by including the royalties as gross income actually received, when they were not actually received, does not give substance to the corporation's deduction, but rather indicates a plan to secure the deduction for the corporation.
7. Pursuant to a corporate resolution to distribute its accumulated surplus, *1532 the amount of the surplus was credited to its principal shareholder, wiping out a debit balance in his personal account, and leaving a credit against which he made withdrawals in ensuing years. Held, that the resolution and book entries effected a distribution and reduction of the surplus, even though the reserve accounts in which the surplus had been carried were wiped out and the surplus was not distributed pro rata among the shareholders, and the accumulated surplus may not be included in the corporation's invested capital for a later year.
8. A journal entry made by an accountant without authority some years after the resolution, purporting to reverse the earlier entries as to the portion taken from profit and loss surplus, on the theory that he could find no authority for it, held to be without substance and ineffective to restore such portion to the corporation's surplus, particularly since the evidence does not show that surplus was reduced by such portion and it was appropriated by the shareholder and he did nothing to bring it back into the corporation's surplus.
9. S, the principal shareholder of a corporation, had for years been engaged in marginal trading*1533 in stocks, and the Government had disallowed deductions taken by him for losses in such transactions. In the taxable year the corporation sought to deduct losses for such year in this account, contending that the account had been transferred to it from S. Held, upon the evidence, that the losses were not sustained by the corporation.
10. An issue whether losses sustained were losses sustained by the petitioner is distinct from the issue whether the petitioner has committed fraud in claiming the deduction in its return. The former involves only the question whether the deduction claimed was unfounded in law or fact and requires no consideration of intent, notive, or conduct in making the return, and the burden of proof is on the taxpayer and not the Commissioner. This is particularly so where the genuineness of the transactions is not questioned.
11. The record in this case discloses that the respondent's disallowance of the loss, based on the reports of revenue agents, was not without reasonable foundation and hence so arbitrary as to require evidenc in the first instance to support it.
12. In claiming the loss on the marginal transactions as a deduction in its*1534 return, the petitioner and its officers wilfully acted contrary to the truth within their knowledge and deliberately made false statements on its return for the purpose of evading its lawful tax.
13. The Board must determine an issue of fraud on the evidence before it; and, if a corporation has been found guilty of fraud, it may not escape the prescribed penalty either on ethical grounds relating to the respondent's method of investigation or out of too high a regard for its deceased officer. Its responsibility for his official acts does not lapse with his death, and when a penalty is determined and presented for review to the Board, the decision may not be deflected by a charge that the investigation was not timely.
14. In meeting his statutory burden of proof, the respondent is not confined to the affirmative evidence adduced by him; if the weight of all the valid evidence in the case establishes fraud, his burden is discharged, and it is immaterial by which of the opposing parties the evidence was introduced.
*421 Respondent has determined a deficiency of $204,905.60 in petitioner's income and excess-profits taxes for 1918, and a 50 per cent fraud penalty of $102,452.80. Petitioner contends that in making the determination of deficiency, respondent erroneously disallowed the deductions of salary paid to its vice president, of royalties to its chief shareholders, and of losses from stock trading. It further contests the exclusion from invested capital of alleged surplus, and denies that it is guilty of any fraud. Several other assigned errors were disposed of by stipulation.
FINDINGS OF FACT.
Petitioner is a New York corporation with principal office at 167 Duane Street, New York City. It was incorporated in 1901, taking over a business of manufacturing and selling shredded cocoanut *422 which had been built up and carried on for twenty-five or thirty years prior thereto by Leopold Schepp. Its accounts were kept and its tax returns made on an accrual basis. In 1918 it had in New York City a factory employing about 100 persons and an office force of seven or eight; it operated a branch factory in Toronto, employing about twenty persons. Prior*1536 to 1913, Schepp and his daughter, Florence L. Schepp, were the record holders of all except 169 of petitioner's 1,000 outstanding shares of stock; and of these 169 shares, all but 23 shares had in fact been assigned to them. In 1913 and thereafter they were the sole shareholders. At incorporation, Schepp became and thereafter remained petitioner's president, receiving an annual salary varying from $25,000 to $100,000, that for 1918 being $50,000.
1. Salary of Florence L. Schepp. - Florence L. Schepp was made a director and later vice president of petitioner, which positions she occupied in 1918. For 1918 she received $20,000. This sum was authorized as salary for 1917 in a resolution of the board of directors passed January 24, 1917. A reasonable allowance for her compensation for 1918 for personal services actually rendered was $4,000.
2. Royalty. - Sometime before the incorporation of petitioner, Leopold Schepp had had the idea of selling cocoanut for the retail trade in containers suitable for household use as cake boxes and bread boxes. This idea had been used in the business before incorporation and continued thenceforth to be used in the business. The design*1537 of the boxes was modified from time to time, the upright boxes used in 1918 having been in use since no later than 1908, and the essential characteristics of the boxes of 1918 having been the same since the organization of the corporation. Sometime before that, the bread and cake boxes had been long and flat.
There was no patent or copyright or registration in respect of the boxes.
A resolution was adopted in 1917 -
to grant a royalty amounting to 6 1/2?? per pound for each pound of Schepp's Package Cocoanut packed in Cake and Bread Boxes, sold during the year 1917 - the sum representing the royalty to be determined at the close of the year, and upon the suggestion of Mr. Leopold Schepp, made payable this year to Florence Schepp. At her option she may withdraw the money at any time.
A royalty account was first set up in 1915, amounts were credited thereto each year, and no debits were made until 1921.
In 1918 a credit of $34,745 was entered by petitioner in this royalty account. In 1921 the accumulated credits amounted to $306,378.66, and the account was debited $283,635.06, which was the amount of a check drawn to Florence L. Schepp, of a simultaneous deposit recorded*1538 in petitioner's cash book and a credit to Florence L. Schepp's personal account.
*423 The petitioner, on its 1918 return, took a deduction of $34,745 as royalty, and the Commissioner disallowed it.
