*4300 1. An amount voted in the taxable year as and for salary for prior years, without previous authorization therefor, is not allowable as a deduction from gross income for the taxable year.
2. Additional salary authorized and paid in a given year as and for salary for that year must be reasonable in amount for services actually rendered in that year in order that it may be deducted from gross income.
*1076 The Commissioner determined a deficiency in income and profits tax of $23,496.24 for the calendar year 1919. It is claimed that the Commissioner erred in refusing to allow a deduction of $36,048.43 for 1919 as additional compensation for petitioner's vice president and general manager.
A claim for additional depreciation was abandoned at the hearing.
FINDINGS OF FACT.
Petitioner is a Virginia corporation engaged in the manufacture and sale of brick and mill work, and in the sale of building supplies, lumber, and fuel, with principal office at Roanoke.
It was organized in 1906. J. G. Payne, C. S. Adams, and Taylor Gleaves, all of Lynchburg, *4301 were the incorporators, directors, and original stockholders, each owning one-third of the authorized capital stock. Prior to that time they had been partners in a contracting business at Lynchburg under the firm name of Gleaves & Co. Upon organization of petitioner, Adams and Payne transferred their stock to a corporation controlled by them, known as Adams Brothers-Payne Co. During the taxable year petitioner's stock was therefore owned two-thirds by this corporation and one-third by Gleaves. Payne was president; Adams, secretary and treasurer; and Gleaves, vice president and general manager. These men constituted petitioner's board of directors.
Upon organization and pursuant to the by-laws, Gleaves was placed in charge of petitioner's business and was given authority to act for the board of directors. Article 4 of the by-laws provided: "The Board of Directors may confer upon the manager authority to act for the Board and may delegate to him such other powers and functions as it may be deemed proper." Gleaves immediately moved to Roanoke and thereafter, until his death in 1920, spent all of his time *1077 and energy to the affairs of the petitioner. Payne and Adams*4302 acted merely in an advisory capacity, giving little or no personal attention to the business. They drew no salaries for the first two years. Beginning in 1909, Adams drew a compensation of $750 per annum. Payne's withdrawals are not disclosed. After August 28, 1919, Adams' salary was increased to $1,500 per annum. No dividends were paid prior to March, 1920, all profits being left in the business. Payne died in 1910 and Adams succeeded him as president.
Upon petitioner's organization, Gleaves' salary was fixed at $300 per month and some time later it was increased to $5,000 per annum. The action in fixing Gleaves' original salary and in granting the increase was more or less informal and was not recorded in the minutes, which were kept at Lynchburg. Gleaves and the other officers had a "drawing account." The drawing accounts were handled by charging the officers with amounts withdrawn and periodically crediting them with salaries. At the time of petitioner's organization there was a general understanding among the officers that if the business prospered additional compensation would be paid.
From year to year prior to 1919, Gleaves, in addition to his salary, withdrew*4303 various sums of money which in the aggregate totaled more than $36,000, and in 1919 the total withdrawals amounted to more than $42,000. The amounts withdrawn by Gleaves were charged on petitioner's books to his drawing account, which was carried in accounts receivable.
While Adams had knowledge that Gleaves had a drawing account, it was not until 1919, when Gleaves advised him, that he knew the amount of the withdrawals.
In July, 1919, Gleaves went to Adams and disclosed the amount of his withdrawals, and at that time stated that in accordance with the understanding existing at the time of incorporation, he would have to be paid additional compensation. He also advised Adams that he thought of severing his connection with the petitioner if his request was not granted. Accordingly, after some conferences between Gleaves and the other officers of the petitioner, a meeting of the board of directors was held on August 28, 1919, at which meeting Gleaves and Adams were present, and the following action was taken:
The President (Adams) stated the object of the meeting was to discuss the question of salaries to the officers of the company, and suggested that an account on the books*4304 against Mr. Taylor Gleaves, amounting to $36,048.43 be credited to the account of Mr. Taylor Gleaves, charged against profit and loss account; the object of this being to take this action instead of raising salaries at this time, as results obtained in the business were more due to Mr. Gleaves' efforts than anyone else and in recognition of his valuable services, and it was thought best to balance this off at one time rather than to credit bonus at the end of each year as has been done by a good many concerns.
*1078 Salaries of the company, on motion of Mr. Gleaves, seconded by Mr. Adams, until changed, were fixed as follows: Taylor Gleaves, $5,000 per year; C. S. Adams, $1,500 per year. This motion was unanimously carried.
This, incidentally, was the first time that the salaries of the officers had appeared in the minutes of the petitioner.
From the time of its organization, Gleaves had had practically entire management and control of the petitioner and its business at Roanoke. The company had been successful in its operations and progress had been made. All this, in a large measure, was due to the efforts and ability of Gleaves, and rather than lose his services*4305 the foregoing action was taken by the petitioner. However, during the year 1919, Gleaves was in poor health and during that time he spent a good deal of time away from his office, and as a result thereof the services rendered by him in that year were not of the same valuable type as rendered in preceding years.
In March, 1920, Gleaves suddenly died from heart trouble and shortly thereafter it was discovered that he had for a period of six years, from 1914 to 1919, authorized the bookkeeper to pass salary credits to his drawing account at the rate of $10,000 per annum instead of $5,000 per annum, as had been authorized by the directors. In its returns for the same years, the petitioner deducted from gross income the amount of $10,000 as salary to Gleaves, of which amount $5,000 was wholly unauthorized and the Commissioner allowed the deductions. The "stuffing" of his salary was possible on the part of Gleaves because of his almost complete control of the business. The other officers knew nothing of that action until after his death.