3. Invested Capital. - At a meeting of a petitioner's board of directors, held February 20, 1912, it was:
Moved by Mr. Harry Belgard and seconded by Mr. Francis Wandell that the accumulated surplus of the company be paid out to the stockholders. Carried.
Under date of March 1, 1912, Schepp's personal drawing account was credited with $523,537.22, and the following entry appears in the journal:
| Sundries to L. Schepp Dr | $523,537.22 | |
| Dividend a/c | $10,000 | |
| Contingent Exp | 30,000 | |
| Contingent Employees Saly | 39,422.55 | |
| Contingent Depreciation | 21,500 | |
| Building Fund | 200,000 | |
| Contgt. Fund | 25,424.75 | |
| Gen'l. Pr. & Loss a/c | 197,189.92 | |
| Representing surplus as per order of stockholders | 2/20/12 |
This entry resulted in eliminating a debit of March 1, 1912, of $379,940.87 in Schepp's personal account, and creating a credit of the difference of $143,596.35, on which Schepp immediately began to draw. Each of the above amounts was in its entirety debited*1539 in the respective accounts then carried on the books, and the said accounts were thereby wiped out. The $197,189.92 was debited to profit and loss. At the close of 1912 and succeeding years, Schepp's personal account showed the following balances:
| Dec. 31, 1912 | $186,171.41 |
| Dec. 31, 1913 | 95,262.49 |
| Dec. 31, 1914 | 146,730.58 |
| Dec. 31, 1915 | $202,502.05 |
| Dec. 31, 1916 | 264,522.59 |
| Dec. 31, 1917 | 81,847.12 |
Of the amounts transferred by the above journal entry, $28,000 had been appropriated by directors' resolutions in 1909 and 1910, and on March 31, 1910, the aggregate of these appropriations was expressly described as set aside "to provide for new machinery and appliances, betterments, repairs, legal expenses, discounts, allowances, and bad accounts, and all contingencies not otherwise provided for." The building fund was appropriated by resolution, June 17, 1909, which, after reciting that petitioner required factories of its own with which to meet competition, resolved that $200,000 be set aside and increased every six months or every year for procuring proper accommodations.
On February 20 and March 1, 1912, Schepp held 672 of petitioner's 1,000 outstanding*1540 shares; Florence L. Schepp held 159 shares, and ten other individuals, most of whom were employees, were the record holders of the remaining 169, in amounts varying from 1 to 100 *424 shares. The entire amount of $523,537.22, accumulated surplus, was, however, credited to Schepp, and none to other shareholders. On March 1, 1912, petitioner had a cash account with the Broadway Fidelity Trust Company which showed a balance of $19,552.62, and one with the Irving Exchange National Bank which showed a balance of $49,137.73.
Under date of December 31, 1917, petitioner's journal contains the following entry:
| Leopold Schepp | $197,189.92 | |
| Surplus Jan. 1917 | $197,189.92 | |
| To reverse entry erroneously made in 1911 restoring amount of $197,189.92 to surplus account. No authority for entry in 1911 can be found. |
Schepp's personal account was debited with said amount. These entries were made by an accountant employed to close petitioner's books and prepare its Federal tax returns. He acted without instructions from or consultation with the secretary. The year 1911 in the entry was erroneously written for 1912. In its tax return for 1918, petitioner included*1541 in invested capital the aforesaid $197,189.92; respondent excluded it.
The respondent, in determining petitioner's war-profits taxes for the calendar year 1918, used the following figures:
| 1911 | 1912 | 1913 | |
| Net income reported previous examinations | $113,803.74 | $92,296.02 | $137,503.48 |
| Plus Federal income tax paid during year | 597.17 | 364.10 | |
| Total for each year | 113,803.74 | 92,875.19 | 137,867,58 |
| Less dividends received in 1913 | 900.00 | ||
| Net total for 1913 | 136,967.58 | ||
| Average net income pre-war period | 114,548.84 | ||
| Pre-war invested capital (per 1917 return) | 167,576.75 | 297,189.92 | 382,394.50 |
| Average adjusted pre-war capital, schedule | 282,387.06 | ||
| Average net income pre-war period | 114,548.84 | ||
| Exemption | 3,000.00 |
On December 31, 1917, petitioner had no inadmissibles among its assets; on December 31, 1918, it had inadmissibles consisting of 100 shares of Great Northern Railway preferred stock, bought December 30, 1918, at a cost of $9,450.
4. Stock Trading Loss Deduction. - During 1918 and for many years prior thereto, Schepp and petitioner each made use of their surplus funds, amounting to millions of dollars, by lending*1542 them on call to stock exchange firms, and taking stocks and bonds as collateral security. These loans were made on regular collateral agreement forms and handled according to banking practice except that some collateral was accepted which banks would not consider. Where loans made consisted partly of Schepp's funds and partly of petitioner's, interest was properly apportioned between them. In negotiating *425 these loans both Schepp and petitioner were usually represented by Belgard, petitioner's secretary. Many of the transactions were with Miller & Company, a stock exchange house which showed itself very accommodating in accepting loans when there was a flood of money on the market. During 1918 it borrowed for short periods sums aggregating $755,000. Records of these transactions were kept in a small memorandum book which distinguished between loans of Schepp and those of petitioner.
Prior to 1918, Miller & Company requested that in return for accommodations a stock trading account be started. Schepp thereupon opened personal accounts. He traded on a large scale and sustained losses which he endeavored to deduct from his gross income in 1913, 1914, and 1915, but*1543 which were disallowed by the Government on the ground that stock trading was not a part of his business. Similar losses of Florence L. Schepp were likewise disallowed. Schepp entered into a lengthy controversy with the Commissioner over the deductibility of these losses, and in 1915 took the matter up with a local law firm which was handling his and petitioner's tax matters.
In addition to trading with Miller & Company, Schepp personally carried large accounts with other brokerage houses, the records of which were kept by petitioner's secretary in a file of memoranda. During 1917 the secretary opened a record book or blotter, designated as "Stocks & Bonds, L. Schepp," in which transcripts of the brokers' memoranda were made daily under each of the several accounts. This blotter included, among others, four accounts with Miller & Company, designated as "Miller & Company, Short a/c," "Miller & Co., Long a/c," "John Berens, Short a/c," "John Berens, Long a/c." In correspondence with the broker, the first two accounts were known as #11 Short and #11 Long, the latter two, as Berens Short and Berens Long. The book contained no notation indicating to whom the accounts belonged until*1544 long after 1918, when employees and auditors inserted under the heading of each account the words "with L. Schepp Co." and wrote the words "L. Schepp Co." over the first entries for 1918. On the edges of several pages of the blotter containing these accounts are notations indicating that Miller & Company held Liberty bonds as collateral. During 1918 both Schepp and petitioner owned such bonds. The first entry under any of the Miller & Company accounts bears date of August 31, 1917, but the number of recorded transactions prior to 1918 was very small.
During 1918 Schepp advanced payments of margin to Miller & Company by personal check and by petitioner's check; in cases where petitioner's check was used, the amount was charged to *426 Schepp personally on petitioner's books, but at the end of the year the whole account was charged back to petitioner by crediting Schepp with the losses and charging them to petitioner in its profit and loss account. Monthly trial balances of the stock transactions were made from the blotter, but, with the exception of the transactions in Liberty bonds and certain investment securities and also the loss entry at the end of the year here in*1545 question, transactions with Miller & Company recorded in the stock account blotter were not reflected in petitioner's general books. Prior to 1918 petitioner had bought and sold securities for investment.
Under date of December 31, 1918, petitioner's journal contains the following entry:
| (Profit & Loss on Sale of Securities.) | Debits | Credits |
| Stock & Bond Losses | $263,024.48 | |
| Leopold Schepp | $263,024.48 | |
| Speculative losses for acct. of the company with Miller & Co. Brokers. |
Under the same date Schepp's personal account in the general ledger was credited with said sum; entries of it were made under a new account headed "Stock and Bond Losses," and it was debited to the profit and loss account. At the close of 1917 there were no entries on petitioner's books reflecting a profit or loss from the four accounts.
During 1918 and the latter part of 1917, correspondence with Miller & Company concerning these accounts was conducted sometimes in petitioner's name and sometimes in Schepp's; memoranda of orders and transactions were made out under the account designations, as, e.g., "Account #11." In correspondence Schepp sometimes referred to the #11 and Berens*1546 accounts as "my accounts;" at other times he used language inconsistent with ownership, directing on November 17, 1917, for example, a transfer from his account to the Berens account, which he guaranteed, "as though it were my own." In correspondence during 1921, petitioner gave instructions concerning the #11 account, but Miller & Company in reply addressed Schepp personally regarding it. At some time during 1918 Schepp advised Belgard, petitioner's secretary, that trading under the four accounts was for petitioner. In transactions on Wall Street it is not unusual to designate an account by number in order to conceal the trader's name from employees of the broker's firm.
Petitioner's original charter did not authorize it to deal in securities, and as a result of the Commissioner's ruling that losses sustained in the course of ultra vires acts could not be deducted by a corporation, it was advised by counsel in November, 1920, that its charter be amended to permit of such activities, and the corporate powers were so extended by amendment dated December 30, 1922. *427 In May, 1922, the Commissioner advised petitioner that the aforesaid opinion had been overruled by*1547 Law Opinion No. 1092, and that losses sustained as a result of marginal trading on the stock exchange could be deducted.
In its tax return for 1918 petitioner deducted $268,692.50 as losses from dealing in securities. These losses comprised those from the Miller & Company accounts and also from Liberty bond transactions. A revenue agent determined the amount of these losses to be $267,875, but recommended the disallowance of the deduction on the ground that said losses were personal to Schepp. Respondent adopted this recommendation in arriving at his determination of deficiency.
In seeking to induce respondent to revise this determination, petitioner submitted to him during 1927 a brief, verified under oath by Belgard, its secretary, containing the following statements respecting losses under the four accounts:
* * * after September 16, 1918, and prior to the closing of the books for the year 1918, Mr. Schepp and his daughter * * * determined for the corporation that the company was engaged in the stock transactions' business, at least to the extent of the dealings done through the brokerage firm Miller & Co.The Schepp Company took upon itself the losses through that account*1548 of $268,692.50, and Mr. Schepp retained as personal to himself and his daughter the remaining losses reflected in accounts with other brokers amounting to $214,646.94 * * *. The company desired to assume that loss because the Bureau had disallowed such losses to Mr. Schepp personally. * * * The 1918 treatment of the stock trading was retrospective and no attempt was made to show it otherwise upon the books.
In another brief filed for petitioner, the question was thus stated:
* * * The peculiar question relating to the years 1918 and 1919 is, can a corporation sustain a loss by assuming the loss of a stockholder, through the crediting of the stockholder with the amount of that loss upon the company's account with the stockholder? * * *
On October 30, 1917, Schepp was advised by his attorneys that petitioner's surplus earned prior to 1917, if invested in Liberty bonds, could be included in invested capital. In June, 1918, an auditing company likewise recommended the purchase of such bonds with surplus funds. During 1917 and 1918 petitioner bought and sold Liberty bonds for cash on its own account and with its own funds, entering the purchases and sales regularly on its books. *1549 As a result of these transactions it sustained, in 1918, a loss of $5,788.62, which it claimed as a deduction on its tax return, but which the Commissioner disallowed.
5. Fraud. - The petitioner's return for 1918 wilfully understated its income, and was falsely and fraudulently made and filed with intent to evade its lawful tax.
*428 OPINION.
STERNHAGEN: Of numerous assignments of error in the respondent's determination of deficiency, there remain five principal issues to be decided by the Board, and these will be taken up in order.