The petitioner accounted and made return of its income on the basis of cash receipts and disbursements.
In its return for the year 1919, the*4306 petitioner deducted the amount of $36,048.43 as additional compensation or bonus to Gleaves. Upon audit of the return, the Commissioner disallowed the deduction on the ground that the amount represented an extraordinary and nonessential expense, and also decreased the petitioner's invested capital by the amount of $36,048.43 on the ground that the payment ot Gleaves constituted a disbursement of capital.
OPINION.
LOVE: The Commissioner concedes that he erred in treating the amount of $36,048.43 paid to Gleaves under the circumstances above described, as a disbursement of capital, thereby reducing the petitioner's invested capital by that amount. Accordingly, petitioner's invested capital should be adjusted by including therein the amount erroneously excluded.
The sole remaining issue is whether the additional compensation in the amount of $36,048.43 credited to Gleaves in the year 1919, *1079 pursuant to the action taken by the board of directors on August 28, 1919, may be deducted from gross income for that year.
It is necessary, first, for us to determine the status of the additional compensation in question. *4307 Was it voted as and for salary for 1919, although measured by services rendered prior to that year, or, was it voted and paid in 1919 as and for salary for services rendered in prior years? If the compensation voted and paid in 1919 was the payment of additional salary as and for prior years, without previous authorization therefor, it would not properly be deductible in 1919. .
The petitioner takes the position that the amounts withdrawn by Gleaves, in addition to his fixed or regular salary, in the years from 1906 to and including 1919, constituted additional compensation in the amount withdrawn as and for the year in which the withdrawal occurred, and that the total amount having been authorized in 1919, it is properly deductible in that year.
The record discloses that at the time of petitioner's incorporation there was a general understanding reached among the three officers, directors, and stockholders that if the business prospered and was a financial success, additional compensation would be paid. But in our opinion, such an understanding falls far short of an authorization of additional*4308 compensation. The most that can be said of that agreement or understanding is that it evidenced an intention later to authorize extra compensation if the petitioner prospered. It is clear that during the years prior to 1919 there was no legal obligation to pay additional compensation. It was not until 1919 that corporate action was taken in respect thereto. As we stated in Vaughn & Barnes, inc., supra:
If the interpretation be that contained in the second query above, then we are of the opinion that the deduction should not be allowed. That is to say, if the compensation voted and paid in 1922 was the payment of additional salaries as and for a prior year, without previous authorization therefor, it would not properly be allowable in 1922. The reason is obvious. To hold otherwise would permit a corporation with a large surplus in 1922 to effectually dispose of that surplus by voting salaries over a long series of prior years. No simpler method of evading taxes could be thought of. ; *4309 ; ; ; ; ; .
The record discloses that for a period of six years, from 1914 to 1919, without the knowledge of the other officers, Gleaves "stuffed" his regular salary to the extent of $5,000 annually, and that in its returns for those years the amount of $10,000 was deducted as and for salary to Gleaves. It is obvious, therefore, that during each of *1080 those years Gleaves received an additional salary of $5,000. In asking for a deduction in 1919 of the amount of $36,048.43 the petitioner is, in effect, claiming a deduction for additional compensation, part of which is for the years 1914 to 1919, for which years the petitioner has heretofore deducted and the Commissioner allowed additional salary in the amount of $30,000, which amount is in addition to the $36,048.43. However, without considering the fact that the petitioner has heretofore deducted*4310 additional salary for Gleaves for 1914 to 1919, and that the Commissioner has allowed the deductions, we are of the opinion that the deduction claimed in 1919 as and for additional compensation for years prior thereto is not properly deductible in that year, it not having been previously authorized.
However, during the year 1919 prior to the corporate action taken in August, Gleaves had withdrawn, in excess of his salary credits, approximately $1,750. Under the petitioner's contention therefore, this amount having been voted and paid as and for salary for 1919, would be, under certain conditions, deductible.
To constitute an allowable deduction, the salary voted as and for 1919 must be reasonable for services performed in that year. In other words, if the amount of $10,000 deducted by the petitioner and allowed by the Commissioner as salary for Gleaves for 1919 plus the additional amount of $1,750 is reasonable for services rendered by Gleaves in 1919, then it would properly be deductible.
The record shows that subsequent to 1914 and including 1919 the petitioner deducted and the Commissioner allowed the amount of $10,000 as salary for Gleaves. There is nothing in the*4311 record to indicate that a salary in excess of $10,000 was reasonable. It is conclusively shown that the services rendered by Gleaves in 1919 were less valuable than those rendered in prior years, as he was ill and away from his office most of the time during that year. Furthermore, the resolution of August 28, discloses that at that time Gleaves' services were considered by the petitioner to be worth $5,000 per annum.
However, the Commissioner has allowed and now admits that $10,000 was reasonable compensation for Gleaves for the year 1919.
We conclude, therefore, that the petitioner is not entitled to deduct from gross income for the year 1919 the amount of $36,048.43 or any amount in excess of $10,000 as allowed by the Commissioner as compensation for that year.
Judgment will be entered on 15 days' notice, under Rule 50.
Considered by TRUSSELL, SMITH, and LITTLETON.