1. Salary. - The petitioner paid Florence Schepp $20,000 in 1918 by crediting the amount to her personal account on its books, from which her personal bills were paid and debited. The petitioner deducted this amount among its business expenses, the Commissioner disallowed the deduction entirely, and the petitioner now assails this disallowance.
The Revenue Act of 1918, section 234(a)(1), permits the deduction of
All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services*1550 actually rendered * * *.
Florence Schepp was the daughter of the founder of the business and in 1918 she and her father owned all of its shares, the father being the president - "the brains" and directing head of the company, and personally engaged in all phases of its business - and the daughter being the vice president. She was also a director. The specific services she performed for the company were slight, consisting of suggestions as to an improved canvas cover for the storage bins, assisting in the preparation of the negligible amount of advertising (the total cost of which was about $500), suggesting improved toilet and other sanitary facilities at the factory, consulting with her father about improved retail containers, acting as her father's amanuensis on a trip to Toronto, and discussing matters of a general nature with her father and with the secretary of the company. She had no desk at the corporation's office, failed to attend the one directors' meeting of the year, and sometimes made no appearance at the office for a week or more. The amount which was allotted to her varied between $3,000 and $25,000. The president's salary varied between $25,000 and $100,000, *1551 being $50,000 in 1918. The secretary received $6,000, and the treasurer $2,100. The latter were regularly employed and occupied in the petitioner's business.
The evidence before us supports the conclusion that the personal services actually rendered by Florence Schepp were not worthless, as determined by respondent. A reasonable allowance therefor, however, would not, in our opinion, exceed $4,000, and this has been found as a fact.
The petitioner argues that the judgment of the directors is presumptively reasonable and that the evidence supports the presumption; that the test of the statute must be applied to the single aggregate *429 amount of all officers' salaries; and that the aggregate sum of all salaries paid to its officers is reasonable in the light of petitioner's history and in proportion to corporate earnings. But, in our opinion, the argument must fail.
While the judgment of the corporate directors is not to be disregarded, there is no rule that it is conclusive or that it comports with the statutory qualifications of the tax deduction. Directors have a fairly free hand in fixing corporate salaries, and if the Government were seeking to prevent or*1552 set aside their payment, a heavy burden would be upon it. But, however honest may be the directors' judgment and however great their power to effectuate it, these do not determine the deductibility of such amounts under the tax law. For the purpose of determining taxable net income, the deduction is limited to amounts which are reasonably commensurate with the personal services actually rendered and thus are no more than ordinary and necessary expenses of carrying on the business. Hence the directors' duty to the corporation is no criterion of the Commissioner's duty to limit the tax deduction within the statutory bounds, and the two are not in conflict. When the Commissioner has made a determination, the taxpayer who attacks it must prove by evidence of the services rendered and their value that a correct determination would exceed that of the Commissioner. Where the payments are to kinsfolk or to shareholders, the proof must also show that they were not influenced by family consideration and were not disguised distributions of profits. See *1553 Botany Worsted Mills v. United States,278 U.S. 282">278 U.S. 282; Becker Bros. v. United States, 7 Fed.(2d) 3; United States v. Philadelphia Knitting Mills,273 Fed. 657; Benz Bros. Co.,20 BT.A. 1214; C. S. Ferry & Son, Inc,,18 B.T.A. 1261">18 B.T.A. 1261; Home Industry Iron Works,8 B.T.A. 1267">8 B.T.A. 1267; Meyer Hecht,2 B.T.A. 319">2 B.T.A. 319; Gustafson Mfg. Co.,1 B.T.A. 508">1 B.T.A. 508.
The suggestion has not heretofore been considered in the decided cases that the deduction must be tested as an aggregate amount and that no single salary may be held nondeductible unless the sum of all salaries is too large. We think the statute requires no such construction. Each of the deductions of section 234 is described as a class, and several are described by the term "a reasonable allowance." To test the salary deduction by ascertaining the ratio of the aggregate salaries to net earnings or gross sales would result in the recognition of a mathematical gross maximum and either the disregard within that figure of any relation between individual service and the compensation therefor, however plainly disproportionate, *1554 or else the consideration of the sum of all services and the relation of the whole to the gross salaries paid. This would practically nullify the clear statutory language and be at variance with the judicial *430 tests laid down in the decisions above set forth. While it might superficially appear that the total paid to all four of petitioner's officers is small in comparison to its gross sales and net earnings, it does not appear that the amount credited to Florence Schepp is reasonable in comparison to her service. There is no evidence whatever of services and salaries actually performed and paid by and to other individuals in the same or comparable businesses, and no evidence of how much the company would have to pay to get someone else to do what Florence Schepp did. Becker Bros. v. United States, 7 Fed.(2d) 3; Becker Bros.,9 B.T.A. 1260">9 B.T.A. 1260, affd., 37 Fed.(2d) 1010. But the evidence shows that there were services performed and as best we can we are required to fix the statutory deduction indicated by the evidence.
2. Royalty. - The petitioner claims the right to a deduction for 1918 of $34,745 as royalty "paid*1555 or credited" to Florence Schepp. It argues that Leopold and Florence Schepp had a valuable property right in the idea and design of the cake and bread boxes, and that a royalty computed at 4?? a pound on all package cocoanut sold in such boxes in 1918 was deductible as an ordinary and necessary expense.
There are, in our opinion, several different reasons why the petitioner's claim can not succeed. Neither Leopold Schepp nor his daughter had such a property as would support a claim for royalty from this petitioner. Cf. Thornburgh Mfg. Co.,17 B.T.A. 29">17 B.T.A. 29, 34. There was neither a patent nor a copyright, nor yet a trademark, and, so far as this record shows, the subject matter of the alleged royalty was not susceptible of patent, copyright or trademark. There is nothing which can be called an invention. The subject is not the physical box, and it is not the design, style or decoration of the box. It is solely the idea of selling cocoanut to the retail trade in these containers in order to attract consumers - a mere method of distribution. No authority is cited which supports the view that such an idea is patentable or in any way property which the petitioner*1556 might not freely use or for the use of which it would be required to pay a royalty or other consideration.
But, passing that, it appears that the basic idea - namely, that of using cake and bread boxes - was disclosed by Schepp before incorporation and was adopted by the corporation with his full knowledge and consent as part of the business which it acquired in 1901 in exchange for its shares. The subsequent modifications of the box may be regarded as incidental improvements of the predominant idea, and made while Schepp was employed by the corporation. The 1918 model dates back to 1908 or earlier. During all this time Schepp knowingly consented to and promoted the extensive use of the idea and permitted the corporation to incur obligations for the *431 manufacture of such boxes and the distribution of its product in them. He would have been completely estopped either to prevent such use or to demand payment therefor. Cf. Gayler v. Wilder, 51 U.S. 477">51 U.S. 477;Marsh v. Nichols, Shepard & Co.,128 U.S. 605">128 U.S. 605; *1557 Baldwin Co. v. R. S. Howard Co.,238 Fed. 154; certiorari denied, 243 U.S. 636">243 U.S. 636.
Since he was in no position to impose upon the corporation any obligation, it can not be said that any amount which he, the principal shareholder, might cause the corporation to pay was a royalty or otherwise an ordinary and necessary expense of the business. There is no occasion to consider whether the amount was reasonable. It seems plain that whatever amount was paid or credited was a mere distribution of profits to the sole shareholders under a misnomer. The resolution of 1917 adds no legal sanction to the royalty claim, - and this is especially so as to the 4 cents claimed for 1918, as the resolution is by its terms confined to 1917, and provides for a 6 1/2-cent payment.
In 1915 the "royalty account" was first established, and credits thereto were made without the name in the ledger of any obligee thereof. Had there actually been an obligation to either Leopold or Florence Schepp for royalties there might have been some ground for treating the credits to the royalty account or the royalties payable account as book accruals of liability. But since, as has*1558 been seen, there was in substance no such liability, the mere crediting of the amounts in these royalty accounts can have no force to prove the deductibility of the items.
Not until 1921 is there an attempt to reflect on the ledger an obligation to Florence Schepp, and even that attempt is surrounded by ambiguity. At that time the royalty account contained credits accumulated since 1915 of $306,378.66. Against this was now made a debit entry of $283,635.06, a check was drawn to the order of Florence Schepp and deposited apparently to the credit of the corporation and so entered in its cash book. Thereafter the amount was credited to the Florence Schepp loan account. Why this roundabout course was taken is not explained. If the royalty credit had already represented an incurred liability to Florence Schepp, there was no occasion for any further accounting until the liability was discharged. The drawing of the check in 1921 was only a simulation of payment, because simultaneously it was deposited to the corporation's account. The credit then entered in the Florence Schepp loan account would indicate that she, having been paid her royalty, was now lending the amount to the corporation. *1559 All this was clearly fictitious accounting, regardless of the fact that it was carried on until 1926 and 1927. And the fact that Florence Schepp projected *432 the fiction into her personal-tax return, made on the cash basis, by including as gross income actually received in 1918 the $34,745 which, as has been seen, she did not actually receive in that year, does not give substance to the corporation's deduction. Its only significance is to indicate the care and thoroughness with which the plan for the deduction was attempted to be fulfilled.
We are of opinion, therefore, that there was no basis for a royalty and that no liability for an ordinary and necessary business expense was paid or incurred in the taxable year in question. The respondent correctly determined that the item claimed was not a deduction.
3. Invested Capital. - On its return the petitioner included in its invested capital of January 1, 1918, the amount of $197,189.92 which had been entered in its books in 1917 as a credit to surplus taken from Leopold Schepp's personal account. The respondent, in determining the deficiency, held that this amount was not within petitioner's statutory invested*1560 capital. Petitioner now claims not only that this amount falls within invested capital, but also that the entire amount of $523,537.22 should be restored to its statutory surplus. It argues that, notwithstanding the resolution and accounting of 1912 and the more substantive facts of that period, the amount did not actually leave the corporation's surplus; and, furthermore, that if it did go out of surplus, then $197,189.92 of it came back by the reversing entry of 1917.
We are of opinion that the evidence supports the respondent's determination and establishes that no part of the $523,537.22 is within invested capital of 1918. The question is limited to section 326(a)(3), Revenue Act of 1918, which includes in invested capital "paid-in or earned surplus and undivided profits," there being no contention and no evidence that the amount represents cash or property, tangible or intangible, paid in for stock or shares.
On February 20, 1912, the directors, upon motion of two of their number who were minority shareholders and employees, voted to distribute the accumulated surplus; and on March 1, 1912, with express reference to this vote, the amount of $523,537.22 was credited to*1561 L. Schepp and debited to the various reserve accounts which had been set up on petitioner's books as a method of appropriating surplus. No objection was made to this at that time or afterwards by any shareholder. A year later Leopold Schepp acquired all the shares of others except those of his daughter.
That the distribution of 1912 was more than an empty bookkeeping entry is clear. It completely wiped out Schepp's debit balance of $379,940.87, giving him a credit of $143,596.35 (which was less than the figure of $197,189.92). To the extent of $379,940.87, there was an immediate disposition and appropriation of *433 the surplus. Of the remaining $143,596.35, withdrawals were made by Schepp, so that by June 25, 1912, his balance was reduced to $92,903.44, there having been no intervening credits. At the end of the year 1912 it was still only $186,171.41, or less than the $197,189.92; a year later it was $95,262.49, and a year later, on December 31, 1914, after having the day before dropped below $60,000, it was still only $146,730.50. Not until December 31, 1915, more than three years after the original distribution, was Schepp's credit ($202,502.05) sufficiently high*1562 to be free from the need of the $197,189.92.
In view of this treatment of the surplus in a way consistent only with its complete appropriation by Schepp, there is no merit to the argument that the resolution and book entry were ineffective. Petitioner urges that after so carefully setting up these various reserves, it is not to be believed that there was an intention to wipe them out by distribution, and this to a single shareholder. But the directors had the right to do so, and the direct evidence that they did so without complaint from shareholders leaves no room for debate as to the wisdom or reasonableness of their action. We see nothing either in the resolution itself or the surrounding circumstances to support the petitioner's contention that only an ordinary dividend of 2 per cent or 4 per cent was intended by the resolution. Nor is the effectiveness of the distribution lessened by the fact that it all went to Schepp. A distribution may be valid although not apportioned to shareholdings, and when the shareholders make no objection the corporation itself has no ground for attack. *1563 Joseph Goodnow & Co.,5 B.T.A. 1154">5 B.T.A. 1154; Henry F. Michell Co.,16 B.T.A. 1297">16 B.T.A. 1297; cf. Leo G. Hadley,6 B.T.A. 1031">6 B.T.A. 1031; 36 Fed.(2d) 543.
The decision in Eaton v. English & Mersick Co., 7 Fed.(2d) 54, although somewhat similar, is not sufficiently so to be controlling. The court found that the resolution was itself not a declaration of dividend, that in fact it was not so intended, that in fact it was not so treated, and that under Connecticut law it could not be so held. All of these circumstances led the court to hold that surplus had not in fact been reduced. In the present case there was a deliberate recognition of the distribution in the conduct of everyone concerned. Flynn v. Haas Bros., 20 Fed.(2d) 510, was likewise predicated upon the lack of substantial recognition of a distribution by the corporation or the shareholders, holding that the resolution and book entry alone did not give substance to the alleged distribution as against conduct showing intent to be otherwise. Here the resolution is clear and has never been revoked or changed, the corporation acted upon it by crediting*1564 the amount to Schepp, wiping out his indebtedness and permitting him to draw upon the balance, as he did, and there is no evidence that the corporation ever intended otherwise and no *434 inconsistent acts or conduct. Cf. Elgin Butter Tub Co.,12 B.T.A. 1313">12 B.T.A. 1313. In our opinion, therefore, the amount was not paid-in or earned surplus in 1918 and is not to be included in petitioner's invested capital.
But, argues the petitioner, at least the $197,189.92 must be included in invested capital because before 1918 it was effectively restored to surplus by the journal entry of 1917. This, we think, is not so. In contrast with the substantial effect of the entry of 1912, we find no substance whatever in the entry of 1917. It purported only to reverse pro tanto the entry of 1912 (1911 was obviously an error) upon the supposition that it was erroneous as to the profit and loss surplus as no authority for it could be found. As we have seen, there was full authority for the entry in the resolution of distribution and it was not erroneous. Surely there is no reason to say it was at the same time erroneous as to $197,189.92 and effective as to the rest. The entry*1565 was made by an accountant who knew nothing about the facts and who acted without instructions from the secretary or, so far as the record shows, from anyone else. It was not made as a record of any fact or transaction which substantively took place.
Furthermore, as has been seen, the 1912 credit of $523,537.22 immediately wiped out Schepp's debit of $379,940.87 and within four months thereafter was further withdrawn, bringing the remaining credit balance down to $92,903.44 at the end of June, 1912, and was not for three years above the $197,189.92 figure. If it be suggested that these figures are not reflective of the true condition because of the omission ratably to accrue salaries monthly, it may be said that, so far as the evidence discloses, the entry upon the books of accrued salaries would still leave Schepp's credit balance for the same period at a figure below $197,189.92. Thus it appears that, not only was the amount authorized and credited, but it was actually appropriated by Schepp in part immediately and in greater part soon after. The credit went on for over five years at Schepp's individual disposal. In view of this record and the conduct of the persons acting*1566 under it, there is no support for a contention that as to this lesser amount the surplus was never reduced. And having been reduced in fact, so that Schepp had and exercised a right in respect of it, it would require more than an entry on the corporation's books to bring it back into the corporation's rightful surplus. So far as the evidence shows, Schepp neither gave back the amount nor acted so as to estop himself to deny it; and, as has been seen, the entry itself appears merely as an accountant's mistake. Under these circumstances, L. H. Manning & Co.,10 B.T.A. 633">10 B.T.A. 633, is not controlling.
*435 The petitioner, in our opinion, had no right to include the $197,189.92 in its invested capital and respondent correctly disallowed it; nor has petitioner any right to have its invested capital increased by including any part of the $523,537.22. The respondent is sustained. Adjustment will be made as stipulated in respect of petitioner's inadmissible assets.
4. Stock Trading Losses. - The petitioner deducted $268,692.50 as a loss sustained by it in 1918 in dealing in securities. The respondent disallowed $267,875 because it was not sustained by the petitioner, *1567 and extensive proof of the circumstances has been made by the petitioner in an effort to establish the loss as its own. This circumstantial proof has been substantially all set forth in the findings and need not be repeated. In our opinion, it not only falls short of proving a loss by the petitioner, but rather strengthens the respondent's determination that the loss was not that of the petitioner.
The difficulty and such doubt as there is on this point are attributable to Schepp and the corporation. Instead of conducting their businesses clearly and distinctly separately, they voluntarily mingled them with resulting uncertainty and confusion. To Schepp the corporation was a mere convenience and, since he was accountable to no one else, he treated it as such without strict regard to the integrity of its separate function. As between him and the corporation, it was of no importance how their financial affairs were accounted for. If, therefore, the evidence upon the present issue prevents an affirmative conclusion favorable to petitioner, the failure is chargeable to petitioner and its officers and need arouse no feeling of hardship.
The corporation in prior years made no*1568 pretense of marginal trading in securities. Such trading was not its ordinary function. Schepp, on the other hand, had carried on speculative trading for a number of years, and had consistently claimed the right to deduct the resulting losses. It was only because the Government denied this right (whether rightly or wrongly) that the attempt was made to attribute the losses to the corporation. The first definite and unequivocal act of recognition by the corporation to this end was the book entry of December 31, 1918, after the transactions of the year had taken place. This was the first such entry on the corporation's general books. The blotter which had been currently used to note the stock transactions was a memorandum book and entirely independent of the corporation's accounts in so far as marginal trades were concerned. No current postings were made from it to the corporation's general books and, so far as appears, the *436 marginal trading shown by the blotter was not reflected in any trial balance or other periodic financial summary. Indeed, in the first instance, the losses were reflected in Schepp's personal account, and only at the end of the year credited to*1569 him and debited to the corporation's profit and loss. On the other hand, there were contacts between the blotter and the cash book as to a few investment transactions, admittedly of the corporation, in Liberty bonds and stocks. The testimony of the witnesses added no certainty to the record in lieu of this indefiniteness of the bookkeeping. Even if any of the margin transactions could be attributed to the corporation, it would be necessary to exclude those prior to September, when, as shown by the evidence, Schepp is said to have first determined to have the corporation trade in stocks. But, in view of our decision as to the transactions of the entire year, it is unnecessary to discuss the force of the evidence in this respect.
We hold that the petitioner did not sustain the losses claimed as the result of stock margin transactions. Adjustment should be made to allow the loss of $5,788.62 sustained in the sale of Liberty bonds.
The petitioner argues that, since the respondent has imposed a fraud penalty predicated upon this deduction, it is the respondent's burden to prove not only the elements of fraud, but also the error of the deduction. This, in our opinion, is an unsound*1570 view. It confuses the substantive issue, whether the losses were sustained by petitioner, with the issue whether, in taking such a deduction petitioner wilfully understated its income for the purpose of evading its lawful taxes. These issues are clearly separate, for, although the determination of fraud necessarily implies falsity in the claim of loss, yet the respondent can and may determine the deduction to be based on a false or incorrect claim and still find no justification for imposing the fraud penalty. In either event his determination disallowing the loss deduction is by law presumed to be correct, while his determination of fraud carries no such presumption because section 601, Revenue Act of 1928, amending section 907(a), Revenue Act of 1926, provides:
* * * In any proceeding [before the Board] involving the issue whether the petitioner has been guilty of fraud with intent to evade tax * * * the burden of proof in respect of such issue shall be upon the Commissioner. * * *
It is not difficult to separate and distinguish these issues in a case such as this. Deductions are frequently taken through error of law or fact which involve no suggestion of fraud. The require*1571 no consideration of intent, motive or conduct in making the return. Bona fides is not questioned, in either the moral or unmoral sense of that term. The question is only whether the deduction was unfounded in fact or law. When, however, the Commissioner adds *437 a fraud penalty, he in effect asserts that fraud has been practiced in the return; not merely that the transactions in which the deduction is grounded lacked bona fides, but that, whether or not the transactions were themselves bona fide, their treatment in the return embodied a fraudulent understatement. As to the issue raised by his determination of fraud, the burden is upon him; and he may fail to sustain such burden, notwithstanding the determined and presumed error in the return. In other words, both parties may fail through inadequate proof on their several issues, and thus the deficiency would be sustained and the penalty set aside.
The petitioner cites two decisions, Taplin v. Commissioner, 41 Fed.(2d) 454, and Budd v. Commissioner, 43 Fed.(2d) 509, decided by the Circuit Courts of Appeals of the Sixth and Third Circuits, respectively. These cases, however, *1572 do not, in our opinion, support petitioner's view. In respect of sales ultimately held to have been made, the Commissioner had challenged their bona fides and determined that they were sham and hence that no losses were sustained. He had not determined fraud or imposed penalties. The courts, however, held that his determination of lack of bona fides was essentially a determination of fraud, and, since fraud is never presumed, that the burden was upon the Commissioner who had in effect asserted it. In the Budd case, the court regarded the above quoted provision of section 601 of the 1928 Act as applicable to not only a direct issue of fraud, but also the issue as translated from the challenge of bona fides when no penalty was imposed.
This we have difficulty in understanding. But there is no difficulty in seeing the difference between those cases and this. Here there is no doubt as to whether the transactions were genuine or sham. That such sales occurred is admitted by all, and the Commissioner does not intimate that they lacked vitality. The entire question is whether these recognized transactions were by petitioner. The respondent's determination that they were not*1573 by petitioner is not ipso facto the equivalent of a charge of fraud. It may represent either a difference of view as to the legal significance of facts or a difference in inferences of fact to be drawn from a confused mass of evidence. To say that, standing by itself, it was the same as a fraud charge, and upon that translated premise, to apply section 601 and throw the burden of proof upon respondent, would be merely a confusion of issues which generally and by statute are readily distinguishable.
Nor can we say that the burden as to the loss deduction is on respondent because of the statements and conduct of the several examining revenue agents. There was, according to the present record, sufficient ground to disallow the claimed deduction; and upon *438 this the respondent made the definitive determination which petitioner assails. We are far from the opinion that this determination is so wholly arbitrary or wanting in probable foundation or merit as to require evidence in the first instance to support it. See *1574 Pennant Cafeteria Co.,5 B.T.A. 293">5 B.T.A. 293; Jacob F. Brown,18 B.T.A. 859">18 B.T.A. 859, 867; Edgar M. Carnrick,21 B.T.A. 12">21 B.T.A. 12, 21; Benedict Crowell,21 B.T.A. 849">21 B.T.A. 849, 851; James P. Gossett,22 B.T.A. 1279">22 B.T.A. 1279, 1284.
5. Fraud Penalty. - Having held as we have that the petitioner did not sustain the loss which it deducted, it becomes necessary to decide whether the respondent has correctly determined that a fraudulent return was wilfully made by the petitioner corporation with intent to evade tax, and added to the tax 50 per cent of the amount of the deficiency. Section 250(b), Revenue Acts of 1918 and of 1921; section 275(b), Revenue Acts of 1924 and of 1926; section 293(b), Revenue Act of 1928. Upon this issue the burden is, by section 601, placed upon the respondent. The issue is restricted by respondent's specification that the fraud is in the deduction taken for losses sustained in marginal trading in stocks. Since respondent makes no specification of fraud in respect of any of the other items in the return which have been determined by him and held by us to be incorrect, our consideration of fraud leaves out those*1575 items entirely.
We can not, however, escape the definite view that in taking the deduction for stock-trading losses on its return, the petitioner and its officers wilfully acted contrary to the truth within their knowledge and that it deliberately made false statements on its return for the purpose of evading its lawful tax. No one reading this record could reasonably escape the belief that the petitioner's president and its secretary were astute and intelligent business men who were fully aware of the facts and implications of their business and reasonably cognizant of the general effect upon the corporation's tax liability of its acts and transactions. There is no room for an extenuating plea of ignorance or inadvertence. What was done was done deliberately and knowingly. That it was done incorrectly appears not only from our foregoing discussion in the light of the burden of proof which rested on petitioner, but also from a consideration of the evidence irrespective of the petitioner's burden. In other words, giving full consideration to all the evidence, we are clearly of opinion that the petitioner did not engage in the marginal transactions and hence that it sustained*1576 no loss on account thereof. As to the years earlier than 1918, this is practically beyond dispute. When the trading accounts were opened they were intended and understood to be the transactions of Schepp individually. For several years this was the accepted fact. These accounts were never closed, and, in 1918, Schepp had *439 no intention of closing them. (The #11 account was expressly closed in a later year.) No new accounts were opened in 1918 at any time before the end of the year. Only two things happened to give any color to the notion that the account became that of the corporation - one, that Schepp sometime in 1918, probably as late as September, told Belgard that the accounts with Miller & Company would be those of the corporation, and, two, that the corporation, on December 31, 1918, at Schepp's direction, transferred the net loss which appeared in Schepp's personal account on its general books from such personal account to its own profit and loss account. The testimony of the broker's representative indicates no change in the handling of the accounts or the responsibility of Schepp. The accounts continued to be carried by the same anonymous designations with*1577 Schepp's individual guaranty.
But even these two facts, if they proved that the corporation were engaged in trading with Miller & Company, would affect only such transactions as took place subsequent to the president's determination and announcement. Thus the many transactions of the first two-thirds of the year would still remain those of the individual, and such of the deducted losses as resulted therefrom were entirely beyond the reach of the corporation. Belgard testified orally that Schepp's statement to him was made "sometime in 1918" and "I think the early part," while the petitioner's written statement to the Bureau which Belgard verified in writing was that "after September 16, 1918, and prior to the closing of the books for 1918" the determination of Schepp and his daughter was made. This deliberate written statement verified by Belgard is more reliable than his vague recollection at the hearing. So, in any event, the petitioner knowingly and deliberately founded its deduction upon a great many transactions with which it had no connection and from the result of which it had not suffered. Of course its voluntary book entry at the end of 1918, even if it were an assumption*1578 of the misfortunes of the year, would be gratuitous and not a loss.
The rationale seems to have been that Schepp had suffered trading losses which, despite his protests, the Bureau had persistently disallowed as deductions; thereupon the corporation began to deduct them, regardless of whether it had suffered them or not, and the books were by a single closing entry adjusted to that end. This we think was without warrant in law, deliberately contrary to fact, and hence within the statute prescribing the penalty.
Schepp died in 1926, and consequently his presence and testimony were not available at the trial in 1931. This has caused us to ponder long upon this determination of a fraudulent return. The petitioner criticises the respondent for making this determination after Schepp's *440 death. Our function, however, is to consider the evidence as it appears and decide whether it establishes the fraud which respondent has determined. If, as has been found, the corporation was guilty of fraud, it may not escape the prescribed penalty either on ethical grounds relating to the respondent's method of investigation or out of too high a regard for its deceased president. Its*1579 responsibility for his official acts did not lapse with his death, and when a penalty is determined and presented to this Board for review under the rules of evidence, the decision may not be deflected by a charge that the investigation was not timely. The statute clearly intends a fraud charge to be without limitation of time, and it places the burden of proof on respondent. We have no authority to add a standard of conduct as a further condition. Ernest M. Bull, Executor,7 B.T.A. 993">7 B.T.A. 993, 1000; James Couzens,11 B.T.A. 1040">11 B.T.A. 1040, 1148, 1158. It should be said, however, that we have given full consideration to the possibility that Schepp's testimony might have served to strengthen petitioner's defense, and have in the light of that possibility weighed the evidence with the utmost care. It is only because the evidence of fraud is compelling that we have reached this conclusion, however regrettable it may be that the record may not contain Schepp's testimony on the subject.
It is also urged by petitioner that respondent's affirmative evidence upon the fraud issue utterly fails to support the determination. If the respondent's statutory burden of proof*1580 could be discharged only by means of the testimony of the Government witnesses brought forward in his behalf, we should at once say that such testimony was inadequate to sustain the charge of fraud. But we do not understand that this is what the respondent's burden of proof means. 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 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*1581 supports the respondent's determination.
*441 The penalty is sustained at 50 per cent of the amount of the deficiency.
6. Other issues have either been withdrawn by petitioner or conceded by respondent, and the parties can readily, in accordance with their statements made at the trial and appearing in the record, readjust the deficiency in respect thereof.
Reviewed by the Board.
Judgment will be entered under Rule 50.
LANSDON dissents.
SMITH and BLACK dissent as to the imposition of the fraud penalty.
VAN FOSSAN, dissenting in part: It is elemental that fraud must be proved by clear and convincing evidence; a mere preponderance is not sufficient. When the evidence in this case is subjected to this test, I find myself unable to concur in the imposition of the penalty for fraud.